CHAPTER 01 COST ANALYSIS AND COST DETERMINATION

Learning outcomes After com !eting t"is c"a ter #ou $i!! %e a%!e to& define key costing terms understand the framework of conventional cost ascertainment

1'0 Intro(uction Cost accounting is a management information system which analyses past, present and future data to provide a bank of data for the management accountant to use. Management accounting is the application of the principles of accounting and financial management to create, protect, preserve and increase value so as to deliver that to the stakeholders of profit and not for profit enterprises, both public and private. 1'1 A Cost In the Oxford ictionary !cost" means !the price paid for something". #ut in the management terminology, !cost" refers to expenditure and not to price. $he Institute of Cost and Management %ccountants, &ondon, has defined cost as !the amount of expenditure incurred on or attributable to a given thing or activity". Cost ' (uantity used x price 1') Cost units Costs are always related to some ob)ect or function or service. *or example, the cost of a car, a haircut, a ton of coal. +uch units are known as cost units and can be formally defined as !% unit of product or service in relation to which costs are ascertained". E*am !e+, In(ustr# %utomobile %pparel +and Mobile phone Cost o%-ect Cars produced Items produced Cubes Mobile phones

,ospital +chool. university -assenger transport

-atients treated +tudents enrolled -assengers travelled

1'. Cost Centres Cost centre is a production or service location, function, activity or item of e(uipment for which costs are accumulated. In other words a cost centre is a collecting place for costs. $he costs will be collected in these cost centres until the costs are related to the units. E*am !es+, T# e of cost centre +ervice location *unction %ctivity Item of e(uipment E*am !es Canteen +ales, marketing -ackaging, (uality control /ashing plant, photocopier machine

1'/ Cost C!assification Cost classification is $he arrangement of items in logical groups having regard to their nature or purpose $he costs can be classified in different nature. $he same cost item may be classified in different ways depending on the cost classification method. $he method of cost classification and level of detail re(uired will depend on the purpose of cost classification, thus purpose of cost classification can be, Cost planning ecision making +tock valuation Cost control -roduct -ricing

1'0 Different Cost C!assification Met"o(s 0. %ccording to the elements 1. Costs classification according to the purpose 2. Cost classification according to the functions 3. Cost classification according to the behaviour

1'0'1 Accor(ing to t"e e!ements Cost elements are the constituent parts of costs according to the factors upon which expenditure is incurred, material, labour, and expenses. In other words, this is how the total cost is composed of. If you consider a cost ob)ect such as a bottled water product the following cost elements can be identified. P!astic %ott!e an( t"e !i( /ater &abel +alary of the machine operator +alary of the (uality controller +alary of the lab supervisor +alary of the deliverymen +alary of the accountant *actory rent 5lectricity %dvertising $ransport cost -lant depreciation
3

%ll these items can be categori4ed as material

%ll these items can be categori4ed as labour

%ll these items can be categori4ed as expenses

1'0') Costs c!assification accor(ing to t"e ur ose /hen costs are classified having regard to their purpose, they are grouped according to the reason for which they have been incurred. %ccordingly, the costs can be classified as6 1'0')'1 Direct costs Costs may be classified in numerous ways, but a fundamental and important method of classification is into direct and indirect costs. irect costs 7comprising direct material costs, direct wages cost and direct expenses8 are those costs which can be directly identified with a )ob, batch, product or service. $he total of direct costs is known as prime cost, Direct materia! 1 (irect !a%our 1 (irect e* enses 2 rime cost 1'0')') In(irect costs %ll material, labour and expense costs which cannot be identified as direct costs are termed indirect costs. $he three elements of indirect costs6 indirect materials, indirect labour and indirect expenses are collectively known as overheads. $ypical examples of indirect costs in the production area are the following. I9 I:5C$ M%$5:I%&+; I9 I:5C$ &%#O<:; I9 I:5C$ 5=-59+5+; &ubricating oil, stationery, consumable materials, maintenance materials, spare parts for machinery *actory supervision, maintenance wages, store men"s wages, :ent and rates for the factory, plant insurance, Pur ose E!ements Material > &abour > 5xpenses Tota! cost ' 2 ' 2 ' Direct costs irect Material > irect &abour > irect 5xpenses Prime cost 1 > 1 > In(irect costs Indirect Material > Indirect &abour > Indirect 5xpenses O3er"ea(s

1'0' . Cost c!assification accor(ing to t"e functions ,ere the Classification is under four ma)or functions of business; 7a8 -roduction cost;?It is also known as manufacturing factory cost incurred@ in converting raw material into finished product.

7b8%dministration cost; ? %dministration cost is incurred for over all planning, organi4ing and control of the enterprise

7c8+elling cost; ? +elling costs are also known as selling expenses and selling overheads which comprise of all the expanses of selling department including product promotion and advertising.

7d8 istribution cost; ? It is cost of se(uence of operations which begin with making the packed product available for dispatch and ends with making the reconditioned, returned empty package, If you consider the previous example the cost ob)ect being a bottled water product the following cost elements can be categori4ed into their respective functions. -lastic bottle and the lid /ater &abel +alary of the machine operator +alary of the (uality controller +alary of the lab supervisor *actory rent 5lectricity -lant depreciation
5

%ll these items can be categori4ed as production costs

+alary of the deliverymen %dvertising $ransport cost Interest cost paid

%ll these items can be categori4ed as selling and distribution costs this item can be Categori4ed as finance costs %ll these functional costs can be categori4ed as non production costs.

1'0'/ Cost c!assification accor(ing to t"e %e"a3ior #ased on nature or behavior, cost is classified into fixed, variable and semi variable costs. 4i*e( cost+ , A% cost which tends to be unaffected by variations in volume of outputB. It is sometimes referred to as period costs. $otal cost

&evel of activity 5g;?+alary of managing director, rent of single factory, depreciation of single machine 7straight line8 5aria%!e costs+ , A% cost which tends to vary directly with volume of output. 5.g.6?raw material cost, direct labour cost, sales commission

$otal cost

&evel of activity Semi, 3aria%!e costs+

6

% semi?variable cost is a !cost containing both fixed and variable components and which is thus partly affected by fluctuations in the level of activity. 5g; 5lectricity bill, tax and gas +emi variable cost ' fixed cost > variable cost $otal cost $C

*C

&evel of activity %s per cost behaviour, fixed cost remains constant to a particular level of output where as variables cost has tendency to change proportionately. E*am !e $he following information is given with regard to =CD -lc per year. &E: :ent for the factory Insurance of the factory -lant depreciation 2FF,FFF 0FF,FFF GH,FFF

$he cost accountant of the company has obtained the following other information with regard to one unit of product =. irect materials used irect labour esigner fee *ind out the total cost of making 0. O unit 1. H,FFF units 2. 0F,FFF units 1 Egs at &E:. 1H per Eg 2 hours at &E:. 1F per hour &E:.0HF

1'6 Cost %ui!( , u ,aving defined direct and indirect costs, the framework of cost build up can be shown thus; I:5C$ M%$5:I%& > I:5C$ &%#O<: > I:5C$ 5=-59+5 ' -:IM5 CO+$ I9 I:5C$ M%$5:I%& > I9 I:5C$ &%#O<: > I9 I:5C$ 5=-59+5 ' OI5:,5% +

-:IM5 CO+$ > OI5:,5% + ' $O$%&CO+$ 1'7 Pre aration of Cost S"eet $he calculation of cost of production at various stages can be shown by means of a statement called !cost sheet". Cost sheet is an analytical presentation of the cost of the product in the form of a statement and shows the various elements and components of cost. $he specimen of a cost sheet may be given as follows;? Cost S"eet -eriod ............. -articulars of items Out put.................. $otal 7:s8 -er <nit 7:s8

irect materials consumed irect wages irect expenses -rime cost *actory overhead *actory cost Office and %dministration overhead Cost of production +elling and istribution overhead $otal cost

? ? ? ? ? ? ? ? ? ?

