Cost-and-Management-Accounting-munotes

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INTRODUCTION OF COST &
MANAGEMENT ACCOUNTING
Unit Structure
1.0 Objective
1.1 Introduction To Cost And Management Accounting
1.2 Distinction And Relationship Among Financial Accounting, Cost
Accounting And Management Accounting
1.3 Role of Cost In Decisi on Making Analysis
1.4 Classification of Cost
1.0 OBJECTIVE
 Understanding the concepts related to Financial, Cost and
Management Accounting.
 Understanding the role of cost
 Understanding the various classification of cost for product and
services.
1.1 IN TRODUCTION
Accounting comprises compilation, record, categorization and
demonstration of financial data. The word “Accounting” can be classified
into 3 classifications viz. Financial Accounting; Management Accounting
and Cost Accounting.
Financial Accounti ng has arisen with the growth of large -scale business in
the form of joint stock companies. General community money is involved
in share capital; companies act has provided a legal framework to the
present -day operating results and financial position of th e company.
Financial accounting is concerned with the preparation of a profit and loss
account and balance sheet to disclose information to the shareholders. If
financial accounting is oriented towards the preparation of a financial
statement which summar izes the result of operations to select a proper
period of time and show the financial position of the business on a
particular day. Financial accounting is concerned with providing
information to the external users so preparation of financial statements i s a
statutory obligation. Financial accounting is required to be prepared in
accordance with the generally accepted accounting principles and the
practice. In fact the corporate law that governs the enterprise not only
makes it mandatory to prepare such ac counts but also lays down the munotes.in

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Cost & Management
Accounting format and information to be provided in such accounts. In sharp contrast
management accounting is entirely optional and there is no standard
format for preparation of the report. Financial accounts relate to the
business as a whole while management accounts focus on a part of
segments of the business. In sharp contrast management accounting is
entirely optional and there is no standard format for preparation of the
report. Financial accounts relate to the business as a whole w hile
management accountant accounts focus on a part of segments of the
business.
Management accounting does a new approach to accounting. The term
management accounting is composed of two words management and
accounting. It refers to accounting for the man agement. Management
accounting is a modern tool for management. Management accounting
provides the techniques for internal interpretation of accounting data.
Your accounting should serve the needs of management. The management
is concerned with decision ma king. So the role of management accounting
is to facilitate the process of decision making by the management. The
managers in all types of organizations needs information about the
business activity activities to plan, accurately for the future and make th e
decisions for achieving the goal of the enterprise and certainly it is the
characteristics of the decision -making process and uncertainty cannot be
eliminated also together but can be reduced the function of management
accounting is to reduce the uncerta inty and helps the management in
decision making process. Management accounting is the field of
accounting which deals with providing information including the social
accounting information to the managers to use in planning, decision
making, performance e valuation, control, management of costs and cost
determination for financial reporting. Management accounting contains
reports prepared to fulfill the needs of management.
Cost Accounting: Way back to 15 century no accounting system was
there. It was a bar ter system rebuilt in the last year of the 15th century
Luca Pacioli, an Italian found out the double entry system of accounting in
the year 1494. Later it was developed in England and all over the world up
to the 20th century. During these 400 years the p urpose of cost accounting
needs to serve as a small branch of financial accounting except for a few
Royal wallpaper manufacturing factories in France and some iron Masters
and bottles in 18 centuries. The period of 1880AD – 1925 AD saw the
development of c omplex product design and the emergence of multi
activity diversified corporation like dew point, General Motors et cetera It
was during this period that the scientific management was developed
which led the accountant to convert physical standards into co st standards
and later being used for warrants analysis and control. During World War
I and II the social importance of cost accounting grew with the growth of
each country’s defense expenditure. In the absence of a competitive
market for most of the mater ial required for war, the government in
several countries placed a cost plus contract under which the price to be
paid per porch cost production plus an aggregate rate of profit. The
reliance on cost estimation by parties to defense contracts continued aft er munotes.in

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Introduction Of Cost &
Management Accounting World War II. In addition to the above the following factors have made
accountant to find new techniques to serve the industry : -
1. Limitations placed on financial accounting.
2. Improved cost consciousness.
3. Rapid industrial development after the In dustrial Revolution and
world wars.
4. To control galloping price rises, the cost of computing the precise
cost of product and services.
5. To control cost several legislations passed throughout the world and
India too such as Essential Commodities Act, In dustrial
Development and Regulation Act.
In India, prior to Independence there were few cost accountants and they
were qualified mainly from high CMA London during the Second World
War the need for developing profession in the country was filled and
leader ship of forming an Indian institution was taken by some members of
the defense service employed at Kolkata however the enactment of the
cost and Works accountants of India act 1959 the Institute of cost and
Works accountants of India was established at Kol kata the profession as
and further importance in 1968 when the government of India introduced
cost audit under section 233 (8) of the companies act 1956 at present
under section 148 of companies act 2013.
1.2 DISTINCTION AND RELATIONSHIP AMONG
FINANCIAL A CCOUNTING, COST
ACCOUNTING AND MANAGEMENT
ACCOUNTING
1.2.1 Financial Accounting & Cost Accounting
A. Financial accounting provides information about the business in a
general way that is profit and loss account, balance sheet of the business to
the owners and other outside partners whereas cost accounting provides
information to the management for proper planning, operation, control and
decision -making.
B. Financial accounting classifies records and analyzes the transaction in a
subjective manner that is ac cording to the nature of expenses whereas cost
accounting records the expenditure in an objective manner that is
according to the purpose for which the costs are incurred.
C. Financial accounting leaves and means in the face of the recording
aspect without attaching any importance to control whereas cost
accounting provides a detailed system of control for materials, labor and
overhead cost with the help of standard costing and budgetary control. munotes.in

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Accounting D. Financial accounting reports operating results and financi al position
usually at the end of the year whereas cost accounting gives information
through cost report to the management as and when desired.
E. Financial accounts or accounts of the whole business are independent in
nature whereas cost accounting is onl y a part of financial accounts and
disclose profit or loss of each product, job or services.
F. Financial accountants record all the commercial transactions of the
business and include all the expenses that are manufacturing, office,
selling etc. whereas c ost accounting relates to the transaction connected
with the manufacturing of goods and services means expenses which enter
into production.
G. Shall accounts are concerned with the external transaction that is the
transaction between the business concern and the third -party whereas cost
accounts are concerned with internal transactions which do not involve
any cash payment or receipt.
H. In financial accounting only transactions which can be measured in
monetary terms are recorded whereas in cost accountin g non -wanted
information like number of units, number of hours are used.
I. Financial accounting deals with the actual figures and facts only whereas
cost accounting deals with the partly facts and figures and partly estimates
and standards.
J. Financial a ccounting does not provide information on efficiencies and
various workers, plant and machineries whereas cost accountant provides
valuable information on the efficiencies of employee plant and
machineries.
K. In Financial accounting stocks are valued at c ost or market price
whichever is lower whereas in cost accounting stocks are valued at cost
only.
L. Financial accounting is a positive sign as it is a subject to legal entities
with regard to preparation of financial statements whereas cost accounting
is not only positive science but also normative because it includes
techniques of budgetary controls and standard costing.
M. Financial accounts are kept in such a way to meet the requirements of
companies act 2013 as per section 128 and income tax act 1961 s ection
44AA whereas generally the cost accounts are kept voluntarily to meet the
requirements of the management only in some industries cost accounting
records are kept as per the companies’ act.
1.2.2 Cost Accounting and Management Accounting
Management a ccounting is primarily concerned with the management. It
involves application of appropriate technique and concept which helps the
management in establishing a plan for reasonable economic objectives. It
helps in making rational decisions for accomplishmen t of these objectives. munotes.in

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Introduction Of Cost &
Management Accounting Any workable concept or technique whether it is drawn from cost
accounting, financial accounting, economics, mathematics and statistics
can be used in management accountancy. The data used in management
accountancy should satisfy onl y one broad test. It should serve the purpose
that it is intended for. A management accountant gathers, summarizes and
analyzes the available data and presents it in relation to specific problems,
decisions and debt to the task of a management. A managemen t
accountant reviews all the decisions and analyzes from a management
point of view to determine how these decisions and analysis contribute to
overall organizational objectives. Accountants judge the relevance and
adequacy of available data from managemen t point of view.
The scope of management accounting is broader than the scope of cost
accountancy. In cost accounting the primary emphasis is on cost and it
deals with its collection analysis, relevance interpretation and
presentations for various problems of management accountancy utilizing
the principles and practice of financial accounting and cost accounting in
addition to other management techniques for efficient operations of a
company. It widely uses different techniques from various branches of
know ledge like statistics, mathematics, economics, law and psychology to
assist the management in its task of maximizing profits or minimizing
losses. The main thrust in management accountancy is towards
determining policy and formulating plans to achieve the desired objectives
of management. Management accounting makes corporate planning and
strategy effective.
1.3 ROLE OF COST IN DECISION MAKING ANALYSIS
A cost system reveals unprofitable activities, losses or inefficiencies
occurring in any form such as wast age of manpower, ideal time and last
time. Wastage of material in the form of spoilage, excessive scrap and
wastage of resources for example inadequate utilization of plant,
machinery and other facilities. Cost locates the exact cause for decrease or
incre ase in the profit or loss of the business. It identifies the unprofitable
product or product line so that these may be limited or alternative
measures may be taken. Cost furnishes suitable data and information to
the management to serve as guides in making decisions involving
financial consideration.
Cost is useful for Price fixation purposes. Although the sale price is
generally related more to economic conditions prevailing in the market
than to cost, the latter serves as a guide to test the adequacy of selling
prices. With the application of standard costing and budgetary control
methods the optimum level of efficiency is set. The cost comparison helps
in cost control, comparison maybe period to period, of the figures in the
respect of the same unit or f actory or several units in an industry by
employing uniform cost and inter -firm comparison methods. Comparison
may be made in respect of cost of jobs, process or cost centers. Cost
system provides ready figures for use by the government, wage tribunal
and boards and labor and trade unions. When a concern is not working to
full capacity due to various reasons such as shortage of demands or munotes.in

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Accounting bottleneck in production, the cost of ideal capacity can readily work out
and be repealed to the management. Introductio n of a cost reduction
program combined with operation research and value analysis techniques
leads to economic growth.
Marginal costing is employed for suggesting a source of action to be taken
so it is a useful tool for the management for making decisions .
Determination of cost centers or responsibility centers to meet the need of
cost accounting system ensures that the organ organizational structure of
the consent has been properly laid and the responsibilities can be properly
defined and fixed on individ uals. Perpetual inventory system which
includes a procedure for continuous stocktaking is an essential feature of
caste system. The operation of a system of a cost audit in the organization
prevents manipulation and fraud and assists in furnishing correct and
reliable cost data to the management as well as to the outside parties like
shareholders, the consumers and the government.
1.4 CLASSIFICATION OF COST
Cost accounting standard one, the base for cost classification is as follows:
1. Nature of Expenses
2. Relation to Object
3. Functions or Activities
4. Fixed, Semi Variable and Variables
5. Management Decision Making
6. Production Process
7. Time Period
1. Classification By Nature Of Expenses:
Costs should be gathered together in their natural groupings s uch as
material, labor and other direct expenses. The items of cost differ on the
basis of their nature; the element of cost can be classified in the three
categories 1. Material, 2. Labour And 3. Expenses
(1)Material cost is the cost of material of any na ture used for the purpose
of production of a product or a service. It includes the cost of material,
freight in words, taxes and duties, insurance etc., directly attributed to the
acquisition, but excluding the trade discount, duty drawback and refund on
account of excise duty and VAT.
(2)The labor post means the payment made to the employees, permanent
or temporary for their service. Labor cost includes salaries and wages paid
to permanent employees, temporary employees and also to the employees
of the con tractor. Here salaries and wages include all the benefits like
provident fund, gradually, ESI, over time and incentives. munotes.in

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Introduction Of Cost &
Management Accounting (3)The expenses or other than material cost and labor cost which are
involved in an activity.
2. Classification By Relation To Object I .E. Cost Center Or Cost Unit
Expenditures can be allocated to a cost center or cost object in an
economically feasible way then it is called direct otherwise the cost
component will be termed as indirect. According to these criteria for
classification, mat erial cost is divided into direct material cost and indirect
material cost, the labor cost is divided into direct labor direct labor cost
and indirect labor cost and expenses are divided into Direct expenses and
indirect expenses.
(1)The direct material co st is the cost of materials which can be directly
allocated to the cost center or cost object in an economically feasible way;
whereas the indirect material cost is the cost of material which cannot be
directly allocable to a particular cost center or cost object.
(2)The direct labor cost is a cost of wages of those workers who are
readily identified or linked with the cost center or cost object; whereas
indirect labor cost is the cost of wages of employees which are not directly
allocable to a particular c ost center.
(3)The direct material expenses are expenses other than the direct material
and direct labor which can be identified or linked with a cost center or cost
object whereas the indirect expenses are the expenses other than of the
nature of material or labor cannot be directly allocable to a particular cost
center.
3. Classification By Function Or Activities
A business enterprise performs a number of functions like manufacturing,
selling, research etc. Cost may be required to be determined for each of
these functions and on this basic functional cost may be classified into
Production or manufacturing cost; Administration cost; Selling and
distribution cost; Research and development cost.
(1) Production Or Manufacturing Cost: production cost is the co st of
all items involved in the production of a product or services. This refers to
the cost of operating the manufacturing division of an undertaking and
includes all costs incurred by the factory from the receipt of raw materials
and supply of law labor and services until production is completed and the
finished product is packed with the primary packing. Direct material,
direct labor, direct expenses, factory overheads are considered as a
production or manufacturing cost.
(2) Administration Cost: the adm ission cost or expenses incurred for
general management of an organization. These are in the nature of indirect
cost and also termed as administrative overheads. For understanding the
administration cost it is necessary to know the scope of administrative
functions. The administrative functions in any organization are concerned
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Accounting operation of an organization but administrative functions will not include
control activities concerned wit h the production, selling and distribution
and research and development therefore the administration cost is the cost
of administrative function such as salary of office staff accounts and
directors, rent rate and appreciation of office building, postage s tationery
and telephone bills, office supplies and expenses, and the general
administration expenses.
(3) Selling And Distribution Cost: selling cost or indirect cost related to
selling of products or services and include all indirect cost in sales
managem ent for the organization. Distribution costs are the costs incurred
in handling products from the time it is completed in the work until it
reaches the ultimate consumers. Selling function includes activities
directed to create and stimulate demand for com pany products and secure
orders. Distribution cost incurred to make the sellable goods available in
the hands of the customer. The selling and distribution cost include (A)
salaries and commission of a salesman and sales managers, (b) expenses
of advertise ment and insurance, (c) the rent, rates, depreciation and
insurance of sales office and warehouses, (d) cost of insurance, freight,
export, duty, packaging, shipping and (e) maintenance of delivery vans.
(4) Research & Development Costs: Research & develop ment costs are
the cost for undertaking research to improve quality of present product or
improve process of manufacture, develop a new product, market research
and commercialization thereof. Did you search and development cost
comprises development of new product, improvement of existing
products, finding new uses for known products, solving technical problem
arising in manufacture and application of products and development cost
includes the cost incurred for commercialization or implementation of
researc h findings.
4. Classification Based On Behavior
5.4.1. Fixed cost is the cost which does not vary with the change in the
volume of activity in the short run. This cost is not affected by
temperature fluctuation in activity of an enterprise. These are also known
as a period cost for example rent, depreciation etc.
5.4.2. Variable cost is the cost of an element which tends to directly vary
with a volume of activity. Variable cost has two parts: variable direct cost
and variable indirect cost. Variable indirec t costs are termed as variable
overheads for example direct labor, outward freight etc.
5.4.3. Sammy variable cost contains both fixed and variable elements.
They are partly affected by fluctuations in the level of activity. These are
partly fixed and part ly variable cost and vice versa for example factory
supervision, maintenance etc.
5. Classification Based On Management Decision Making
5.5.1. Marginal cost is the aggregate of variable cost that is prime cost +
variable overheads. Marginal cost per unit is the change in the amount at munotes.in

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Introduction Of Cost &
Management Accounting any given volume of output by which the aggregate cost changes if the
volume of output is increased or decreased by one unit. Marginal costing
system is based on the system of classification of cost into fixed and
variable. T he fixed cost is excluded and only the marginal cost that is the
variable cost or taken into consideration for determining the cost of
product and the inventory of work in progress and completed products.
5.5.2. Cost is the change in the cost due to change in activity from one
level to another.
5.5.3. Opportunity cost is the value of alternative foregone by adopting a
particular strategy or employing resources in a specific manner. It is the
return expected from an investment other than the present one. The se
refers to posts which result from the use or application of material, labor
or other facilities in a particular manner which has been foregone due to
not using the facility in the manner originally planned.
5.5.4. Replacement Cost is the cost of an acid in the current market for the
purpose of replacement. The replacement cost is used for determining the
optimum time of replacement of an equipment or machine in
consideration of maintenance cost of the existing one and its productive
capacity.
5.5.5. Relevant cost or cost which are relevant for specific purpose or
situation. In the context of decision -making, only those costs are relevant
to the decision at hand. Since we are concerned with the future cost only
while making a decision, historical cost, unl ess they remain unchanged in
the future period or irrelevant to the decision -making process.
5.5.6. Sunk costs which are incurred, that is some is the past and or not
relevant to the particular decision -making problem being considered. Sunk
costs are those that have been incurred for a project and which will not be
recovered if the project is terminated. While considering the replacement
of a plant did appreciate the book value of the older one, it is irrelevant as
the amount is some cost which is to be wri tten off at the time of
replacement.
5.5.7. Normal cost is a cost that is normally incurred at a given level of
output in the conditions in which that level of output is achieved.
Abnormal cost is an unusual and typical cost whose occurrence is usually
irregular and unexpected and due to some abnormal situation of the
production.
5.5.8. Avoidable costs are those which under a given condition of
performance efficiency should not have been incurred. Unavoidable costs
which are inescapable costs, which are ess entially to be incurred, within
the limits. It is the cost that must be incurred under a programme of
business restrictions.
5.5.9. Engineered cost relates to an item where the input has an explicit
physical relationship with the output. For example, in th e manufacture of a
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Cost & Management
Accounting and labor time consumed and the amount of variable manufacturing
overhead on the one hand and units of products produced on the other.
5.5.10.Uniform costing app lies to costing principles and procedures which
are adopted in common by a number of undertakings which desire to have
the benefits of a uniform system. The methods of uniform costing may be
extended so as to be useful in interfirm comparison.
6. Classific ation By Nature Of Production
5.6.1. Batch Costing: Batch costing is the aggregate cost related to a cost
unit which consists of a group of similar articles which maintains its
identity throughout one or more stages of production. In this method the
cost o f a group of products is ascertained. The unit cost is a batch or
group of identical products instead of a single job, order, or contract.
5.6.2. Process Costing: production process such that goods are produced
from one sequence of continuous or effective operations or processes, the
cost incurred during the period which is considered as a process cost. The
process cost per unit is detected by dividing the process cost by the
number of units produced in the process during the period. Process costing
is emp loyed in the industry where a continuous process of manufacturing
is carried out.
5.6.3. Operation Cost: Operation cost is the cost of specific operation
involved in the production process or business activity. The cost unit in
this method is operation ins tead of process; when the manufacturing
method consists of a number of distinct operations, operation costing is
suitable.
5.6.4. Operating Cost: Operating cost is the cost incurred in conducting a
business activity. Operating cost refers to the cost of un dertaking which
does not manufacture any product but which provides services.
5.6.5. Contract Costing: Contract cost is the cost of a contract with some
terms and conditions between contractor and contractor. This method is
used in undertakings, carrying o ut, building or construction contracts like
contractional engineering concerns.
5.6.6. Joint Cost: Joint costs are the common cost of facilities or services
employed in the output of two or more simultaneously produced or
otherwise closely related operatio ns, commodities or services. When a
production process is such that from a set of same input two or more
distinguish different products are produced together, products of greater
importance are termed as Joint Products and products of minor importance
are termed as By -Products and the costs incurred prior to the point of
separation are called Joint Cost.


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Introduction Of Cost &
Management Accounting 7. Classification By Time
5.7.1. Historical Costs: Historical costs are the actual costs of acquiring
assets or producing goods or services. They are post mortem costs
ascertained after they have been incurred and they represent the cost of
actual operational performance. Historical costing follows a system of
accounting to which all values are based on costs actually incurred as
relevant from time to time.
5.7.2. Predetermined Costs: Predetermined costs for a product are
computed in advance of the production process, on the basis of a
specification of all the factors affecting cost and cost data. Predetermined
cost may be either standard or estimated.
5.7.2. 1. Standard Cost: A predetermined norm applies as a scale of
reference for assessing actual cost, whether these are more or less. The
standard cost serves as a basis of cost control and as a measure of
productive efficiency, when ultimately posed with an a ctual cost.
5.7.2.2. Estimated Cost: Estimate costs of a product are prepared in
advance prior to the performance of operations or even before the
acceptance of sale order. Estimated cost is found with specific reference to
product in questions and the act ivity levels of the plant. It has no link with
actual and hence it is assumed to be less accurate than the standard cost.

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ELEMENTS OF COST
Unit Structure
2.0 Objective
2.1 Elements of cost - Materials, Labor, and Overheads
2.2 Allocation and apportionment of overheads
2.0 OBJECTIVE
1. Understanding the difference between direct and indirect cost as
well as apportionment and allocation of cost
Cost is a measurement in monetary terms of the number of resources used
for the production of goods or rendering services. Cost in simple words
means the total of all expenses. Cost is also defined as the amount of
expenditure incurr ed on or attributable to keeping things or to a certain
cost of given things. It is that which is given or in Satish satisfied to obtain
something. The cost of an article consists of actual outgoings or
ascertained charges incurred in its production and sa le. The cost ended
down and it is always advisable to qualify the word cost to show exactly
what it means for example prime cost, factory cost, etc. What is also
different from value is the cost is measured in terms of money whereas
value is in terms of th e usefulness or utility of an article.
2.1 ELEMENTS OF COST
1.1. Direct Material Cost :
The direct material cost can be defined as the cost of material which can
be attributed to its cost object in an economically feasible way. Are those
materials which c an be identified in the product or can be conveniently
measured and charged to the product therefore these materials directly
enter the product and form a part of Finnish products for example timber
in furniture making, cloth in dressmaking, bricks in buil ding a house. The
following or normally classified as a direct material:
1. All raw materials like jute in the manufacture of gunny bags, pig iron in
the foundry, and fruit in the canning industry.
2. Material specifically purchased for a specific job, pro cess, or order like
glue for bookbinding, and starch powder for dressing yarn.
3. Parts or components purchased or produced like batteries for transistor
radios.
4. Primary packing material like cotton, wrapping cardboard boxes. munotes.in

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Elements Of Cost 1.2. Indirect Material Cos t
Materials the cost of which cannot be directly linked to a particular cost
object. Indirect materials are those materials that do not normally become
a part of the finished product. It has been defined as the materials which
cannot be allocated but which can be appropriated to or absorbed by the
cost center or cost unit. Pizza stores used in the maintenance of
machinery, building like will you break and cotton waste bricks and
cement; stores used by the service department like non -group to
departments lik e power House boiler house and canteen; deals which do
not which are due to their cost being small and not consider worthwhile to
be treated as direct materials.
1.3. Direct Labour Cost
The cost of an employee can be linked to a cost object in an economic ally
feasible way. In simple words, it is that labour that can be identified only
to a particular job, product, or process or expanded in converting the raw
material into finished goods. Wages of such labour or known as direct
wages therefore it includes t he payment made to the following group of
laborers like labour engaged inthe actual production of the product or in
carrying out of an operation or process; the labour engaged in adding the
manufactured by way of supervision, maintenance tools settings,
transportation of material; inspector, analyst especially required for such
production.
1.4. Indirect Labour Cost
The labour cost cannot be directly linked to a particular cost object. The
wages of that labour which cannot be allocated but which can be
appo rtioned by the cost center first unit is known as indirect labour. In
other words paid to labour which are employed other than on power
production constitute indirect labour cost example of such labour or
charge hands and supervisors; maintenance workers; main employed in
the service department, material handling and internal transport;
apprentice, trainees, and instructors; clerical staff and labour employed in
time office and security office.
1.5. Direct Expenses Cost
The direct expenses or expenses rela ting to the manufacture of products or
rendering of services can be identified or linked with the cost object other
than direct material cost and direct labour cost. Direct expenses include all
expenditures other than direct material or direct labour that is specifically
incurred on a particular product or process. Search expenses are charged
directly to the particular cost account concerned as a part of the prime
cost. Examples of direct expenses or excise duty, royalty, architects fees,
cost of rectifying defective work, travel expenses to the cities,
experimental expenses of pilot projects, expenses of designing or drawing
patterns or models, repairs and maintenance of plants obtained on higher,
higher or special equipment obtained for a contract. munotes.in

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Cost & Management
Accounting 1.6. Indirect Material Cost
The indirect material cost cannot be directly linked to the manufacture of a
product or rendering services which can be identified or linked with the
cost object other than indirect material cost and indirect labour cost.
1.7. Overhe ads
Overhead comprises indirect material, indirect implied cost, and indirect
expenses which are not directly identifiable or allocable to a cost object.
Overheads may be defined as the aggregate of the cost of indirect
material, indirect labour, and such other expenses including services as
cannot conveniently be charged directly to a specific cost. Therefore the
overheads for all expenses other than direct expenses. In general terms,
favorite compromise comprises all expenses incurred for or in connection
with the general organization of the whole or part of the undertaking
which is the cost of operating supplies and services used by the
undertaking and includes the maintenance of capital assets.
1.8. Cost Center
A cost Center is a location, a person, or an item of equipment in or
connected with an undertaking, concerning which cost a certain and used
for cost control.
Call centers are of two types: personal and impersonal power centers. A
personal cost center consists of a person or group of people. An
impersonal cost center consists of a location or item of equipment or a
group of equipment.
In Manufacturing concerns, cost centers generally follow the pattern or
layout of the department or sections of the factory, and accordingly, there
are two types of porn centers production cost centers and service cost
centers. The production cost centers or engaged in production work that is
engaged in converting the raw material into finished products for example
machine shops, welding shops, etc. This service is fo r centers or ancillary
to and renders service to production cost centers for example plant
maintenance, administration, etc.
The number of cost centers and the size of each varies from one
undertaking to another and R depends upon the expenditures involved and
the requirement of the management for control.
1.9. Responsibility Center
Responsibility center in cost accounting denotes a segment of business
organization for the activities of which responsibility is assigned to a
specific person. Therefore a fac tory may be split into many centers and a
supervisor is assigned with the responsibility of the Center. All past
relating to the Center or collected and the management or manager are
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Elements Of Cost achieved concerning cost. Even an individual machine may be treated as a
responsible center for cost control and cost reduction.
1.10.Profit Center
A profit center is the segment of a business that is responsible for all the
activities involved in the pro duction and sales of a product, system, and
services. Therefore a profit center encompasses both the cost that it
incurred and revenue that is generated. Profit centers are created to
delegate the responsibility to individuals and major their performance. In
the concept of responsibility accounting, profit centers are sometimes also
responsible for the investment made for the centers. The profit is related to
the invested capital. Such a profit center may also be termed an
investment center.
2.2. ALLOCATION AND APPORTIONMENT OF OVERHEADS
2.1. Introduction
Accounting for the analysis and collection of overheads, their allocation,
and apportionment of different cost centers, and absorption of products or
services play an important role in the determination of past as well as
control purposes. A system of better distribution of power can only ensure
greater accuracy in the determination of the cost of products or services. It
is, therefore, necessary to follow the standard practices for a location,
apportionment , and absorption of overhead for the profession of cost
statement.
2.2. Definitions
2.2.1. Overheads: Overheads comprise indirect material, indirect
employee cost, and indoor expenses which are not directly identifiable or
a look able to cost objects in a n economically feasible way. Overheads
are to be classified based onthe function to which the overheads are
related viz. Production Overheads, Administrative Overheads, Selling
Overheads, And Distribution Overheads. Overheads may also be classified
based on behavior such as variable overheads, semi -variable overheads,
and fixed overheads.
2.2.2. Collection of Overheads: Collection of overheads means the
pooling of indirect items of expenses from books of accounts and
supportive Records in a logical group h aving regard to their nature and
purpose. Overheads or collected based on pre -planned groupings called
cost pools. Homogeneity of the cost component and introspect of their
behavior and character are to be considered in developing the cost pool.
The variab le and fixed overheads should be collected in separate costs
under a cost center. A great degree of how much unity in the cost pool or
women tend to make an apportionment of overheads more rational and
scientific.
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Cost & Management
Accounting 2.2.3. Allocation of Overheads: allocatio n of overheads is assigning all
items of cost directly to the cost center. An item of expense that can be
directly related to percent is to be allocated to the cost center. For example
depreciation of a particular machine should be allocated to a particula r
cost center if the machine is directly attached to the cost center.
2.2.4. Apportionment of Overheads: Apportionment of overhead is the
distribution of overheads to more than one cost Centre on some equitable
basis. When the indirect cost R - Mama to diff erent cost centers, diesel is
to be apportioned to the cost centers on an equitable basis. For example,
the expenditure on general repair and maintenance returning to the
department can be allocated to the department but has to be apportioned to
various ma chines in the department. If the department is involved in the
production of a single product, repair and maintenance of the department
may be allocated to the product.
2.2.5. Primary and Secondary Distribution of Overheads: In multi -
product environments, there are common service power centers which are
providing services to the various production cost centers and other service
cost centers. The cost of service is required to be apportioned to the
relevant cost center. The first step to be followed is to ap portion the
overhead to different cost centers and the second step is to apportion the
cost of service cost centers to production cost centers on an equitable
basis. The first step is termed a primary distribution and the second step is
termed a secondary distribution of overheads.
2.2.6. Absorptions of Overheads: Absorption overheads are charging of
overheads from a cost center to product or services employing absorption
rate for each cost center which is calculated as follows :
Overhead Absorption Rate = Total Overheads of the cost Center / Total
quantum of the base.
The best is selected based onthe type of the cost center and its contribution
to the product or services for example machine hours, labour hours, and
quantity produced.
2.3. APPORTIONMENT AND ABSORPTION OF
PRODUCTION OVERHEADS
3.1. Overheads are to be apportioned to different cost centers based on
the following two principles :
3.1.1. Cause & Effect: Cause is the process or operation or activity and
effect is the incurrence of cost. Apportionme nt of overheads based on this
criterion ensures better rationality as it is guided by the relationships
between cost object and cost.
3.1.2. Benefits Received: overheads are to be apportioned to the various
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Elements Of Cost 3.2. Primary Distribution of overheads: primary apportionment of items
of production overhead is to be selected to distribute them among the cost
interest following the above principles as given above in 3.1. The basis of
apportionment must be rational to distribute overheads. Once the best is
selected the same is to be followed consistently uniformly. However
change in the base for apportionment can be adopted only when it is
considered necessary due to changes in circumstances like change in
technology, degree of mechanization, and product mix it is C. In the case
of such a change, proper disclosure of cost records is essential.
3.3. Secondary Distribution of Overheads: secondary distribution of
overheads may be done by following either a reci procal basis or not a
simple basis. While reciprocal basis considers the exchange of service
among the service department, non -reciprocal basis considers only one -
directional service flow from the service cost center to other production
cost centers.
3.3.1 . Reciprocal basis is the service rendered by certain service
percentages that are also utilized by the other POP centers. In reciprocal
secondary distribution the cost of service percentage or opportunity to
production cost centers as well as the other co st centers.
3.3.2. In non -reciprocal secondary distribution the cost of service cost
centersare apportioned to the production cost centers, and the steps
involved are
(1) the cost of the first service cost center is apportioned on a suitable
basis to prod uction centers;
(2) the next step is to apportion the cost of the second service center to the
production costcenter as indicated in step (1);
(3) The process is to be continued till the cost of all service cost centers is
apportioned.
3.4. Apportionment and Absorption of Administrative Overheads
Administrative Overheads include the following items of cost :
1. Printing and Stationary, other office supplies
2. Employee cost – salaries of staff
3. Establishment expenses – office rent and rates, insurance,
depreciation of office building and other assets, legal expenses, audit
fees, bank charges, etc.



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Cost & Management
Accounting 3.5. Apportionment and Absorption of Selling & Distribution
Overheads
Selling overheads and distribution overheads are collected under different
cost full suc h as :

1. Sales employee cost
2. Rent
3. Traveling expenses
4. Warranty claim
5. Brokerage and commission
6. Advertisement relating to sales and sales promotion
7. Sales incentives
8. Bad debt
9. Secondary packaging
10. Freight and forwarding
11. Warehou sing and storage
12. Insurance etc.




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PREPARATION OF COST SHEET
Unit Structure
3.0 Objective
3.1 Introduction
3.2 Preparation of Cost Sheet
3.0 OBJECTIVE
1. Ability to prepare the cost sheet
3.1 INTRODUCTION
One of the objectives of the cost accounting system is sad as the
attainment of a cost -for-cost object. The cost object may be the product,
service, or any cost Center the calculation of cost includes element -
selection of cost, accumulation of the cost so collected for a certain
volume or period, and then arranging all these accumulated cos ts into a
sheet to calculate the total cost for the cost object. In this chapter, a
productor service will be the cost object for cost calculation and cost
ascertainment. A cost sheet or cost statement is “a document which
provides detailed cost informatio n”. In a typical cost, cost information is
presented based on functional classification however the other
classification may also be adopted as per the requirement of the user of the
information.
The Functional Classification Of Element Of Cost
Under this classification costs, a divided according to the functions for
which they have been incurred. The following are the classification of
costs based on functions.
1. Direct Material Cost
2. Direct Employee Cost
3. Direct Expenses Cost
4. Production or Manufacturing Ove rheads
5. Administration Overheads
6. Selling Overheads
7. Distribution Overheads
8. Research & Development Overheads


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Cost & Management
Accounting Cost Heads In A Cost Sheet
As classified based on functions are grouped into the following cost head
in a cost sheet.
1. Prime Cost
2. Cost of Production
3. Cost of Goods Sold
4. Cost of Sales

1. PRIME COST: Prime cost represent the total direct material cost,
direct employee cost, and direct expenses the total cost of each element
has to be calculated separately.