? ? ? ? ? ? ? ? ? ?

E*am !e+, Sat#am Pro(ucts P!c' supplies you with the following information relating to product !=" for the month of January 1F00. :aw materials consumed irect wages 9o. of machine hours worked Machine ,our :ate Office overhead +elling overhead 9o. Of units manufactured 9o. Of units sold &E:. KF,FFF &E:.. 2K,FFF HFF &E:. 1F 1FL on works cost &E:.1 per unit sold H,FFF 3,FFF M &E:. 2H per unit

Cou are re(uired to prepare a cost sheet in respect of the above showing cost and profit per unit.

1'8 Cost estimation Cost estimation? $he determination of cost behaviour according to the level of activity. Cost estimation is widely used in planning and decision making. $here are several methods that are commonly used to determine the relationship between cost and activity level. 1'8'1 Hig" 9!o$ met"o( In high low method the highest and the lowest activity levels are selected in order to identify the variable cost which is then used to ascertain the fixed cost. $he given below are steps of high low method. 0. +elect the highest and the lowest values from the independent variable that is from the activity level and their respective costs. 1. Calculate the change in the activity level and the change in the cost to calculate the variable cost per unit.

Iariable cost per unit '

Change in the total cost Change in the activity level

<p to Certain level as the fixed cost generally do not change when the activity level changes, the change in the total cost is totally attributable to the variable costs. $hat is the underlying rationale in calculating the variable cost per unit as above. +ubstitute the variable cost per unit to the following cost e(uation to get the fixed cost *ixed cost' $otal cost Iariable cost per unit x 9umber of units evelop the cost function as follows $otal cost ' *ixed cost > variable cost per unit x 9umber of units E*am !e+ T"e num%er of atients 1GH 0HF
10

Tota! cost :L;R.< 11F,K1H 0NK,1HF

Re=uirement Calculate the cost of treating 1HF patients

Test #our ;no$!e(ge+

1' /hich of the following are direct expenses 7i8 $he cost of +pecial designs, drawing or layouts 7ii8 $he hire of tools or e(uipment for a particular )ob 7iii8 +alesman"s wages 7iv8 :ent, rates and insurance of a factory a. b. c. d. )' 7i8 and 7ii8 7i8 and 7iii8 7i8 and 7iv8 7iii8 and 7iv8

/hich of the following are indirect costsO i. $he depreciation of maintenance e(uipment. ii. $he overtime premium incurred at the specific re(uest of a customer.
11

iii. a. b. c. d. .'

$he hire of a tool for a specific )ob. Item 7i8 only Items 7i8 and 7ii8 only Items 7ii8 and 7iii8 only %ll of them

% cost unit is a. $he cost per hour of operating a machine b. $he cost per unit of electricity consumed c. % unit of product or service in relation to which costs are ascertained d. % measure of work output in a standard hour.

/' % cost centre is a. % unit of product or service in relation to which costs are ascertained b. %n amount of expenditure attributable to an activity c. % production or service location, function, activity or item of e(uipment for which costs are accumulated. d. % centre for which an individual budget is drawn up. 0' -rime cost is 7i8 all costs incurred in manufacturing a profit 7ii8 $he total of direct costs. 7iii8 $he material cost of a product. 7iv8 $he cost of operating a department

Practice >uestions 01<

$he following particulars relating to the year 1FFP. 1F0F have been taken from the books of a Chemical works manufacturing and selling a chemical mixture; Stoc? on 1 9 / 9 )00@ :aw materials *inished mixture *actory stores
12

1FFF Egs HFF Egs

&E:. 1FFF &E:. 0GHF &E:.G1HF

Purc"ases+ :aw materials *actory stores Sa!es+ *inished mixture *actory scraps *actory wages -ower epreciation of machinery Sa!aries+ *actory Office +elling E* enses+ irect Office +elling Stoc?s as on .1A0.A)010 :aw materials *inished mixture *actory stores 01FF Egs 3HF Egs &E:. H,HHF &E:. 0N,HFF &E:. 0N,1FF &E:. 0N,FFF &E:. G1,11F &E:. 2G,11F &E:. 30,HFF 0H2,FHF kgs HFF Egs &E:. P0N,FFF &E:. N0GF &E:. 0GN,KHF &E:. 2F,3FF &E:. 0N,FFF 0KF,FFF kgs &E:. 0NF,FFF &E:.. 13,1HF

$he stock of finished mixture at the end of the year is to the valued all the factory cost of the mixture for that year. $he purchase price of raw material remained unchanged throughout 1FFP.1F0F. -repare a statement giving the maximum possible information about cost and its break up for the year 1FFP. 1F0F.

0)< $he following information is given Output 7<nits8

13

Cost 7&E:8

HF H1 GH G2 HH Re=uirement

0,GHF 0,K1F 1,HFF 1,KFF 0,KHF

<sing the high low method find the cost of producing G1 units.

CHAPTER 0) O5ERHEADS
Learning outcomes After com !eting t"is c"a ter #ou $i!! %e a%!e to&

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understand the principles of overhead absorption and the common based used calculate under. over absorption understand the principles of overhead apportionment know how to deal with the overheads of service departments

)'0 Intro(uction Overheads are those costs of indirect materials, indirect labour and indirect expenses which can"t be directly attributed to a specific product or a service. )'1 C!assification of O3er"ea( Cost O3er"ea(s Base( on t"e nature Indirect materials Indirect labour Other indirect cost Cor? an( t"e function -roduction overhead %dministration overheads +elling and distribution overheads Base( on t"e %e"a3ior *ixed overheads Iariable overheads +emi variable overheads Base( on t"e contro!!a%i!it# Controllable overheads <n controllable overheads

)') O3er"ea( Distri%ution Process Overheads are an indirect cost and cannot be attributed to a specific production or a service. $herefore, overheads need to be accumulated over the period and allocated to the production on a logical basis. Ste s of O3er"ea( Distri%ution Process a. %ccumulation of overheads b. %llocation of overheads to the cost centers. i Identify the overheads ii iii %llocation of overheads :e? allocation of overheads of service cost centers to the production cost centers. 7+econdary allocation8

15

c. %bsorption of overheads i etermination of absorption rate. ii etermining the cost of unit with the absorption rate.

a' Accumu!ation :Co!!ection of O3er"ea( Cost< Initial step of overheads allocation is to collect overheads under each category from different sources.

E*am !e+ O3er"ea( cost *actory rent *actory rate 5lectricity epreciation Sources lease agreement %ssessment of rates 5lectricity bill *ixed assets register

%' A!!ocation of o3er"ea(s to t"e cost centers

i'

A!!ocation of O3er"ea( cost Identify the overheads is where the directly attributable overheads for a specific production or service centre are re served for that production or service centre. 5g; Indirect wages in the packing section of a garment factory is reserved as a cost item in that division.

ii A

ortionment of O3er"ea( cost %pportionment of overhead costs is where the overheads which are not directly attributable for a specific cost centre, are apportioned or allocated among the cost centers on a rational and a logical basis.
16

Qiven below are some bases commonly used in apportioning the overheads.

O3er"ea(s *actory rent, rates, building maintenance :estaurant expenses, staff welfare, staff supervisory expenses :epair cost and insurance costs of assets and depreciation. Material maintenance cost and storage cost. 5lectricity, heating and air condition

Basis for t"e a *loor area 9o. of employees

ortionment

Cost of fixed assets. Ruantum of raw materials used $echnical estimates

E*am !e+ 01

Cou are provided with the following information extracted from books of =C ltd.

escription

$otal

-roduction cost centers % # 2FF 2,0FF 00,GFF 1FF 1FF,FFF 21F 03 31F K,2FF 0G,PFF 2FF 01F,FFF 10F 12

+ervice cost centres = GF 0,KFF K,1KF 0K NF,FFF 1F 2 C 0F 3,3FF 0N,3FF 2F ? ? ? ?

imension s(uare meters Issue of indirect materials Indirect labour 7&E:.8 9o. of employees Ialue of plant S machinery 7&E:.8 5stimated kilowatt ,eating units Issue of materials number of re

NFF 0H,3FF H3,1KF H3K 3FF,FFF HHF 3F

17

?(uestions

0,GHF

0,FFF

HGH

0GH

Other expenses &E:. :ent %dministration -lant depreciation NF,FFF 10,N3F 3F,FFF ,eating S &ighting Machinery insurance -ower &E:. 1F,FFF 3,FFF H,HFF

Cou are re(uired to show, how the overheads are allocated and apportioned among each cost centers.

iii< Re,a

ortionment of o3er"ea(s of ser3ice cost centers to ro(uction cost centers

$he ultimate ob)ective of the overheads distribution process is to determine the amount of overheads to be included in the cost of an item. $herefore, the overheads of the service cost centers need to be re apportioned to the production cost centers on a reasonable basis.

*ollowing bases can be used in apportioning the overheads of service cost centers to the production cost centers. Ser3ice cost center +tores Maintenance division %dministration division Basis of a ortionment

9o. of material re(uisition notes 9o. of hours used for maintenance 9o. of employees

-ractically, the following methods are used to apportion the overheads of service cost centers to the production cost centers. a. %pportionment of overheads of service cost centers only among the production cost centers. b. %pportionment of overheads of service cost centers among the production cost centers and also among the service cost centers.
18

a' A ortionment of o3er"ea(s of ser3ice cost centers on!# among t"e ro(uction cost centers' Overheads attributable for the service cost centers are apportioned only among the production cost centers only if the services of the service cost centers are provided to the production cost centers. $hen overheads of the service cost centers are apportioned only for those production cost centers to which the service cost centers have provided their services. E*am !e+ 0) Cou are re(uired to apportion the overheads of each service cost centers of the above example F0 to the production cost centers as follows. -roduction cost centers % = overheads C ? Overheads HF L 3F L # HF L KF L

%' A ortionment of o3er"ea(s of ser3ice cost centers among t"e centers an( a!so among t"e ser3ice cost centers'

ro(uction cost

$he overheads of service cost centers should also be apportioned to the service cost centers as well as to the production cost centers, when the services of the service cost centers are provided for both production and service cost centers.

$here are three methods for the above. a. Continuous %llotment Method b. +imultaneous 5(uation Method c. 5limination Method. E*am !e+ 0. Cou are re(uired to apportion the overheads in the example F0 among each service cost centers as follows. -roduction cost centers % # +ervice cost centers = C

19

= overheads C ? Overheads

1F L 3F L

2F L HF L

? 0F L

HF L ?

)'. A%sor tion of O3er"ea( Cost

istribution of overheads of the production cost centers among the cost units based on an accepted rational basis is known as the absorption of overheads.

)'.'1 Determining t"e a%sor tion Rate

$he basis used to distribute the overheads among the cost units is the overheads absorption rate. $he following bases are generally used for the absorption.

a. -roduction unit #asis b. irect &abour ,our #asis c. Machine ,our #asis d. irect &abour Cost #asis e. irect Material Cost #asis f. -rime Cost #asis. Qenerally, overheads absorption rates are calculated as follows.

Overheads %bsorption :ate 7O%:8 '

$otal 5stimated Overheads of the cost centre +elected #ase

$raditionally, estimated values are used to determine the overheads absorption rates.
20

a' Pro(uction Dnit %asis -roduction unit basis will be the most suitable method to determine the overheads absorption rate, when the goods produced are identical in a factory or a production cost centre. Overheads %bsorption :ate 7O%:8 ' $otal 5stimated Overheads for the period $otal estimated 9o. of units for the period

%' Direct La%our Hour Basis <se of direct labour hours will be the most suitable method in determining overheads absorption rate, where the production is mainly based on labour. Overheads %bsorption :ate 7O%:8 ' c' Mac"ine Hour Basis $here is a direct connection between the overheads and the machine operation in a capital oriented production entity and since most of the overheads are machine related overheads this is suitable basis for absorption of overheads. 5g; -ower, machine maintenance, machine repairs and depreciation of machine. $herefore, the most suitable basis to determine the overheads absorption rate should be the machine hours basis. Overheads %bsorption :ate 7O%:8 ' $otal 5stimated Overheads for the period 5stimated total machine hours. $otal 5stimated Overheads cost for the period $otal estimated 9o. of labour hours for the period

(' Direct La%our Cost Basis $his is fre(uently used rate in practice and is easy to apply. irect wages paid are related to time, but because of varying rates paid to different personal, piecework and bonus system, there is not an exact correlation between wages paid and time elapsed. Overheads %bsorption :ate 7O%:8 ' $otal 5stimated Overheads for the period x 0FF

5stimated $otal irect &abour Cost for the period

21

e' Direct Materia! Cost Basis In a cost centre where there is a close relationship between overhead cost and direct material cost, direct material cost can be used as a basis for absorption of overhead cost. Overheads %bsorption :ate 7O%:8 ' $otal 5stimated Overheads for the period x 0FF

5stimated $otal irect Material Cost for the -eriod

f' Prime cost %asis In a certain cost centre where there is close relationship between prime cost and overhead cost, the basis of prime cost can be used as a mean of overhead absorption in that cost centre. ,owever, there is no direct relationship between prime cost and overhead cost generally6 therefore this basis is also not considered as suitable basis. Overheads %bsorption :ate 7O%:8 ' $otal 5stimated Overheads for the period 5stimated $otal -rime Cost for the period x 0FF

E*am !e+ 0/ *ollowing one the budgeted information of %#C -lc. *or the year of 1FFF. irect Material Cost irect &abour Cost Overheads 9o. of -roduction <nits Machine ,ours &abour ,ours -rime Cost of a <nit is as follows. &E:. irect Material 7H Eg M &E:.1F8 irect &abour 7H hours M &E:.0F8 0FF HF &E:. 1FF,FFF &E:. 0FF,FFF &E:. 0KF,FFF 1,FFF 3,FFF 0F,FFF

22

-rime cost $wo machine hours are re(uired for one unit.