Direct Material Cost XXX
+ Direct Employee Cos t XXX
+ Direct Expenses XXX
Prime Cost XXX

1.1 Direct Material Cost: ost of direct material consumed the cost of
direct concern is calculated as follows.
Direct Materials Consumed = Opening Stock of Material + Additional
Purchase of Material – Closing St ock of Material.

1.2. Direct Employee Cost I is the total of payment made to the
employees who are engaged in the production of goods and provision of
services. Employee cost is also known as Labour Cost and it includes the
following :
(a) Wages and Salary
(b) Allowances and incentives
(c) Payment for overtimes
(d) Employer’s contribution to PF and other welfare funds
(e) Other benefits such as leave with pay, free or subsidized food, leave
travel concessions, etc.

1.3. Direct Expenses: other than direct material cost and direct
employee costs which are incurred to manufacture a product or for
provision of service and can be directly traced in an economically feasible
manner to cost object. The following are examples of direct expenses.
(a) Royalty paid / payable for production or p rovision of services.
(b) Higher charges paid for hiring specific equipment
(c) Asked for product or services specific design or drawing
(d) The cost of the product or service -specific software
(e) Other expenses are directly related tothe production of goods or
provisio n of services.
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Preparation of Cost Sheet 2. COST OF PRODUCTION: In a conventional cost sheet, this item
of cost can be seen. It is the total of prime cost and factory -related to ts
and overheads.


Direct Material Cost XX
Add: Direct Employee Cost XX
Add: Direct Expenses XX
PRIME COST XXX
Add: Factory Overheads XX
Gross Works Cost XXX
Add: Opening Stock of Work in Process XX
Less: Closing Stock of work in process (XX)
Factory Cost of Works Costs XXX
Add: Quality Control Cost XX
Add : Research & Development Cost (process -
related) XX
Add: Administrative overheads (process -related) XX
Less: Credit for recoveries (if any) (XX)
Add: Packing Cost (Primary stage packing) XX
COST OF PRODUCTION XXX

2.1. Factory Overheads: It is also known as a work for production or
manufa cturing overhead it includes the following indirect cost :
a. consumable stores and spares
b. Presentation of plant and machinery, factory building
c. Lease rent of production assets
d. Repair and maintenance of plant and machinery, factory buildings.
e. Direct employee cost is connected with production activities.
f. Insurance of plant and machinery, factory building, stock of Raw
Materials, and working process
g. Service department costs such as control room, engineering, tenancy,
and pollution control.


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Cost & Management
Accounting 2.2. The stock of Work in Process: the cost of opening and closing
stock of work in process is adjusted to arrive at the factory or work cost.
They work in process stop is valued based ona percentage of completion
in respect of each element of cost.

2.3. Quality control cost is the cost of resources consumed towards the
quality control procedures.
2.4. Research and development cost includes only those research and
development -related cost that is incurred forthe improvement of process,
system product, or services.

2.5. Administrative overhe ad includes the cost of production admission
only; the general administration over it is not included in production cost.

2.6. Credit for recoveries is the realized or realizable value of scrap or
waste that is deducted.

2.7. Packing cost is packing material that is essential to hold and
preserve the product for its use by the consumer.

3. COST OF GOODS SOLD: it is the cost of production for good food.
It is calculated after adjusting the values of opening and closing stock of
Finnish goods it can be calculated as follows.

Direct Material Cost XX
Add: Direct Employee Cost XX
Add: Direct Expenses XX
PRIME COST XXX
Add: Factory Overheads XX
Gross Works Cost XXX
Add: Opening Stock of Work in Process XX
Less: Closing Stock of work in process (XX)
Factory Cos t of Works Costs XXX
Add: Quality Control Cost XX
Add : Research & Development Cost (process -
related) XX
Add: Administrative overheads (process -related) XX
Less: Credit for recoveries (if any) (XX)
Add: Packing Cost (Primary stage packing) XX munotes.in

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Preparation of Cost Sheet COST O F PRODUCTION XXX
Add: Cost of Opening Stock of Finished Goods XX
Less: Cost of Closing Stock of Finished Goods (XX)
COST OF GOODS SOLD XXX

4. COST OF SALES: It is the total cost of product incurred to make
the product available to the customers or consu mers. It includes the cost of
goods sold administration and marketing expenses it is calculated as
below.

Direct Material Cost XX
Add: Direct Employee Cost XX
Add: Direct Expenses XX
PRIME COST XXX
Add: Factory Overheads XX
Gross Works Cost XXX
Add: Opening Stock of Work in Process XX
Less: Closing Stock of work in process (XX)
Factory Cost of Works Costs XXX
Add: Quality Control Cost XX
Add : Research & Development Cost (process -
related) XX
Add: Administrative overheads (process -related) XX
Less: Credit for recoveries (if any) (XX)
Add: Packing Cost (Primary stage packing) XX
COST OF PRODUCTION XXX
Add: Cost of Opening Stock of Finished Goods XX
Less: Cost of Closing Stock of Finished Goods (XX)
COST OF GOODS SOLD XXX
Add: Admin Overh eads XX
Add: Selling Overheads XX
Add: Packing Expenses XX
Add: Distribution Overheads XX
COST OF SALES XXX
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Cost & Management
Accounting THE FINAL COST SHEET
The main advantage of the cost sheet is it provides the total cost figure as
well as the cost per unit of production. It helps in cost comparison, it
facilitates the preparation of cost estimate required for submitting tenders,
it also provides sufficient help in arriving at the figures of selling price and
it facilitates the cost control by disclosing operational efficienc y.
PARTICULARS TOTAL COST
(RS.) COST PER
UNIT (RS.)
Direct Material Cost XX XX
Add: Direct Employee Cost XX XX
Add: Direct Expenses XX XX
PRIME COST XXX XXX
Add: Factory Overheads XX XX
Gross Works Cost XXX XXX
Add: Opening Stock of Work in
Proces s XX XX
Less: Closing Stock of work in
process (XX) (XX)
Factory Cost of Works Costs XXX XXX
Add: Quality Control Cost XX XX
Add : Research & Development
Cost (process -related) XX XX
Add: Administrative overheads
(process -related) XX XX
Less: Credit for recoveries (if any) (XX) (XX)
Add: Packing Cost (Primary stage
packing) XX XX
COST OF PRODUCTION XXX XXX
Add: Cost of Opening Stock of
Finished Goods XX XX
Less: Cost of Closing Stock of
Finished Goods (XX) (XX)
COST OF GOODS SOLD XXX XXX
Add: Admin Overheads XX XX
Add: Selling Overheads XX XX
Add: Packing Expenses XX XX
Add: Distribution Overheads XX XX
COST OF SALES XXX XXX
Add: Net Profit XX XX
SALES XXX XXX
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Preparation of Cost Sheet Q1. The following data relates to the manufacture of a standard product
during April 2023.
Raw Material Rs. 180,000
Direct Wages Rs. 90,000
Machine Hours Worked 10,000
Machine Per Hour Rate Rs. 8
Administration Overheads Rs. 35,000
Selling Overheads Per Unit Rs. 5
Units Produced 4,000
Units Sold 3600
Selling Price Per Unit Rs. 125

You are required to preparea cost sheet in respect of the above following:
Cost Per Unit & Profit for the month.
Answer:
Cost Particulars Total
Cost Rs. Cost Per Unit
Rs.
Raw Materials 180,000 = Rs. 180,000 / 4000 Units
= Rs. 45/ Unit
Add : Direct Wages 90,000 = Rs. 90,000 / 4000 Units
= Rs. 22.5 / Unit
Prime Cost 270,000 = Rs. 45 + Rs. 22.5
= Rs. 67. 50
Add : Factory Overheads
(10,000 hrs x Rs. 8 ) 80,000 = Rs. 80,000 / 4000 Units
= Rs. 20
Cost of Production 350,000 = Rs. 67.50 + R s. 20
= Rs. 87.50
Less : Closing Stock of
finished goods
(4000 Units – 3600 Units) 35,000
Cost of Goods Sold 315,000 Rs. 87.50
Add: Admin Overheads 35,000 Rs. 8.75
Add: Selling Overheads
(3600 units x Rs. 5) 18,000 Rs. 5.00
Cost of Sales / Total C ost 368,000 Rs. 101.25
Add: Profit 82,000
Sales (3600 units x Rs.
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Cost & Management
Accounting Q2. The following information has been obtained from the records of
XYZ Company for the period 1st Dec to 30th Dec. 2023.
On 1st Dec.
2023
Rs. On 30th Dec.
2023
Rs.
Cost of raw material 60,000 50,000 Cost of work in progress 12,000 15,000 Cost of stock of finished goods 90,000 1,10,000 Purchase of raw materials during Dec. 2023 4,80,000 Wages Paid 2,40,000 Factory Overheads 1,00,000 Admin Overheads (Production related) 50,000 Selling & Distribution Overheads 25,000 Sales 10,00,000
Prepare a cost sheet.
Answer:
Cost Particulars Total Amount
(Rs.)
Opening Stock of Raw Materials 60,000 Add: Purchases of Raw Materials 4,80,000 Less: Closin g Stock of Raw Materials (50,000) Raw Materials Consumed 4,90,000 Add: Direct Wages 2,40,000 Prime Cost 7,30,000 Add: Factory Overheads 1,00,000 Works Cost 8,30,000 Add: Opening Stock of Work in Progress 12,000 Less: Closing Stock of Work in Progre ss (15,000) Factory Cost 8,27,000 Add: Admin Overheads 50,000 Cost of Production 8,77,000 Add: Opening Stock of Finished Goods 90,000 Less: Closing Stock of Finished Goods (1,10,000) Cost of Goods Sold 8,57,000 Add: Selling & Distribution Overheads 25,000 Cost of Sales 8,82,000 Add: Net Profit 1,18,000 Sales 10,00,000 munotes.in

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INTRODUCTION TO DIFFERENT
COSTING TECHNIQUES & METHODS
Structure:
4.1. Objectives
4.2. Introduction of Techniques of Costing
4.3. Various Techniques of Costing
4.4. Introduction of Methods of Costing
4.5. Various Methods of Costing
4.6. Job Costing
4.7. Process Costing
4.8. Difference between Job Costing & Process Costing
4.9. Service Costing
4.10. Summary
4.11. Illustrations
4.12. Exercises
4.1. OBJECTIVES
The primary goals of this unit are to familiarize you with:
 To know the methods of Costing
 To know the Techniques of Costing
 To understand the concept of Job costing.
 To understand the concept of Process Costing.
 To know accounting treatment of process costing
 To understand the concept of Service Costing
 To know accounting treatment of service costing

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Cost & Management
Accounting 4.2. INTRODUCTION OF TECHNIQUES OF COSTING
The way in which the cost of a good, service, or activity is determined is
referred to as a 'technique' or a 'type'. However, these terminologies
(techniques or types) also unavoidably denote the kinds of costs tha t are
being determined, such as historical cost, standard cost, absorption (full)
cost, marginal cost, etc. It is evident that the phrase "techniques of
costing" refers simply to the method(s) used to calculate costs, such as job
costing or process costing , without mentioning the several categories of
expenses (historical, standard, full, or marginal) that are calculated using
the two methods of costing (Job or Process Costing).
4.3. VARIOUS TECHNIQUES OF COSTING
The following are generally the techniques o f costing:
(1) Historical Costing: The historical costing method involves calculating
costs after they have already been incurred.
(2) Standard Costing: Standard costing involves establishing and using
standard costs, comparing them to actual costs, and de termining the
variances so that corrective action can be performed. Standard costs are
the predetermined costs in accordance with the film's most effective
operation and resource use.
(3) Absorption or Full Costing: All production expenses, both fixed and
variable, are applied to the goods using this costing methodology. Jobs,
procedures, etc., are accounted for in the overall cost.
(4) Variable or Marginal Costing: With the variable costing approach,
only variable production costs are applied to products o r jobs; as a result,
only variable costs, is included in the cost of the products or tasks. All the
variable expenses are deducted from sales to find out contribution, most of
the decisions are taken on the basis of contribution. For decision making
purpos e fixed cost is eliminated.
(5) Uniform Costing: In reality, uniform costing is an attempt by many
undertakings and organisations to utilise comparable costing concepts
and/or procedures rather than a method of costing.
4.4. INTRODUCTION OF METHODS OF COST ING
As has already been established, "costing" refers to the methods and
procedures used to calculate the expenses associated with producing a
good or providing a service. Depending on the nature of the product, the
method of manufacturing, and the unique business circumstances, many
methodologies are used in business organisations to determine costs. For
instance, production is continuous while raw materials go through various
stages in a textile or steel industry. In several other businesses, production
is carried out in response to particular orders from various customers, and
each work is plainly distinct from the others. All actions and costs
incurred in service industries like transportation, healthcare, banking, etc.
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Introduction To Different
Costing Techniques &
Methods 4.5. VARIOUS METHODS OF COSTING
There are two methods of costing:
(A) Job Costing
(B) Process Costing
The two ways of costing mentioned above are the only ones that differ
from all other methods. The following are all conceivable job an d process
costs variations:
(A) Job Costing
When production is carried out in accordance with a specific order and
client specifications, job costing is applied in the firm. Each task (or
product) stands alone from the others and is unique. Construction,
shipbuilding, furniture manufacturing, and repair businesses frequently
use this technique. There are several types of job costing:
(1) Batch Costing:
To calculate the cost of a group of identical or related products, batch
costing is used. The unit is a gr oup of related products grouped together,
not a specific item within the batch. This technique can be applied to the
production of hardware, pharmaceuticals, components, and other goods
that are produced in different batches.
(ii) Contract Costing:
Both ho me builders and civil contractors employ this costing technique,
which is based on the task costing theory. When relevant charges are
collected, the contract becomes the cost unit.
(ii) Multiple or Composite Costing:
This approach of costing is employed in sectors where the nature of the
product is complex, such as the automotive, aerospace, and other
industries. In these situations, costs are accrued for the many parts that
make up the finished product and are then added together to determine the
entire co st of the product.
(B) Process Costing:
This costing approach is employed in sectors like chemicals, oil, gas,
paper, etc. where manufacturing occurs continually. It is challenging to
link costs to particular units, therefore the total cost is calculated a s an
average across all manufactured units. At each stage of manufacturing,
overall cost and per unit cost may be computed for control purposes.

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Cost & Management
Accounting Process costing has the following variants:
(i) Unit or Single Output Costing:
When a single item is created and the end production is made up of
uniform units, this method is applied. By dividing the entire cost by the
total number of units made, one may determine the cost per unit.
(ii) Operating (Service) Costing:
The operating costing method is employed by b usinesses like hospitals,
power plants, and transportation that provide services rather than
producing physical goods. Depending on the type of service being
provided, different cost units are used by these service companies. But
typically, the units used are passenger miles, tonne miles in transportation,
patient beds in hospital, and per students in college.
(iii) Operation Costing:
Instead of focusing on the process, this costing method seeks to determine
the costs of each activity. This approach relies on the assumption that
output is obtained through a variety of operations. The operations costing
method is used in industries with different operations are part of the
process. At the conclusion of each process, it provides better control and
makes it ea sier to calculate the unit operation cost.
4.6. JOB COSTING
A costing technique known as "job costing" is used to calculate the price
of certain jobs or lots of production that are typically produced in
accordance with customer's standards. No two orders a re necessarily alike,
and not all orders go through the same manufacturing process, which is
the key characteristic of the job order pricing system. Construction,
contracting, production of machine tools, furniture, foundries, job
printing, and general eng ineering are examples of industries that typically
use the job order system to produce orders according to customer
specifications.
4.6.1. Advantages Job costing has the following advantages:
1. More precise costing is possible, because all costs are comp iled and
directly associated with a particular order or product.
2. It is easy since the hours of direct labour and direct materials are
documented by product or job.
3. Job cost sheets can be used to predict future work and manage
efficiency.
It offers a foundation for comparing job costs to one another or job cost
sheets to cost estimates.
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Introduction To Different
Costing Techniques &
Methods 4.6.2. Job costing has the following disadvantages:
1. It necessitates meticulous record -keeping for many jobs.
2. Keeping records for several tasks could be challen ging.
3.Despite not being the cause, a job may be charged for inefficiencies.
4.7. PROCESS COSTING
Process costing is a type of operations costing that is utilised when
standardised commodities are produced in big quantities with a constant
stream of produ ction. The chemical, petroleum, textile, steel, rubber,
cement, plastic, footwear, sugar, and coal sectors all employ this costing
technique. This costing technique is equally applicable to companies that
manufacture small electrical components, screws, an d nuts. The assembly -
type sector of the economy, which produces things like typewriters, cars,
planes, and home electronics like washing machines, refrigerators,
electrical irons, radios, and television sets, also uses process costing.
4.7.1. Features of P rocess Costing:
a) The various processes that make up a factory are split into cost
centres.
b) Each process has its own account, which is kept up to date.
c) Each process's individual direct and indirect costs are noted.
d) The production is continuous and the final product is the end result
of series of processes.
e) One process' output serves as the input for another, until the finished
product is obtained.
f) The steps taken to process the product are predetermined and
followed exactly.
g) At one or more stages, multiple pr oducts, with or without
byproducts, are created sequentially.
h) Controllable and preventable wastes typically occur at various
phases of production.
4.7.2. Proforma of Process Account:
Process Accounts
Particular Quantity Amou
nt Rs. Particular Quantity Amoun
t Rs.
To Previous
Process A/c
(in case of
subsequent
process) XX XX By Normal Loss A/c
(% of input) XX XX
To Raw
Material XX By Weight loss XX - munotes.in

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Cost & Management
Accounting To Wages XX By Scrap XX XX
To Factory
Overhead XX By Sale of by -
product XX XX
To Abnormal
Gain A/c XX XX By Abnormal Loss
A/c XX XX
By Next Process
A/C or Finished
Goods A/c (in the
case of last process) XX XX
XX XX XX XX

4.7.3. Normal Loss: It is the part of process loss that is discovered under
typical situations. A loss is unavoidable. It can't be prevented. Despite the
management's efforts, it still happens. It is also known as a non -
controllable loss, such as a loss through theft or evaporation. Normal loss
is determined as a specific proportion of the units of input used in the
relevant proce ss. On the basis of scientific research into the production
process and the nature of the raw materials, the percentage of the normal
loss is determined in advance. Normal loss has a scrap value. The output
of the relevant process is responsible for coveri ng the cost of normal loss
in the absence of scrap value.
Journal Entries related to Normal Loss:
a) For the scrap value of normal loss:
Normal Loss A/c Dr.
To Process A/c
b) For adjustment of the shortfall in the sale of normal loss:
Abnormal Gain A/c Dr.
To Normal Loss A/c
c) For realization of the scrap value of normal loss
Cash A/c Dr.
To normal loss A/c
Normal Loss Accounts
Particular Quantity Amount
Rs. Particular Quantity Amount
Rs.
To Process
A/c XX XX By
Abnormal
Gain A/c XX XX
By Cash A/c
(Sale ) XX XX
XX XX XX XX
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Introduction To Different
Costing Techniques &
Methods 4.7.4. Abnormal Loss:
It is a part of the process loss that results from abnormal conditions in the
factory, such as a labour strike, equipment breakdown, a power outage,
accidents, etc. Abnormal loss can be prevented. The manageme nt can
handle it by taking the appropriate safety precautions. Along with regular
loss, abnormal loss also happens.
Journal Entries related to abnormal Loss:
a) For the value of abnormal loss
Abnormal loss A/c Dr.
To Process A/c
b) For the scrap realized
Cash A/c Dr.
To Abnormal loss A/c
c) For transfer of the balance to costing profit & loss a/c
Costing Profit & Loss A/c Dr.
To Abnormal loss A/c
Abnormal Loss Accounts
Particular Quantity Amount
Rs. Particular Quantity Amount
Rs.
To Process
A/c XX XX By Cash A/c
(Sale) XX XX
By Costing
P & L A/c - XX
XX XX XX XX

4.7.5. Abnormal Gain:
When the actual wastage (loss) is less than the normal wastage or the
actual output is higher than the expected output, abnormal gain results.
The production department' s increased efficiency leads to abnormal gain.
Journal Entries related to abnormal Gain:
a) For the value of abnormal Gain
Process A/c Dr.
To Abnormal Gain A/c
d) For the adjustment of the scrap value of abnormal gain
Abnormal gain A/c Dr.
To Normal loss A/c
e) For transfer of the balance to costing profit & loss a/c
Abnormal gain A/c Dr.
To Costing Profit & Loss A/c
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Cost & Management
Accounting Abnormal Gain Accounts
Particular Quantity Amount
Rs. Particular Quantity Amount
Rs.
To Normal
Loss A/c XX XX By Process
A/c XX XX
To Costing
Profit & Loss
A/c - XX
XX XX XX XX

4.7.6. Process Stock Accounts:
In some circumstances, a separate stock account is kept in addition to the
relevant process account. To have control over stock at various locations,
separate stock accounts should be kept.
Process Stock Accounts
Particular Quantity Amount
Rs. Particular Quantity Amount
Rs.
To Balance
b/d
(Opening
Stock) XX XX By Next
Process A/c
(Transfer to
next
Process)
(Balancing
Amt.) XX XX
To Process
A/c (Transfer
from
process) XX XX By Balan ce
c/d
(Closing
Stock) XX XX
XX XX XX XX

4.7.7. Formula for calculation of Process Cost:

The above rate is used to calculate amount of Abnormal Loss, Abnormal
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Introduction To Different
Costing Techniques &
Methods
4.8. DIFFERENCE BETWEEN JOB C OSTING &
PROCESS COSTING
The main point of difference between job costing and process costing are
given here as under:
Basis Job Costing Process Costing
1) Nature Every task is distinct
from and independent to
others. As goods are made in a
continuous flow, they lose
their unique identities.
2) Cost
ascertainment Each job's costs are
calculated independently. Each process or
department's costs are
tallied on a timely basis.
3) Specific
orders Production goes against
the established order. The product is
homoge neous and
production is continuous.
4) Applicability When it is necessary to
associate costs with a
particular product or job,
job costing might be
used. On the other side, process
costing is utilised when
producing large quantities
of identical goods
conti nually through
various departments or
processes.
5) Purpose Production in job costing
typically depends on the
order and specifications
from the customer. Production is done using
process costing in order to
store inventory and sell it
later.
6) Degree of
control The production is not
continuous, and each
product unit is unique,
making proper
management somewhat
challenging. Since the production is
uniform and more stable,
proper control is
comparatively simpler.
7) Transfer Unless there is an excess
of work o r production,
transfers from one job to
another are uncommon. As the product progresses
from one process to
another, costs are
transferred from one to the
next.
8) Unit cost In job costing, unit cost is
calculated by dividing
the cost of the job order
by th e number of units of
the production. Unit costs are determined
by dividing departmental
or process cost by process
production in process
costing.
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Accounting 4.9. SERVICE COSTING
Operating costing is another name for service costing. It is most frequently
used in s ituations where services are provided but no products are
manufactured or produced. According to the Institute of Cost and
Management Accountants (UK) operating costing is “that form of
operation costing which applies where standardized services are provid ed
either by an undertaking or by a service cost center within an
undertaking”.
4.9.1. Cost unit: The term cost unit may be defined as a unit of quantity
of product, service in respect of which cost is ascertained. The following
cost units are usually appl ied in different service undertaking:
4.9.2. Composite cost unit: It should be noted that several cost units in
the below table, such per tonnes, per kilometre or beds per day, are
composed of two components. Composite cost units are two -part cost
units. C omposite cost units are excellent tools for cost management. E.g.
Price per passenger mile.
Nature of Business Possible Cost Unit
Public carriers, trucks, goods
trains Per ton kms or per km
Electricity supply Per kilowatt hours
Passenger buses and train s Per km or passenger kms
Hospitals Per patient day, Per bed per day
Road maintenance Per km of road
Hotels Per room, Room Day
Canteen Per meal
Water supply Per 1000 gallons
Cinema Man shows

4.9.3. Characteristics of Operating/ Service Costing:
a) The cost -of-service output can be calculated using this way of costing.
b) The majority of firms that don't produce any tangible goods use this
way of costing. However, this approach of costing is also widely used
by manufacturers and nonprofit organisations.
c) Typically, the cost -of-service output is not calculated using a "single
cost unit." In many situations, "Composite Cost Unit" is applied to
compute cost -of-service output.
d) Because everything is intangible, determining the cost -of-service
output is very subj ective.
e) A significant portion of the cost -of-service output involves fixed costs.
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Introduction To Different
Costing Techniques &
Methods 4.9.4. Transport Costing:
The fundamental goal of transport costing is to calculate the operational
costs of each vehicle and apply these costs to specific units, such as
tonnes, kilometres, tonnes per mile, passengers per mile, etc.
The cost determination is important for the following purpose:
a) To determine the fare that will be imposed for transporting a
passenger for a specific distance.
b) To determine the freight that will be charged for transporting
products to various locations.
c) To assess alternate forms of transportation.
d) To figure out how much should be charged to various departments
employing the services.
A specimen of operating cost sheet is given below:
Operating cos t sheet for the month of _________.
Particular Total Rs.
A) Standing Charges/ Fixed Cost:
Insurance XX
Depreciation* XX
Salary of permanent staff # XX
License fees XX
Administrative expenses XX
Road tax XX
Garage rent XX
Hire charges XX
Interest XX
Total (A) XX

B) Running and Maintenance Costs:
Cost of Diesel XX
Cost of oils, grease, etc. XX
Driver’s Salary # XX
Conductor Salary # XX
Tyre, Tube, etc XX
Total (B) XX
C) Total Cost (A+B) XX
D) Total Ton Kilometers XX
E) Cost per Ton K ilometers
XX
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Accounting * Generally, Depreciation will be treated as fixed cost/ standing charges.
But when depreciation is charge on the basis of kilometers run, then
depreciation is treated as running cost.
# Salary or wages paid to drivers, conduct ors and cleaners will be treated
as ‘Running and Maintenance cost’ on the assumption that no payment to
be made when there is no work. However, salary or wages paid to
permanent drivers, conductors or cleaners will be treated as fixed cost.
4.9.5. Hotel Co sting/ Canteen Costing: Operating costing is also used by
hotels, eateries, and cafeterias. The main goals of hotel costing are to
establish the price for housing guests and to establish the room rent that
will be charged to visitors. The majority of expen ses incurred by hotels
are fixed costs .Examples include the depreciation of a building and its
equipment, furniture, and other items, insurance, the salaries of managers
and permanent employees, and the expense of maintaining a garden and a
lawn. The hotel s also pay variable expenses. Examples include the price
of power, the pay of temporary attendants, the expense of complimentary
food and drink, etc. the cost of transportation for pickups and drops at the
airport, the train station, etc. The term "composi te unit," such as room -
night, room -day, etc., is used to determine pricing. The proportion of
occupancy and seasonal influence should be taken into account while
determining room rent.
Additionally, many hotels have restaurants. Restaurants are typically
considered a separate profit centre. Restaurant -related fixed and variable
costs are all budgeted individually. Some shared expenses are allocated on
an equitable basis.
Cost determination is important for the following:
a) To ascertain the operating cost of r unning a hotel.
b) To fix the room rent per day.
Canteen Operating cost sheet for the month of _________.
Particular Rs.
A) Provisions:
Bread XX
Biscuits XX
Cakes XX
Eggs XX
Fish XX
Vegetables XX
Milks XX
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Introduction To Different
Costing Techniques &
Methods Meat XX
Others XX
Total (A) XX
B) Labour and Supervision:
Supervisor XX
Cooks XX
Helpers XX
Counter Clerks XX
Cleaners XX
Sweepers XX
Total (B) XX
C) Maintenance Costs:
Crockery XX
Glassware XX
Towels XX
Rent XX
Gas XX
Insurance XX
Light XX
Total (C) XX
D) Total Oper ating Cost (A+B+C) XX
E) Number of meals served XX
F) Cost per meal Served
XX

4.9.6. Hospital Costing: Finding out how much it will cost to provide
patients with medical care and figuring out how much to charge are the
two basic goals of h ospital costing. Most expenses are fixed in nature. The
expense of air conditioning, or the depreciation of a structure or piece of
equipment like an X -ray machine or a CT scanner. In general, indoor
patients receive care using "composite cost units," whil e outdoor patients
receive care using "single cost units."
Cost determination is important for the following:
a) To ascertain the operating cost of running a hospital.
b) To fix the room rent per day or bed.
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Cost & Management
Accounting Particular Total Rs. Per unit
Rs.
A) Standing Charges/ Fixed Cost:
Insurance XX
Depreciation XX
Staff Salaries XX
Administration expenses XX
Cost of Oxygen, X -Rays, etc. XX
Total (A) XX XX
B) Variable Costs:
Doctor’s fees XX XX
Food XX XX
Medicines XX XX
Diagnostic Services XX XX
Hire charges of extra beds XX XX
Toilet & Bathrooms supplies XX XX

Total (B) XX XX
C) Total Operating Cost (A+B) XX XX
D) Number of patient days XX
E) Cost per patient day (
XX

4.10. SUMMARY
Process costing is the component of operation costing that is used to
calculate the cost of the final product at each stage or process of
production. In industries where the manufacturing process is split into two
or more processes, this a ccounting approach is applied. Finding the
process's overall cost as well as its per -unit cost for each and every
process is the goal. Textile, oil, cement, pharmaceutical, and other
industries are often those that use process costing.
Operating costing is a form of costing used by businesses that offer
services rather than produce goods. Operating costing places more focus
on determining the cost of providing services than it does on the cost of
producing a product. Within an organisation, it is used by tr ansportation
firms, gas and water utilities, energy providers, canteens, hospitals,
theatres, schools, etc. Additionally, some departments that support the
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Introduction To Different
Costing Techniques &
Methods 4.11. ILLUSTRATIONS
Illustration 1 ) (Process Costing)
ABC Ltd. submits the following information in respect of its product
which passes through three consecutive processes viz P, Q and R for the
month ended 31st March, 2022:

Particulars P Process Q Process R Process
Quantitative
Inform ation
Basic Raw Material at Rs.
15.00 per kg. (Kgs.) 60,000 - -
Output during the month (Kgs.) 46,500 31,000 19,000
Stock of Process Output
On 01 -02-2008 (Kgs.) 6,000 5,000 4,000
On 29 -02-2008 (Kgs.) 7,500 6,000 3,000
Other Additional
Information
Process Material (Rs.) 2,55,000 5,40,000 4,50,000
Direct Labour (Rs.) 1,45,000 1,05,000 90,000
Machine Overheads 80% of
Direct
Labour 150% of
other
factory
overhead 40% of process
Material
Other Factory Overheads (Rs.) 1,68,000 2,25,000 97,000
Normal Loss (%) 20% 30% 40%
Value of Opening Stock
per kg. (Rs.) 29 70 145
Scrap Value Per Kg. (Rs.) 12 14 16

The Percentage of normal loss is computed on the number of units
entering in the process concerned. Closing stock is to be v alued at the
respective cost of each process during the month. You are required to
prepare:

(a) Process Accounts (b) Process Stock Accounts (c) Normal Loss
Account (d) Abnormal Loss Account (e) Abnormal Gain Account.




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Cost & Management
Accounting Solution:
Process P Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To Basic Raw
Material
(@Rs.15/ -) 15 60000 900000 By Normal
Loss (20%) 12 12000 144000
To process
Material 255000
To Labour 145000
To Machine
Overhead By Abnormal
loss 30 1500 45000
(80% on
Labour) 116000
To Factory
Overhead 168000 By Output
transfer to
process P
Stock A/c 30 46500 1395000 60000 1584000 60000 1584000





Process P Stock Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To balance b/d 29 6000 174000 By Process Q A/c 45000 1344000
To Process P A/c 30 46500 1395000 by balance c/d 30 7500 225000
52500 1569000 52500 1569000




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Introduction To Different
Costing Techniques &
Methods Process Q Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To Process P
Stock A/c 45000 1344000 By Normal
Loss A/c
(30%) 14 13500 189000
To process
Material 540000
To Labour 105000 By Abnormal
loss 75 500 37500
To Machine
Overhead (150%
of Other Factory
Overhead) 337500 By Output
transferred
to process Q
Stock A/c 75 31000 232500
0
To Factory
Overhead 225000
45000 2551500 45000 255150
0



Process Q Stock Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To balance
b/d 70 5000 350000 By Process
R A/c 30000 2225000
To Process Q
A/c 75 31000 2325000 by balance
c/d 75 6000 450000
36000 2675000 36000 2675000

Process R Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To Process Q
Stock A/c 30000 2225000 By Normal
Loss A/c
(40%) 16 12000 192000
To process
Material 450000
To Labour 90000
To Machine
Overhead
(40% of
Material) 180000 By Output
transferred
to process R
Stock A/c 158.33 19000 3008333
To Factory
Overhead 97000
To Abnormal
Gain A/c 158.33 1000 158333
31000 3200333 31000 3200333 munotes.in

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Cost & Management
Accounting



Process R Stock Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To balance b/d 145 4000 580000 By finished
Stock A/c 20000 3113328
To Process R A/c 158.3 19000 3008327 by balance c/d 158.33 3000 4749 99
23000 3588327 23000 3588327

Normal Loss Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To Process P A/c 12 12000 144000 By Abnormal Gain 16 1000 16000
To Process Q A/c 14 13500 189000 By Cash A/c 36500 509000
To Process R A/ c 16 12000 192000
37500 525000 37500 525000

Abnormal Loss Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To Process P A/c 30 1500 45000 By Cash A/c (P) 12 1500 18000
To Process Q A/c 75 500 37500 By Cash A/c (Q) 14 500 7000
By Costing P & L A/c 57500
82500 82500

Abnormal Gain Account
Particular Rate Unit Rs. Particular Rate Unit Rs.
To Normal Loss A/c 16 1000 16000 By Process R A/c 158.33 1000 158333
To Costing P & L A/c 142333
1000 158333 1000 158333
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Introduction To Different
Costing Techniques &
Methods Illustration 2) (Hotel Costing)
The following are the information given by the owner of a hotel situated at
Mumbai, Maharashtra. You are required to advise him what rent should be
charged per day per room from guests so that he can earn 25% profit on
cost excluding interest.
a) Staff salaries per year= Rs.80,00,000.
b) Room attendance salary Rs.200 per day. The salary is paid on daily
basis and services of room attendance is needed only when the room
is occupied. There is one room a ttendant for each room.
c) Lighting, heating and power: The normal lighting expenses for a
room if it is occupied for the whole month is Rs.5,000. Power is
used only in winter and normal charges per month if occupied for a
room is Rs.2,000.
d) Repairs to buildi ng Rs.10,00,000 per year.
e) Sundries Rs.11,40,000 per year.
f) Interior decoration Rs.10,00,000 per year.
g) Cost of building Rs.4,00,00,000. Rate of depreciation is 5%.
h) Other equipments Rs.1,00,00,000. Rate of depreciation is 10%.
i) Interest @ 5% is to be charg ed on its investments of Rs.5,00,00,000
on the building and equipment.
There are 100 rooms in the hotel. 80% of the rooms are normally occupied
in summer and 30% of the rooms are occupied in winter. You assume that
period of summer and winter is 6 months e ach. Normal days in a month
may be assumed to be 30 including the month of February.
Solution:
Operating cost sheet
Particular Rs. Cost per year
Rs.
Staff Salaries 80,00,000 Room attendant salary (WN 1) 39,60,000 Lighting (WN 2) 33,00,000 Power (2,0 00 x 6 x 100 x 30%) 3,60,000 Repairs 10,00,000 Sundries 11,40,000 Interior Decoration 10,00,000 Depreciation: On
Building (WN 3) 20,00,000 On
Equipment (WN 4) 10,00,000 30,00,000 Interest on Investments 25,00,000 Total Costs per year 2,42,60,000 munotes.in

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Cost & Management
Accounting Revenue required to earn a profit of 25% on
Cost: Rs.
Total costs per year (including interest) 2,42,60,000 Add: Profit @ 25% on cost (excluding interest)
[(Rs.2,42,60,000 – Rs.25,00,000) 25 %] 54,40,000 2,97,00,000

Working notes:
1) Calculation of Room Attendants Salary per year:
Summer: 200 x 100 x 80%x 30 x6 = Rs.28,80,000
Winter: 3200 x 100 x 30%x 30 x 6 = Rs.10,80,000
Total =Rs.39,60,000
2) Calculation of Lighting Char ges per year:
Summer: 5,000 x 6 x 100 x 80% = Rs.24,00,000
Winter: 35,000 x 6 x 100 x 30% = Rs. 9,00,000
Total =Rs.33,00,000
3) Depreciation on Building:
5% of Rs.4,00,00,000 =Rs.20,00,000
4) Depreciation on Equipment
10% of Rs.1,00,00,000 = Rs.10,00,000
5) Calculation of Room Days:
Summer: 100 x 80% x 30 x 6 = 14,400
Winter: 100 x 30% x 30 x 6 = 5,400
Total =19,800

Illustration 3) (Transport Costing)
The following expenses were incurred by a company in connection with
two Trucks for 25 day s.
Particular Truck A Truck B
Driver's Wages 1,20,000 1,25,000 Cleaner's Wages 1,30,000 1,30,000 Petrol 1,50,000 2,30,000 Depreciation 3,20,000 2,10,000 munotes.in

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Introduction To Different
Costing Techniques &
Methods Oil 18,000 25,000 Repairs 1,40,000 1,40,000 Supervision 80,000 80,000 Garage Overhead 1,40,000 1,20,000 Road tax 45,000 45,000 Other Expenses 35,000 40,000
Truck A carried 100 tons of raw material and covered a distance of 3,000
kilometers in 25 days. Truck B carried 120 tons of raw material and
covered a distance of 4,500 kilometers in 25 days.
Find out the cost per ton -kilometer. Prepare an operating cost sheet in
summary form for the two Trucks for July, 2022.
Solution:
Operating cost sheet for the month July, 2022
Particular Truck A Truck B
A) Standing Charges/ Fixed Expenses
Driver's Wag es 1,20,000 1,25,000 Cleaner's Wages 1,30,000 1,30,000 Depreciation 3,20,000 2,10,000 Supervision 80,000 80,000 Garage Overhead 1,40,000 1,20,000 Road tax 45,000 45,000 Other Expenses 35,000 40,000 Total Standing Charges (A) 8,70,000 7,50,000
B) Running & Maintenance Cost:
Petrol 1,50,000 2,30,000 Oil 18,000 25,000 Repairs 1,40,000 1,40,000 Total Running & Maintenance Cost
(B) 3,08,000 3,95,000 C) Total Operating Cost (A+B) 11,78,000 11,45,000 D) Total Ton Kilometers 3,00,000 5,40,000 E) Cost per Ton Kilometers
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Cost & Management
Accounting Calculation of Ton Kilometer:
Truck A =

Truck B =

Illustration 4) (Transport Costing)
A transport company is running four buses between Mumbai and Pune,
covering a dis tance of 100 kms, the seating capacity each bus is 40
passengers. The following particulars are obtained from its books for the
month of October, 2022:
Particular Rs.
Wages of drivers, conductors 48,000 Salaries of office staff 15,000 Honorarium of acco untant 5,000 Diesel, oil, etc. 80,000 Repairs and maintenance 16,000 Road tax and insurance 32,000 Depreciation 52,000 Interest and other charges 40,000
Actual passengers carried were 75% of the seating capacity. All the buses
ran for 30 days. Each bus made one round trip per day. Find out the fare
the company should charge per passenger/km if it wants a profit of 20%
on the takings.
Solution:
Operating cost sheet for the month October, 2022
Particular Rs.
A) Standing Charges/ Fixed Expenses
Wages of drivers, conductors 48,000 Salaries of office staff 15,000 Honorarium of accountant 5,000 Road tax and insurance 32,000 Depreciation 52,000 Interest and other charges 40,000 munotes.in

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Introduction To Different
Costing Techniques &
Methods Total Standing Charges (A) 1,92,000
B) Running & Maintenance Cost :
Diesel, oil, etc. 80,000 Repairs and maintenance 16,000 Total Running & Maintenance Cost (B) 96,000 C) Total Operating Cost (A+B) 2,88,000 D) Total Passenger Kilometers 7,20,000 E) Cost per Passenger Kilometers
Rs.0.40
Calculat ion of Passenger kilometer:
Passenger km= Distance x Seating capacity x Occupancy rate x No. of
days x No. of trips x No. of buses
= 100 kms x 40 passengers x 75% x 30 days x 2 x 4
=7,20,000 passenger - kilometer
Calculation of fare to be charge per passeng er per km:
Let fare per passenger -km be





Bus fare to be charge per passenger per km = Rs.0.50/ -






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Cost & Management
Accounting 4.12. EXERCISES
A) Fill in the blanks:
1) Operating costing is also known as ____________.
2) Unit of cost for passenger transport is ____ ________.
3) Rent of premises is __________ cost.
4) In process Costing _________ product is manufactured.
5) Percentage of ________ loss decided in advance.
6) Abnormal loss is valued at _________.
(Answers: 1) Service Costing, 2) per passenger km, 3) Fixed, 4)
Stand ardized, 5) normal, 6) Process cost)
B) State whether each of the following statement is True or False.
1) Normal loss is controllable.
2) Process account is credited by scrap value of Normal loss.
3) Abnormal loss cannot be avoided.
4) Driver’s salary is a variable cost.
5) Cost of diesel is running cost.
6) Unit of cost for hospital is per kilometer.
(Answers: 1) False, 2) True, 3) False, 4) False, 5) True, 6) False)
C) Theory Questions.
1) Write a note on Normal Loss.
2) Write a note on Process Costing.
3) What are the methods of costing?
4) Write a note on service costing.
5) What is the difference between Job Costing & Process Costing?
6) What is transport costing? What are its objectives?

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MARGINAL COSTING
Unit Structure:
5.1. Objectives
5.2. Introduction
5.3. Meaning of Marginal Costing
5.4. Features of Marginal Costing
5.5. Advantages of Marginal Costing
5.6. Limitations of Marginal Costing
5.7. Marginal Costing and Absorption Costing
5.8. Contribution
5.9. Profit Volume Ratio
5.10. Break Even Point
5.11. Required Sales for Desired Profit
5.12. Margin of Safety
5.13. Other formulas
5.14. Managerial Uses of Marginal Costing
5.15. Impact of changes of various items
5.16. Some important Rela tionship
5.17. Summary
5.18. Illustrations
5.19. Exercises
5.1. OBJECTIVES
The primary goals of this unit are to familiarize you with:
 To grasp the notion of Marginal Costing, read on.
 to understand the characteristics, benefits, and drawbacks of marginal
costing
 To comprehend the distinction between Marginal and Absorption
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Cost & Management
Accounting  Understanding the concepts of Contribution, Profit Volume Ratio,
Break Even Point, and Margin of Safety, as well as how to calculate
them.
 In managerial decision -making, marginal costing is used.
5.2. INTRODUCTION
Certain expenses are a mix of fixed and variable expenses. Semi -variable
costs are what they're known as. In order to make managerial decisions,
the mixed costs must be divided into fixed and variable costs. Variable
costs fluctuate in response to variations in output volume or activity level.
Fixed cost, on the other hand, is time -related and does not fluctuate with
changes in activity level.
The calculation of product cost, which includes direct material, direct
labour, direct costs, and variable overheads, is the subject of marginal
costing. It's important to remember that variable cost per unit is constant,
whereas fixed cost per unit increases with the level of output. Direct
costing, contributory costing, variable co sting, differential costing, and
incremental costing are all terms for marginal costing.
5.3. MEANING OF MARGINAL COSTING
Marginal Cost is defined as “the amount at any given volume of output by
which aggregate costs are changed if the volume of output is increased or
decreased by one unit.” Prime Cost plus Variable Overheads is known as
Marginal Cost. A constant ratio that may be represented as an amount per
unit of production is known as marginal cost. Fixed cost, but at the other
hand, signifies a set am ount of money spent over the course of an
accounting period and is not generally traceable to a specific unit.As a
result, fixed costs are also known as time costs, period costs, standby
costs, capacity costs, and constant costs. Direct cost, activity cost , volume
cost, or out -of-pocket costs are all terms for variable cost or marginal cost.
Marginal costing is “the ascertainment of marginal costs and of the effect
on profit of changes in volume or type of output by differentiating
between fixed costs and v ariable costs.” It is a process in which costs are
categorized as fixed or variable, and many managerial decisions are made
as a result of this classification. The split of total expenses into fixed and
variable costs is a key feature of marginal costing, without which it would
not exist.
5.4. FEATURES OF MARGINAL COSTING
a) The cost factor is the distinction between fixed and variable costs.
b) Only variable costs are taken into account when computing product
costs.
c) Work in progress and stock of finish goods are valued at a variable
cost.
d) It is a technique of cost recording and cost reporting.
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Marginal Costing
f) This technique includes breakeven analysis and cost volume profit
analysis.
g) Contribution is used to determine the profit ability of various products.
5.5. ADVANTAGES OF MARGINAL COSTING
a) Marginal costing systems are easier to use than absorption costing
systems since they do not have to deal with overhead apportionment
and recovery overhead.
b) Making judgments based on margina l cost presentations is easier;
for example, marginal costing indicates which items contribute and
which fail to cover their variable costs.
c) The marginal costing technique aids management in profit
forecasting. The sales volume can be planned by the manage ment in
order to achieve the needed profit.
d) When a company is made up of numerous units and produces a
variety of products, marginal costing can be used to assess the
performance of individual components.
e) Managerial decisions can be made using marginal c osting, and some
examples are as follows: Make or buy decision, accept or reject an
order, determining the selling price under various scenarios,
substituting one product for another, etc. Getting the most out of
your labour or machine hours. Alternative o ptions are assessed.
Expanding or not expanding the business, diversification, and
shutting down or not shutting down the business are all options.
f) It is feasible since fixed costs are eliminated. Inventory is valued at
its lowest possible cost. As a resu lt, it is more realistic and
consistent.
g) Management reporting is more meaningful because it is focused on
sales figures rather than output.
5.6. LIMITATIONS OF MARGINAL COSTING
a) Difficulty in Analysis of overheads: Under certain circumstances
and in specifi c corporate contexts, separating fixed and variable expenses
becomes extremely difficult. The precision with which marginal costing
results are produced is determined on how precisely costs are categorised.
b) Inappropriate basis for pricing decision : When us ing marginal
costing, there is a risk of making too many sales at marginal cost or
marginal cost plus a some portion of fixed cost, leading to a reduction in
fixed overhead recovery. During times of depression or increased
competitiveness, this situation m ay occur.
c) Under valuation of inventory : Inventory is valued at variable costs
in marginal costing. It could cause issues with inter -firm product transfers
at marginal costs, resulting in increased profits. Employees may seek a
raise in pay and other perks. The practice of excluding fixed costs from
inventory costs appears to be contrary to recognized accounting practice.
d) Not suitable in long run: Within a restricted spectrum of activity,
this premise is partially correct. Changes in pricing due to scarcity of
labour and materials, trade discounts for bulk purchases, and changes in munotes.in

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Cost & Management
Accounting men's productivity, among other factors, will affect the marginal cost per
unit.
e) Not acceptable for tax purpose: For inventory valuation, income
tax authorities do not recognize ma rginal costing.
f) Less effective in capital intensive industry : This method may not
be appropriate for businesses with a substantial stock of work -in-progress,
such as the contact and shipbuilding industries. If fixed expenses are not
taken into account whil e valuing work -in-progress, losses may occur in
the early years of the contract. After the contract is completed, a large
profit will be shown.
g) Ignores fixed cost: New cost -effective machinery have become
accessible as science and technology has progressed , resulting in lower
labour costs and higher fixed expenses. A costing system that ignores a
large element of the cost, namely fixed costs, cannot be very effective.
5.7. Marginal Costing and Absorption Costing
In absorption costing, expenses are classifie d on a functional basis,
whereas in marginal costing, expenses are classified according to their
nature. Fixed expenses are divided over goods depending on a
predetermined level of output in absorption costing. Because fixed
expenses are constant, this typ e of recovery will result in either an over - or
under -recovery of expenses, depending on whether the actual production
is larger or less than the estimate utilized for recovery. Because the
contribution is used as a resource to fulfil fixed expenses, this problem
will not emerge in marginal costing.
Differences between Absorption Costing and Marginal Costing
Absorption Costing Marginal Costing
a)For product costing and inventory
valuation, both fixed and variable
costs are taken into account. a) For produc t costing and
inventory valuation, only variable
costs are taken into account.
b) In absorption costing, the cost
per unit decreases as production
increases because the fixed cost
decreases, whereas the variable cost
per unit remains constant. b) Because marginal costing is
based on variable cost, the cost per
unit remains constant regardless of
production.
c) It could result in under and over
absorption of expenses. c) It will not cause a problem of
under or over absorption .
d) Because fixed costs are i ncluded
in closing stock, it indicates a
higher profit. d) As fixed costs are removed from
closing stock, it indicates a lower
profit.
e) It does not reveal the relationship
between cost, volume, and profit. e) The link between cost, volume,
and profit is an important aspect of
marginal costing.
f) Sales minus the cost of goods
sold equals profit. f) Contribution minus fixed costs
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Marginal Costing
Marginal Cost Statement
Particular Total Cost Rs. Per Unit Rs.
Sales XX XX
Less: Variable Cost XX XX
Contri bution XX XX
Less: Fixed Cost XX XX
Profit XX XX

5.8. CONTRIBUTION:
The difference between the selling price and the variable cost is referred to
as contribution. Contribution is named for the fact that it helps to recover
fixed costs and profits.
 The following formulas are used to calculate Contribution:

Or

Or

5.9. PROFIT VOLUME RATIO
P/V ratio is a common term for this. It expresses the connection between
sales and contributions. It's a percentage figure. It's a metric that measures
how quickly a company makes money. A high ratio suggests a high level
of profitability, whereas a low ratio indicates a low level of profitability.
The profit volume ratio shows how stable the company's product is. Profit
volume analysis is used to calculate break ev en for a product or a
collection of items, as well as to see how profit changes as price, volume,
costs, or any combination of these factors are changed. Profit volume ratio
and contribution are strongly intertwined. Contribution can be improved to
increas e the profit volume ratio, and contribution can be improved by:
i) Increasing the selling price
ii) Decreasing the marginal or variable costs.
iii) Putting more emphasis on those products which have higher profit
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Cost & Management
Accounting  The following formulas are used to calculate P/V ratio:











5.10. BREAK EVEN POINT
The point at which total income equals total expense is known as the
break -even point (BEP). It's the point at which there's no profit or loss in
terms of output or sales. Contribut ions are just enough to cover fixed costs
at this point. When the output or sales activity reaches this level, the
company begins to make a profit. Below this level of output or sales, a
loss occurs.
 The following formulas are used to calculate Break Even Point
(BEP):
Break Even Point (BEP) in Rs.:

Or

Or

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Marginal Costing



Break Even Point (BEP) in Units:

Or

Or

Cash Break Even Point (BEP):



Assumptions in Break Even Analysis:
a) All costs can be broken down into two categories: fixed and
variable.
b) Fixed c osts stay the same at all levels of activity.
c) Variable costs fluctuate in total with production. It means that the
variable cost per unit stays the same.
d) At all levels of activity, the selling price per unit remains constant.
e) Men's and machines' technologi cal approaches and efficiency will
not be altered.
f) The market is large enough to absorb the full output.
5.11. REQUIRED SALES FOR DESIRED PROFIT:
The Break Even Point calculation can be used to calculate profit and loss
at various stages of production. Pro fit is zero at Break Even Point, but the
profit value is used to calculate the sales volume required to make a
specified profit. For this reason, the equations below can be used.

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Cost & Management
Accounting In units:

Or

In Value:

Or

Or

5.12. MARGIN OF SAFETY
The gap betwe en actual sales and sales at Break Even Point is the margin
of safety. It's the difference between the current sales value and the Break
Even Sales. A company's strength is measured by its margin of safety. A
high margin of safety means that profit will be made even if the selling
price falls. M/S (margin of safety) is a common abbreviation for margin of
safety.
 The following formulas are used to calculate margin of safety
(M/S):

Or

Or

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Marginal Costing


Or

Or

7.13. OTHER FORMULAS:








5.14. MANAGERIAL USES OF MARGINAL COSTING:
Management can utilize marginal costing to make various policy
decisions, profit planning, and cost control. Here are a few examples of
managerial issues where marginal costing might he lp in decision -making.
a) Price Fixation: Fixed costs are neglected in marginal costing, and
price is decided solely on the basis of variable costs. Under typical
business conditions, the fixed price must cover all costs; otherwise, the
company may lose money . In some cases, such as when there is a trade
depression, dumping, seasonal demand fluctuations, or a highly
competitive market, pricing is determined using marginal costing rather
than full costing.

b) Accepting Special Order and Exploring Additional Marke ts:
Accepting a special order above the marginal cost and at a lower price
than the regular selling price might boost a firm's total earnings in the case
of spare capacity. The extra earnings generated by the particular order will
go to the company. When an additional order is taken at a lower price than
the current pricing in order to use idle capacity, it must be carefully
examined to ensure that it will not have an adverse effect on the
company's usual market and goodwill. Because it will influence
relationships with other dealers, the special order from a local dealer
should not be accepted.

c) Profit Planning: Marginal costing is extremely useful for
evaluating the level of activity required to obtain the desired profit. The
division of expenses into fix ed and variable costs aids management in munotes.in

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Cost & Management
Accounting planning and analyzing profit as a result of changes in volume, selling
price, fixed costs, and variable costs.
d) Key Factors or Limiting Factor: According to the marginal
costing method, the product with the largest contribution per unit is
preferred. As long as it is able to sell as much as it can create, this
inference is true. However, an organization may be able to sell whatever it
makes, but output may be constrained owing to a lack of raw materials,
labour, elec tricity, plant capacity, or money. These are referred regarded
as key or limiting Factor. The firm's production and profit are limited by a
crucial element or limiting factor. In this case, management must decide
whether output should be expanded, decrease d, or stopped. In these
circumstances, the product is chosen based on the contribution per unit of
a limited factor of production. The key factor, or scarce factor, should be
used in a way that maximizes contribution per unit of limited resource.


e) Sales Mix Decisions: Profit is calculated by deducting fixed costs
from contribution in marginal costing. It implies that management should
make every effort to maximize the contribution. When a company
develops a range of product lines, the difficulty of determ ining the
appropriate sales mix arises. The optimal sales mix is the one that
generates the most revenue. The products that contribute the most should
be kept, and their production should be enhanced in response to demand.
Depending on the situation, produ cts that contribute less should be
lowered or discontinued.

f) Make or Buy Decisions: A specific component utilised in the main
product can be purchased or made in its own factory using idle capacity.
The marginal cost of producing in the unit is compared to the market price
in such a make or buy decision. If the component's marginal cost is less
than the purchase price, it should be made in its own unit; otherwise, it
should be purchased from the market. Because fixed expenses are
assumed to have already bee n incurred, they are not included in the cost of
manufacturing; the additional cost is simply variable cost.

g) Adding or Dropping Decisions: A company may have multiple
product lines or departments. With the passage of time or owing to
technical advancement s, certain product lines or divisions may prove to be
unproductive. Such goods or divisions may be phased out of production.
In these cases, the marginal costing approach can help you make a
decision. It aids in the introduction of a new product line and s erves as a
solid guide for determining the best combination based on available
resources and product demand. Different products or departments'
contributions should be compared, and the product or department with the
lowest P/V ratio should be eliminated.

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Marginal Costing
h) Suspension of Activities: When demand for a product is
insufficient to cover fixed expenses during a period of economic downturn
and fierce competition, management may consider temporarily suspending
operations. If a percentage of fixed expenses, such as the wage of
temporary employees, is escapable, the quantity of the contribution should
be more than the escapable fixed costs. When manufacturing is restarted
after a period of suspension, various additional or specific costs, such as
plant and machinery overhauling, are incurred. These expenses are
referred to as "extra shutdown costs." The amount of contribution is
compared to the net escapable fixed costs once these costs are removed
from the escapable fixed costs. The production should be continued if the
contribution is larger than the net escapable fixed cost, and vice versa.
5.15. IMPACT OF CHANGES OF VARIOUS ITEMS ON
CONTRIBUTION, PROFIT VOLUME RATIO, BREAK
EVEN POINT, MARGIN OF SAFETY.
Change in Contribu
tion
(Total
Rs.) Contribution
(Rs. Per
unit) Profit
Volume
Ratio Break
Even
Point Margin
of Safety
Increase in
Sales Volume
(Unit) Increase No change No
change No
change Increase
Decrease in
Sales Volume
(Unit) Decrease No change No
change No
change Decrease
Increase in
Selling price
per unit Increase Increase Increase Decrease Increase
Decrease in
Selling price
per unit Decrease Decrease Decrease Increase Decrease
Increase in
Variable cost
per unit Decrease Decrease Decrease Increase Decrease
Decrease in
Variable cost
per unit Increase Increase Increase Decrease Increase
Increase in
Fixed cost No
change No change No
change Increase Decrease
Decrease in
Fixed cost No
change No change No
change Decrease Increase
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Accounting 5.16. SOME IMPORTANT RELATIONSHIP
•

Sales (100%) = Variable Cost (%) Plus P/V Ratio (%)
100% = 75% + 25%
100% = 70% + 30%
100% = 40% + 60%
100% = 65% + 35%
100% = 80% + 20%
100% = 78% + 22%
100% = 82% + 18%

•

Sales (100%) = BEP(%) Plus MOS(%)
100% = 75% + 25%
100% = 70% + 30%
100% = 40% + 60%
100% = 65% + 35%
100% = 80% + 20%
100% = 78% + 22%
100% = 82% + 18%

5.17. SUMMARY
Material, labour, and expenses are the three components of costs. These
costs are divided into two categories: fixed costs and variable costs.
Absorption costing and marginal c osting can be used to determine the cost
of a product or process. The cost of a product is established using
absorption costing or full costing, which takes into account both fixed and
variable costs. In marginal costing, only variable expenses are taken i nto
account when computing the cost of a product, while fixed costs are levied
against the period's revenue. In comparison to absorption costing,
marginal costing is a significant improvement. munotes.in

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Marginal Costing
The computation of marginal cost is a part of marginal costing. Variable
costs are another name for marginal expenses. Direct material, direct
labour, and variable overheads make up this category. Price fixation,
profit planning, add and drop decisions, make or buy decisions, sales mix
decisions, and other managerial decisions are all aided by marginal
costing.
There are a few drawbacks to using marginal costing. It's a time -
consuming and difficult operation to categories expenses into fixed and
variable aspects. Assumed in marginal costing, the behaviour of the per
unit variable and the total fixed cost is dubious. Despite these drawbacks,
marginal costing is a useful tool for making business decisions in a variety
of situations.
Break even analysis aids in determining the level of production at which
total costs and t otal revenue are equal. Losses occur below this level of
production, whereas profits occur above this level. This analysis, like
marginal costing, is based on cost classification into fixed and variable
costs. Break even analysis is useful for determining the impact of Sales
volume changes, costs, selling price, and product mix on profit.
5.18. ILLUSTRATIONS
Illustration 1) The following information was extracted from the books of
Sam Ltd.
Particular Rs.
Sales (10,000 unit) 1,00,000
Variable Cost 60,000
Fixed Cost 30,000
Find out: 1) P/v Ratio
2) Break Even Point
3) Margin of Safety
4) Sales require to earn profit of Rs.20,000/ -
5) Profit when sales are Rs.3,00,000/ -





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Cost & Management
Accounting Solution:
Marginal Cost Statement (10,000 units)
Particular Per Unit Rs. Total Rs. Sales 10 100000
Less: Variable Cost 6 60,000
Contribution 4 40,000
Less: Fixed Cost 30000
Profit 10,000

1) Contribution
Contribution=Sales -Variable Cost
= 100000 - 60000
Contribution= Rs.40,000/ -
2) P/v Ratio:




= 40%
3) Break Even Point:
a)



= Rs.75,000/ -
b)



= 7,500 Units
4) Margin of Safety:

= 1,00,000 – 75,000
= Rs.25,000/ -
5) Sales require to earn profit of Rs.20,000/ - munotes.in

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Marginal Costing




= Rs.1,25,000/ -
6) Profit when sales are Rs.3,00,000/ -


= Rs.1,20,000/ -


= 120000 - 30000
= Rs.90,000/ -
Illustration 2) The turnover and Total costs during the two periods were
as follows:
Sales Total cost 1st Period 25,000 20,000
2nd Period 37,500 27,500
Calculate:
1) P/v Ratio
2) Fixed Cost
3) Break Even Point
4) Amount of profit or loss when sales are Rs.20,000/ -.
5) Amount of sales required to earn a profit of Rs.7,500/ -.
6) Margin of safety, when sales are Rs.30,000/ -
Soluti on:
1) P/v Ratio :
Particular 1st Period
Rs. 2nd Period
Rs. Difference
Sales 25,000 37,500 12,500
Total cost 20,000 27,500 20000
Profit 5000 10,000 5,000 munotes.in

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Cost & Management
Accounting



= 40%
2) Fixed Cost:



= Rs.10,000/ -



= Rs.5, 000/-
3) Break Even Point:


= Rs.12,500/ -
4) Amount of profit or loss when sales are Rs.20,000/ -.



= Rs.8,000/ -


= 8000 - 5000
= Rs.3,000/ -
5) Amount of sales required to earn a profit of Rs.7,500/ -.



= Rs.31,250/ -
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Marginal Costing
6) Margin of safety, when sales are Rs.30,000/ -



= Rs.17,500/ -
Illustration 3) SSM Ltd has the following data for the coming year:
Particular Rs.
Sales (1,00,000 Units) 1,00,000
Variable costs 40,000
Fixed costs 50,000
a) Find out P/V Ratio, BEP and MOS
b) Find out revised P/V Ratio, BEP and MOS in following situations:
i) 20% increase in physical sales volume.
ii) 20% decrease in physical sales volume.
iii) 5% increase in variable costs per unit.
iv) 10% decrease i n Fixed costs.
Solution:
Marginal Cost Statement (100000 units)
Particular Per Unit Rs. Total Rs.
Sales 1 100000
Less: Variable Cost 0.40 40,000
Contribution 0.60 60,000
Less: Fixed Cost 50000
Profit 10,000

a) Find out P/V Ratio, BEP and MOS
1) Contribution



Contribution= Rs.60,000/ -

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Cost & Management
Accounting 2) P/v Ratio:




60%
3) Break Even Point:
i)



= Rs.83,333/ -
ii)



= 83,333 Units
4) Marg in of Safety:

= 1,00,000 – 83,333
= Rs.16,667/ -
b) Find out revised P/V Ratio, BEP and MOS in following situations:
i) 20% increase in physical sales volume
Particular Units
old sales volume 100000
add: 20% increase 20000
new sales volume 120000




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Marginal Costing
Marginal Cost Statement (120000 units)
Particular Per Unit Rs. Total Rs. Sales 1 120000
Less: Variable Cost 0.40 48,000
Contribution 0.60 72,000
Less: Fixed Cost 50000
Profit 22,000







ii) 20% decrease in physical sales volume.
Particular Units
old sales volume 100000 Less: 20% decrease 20000
new sales volume 80000

Marginal Cost Statement (80000 units)
Particular Per Unit Rs. Total Rs.
Sales 1 80000
Less: Variable Cost 0.40 32,000
Contribution 0.60 48,000
Less: Fixed Cost 50000
Profit -2,000 munotes.in

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Cost & Management
Accounting






iii) 5% increase in variable costs per unit.
Particular Rs. Per unit
Old variable cost per unit 0.4
Add: 5% 0.02
New variable cost per unit 0.42

Marginal Cost Statement (100000 units)
Particular Per Unit Rs. Total Rs. Sales 1 100000
Less: Variable Cost 0.42 42,000
Contribution 0.58 58,000
Less: Fixed Cost 50000
Profit 8,000






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Marginal Costing
iv) 10% decrease in Fixed costs.
Particular Rs.
Old fixed cost 50000 Less: 10% decrease 5000
New fixed cost 45000
Marginal Cost Statement (100000 units)
Particular Per Unit Rs. Total Rs. Sales 1 100000
Less: Variable Cost 0.42 42,000
Contribution 0.60 60,000
Less: Fixed Cost 45000
Profit 15,000







Illustration 4) A company annually manufactures and sells 20,000 units
of a product, the selling price of which is Rs.50 and profit earned is Rs.10
per unit.
The analysis of cost of 20,000 units is
Material Cost Rs.3,00,000
Labour Cost Rs.1,00,000
Overhead (50% variable) Rs.4,00,000

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Cost & Management
Accounting You ar e required to compute:
(i) Contribution per unit and in Rs.
(ii) P/V Ratio
(iii) Break Even Sales in Rs.
(iv) Break Even Sales in Units
(v) Sales required to earn a profit of Rs.4,00,000
(vi) Profit when sales are 18,000 units
(vii) Margin of safety when actual sales are Rs.7,00,000
Solution:
Marginal Cost Statement (20000 units)
Particular Per Unit Rs. Total Rs. a) Sales 50 1000000
b) Less: Variable Cost
Material 15 300000
Labour 5 100000
Overhead (50%) 10 200000
Total Variable cost 30 600000
c) Contribution (a -b) 20 400,000
d) Less: Fixed Cost
Overhead (50%) 200000
e) Profit (c -d) 200,000

(i) Contribution per unit and in Rs.


= Rs.4,00,000/ -

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= Rs. 20 per unit
(ii) P/V Ratio


= 40%
(iii) Break Eve n Sales in Rs.


= Rs.5,00,000/ -
(iv) Break Even Sales in Units


= 10000 units
(v) Sales required to earn a profit of Rs.4,00,000


= Rs.15,00,000/ -



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Accounting (vi) Profit when sales are 18,000 units
Marginal Cost Statement (18000 units)
Particular Per Unit Rs. Total Rs. a) Sales 50 9,00,000
b) Less: Variable Cost 30 5,40,000
c) Contribution (a -b) 20 3,60,000
d) Less: Fixed Cost 2,00,000
e) Profit (c -d) 1,60,000
OR
sales are 18,000 units i.e.
Sales = 18,000
50 = Rs.9,00,000/ -


= Rs.3,60,000/ -


= 360000
200000
= Rs.1,60,000/ -
(vii) Margin of safety when actual sales are Rs.7,00,000


= Rs.2,00,000/ -
Illustration 5) The following information is related to Laxman Limited
for the year ending 31st March, 2022:
Sales – 24,000 units @ Rs.200 per unit;
profit volume ratio – 25% and Break -even point – 50% of sales.
You are required to calculate:
a) Fixed cost for the year
b) Profit earned for the year
c) Units to be sold to earn a target net profit of Rs.11,00,000 for the year
d) Selling price per unit if break -even point is to be brought down by
4,000 units
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Solution:
a) Fixed cost for the year
Break -even point = 50% of sales
Sales – 24,000 units @ Rs.200 per unit = Rs.48 ,00,000
Break -even point = Rs.24,00,000/ -






b) Profit earned for the year


= Rs.12,00,000/ -


= 1200000
600000
= Rs.6,00,000/ -
c) Units to be sold to earn a target net profit of Rs.11,00,000 for the year



= Rs.50/ - per unit


= 34000 units munotes.in

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Cost & Management
Accounting d) Selling price per unit if break -even point is to be brought down by
4,000 units
Old BEP 12000 units LESS: 4000 units
NEW BEP 8000 units






If P/v Ratio is 25% t hen Variable cost to Sales ratio will be 75%.
Original Variable cost per unit = Original selling price

= 200
75%
= Rs.150/ -
New selling price = New contribution per unit + Variable cost per unit
= 75 + 150
New sellin g price = Rs.225/ - per unit
Illustration 6) The following information is provided:
Ratio of Variable cost to sales 80%
Break -even point occurs at 60% of sales capacity
Fixed cost Rs.300000/ -
Calculate:
1) P/V ratio
2) Sales at Break -even point
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4) Profit at 75% of sales capacity
Solution:
1) P/V ratio:
Ratio of Variable cost to sales 80%
Sales = P/V ratio + Variable cost to sales ratio
100% = P/V ratio + 80%
P/V ratio = 20%
2) Sales at Break -even point




= Rs.15,00,000/ -
3) Sales and profit at 100% of sales capacity










= Rs.5,00,000/ -


= 500000
300000
= Rs.2,00,000/ -
4) Profit at 75% of s ales capacity
Sales at 75% Capacity = 2500000
75%
= Rs.18,75,000/ -
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Accounting


= Rs.3,75,000/ -


= 375000
300000
= Rs.75,000/ -
OR
You can prepare Marginal Cost statement to find out Profit.
5.19. EXERCISES
A) Fill in the blanks:
1. The technique of marginal costing is based on classification of costs
into ___________ and ____________.
2. Contribution is the sum of _________ and ___________.
3. Profit -volume ratio is the relationship between ___________ and
__________ .
4. In absorption costing, closing stock is valued at ________________.
5. Margin of safety is excess of actual sales over ________ Sales.
6. If contribution is Rs.40,000 and Sales is Rs.1,00,000, P/V ratio is
_______.
7. If fixed cost is Rs.12,00,000 and P/V ratio i s 20%, the BEP is
_______.
(Answers: 1) fixed and variable, 2) fixed cost and profit, 3) Contribution
and Sales, 4) Total Cost, 5) Break Even, 6) 40%, 7) Rs.60,00,000/ -,
B) State whether each of the following statement is True or False.
1. Fixed cost per uni t remains constant.
2. Variable cost per unit remains constant.
3. Contribution is the difference between the total sales and fixed cost.
4. At Break Even Point contribution equals to fixed cost.
5. P/V ratio can be improved by decreasing the selling price.
6. P/v ratio can be improved by reducing the fixed costs.
(Answers: 1) False, 2) True, 3) False, 4) True, 5) False, 6) False)
C) Theory Questions.
1. What is Marginal Costing? What are its features?
2. What are the advantages and limitations of Marginal Costing?
3. Distinguish between absorption costing and Marginal Costing.
4. Write short note on Break Even Point.
5. What factors affects Break Even?
6. Write note on Margin of Safety.
7. What are the managerial uses of Marginal costing?