0HF

Cou are re(uired to calculate the overheads absorption rate and to determine the cost per unit.

)'/ O3er"ea( Cost Dn(er A O3er A%sor tion Over . under absorption of overheads are the differences between the actual overheads incurred during the period and the overheads included in the production cost for the period. Over %bsorption <nder %bsorption ' ' Overheads %bsorbed T %ctual Overheads Overheads %bsorbed U %ctual overheads

$he over . under absorbed overheads, thus, calculated are transferred to the profit and loss account. %ccordingly, Over %bsorption <nder %bsorption E*am !e+ 00 %nnual budgeted overhead cost at =C% -lc. is &E:. 1HF,FFF and the budged annual production hours 01H,FFF. %ctual information for the year of 1F0F is given below. %ctual Overheads %ctual irect &abour &E:. 1H2,HFF 01N,FFF -rofit and &oss %ccount is Credited. -rofit and &oss %ccount is ebited

Cou are re(uired to calculated the under . over absorption for the year.

23

Test #our ;no$!e(ge+

1' % method of dealing with overheads involves spreading common costs over cost centers on the basis of benefit received. $his is known as; a. Overhead absorption b. Overhead apportionment c. Overhead allocation d. Overhead analysis %n overhead absorption rate is used to; a. +hare out common costs over benefiting cost centers b. *ind the total overheads for a cost centers c. Charge overheads to products. d. Control overheads.

)'

F2' Over absorbed overheads occur when; a. absorbed overheads exceed actual overheads. b. absorbed overheads exceed budgeted overheads. c. actual overheads exceed budgeted overheads. d. budgeted overheads exceed absorbed overheads. Data for =uestions 0/ an( 00 #udgeted labour hours #udgeted overheads %ctual labour hours %ctual overheads NHFF &E:. 03N,GHF GP1N &E:. 03K, 1FF

0/'

#ased on the data given above, what is the labour hour overhead absorption rateO
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a. &E:. 0G.HF per hour b. &E:. 0G.1F per hour c. &E:. 0N.33 per hour d. &E:. 0N.GK per hour.

00'

#ased on the data given above, what is the amount of overhead under ?. over absorbedO a. &E:. 1,HHF under absorbed. b. &E:. 1,H1P over absorbed. c. &E:. 1,HHF over absorbed. d. &E:. G,3KF under absorbed.

Practice >uestions 01<

$he following information relates to a production division for a particular period. #udgeted ata irect material cost irect labour cost -roduction overheads 9o. of irect labour hours :s. 1FF,FFF :s. HFF,FFF :s. HFF,FFF 0FF,FFF hours %ctual ata :s. 2FF,FFF :s. 3HF,FFF :s. GFF,FFF 00F,FFF hours

It is one activity done during the period and details of which are given as follows. irect material cost irect labour cost 9o. of direct labour hours :s. G,HFF :s. 3,FFF 0,KFF hours
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0. $he overheads absorption rates on the bases of direct labour hours and direct material cost. 1. $he cost of activity using the overheads absorption rate calculated above 9o.0. 2. $he over . under absorption of overheads for the period, assuming the direct labour hour rate is used and mention the re(uired according for the same.

0)<
%#C &td. is a small company which manufactures two products, % and #, in two production departments, machining and assembly. % canteen is operated as a separate production service department. $he budgeted production and sales in the year to 20 March 1F0F are as follows. -roduct % +ales price per unit +ales 7units8 -roduction 7units8 Material cost per unit &E:. HF 11FF 1FFF &E:.03 -roduct # &E:. GF 03FF 0HFF &E:. 01

-roduct % ,ours per unit irect labour Machining department 7:s. N per hour8 %ssembly department 7:s. K per hour8 1 0

-roduct # ,ours per unit

2 1

26

Machine hours per unit Machining department %ssembly department 2 0.1 3 0

#udgeted production overheads are as follows. Machining department &E:. %llocated costs %pportionment of other general -roduction overheads 1K,FFF 2K,FFF 9umber of employees *loor area 7s(uare meters8 Re=uire( a8 Calculate an absorption rate for overheads in each production department for the year to 20st March 1F0F and the budgeted cost per unit of products % and #. b8 +uppose that in the year to 20 st March 1F0F 1,1FF units of -roduct % are produced and 0,HFF units of -roduct #. irect labour hours per unit and machine hours per unit in both departments were as budgeted. %ctual production overheads are as follows. Machining department
27

%ssembly department &E:. 1H,FFF

Canteen &E:. 01,FFF

$otal &E:. 3G,FFF

0F,FFF

01,FFF 2G,FFF 1F 1,FFF

N,FFF 1F,FFF 0 HFF

3K,FFF P2,FFF H0 G,HFF

2F H,FFF

%ssembly

Canteen

$otal

&E:.

department &E:.

&E:.

&E:.

%llocated costs %pportioned share of general -roduction overheads

2F,GFF

1G,KFF

0F,FFF

KN,2FF

0G,FFF 3G,GFF

N,FFF 2H,KFF

H,FFF 0H,FFF

2F,FFF PN,2FF

Calculate the under or over absorbed overhead in each production department and in total.

0.< Ram Lt( manufactures two products, product % S #. $he company has three production cost centers and two service cost centers. Information related to production and service cost centers are given below.

Cost center Cutting *inishing -acking +tores Maintenance

Indirect Material 7&E:.. !FFF"8 0,HFF 0,GHF HFF NFF GHF

Indirect &abour 7&E:.. !FFF"8 NFF HFF 1FF 0HF 0FF

Machine hours 1N,FFF 01G,H0F KG,1GH ? ?

&abour hours 033,GFF 21,FFF 1P,HFF ? ?

Ot"er o3er"ea(s+ &E:. !FFF"

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:ent 5lectricity #uilding Insurance Machinery Insurance ,ealth Insurance +taff $ransport

33,01H 21,HFF 0,GHF 1,1NF 0,PHF 1,F1H

$he following additional information is also available;

Cutting 9o. of employees *loor area 7s(. meters8 Cost of Machinery 7&E:.8 1F 1,FFF 0,FFF,FFF

*inishing 0FF 0H,FFF 01,FFF,FF F

-acking 0H 2,FFF 1,HFF,FFF

+tores 0F 3,FFF 2,NFF,FFF

Maintenance H 0,FFF 2,HFF,FFF

+taff transport is provided for employees of the Cutting, *inishing and -acking cost centers only.

+ervice cost center overheads are allocated in the following basis;

Cutting +tores Maintenance 1HL 2FL

4inis"ing HF L KF L

Pac?ing 0H L 0F L

Stores ? ?

Maintenance 0F L ?