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BUDGETING AND BUDGETARY
CONTROL
Unit Structure:
6.1. Objectives
6.2. Introduction
6.3. Meaning of Budgeting
6.4. Definition of Budget and Budgetary Control
6.5. Objectives of Budgeting
6.6. Advantages of Budgeting
6.7. Limitations of Budgeting
6.8. Essen tials of Effective Budgeting
6.9. Steps for Budgetary control
6.10. Classification of Budgets
6.11. Summary
6.12. Illustrations
6.13. Exercises
6.1. OBJECTIVES
The main objectives of this unit are to acquaint you with:
 The concept of Budget and Budgetary c ontrol
 The establishment of effective Budgetary control system.
 Classification of various types of Budgets
 Preparation of different types of Budgets
6.2. INTRODUCTION
Attainment of objectives of the enterprise determines the efficiency of a
management. The management can be considered effective when it
achieves the objective with minimum efforts and cost. The course of
action must be prepared in advance as it requires appropriate planning.
Profit planning and budgeting can help to acquire effective manageme nt
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Accounting and budgeting. The effective technique for cost control is budgeting.This
is the process of pre -estimation of cost, revenue, profit and other figures
for the next year or period and on that basis, actual expenses incurred
revenue generated/earned. To measure the actual performance budget is
used as a standard. First the deviations are observed and, on that basis,
responsibility is fixed for deviations. This unit we are going to explor e the
basic concepts of budgeting, its classification and preparation of budgets.
6.3. MEANING OF BUDGETING
Budget and Budgetary control are the two important functions of the
budgeting process. Budget is a planning function while budgetary control
is a co ntrolling system. A manager keeps the future in mind and looks for
alternative courses of action and predetermines an action plan for the
events and possibilities of future problems.
6.4. DEFINITION OF BUDGET AND BUDGETARY
CONTROL
If we take the literary m eaning of the word budget then it is a statement of
income and expenditure of a selected period. According to principle, the
meaning is likewise in the context of business. An individual person, a
family, a local authority, state or any country can have th eir respective
budget. Therefore, it is necessary that a business concern must have its
own budget so that the objectives of the business can be attained.
So a budget can give better work results to a business enterprise. ICMA,
London defines the budget as “Budget is financial and/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”.
This can also be evaluated as controlling the process of calibr ating current
performances and guiding them towards predetermined goals. In the
planning process some desired results are predetermined which can be
controlled by checking existing actions. The tool to control to achieve the
budgeted goals can also be calle d as budgetary control. Therefore, the
budgetary control is a tool of control to achieve the budgeted goals.
I.C.M.A., London defines budgetary control as, “Budgetary control is the
establishment of budgets relating to the responsibilities of executives to
the requirement of a policy and the continuous comparison of actual with
budgeted results either to secure by individual action the objectives of that
policy or to provide a basis for its revision.”



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Budgeting And Budgetary
Control 6.5. OBJECTIVES OF BUDGETING
Budgeting is help to achieve desire goals of the organization. Budgeting is
effective planning and controlling tool. The objectives of Budgeting are:
a) Budgeting makes it possible to control expenses and increase
income.
b) With the preparation of budget, the production process is carried out
smoothly and efficient manner.
c) The budget helps in maintaining the coordinator in the various
functions of the organization. This is important for any type of
organization.
d) The Budget makes it easier to compare the actual figures with
budget figures a nd find out the deviations in them. So, the
responsibility can be fixed and corrective actions can be taken.
e) Budgets are helpful for forecasting the operating activities and
financial position of a business enterprise.
f) Budgets help to fix the responsibilit y of the divisional managers and
departmental managers.
g) To ensure that actions taken are in accordance with the targets and if
required, to take suitable corrective action.
h) To predict short -term and long -term financial positions for better
financial positi on and management of working capital in better
manner.
6.6. ADVANTAGES OF BUDGETING
Following are the advantages of Budgeting:
1. Budget can be used to maximize the utilization of the resources
available so that maximum return can be ensured.
2. In the process o f fulfillment of targets, budget increases awareness
about business enterprise at all levels of management.
3. Budgeting is helpful in better co -ordination between different
functions or activities of business organization and hence, better
understanding betwe en different fu nctions.
4. Budgeting is a process of self -examination and self -criticism which
is essential for the success of any organization.
5. For the support of top management budget makes an effective path.
6. To Prefix the goals and push up the forces tow ards their achievement
budgeting plays an important role.
7. To createan attitude of cost consciousness throughout the
organization, budgeting stimulates the effective use of resources
8. Different performances of different departments can be measured
through bu dgeting which helps in production activities.




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Accounting 6.7. LIMITATIONS OF BUDGETING
1. Risk of Rigidity: Sometimes Budget createsa sense of rigidity in the
minds of people who are working in the organization. There fore, it is
the need that the budget should be dynam ic in nature, so that it can be
updated according to situation.

2. Budgets fail if estimates are not accurate: The budget rely upon
precision of estimates. Therefore, all the information must be
considered to make the estimates. Advanced statistical techniqu es can
be used to make accurate estimates even though forecasting is not an
exact science. Therefore, Certain amount of judgment and proper
interpretation is required to prepare a budget

3. Budgeting is an expensive process: Too much time and cost is
invol ved in the installation and implementation of the budgeting.
There fore, small organizations cannot afford to it. The large
organization also conducts cost benefit analysis before installing such
a system. The system can only be adopted if the benefit exce eds the
cost. Experienced man -power, technical staff, analysis, control are
needed therefore it is a costly affair.

4. Continuous monitoring is required: To check how far the plans and
budgets are helpful in achieving the goals of the organization, the
manag ement must be active in monitoring Budgetary system. Merely
installing the budgeting system does not imply that it is effectively
carried out.

5. Support by Top Management: In any organization support from
management members plays an important role. Similarl y for the
success of budgeting top management must provide its support. If
there is a lack of support, the budget system might collapse.

6. Budgeting is not a substitute for management: Budgeting is only a
tool and not a substitute for the management. Budge ting system is a
tool for management. Therefore, can be considered as a system of
monitoring rather than the principal activity.
6.8. ESSENTIALS OF EFFECTIVE BUDGETING
a) To lay out accurate and timely information the accounting system
should be good.
b) The man agement must give proper support and co -operation.
c) The Staff must be strongly and properly motivated towards the
systems.
d) The organization must assign the responsibility to the deserving units
of the organization and should distinctively explain the organi zational
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Budgeting And Budgetary
Control e) The organization should set the objectives and the target should be real
and not exaggerated. The management must keep in mind the long -
term plan of the organization while forming the objectives.
f) The person in charge of a particular tas k must be briefed about his
duties and the task, he is responsible for.
g) Budgets should be prepared for the future periods on the basis of
expected course of actions.
h) while establishing budgets, the budgets should be updated for the
events
i) The management s hall keep in mind that the budget must be flexible
enough for mid -term revision.
j) The whole organisation must be committed to budgeting.
k) A master budget should be classified into various functional budgets
where as a general budget should be quantifiable.
l) On periodical basis the budget should be monitored. Responsibility
should be fixed and the variances from the standard yardsticks should
be fixed.
m) The Budgetary performance should be linked to the reward system
effectively.
6.9. STEPS FOR BUDGETARY CONTROL
The steps for Budgetary Control can be drawn as follows: -
(i) Establishment of Budgets: preparation of various budgets such as
sales Budget, production budget, overhead expenses budget, cash
budget etc. are the primary functions of budget control.
(ii) Responsibilities of executives: The responsibilities of executives
should be fixed as per the budgetary control system by preparing the
budget.
(iii) Policy making: The policies are made according to the budgets and
then the responsibilities are distribut ed to the executives.
(iv) Comparison of actuals with budgets: The budgets are finalized and
then they are compared with the actual. If there are any deviations in
the budget, they are called variances.
(v) Achieving the desired result: In order to find co mparison of actuals
with the budgeted results the budgetary control system is used. It is
also used to find the variance, and if there are any variances they are
properly analyzed.
(vi) Reporting to Top Management: To take the appropriate action on
the va riances, causes of variances are established. Afterwards, they
are reported to top management.
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Accounting 6.10. CLASSIFICATION OF BUDGETS
Budgets can be classified into different categories on the basis of:
a) Time,
b) Nature of expenditure and receipt
c) Functions
d) Flexibil ity.

Classification of Budgets
a) Time b) Nature of
expenditure and
receipt c) Functions d)
Flexibility
i) Long
term i) Capital Budget i) Sales i) Fixed
ii) Short
term ii) Revenue Budget ii) Production ii) Flexible
iii) Cost of Production
iv) Pu rchase
v) Cash Budget
vi) Personal or Direct
Labour

viii) Capital
Expenditure Budget
ix) Research Budget
x) Master Budget

a) Classification according to Time:
i. Long Term Budget: Generally, a budget covering the period of
more than a year can be considered as long -term budget.
ii. Short term budget: The budget which is prepared for a very short
time of period is called as short -term budget.


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Control b) Classification according to Nature of expenditure and receipt:
i) Capital Budget: The budget which i s prepared for capital receipts and
expenditure such as obtaining loans, issue of shares, purchase of assets
is called as capital budget.
ii) Revenue Budget: The budget which covers revenue receipts and
expenses for a certain period is called Revenue Budge t. Examples:
Sales, other incomes, purchases, administrative expenses etc. is called
as revenue budget.
c) Classification according to functions:

i. Sales Budget: In order to show accuracy as far as possible of the sales
anticipated during the period of the bud get the sales budget is prepared.
The sales manager assisted by research personnel prepares the sales
budget. The sales budget focuses on forecast of total sales which are
expressed in terms of money or quantity. This is the most important
budget on which all other budgets are based.

ii. Production Budget: The production budget generally shows the
production of the budget period. The production budget is dependent
upon sales budget. It exhibits the quantity in terms of period, areas, etc.
The work manager look s after the preparation of overall production
budget while the departmental manager is responsible for departmental
production budgets.

iii. Cost of Production Budget: It shows the cost of production. For the
different elements like direct materials budget, di rect labour budget,
factory overheads budget, office overheads budget, selling and
distribution overhead budget, etc. separate budgets can be prepared.

iv. Purchase Budget: This budget generally shows the quantity and value
of purchase required for production . The materials which are to be
purchased quantity -wise and period -wise are enlisted in this budget.
This budget is correlates with the sales and production planning.

v. Cash Budget: Cash budget shows the cash position of for a specific
period of time of diff erent time period. It generally shows the balance
of cash in hand at the end of different period and the estimated amount
of receipt of the period. Cash budget covers the important aspect such
as cash sales, collection from debtors and other receipts and p ayment to
suppliers, payment of wages, payment of other expenses etc.

vi. Personnel Budget: The labour budget is also known as personnel
budget. The budget decides the persons or labour required during a
period of production. The personnel budget is also divi ded into direct
and indirect budgets.
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Accounting vii. Capital Expenditure Budget: Capital expenditure budget is an outlay
prepared on fixed assets viz. Land, Building, Plant & Machinery etc.
during the period of budget. This budget is prepared for the period of 5
to 10 y ears. To control the management process of the budget, it is
broken down into small period. Generally, it is the responsibility of the
head of the accounts to prepare the capital expenditure budget who is
assisted by the plant manager and other functional heads. The
functional heads have deep knowledge of Plant utilisation budget, Long
term business policy, and Potential demand for certain products, etc.
After the analysis of all the information a company may decide for
extension factory capacity, purchase of new factory.

viii. Research and Development Budget (R & D Budget): It is essential
for every company to do research so that effective growth and
development can take place. Therefore, research and development
budget is prepared. The budget covers the importa nt aspects such as
materials, equipment and supplies, salaries, expenses, and other costs
relating to design, development, and technical research projects.

ix. Master Budget: To cover all the functions of business organization
master budget is prepared. Maste r budget shows the profit or loss of
financial position. It includes the summary of finalized profit plan by
combining all the budgets of a particular period into one harmonious
unit, thus it shows the budget covering all the aspects. All the
subsidiary fun ctional budgets are included in the master budget. The
management does the analysis of the master budget before it is brought
into action. It is made sure that the profit position disclosed in the
budget is satisfactory.

d) Classification on the basis of Fle xibility:

i. Fixed Budget: A budget prepared on the basis of a standard or a fixed
level of activity is called a fixed budget. Even if the level of activity is
changed there is no change in the fixed budget. If there is no change in
the output or sales the s ame fixed budget can be continued.

ii. Flexible Budget: To give the budgeted cost any level of activity,
flexible budget is prepared. After considering the fixed and variable
elements of cost such budget is prepared.
6.11. SUMMARY:
The management can be cons idered effective when it achieves the
objective with minimum efforts and cost. To make a management more
effective budgeting and budgetary control plays a very important role.
Budget and budgetary control has some objectives which helps the
management and its personnel to work productively. There are many
kinds of budgets which are prepared according to the required functions of
a management for a particular period. Therefore, the budget plays an
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Budgeting And Budgetary
Control 6.12. ILLUSTRATIONS:
Illustration 1) (Production and Purchase Budget)
The following are the estimated sales of ABC Limited for eight months
ending 31st October 2022.
Month estimated sales unit April 2022 12,000 units
may 2022 13,000 units
June 2022 9,000 units
July 2022 8,000 units
August 2022 10,000 units
September 2022 12,000 units
October 2022 14,000 units
November 2022 12,000 units

As a matter of policy, the company maintains the closing balance Are
finished goods and raw material as follows:
i. Finished goods - closing stock of a month will be e 50% of the
estimated sales for the next month.
ii. Raw material - closing stock of a month will be equal to estimated
consumption for the next month.
Each unit of production consumes 2 kg of raw mater ial costing
rupees 6 per kg.
Prepare the following budgets for the half year ending 30th
September 2022.
i. production budget (month wise in units)
ii. raw material purchase budget (month wise in units and in cost)
Solutions:
ABC Limited
Production budget for h alf year ending 30th September 2022
Particular April May June July August September Sales (units) 12,000 13,000 9,000 8,000 10,000 12,000
Add: -
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Accounting stock
18,500 17,500 13,000 13,000 16,000 19,000
Less: -
openin g
stock (6,000) (6,500) (4,500) (4,000) (5,000) (6,000)
Estimated
production 12,500 11,000 8,500 9,000 11,000 13,000

Raw material purchase budget for the half year ending 30th September
2022
Particular April May June July August September Estimated
production 12,500 11,000 8,500 9,000 11,000 13,000
Material at
2 kg per
unit of
production
(Kg) 25,000 22,000 17,000 18,000 22,000 26,000
Add: -
closing
stock 22,000 17,000 18,000 22,000 26,000 26,000
Less: -
opening
stock (25,000) (22,000) (17,000) (18,0 00) (22,000) (26,000 )
Purchases
(Units) 22,000 17,000 18,000 22,000 26,000 26,000
Cost @
Rs.6/ - per
Kg (Rs.) 1,32,000 1,02,000 1,08,000 1,32,000 1,56,000 1,56,000


Illustration 2) (Flexible budget)
PQR Limited is currently working at 50% capacit y. Prepare flexible
budget and estimate the profit for 60%, 70% and 80% capacity. The
company produces 10,000 units at 50% capacity.
a) At 60% capacity the raw material cost will increase by 2% and selling
price fall by 2%.

b) At70% capacity the raw material c ost will increase by 4% and selling
price fall by 4%.
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Control c) At 80% capacity the raw material cost will increase by 5% and selling
price fall by 5%.

d) At 50% capacity the product cost is rupees 180 per unit and it is sold
at Rs.200 per unit.

The cost per uni t at 50% capacity is as follows:
Material Rs.100
Labor Rs.30
Factory overhead Rs.30 (40% Fixed) Administrative overhead Rs.20 (50% Fixed) Total Rs.180

Solution:
PQR Limited
Flexible budget
Capacity 50% 60% 70% 80%
Units 10000 12000 14000 16000
Particulars Per
Unit
Rs. Total
Rs. Per
Unit
Rs. Total
Rs. Per
Unit
Rs. Total
Rs. Per
Unit
Rs. Total
Rs.
A) Sales 200 2000000 196 2352000 192 2688000 190 3040000
B) Variable Costs
Direct Materials 100 1000000 102 1224000 104 1456000 105 1680000
Direct Labour 30 300000 30 360000 30 420000 30 480000
Variable
Overhead
Factory
Overhead 18 180000 18 216000 18 252000 18 288000
Administrative
Overhead 10 100000 10 120000 10 140000 10 160000
Total Variable
Costs 158 1580000 160 1920000 162 2268000 163 2608000
C) Contribution
(A-B) 42 420000 36 432000 30 420000 27 432000
D) Fixed Overhead
Factory
Overhead 12 120000 10 120000 8.57 120000 7.5 120000
Administrative
Overhead 10 100000 8.33 100000 7.14 100000 6.25 100000
Total Fixed
Overhead 22 220000 18.33 220000 15.71 220000 13.75 220000
E) Profit (C -D) 20 200000 17.67 212000 14.29 200000 13.25 212000
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Accounting Illustration 3) (Sales and Production budget)
MNP Limited submit the following data of its p roduct manufactured
during the first quarter of 2021 and 2022.
Particular
Sales:
January 2021 30,000 units
February 2021 25,000 units
March 2021 35,000 units
Selling price per unit in 2021 Rs.20
Targets for the first quarter of 2022
Increase in s ales quantity 10%
Increase in sale price 10%
Stock as on 1st January 2022 (percentage of January 2022
sales) 50%
Start as on 31st March 2022 25,000 units
Stock as on 31st January 2022 and 28 February 2022 (as
percentage of subsequent month sales) 50%
Prepare sales and production budget for first quarter of 2022.
Solution:
Sales Budget
Particular January
2022 February
2022 March
2022
Sales of 2021 Units 30000 25000 35000
Add: increase by 10% 3000 2500 3500
Estimated Sales Units for 2022 33000 27500 38500
Sales Price per unit Rs. 22 22 22
Total Sales price Rs. 726000 605000 847000
Production Budget
Particular January
2022 February
2022 March
2022
Estimated Sales Units for 2022 33000 27500 38500
Add: Closing Stock 13750 19250 25000
4675 0 46750 63500
Less: Opening Stock 16500 13750 19250
Estimated Production 30250 33000 44250
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Budgeting And Budgetary
Control Illustration 4)
XY limited estimates sales of its product ‘Z’ during the last five months of
2022 as under;
Month Units
August 21,600
September 31,200
Octobe r 24,400
November 20,800
December 19,600

a) Inventory of product ‘Z’ at the end of every month is to be equal to
50% of sales estimate for the next month. Closing inventory of July
was maintained on the above basis. There was no work in progress at
the en d of any month.

b) Every unit of product requires two types of material in the following
quantities
Material P - 5 liters, material Q - 6 liters

c) Material equal to 25% of the requirement for the next month
consumption are kept as a closing stock.

d) The stock po sition on 31st July was as under:
Material P - 32,000 liters, material Q - 28,000 liters

e) The purchase price of material P is Rs.3 per liter and material Q is
Rs.2 per liter.

f) There will not be closing stock of material P & Q on 30th November
2022.
From the above information prepare following budgets for the period
August to November 2022.
1) Production budget
2) Material consumption budget
3) Purchase budget showing quantity and value.





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Accounting Solution:
Production Budget
Particular August September October November
Estimated Sales 21600 31200 24400 20800
Add: Closing Stock 15600 12200 10400 9800
37200 43400 34800 30600
Less: Opening Stock 10800 15600 12200 10400
Estimated Production 26400 27800 22600 20200

Material Consumption Budget
Particular August Septem ber October November
Material A (5 liter per unit) 132000 139000 113000 101000
Material B (6 liter per unit) 158400 166800 135600 121200

Total Material
Consumption 290400 305800 248600 222200

Purchase Budget (Material P)
Particu lar August September October November
Material Consumption 132000 139000 113000 101000
Add: Closing Stock 34750 28250 25250 0
166750 167250 138250 101000
Less: Opening Stock 32000 34750 28250 25250

Estimated Material to be
Purchase 134750 132500 110000 75750

Rs. Per liter 3 3 3 3

Estimated Purchase Cost 404250 397500 330000 227250
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Control
Purchase Budget (Material Q)
Particular August September October November
Material Consumption 158400 166800 135600 121200
Add: Clo sing Stock 41700 33900 30300 0
200100 200700 165900 121200
Less: Opening Stock 28000 41700 33900 30300

Estimated Material to be
Purchase 172100 159000 132000 90900

Rs. Per liter 2 2 2 2

Estimated Purchase
Cost 344200 318000 264000 181800

Illustration 5) (Sales Budget)
The Unique Ltd. manufactures two brands of pens - one sold under the
name 'Hero' and another under the name of 'Honda'. The sales department
of the company has three departments in different areas of t he country.
a) The sales budgets for the year ending 31st March, 2022 were
Hero: Department I = 3,00,000, Department II = 5,62,500;
Department III = 1,80,000 and
Honda: Department I = 4,00,000; Department II = 6,00,000 and
Department III = 20,000.

b) Sellin g price are Rs.3 and Rs.1.20 in all departments for Hero and
Honda.

c) It is estimated that by forceful sales promotion the sale of 'Honda' in
Department I will increase by 1,75,000.

d) It is also expected that by increasing production and arranging
extensiv e advertisement Department III will be enabled to increase
the sale of 'Honda' by 50,000.

e) It is recognized that the estimated sales by Department II represent
an unsatisfactory target. It is agreed to increase both estimates by
20%.
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Accounting Prepare a Sales B udget for the year ended 31stMarch, 2023.
Solution:
Unique Limited
Sales Budget for the year ended 31st March, 2023
Departments Hero Honda
Qty Rate Amt. Rs. Qty Rate Amt. Rs. Department I 300000 3 900000 575000 1.2 690000
Department II 675000 3 2025000 720000 1.2 864000
Department III 180000 3 540000 70000 1.2 84000
Total 1155000 3465000 1365000 1638000

Working notes
1) Honda Department I
Sales For 2022 400000 Add: increase 175000 Sales For 2023 575000
2) Honda Department II I
Sales For 2022 20000
Add: increase 50000
Sales For 2023 70000

3) Honda Department II
Sales For 2022 600000 Add: increase by 20% 120000 Sales For 2023 720000
4) Hero Department II
Sales For 2022 562500 Add: increase by 20% 112500 Sales For 2023 675000
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Control 5) Sales for Hero for Department I and Department III will be same as in
the year 2022.
Illustration 6) (Cash Budget)
Prepare a cash budget for three months ending 30th June 2022 from the
following information:
Month Sales Material Wages Overheads
February 1,40,000 96,000 30,000 17,000
March 1,50,000 90,000 30,000 19,000
April 1,60,000 92,000 32,000 20,000
May 1,70,000 1,00,000 36,000 22,000
June 1,80,000 1,04,000 40,000 23,000

a) Credit terms are 10% sales are on cash, 50% of c redit sales are
collected next month end and the balance in the following month.

b) Creditors: Materials two Months
Wages ¼ Months
Overheads ½ Months

c) Cash and bank balance on 1st April 2022 is expected to be
Rs.60,000.

d) Other relevant information are:
i. Plant and machinery will be installed in February at a cost of
Rs.9,60,000. The monthly installment of Rs.12,000 are payable from
April onwards.

ii. Dividend at the rate of 5% on preference capital of Rs.12,00,000 will
be paid on 1st June 2022.

iii. Advanced to be rec eived for sale of vehicles Rs.90,000 in June 2022.

iv. Dividend from investment amounting to Rs.10,000 are expected to
be received in June 2022.

v. Income tax advance to be paid in June is Rs.20,000.







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Accounting Solution:
Cash Budget
Particular April May June
A Opening Balance 60000 47500 46000
Add: Receipts:
1 Cash Sales 16000 17000 18000
2 Advance Received 0 0 90000
3 Dividend Received 0 0 10000
4 Collection From Debtors 130500 139500 148500
B Total Receipts 146500 156500 266500
Less: Payments:
1 Payment for P&M 12000 12000 12000
2 Dividend 0 0 60000
3 Income Tax Paid 0 0 20000
4 Creditors for material 96000 90000 92000
5 Wages 31500 35000 39000
6 overheads 19500 21000 22500
C Total Payable 159000 158000 245500
D Closing Balance (A+B -C) 47500 46000 67000


Working Notes:
1 Cash Sales and Collection from Debtors
February March April May June
Sales 140000 150000 160000 170000 180000
Less: Cash Sales 10% 14000 15000 16000 17000 18000
Credit Sales 90% 126000 135000 144000 153000 162000
1st 50% 63000 67500 72000 76500
2nd 50% 63000 67500 72000 76500 Collection from Debtors 130500 139500 148500
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Budgeting And Budgetary
Control 2) Creditors for Material
February March April May June
Material 96000 90000 92000 100000 104000
Paid 96000 90000 92000

3) Wages
February March April May June
Wages incurred 30000 30000 32000 36000 40000
¾ 22500 22500 24000 27000 30000
¼ 7500 7500 8000 9000
Wages Paid 31500 35000 39000

4) Overheads
February March April May June
overheads incurred 17000 19000 20000 22000 23000 1/2 8500 9500 10000 11000 11500 1/2 8500 9500 10000 11000 overheads Paid 19500 21000 22500
Illustration 7) (Cash Budget)
Prepa re cash budget of Master Limited.
Particular Quarter
I Quarter
II Quarter
III Quarter
IV
Opening cash
balance 10,000 - - -
Receipt:
Collection from
customer 1,25,000 1,50,000 1,60,000 2,21,000

Payment:
Purchase of material 20,000 35,00 0 35,000 17,000
Other expenses 25,000 20,000 20,000 17,000
Salary and wages 90,000 95,000 95,000 1,09,200
Income tax 5,000 - - -
Purchase of furniture - - - 20,000 munotes.in

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Cost & Management
Accounting The company desires to maintain a cash balance of Rs.15,000 at the end of
each quarter. Cash can be borrowed or repaid in multiple of Rs.500 at an
interest of 10% per annum. Management does not want to borrow cash
more than what is necessary and want to replay as early as possible. In any
event, loan cannot be extended beyond four quarters. Interest is computed
and paid when the principal is repaid. Assume that borrowing take place at
the beginning and repayment are made at the end of the quarter.
Solution:
Master Limited
Cash Budget
Particular Rs. 1ST
Quarter Rs. 2ND
Quarter Rs. 3RD
Quarte r Rs. 4TH
Quarter AOpening Balance 10000 15000 15000 15325
Add: Receipts:
1 Collection from
Debtors 125000 150000 160000 221000
BTotal Receipts 125000 150000 160000 221000
Less:Payments:
1 Purchase of
Materia l 20000 35000 35000 17000
2 other expenses 25000 20000 20000 17000
3 salary and wages 90000 95000 95000 109200
4 income tax 5000 0 0 0
5 Purchase of
Machinery 0 0 0 20000
CTotal Payable 140000 150000 150000 163200 DCash Balan ce
(A+B -C) -5000 15000 25000 73125 EAdd: Loan taken 20000 0
F Less: Loan
Repayment 0 0 9000 11000 GLess: Interest on
Loan paid 0 0 675 1100
HClosing Balance
(D+E -F-G) 15000 15000 15325 61025

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Budgeting And Budgetary
Control Illustration 8) (Master Budget)
Mac L imited requires you to calculate and present the budget for the next
year from the following information.
Sales:
Product A Rs. 3,00,000
Product B Rs. 5,00,000
Direct Material 60% of Sales
Direct Wages 20 Workers @ Rs. 150 per month
Stores and spares 2½ % on Sales
Depreciation on Machinery Rs. 12,600
Light and Power Rs. 5,000
Factory Overhead:
Indirect Labour:
Works Manager Rs. 500 per month
Foreman Rs. 400 per month
Repairs and maintenance 10% on direct wages
Administration, selling and distribution expenses Rs. 14,000 per year.
Solution:
Master Budget for the period ending __________
Particular Rs. Rs. Rs.
Sales (as per Sales Budget)
Product A 3,00,000
Product B 5,00,00 0 8,00,000
Less- Cost of Production (as
per Cost of Production
Budget) :
Direct Materials 4,80,000
Direct Wages 36,000
Prime Cost 5,16,000 munotes.in

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Accounting
Factory Overhead:
Variable:
Stores and Spares (2½% of
Sales) 20,000
Light and Power 5,000
Repairs and Maintenance 8,000 33,000
Fixed:
Works Manager’s Salary 6,000
Foreman’s Salary 4,800
Depreciation 12,600
Sundries 3,600 27,000
Works Cost 5,76,000
Gross Profit 2,24,000
Less: Administration, Sel ling
and Distribution Overheads 14,000
Net Profit 2,10,000

6.13. EXERCISES
A) Fill in the blanks:
1. The most important budget on which all other budgets are based is
__________.
2. A summary of budget which contains all functional budgets is called
_____ __.
3. In the preparation of budgets _______ limits the volume of budget
activity.
4. _________ is responsible for the preparation and execution of sales
budget.
5. Production budget is based on ___________ budget.
6. A budget which is prepared to change according to the level of
activity is called _______.
(Answers: 1) Sales Budget, 2) Master Budget, 3) Key factor, 4) Sales
Manager, 5) Sales, 6) Flexible Budget)
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Budgeting And Budgetary
Control B) State whether the following statement are True or False.
1. A budget is both a plan as well as a control tool.
2. A budget manual contains a summary of all functional budgets.
3. A budget is a plan of the management for a future period expressed
in quantitative terms.
4. Direct materials are generally included in overhead budget.
5. Cash budget indicates the amount of l oan required as well as the
time when it is needed.
6. A Master Budget is the master plan drawn up by the organisation for
the budget period.
7. Fixed budget is suitable for fixed expenses.
8. Fixed budgeting is useful when there is no significant variations in
the budgeted output and actual output.
(Answers: 1) True, 2) False, 3) True, 4) False, 5) True, 6) True, 7)
True, 8) True)
C) Theory Questions.
1. What is Sales Budget? How is it prepared?
2. What is Cash Budget? How is it prepared?
3. What are fixed and flexible bud gets?
4. Define budgeting and budgetary control. State objective of
Budgeting.
5. Explain in brief different types of budgets.