29

Overhead cost of the cutting cost center will be absorbed based on labour hours and finishing and packing cost centers overhead cost is absorbed based on machine hours. Cost structure of producing one unit of product % and # are given below;

% irect Material 7&E:.8 irect &abour 7&E:.8 &abour hours cutting Machine hours *inishing Machine hours -acking 03H 1H F.0 F.1 F.0

# 1FH GH F.1 F.H F.1H

You are re=uire( to6 compute the expected selling price of product % S # if the company expects to keep 3F L margin on total cost. 0/< +tar Co. &td.., has three production departments and two service departments. $he actual expenses of the factory for the month of January, 1F01 are as follows;? L;R' Indirect Materials; -roduction ept. % -roduction ept. # -roduction ept. C +ervice ept. +ervice ept. R Indirect /ages; -roduction ept. % -roduction ept. # -roduction ept. C +ervice ept. +ervice ept. R
30

L;R'

P0F 1,032 N3G 2FF 2FF 3,HFF

0,1FF 1,FFF 0,FFF NFF 0,FFF K,FFF

:ent of the factory +upervision charges &ighting epreciation of Machinery $he following further details are available;? $otal %rea 7s(.ft8 &ight -oints 9umber of workers Ialue of Machinery 7&E:.8 /orking ,ours 0,FFF 1,HFF 0,3FF 2,FFF NF 2F HF,FFF % KFF 0K K 1H,FFF # 0,1FF 3F 01 0K,FFF C HFF 0F H 1,FFF HFF N H H,FFF

N,FFF 3,FFF 3,FFF H,FFF

R 1FF K 1 1,FFF

5xpenses of service departments - and R are apportioned as follows;? % R 2FL 0FL # 3FL 1FL C 1FL HFL ? 1FL R 0FL ?

Cou are re(uired to work out the production hour rate of recovery of overhead in departments %, # and C. 00< $he #udgeted data relating to the production department of $%$% manufacturing &td are given below. &E:. -roduction Overhead cost irect Material cost irect labour cost
31

P, FF,FFF N, FF,FFF 0,FFF,FFF

Machine hours irect labour hours 9o. of units

1HF,FFF 3F,FFF 1H,FFF

#ased on the above information calculate budgeted production overhead absorption rate using five different methods.

CHAPTER 0. COSTINE METHODS

Learning outcomes After com !eting t"is c"a ter #ou $i!! %e a%!e to&
32

Enow what the re(uirements are for )ob costing Enow the book keeping entries for )ob costing esign a )ob cost card <nderstand batch costing

.'0 Intro(uction Methods that are to be adopted in determining the cost of a unit of production are known as costing methods. % business should determine the cost of goods or services produced by them selecting the most appropriate costing methods to its organi4ation. Costing Met"o(s 0. Job Costing 1. #atch Costing 2. +ervice Costing .'1 Fo% Costing

$his costing method is used when goods are produced through effective production process within very short period on the specific orders of customers.

5g;

-roducing specific machines at the re(uest of a customer. :epair of motor vehicles

.'1'1 Fo% Cost Car(A Fo% Car(

In )ob costing, a separate )ob card is maintaining for each )ob and all cost relevant to that )ob is recorded in this card.

33

4ormat of a Fo% Car(

Customer VVVVVVVVVVV.. 5xpected expenditure 7&E:.8VVVV.. 5stimated value 7&E:.8VVVVVV.. -articulars irect Materials irect labour irect expenses Prime cost -roduction overhead Pro(uction cost 9on -roduction overhead Tota! cost -rofit Se!!ing rice > I%$ Invoice Ialue VVVVVVVVVVVVV -repared by xx Rty. =x =x

Job numberVVVVVVVVVVVV. ate of commencementVVVVVV. ate of completionVVVVVVVV.. <nit price 7&E:8 Ialue 7&E:.8 x = =xx =xx =xx =xx = xxx =xx =xx =xx =xx =xx =xx =xx VVVVVVVVVVVVVVVV %pproved by $otal 7&E:.8 Ialue

34

E*am !e+,

Information related to the )ob 9o. FF10 of #rown Company is given to you as follows.

&E:. Cost of irect Materials irect labour cost epartment % 70,FFF hours at 0F L per hour8 epartment # 7NFF hours at 0H L per hour8 1H,FFF 0F,FFF 01,FFF

5stimated production overhead and direct labour hours of each department are as follows.

De artment A -roduction overhead cost 7&E:.8 irect labour hours HF,FFF 0F,FFF

De artment B GH,FFF 01,HFF

9on production overhead expenses 7administration selling and distribution overheads8 are identified as 0F L of production cost. If expected profit from this )ob is 1F L of selling price determines the price of the )ob

.'1') 4eatures of Fo% costing $he following are the features of industries and firms where )ob costing is usually applied. $he costing method has to be adopted to suit the specific features in an industry or a firm6 i< ii< iii< i3< 3< 3i< Jobs are undertaken against the orders of the customers, as per their instructions. -roduction is not mean for stock and future sales, $he production is not continuous $he )obs differ from each other re(uiring different methods, materials or skills and treatment. $he )obs go through different operations and department as per their specific re(uirements. $here is no uniformity in the flow of production. 5ach )ob is treated as a cost unit and a production or )ob order number is issued .$he )ob is identified with such number throughout the different stages of production. +eparate cost sheet is prepared for each )ob to ascertain its cost and profit.
35

.')

Batc" Costing

#atch costing is used to determine the cost of a unit when similar goods are produced at a time on the specific order of a customer. $his method is used when specific unit are too small to cost individually. 5g; %pparel production on foreign order -roduction of shoes on sub contract basis ,ere, unit cost is calculated in the following manner. <nit cost ' $otal cost of batch 9umber of units produced /hen there are uncontrollable wastage in production activities total cost may be divided by expected good units of production in order to obtain the unit cost. 5xpected goods units ' Input 9ormal wastage

E*am !e+, Q+- company has received HFF units of specific order for component = produced by them. $he related information is as follows. irect Material cost irect labour cost ? &E:.. GH,FFF ? epartment % 73HF hours at &E:. 2F.' per hour8 ? epartment # 70GH hours at &E:. HF.' per hour8 ? epartment C 71HF hours at &E:. 3F.' per hour8

epartment % has spent 2FF machine hour of this )ob.

5stimated overhead cost and overhead absorption rates of the company are as follows.

epartment

5stimated overhead cost 7&E:.8

#asis of absorption

36

% # C

2FF,FFF 13F,FFF 11F,FFF

Machine hours irect labour hours irect labour hours

5stimated direct labour hours

? ? ?

epartment % epartment # epartment C epartment %

1H,FFF 1F,FFF 3,3FF 0H,FFF

5stimated machine hours Cou are re(uired to compute,

0. $otal cost of the batch 1. <nit cost of the batch 2. If the selling price of a unit is &E:.. 2FF.' profit from the rate of the batch. .'. Ser3ice A O erationa! Costing +ervice costing is found in those institutions whose basis ob)ective is to provide service. $herefore it is used to determine the cost of a unit of service provided to by them. $he cost of a unit of services is determined by considering the total cost incurred during a particular period.