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STANDARD COSTING AND VARIANCE
ANALYSIS
Unit Structure:
7.1. Objectives
7.2. Introduction
7.3. Meaning of standard cost & standard costing
7.4. Objectives of standard costing
7.5. Advantages of standard costing
7.6. Limitations of standard costing
7.7. Ty pes of standards
7.8. Variance analysis
7.9. Classification of Variance
7.10. Material Variances
7.11. Labour Variance
7.12. Summary
7.13. Illustrations
7.14. Exercise
7.1. OBJECTIVES
After studying the unit, the students will be able to:
 Understand the c oncept of Standard Cost and Standard Costing
 Understand how standard costing operates
 Explain the benefits of standard costing
 Calculate the material, labour, overhead and Sales Variances
 Understand the use of standard costing for cost reduction
7.2. INTRO DUCTION
One of the most significant tasks of management accounting is to aid
managerial control, and cost control is a key part of managerial control.
The ability to regulate costs effectively is critical to managerial efficiency.
As a result, cost plannin g and control are critical. One of the most
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Standard Costing And
Variance Analysis operations is standard costing. All expenses are pre -determined in
standard costing, and the pre -determined costs are then compared to the
actual costs. Variance is the difference between pre -determined costs and
actual costs, which is analysed and probed for reasons. The deviations are
then reported to management, who will take corrective action to ensure
that actual costs match pre -determi ned costs. Actual expenses are only
determined in historical costing after they have been incurred. Only when
they are compared to predetermined expenses. Such charges are useless to
management in terms of cost control and decision -making. As a result,
standard costing is employed as a tool for company operations planning,
decision -making, and control. This unit will cover the fundamentals of
standard costing.
7.3. MEANING OF STANDARD COST & STANDARD
COSTING
The term "standard" refers to a yardstick or a be nchmark. Under certain
circumstances the standard cost determines the charges of services or
products. The required amount of raw material to produce a unit of
product is determined and then the cost of raw material is estimated. This
becomes the standard material input. When actual raw material usage or
costs differ from the standards, the difference, known as 'variance,' is
reported to the responsible manager. When the extent of the one variance
is large, a thorough investigation will be conducted to esta blish the
sources of the variance.
Backer and Jacobsen put this into perspective as “Standard cost is the
amount the firm thinks a productor the operation of the process for a
period of time should cost, based upon certain assumed conditions of
efficiency, economic conditions and other factors.”
The CIMA, London has defined standard cost as “a predetermined cost
which is calculated from management standards of efficient operations
and the relevant necessary expenditure.”They are the predetermined
expenses b ased on a technical assessment of materials, labour, and
overheads for a specific timeframe and set of operating conditions. To put
it another way, a standard cost is the anticipated cost of a unit of product
or service.
Standard costing is the practice of employing standard costs for the goal of
cost control. It's a cost accounting system that determines how much a
thing should cost under current circumstances. Only when production has
begun can the true cost be determined. The predetermined cost is
compar ed to the actual cost, and any variance encourages management to
take appropriate corrective action.
The steps in standard costing are as follows:
1. Creating a set of standard costs for various cost aspects
2. Determination of actual costs
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Cost & Management
Accounting 4. Identifying the sources of the differences by analyzing them.
5. Taking corrective action and overcoming variances.
7.4. OBJECTIVES OF STANDARD COSTING
1. Cost Control: The primary goal of standard costing is to assist
management with cost control. This could be used as a benchmark to
gauge efficiency by comparing real costs to it. At regular intervals,
management can compare actual costs to standard costs and take
corrective action in order to keep expenses under contro l.
2. Management by Exception: The second goal of standard cost is to aid
management in cost control by using the exception principle. Standard
cost aids in the prescription of standards, and management's attention is
raised only when actual performance de viates from the specified
standards. Its attention is solely focused on variations.
3. Develops Cost Conscious Attitude: Another goal of standard cost is to
make everyone in the company more cost conscious. It teaches employees
the value of efficient opera tions in order to decrease expenses through
collaborative efforts.
4. Fixation of Prices: To assist management in developing production
policies, determining price quotations, and filing tenders for diverse
products. This is easier to achieve using standar d costing rather than actual
costs. It also contributes to the expansion of production policies. In
production planning, standard costs eliminate the reflection of unexpected
price changes.
5. Fixing Prices and Formulating Policies: Standard costing also s erves
to assist management in deciding prices and formulating production
policies. It also aids management in profit planning, product pricing, and
inventory pricing, among other things.
6. Management Planning: Management plans budgets at various levels at
regular periods in order to increase revenue through various product
combinations. Standard costing, rather than actual expenses, is more
convenient for this purpose because it is done in a scientific and rational
manner, taking into account all technical considerations.
7.5. ADVANTAGES OF STANDARD COSTING
1. To measure efficiency: Standard Expenses serve as a benchmark
against which real costs can be compared. The management can evaluate
the effectiveness of various cost centers by comparing real costs to
standard costs. In the absence of standard costing, efficiency is determined
by comparing real costs over time, which is difficult to do because the
conditions in both periods may alter.
2. To fix prices and formulate policies: When calculating prices and
formulating production policies, standard costing is beneficial. The
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Standard Costing And
Variance Analysis also assists in determining the costs of various things. It facilitates
management in the early development o f production and pricing plans, as
well as profit planning, product pricing, and tender price quotation. It also
aids in the provision of cost estimates when developing new items.
3. For Effective cost control: Standard costing has a number of
advantages, one of which is that it improves in cost control. Variances are
calculated by comparing actual costs to standard costs. These variations
make it easier for management to spot inefficiencies and take corrective
action as soon as possible.
4. Management by e xception: Management by exception indicates that
each individual has a set of goals to attain, and everyone is expected to
meet these goals. The principles of management by exception are used to
conduct variance analysis and reporting. Top management may b e more
interested in the variations from the standards than in the details of actual
performance in order to take corrective action in a timely manner.
5. Valuation of stocks: Stock is valued at standard cost, and any
difference between standard cost and a ctual cost is moved to the variance
account under standard costing. As a result, stock valuation is simplified,
and a lot of clerical work is reduced to a minimum.
6. Cost consciousness: Standard pricing places a greater emphasis on cost
variations, making the entire organization more cost conscious. It helps
employees understand the necessity of efficient operations so that joint
efforts can be made to minimize costs to the bare minimum.
7. Provides incentives: Men, materials, and machines can all be
emplo yed efficiently under a standard costing scheme. Schemes can be
designed to reward persons who meet their goals. It improves employee
efficiency, production, and morale.
8. Facilities delegation of authority: Each department or individual can
delegate auth ority and assign responsibility using the Standard Costing
method. This also strengthens the company's overall organization.
9. Prompt decision -making: Prior to the start of manufacturing,
production and pricing policies might be established. This facilita tes quick
decision -making.
7.6. LIMITATIONS OF STANDARD COSTING:
1. Difficulty in setting standards: Setting standards is a complex
undertaking that necessitates extensive scientific investigation such as
time studies, motion studies, and so on. When stan dard is set too high, it
may cause workers to become frustrated. As a result, establishing
appropriate criteria is extremely challenging.

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Cost & Management
Accounting 2. Not suitable to small business: Standard costing is not appropriate for
small businesses since it necessitates exte nsive scientific research, which
is costly. As a result, small businesses may find it difficult to use the
system.
3. Not suitable to all industries: Standard costing is not appropriate for
industries that manufacture non -standardized goods, nor is it appr opriate
for job or contract costing. Likewise, standard costing is difficult to
implement in sectors where the production process spans multiple
accounting periods.
4. Difficult to fix responsibility: Fixing accountability is a difficult issue.
Controllabl e and uncontrolled variations must be distinguished since only
controllable variances can be assigned to a responsible party. Controllable
and uncontrollable deviations are difficult to distinguish since what is
controllable in one context may become uncon trollable in another. As a
result, under standard costing, determining accountability is extremely
difficult.
5. Technological changes: Standard costing may not be suitable for
organizations and industries that experience frequent technology shifts.
When t echnology changes, the manufacturing process necessitates a
revision of the standard. The approach is not ideal for industries where
methods and techniques of production are capable of rapid change since
frequent modification of standards is a costly proce ss.
6. Standards can sometimes have a negative psychological impact. If the
standard is set too high, failure to meet it will cause dissatisfaction and
resistance to grow.
7. The approach is effectively ineffectual due to management's lack of
interest in s tandard costing.
7.7. TYPES OF STANDARDS
There are different types of standards stated as follows:
a) Ideal Standard: When material and labour prices are at their
lowest, the ideal standard indicates the highest degree of performance
possible. When the best equipment and designs are combined with
maximum efficiency, the highest production is attained by with minimum
cost. This type of standard, on the other hand, is criticized since it is
practically impossible.

b) Normal Standard: Under regular operating condi tions, a normal
standard can be obtained. The usual activity is defined as the number of
standard hours required to produce at a level of efficiency, sufficient to
meet the average sales demand across time. This standard necessitates
some foresight. Varian ces are variations from normal efficiency, normal
sales volume, or normal production volume in this system.
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Standard Costing And
Variance Analysis c) Basic Standard: Only when a basic standard is likely to remain
consistent over a lengthy period of time is it used. For the purposes of
comparison, a base year is chosen. Because the basic standard does not
represent what should be achieved in the current time, when the basic
standard is adopted, current standard should also be established.

d) Current Standard: The current standard represents manageme nt's
forecast of current -period expenses. These are the costs the company will
incur if the expected prices for products and services, as well as the usage
required to generate the planned output, are paid.

e) Expected Standard: Based on existing conditions, this is the
standard that is predicted to be met during the budget period. The
standards are established based on projected performance after allowing
for inevitable losses and deviations from perfect efficiency. Standards are
usually set on a short -term basis and must be revised frequently. This is a
more practical standard than the ideal standard.
7.8. VARIANCE ANALYSIS
Variance is defined as the difference between a standard cost and the
similar actual cost generated during a period in standard costing. Variation
analysis is the act of an alysing variances by splitting the total variance
into smaller segments so that management can allocate responsibility for
any deviations from the norm. As a result, variance analysis refers to the
measurement of the di fference between actual and desired performance.
Depending on whether the actual cost is less or more than the standard
cost, variance can be beneficial or detrimental. The variation is referred to
as 'favourable' if the actual cost is less than the standa rd cost, and
'unfavourable' or 'adverse' if the actual cost is larger than the standard cost.
The effect of favourable variance improves profit and is a measure of the
organization's efficiency. Unfavorable variance, on the other hand, refers
to a loss of business and is an indication of inefficiency in the
organisation.
7.9. TYPES & CLASSIFICATION OF VARIANCE
Following are the types of variances:
a) Controllable and Uncontrollable variance: Controllable variances
are those that the department heads can regul ate, whereas uncontrollable
variances are those that are beyond their control. Controllability, on the
other hand, is a subjective concept that fluctuates depending on the
scenario. The standard may need to be revised if the uncontrollable
deviations are c onsiderable and persistent.

b) Favorable and Adverse Variance: Variations that are beneficial to
the firm are referred to as favourable variances, while those that are
detrimental to the company are referred to as adverse variances. When it
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Cost & Management
Accounting is lower than the standard cost. Adverse variances, on the other hand,
indicate that the actual cost is higher than the standard cost. In the case of
sales variance, however, the situation will be reversed. Actual sales are
higher than budgeted, indicating a positive variance.In short, positive or
favorable variance is denoted by the letter 'F,' while negative or adverse
variance is denoted by the letter 'A.'
Classification of Variance
Variances ma y be classified into two categories viz., cost variances and
sales variances. The cost variance may again be sub -divided into variances
for each element of cost as shown in the following chart:

7.10. MATERIAL VARIANCES
7.10.1. Direct Materials Cost Varia nce:
The difference between the actual direct material cost incurred and the
standard direct material cost provided for the output accomplished is
known as direct materials cost variance. The standard cost of materials for
actual production is calculated b y multiplying the standard price by the
standard quantity for actual output. The actual cost is derived by
multiplying the actual price by its actual quantity consumed. The
following formula can be used to compute the Direct Material Variance:
Direct Mater ial Cost Variance = Standard Material Cost for actual output
– Actual Material Cost
OR
Direct Material Cost Variance = (SQ X SP) – (AQ X AP)
Where,
SQ = Standard Material Quantity for actual output
SP = Standard Material Price per unit
AQ = Actual Materia l Quantity used
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Standard Costing And
Variance Analysis Standard Material Cost for actual output = Standard Material Quantity for
actual output X Standard Material Price per unit
Actual Material Cost = Actual Material Quantity used X Actual Material
Price
Direct mater ial cost variance occurs when the price of materials changes,
or when the quantity of material utilised changes, or when both.The
variance will be favourable if the standard cost is higher than the actual
cost; however, if the actual cost is higher than th e standard cost, the
variance will be unfavourable or negative.
7.10.2. Direct Materials Price Variance:
The differential seen between actual and standard material price per unit
applied to the actual quantity of goods acquired or consumed. The
following f ormula can be used to compute the Direct Material Cost
Variance:
Direct materials price variance = (Standard Price – Actual Price) x Actual
Quantity,
OR
Direct materials price variance = (SP – AP)x AQ
If the standard price is higher than the actual price, the variance is
favourable; if the actual price is higher than the standard price, the
variance is negative or adverse.
Material price variance may arise due to the following reasons:
a) A change in the material's fundamental current value
b) A change in the pu rchase quantity or an uneconomical purchasing
order size.
c) Failure to purchase materials in a timely manner.
d) A change in the quality or specification of the acquired material.
e) Using a cheaper or more expensive alternative material.
f) Changes in the system of taxes and duties,
g) Organizational acquisitions that are weak or strong, etc.
7.10.3. Direct Materials Usage Variance:
Material Usage Variance is the difference between the standard quantity
for actual production and the actual quantity used, resulting in a portion of
material cost. To put it another way, it's the difference between the
standard quantity for actual output and the actual quantity multiplied by
the standard price of material. The following is the material usage
variance formula:
Direct mater ials usage variance = Standard Price x (Standard Quantity for
actual output – Actual Quantity)
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Cost & Management
Accounting OR
Direct materials usage variance = SP x (SQ – AQ)
When the standard quantity is greater than the actual quantity the variance
will be favourable, and vice vers a.
Material usage variance will arise due to the following reasons:
a) Use of substandard or faulty materials.
b) Use of substandard plant and machinery, as well as poor or incorrect
maintenance, resulting in breakdowns and increased material usage.
c) Inadequate i nspection and supervision.
d) Material theft or pilferage.
e) Accounting problems, and so on.
7.10.4. Direct Materials Mix Variance:
Material Mix Variance is the portion of the material usages variance
caused by a discrepancy in the standard and actual compositi on of the
material mixture. It signifies that the source of variance is due to a
difference in the actual material mix's ratio compared to the standard
material mix's ratio. Changes in the composition of the materials mix are
one of the reasons for variati ons in material utilization.
Material Mix variance = (Revised Standard Quantity – Actual Quantity) x
Standard Price.
OR
Material Mix variance = (RSQ – AQ) x SP
Where,
RSQ = Revised Standard Quantity
Revised Standard Quantity =

If the actual quantity is more than revised standard quantity, an adverse
variance will occur and vice versa.
Material mix variance may arise due to the following reasons:
a) Actual mix can differ from standard mix.
b) Production department inaccuracy in using suitable mix.
c) Failure of one or more mix components to arrive at the correct
moment.
d) Delays in raw material deliveries, etc.


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Standard Costing And
Variance Analysis 7.10.5. Direct Materials Yield Variance:
The difference between the standard cost of production reached and the
actual total quantity of material s used, multiplied by the standard weighted
average price per unit, is known as Material Yield Variance.
Material yield variance= (Standard Production for Actual Mix – Actual
Production) x Standard Cost Per Unit
Material Yield Variance = (Standard Yield – Actual Yield) x Standard
output price
Or
Material Yield Variance = (Standard Quantity – Revised Standard
Quantity) x Standard Price.
The material yield variance may be caused due to the following reasons:
a) Inadequate manner of operation
b) Inadequate quantity of material purchased
c) Improper handling, etc.
7.11. LABOUR VARIANCES
7.11.1. Direct labour cost variance:
It's the difference between the activity's set standard direct labour cost and
the actual direct labour cost incurred. The formula is as follows:
Direct Labour Cost Variance = Standard Labour Cost for Actual Output –
Actual Labour Cost
or
Direct Labour Cost Variance = (Std. hours for actual output X Std. Rate)
– (Actual hours X Actual rate)
or
Direct Labour Cost Variance = (SH X SR) – (AH X AR)
7.11.2. Direct Labour Rate Variance: The fraction of the usage variance
owing to the difference between the standard rate indicated and the actual
rate paid is called labour rate variance. It can be calculated using the
following formula:
Direct Labour Rate V ariance = (Standard Rate – Actual Rate) X Actual
Hours
Or
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Accounting The variance will be favourable if actual rate is less than the standard rate
and it will be adverse if actual rate is more than the standard rate.
Labo ur rate variance arises due to the following reasons:
a) A change in the hourly salary or piece rate
b) Overtime and night shift work in excess of or below the standard, or
when the standard makes no provision.
c) Wage rates paid to casual labourers, which may be h igher or lower.
d) New employees are not paid at full wage rates, and so on.
7.11.3. Direct Labour Efficiency Variance: The gap between the
standard labour hours prescribed for actual output and the actual hours
paid for is the labour efficiency ratio. This v ariation aids in the control of
worker efficiency as well as labour costs. The following formula can be
used to compute the variance:
Direct Labour Efficiency Variance = (Standard hours for actual
production – Actual hours worked) X Standard Rate
Or
Direc t Labour Efficiency Variance = (SH – AH) X SR
If actual time taken for doing a work is more than the specified standard
time, the variance will be unfavourable and vice versa.
Direct Labour efficiency ratio arises due to one or more of the following
reason s:
a) Faulty machinery and equipment
b) Inadequate supervision
c) Use of defective or non -standard materials
d) Inadequate worker training
e) Poor working conditions
f) Changeover of workers from one operation to another, often known
as labour turnover.
g) Changes in manu facturing techniques
h) Time lost owing to a delay in receiving instructions, raw materials,
or tools.
i) Power outages, etc.
7.11.4. Labour Idle Time Variance: Idle time variance in the workplace
is a sub -variant of labour efficiency variance. It is the standar d wage paid
during idle hours owing to unusual circumstances such as strikes,
lockouts, machinery breakdowns, power outages, raw material shortages,
and so on. The abnormal idle time should be distinguished from the labour
efficiency variance since it is c aused by factors outside the workers'
control. Otherwise, it will demonstrate worker inefficiency. This
difference will always be negative or adverse.
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Standard Costing And
Variance Analysis It is calculated as follows:
Idle Time Variance = Idle Hours X Standard Rate
7.11.5. Direct Labour Mix Variance: Gang composition variation is
another name for it. It's a portion of the variation in labour efficiency.
Only when two or more different categories of workers are employed, and
the composition of real grade workers differs from the standard
comp osition of workers, does labour mix variance occur.
Direct Labour Mix Variance = (Revised Standard Hours – Actual Hours)
X Standard Rate
Where,
RSH = Actual Total Hours Worked X Standard Ratio of Workers
Or
RSH =

Where, Actual Hours Worked = Actual hours – Idle Time
7.11.6. Direct Labour Yield Variance: Material Yield Variance is a
comparable concept. It investigates how actual yield affects labour costs
when output differs from the standard.
The formula for LYV is:
Direct Labour Yield Varian ce = (Actual yield – Standard yield) X
Standard labour cost per unit of output
Or
Direct Labour Yield Variance = Standard Cost Per Unit × (Standard
Output for Actual Mix – Actual Output)
7.12. SUMMARY
Standard costing is a management strategy for monitorin g costs. We have
used standards as performance indicators throughout the process. Any
activity necessitates cost analysis and control. Material, labour, and
overheads are all included in the price. Because of changes in usage, raw
materials, technology, an d production methods, we sometimes need to
alter the standards. It is necessary to implement this under the supervision
of a committee for the activity in order to ensure effective organisation. It
is a continuous activity aimed at maximizing resource usag e.


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Cost & Management
Accounting 7.13. ILLUSTRATIONS:
Illustration 1)
A Manufacturing concern which has adopted standard costing furnished
the following information:
Standard Material for 700 kg finished products 1000 Kg
Standard price of Material Rs.1 per kg
Actual Output 2,10,000 kg
Actual Material Used 2,80,000 kg
Cost of Material Rs.2,52,000
Calculate: Standard Quantity for actual output and Actual Price per Kg.
Solution:
Standard Quantity for actual output (SQ):



= 3,00,000Kgs
Actual Pr ice per Kg (AP) =
=
= Rs.0.90 per
kg
Standard Price (SP) = Rs.1 per kg
Actual Quantity (AQ) = 2,80,000Kgs
Illustration 2) (Material Variances)
From the following information, Calculate: Material Cost Variance,
Material Pric e Variance, and Material Usages Variance.
Standard Quantity for 100 Units 800Kg
Standard rate per Kg Rs.6.40
Actual Production 45,000 Units
Actual Material Used 3,50,000Kgs
Actual Material Cost Rs.22,05,000

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Standard Costing And
Variance Analysis Solution:
Standard Quantity for actual output (SQ):



= 360000 Kgs
Actual Price per Kg (AP) =
=
= Rs.6.30 per
kg
Standard Price (SP) = Rs.6.40 per kg
Actual Quantity (AQ) = 3,50,000Kgs
1) Direct Material Cost Variance = (SQ X SP) – (AQ X AP)
= (360000X 6.40) – (350000 X 6.30)
=2304000 – 2205000
=Rs.99,000 (F)

2) Direct materials price variance = Actual Quantityx(Standard Price –
Actual Price)
= 350000 x (6.40 – 6.30)
= Rs.35,000 (F)

3) Direct materials usage variance = Standard Price x (St andard
Quantity – Actual Quantity)
= 6.40 x (360000 – 350000)
= Rs.64,000 (F)
Verification: MCV = MPV + MUV
Rs.99,000 (F) = Rs.35,000 (F) + Rs.64,000 (F)
Illustration 3) (Material Variances)
The standard material cost for 1,000 kg of chemical Z is made up:
Chemical A 300 kg. @ Rs.4 per kg
Chemical B 400 kg. @ Rs.5 per kg
Chemical C 800 kg. @ Rs.6 per kg
In a batch 5,000 kg. of chemical Z were produced from a mix of
Chemical A 1,400 kg. @ Rs.5,880
Chemical B 2,200 kg. @ Rs.10,560
Chemical C 4,400 kg. @ Rs.28,600 munotes.in

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Accounting Calculate: Material Cost Variance, Material Price Variance, Material
Usages Variance, Material Mix Variance, Material Yield Variance.
Solution:
Material Standard Actual Revised
Standard
Quantity Price Amount
Rs. Quantity Price Amount
Rs. Quan tity
A 1500 4 6000 1400 4.20 5880 1600
B 2000 5 10000 2200 4.80 10560 2133
C 4000 6 24000 4400 6.50 28600 4267
7500 40000 8000 45040 8000

Revised Standard Quantity =

A= 1500/7500*8000=1600
B=2000/7500*8000=2133
C=4000/7500*8000=42 67
Actual Price=Actual Price / Actual Quantity
A=5880/1400=Rs.4.20/ -
B=10560/2200=Rs.4.80/ -
C=28600/4400=Rs.6.50/ -
1) Direct Material Cost Variance = Standard Material Cost for actual
output – Actual Material Cost
= 40,000 – 45,040
= Rs.5040 (A)

OR
Direct Ma terial Cost Variance = (SQ X SP) – (AQ X AP)
A = (1500X 4) – (1400X4.20) =Rs.120 (F)
B = (2000X 5) – (2200X4.80) =Rs.560 (A)
C = (4000X 6) – (4400X6.50) = Rs.4600(A)
Rs.5040 (A)

2) Direct materials price variance = (Standard Price – Actual Price ) x
Actual Quantity
A = (4 –4.20) x1400=Rs. 280(A)
B = (5 –4.80) x2200=Rs. 440(F)
C = (6 –6.50) x 4400= Rs.2200(A)
Rs.2040 (A)
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Standard Costing And
Variance Analysis 3) Direct materials usage variance = Standard Price x (Standard
Quantity – Actual Quantity)
A = 4x (1500 – 1400) =Rs. 400(F )
B = 5x (2000 – 2200) =Rs. 1000(A)
C = 6x (4000 – 4400) = Rs. 2400(A)
Rs.3000 (A)

4) Material Mix variance = Standard Price x (Revised Standard
Quantity – Actual Quantity)
A = 4x (1600 – 1400) =Rs. 800(F)
B = 5x (2133 – 2200) =Rs. 335(A)
C = 6 x (4267 – 4400) = Rs. 798(A)
Rs.333 (A)

5) Material Yield Variance = Standard Price x (Standard Quantity –
Revised Standard Quantity)
A = 4x (1500 – 1600) =Rs. 400 (A)
B = 5x (2000 – 2133) =Rs. 665(A)
C = 6x (4000 – 4267) = Rs. 1602(A)
Rs.2667 (A)
Verification: MCV = MPV + MUV
Rs.5040 (A) = Rs.2040 (A) + Rs.3000 (A)
MUV = MMV + MYV
Rs.3000 (A) = Rs.333 (A) + Rs.2667 (A)
Illustration 4) (Material &Labour Variances)
The following information is available from the cost records of AB & Co.
for the month of June, 2022.
Actual rate and prices are:
Material purchased 24,000 kg for Rs.1,05,600
Material consumed 22,800 kg
Actual wages paid for 5,940 hours Rs.29,700
Unit produced 2160 units.
Standard rate and prices are:
Direct Material rate is RS.4.00 pe r unit
Direct Labour rate is Rs.4.00 per hour
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Accounting Standard requirement is 2.5 hours per unit
Calculate all material and labour variances for the month June, 2022.
Solution:
Material Variances:
Standard Quantity for actual output (SQ):



= 21,600Kgs
Actual Price per Kg (AP) =
=
= Rs.4.40 per
kg
Standard Price (SP) = Rs.4.00 per kg
Actual Quantity (AQ) = 22,800 Kgs (Actually consume)
1) Direct Material Cost Variance = (SQ X SP) – (AQ X AP)
= (21600X 4.00) – (22800 X 4.40)
=86400 – 100320
=Rs.13,920 (A)

2) Direct materials price variance = Actual Quantityx(Standard Price –
Actual Price)
= 22,800 x (4.00 – 4.40)
= Rs.9,120 (A)

3) Direct materials usage variance = Standard Price x (Standard
Quantity – Actual Quantity)
= 4.00 x (21,600 – 22,800)
= Rs.4,800 (A)
Verification: MCV = MPV + MUV
13,920 (A)= 9,120 (A) +4,800 (A)
Labour Variances:
Standard Hours for actual output (SH):



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Standard Costing And
Variance Analysis Actual Rate per H ours (AH) =
=
= Rs.5.00 per
Hours
Standard Rate (SR) = Rs.4.00 per hours
Actual Hours (AH) = 5,940 Hours
1) Direct Labour Cost Variance = (SH X SR) – (AH X AR)
= (5400 X 4.00) – (5940 X 5.00)
=21600 – 29700
=Rs.8,100 (A)

2) Direct LabourRate variance = Actual Hours x(Standard Rate –
Actual Rate)
= 5940 x (4.00 – 5.00)
= Rs.5,940 (A)

3) Direct Labour efficiency variance = Standard Rate x (Standard
Hours – Actual Hours)
= 4.00 x (5400 – 5940)
= Rs.2,160 (A)
Verification: LCV = LRV + LEV
8,100 (A)= 5,940 (A)+ 2,160 (A)
Illustration 5) (Labour Variances)
The standard labour and the actual labour engaged in a week for a job are
as under:
Particular Skilled
Workers Semi -Skilled
Workers Unskilled
Workers
Standard no. of
Workers in the gang 320 120 60
Standard Wage rate
per hour (Rs.) 3 2 1
Actual no. of workers 280 180 40
Actual Wage rate per
hour (Rs.) 4 3 2

During the 40 -hour working week the gang produced 18,000 standard
labour hours of work.
Calculate: Labour Cost Variance, La bour Rate Variance, Labour
Efficiency Variance, Labour Mix VarianceandLabour Yield Variance.
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Accounting Labour Standard Actual Revised
Standard
Hours Rate Amount
Rs. Hours Rate Amount
Rs. Hours
Skilled 11520 3 34560 11200 4 44800 12800
Semi -
Skilled 4320 2 8640 7200 3 21600 4800
Unskilled 2160 1 2160 1600 2 3200 2400
18000 45360 20000 69600 20000

Standard Hours= Standard Hours /Total Standard output * Actual
output
A=320*40/20000*18000=11520
B=120*40/20000*18000=4320
C=60*40/20000*18000=2160
Revi sed Standard Hours =

A= 11520/18000*20000=12800
B=4320/18000*20000=4800
C=2160/18000*20000=2400
1) Direct Labour Cost Variance = Standard Labour Cost for actual
output – Actual Labour Cost
= 45,360 – 69,600
=Rs.24,240/ - (A)

2) Direct LabourRate va riance = Actual Hours x(Standard Rate –
Actual Rate)
Skilled = 11,200 x (3.00 – 4.00) = Rs.11,200/ - (A)
Semi Skilled = 7,200 x (2.00 – 3.00) = Rs.7,200/ - (A)
Unskilled = 1,600 x (1.00 – 2.00) = Rs.1,600/ - (A)
= Rs.20,000/ - (A)


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Standard Costing And
Variance Analysis 3) Direct Labour effi ciency variance = Standard Rate x (Standard
Hours – Actual Hours)
Skilled = 3 x (11,520 – 11,200) = Rs.960/ - (F)
Semi Skilled = 2 x (4,320 – 7,200) = Rs.5,760/ - (A)
Unskilled = 1 x (2,160 – 1,600) = Rs.560/ - (F)
= Rs.4,240/ - (A)

4) Labour Mix v ariance = Standard Rate x (Revised Standard Hours –
Actual Hours)
Skilled = 3 x (12,800 – 11,200) = Rs.4,800/ - (F)
Semi Skilled = 2 x (4,800 – 7,200) = Rs.4,800/ - (A)
Unskilled = 1 x (2,400 – 1,600) = Rs.800/ - (F)
= Rs.800/ - (F)

5) Labour Yiel d Variance = Standard Rate x (Standard Hours –
Revised Standard Hours)
Skilled = 3 x (11,520 – 12,800) = Rs.3,840/ - (A)
Semi Skilled = 2 x (4,320 – 4,800) = Rs.960/ - (A)
Unskilled = 1 x (2,160 – 2,400) = Rs.240/ - (A)
= Rs.5,040/ - (A)
Verifica tion: LCV = LRV + LEV
Rs.24,240/ - (A) = Rs.20,000/ - (A) + Rs.4,240/ - (A)
LEV = LMV + LYV
Rs.4,240/ - (A) = Rs.800/ - (F) + Rs.5,040/ - (A)
7.14. EXERCISES
A) Fill in the blanks:
1. Difference between standard cost and actual cost is called as
___________.
2. Idle time variance is always ___________.
3. Standard quantity for material P is 60 kg with a price of Rs.40,
Actual quantity is 88 kg with a price of Rs.50, if actual output is
180kgs against the standard of 90kgs the standard quantity for actual
output is ___ ________.
4. Excess of actual cost over standard cost is a ___________ variance.
5. Material price standard is set by ___________ department.
(Answers: 1) Variance, 2) unfavourable, 3) 120 kgs, 4) Adverse, 5)
Purchase)



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Accounting B) State whether each of the following sta tement is True or False.
1. Ideal standard is difficult to achieve.
2. A cost variance is a difference between standard cost and actual cost.
3. A manager is blamed for non -controllable adverse variance.
4. Idle time variance is always adverse.
5. Purchase manager is re sponsible for material price variance.
6. Labour cost variance = Labour rate variance + Labour efficiency
variance.
7. Controllable cost variance is always favourable.
8. Labour efficiency variance may arise due to defective method of
operation.
(Answers: 1) True, 2) True, 3) False, 4) True, 5) True, 6) True, 7) False, 8)
True)
C) Theory Questions.
1. What are the advantages and disadvantages of Standard Costing?
2. Write a note on types of Standards.
3. Write a note on classification of variance?
4. Write a note on Material V ariances.
5. Write a note on Labour Variances.
6. What do you mean by Standard Costing? Explain the objectives of
Standard Costing.
7. Write a note on Material Price Variance.



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123 8
RESPONSIBILITY ACCOUNTING AND
TRANSFER PRICING
Unit Structure:
8.1. Objectives
8.2. Introduction
8.3. Meaning and Concept of Responsibility Accounting
8.4. Uses of Responsibility Accounting
8.5. Types of Responsibility Centres
8.6. Measuring Divisional Performance
8.7. Meaning of Transfer Pricing
8.8. Objectives of Sound Transfer Pricing
8.9. Methods of Transfer Pricing
8.10. Summary
8.11. Exercises
8.1. OBJECTIVES
This unit's primary objectives are to familiarise you with:
 Recognize the idea of Responsi bility Accounting .
 Describe the many methods used to gauge divisional performance.
 To discuss about the many responsibility centres.
 Recognize the idea of transfer pricing.
 To be familiar with the various transfer pricing techniques.
8.2. INTRODUCTION
The responsibility accounting, which is useful in exercising cost control, is
one of the newer breakthroughs in the subject of management accounting.
A form of accounting known as "responsibility accounting" recognises
numerous responsibility centres across th e organisation and reflects the
intentions and activities of each of these centres by allocating specific
revenues and costs to the one with the relevant duty. Additionally, it is
known as activity accounting and profitability accounting.

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Accounting 8.3. MEANING AN D CONCEPT OF RESPONSIBILITY
ACCOUNTING
The word "responsibility accounting" refers to the accounting procedure
that documents how effectively managers have carried out their duties. It
is an information system that control reports by compiling and presenti ng
expense and revenue data in accordance with established responsibility
areas within a corporation. It is also known as activity accounting or
profitability accounting.
The Responsibility accounting system Make the following important
assumptions:
a) The r esponsibilities for which managers should be held accountable
are outlined.
b) Managers are only given the tasks and responsibilities that they have
a large amount of direct influence over it.
c) The manager should actively take part in setting the objective or
budget plan that will be used to gauge their performance.
d) With efficient and effective performance, the goals established for
each area of responsibility should be reachable.
e) Performance reports must to include pertinent data regarding each
area of resp onsibility.
f) Managers of responsibility centres should work to meet the budgets
and goals set for their individual areas of responsibility.
8.4. USES OF RESPONSIBILITY ACCOUNTING
An essential tool in the management control process is responsibility
accounti ng, which concentrates on the managerial levels. It serves many
purposes and offers numerous advantages. Here is a list of them:
i) Performance Evaluation: The greatest advantage might be that it is
possible to evaluate individual managers on a cost basis when
accountability is localised. When a manager is held accountable for
everything he does, he becomes more watchful. The manager has access
to information from the responsibility accounting system that aids in
managing operations and assessing employee p erformance.
ii) Delegating Authority: Without adequate delegation of authority, large
corporations can rarely survive. Responsibility accounting makes it
happen by definition. Its core idea is decentralization of power, and
delegation of authority follows .
iii) Motivation: Accounting information is used for planning and
management in responsibility accounting. When managers are aware that
they are being assessed, they are motivated to give their all to achieving
the goals that have been established for them . It has strong stimulating
effects. In actuality, responsibility accounting is built on inspiring
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Responsibility
accounting and transfer
pricing objectives for accomplishment and serve to inspire management to boost
revenues or save co sts.
iv) Corrective Action: If a performance is unsatisfactory, the accountable
party must be named. Corrective action cannot be taken until the
offending subordinate has been identified. Under responsibility accounting
makes taking corrective action simpl er because authority structures are
clearly defined. After determining the root causes of the issue, the control
measure must be implemented right away for it to be effective.
v) Management by Objectives: Before the start of the term or period, the
heads of divisions and departments gave clear objectives. They are held
accountable for achieving these goals. Excesses are rewarded while
deficiencies are penalized. Such a framework aids in creating the
management by objectives philosophy (MBO).
vi) Management by Exception: Reporting on performance here focuses
on deviations or exceptions from the plan. The responsibility accounting is
filled with this concept. Managers benefit from investing their time on
significant differences with the most room for improvem ent. The key to
the system's effectiveness is the administrative focus on exceptional or
unusual items of deviation as opposed to on all of them.
vii) High Morale and Efficiency: Once it is obvious that awards are
conditional upon performance, it greatly r aises morale. If an operational
foreman is judged based on decisions in which he was not involved, this
will lead to severe disappointment.
8.5. TYPES OF RESPONSIBILITY CENTERS
An area of responsibility that is under one person's authority is known as a
responsibility centre. Typically, the responsibility centre types listed
below are present;
1. Cost center:
A manager is held accountable for the costs incurred in a certain division
of a company known as a cost centre. A cost centre only bears the expense
of its operations. The cost variance, which is determined by comparing the
actual cost to the budgeted cost for a particular period, serves as the basis
for the cost center's performance rating. Although they do not have control
over income, cost centre manage rs may have some or all of the cost in
their area of the business. The most common type of responsibility centre
is the cost centre. Production and service departments are categorised as
cost centres in manufacturing businesses. A cost centre can also be
described as a marketing division, a sales region, or a single salesperson.
The costs that they and their employees can influence fall under the
purview of the cost centre managers.