5g;? Ser3ice Canteen 5ducational institute ,ospital Dnit of cost a meal a course . a student a day of patient . surgery

$he cost of a unit of service can be computed as follows. Cost of a unit of service ' $otal cost of period <nits of services during that period

E*am !e+,
37

/hilton &anka ,otel which is in /hilton group has 0FF of single rooms and HF of double rooms. ,otel expects to utili4e NF L of both single and double rooms over the year. Cost structure of rooms is as follows. Iariable cost ? for single room per day ?for double room per day *ixed cost ? for single room per day ?for double room per day &E:. 0,HFF &E:. 1,FFF &E:.0,FFF &E:.0,KFF

It is expected to keep profit margin of 1F L of the cost. Cou are re(uired to compute, 0. :ent to be charged for single room per day. 1. :ent to be charged for double room per day.

Test #our ;no$!e(ge+

1< +tate which of the following are characteristics of )ob costing; i homogeneous products, ii customer ? driven production iii complete production possible within a single accounting period. % .i. only # i. %nd ii. only

38

C ii and iii. only i and iii. only 5 %ll of them

)<' +tate which of the following are characteristics of service costing; i. high levels of indirect costs as a proportion of total costs. ii. use of composite cost units. iii.use of e(uivalent units. % .i. only # i. %nd ii. only C ii only ii and iii. only 5. %ll of them

Practice >uestions 01<

Information given below is related to two )obs of %#C -lc.

39

Job % 7&E:.8 irect material cost irect labour cost +elling price -rofit percentage to total cost N,FFF K,FFF 3P,HFF 0F L

Job # 7&E:.8 2,HFF 2,FFF 13,0HF 0H L

/hile the production overhead is charged as a percentage of direct labour cost, non production overhead is charged by the company as a percentage of production cost.

Cou are re(uired to compute, 0. $he overhead absorption rates for production overhead cost and non production overhead cost. 1. -roduction overhead cost, non production overhead cost and the profit of the above two )obs.

0)<
/e print &td is a printer that undertakes a variety of customer orders. $hey have received an order from a Commerce +ociety of a leading school to print book marks for a fund raising activity. $he customer re(uires a (uotation for 0F,FFF and 1F,FFF book marks. *rom the past figures and the budgeted information, the following data have been estimated.

esign evelopment of stencil -aper Machine and tool setting Ink and other consumables -rinter"s wages Notes+ -rinter"s wages vary with volume.

&E:. 2,FFF &E:. G,FFF &E:. KFF per 0,FFF book marks 1 hours at :s. 0,FFF per hour &E:. 1 per book mark H hours &E:. GHF per hour for a production run of 0F,FFF book marks

40

Qeneral overheads are &E:.. 0HF,FFF per period during which 0,FFF printer hours are expected to work. $he company usually applies 1H L mark up on total cost for any customer order. Re=uirements -repare the (uotation for 0F,FFF book marks and 1F,FFF book marks specifying the cost per book mark.

0.<
Cou are re(uired to prepare a #atch Cost +heet of an engineering works showing the cost of #atch 9o. NNF0 of 0,FFF units from the following information. Cou are given that the batch passes through three departments, x, y and 4. Costs incurred for the batch are; Direct Materia!s issue(+ ept. x ept. y ept. 4 Direct Cages+ ept. x ept. y ept. 4 4actor# O3er"ea(+ ept. x ept. y ept. 4 0HF L on direct wages. M :s. 0F per labour hour. KK
41

H,3FF kgs. M &E:.0F per kg. KFF kgs M &E:.N per kg. HFF kgs. M &E:.1F per kg.

0,FFF hours M &E:.1 per hour. 1FF hours M &E:.1.HF per hour. 0,FFF hours M &E:.0.HF per hour.

L on direct wages.

%fter the batch is complete KFF kgs of raw materials issued to ept. x are found to be surplus and returned to stores.

0/<
$he following direct costs were incurred on Job 9o. 0FH of %#C 5ngineering works.

Materials /ages epartment % epartment # Overhead expenses were estimated as follows I. Iariable overhead epartment % epartment #

&E:. 2,30H

NF hours M &E:.. 1.HF per hour KF hours M &E:.. 3.FF per hour

&E:.H,FFF for 3,FFF direct labour hours &E:.K,FFF for 2,FFF direct labour hours

ii.

*ixed overhead

5stimated at &E:. G,HFF .' for 0F,FFF hours normal working time of the factory.

Cou are re(uired to calculate the cost of Job 9o. 0FH and estimate the percentage of profit earned if the price (uoted was &E:. 3,GHF.'.

42

CHAPTER 0/ MAREINAL AND ABSORPTION COSTINE

Learning outcomes After com !eting t"is c"a ter #ou $i!! %e a%!e to& know what is meant by Marginal Costing and Contribution understand the differences between Marginal and %bsorption Costing calculate stock valuations using Marginal or %bsorption Costing

Pre aration of Profit Statements un(er Margina! an( A%sor tion costing met"o(s /'1 Margina! cost It is the change taken place in the total cost when the production is increased or decreased by an additional unit from the existing level of production. Marginal ' cost Iariable ' Cost Iariable -roduction > Iariable %dministration > Iariable +elling and

43

cost

Overhead cost

istribution Overhead cost

,ere, Iariable -roduction ' cost irect Material > cost irect &abour > cost irect 5xpenses > Iariable -roduction Overhead cost

/'1'1 Contri%ution It is known as the difference between the selling price of particular goods or services and its variable cost. +ince it is assumed that the variable cost per unit and the selling price per unit are constant in marginal costing, contribution received by a unit is constant at any level of activity. <nit Contribution ' <nit +elling -rice <nit Iariable Cost %ccordingly, $otal Contribution ' <nit Contribution x +ales Ruantity

Or $otal Contribution ' $otal +ales :evenue $otal Iariable Cost Or $otal contribution ' $otal *ixed Cost > .? profit . &oss Or $otal Contribution ' $otal +ales = -rofit Iolume :atio %ccordingly, $otal -rofit ' $otal Contribution $otal *ixed Cost E*am !e+,

44

%#C produces product !=" of which selling price per unit is &E:. 0FF.' and the variable cost per unit is &E:. KF.'. $he fixed cost per month is &E:. 1FF,FFFand the monthly sales (uantity is 0F,FFF units. Cou are re(uired to calculate, 0. Contribution of a unit of product !=" 1. $otal contribution received from the product ! =" for a month. /'1') Im ortance of t"e Contri%ution Contribution is important to the management as it is provided the re(uired information to the managerial decision making. <nder this, contribution is helpful to make the following decisions. 0. $o determine whether it is profitable or not by different production activities or by the process of the business. 1. $o make re(uired decision in introducing a new product to the market. 5g; to decide the selling price. 2. $o decide whether the goods can be supplied on the market price of a production. 3. $o decide whether the particular raw material should be purchased from outside or should be produced within a firm. H. $o decide the break even point or an instance where neither occurring profit nor loss from the product. K. $o decide a profitable sales mix or a profitable production method. G. $o decide whether one particular product can be stopped when making a number of products.

/'1'. Margina! Costing $he cost is classified as fixed and variable in the marginal costing +tocks are valued as variable . production cost *ixed cost considering as a term cost 7periodic cost8 is deducted fully in calculating the profit.

Profit Statement on Margina! Costing &E:. +ales value Iariable cost

45

&E:.

&E:. =xxx

Opening stock of finished goods 7to variable production cost8 -roduction cost irect material cost irect labour cost irect expenses -rimary cost -roduction overhead cost Closing stock of finished goods 7to variable production cost8 =xx =xx =xx =xx xxx

=xx

=xx 7xxx8

=xx 5stablishment S %dministration cost +elling S istribution Contribution *ixed cost -roduction 5stablishment S administration +elling S distribution -rofit . &oss 7xxx8 7xxx8 7xxx8 7xxx8 xxx =xx xxx 7xxx8 xxx

T"is can %e summariGe( as fo!!o$s' &E:. +ales value Iariable cost Contribution *ixed cost -rofit . &oss /') A%sor tion Costing
46

xxx 7xxx8 xxx 7xxx8 xxx

In *inancial %ccounting, revenue statement is prepared using absorption costing method. <nder this, cost is not classified as fixed and variable and absorb all costs in to cost unit. $hus, the cost is classified here as production and non production. +tocks are valued at the total production cost thus, it includes the fixed production overheads. *ixed overhead costs are being absorbed in to the stocks in accordance with the overhead cost absorption rates.

Profit Statement on A%sor tion Costing &E:. +ales Ialue Cost of sales Opening stock of finished goods -roduction cost irect material cost irect labour cost -roduction overhead cost Closing stock of finished goods Qross -rofit 5stablishment S %dministration cost +elling S istribution cost 9et -rofit $his can be summari4ed as follows &E:. +ales value Cost of sales Qross -rofit 5stablishment S %dministration cost +elling S istribution cost 9et -rofit
47

&E:.

&E:. H***

H**

H** =xx =xx =xx 7xxx8 7xxx8 =xx 7xx8 7xx8 xxx

xxx 7xxx8 xxx 7xx8 7xx8 xxx

E*am !e+, -R: -lc produced 0F,FFF units in July 1F0F and which were sold by &E:.. 0FF.' per unit. Other relevant information for the month is as follows. &E:. irect material cost irect labour cost irect expenses -roduction overhead cost Iariable *ixed %dministration overheads cost Iariable *ixed +elling overhead cost Iariable *ixed 1HF,FFF 0FF,FFF GH,FFF HF,FFF KF,FFF 3F,FFF 3F,FFF HF,FFF NH,FFF

Cou are re(uired to prepare profit statements based on marginal and absorption costing methods.

Practice =uestions 01<

C#% -lc produces product A%B and sales of each unit at &E:. HF.'. Information related to the month of 1F0F is as follows. Iariable production overhead cost per unit &E:. irect material cost irect labour cost
48

01 FN

irect expenses Iariable production overhead cost

F2 F1 1H

*ixed cost 7&E:..8 #udgeted -roduction overheads cost %dministrative overheads cost +elling S istribution overheads cost KF,HFF 1P,2FF 1H,FFF %ctual HH,FFF 1P,2FF 1H,FFF

Iariable administration cost is &E:.. 2H,GFF.' Iariable selling S distribution cost is 0F L of sales value. %verage production of the month is 00,FFF units. -roduction and sales data of the month is as follows. <nits Opening finished stock +ales -roduction 0,1FF 00,FFF 0F,1FF

Cou are re(uired to, 0. -repare profit statements based on both marginal and absorption methods. 1. -repare a profit reconciliation statement under both marginal and absorption methods.

0)<
$he following data have been extracted from the budgets and standard costs of %#C -lc, a company which manufactures and sells a single product. &E:. per unit +elling price irect materials cost irect wages cost Iariable overhead cost
49

3H.FF 0F.FF 3.FF 1.HF

*ixed production overhead costs are budgeted at &E:.. 3FF,FFF per annum. 9ormal production levels are thought to be 21F,FFF units per annum' #udgeted selling and distribution costs are as follows. Iariable *ixed &E:. 0.HF per unit sold &E:. NF,FFF per annum

#udgeted administration costs are &E:. 01F,FFF per annum. $he following patterns of sales and production are expected during the first six months of 1F01. January March +ales 7units8 -roduction 7units8 $here is no stock on 0st January 1F01. -repare profit statements for each of the two (uarters, using the following i8 ii8 Marginal costing %bsorption costing KF,FFF GF,FFF %pril ? June PF,FFF 0FF,FFF

0.<
$he following data were taken from the records of a company.

-eriod 0 -roduction +ales Opening +tock Closing +tock 2F,FFF 2F,FFF ? ?

50

-eriod 1 2N,FFF 1G,FFF ? 00,FFF

-eriod 2 1G,FFF 2N,FFF 00,FFF ?

%ll the above in Egs $he firm makes a single product the financial details of which are as follows 7based on a normal activity level of 2F,FFF Egs8 Cost per Eg. 7&E:.8 irect material irect labour -roduction overheads ' 2FFL of labour 0.HF 0.FF 2.FF H.HF

+elling price per Eg. :s. P

%dministrative overheads are fixed at :s. 1H,FFF .' and one third of the production overheads are fixed. -repare separate operating statements on marginal costing and absorption costing principles.

CHAPTER 00 PROCESS COSTINE

Learning outcomes

51

After com !eting t"is c"a ter #ou $i!! %e a%!e to& know the features of -rocess Costing distinguish between 9ormal S %bnormal &osses and %bnormal Qains understand how to calculate 5(uivalent <nits know how to value /ork in -rogress using either *I*O or %verage Cost prepare -rocess %ccounts with opening and closing /I-

0'0 Intro(uction

-rocess costing is found in those industries that convert raw materials in to a finished product through number of processes. Methods using in these situations is process costing.

E*am !e+, Oil refinement Manufacturing li(uor -roduction of soap -roduction of paints

0'1 S ecia! 4eatures of Process Costing

0. +ince this is continues production process output of one process becomes input of next process. 1. $here may be closing work in progress at the end of each process. 2. $here may be losses in processes because of wastages, evaporation. 3. $here are by products and )oint products at the end of certain processes. H. Cost of any process is distributed among the all units produced including the work in progress.
52

0')

Loss A Caste A Scra

In a certain production process, if a smaller (uantity of processed goods is obtained to a larger (uantity of raw materials used the loss in production arises as a result of break downs, evaporation, fragility and not match with (uality re(uirement. $his loss in production is known as loss. $here may or may not be sales value for this loss

$his loss can be divided into two categories.

0. 9ormal &oss 79&8 1. %bnormal &oss 7%9&8

0'.

Norma! Loss

$he losses that can be expected in certain production process during thee manufacture is known as normal loss. $his loss can be identified at the beginning of production process and it can usually be allowed for in costing the product. $his will be based on past experience and technical estimates.

In process costing there are three ways of estimating normal loss.

0. %s a percentage of input 1. %s a percentage of output 2. %s a percentage of active units

Acti3e units 2 O ening CIP units 1 In ut units 9 C!osing CIP units

53

In process costing it is assumed that the normal loss should be borne by the good processed units. +ince this normal loss is absorbed by good units there is no cost related to normal loss.

%ccordingly cost of processed unit is computed as follows.