2. Revenue center:
A department inside an organisation known as a revenue cen tre is
principally in charge of producing sales revenue. A revenue centre
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Accounting costs but has no influence over costs or asset investments. By contrasting
actual revenue with anticipated rev enue, revenue centre performance is
assessed. Examples of revenue centres include the marketing manager for
a specific product line or a single salesperson.

3. Profit center:
A department inside a company known as a profit centre accumulates both
revenue and expenses. You make a profit is the profit center's primary
goal. Whether a profit centre has generated the projected amount of
revenue determines how well it is performing. A profit centre is a division
of the company that manufactures and markets the pro duct. Managers of
profit centres are more focused on finding ways to boost the center's
revenue, whether through improved production or distribution techniques.

4. Investment center:
Profit and investment are both under the control of the Investment centre.
The manager of the investment centre has responsibility over the center's
assets, investments, and revenue. Additionally, he develops the inventory
policy, which decides the investment in inventory, as well as the credit
policy, which directly affects debt collection.
8.6. MEASURING DIVISIONAL PERFORMANCE
A responsibility center's performance can be evaluated using the methods
listed below:
1) Variance Analysis: This method establishes standard costs and
budgets as a baseline against which actual performance c an be measured.
Corrective action must be made whenever there is a difference between
the two. The standard cost and budget set for each centre are used to
evaluate the performance of the cost centre and revenue centre. On the
basis of performance evaluati on, efforts are made to raise revenue from
the revenue centre while reducing cost from the cost centre.

2) Profit: The performance of a profit centre can be evaluated using
this metric. It is advised that divisional revenue less divisional cost should
be use d to gauge the success of the profit division. As it is assumed that all
costs, fixed or variable, are under the divisional manager's control,
controllable profit is a far better indicator of performance. The total cost
may be a good way to gauge a divisio n's performance, but it is not a good
way to gauge the performance of the divisional manager because that
would mean holding him accountable for costs that he has no direct or
indirect control over.

3) Return on investment (ROI):
This metric reflects the div isional profit as a percentage of firm
investment. This is determined as:
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Responsibility
accounting and transfer
pricing The asset turnover and net profit margin are two additional ratios that can
be used to break down the ROI ratio.


The ROI formula recognises that the relationship between the div ision's
net income and the asset employed in the development of that income,
rather than the division's operating profit's absolute size, provides a basis
for evaluating its success.

ROI has the following advantages:
a) It provides a better indicator of the profitability of the division by
linking net income to investments made in the division.
b) It can serve as the foundation for other ratios that are helpful for
analytical purposes.
c) Because it is based on financial accounting measurement, it is simple
to unde rstand.
d) It can be used to compare the outcomes of different firms as long as
they are in the same sector and are similar in size.
ROI has the following disadvantages:
a) It is challenging to find a satisfactory definition of profit and
investment. Profit enc ompasses a variety of ideas, including
controlled profit, profit after taxes, and profit before tax, etc.
Similarly, the term "investment" can refer to a variety of things,
including gross book value, net book value, historical cost of an
asset, current co st of an asset, and whether or not an asset includes
intangibles.
b) In order to compare the ROI of various companies, it is essential that
the companies utilise comparable stock valuation, fixed asset value,
overhead allocation, and other accounting policies and
methodologies.
c) ROI may persuade a divisional manager to create a high investment
choice. The divisional manager may refuse additional investments
that would lower the division's ROI but raise the worth of the
company.

4) Residual income (RI): Residual in come can be defined as the net
income of a division, less the imputed capital charge on the asset used by
the division. The needed rate of return is applied to the division's
investment base to determine the capital charge, which is the lowest
allowable ra te of return. Theoretically, the rate of return ought to equal the
division's cost of capital, but in most circumstances, it is a cutoff rate
determined by the goals and strategies of the company. RI is determined
by:


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Accounting


RI has following advantages:
a) As in vestments are not rejected only because they reduce the
divisional manager's ROI, it averts suboptimal decisions.
b) By embracing possibilities that generate returns above the cost of
capital, it maximises corporate growth and increases shareholder
wealth.
c) Divisional managers are informed of the opportunity cost of money
thanks to the cost of capital charge on divisional investments.
d) By applying the company's cost of capital to each division, it is
guaranteed that decisions made by various divisions will not conflict
with those of the organisation as a whole.

RI has following disadvantages:
a) Divisional profit and divisional investment are difficult to define in a
way that is satisfying.
b) Determining an appropriate cost of capital may be challenging.
c) It could b e challenging to identify controllable and uncontrollable
factors at the divisional level.
Illustration 1) Division P&R are both considering an outlay on new
investment projects.
Particular Division P Division R
Investment outlays Rs.2,00,000 Rs.2,00,000
Net return on the new investment Rs.32,000 Rs.22,000
Current ROI 18% 11%

The company’s cost of capital is 13%. Should the project be accepted or
rejected?
Solution:
i) Using ROI:


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Responsibility
accounting and transfer
pricing Division P should be rejected the new investment as its ROI is 16% whi ch
is less than the current ROI of 18%. Division R can accept the investment
as its current ROI of 11% is equal to new ROI on new investments.
ii) Using RI:

Particular Division P Division R
Investment 2,00,000 2,00,000
Net income on new investment 32,000 22,000
Less: Imputed cost of Capital 13% 26,000 26,000
Residual Income 6,000 (4,000)

Division P should accept the investment as it will make RI of Rs.6,000
and Division R should be rejected it because it will give a loss of
Rs.4,000.
8.7. MEANING OF TRA NSFER PRICING
Transfer pricing is a problem that arises when goods or services are
moved internally within sections of divisionalized businesses where profit
or investment centres are established. In a decentralized organisation, a
transfer price is the lo cal value at which commodities and services are
transferred between divisions. For products that are supplied from the
selling division to the buying division, known as intermediate products,
transfer prices are typically established. Final products are th e goods that
are produced by the purchasing department and distributed to customers.
8.8. OBJECTIVES OF SOUND TRANSFER PRICING
How should the transfer price of goods and services between divisions be
priced is a concern. The selling division receives money through the
interdivisional transfer of goods and services, and the purchasing division
incurs costs. Since revenue for one division can only be generated at the
expense of another, the pricing charge will have an impact on both
divisions' profits. For in stance, charging greater prices for such a transfer
of goods and services will profit the selling division. But this will mean
increased costs for the purchasing department. A number of requirements
should be met when determining transfer prices.
a) Transfer prices ought to make measuring divisional performance more
precise.
b) Transfer pricing should encourage the divisional manager to make
decisions that will benefit the business as a whole and maximise the
profitability of their division.
c) The transfer price sh ould guarantee the preservation of divisional
autonomy and power. Decentralization's primary goal is to provide
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Accounting success of a profit centre or investment centre. Therefore, it is
improp er to provide a divisional manager authority by putting them in
charge of divisional operations and then revoke it by prescribing
transfer prices that have an impact on the division's performance.
d) Transfer pricing should enable goal congruence, which in pr actice
means that the divisional manager's goals and the company's
overarching goals are aligned.
8.9. METHODS OF TRANSFER PRICING
Pricing the output of one division in comparison to another can be done in
a variety of ways. The decision -making, product co sting, and performance
assessment of various organisational divisions will all be significantly
impacted by the choice of an acceptable transfer price.
Transfer pricing techniques can generally be divided into two types.
They are:
(1) Cost -based and
(2) Market Price -based.
Each of the two procedures mentioned above has a number of variations,
which are covered in more detail below.
1) Market Price Based
This method consists of the following methods:
a) Market Price
b) Adjusted Market Price, and
c) Negotiate d Price

a) Market Price: Any price that can be used as a transfer price is one that
is either a market price or the price of a comparable product that is on the
market and whose details are known. At this market pricing, the selling
and buying divisions a re free to engage in unlimited sales and purchases.
Trading with other managers or outsiders is unimportant to the managers
of the selling and purchasing divisions. As long as the supplying unit is
functioning at capacity, this is OK from the company's per spective. When
there is a competitive external market for the transferred goods, the market
price is relevant for determining the transfer price. This strategy has the
advantage that it can be seen as an opportunity cost to a division as there
is a choice as to whether or not to buy from an outside market.
Furthermore, managers have control over their transfer price, making it
easier to measure performance. This strategy also helps to ensure the
divisions' profit independence, which is another benefit. The selling
division does not transfer any profits to the buying section.

b) Adjusted Market Price: This pricing is based on the market price, but
it has been modified to account for costs like sales commission and bad
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c) Negotiated Price: When there is a foundation for negotiation between
the divisional managers, this price may be offered. Typically, the agreed -
upon price can be either the market price or the cost price. One basis, for
instance, might be the contribution margin on the product being
transferred that is split between the transferor and the transferee, or it
might be the entire cost that the transferer or transferee could suggest, or
the market price. Between these two figures, both division s may be
negotiated. Sometimes the agreed -upon price will be determined by the
manufacturing cost plus a surcharge on top of the estimated market price.

2) Cost Price Based:
Cost Price is an additional approach that can be used to apply a transfer
price whe n moving production across divisions. Companies may choose to
employ some of the cost -based transfer pricing strategies listed below
when there are no external markets or when information about external
market prices is not easily accessible.
a) Absorption Cost
b) Cost Plus Profit Margin
c) Marginal Cost
d) Standard Cost
e) Opportunity Cost
f) Dual prices
Let us study about these methods in brief.

a) Absorption Cost: The complete cost incurred in producing a product is
the basis for absorption or full cost . The selling division cannot realise a
profit on the products moved when full cost alone is employed for transfer
pricing. The drawback of this approach is that any additional costs brought
on by inefficiency may be transferred to other divisions.

b) Cost Plus Profit Margin: Under absorption costing, the selling
division cannot realise a profit on the transferred items when cost alone is
employed for transfer pricing. A selling division is discouraged by this.
Some businesses base their transfer prices on cost plus profit margin in
order to get around this issue.This includes the item's purchase price plus
any markup or additional profit margin. The selling division receives a
profit contribution on the units moved using this manner. Performance
evaluation s based on divisional operating profits are advantageous for the
transferring division as well. However, it also has the disadvantage of
absorption costs, which means that any inefficiencies may also seep into
other divisions.

c) Marginal Cost: The margin al cost is a different transfer pricing
strategy that should be used. When moving output from one division to
another division, all costs that alter due to changes in activity level should
be considered when determining the transfer price. However, because it
has no effect on profit or fixed expenses, this strategy is ineffective at
inspiring divisional managers.
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Accounting d) Standard Cost: Any discrepancies or inefficiencies in the selling
division are transferred to the buying division if actual costs are used as
the foundation for the transfer price. Standard costs are typically used as
the foundation for transfer pricing in cost based systems to encourage
accountability in the selling division and to identify differences across
divisions. The buyer's risk is decr eased by the use of standard charges.
The buyer avoids being charged with the seller's cost overruns because
they are aware that the usual charges would be passed.

e) Opportunity Cost : It stands for the chance that was lost because one
line of action was chosen over another. As a result, if items are transferred
internally, the organisation may forfeit a potential source of profit that
would have come from an outside sale. In cases when the market is
imperfect, an opportunity cost technique will often be u tilised to define a
range of transfer prices. If commodities are transferred internally, the
transfer price should equal the difference cost to the selling division plus
the implied opportunity cost to the company if the selling division has
enough sales i n the intermediate market that it would have had to forgo
those sales otherwise. The equations are:

Transfer Price = Differential cost to the selling division + Implicit
opportunity cost to company if goods are transferred internally.

f) Dual Prices: In a dual price transfer pricing scenario, the selling
division makes a profit by selling the transferred goods at full cost plus
profit margin. The market price, however, is the transfer price for the
buying division. A unique centralised account could be us ed to account for
the variance in transfer prices between two divisions. This approach
would preserve cost information for successive buyer departments and
would promote internal transfers by giving the selling divisions a profit on
such transfers.

As com modities are transferred at a profit or markup, dual prices provide
motivation and incentives to selling divisions. The most suitable base for
the buying division might be thought of as market price. Thus, a dual
pricing structure encourages both the selli ng and buying divisions to make
decisions that are in line with the broader decentralisation objectives.
8.10. SUMMARY
A system of responsibility reporting and control at each managerial level
is known as responsibility accounting, sometimes known as
"Resp onsibility reporting."It is centred on functional activities, for which
certain managers are responsible. When developing a system, one must
consider both its process and structure. The four primary strategies or
principles of responsibility accounting are as follows: I) Restructuring the
organisation into cost, revenue, profit, or investment centres according to
responsibility,(ii) dividing costs into those that are under your control and
those that are not,(iii)Flexible budgeting, and (iv) Performance
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Responsibility
accounting and transfer
pricing three techniques handle responsibility accounting implementation. It has
several uses and offers numerous benefits because the responsibility
centers are the main emphasis. It is a cruc ial tool for management control.
A responsibility accounting system provides data that aids in operation
control and assesses subordinate performance. Corrective action,
management by objectives, and authority delegation are made easier by it.
Because the rewards are related to the achievement, it also boosts morale.
In addition to other factors, the managers' active cooperation is essential to
the system's success. Large decentralized organisations that could treat
departments and divisions as managerial l evels of responsibility have also
adopted it. The success of individual divisions is primarily measured
through responsibility accounting. The most widely used metrics for
evaluating the performance of a division are Return on Investment and
Residual Incom e.
Transfer price is the cost at which the providing division charges the user
division for receiving its output. The choice of a suitable transfer price
will have a big impact on the decision -making and performance
assessment of different company division s. Transfer prices can be set
using a variety of techniques. These techniques fall into two categories:
market price - and cost -based. The market price based consists of (a)
market price, (b) adjusted market price, and (c) negotiated price methods.
Cost bas ed method may again be sub -divided into (a) absorption cost(b)
Cost plus profit margin, (c) Marginal Cost, (d) Standard cost and (e)
Opportunity cost methods. The divisional managers must remember
organisational objective congruence regardless of the trans fer price
technique used because an action taken by one division should not have a
negative impact on the group as a whole.
8.11. EXERCISES
A) Fill in the blanks:
1) In market -based transfer pricing, transfer price is calculated on the
basis of _______.
2) Resid ual income indicates profitability of _________ center.
3) Manpower department is ______ center.
4) Whole organisation is a _______ center.
5) ROI indicates overall profitability of _________ center.
6) The manager of profit center has control over revenue, cost and
_________.
(Answers: 1) Market price, 2) Profit, 3) Cost, 4) invest ment, 5)
Investment, 6) Profit,
B) State whether each of the following statement is True or False.
a) ROI and RI both the methods are to be used in performance
evaluation.
b) Transfer price is th e price at which goods are transferred from one
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Accounting c) The negotiated transfer price is decided by mutual consultation by the
transferer department and transferee department.
d) HR department is a profit center.
e) ROI is return on Fix ed assets.
f) Production department is a investment center.
g) Cost variance is a difference between standard cost and actual cost.
(Answers: 1) True, 2) True, 3) True, 4) False, 5) False, 6) False, 7) True)
C) Theory Questions.
1) Write a note on ROI.
2) Write a note on RI.
3) What is responsibility accounting?
4) What are the different types of responsibility center?
5) Explain the various techniques to measure the performance of a
responsibility center?
6) What are the different methods of Transfer pricing?
7) What is Transfer pri cing? Objectives of sound Transfer pricing.

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ACTIVITY BASED COSTING AND
ACTIVITY BASED MANAGEMENT
Unit Structure
9.0 Objectives
9.1 Definitions – Stages in Activity Based Costing (ABC) .
9.2 Purposes and Benefits of Activity Based Costing.
9.3 Cost Drivers.
9.4 Problems on Activity Bases Co sting.
9.5 Summary
9.6 Questions
9.7 References
9.0 OBJECTIVES:
 To study the Definitions of Activity Based Costing.
 To examine Stages in Activity Based Costing.
 To elaborate Purposes of Activity Based Costing.
 To understand Benefits of Activity Based Costing.
 To Know the cost Drivers
 To solve Problems on Activity Bases Costing.
 To understand the Activity Based Management
 To evaluate advantages of Activity Based Manageme nt
9.1 DEFINITIONS – STAGES IN ACTIVITY BASED
COSTING
9.1.1.Definition:
CIMA defines ‘Activity Based Costing (ABC) ’ as “An approach to the
costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to
activities, and activities to cost objects based on consumption estimates.
The latter utilise cost drivers to attach activity costs to outputs.”
According to Horngren, Foster and Datar ‘ABC is not an alternative
costing system to job costi ng or process costing. Rather ABC is an
approach to developing the cost numbers used in job costing or process
costing systems. The distinctive feature of ABC is its focus on activities as
the fundamental cost objects. In contrast most traditional approach es used
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Accounting systems, not tailored to the activities found in individual organisations.
The ABC approach has the potential to provide managers with
information they find more useful for costi ng purposes.
According to Dansby and Lawrence ‘In ABC costs are not initially traced
to departments. Instead, costs are first traced to activities and then to
products: Activities causing overheads (or cost drivers) are identified.
These activities are lat er used as a base for allocating overhead costs to
products.
Activity Based Costing is based on the belief that in production process
there are various activities which give rise to costs. ABC creates a link
between activities and products by assigning a c ost of activities to
products based on an individual product.
9.1.2:Meaning of some terms used in ABC
a. Activity – Activity is an event that incurs cost.
b. A Cost Object – It is an item for which cost measurement is required
e.g. a product or a customer.
c. A Cos t Driver – It is a factor that causes a change in the cost of an
activity.
There are two categories of cost driver.
i. A Resource Cost Driver – It is a measure of the quantity of
resources consumed by an activity.
ii. An Activity Cost Driver –It is a measur e of the frequency and
intensity of demand, placed on activities by cost objects.
d. Cost Pool - It represents a group of various individual cost items. It
consists of costs that have same cause effect relationship. Example
Machine set -up.
9.1.3 Some example s of cost drivers:
Functional Areas Activities Suitable Cost Drivers
Material
Management Issue of Purchase
order No. of Purchase orders
Inspection of
materials No. of Purchase orders
Stores
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Activity Based Costing
and Activity Based
Management
Servicing of
requisitions No. of requisitions
Inspection and
verification no. of times inspected
Stock taking value of stock

Personnel
Management Recruitment of
employees No. of employees recruited
Maintenance of
Leave records and
attendance No. of employees

Marketing Demand Creation Increase in sales
Advertising Increase in sales
Dispatches No. of Orders
Research &
Development Research No. of Research projects

9.1.4:The design of ABC system involves following stages:
(1) Identifying activities.
(2) Assigning costs to activity cost centres
(3) Selecting appropriate cost drivers
(4) Assigning the cost of activities to products .
These stages may be considered in detail:
1. Identifying Activities:
Identification of the functional areas is the first step for ABC. For example
production will involve activities like ordering, receiving, material
handling, packing, dispatching, use of machine, use of labour etc.
The activities may be basically fall into four categories as suggested by
Cooper and Kaplan.
(a) Unit Level Activities or Primary Activities:
These are those activities for which the consumption of resources can be
identified with the number of units produced. The cost of primary
activities (like use of indirect materials and consumabl es, testing of every
item produced) may be correlated to number of units produced (i.e. on
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Accounting (b) Batch Level Activities:
The activities such as setting up o f a machine or processing a purchase
order are performed each time a batch of goods is produced. The cost of
batch related activities varies with number of batches made, but is
common (or fixed) for all units within the batch. These are manufacturing
suppo rt activities (like material ordering, machine set -up costs, inspection
of products etc).
(c) Product Level Activities:
These are the activities which are performed to support different products
in product line example like designing of the product, keepi ng technical
drawings of product, activities upto date, advertising of a specific product
is called product level
(d) Facility Level Activities:
Certain activities cannot be related to a particular product, instead may be
related to certain facilities like maintaining the building, security of plant,
salaries of production manager, advertisement to promote organisation.
2. Assigning Costs to Activity Cost Centres:
The second stage assigns the cost to the activity cost centre or cost pool.
The resources cons umed by the activity are to be apportioned on some
suitable basis to the cost centre. Resources utilized for advertising will be
a part of the marketing department. Even cost of distribution will be a part
of marketing department.
3. Selecting Appropriate Cost Drivers:
In the third stage the factors that influence cost of a particular activity are
identified. The factors that influence the activity are called as cost drivers.
Example recruitment of employees by personnel department the cost
driver being no. of employees recruited, Purchasing activity by purchase
department the cost driver being Number of orders etc. The organisation
needs to be divided into functional areas and cost drivers of each
functional area need to be identified. The table given in 4. 1.3. Explains the
cost drivers applicable for each functional area.
2. Assigning the Cost of the Activities to Products:
In this fourth and final stage the cost drivers cost is assigned to the service
or product on which it was incurred. The cost driver shou ld be measurable
in a way that enables it to be identified with individual products.


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Activity Based Costing
and Activity Based
Management 3. CALCULATE ACTIVITY COST DRIVER RATES FOR
EACH ACTIVITY,
The Activity Cost driver rate is calculated as follows:

9.2 PURPOSES AND BENEFITS OF ACTIVITY BASED
COSTING.
9.2.1 :Purposes and Benefits of ABC:
1. ABC provides more accurate cost information for the product.
2. ABC aids management by providing meaningful information
regarding the cost for decision making. It helps in decision making
like transfer pricing, make or buy the product etc.
3. It provides accurate and reliable cost information of product and
services. It helps in improving productivity and efficiency of the
firm.
4. It helps in framing pricing policy for the firm. The data collected by
ABC technique related to cost and overheads aids in deciding about
pricing for various levels of output. Pricing policy of the company is
more competitive as ABC provides accurate cost information related
to the product
5. ABC will be more useful if there is significant size of batch lev el
and product level activities.
6. Allocation of overheads or expenses can be ascertained by
identifying the cost driver, the functional area and the product or
service.
7. The focus of ABC is to find out the unit cost of each expense related
to the product.
8. ABC technique provides due importance to non -manufacturing cost
which constitute a substantial portion of total cost It can help in
devising cost reduction strategy by eliminating unimportant cost or
wasteful expenditure.
9. ABC helps creates cost consciousness and so identifying areas which
needs improvement so that organisation becomes cost effective.
10. ABC is beneficial to organisation having multiple products offering.
It can help organisation in decision of discontinuing certain product
line or adding a new p roduct line.

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Accounting 9.2.2 Limitations of Activity Based Costing(ABC)
1. It is not suitable for small organisations.
2. It is expensive in comparison with traditional costing system. The cost
of maintaining ABC system should justify the benefits.
3. It is beneficial for organization with multiple products and not for
organisations with limited products.
4. Selection a suitable cost driver may be difficult and inappropriate.
5. ABC is not beneficial to those organisations whose overheads form a
small proportion of the total cos t.
6. Allocation of all overhead cost to specific activities is a tedious job.
7. ABC implementation may require change in basic structure of
calculation of data under other cost accounting system like marginal
costing, standard costing etc.
8. ABC is a complex sys tem to understand all stakeholders may not be
comfortable with the system.

9.3 COST DRIVERS.
Definition
A Cost Driver is a factor that causes a change in the cost of an activity.
For example, number of units of electricity consumed decided the
electricity c harge, The number minutes or seconds of talk time decides the
telephone bill. So, the units of electricity consumed and the number
minutes of talk time are called as cost drivers.
There are two categories of cost driver. A Resource Cost Driver and An
Activ ity Cost Driver.
A Resource Cost Driver – It is a measure of the quantity of resources
consumed by an activity.
An Activity Cost Driver –It is a measure of the frequency and intensity of
demand, placed on activities by cost objects.
Some examples of cost dr ivers are
1. Number of customers
2. Number of set -ups
3. Number of machine hours
4. Number of purchase orders
5. Number of orders completed
6. Number of labor hours
7. Number of orders packed and deliver
8. Number of product returns from customers
9. Number of service calls.
10. Number of research projects.
11. Number of advertisements
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Activity Based Costing
and Activity Based
Management Cost drivers are an integral part of ABC costing system. The cost
incurred on a product or a service is decided by the resources utilized
by the Cost driver. The cost driver is the cau se of the cost of the
product. A cost driver is factor which creates the cost.
Cost drivers can derive profitability of the resource utilized,
profit/revenue to be derived from each customer etc which help
management to make better decisions.
The major dra wback of Cost drivers is that the fixed cost even have to
be bifurcated in terms of Variable factors.
It is said that activities consume resources while customers ,products
and channels of production consume activities.
For example if there is a Product A ,Number of units produced is 300
units ,having cost drivers like setup cost of production of Rs
10,000,Machine hour utilisation cost of Rs10,000,Customer servicing
Cost of Rs 7,000.
Then the total cost of Product A =Setup cost+Machine Utilisation Cost
+Cus tomer Servicing Cost
Total cost of Product A=10,000+10,000+7,000=27,000
Cost per unit of product A = Total cost/Number of units
= 27,000/300=Rs.90 per unit.
9.4 PROBLEMS ON ACTIVITY BASES COSTING.
Q.01. Tops Ltd. assemble two products from bought in component s A and
B. Details of manufacture are :
A B
Output in units 10,000 15,000
Component Numbers 8 4
Component Cost (Rs.) 4.5 3.6
Number of Production Runs 200 50
Machine Hours per 100 units 2.6 5.3
Items packed in cartons of Overhead Costs
are budgeted at : 10 50
Component Purchasing and Handling (Rs.) 14000
Production Control 18,000
Machine Set -up Costs 25,000
Machine Running Costs 64,355
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Accounting Required :
a) Calculate the overhead recovery rates using Activity -Based Costing.
b) Work out the cost of production of the two components.
Solution:
Key: Calculate cost driver rates and apply them for activity consumption
to find out cost.
Determination of recovery rates:
1. Cost per components = 14,000/12 = 1166.67
2. Cost per Production run = 18 ,000/250 = 72
3. Cost per set -up per production run = 25,000/ 250 = 100
4. Cost of Machine Running per hour = 64,355/ 1,000 = 61.29

A: 2.6/100 X 10,000 = 260
B: 5.3/ 100 X 15,000 = 795
=1,055

5. Packing cost per carton = 31 ,200/ 1,300 = 24
Carton A: 1,000
Carton B: 300
= 1,300
Cost of Production
Component A Component B
Rs. Rs.
Purchasing and Handling 9,333 4,667
Production Control 14,400 3,600
Set Up Cost 20,000 5,000
Machine Running Cost 15,935 48,726
Packing Cost 24,000 7,200
Total 83,668 69,193

Q.02. LG ltd has collected the following data for its two activities.
Activity cost rate is calculated on the basis of cost driver capacity. Activity Cost Driver Capacity Cost (Rs.)
Power Kwh 50,000 kwh 2,00,000
Quality Inspections No of inspections 10,000 Inspections 3,00,000
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Activity Based Costing
and Activity Based
Management The company makes three products Alpha, Beta and Theta.
Consumption of cost drivers reported for the year ended 31st March, 2017.
Product Kwh Quality inspections
Alpha 10,000 3,500
Beta 20,000 2,500
Theta 15,000 3,000
Prepare a statement of allocation of cost to each product under ABC.
Solution:
Key : Calculate cost driver rates and apply them for activity consumption
to find out cost.
Cost per kwh = 2,00,000/ 50,000 = 4
Cost per Inspection = 3,00,000 / 10,000 = 30
Statement of Allocation of Cost under ABC
Alpha
Rs. Beta
Rs. Theta
Rs.
Power @ Rs. 4 per kwh 40,000 80,000 60,000
Quality Inspection 1,05,000 75,000 90,000
Total 1,45,000 1,55,000 1,50,000

Q.03. ACL Ltd has four different customers prompt, regular, careless, and
defaulter. A single product is sold to them at different prices due to trade
discount offered. Prepare customer profitability statement.
Details about four customers
Prompt Regu lar Careless Defaulter
Units sold 600 800 1,000 700
S.P. Rs. 25 25 25 25
Trade discount Nil 8% 16% 12%
No of Sales visits 2 4 6 3
No of purchase orders 30 20 40 20
No of deliveries 10 15 25 14
KMS per journey 20 30 10 50
No of rush deliveries – – 1 2


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Accounting Activity Cost per Activity Rs.
Sales visits 210
Order placing 60
Product handling 10
Normal delivery cost 2 per km
Rushed delivery cost 200 per delivery
Solution:
Key : Calculate cost driver rates and apply them for activ ity consumption
to find out cost.
Customer Profitability Statement
Prompt
Rs. Regular
Rs. Carless
Rs. Defaulter
Rs. Activity
Sales Visits @ 210 420 840 1,260 630
Order Placing @ Rs. 60 Per Order 1,800 1,200 2,400 1,200
Product Handling @ Rs. 10 Per Delivery 100 150 250 140
Delivery Cost Rs. 2 per km 40 60 20 100
Rushed Delivery Cost @ Rs. 200 - - 200 400
Total Cost 2,360 2,250 4,130 2,470
Profit 12,640 16,150 16,870 12,930
Sales 15,000 18,400 21,000 15,400

Q.04. Siemens Ltd. manuf actures two types of machinery model X 150
and X 170
It absorbs overheads on the basis of direct labour hrs. The budgeted
overheads and direct labour hours for March, 2017 are Rs. 12,42,500 and
20,000 hours respectively. The information about the products is as
follows:
X 150 X 170
Budgeted production 2500 units 3,125 units
Direct Material cost Rs. 300 per unit Rs. 450 per
unit Direct Labour
X 150 3hrs @ Rs. 150 Rs. 450
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Activity Based Costing
and Activity Based
Management Activities : Rs.
Order processing 2,10,000
Machine processing 8,75,000
Product Inspection 1,57,500
Total 12,42,500
The data relating to these activities:
Orders
Processed Machine hrs .
worked Inspection
hrs.
X 150 350 23,000 4,000
X 170 250 27,000 11,000
600 50,000 15,000
Calculate cost under ABC
Solution:
Key: Calculate cost driver rates and apply them for activity consumption
to find out cost.
Siemens Ltd.
1. Order Processing pe r Order = 2,10,0000 / 60 = 350
2. Machine Processing per hr. = 8,75,000 / 50,000 = 17.50
3. Product Inspection per inspection hr. = 1,57,500 / 15,000 = 10.50
X 150 X 170
Rs. Rs.
Budgeted Production (Units) 2,500 3,125
Direct Materials (2,500 X 30 0) /
(3,125 X 450) 7,50,000 14,06,250
Direct Labour (2,500 X 450) /
(3,125 X600) 11,25,000 18,75,000
Prime Cost (A) 18,75,000 32,81,250
Add : Overheads
Order Processing @ Rs. 350 per
order 1,22,500 87,500
Machine Processing @ 17.5 per
hr. 4,02,500 4,72,500
Production Inspection @ Rs.
10.5 per hr. 42,000 1,15,500
(B) 5,67,000 6,75,500
Total (A + B) 24,42,000 39,56,750
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Accounting Q.05. PTL plans to use. ABC to decide its cost. At present it allocates
factory overheads to products on the basis of direc t labour hours. Total
factory overheads are as follows:
Department Factory overheads ( Rs.)
Product support 2,25,000
Production (Factory overheads only) 1,75,000
Total cost 14,00,000
The company performs four major activities in production support
departmen t. These activities along with their budgeted costs are as
follows:
Production Support Budgeted cost activities (Rs)
Set up
Production control
Quality control
Materials management 4,28,750
2,45,000
1,83,750
3,67,500
Total 12,25,000

The company supplies following details:
Produ
cts No. of
units Direct
labour
hrs. Set-
ups Production orders InspectionMaterial requisitionsA 10,00
0 25,000 80 80 35 320
B 2,000 10,000 40 40 40 400
C 50,000 1,40,00
0 5 5 0 30
62,000 1,75,0
00 125 125 75 750

Required :
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Activity Based Costing
and Activity Based
Management Solution:
Key : Calculate cost driver rates and apply them for activity consumption
to find out cost.
Factory Overhead per hr. = 1,75,000 / 1, 75,000 = 1
Cost per set up = 4,28,750 / 125 = 3,430
Cost per Order = 2,45,000 / 125 = 1,960
Cost per Inspection = 1,83,750 / 75 = 2,450
Cost per requisition = 3,67,500 / 750 = 490
Cost as per ABC
A
Rs. B
Rs. C
Rs.
Product Support
Set up Cost @ Rs. 3,430 2,74,400 1,37,200 17,150
Production Control @ Rs. 1,960 per Order 1,56,800 78,400 9,800 Quality Control @ Rs. 2,450 per Inspection 85,750 98,000 - Material Management @ Rs. 490 per Requisition 1,56,800 1,96,000 14,700
Production
@ Rs. 1 per hr. 25,000 10,000 1,40,000
6,98,7 50 5,19,600 1,81,650

Cost as per direct labour hour basis
Cost per labour hour = 14,00,000 / 1,75,000 = 8
Total Cost
A (Rs.) B (Rs.) C (Rs.)
Overheads per hr. Rs. 8 2,00,000 80,000 11,20,000
Total 2,00,000 80,000 11,20,000


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Accounting Q.06. The budgeted overh eads and cost drivers’ volume of XYZ Ltd are
as follows :
Cost Pool Budgeted
overheads
(Rs.) Cost driver Budgeted
volume ( Rs.)
Material procurement 5,80,000 No of orders 1,100
Material handling 2,50,000 No. of movements 680
Set up 4,15,000 No of set up 520
Maint. 9,70,000 Main. hrs 8,400
Quality control 1,76,000 No. of inspections 900
Machinery 7,20,000 No. of machine hrs 24,000

The company has produced a batch of 2600 components of AX -15, its
material cost was Rs. 1,30,000 and labour cost was Rs. 2, 45,000. The
usage activities of the said batch are as follows
Material orders 26 Maint. Hrs. 690 Material movement 18 Inspection 28 Setups 25 Machine hrs 1,800

Ascertain the cost driver rates. Ascertain the cost of batch of component
using ABC.
Solutio n:
Key : Calculate cost driver rates and apply them for activity consumption
to find out cost.
Calculation of Cost Driver Rates
1. Cost per Order = 5,80,000 /1,100 = 527.27
2. Material Handling per Movement = 2,50,000 / 680 = 367.65
3. Cost per set up = 4,15,00 0 / 520 = 798.08
4. Cost per Maintenance hr. = 9,70,000 / 8,400 = 115.48
5. Cost per Inspection = 1,76,000 / 900 = 195.56
6. Cost per Machine Hr. = 7,20,000 /24,000 = 30


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Activity Based Costing
and Activity Based
Management Statement of Cost under ABC
Particulars Rs. Rs.
Direct Materials 1,30,000
Direct Labour 2,45,000
Prime Cost 3,75,000
Overheads
Material Procurement (26 ´
527.27) 13,709
Material Handling (18 ´ 367.65) 6,618
Set up (25 ´ 798.08) 19,952
Maintenance (690 ´ 115.48) 79,681
Inspection (28 ´ 195.56) 5,476
Machinery (1,800 ´ 30) 54,000 1,79,436
5,54,436

9.5 SUMMARY
CIMA defines ‘Activity Based Costing(ABC)’ as “An approach to the
costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to
activities, and activities to cost objects based on consumption estimates.
The latter utilise cost drivers to attach activity costs to outputs.” Activity
Based Costing is based on the belief that in production process there are
various activiti es which give rise to costs. ABC creates a link between
activities and products by assigning a cost of activities to products based
on an individual product. The design of ABC system involves stages like
Identifying activities, assigning costs to activity cost centres, selecting
appropriate cost drivers, assigning the cost of activities to products and
calculating activity cost per unit. The identification of activities basically
falls into four categories as suggested by Cooper and Kaplan. They
are unit level activities or primary activities, batch level, product level
activities and facility level activities. Benefits of ABC are ABC provides
more accurate cost information for the product. ABC aids management by
providing meaningful information regarding th e cost for decision making.
It helps in decision making like transfer pricing, make or buy the product
etc. It helps in framing pricing policy for the firm. ABC helps creates cost
consciousness and so identifying areas which needs improvement so that
organ isation becomes cost effective. Limitations of Activity Based
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Accounting system as compared to traditional costing system and so may not justify
the cost. It is of limited use if the overhead f orms a small proportion of the
total cost of production. A Cost Driver is a factor that causes a change in
the cost of an activity. For example, number of units of electricity
consumed decided the electricity charge, The number minutes or seconds
of talk t ime decides the telephone bill. So the units of electricity consumed
and the number minutes of talk time are called as cost drivers. There are
two categories of cost driver. A Resource Cost Driver and An Activity
Cost Driver. Some examples of cost drivers are Number of customers,
Number of set -ups, Number of machine hour’s etc. Cost drivers are an
integral part of ABC costing system. The cost incurred on a product
or a service is decided by the resources utilized by the Cost driver. The
cost driver is the cause of the cost of the product. A cost driver is
factor which creates the cost. The major drawback of Cost drivers is
that the fixed cost even has to be bifurcated in terms of Variable
factors. It is said that activities consume resources while customers ,
products and channels of production consume activities.
9.6 QUESTIONS
Q.01. Theory questions:
1. What is Activity based Costing (ABC)?
2. What are the advantages and limitations of ABC costing system?
3. What is a cost driver explain in detail with examples?
4. What are the steps or stages of ABC costing?
5. Explain in detail the four categories of identification of activity?
Q.02. Fill in the blanks:
1. The distinctive feature of ABC is its focus on activities as the
………. objects.
2. ABC stand for ……….
3. ABC creates a …….. betwee n activities and products
4. Activities are used as a base for …….. overhead costs to products.
5. ABC technique provides ……and …….. cost information.
6. ABC enables the management in formulating an effective …….
while fixing prices.
7. ABC helps in Identifying ………
8. ABC technique Assigning costs to activity ……
9. ABC helps in Selecting appropriate ………
10. ABC Assigning the cost of activities to ……..
Answers: 1. fundamental cost 2. Activity Based Costing 3. link 4.
allocating 5. accurate , reliable 6. pricing policy 7. Activit ies 8. cost
centres 9. Cost drivers 10. Products


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Activity Based Costing
and Activity Based
Management Q.03 Complete the Following Table:
Sr. No. Functional Areas Activities Suitable Cost Drivers
01 Material Management
02 Stores Management
03 Quality Control
04 Personnel Management
05 Market ing
06 Research & Development
07 Matching

9.7 REFERENCES: RECOMMENDED BOOKS
1) Advanced Cost Accounting Jain - Narang.
2) Advanced Cost Accounting B. K. Bhar.
3) Advanced Cost & Management Accounting Saksena Vaishtha
4) Cost & Management Accounting : Problems &Solutions P. V.
Rathanam.
5) Advanced Cost Accounting N. K. Prasad.
6) Advanced Cos ting & Management Accountancy Subhash Jagtap.
7) Advanced Cost Accounting Sharma Nigam.
8) Cost Accounting Wheldon.
9) Journal of I. C. W. A. The Management Accountant.
10) Cost Accounting : A Management Emphasis Horngreen.




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TARGET COSTING
Unit Structure
10.0 Learning Objectives
10.1 Introduction
10.2 Target Costing
10.3 Meaning and Principles of Target Costing
10.4 Methodology of Target Costing
10.5 Procedures of Target Costing
10.6 Advantages of Target Costing
10.7 Implementation of Target Costin g
10.8 Summary
10.9 Questions
10.10 References
10.0 OBJECTIVES
After studying this unit, you will be able to:
 State the principles of Target costing
 Identify the Methodology involved in Target costing
 Discuss the Procedures of Target Costing
 State the advantages a nd disadvantages of Target costing
10.1 INTRODUCTION
In this Unit, we will study Target costing determines life cycle which
should be sufficient to create specified functionality and quality while
maintaining the product's intended profit margin. The evalu ation, benefits
and challenges involved in Kaizen costing.
It is always utilized to lower cost in the context of pricing in a competitive
world by constant improvements and replacement of technology and
processes. In general, the cost of any product is det ermined by analyzing
the best structure of the country's main competition.
10.2 TARGET COSTING
Target costing is a cost management method. The gap between goal sales
and target margin is known as target cost. It is, in this manner, the
difference between a ssessed selling cost of a proposed item with
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It first emerged in Japan in the 1960s as a response to challenging market
conditions. A proliferation of consumer and industrial products from
western f irms was overcrowding the market in Asia, and Japanese firms
were also short on the resources and skills needed to develop new
concepts, tools, and techniques required to compete with the toughest
western competitors in terms of quality, cost, and producti vity.
Target costing is widely used in Japan, with more than 80% of companies
in the assembly industry and more than 60% of enterprises in the
processing industry using it.
Target costing has come from a Japanese term “Gena Kikaku.”
The technique aims to c reate and sell products with the desired profit
margin. The company must understand what value target customers place
on various attributes and aspects of product quality while designing the
product.
On the one hand, this pricing approach is used to suit client requests,
while on the other side; the organization's profit goals are met.
The focus of target costing is on cost reduction at the planning and design
stages of the product life cycle, because this is where the majority of the
product cost is set.
Customers' preferences and the value they place on various qualities and
quality indicators necessitate extensive marketing research. The company
operates within the parameters of maximal attributes and quality it can
provide, as well as the bare minimum a cceptable to target customers.
During the cost -cutting process, cost -engineering techniques are used.
Some of the major methodologies employed include the just -in-time
approach, total quality control, value analysis (also known as value
engineering), and s o on.
Cooper defines target costing as “a disciplined process for determining
and realizing a total cost at which a proposed product with specified
functionality must be produced to generate the desired profitability at its
anticipated selling price in the future”.
Furthermore, both the price and the cost are for a certain product
functionality, which is established by a thorough understanding of the
demands of customers and their willingness to pay for each function.
There is an intrinsic acknowledgment th at there are enough elements in
the process that are fundamentally outside the control of the organization -
the selling price is determined by the marketplace, which includes
worldwide customers, competitors, and general economic conditions.
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Accounting

Fig 10.1 T arget Cost Concept
10.3 MEANING AND PRINCIPLES OF TARGET
COSTING:
Product costing is another name for target costing. It is a new technique,
and today's accountants are changing from traditional costing to product
costing, which takes into account original design and engineering costs, as
well as manufacturing, distribution, and sales and service costs. In Japan,
the concept of target costing is extensively used.
A target cost is the highest amount of cost that may be expended on a
product while still allow ing the company to earn the requisite profit
margin at a given selling price. A specific selling price is used in target
costing. It entails deducting a desired profit margin from a competitive
market price to arrive at a target cost.
It is always utilized to lower cost in the context of pricing in a competitive
world by constant improvements and replacement of technology and
processes. In general, the cost of any product is determined by analyzing
the best structure of the country's main competition.
Profi t is added to the cost to determine the target price. Efforts are being
made to hit the goal cost. Cost accounting, Product Development, and
Engineering departments collaborate on this project.
CIMA – “Target cost is a product cost estimate derived from a
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10.3.1 Formula used to calculate Target Costing:
Selling Price – Profit Margin = Target Cost
Example of Target Costing
ASM Ltd. is a big player that operates in different competitive market. It
sells wrapped foods to customers. ASM can only charge 40 per unit. If the
intended profit Margin of the company is 20% on the selling price,
calculate the target cost per unit.
Solution:
Target Profit Margin = 20% of 40 = 8 per unit
Target cost = Selling Price – Profit Margin
= 40 – 8
= 32 per unit
So, target cost is Rs. 32 per unit.
10.3.2 Objectives of a Target Costing System:
1. Reduce the expenses of new items in order to maintain the required
profit margin.
2. The new items meet the market's requirements for quality, delivery
time, and pricing.
3. Make target costing a business -wide profit management activity to
inspire all firm employees to reach the target profit during new product
development.
10.3.3 Features of Target Costing
1. It is considered an import ant aspect of the creation and launch of new
products.
2. Various sales forecasting methodologies are used to estimate a target
selling price.
3. Given the link between price and volume, the goal selling price is used
to determine target production volumes .
4. The goal of the target costing process is to identify cost -cutting targets.
5. When the permissible cost and the desired cost diverge, a reasonable
amount of judgement is required.


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Accounting 10.3.4 Characteristics of Target Costing
(1) Opportunity Identifica tion –
Opportunities for cost reduction can be easily recognized with the use of
value engineering and value analysis. Value engineering is looking for
ways to change the design in order to reduce costs without sacrificing
product quality.
Similarly, value analysis entails excluding non -value -adding activities that
could reduce costs without lowering product quality. As a result, the
present cost is decreased to the goal cost. When production begins, it is
expected that the overall cost will meet the target while simultaneously
generating a profit.
(2) Estimated Cost –
The target cost is calculated by subtracting the target price from the goal
income.
(3) An Important Aspect of the Design -
Target costs is a well -known component of the design and launch of n ew
products.
(4) Price Target –
It is the product's expected market price. It is a target price that is
calculated using various sales forecasting methodologies, taking into
account product design criteria as well as competitive market conditions.
(5) Cost -cutting goal –
The cost -cutting target is set, which necessitates an estimate of the
existing cost of the new product. It is built on the foundation of existing
technologies and their numerous components. The cost reduction is
determined by the difference between current and desired costs.
10.3.5 Target Costing – Approaches (With Equations)
The customer is at the center of the target costing system. Before
launching a product (or a family of goods), a company uses the target
costing strategy to define the optimum selling price, determine the
feasibility of hitting that price, and then control expenses to guarantee that
the price is met.
The target costing method differs significantly from the traditional
approach to price fixing and cost control.
1. Convention al Approach:
The traditional pricing strategy is cost plus. The strategy is to design a
product that can be manufactured at the lowest cost, then add a desired
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We may present this approach in an equation form as follows:
S = C + P
If the company believes the price is too high, it alters the design to lower
the cost and, as a result, the required selling price. If the company is
unable to determine the projected selling price, the pro duct is released at
the original design's estimated selling price.

Another common strategy is to design a product in such a way that it can
be manufactured at the lowest possible cost, then match the cost to the
expected selling price.
The profit margin is determined as presented in the following
equation:
P = S-C
If the profit margin falls below an acceptable level, the product is
modified to cut the cost as much as feasible until the required profit
margin is reached.
The emphasis in both traditional app roaches is on cost reduction rather
than cost management. After the development stage, cost -cutting
initiatives begin. Both methods result in manufacturing efficiencies that
can be implemented beyond the product design stage. As a result, cost -
cutting oppo rtunities are limited.
According to one study, a cost reduction of up to 10% is possible.
Managers are not compelled to predict how much the customer will pay
for each feature of functionality and quality under traditional
methodologies. Each product used to be thought of as a complete package
of functionality and quality, with little room for customization.
2. Target Costing Approach:
Target costing is a method of costing that starts with the customer's need
and willingness to pay and works backwards. The dep endent variable in
target costing is cost, whereas the dependent variable in traditional
techniques is selling price or profit.
The relationship between the variables can be presented as follows:
C = S-P
The target costing method understands that price, co st, functionality, and
quality all have a trade -off. At the product development stage, managers
assess this trade -off and optimize product functionality and quality within
the limits of expected selling price, target cost, target volume, and target
launch date.

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Accounting Product Development Discipline with Structure:
Understanding customers' needs, industry price dynamics, product
complexity and life cycle analysis, and supplier interactions are all part of
target costing, a highly structured product development di scipline.
The target costing system necessitates the mapping of various client
segments, and the cost and revenue analysis gives data to find the most
profitable segment. The product development and design team identifies
the optimal functionality and desi gn bundle (in terms of margin and pre -
determined target cost) that will be successful in a certain segment.
The Tata 'Rs 0.1 -million automobile' is an example of the target costing
strategy in action. The Rs 0.1 million car was designated one of the year's
trendsetters by Business Week, and Ratan Tata was named one of the
world's 'Most Important People'.
10.4. METHODS OF PRODUCT DEFINITION
ANALYSIS:
Comparison between Traditional Cost Management Approach and Target
Costing Approach
The cost of a product is regarded as a dependent variable resulting from
decisions made concerning the product's functions, features, and
performance capabilities under the Traditional Cost Management
Approach. Because cost estimation occurs late in the development cycle,
costs a re often greater than planned.
The target costing technique, on the other hand, is considerably different.
Target costing is built on three pillars:
1) market -driven pricing, or product orientation toward client
affordability.
2) product cost is treated a s an independent variable, and
3) Efforts made during the development phase of the process to achieve
the goal cost at the outset.
10.4.1 Target Costing vs. Standard Costs: What's the Difference?
The following are the differences between target costing and standard
costs:
Target costing and standard expenses should not be misconstrued as one
and the same. There is a distinction to be made between the two terms.
Standard costs are predetermined costs established by industrial engineers
or cost accountants ba sed on an internal examination of usual situations.
Target costs, on the other hand, are based on external market study and
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Target costing depends primarily on quantitative methodologies;
however non -quantitative methods are often empl oyed:
10.4.2. Analysis of Values
1. The Value Concept:
It can be useful to know what the term 'value' means in this context. In
truth, the term 'value' has diverse connotations for different people. For
example, "value" signifies the quality of the product to a designer, "value"
is the price a salesman can get for the product in the market to a salesman,
and "value" means return on capital used to top management.
An industrial product, on the other hand, may have the following value
concepts:
i) Usefulness :
This refers to the features that the items should have in order to offer the
intended service. A watch, for example, is used to keep track of time. It is
offering its full use value if it delivers fairly accurate time.
The quality of performance is used to determine the usage value. To
determine whether a product is worth the money spent on it, divide its
value for the individual concerned by the price paid for it.
A product can be used for a variety of purposes.
As a result, its utility value can be sepa rated into three groups:
(a) Value for primary usage;
(b) Value for secondary use; and
(c) Value of auxiliary use.
Paint, for instance, has various usage values. Its principal application
value is when it is used to protect a surface. It has a secondary us e value
when used to draw lines on the road for pedestrians to cross.
When it pleases the aesthetic sense, it has a secondary utility value. Such a
functional classification would aid in determining which paint to employ
while keeping the goal in mind. If this is not done, it is possible that
expensive enamel paint will be used where plain paint would have been
more prudent.
(ii) Value for Money:
If the product is manufactured in -house, the value is calculated in terms of
cost. It is a term used to describe the expense of production. When a
product is purchased from a third party, it refers to the cost of the
purchase.
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Accounting (iii) Value of Exchange:
It refers to the amount of money a product might sell for. It is crucial for
the sales department since the profit is the difference between the selling
price (i.e., exchange value) and the product's cost.
As a result, the sales department must determine the product's worth to
customers in comparison to other products on the market. It will assist the
management in det ermining the product's selling price.
(iv) Self -esteem:
The prestige value is another term for this. Certain things or articles are
valuable solely because they are appealing or have desirable
characteristics. A gold watch has a higher perceived value for its owner
than a regular watch, despite the fact that its functionality is similar to that
of a regular watch. A gold watch may be a waste of money for certain
people. It does, however, have a value for someone who desires to impress
others and so gain per sonal gratification.
The technique, also known as value engineering, focuses on improving
value by resulting in a rigorous and in -depth examination of products at
the design stage. The various components can be altered or uniformed. It's
also possible to u se less expensive production processes or technologies.
Such a study exposes the fields in which avoidable expenses exist, and
once these areas have been identified, actions can be taken to eliminate or,
if not possible, reduce such unwelcome expenditures, all while
maintaining quality.
2. Total Quality Management:
It is a quality control method created by the Japanese. Total quality
control also includes quality inspection efforts across the board, rather
than just inside certain divisions.
3. Economic Ord er Quality Analysis and Just -in-Time Material
Requirement Planning:
Firms began utilizing cost -cutting approaches in place of the conventional
way of keeping certain stocks on hand. The just -in-time approach,
material requirement planning, and calculation of economic order quantity
are some of the techniques that help reduce material and consequently
product prices.
Market analysis, competitive analysis, and product mapping are just a few
examples. For this aim, a market feature table might be prepared.


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Fig :10.2 Market analysis
The objective of the table above is to map the attributes needed by various
market segments in one location. It aids in focusing on truly material
qualities or functionalities at a high level market for the possible product
is divided into "natural" market groups – which may be defined by
geographical locations, client types of business, customer wealth, and so
on.
Each market segment's required attributes are divided into three
categories:
i) Basic –
All customers in the catego ry want these, and they're willing to pay for
them.
(ii) Take a step forward –
These are additional or optional features desired by a few customers in the
segment who are willing to pay a higher price for them.
(iii) Premium –
This is the most expensive op tion.
Only a small number of high -end clients are willing to spend even a
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Accounting The chart also shows the market siz+e in each category in terms of the
number of potential units that can be sold or the potential revenue.
Passenger automobiles, writing pens, and a variety of other consumer
durables are examples of such commodities in real life. In such
circumstances, specific market share can be captured by responding to the
wants of the identified clients; as the goal price w ill be greater, a higher
target cost is irrelevant. However, in general, the fundamental product
aimed at a certain segment of the market will have to be sold at a lower
price in order to reach that segment of the market.
5. Market Price Determination Meth ods - Experience Curves or
Learning Curves:
This method plots the product's historical market price as a function of the
industry's cumulative sales of that product. If there is a straight line, it is a
very good predictor of short -term prices.
If the prod uct is cellular telephone network equipment, the price of the
equipment divided by the number of customers it can service is plotted
against the total number of cell -phone subscribers in the world in 'More
than curve.'
6. Using Activity -Based Costing to Ca lculate the Price:
Following the determination of the overall goal cost, cost targets are
established for each of the components, subsystems, and parts that make
up the set of total costs to be included. Value engineering can be used in
this situation as w ell. A matrix is built that connects different product
attributes to the various product pieces.
The ABC analysis of material control can be used to determine which
elements demand more attention in cost -cutting efforts.
7. Techniques for Brainstorming:
Think tanks and think banks can be established to generate new ideas and
unconventional solutions to vexing issues. Brainstorming sessions can be
held by a group of brilliant people from many fields, which may include
employees, suppliers, outside specialist s, and so on, to consider problem
areas and provide new cost -cutting solutions.
There is a perpetual need for product improvement and cost reduction. As
soon as a product is released and accepted in the market, prices tend to
fall. Profitability rises as a result of increased sales, even when profit
margins are low.
As a result, target costing is an excellent strategy for guaranteeing that the
company has lucrative items that are well matched to the needs of its
customers. The entire procedure is straightfo rward, rational, and simple to
carry out. The most important concerns should be prioritized; this will aid
in uniting the various elements of the organization.
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10.5 PRINCIPLES OF TARGET COSTING:
Target costing is a new costing approach that requires work ing backwards
from the selling price to the overall cost. The target costing principle is as
follows:

Fig 10.3 Principles of Target Costing
1. Price -led costing:
Target costing establishes the target cost by determining the market price
at which a produ ct can be sold. The target cost, or the cost at which the
product must be created, is calculated by subtracting the target profit
margin from the target price. It's worth noting that with a target costing
strategy, the price is set first, followed by the t arget product cost. Under
classic cost -plus pricing, the product cost and selling price are established
in the opposite order.
2. Focus on Customer:
Management should listen to the company's customers in order to be
successful at target costing. What product s are they looking for? What
characteristics are essential? What is the maximum amount they are ready
to spend for a specific level of product quality? Customer feedback must
be aggressively sought by management, and products must then be
produced to meet customer demand and provided at a price that they are
prepared to pay. In a nutshell, target costing is a market -driven approach.
3. Focus on process and design:
Target costing relies heavily on design engineering. Engineers must create
a product from the ground up in order for it to be manufactured at the
desired cost. This activity includes specifying the raw materials and
components to be used, as well as labor, machinery, and other aspects of
the manufacturing process. In other words, a product must be developed to
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4. Cross -functional:
To ensure that the product is manufactured as effectively as possible,
every aspect of the manufacturing process must be reviewed. Touch labor,
technology, global sourcing in procurement, and every component of the
manufacturing process must be developed with the desired cost of the
product in mind.
5. Value Chain involvement:
Market research, sales, design engineering, procurement, production
engineering, production scheduling, material handling, and cost
managem ent are just a few of the functions that must be involved in order
to manufacture a product at or below its target cost. Individuals with
knowledge in all of these fields can make significant contributions to the
target costing process. Furthermore, a cross-functional team isn't just a
group of experts who offer their knowledge and then go; they're in charge
of the complete product.
6. Life-Cycle Costs:
When determining a product's target cost, analysts must ensure that all of
the product's life-cycle costs are considered. Product planning and concept
design, preliminary design, comprehensive design and testing, production,
distribution, and customer service are all included in these expenditures.
Traditional cost-accounting methods have tended to focus solely on the
production phase of a product's life cycle, neglecting to account for the
product's other costs.
7. Value -Chain Orientation:
A new product's predicted cost may be higher than the goal cost. Then, in
order to reduce the estimated cost, attempts are made to eliminate non-
value -added costs. In some circumstances, a comprehensive examination
of the company's whole value chain might aid managers in identifying
cost-cutting options.
10.6 METHODOLOGY OF TARGET COSTING:
The process of target costing involves:
1. D etermining the target price in light of market conditions and
competition;
2. Determining the profit margin target;
3. Identifying the maximum permissible cost that must be met;
4. Estimating the likely cost of existing products and processes;
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Planning, Development, and Production Phases of Target Costing
Target costing is a market -driven approach to costing.
The following are the three phases of this methodology:
1. Planning :
All rivals' produ cts must be evaluated in terms of price, sales, quality,
technology, and service, among other factors, before determining a target
cost and determining the market share of one product.

2. Development:
After reviewing and studying various cost -cutting techniq ues and
Activity -based costing, the organization's cost structure must be finalised,
and then an appropriate design must be established.

3. Production:
Production targets are set, and efforts are made to meet them at the lowest
possible cost without compromi sing quality, technology design, or
manufacturing procedures.
10.4 PROCEDURES OF TARGET COSTING

Fig 10.4Methodology of Target Costing

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Accounting 1. Set a selling price :
We must establish a precise selling price that is in line with the market and
the needs of our clients. It can serve as a market and competitor
benchmark.
2. Set target profit :
We must adhere to our company's profit target, which is set by top
management.
3. Calculate target cost :
Calculate target cost by subtracting the goal profit from the selling pr ice
determined in the previous step.
4. Calculate cost gap :
A cost gap exists when the actual cost exceeds the desired cost. As a
result, we must compare the actual and target costs during production.
5. Necessary action to close the gap :
We must examine the c ost of production from beginning to end in order to
determine the core reasons of the gap. The gap is frequently caused by an
inefficient process that has to be improved. In this instance, we must
continue to track the progress of the procedure throughout time
10.6 ADVANTAGES OF TARGET COSTING:
(1) Favourable Influence on Profitability:
Target costing has a positive impact on the organization's profitability
throughout the product life cycle.
(2) Company Competitive Future:
Because the product is created and man ufactured according to market
criteria, this costing aids in the creation of a company's competitive future.

(3) Top to Bottom Commitment:
It aims to identify challenges and supports top -to-bottom commitment to
process and product innovation.

(4) Valua ble Edition to Life Cycle –
This costing might be an excellent addition to life cycle items.

(5) Management Control System –
It employs a management control system to aid manufacturing plans and
find market opportunities that may be converted into real savings in order
to maximise value.



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Some more different benefits are:
1. It helps in guaranteeing that products are better coordinated to their
client's necessities.
2. It helps with adjusting cost of components to customer’s ability to pay
for them. I n the process quality stands improved.
3. It upholds decrease of improvement pattern of the product.
4. It is valuable for decrease of expenses of costs generously.
5. It improves teamwork among all internal organisations involved in
product conception, marketing, planning, development, production,
selling, and distribution.
6. It aids in the engagement of customers and suppliers in order to build
the best product and integrate the complete supply chain more
effectively.
Disadvantages of Target Costing:
1. Low Budget Design:

The design team will have a difficult time completing their work due to
the product’s cost requirement. They must collaborate with other
departments to guarantee that the product stays under budget. They must
limit their innovation i f it results in a cost increase.

2. Depend on market price:
Because we calculate the target cost by subtracting the market price from
the margin, if the market price is incorrect, the entire system will collapse.
We normally have to rely on market prices obtained through market
research, thus any flaws in the study will have an impact on our pricing.
Because some products are comparable yet have different attributes, we
cannot utilise their selling price.

3. Cheaper material or technology:
Some business es may use low -quality materials, resulting in low -quality
products for their clients. The company buys obsolete equipment to save
money, but it has long -term consequences because we stayed with them
for a few years (fixed asset useful life).

4. Productio n cost unrealistic, and estimation cost is too low:
The design team may come up with an extremely restrictive production
budget to meet the goal cost. As a result, the production staffs are under a
lot of pressure. If there is a slight negative variance, the target cost will not
be met. To do the assignment flawlessly, the crew would need to erase any
mistakes or errors, which would only happen on paper.

5. Failure of proper estimation of the quantity:
Even if we achieve the desired cost, we may not be profitable if the sales
volume falls short of the budget. This occurs when the profit margin is
insufficient to pay the whole fixed costs.
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Accounting 10.6.1 Implementation of Target Costing:
1. Conduct market research
To comprehend and establish a customer's wants, the comp any performs
market research. This aids in making practical modifications to existing
items as well as designing new products based on the customer's
perceptions and expectations.
2. Identifying the market
The data gathered through market research proves t o be a boon to the
company. It provides information on the different sorts of products
accessible on the market, the level of competition it may encounter, the
number of competing companies it will have to deal with, and the prices at
which the products ar e now available.
It is also critical to obtain an estimate of the amount that a client perceives
to be reasonable pricing so that modifications can be made.
3. Specifications of the product
Obtaining information about a customer's preferences is a time -consuming
process because their demands and needs differ from one another. The
company considers the typical requirement and transforms it into a
concrete item known as a product.
4. Product development
By examining client wants, prevalent market dynamics, co mpetitor
models, appropriate technology, process capabilities, design alternatives,
and service requirements, the company creates a product that it believes is
acceptable for the current market conditions.
5. Calculate the cost, profit margin, and pricing.
The market survey is what sets a product's target selling price. Standard
margin is also included in the desired selling price by the business
organizations.
6. The process of value engineering
If you want to hit the desired cost, go through the value eng ineering
process.
7. Make improvements to the designs
The firm can do a small -scale trial production to ensure the desired profit
margin, cost, and product performance. It comes to a close when the target
cost and product design are in sync.

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8. Formal appr oval
The top management receives a detailed report about the design of a
particular product, costs to be incurred, and elements of cost and
production process for a formal approval so that the company can say yes
to commercial production.
9. Maintaining ac counts
It is vital to maintain separate accounts for each product design so that you
can verify whether total expenses exceed the target cost for any product.
For a formal permission so that the company can say yes to commercial
production, top management receives a full report regarding the design of
a particular product, costs to be incurred, and components of cost and
manufacturing process.
10. Implementing target costing
The organization gathers the essential data in regard to the costs paid for
each de sign, and this data is collected individually. It maintains a tight eye
on the total cost in order to keep it within the intended range.
10.8 SUMMARY
 Target cost = Target selling price ( -) Target profitmargin
 Target costing is a method for defining produc t cost goals that are
based on market norms.
 Target costing is a cost -cutting strategy. The gap between goal sales
and target margin is known as target cost. It is thus the gap between the
goal margin and the expected selling price of a proposed product wi th
defined functionality and quality.
10.9 QUESTIONS
A. Descriptive Questions
Short Questions
1. Explain the meaning and principles of Target costing.
2. What are the phases in Target costing?
3. Write a note on Target Costing.
Long Questions
1. Explain the advantages and disadvantages of Target Costing.
2. Explain the Methodology of Target Costing.
B. Multiple Choice Questions
1. Target costing has been derived from a ……………. Term.
a. Indian
b. Greek
c. American
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Accounting
2. ……….. is a new costing approach that requires working backward s
from the selling price to the overall cost.
a. Kaizen costing
b. LCC
c. Marginal Costing
d. Target Costing
Answers
1-d, 2-d,
10.10 REFERENCES
References book
 Charles T. Harngreen, Srikant M. Datar, George Foster, Cost
Accounting,
 A Management Emphasis, Pearson Ed ucation, 2008, p. 3. Managerial
Accounting,
 Cost Management Ibid Management Accounting,
 A Strategic Approach Strategic Cost Management Cost Management,
 A Strategic Emphasis Cost Management,
 What is Strategy Cost Management, A Strategic Emphasis Ibid., e t al.,
Ibid., Cost Management Ibid., et al, Ibid., et al., Ibid. Activity
Accounting
Textbook references
 Ravi. M. Kishore, Cost Management, Taxman, Allied Services (p)
Ltd.,
 S. Mukherjee & A.P. Roychowdhury, Advanced Cost and
Management Accountancy, New Ce ntral Book Agency, Calcutta.
 Keith Ward, Strategic Management Accounting, Butterworth
Heirmann Pub.
 John K. Shank, Cases in Cost Management: A Strategic Emphasis,
South -Western Publishing, Thomson Learning.
Website
 https://www.accountingnotes.net/cost -accounting
 https://www.yourarticlelibrary.com/accounting

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LIFE CYCLE COSTING
Unit Structure:
11.0 Objectives
11.1 Introduction
11.2 Life Cycle Costing
11.3 Meaning and Phases of Life Cycle Costing
11.4 Product Life Cycle Phases
11.5 Advantages of Life Cycle Costing
11.6 Disadvantages of Life Cycle Costing
11.7 Features of Life Cycle Costing
11.8 Summary
11.9 Questions
11.10 References
11.0 OBJECTIVES
After studying this unit, you will be able to:
 Describe the characteristics of Life cycle costing
 Identify the various phases involved in Life cycle costing
 Identify the various phases of Product Life Cycle Costing
 State the advantages and disadvantages of Life cycle costing
11.1 INTRODUCTION
In this Unit, we will learn how LCC (Life Cycle Costing) is an important
election of options that have an impact on both current and future
expenses. From the tim e of invention until the time of abandonment, life
cycle costing is a method that tracks and aggregates the real costs and
profits linked to a cost object. Cost and revenue are tracked on a product
per product basis throughout numerous calendar periods in life cycle
costing.


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Accounting 11.2 LIFE CYCLE COSTING
Life cycle costing is also named as whole life costing. It is a procedure to
decide the absolute cost of ownership. The methodology is organized one
which tends to provides information to all components of cost.
A combination of financial, engineering, managerial, and other disciplines
is used to complete life cycle costing. Life cycle costing focuses on the
complete life cycle cost to arrive at the ideal choice.
11.3 MEANING AND PHASES OF LIFE CYCLE
COSTING
Meaning of Life Cycle Costing:
The method used to appraise the total life cycle cost of procurement is
called “life cycle costing”. In other words, life cycle costing is a
procurement interaction which thinks about the overall cost, i.e., amount
of procure ment and life cycle ownership cost of a product.
Traditional costing systems disclose cost object benefits on a calendar
basis (for example, month to month, quarterly, and every year), whereas
life cycle costing does not. Life cycle costing includes tracin g costs and
revenue of an expense object (For example, a product, a project, etc.)
during the course of several months (i.e. projected life of the cost object).
Phases of Life Cycle Costing:
Life cycle costing is a three step process. The primary stage in life cost
planning stage is Designing Life Cycle Costing Analysis, Selecting and
Developing Life Cycle Costing Model, applying Life Cycle Costing
Model lastly recording and exploring the Life Cycle Costing Results. The
next stage is to organize Life Cost a nalysis followed by last stage of
Implementation and Monitoring Life Cost analysis.
LCC Analysis is a multi -disciplinary movement. An analyst, engaged with
life cycle costing, should be completely acquainted with separate cost
components associated with th e life cycle of asset, derivation of cost
information to be gathered and monetary standards to be applied.

Fig 11.1 Phases of Life Cycle Costing: munotes.in

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Life Cycle Costing
Stage 1: Planning Life Cycle Cost Analysis:
The Life Cycle Costing process commences with development of an
idea, which addresses the plan, and scope of the analysis .
The idea should be:
i) Characterize the goals in terms of outputs needed to help an
administrative decision.
ii) Make the definite timetable with respect to arranging of time -frame
for each stage, o perating, specialized and maintenance support
needed for the resource.
iii) Distinguish any hidden conditions, suppositions, limitations and
difficulties (like least resource performance, accessibility necessities
or most extreme capital expense limitation) tha t may confine the
scope of worthy choices to be assessed. Recognize elective strategies
to be evaluated.
iv) Recognize elective approaches to be evaluated. The list of proposed
choices might be refined as new choices are distinguished or as
existing alternativ es are found to disregard the issue limitations.
v) Give an estimate of assets required and a detailing plan for the
investigation to guarantee that the LCC results will be accessible to
help the dynamic cycle for which they are required.
Subsequent stage in LCC Analysis arranging is the determination or
advancement of a LCC model that will fulfil the goals of the examination.
LCC Model is fundamentally a bookkeeping structure which empowers
the assessment of an asset segments cost.
Stage 2: Life Cost Analysis Preparation:
The Life Cost Analysis is basically an instrument, which can be utilized to
control and deal with the continuous expenses of an asset or part thereof.
It depends on the LCC Model created and applied during the Life Cost
Planning stage with on e significant contrast: it utilizes information of real
expenses.
The making of the Life Cost Analysis includes audit and advancement of
the LCC Model as a "real -time" or real cost control instrument. Estimates
of capital costs will be supplanted by the o riginal costs paid. Changes may
likewise be needed to the cost breakdown and cost components to mirror
the resource segments to be observed and the degree of detail required.
Targets are set for the operating expenses and their recurrence of event
depende nt on the assessments utilized in the Life Cost Planning stage.
These objectives might change with time as more exact information is
obtained, from the real asset operating expenses or from the operating
expense of comparable other asset.
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Accounting Stage 3: Impleme nting and Monitoring :
The Life Cost Analysis is implemented by continuously evaluating an
asset's real performance during its operation and maintenance in order to
identify areas where cost savings can be made and to also give feedback
for future life cost planning.
11.4 PRODUCT LIFE CYCLE PHASES

Fig 11.4 Product Life Cycle Phases
Product Life Cycle has Five Phases:
1. Development –
The product is in the research and development stage, which incurs costs
but generates no revenue. Target costing can be uti lized in conjunction
with life cycle costing in this case.
2. Introduction –
The product is launched onto the market. Potential buyers will be
unfamiliar with the product or service, and the company may need to
spend more money on advertising to bring the pro duct or service to the
market's attention.
A company may be permitted to determine its pricing strategy for a new
product if it is new to the market and a competitor has not yet launched a
similar product.
a) If a market penetration strategy is chosen, the go al should be to offer
the product at a low price as early as feasible in order to gain a substantial
part of the market. As a result, this pricing strategy is predicated on cheap
prices and huge volumes.
b) The goal of a market skimming strategy is to sell at a high price in
order to maximize gross profit per unit sold. The product will be
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a-kind" item, and sales volumes will be minimal. The selling price will
gradually decrease, albeit it will be maintained as high as feasible for as
long as possible. This method is frequently employed by high -tech
professionals.
3. Growth –
As demand grows; the product acquires a larger market. The product
begins to generate a profit as sales revenue rais es.
4. Maturity –
As demand for the product grows, it will eventually slow down and enter a
period of relative maturity. It will continue to make money. As a means of
maintaining demand, the product may be updated or improved.
5. Decline - The market will have pu rchased enough of the product and
will thus approach saturation. Demand will begin to decline. It will
eventually become a loss -maker, at which point the company should opt to
stop selling the product or service.

Fig 11.3 Product Life Cycle Phases
FUN DAMENTALS OF PRODUCT LIFE CYCLE COSTING
A product purchased at the lowest initial cost is not always the least
expensive in the long run. The product's total cost of ownership is high,
and it usually outweighs the purchase price. As a result, cost of owner ship
should be addressed in any purchase analysis; otherwise, decisions may
turn out to be incorrect in the long run.
Life cycle costing is a method for estimating the total cost of a
procurement over its entire life cycle. To put it another way, life cycl e
costing is a procurement method that examines an item's full total cost,
which includes the purchase and life cycle ownership costs. Whole life
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Accounting calculating the total cost of ownership. T he strategy is well -structured and
covers all aspects of cost. It can be used to create a spend profile for a
product or service throughout the course of its expected life.
The following items are included in a life cycle cost analysis:
1. Life Cycle Assessm ent: The analysis and value of a product's or
service's environmental consequences that are created or necessitated
by its existence.
2. Whole Life Cost: The overall cost of ownership for an asset
throughout its entire life cycle, sometimes known as 'cradle t o grave'
or 'womb to tomb.'
The results of such an analysis are utilized to assist management in the
decision -making process when there are multiple options from which to
choose. Because the accuracy of this tool may deteriorate over time, it is
useful whe n long -term assumptions apply to all solutions and hence have
the same impact.
Aircraft, computers, military systems, heavy industrial equipment,
automobiles, hospital facilities, buildings, tractors, heat pumps, copying
machines, air -conditioners, refrige rators, audio -visual equipment’s,
medical equipment’s, diesel engines, and electric items are all examples of
where the technique is useful.
Factors that Influence the Technique's Use
1. Rising inflation, though the strategy is equally beneficial in a
recess ion.
2. Budget restrictions: Most businesses face financial constraints, which
makes this strategy beneficial.
3. Raising user understanding of cost effectiveness
4. Increasing competitiveness: In today's economic environment, there is
particularly fierce competiti on.
5. High maintenance costs: Maintenance costs have been rising. The
importance of life cycle costing in establishing, decreasing, and
controlling expenses cannot be overstated.
Applications
1. Determination of the most advantageous procurement strategy;
2. Determination of cost drivers;
3. Selection among various options;
4. Selection of procurement sources;
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6. Optimization of training needs;
7. Forecasting;
8. Improvement of comprehension of basic design associated
paramete rs in product design and development;
9. Policy
Benefits of Product Life Cycle:
The advantages can be divided into four categories, each of which has
been briefly explained:
1. Purchase option evaluation:
Competing bids can be compared based on their total cost of ownership.
Analysis is especially important when it comes to service contracts and
equipment purchases.
2. Increased cost awareness:
Management gains insight into the elements that influence cost and the
resources needed to complete the transaction. It i s possible to identify cost
drivers so that management attention is focused on the most cost -effective
areas of purchasing. Furthermore, increased awareness of cost drivers
identifies places in existing goods that can benefit from management
intervention.
3. More precise cost forecasting:
The whole cost of a procurement can be more accurately forecasted,
resulting in better decision -making at all levels. Furthermore, the research
allows for more precise forecasting of future spending and capital
investments.
4. Cost vs. performance trade -off:
In making purchasing selections, cost is not the only element to consider.
Other considerations to consider include overall fitness vs requirement,
product quality, and service levels to be delivered. This analysis compares
the costs of several purchasing alternatives with their various features.
Principles of Product Life Cycle:
The cost of ownership of an object or service is incurred over the course
of its entire life, not just at the time of purchase. The following are t he
three primary categories of costs that must be considered during the
planning stage:
 Acquisition costs:
These are the expenses incurred between making the decision to proceed
with the procurement and receiving goods or services for operational
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Accounting  Operational costs:
These are expenses incurred during the asset's or service's operational life.
 End-of-life costs:
These are related with the asset or service's disposal, termination, or
replacement. Instead of incurring further costs, the asset may have a resale
value.
The cost of an asset that has been purchased usually does not alter.
Although the notion of life cycle costing may be applied to both
complicated and basic projects, a more developed strategy is necessary for
large projects.
11.5 ADVANTAGE S OF LIFE CYCLE COSTING
The advantages of LCC are as below:
i) Evaluation of purchase alternatives:
Contending recommendations can be assessed based on entire life cost.
Investigation is significant especially for service agreements and
equipment buying choic es.
ii) Better expense mindfulness:
The management gets knowledge into the variables driving expense and
assets needed for the buying. Recognizing cost drivers is possible with the
goal that administration effort is coordinated towards the purchase. Also,
further developed familiarity with cost drivers features existing things
which would profit from involvement of management.
iii) More exact expense forecasting:
Full expense related with an acquisition can be better assessed, leading to
further developed dynamic a t all levels. Also, the investigation prompts
more precise forecasting of future consumption and capital investments.
iv) Performance adjustment against cost:
Cost isn't the sole factor to be considered in buying choices. Different
factors, for example, gener ally wellness against necessity and nature of the
items and levels of service to be given are additionally applicable. This
analysis gives an expense adjustment against the differing attributes of
buying choices.



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11.6 DISADVANTAGES OF LIFE CYCLE COSTING
The procedure of life cycle costing is, on occasion, criticized on the
grounds that:
i) It is considered to be exorbitant;
ii) It is marked as tedious;
iii) Accuracy of information is questioned; and
iv) Collecting information for investigation is a hectic job.
These d isadvantages might apply for a small firm. In addition, cost saving
advantage analysis is consistently attractive prior to executing any method
at all. In nutshell, the advantages far surpass the disadvantages and a full
scale exertion should be made to ap ply this method deliberately.
Case 1 : A dip in business in noticed by a soap manufacturer in sales .The
sales team meeting was conducted and certain improvement areas like
more advertising, sales promotion, free gifts were suggested by the
members. Bharat a sales team member was firm that the product is
redundant and needs to be replaced. The taste of the consumer has
changed and so the product needs to be replaced. As a team leader how
can you apply the life cycle costing concept to the argument of Bharat?
Solution:
Bharat's arguments are centred on Life Cycle Costing Concept. The
product goes through three step process. The primary stage in life cost
planning stage is Designing Life Cycle Costing Analysis, Selecting and
Developing Life Cycle Costing Model, applying Life Cycle Costing
Model lastly recording and exploring the Life Cycle Costing Results. The
next stage is to organize Life Cost analysis followed by last stage of
Implementation and Monitoring Life Cost analysis. Bharat has a valid
reason for dis continuing the product as no amount of marketing and
promotion is going to revive the economic life of the product
11.7 FEATURES OF LIFE CYCLE COSTING:
a. Product life cycle costing traces a product's costs and revenues over
numerous calendar periods duri ng the course of its life cycle.
b. Product life cycle costing tracks research and development expenditures
as well as the total magnitude of these costs for each particular product,
which is then compared to revenue.
C. Different threats and opportunities exist at different stages of the
product life cycle, necessitating different strategic responses.
d. A product's life cycle can be extended by discovering new uses or
consumers, or by boosting current users' consumption.


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Accounting Illustration 1:
A company is plann ing a new clothes production. We get the information
from market to sell at 20,000 units at 41.00/unit. The mark -up of 40% is
on product cost.
(i) Design and development costs 1, 00,000
(ii) Manufacturing costs 20/unit
(iii) End of life costs 40,000
The company estimates that if it were to spend an additional 30,000 on
design, manufacturing costs/ Unit could be reduced.
Required
(a) Calculate target cost of the product?
(b) Calculate the original lifecycle cost per unit and is the product worth
making on that basis?
(c) What is the maximum manufacturing cost per unit, if the additional
amount were spent on design? That could be tolerated to earn its
required mark -up?
Solution:
(a) Cost + Mark -up = Selling price
100% 40% 140%
30 12 42
(b) The orig inal life cycle cost per unit = (1, 00,000 + (20,000 x 20) + `
40,000)/20,000 = ` 34
This cost per unit is more than the intended cost per unit, indicating that
the product is not worth producing.
(c) Maximum total cost per unit = 30.
(1, 00,000 + 30,000 + 40,000)/20,000
= 17.00
Therefore, the maximum manufacturing cost per unit would have to fall
from 20 to (30 - 17) = 13






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11.7 Stages of Product Life Cycle:

Fig 11.4 Stages of Product Life Cycle
A comparative analysis of these phases is given below:
Particular
s Introduction Growth Maturity Decline
Sales Initial stage
and hence
low. Rise in sale at
increasing price Rise in sale at
decreasing
price Saturation stage
and hence sales
start decreasing
Prices Either high /
low Generally retained Prices fall
closer Products may
– Skimming
pricing /
Penetration
pricing at high price.
However, due to
any change in
market conditions,
prices may have
to be reduced to cost have to be sold
at throw away
prices.
Ratio
of
promotion
expenses
to sales Highest at
this stage Amount of Sales
OH increases. But
the ratio of Sales
OH to sales
decreases due to
huge spike in the
Sales. Normal at
this point.
The same
shall also be
industry
standard. Since, the
demand is low
at this stage, no
need to spend
on any
promotional
activities
Competiti
on Negligible Entry of large
number of
competitors Fierce
competition Withdrawal of
products and
hence
competition
disappears
Major
cost R&D,
Design,
Promotion
costs etc Manufacturing, distribution and
support costs Plants re -used,
sold or scrapped


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Accounting Various stages of Product Life Cycle:
Stages Activity description
1) Market research To understand and identify the customer
requirements and how much he is ready to pay for
it and how many units he will buy i.e., Product,
Price and Quantit y
2)Design
specification To identify details such as life of a product,
maintenance cost, maximum manufacturing costs,
quantity required, delivery period, performance
etc.,
3) Design Drawings and process schedules, which define the
product
4) Prototype To produce small quantity called prototype and make adjustments / improvement till the
product meets the specification
5) Developments To analyses, modify and tests the product
manufactured as prototypes
6) Tooling To build / arrange a production line consisting
necessary machinery, tools etc.,
7) Manufacture This involves, Purchase of raw material and use of
labour for making or assembling of a product
8) Selling To create demand for the product and awareness
through campaigns
9) Distribution To move the product from factories to various
locations to meet the demands
10) Support To ensure that necessary spares and expert
servicing professionals are made available at the
respective places to satisfy the customers
grievance which may arise over the life of a
product 11) Decommissioning / Replacement When manufacturing comes to an end, the plant
erected for the manufacturing activities should be
sold, scrapped or re - used.





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Illustrations
Phase of Product life cycle
Identify the phase of product life cycle with reason in each of the
following cases:
Case Phase Reason
There is a lot of
competition and quantity
sold is increasing at 10%,
8% and 6% in the last 3
years Maturity Rise in sale at
decreasing rate
Until last year, there was
no competition and
suddenly during the year
there are many new players
entered the market and
sales for the company has
beenrising Growth 1) Entry of new
competitors
2) Increase
insales
Huge inventory are piled
up at the godown and a
substitute product is also
available in the market at a
lesser price Decline 1) Hugeinventory
2) Availability
of substitutes

Life cycle income statement & Pricing decision
XYZ Ltd., provides data on its new product as follows:
Total cost of R&D and Design incurred during year 1 are Rs .5,00,000 and
Rs.3,20,000 respectively.
Other costs to be incurred are as follows:
Function Costs per unit
(Rs.)
Production 30
Marketing 18
Distribution 11
After sale service 15

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Accounting Sales related information are as follows:
Particulars Option I Option II Option III
Selling price / unit (Rs.) 300 400 500
Sales Quantity (units) 4000 3500 2500

Required:
Compute the net income generated over life cycle of the product in all
three options and suggest which option should be chosen by the
Company?
Solut ion
Income statement
Particulars Cost
per
unit Option I Option II Option
III
Sales Qty 4000 3500 2500
S.P per unit 300 400 500
Sales revenue 12,00,000 14,00,000 12,50,000
Life cycle costs
R&D 5,00,000 5,00,000 5,00,000
Design 3,20,000 3,20,0 00 3,20,000
Production 30 1,20,000 1,05,000 75,000
Marketing 18 72,000 63,000 45,000
Distribution 11 44,000 38,500 27,500
After sales service 15 60,000 52,500 37,500
Total life cycle costs 11,16,000 10,79,000 10,05,000

Life cycle net
income 84,000 3,21,000 2,45,000

The Company may go for Option II, since the net income in the case is
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11.8 SUMMARY
 Life cycle costing is a procedure to decide the absolute cost of
ownership.
 The stages in life cost pl anning stage consists of designing Life
Cycle Costing Analysis, Selecting and Developing Life Cycle
Costing Model, applying Life Cycle Costing Model lastly recording
and exploring the Life Cycle Costing Results. The next stage is to
organize Life Cost anal ysis followed by last stage of Implementation
and Monitoring Life Cost analysis.
11.9 QUESTIONS
Short Questions
1. Define Life Cycle Costing..
2. Explain the advantages of LCC
3. Explain the limitations of LCC
Long Questions
1. What is a LCC? Explain the phases of L CC?
2. Explain the advantages and disadvantages of LCC.
B. Multiple Choice Questions
1. Life cycle costing is also named:
a. whole life costing
b. pure life costing
c. social costing
d. profit costing

2. Life cycle costing is a ……………. step process.
a. One
b. Two
c. Three
d. Four

3. The pri mary stage is life cost planning stage which consists
of………………….‘a. Recording and exploring the Life Cycle Costing
a. Applying Life Cycle Costing Model
b. Selecting and Developing Life Cycle Costing
c. Designing Life Cycle Costing Analysis

4. The most basic form of e conomic value is use …………:
a. Value
b. Exchange
c. Profit
d. social
Answers
1-a, 2-c, 3-d, 4-a, munotes.in

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Accounting 11.10 REFERENCES
References book
 Charles T. Harngreen, Srikant M. Datar, George Foster, Cost
Accounting,
 A Management Emphasis, Pearson Education, 2008, p. 3.
Managerial A ccounting,
 Cost Management Ibid Management Accounting,
 A Strategic Approach Strategic Cost Management Cost
Management,
 A Strategic Emphasis Cost Management,
 What is Strategy Cost Management, A Strategic Emphasis Ibid., et
al., Ibid., Cost Management Ibi d., et al, Ibid., et al., Ibid. Activity
Accounting

Textbook references
 Ravi. M. Kishore, Cost Management, Taxman, Allied Services (p)
Ltd.,
 S. Mukherjee & A.P. Roychowdhury Advanced Cost and
Management Accountancy, New Central Book Agency, Calcutta.
 Keith Ward, Strategic Management Accounting, Butterworth
Heirmann Pub.
 John K. Shank, Cases in Cost Management: A Strategic Emphasis,
South -Western Publishing, Thomson Learning.
Website
 https://www. accountingnotes.net/cost -accounting
 https://www.yourarticlelibrary.com/accounting
 Source:
https://www.yourarticlelibrary.com/accounting/costing/throughput -
costing -or-super -variable -costing/52654


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ENVIRONMENTAL COSTING
Unit Structure
12.0 Objectives
12.1 Introduction
12.2 Definitions – Environmental Costing
12.3 Purposes and Benefits of Environmental Costing
12.4 Problems on Environmental Costing.
12.5 Carbon Footprint Calculator
12.6 Advantages of Environmental Costing
12.7 Summary
12.8 Questions
12.9 References
12.0 OBJECTIVES
 To understand the concept of Environmental Costing
 To study the benefits of Environmental Costing
 To evaluate the challenges of Environmenta l Costing
 To examine direct and indirect Environmental Costing
 To assess different types of Environmental Costing
12.1 INTRODUCTION
The United Nations put emphasis on the issue of climate change in 1992,
drew a convention on it, and began drafting environm ental regulations as a
result. One of the results of all of these exercises is environmental costing.
Business organisations need to consider their duty to the world, so a new
type of accounting called environmental costing has been introduced and
develope d.
Corporate behaviour is regulated to reduce harmful environmental effects.
Understanding environmental costing is crucial to assisting in this .
By using environmental cost management, your company can keep tabs
on the expenses related to the environmenta l impact of its daily
operations. Air pollution, manufacturing emissions, wet land impact, and
waste disposal are just a few of the ways your business might have an
adverse effect on the environment. munotes.in

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Cost & Management
Accounting The costs associated with accounting for environmental c osts include
labour costs as well as the effects on the environment that your business
will have in the present and the future
12.2 DEFINITIONS – ENVIRONMENTAL COSTING
Corporate businesses are struggling to identify their genuine profits —
those that are env ironmentally sustainable. Companies must take the
environment into consideration for this. In order to establish what degree
of profit (if any) would remain if they attempted to leave the planet in the
same condition at the end of the accounting period as it was at the
beginning, they should take into account its most severe external
environmental consequences.
Costs associated with the actual or potential deterioration of natural
resources as a result of economic activity are known as environmental
costs.
These costs can be seen from two different angles: either as (a) costs
caused, which are costs connected to economic units that are actually or
potentially causing environmental deterioration through their own
activities, or as (b) costs borne, which are c osts incurred by economic
units regardless of whether they are the ones responsible for the
environmental impacts.
There are five tiers of environment costs:
1. Conventional costs - Raw materials, operating and maintenance
expenses, as well as direct costs related to capital investments.
2. Hidden costs - Regulatory costs that aren't publicly disclosed, such as
those associated with tracking down environmentally responsible suppliers
and monitoring and reporting on emissions and environmental activities.
3. Contingent costs , including fines and penalties for breaking rules, as
well as ongoing liabilities from failing to clean up contaminated sites.
4. Costs of relationships and image - Less obvious costs and advantages
related to customer perceptions, employe e relations, and community
relations.
5. Societal costs : These are the expenses that organisations place on society
and the environment but for which they cannot be held legally accountable
or made whole by the legal system .
Management frequently lacks awa reness of the scope of environmental
costs and is unable to spot areas where money can be saved.
Environmental expenses can be divided into two groups:

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Environmental Costing
Internal costs:
These expenses have a direct effect on a company's income statement.
There are numerous varieties, including:
 Enhanced controls and systems to prevent penalties and fines.
 Costs of waste removal.
 Product return fees (For instance, in the EU, businesses are required
to offer facilities for customers to recycle returned goods like
batteries and printer cartridges. The cost of these "take backs" must
be covered by the seller of such items.
 Regulatory expenses, like taxes (e.g. companies with poor
environmental management policies often have to bear a higher tax
burden)
 Upfront expenses like acqui ring permits (e.g. for achieving certain
levels of emissions)
 Back -end expenses like decommissioning fees after the project is
finished
External costs:
These are costs that are borne by society as a whole rather than the
business that initially created the m.
For example,
 carbon emissions
 usage of energy and water
 forest degradation
 health care costs
 social welfare costs
Governments are using taxes and regulations to turn these external costs
into internal costs, though they are becoming more and more aware of
them. Companies that degrade forests, for instance, might be required to
implement a tree replacement programme, or they might be given lower
tax breaks on vehicles that have a high environmental impact.
Additionally, some businesses are voluntarily shi fting some external costs
to internal costs.
The US Environmental Protection Agency
The US Environmental Protection Agency makes a distinction between
four types of costs:
(i) Traditional costs: the price of raw materials and energy that have an
impact on the environment.
(ii) Potentially hidden costs: costs that are recorded by accounting
systems but are later disguised as "general overheads".
(iii) Costs that will be incurred in the future, such as clean -up expenses.
(iv) Image and relationship costs: costs that are intangib le by definition,
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Cost & Management
Accounting The Sustainable Development Division of the United Nations
(i) According to the UN Division for Sustainable Development,
environmental costs include Environmental protection -related costs (such
as those associated with pollution prevention efforts) and (ii) Production -
related costs associated with wastage of resources like labour, capital, and
materials,

(ii) More and more organisations need to take into account
environmental cost m anagement accounting as part of their overall
strategy. Let's examine the reasons for this and the best ways to put it into
practise.
The concept of cost -benefit analysis, or CBA, was developed in the field
of study known as welfare economics. It assists i n addressing issues
relating to the relative merits of various outcomes from a societal
perspective. The utilitarian criteria of the eighteenth century are used in
welfare economics. These researchers made an effort to "compare
outcomes on the basis of wha t benefits the greatest number of people in
each situation .
Stages of Cost -Benefit Analysis:
1. Defining the Project or Policy: Economists must understand whose
welfare is being taken into account and the time period in question in
addition to identifying the choice that will be examined.
2. Identifying the Policy or Project's Physical Impacts Determine the
effects of the results (in units). Several instances of this would be: The
project will require 500 hours of human labour or will result in a reduction
in landfill pollution of 3 billion tonnes.
3. Assessing Effects Consider the marginal social benefit or cost of a
particular action or inaction when evaluating its impact. Follow the link
for detailed information on valuation.
4. Discounting of Cost and B enefit A benefit is deemed to be more
valuable the sooner it is received, which is a crucial concept to understand
with CBA. The further out in time a cost is incurred, the less harmful it is
viewed as being. Because of this, all expenses and gains must be
discounted to account for current values. It would be incorrect to treat
receiving a million dollars today and 75 years from now as being on an
equal footing. Future values are converted into present values using a
discount rate.
5. Using the Net Present Value Test: The sum of the benefits in present
value less the sum of the costs in present value is known as net present
value (NPV). If the NPV exceeds 0 In other words, the project should be
approved if the discounted benefits outweigh the discounted cost s.
6. Sensitivity Analysis is used : The phrase "recalculating NPV when the
values of certain key parameters are changed" is used to describe this type munotes.in

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of analysis (Hanley, 79). Knowing which parameter the NPV is most
sensitive to is crucial because there i s uncertainty in CBA. As an
illustration, suppose a company installs 3 filters to cut down on water
pollution and the pollution is reduced by 30%. In a sensitivity analysis, the
effects of a change in the number of filters would be examined. This
would be a very strong indication that the percentage of water pollution is
very sensitive to the number if 4 filters reduced the water pollution by
70%. Hanley refers to the common parameters that should be reviewed
which include:
 Physical input quantities and qu ality discount rate.
 Project lifespan, physical quantities, and output qualities.
12.3 PURPOSE OF ENVIRONMENTAL COSTING
Knowing whether a firm has been upholding its environmental obligations
is helpful. Basically, a business must fulfil the following envi ronmental
obligations.
a) Regulatory Standards: Meeting or surpassing regulatory requirements.
b) Removing Pollution: Removing already -existing pollution and safely
discarding any hazardous materials.
c) Information: Informing potential and present investo rs of the scope and
makeup of the management's precautionary measures (disclosure
required if the estimated liability is greater than a certain percent say 10
per cent of the companies net worth)
d) Operation: Conducting business in a way that prevents env ironmental
harm.
e) Promotion: Highlighting a business with a strong environmental stance.
Control over material and operational efficiency improvements brought
on by the fiercely competitive global market.
g) Cost Increase Control: Maintain control over r ises in the price of raw
materials, waste disposal, and potential liabilities.
12.4 Advantages of Environmental Costing
i) Discloses Utilisation of Natural Resources:
Environmental accounting is useful in displaying the country's usage of its
natural reso urces, the expenditures associated with doing so, and the
income generated from doing so in a transparent manner.
ii) Social Responsibility of Corporations :
The contribution made by various corporations or companies to upholding
their social obligations c an be measured with the use of environmental
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Cost & Management
Accounting iii) Environmental protection:
A company does not exist in a vacuum. It requires the support of social
and natural systems in order to maximise prosperity. A corporate
enterprise's use of the enviro nment's resources can be measured with the
use of environmental accounting. In any case, it must be demonstrated that
a corporate enterprise does not contaminate, pollute, or threaten the
environment while conducting its operations. In actuality, our natio n has
passed a lot of regulations to safeguard the environment.
12.5 PROBLEMS ON ENVIRONMENTAL COSTING
 Financial implications,
 A lack of experienced labour,
 A lack of established standards for environmental accounting,
 A low adoption rate,
 A lack of sp ecialised environmental accounting principles, etc.
12.6 CARBON FOOTPRINT CALCULATOR
Based on the volume of carbon dioxide (CO2) released as a result of your
business operations, your carbon footprint is a gauge of your
environmental impact. You can use th e Carbon Footprint Calculator to
determine your environmental impact. Next, reduce your carbon footprint
by implementing these seven tactics:
 Increase your energy efficiency:
Greenhouse gas emissions are produced in the process of producing
electricity and natural gas and delivering them to your door. You can save
energy and lessen your impact on the environment by installing energy -
efficient building systems and equipment. For advice specific to your
industry, check out the Commercial or Industrial energy efficiency tools.

 Install green energy:
Clean, renewable energy sources like solar and wind can significantly
lessen your environmental impact while lowering your energy costs. There
are numerous federal, state, and local incentives available to reduce the
cost of installing renewable energy. For details on incentives offered in
your area, consult the Database of State Incentives for Renewables and
Efficiency (DSIRE).

 Be water wise:
The heating of the water used in your facility and the treatment of waste
water consume energy and produce emissions. Reduce the temperature of
the water heater and fix any leaks. Reduce water consumption by
installing low-flow showerheads and aerated faucets; this is particularly
effective in lodging and multi -family facilitie s. Consider heat recovery in
buildings with high hot water demand, such as hospitals and restaurants .
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energy from waste fluids to heat or pre -heat water in facilities with high
hot w ater demand.

 Utilize less, recycle more:
Your environmental impact extends beyond energy use and business
operations. It is necessary to produce, ship, and then dispose of every
piece of machinery and equipment in your facility, all of which have an
impac t on the environment. Look for ways to reduce your usage; it could
be as easy as printing on both sides of the page or improving your
preventive maintenance schedule to extend the life of your equipment.
erect a corporate recycling programme.

 Less travel:
Driving to and from work by employees contributes significantly to air
pollution. Encourage (or pay for) the use of public transportation,
encourage carpooling, and whenever possible, permit employees to work
from home. Utilize web conferencing, email, and other low-emission
communications to reduce business travel. If you manage a fleet of
vehicles, only use them when necessary and seek out models that are fuel-
efficient.

 Think about local sourcing:
Whether it's office supplies or manufacturing raw mater ials, all businesses
need resources to operate. These resources must be delivered to your door,
which requires energy use and emissions. Utilizing local vendors can
lessen your impact on the environment and could even result in financial
savings. This practise is known as "near Transport goods more effectively.
If your company delivers goods, think about ways to cut back on shipping
emissions. In general, ground shipments —by truck or rail—are more fuel-
efficient than air shipments. Less fuel will be consume d by fewer full
ground shipments than by numerous light loads. If you don't have enough
inventory to fill entire shipments, think about collaborating with other
nearby companies.
12.7 SUMMARY:
 Corporate businesses are struggling to identify their genuine p rofits —
those that are environmentally sustainable.
 Costs associated with the actual or potential deterioration of natural
resources as a result of economic activity are known as environmental
costs.
 Costs that will be incurred in the future, such as clean -up expenses.
 According to the UN Division for Sustainable Development,
environmental costs include Environmental protection -related costs
(such as those associated with pollution prevention efforts).
 Environmental accounting is useful in displaying the cou ntry's usage
of its natural resources, the expenditures associated with doing so, and
the income generated from doing so in a transparent manner. munotes.in

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Accounting  Based on the volume of carbon dioxide (CO2) released as a result of
your business operations, your carbon foot print is a gauge of your
environmental impact.
12.8 QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Explain the concept of Environmental Costing
2. Definition of Environmental Costing
3. Explain the Environmental Priorities
4. Explain the purpose of En vironmental costing?
5. How Preventing Environmental Damage?
Long Questions:
1. Explain the advantages of CBA.
2. Which are the five tiers of environment costs?
3. Write in detail Carbon Footprint Calculator?
4. Explain the Environmental Planning
5. How different types of Environmental Costing?
B. Multiple Choice Questions:
1. The best way to manage the costs associated with environmental
impact is to integrate all of your ……………..tasks
a. accounting
b. costing
c. economical
d. financial
2. …………….. including fines and penalties for breaking rules, as well as
ongoing liabilities from failing to clean up contaminated sites
a. Conventional costs -
b. Contingent costs
c. Hidden costs
d. Traditional costs
3. Costs associated with the actual or potential deteriorat ion of natural
resources as a result of economic activity are known as :
a. societal cost
b. external costs
c. internal costs
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4. The sum of the benefits in present value less the sum of the costs in
present value is known as :
a. GPA
b. SPV
c. FV
d. NPV
5. Which are costs incurred by economic units regardless of whether they
are the ones responsible for the environmental impacts
a. Costs hidden
b. Costs horne
c. costs borne
d. Costs lorne
Answers:
1- a,2- b,3- d,4- d,5- c

B. Fill in the bl anks:
1. Environmental costs can be seen from two different angles
……………… and …………..
2. The heating of the water used in your facility and the treatment of waste
water consume ………………….. and ………….emissions
3. Costs that accounting systems record but then d isguise as
"…………………" are potentially hidden costs
4. Encourage your staff to participate in the company's
……………….priorities.
5. An environmental policy may be hindered by an
…………..complexity
Answers:
1- costs caused and costs borne
2- energy and produce
3- Over heads
4- Environmental
5- EMS's
C. True or false
1. An ongoing, systematic approach is not necessary for an
environmental management system to function properly.
2. Raw materials, operating and maintenance expenses, as well as direct
costs related to capital investments. munotes.in