Cost of processed unit '

$otal cost of process 5xpected processed units

5xpected processed units ' Input 9ormal loss A%norma! Loss

If actual loss is more than the normal loss it is identified as abnormal. <sually this can be identified at the end of the production process. %bnormal loss will arise due to low (uality of raw materials, using unskilled labourers, machine break downs.

,ere, the cost of processed unit can be computed as mentioned below.

Cost of processed unit '

$otal cost of process 5xpected number of processed units

A%norma! Eain

+ometimes it may be found that there is an abnormal gain when the normal loss is lower than the actual loss.

54

In this case the cost of unit produced can be calculated in the following manner.

Cost of unit produced '

$otal cost of process 5xpected processed units

0'/ Accounting for Process Cost

/hile separate account is maintained for every process here, the production cost of each process 7 irect material cost, irect labour cost and production overhead8 and the output of previous process is debited to the next process account. %t the end of final process the cost off finished stock may be transferred to finished goods stock control account. <sually the values and (uantities both are shown in process accounts.

5arious occasions in accounting for rocess costing

0. -reparation of process accounts where loss has not been taken place. 1. -reparation of process accounts with a normal loss. 2. -reparation of process accounts with an abnormal loss. 3. -reparation of process accounts when a normal loss is taken place and it has sales value. H. -reparation of process accounts when the abnormal loss is taken place and the losses have sales value. K. -reparation of process accounts with an abnormal gains. G. -reparation of process accounts with abnormal gains and the losses have sales value. N. -reparation of process accounts when there is a normal loss and scrap cost to be born for losses.

55

P. -reparation of process accounts when there is abnormal loss and scrap cost to be born for losses. 0F. -reparation of process accounts when there is abnormal gain and scrap cost to be born for losses.

E*am !e+, %#= Company produces product = by completing three processes. In +eptember 1F0F GH,FFF Eg of raw materials were introduced to process 0 and the cost of it was :s. GHF,FFF.'. irect labour cost and the production overhead cost born during the month were H1H,FFF and 11H,FFF respectively.

Cou are re(uired to prepare the process 0 account and other relevant account for the following situation each

+ituation

Input Eg

Output Eg GH,FFF KF,FFF H3,FFF KF,FFF H3,FFF KK,FFF KK,FFF KF,FFF

9ormal loss Eg ? 0H,FFF 0H,FFF 0H,FFF 0H,FFF 0H,FFF 0H,FFF 0H,FFF

%ctual loss Eg ? 0H,FFF 10,FFF 0H,FFF 10,FFF P,FFF P,FFF 0H,FFF

+crap value of a unit 7&E:.8 ? ? ? 0F 0F ? 0F 70F8

0 1 2 3 H K G N

GH,FFF GH,FFF GH,FFF GH,FFF GH,FFF GH,FFF GH,FFF GH,FFF

56

P 0F

GH,FFF GH,FFF

H3,FFF KK,FFF

0H,FFF 0H,FFF

10,FFF P,FFF

70F8 70F8

E*am !e+,

ANS -lc produces product = through three manufacturing processes. Information related to the month of October 1F0F is given below.

-rocess 0 7&E:.8 irect Materials # irect labour 1H,FFF 0H,FFF 1 7&E:.8 0P,FGH 0F,FFF 2 7&E:.8 0P,0NF N,FFF

-rocess 0 is started from 0,FFF units of % at &E:.. 2F.' each. $here is no work in progress stock at the beginning or end of the period.

Output of each process is transferred to next process and the end of the process it is transferred to finished goods stock.

Company charge production overhead for each process as GH L of direct labour cost. *ollowing information is also provided to you.

-rocess

%ctual output of the month

57

9ormal loss percentage of input

Ialue of scrap unit 7&E:..8

0 1 2

PHF N3F GHF

HL 0FL 0HL

0F 1F 2F

Cou are re(uired to prepare process account and other related accounts for the month of October 1F0F.

0'0 T"e conce t of e=ui3a!ent units :ED< %t the end of any given any period there are likely to be partly completed units. It is clear that some of the costs of the period are attributable to these units as well as those that are fully complete. $o be able to spread cost e(uitably over part finish and fully complete units the concept e(uivalent unit is re(uired. $he number of e(uivalent cost calculation purposes, is the number of e(uivalent fully complete units which the partly completely units 7i.e, the /?I? -8 represent.

0'0 '1 C!osing $or? in rogress+ t"e conce t of e=ui3a!ent units :ED<

$o calculate a unit cost of production it is necessary to know how many units were produced in the period. If some units were only partly processed at the end of the period, then these must be taken into account in the calculation of production output. $he concept of e(uivalent units provides a basis for doing this. $he partly finished units 7i.e., the work in progress8 are expressed in terms of how many e(uivalent complete units it represents. *or example, if there are HFF units in progress which are 1H percent complete, these units would be treated as the e(uivalent of HFF x 1HL ' 01H complete units.

E*am !e+, Input materials &abour cost Overhead cost 0,FFF kg M &E:.. P per kg &E:..3,NFF &E:.. H,HNF
58

Outputs

*inished goods; PFF kg Closing work in progress; 0FF kg

$he work in progress is completed;

0FF L as to material KF L as to labour 2F L as to overhead

0'0') O ening $or? in rogress

Opening work in progress consists of incomplete units in process at the beginning of the period. Cour syllabus re(uires you to know how to value work in progress using the average cost method. /ith this method, opening work in progress is treated as follows.

0. $he opening work in progress is listed as an additional part of the input to the process for the period. 1. $he cost of the opening /I- is added to the costs incurred in the period. 2. $he cost per e(uivalent unit of each cost element is calculated as before, and this is used to value each part of the output. $he output value is based on the average cost per e(uivalent unit, hence the name of this method.

59

0'6 Pre aration of rocess account $"en t"ere is o ening $or? in rogress stoc?

/hen there is opening work in progress stock in a certain process accounts can be prepared mainly in two ways according to the manner that the cost of opening work in progress is accounted.

0. *I*O Method 1. /eighted %verage Method 7/%M8

4I4O Met"o( -roduction statement is prepared under the assumption of that the incomplete (uantity of opening work in progress in fully completed during this period, -roduction statement is prepared considering only the cost incurred during this period under each cost component, 7Cost of opening work in progress stock is not considered8 Cost of units produced will be determined by adding the cost incurred during this period and the cost of opening work in progress.

Test #our ;no$!e(ge+

1<

-rocess # had no opening stock, 02,HFF units of raw material were transferred in at :s.3.HF per unit. %dditional material at :s. 0.1H per unit was added in process. &abour and overheads were :s. K.1H per completed unit and :s. 1.HF per unit incomplete. If 00,GHF completed units were transferred out, what was the closing stock in process #O %. &E:.GG,K1H #. &E:.03,32G.HF C. &E:.030,FFF
60

. &E:.10,FFF )< % chemical process has a normal wastage of 0F percent of input. In a period, 1,HFF kg of material were input and there was an abnormal loss of GH kg. /hat (uantity of good production was achievedO %. #. C. . 1,0GH kg 1,1HF kg 1,21H kg 1,3GH kg

Data for =uestions .I /I 0 = plc makes one product, which passes through a single process. etails of the process are as follows;

Materials; H,FFF kg at F.HF cents per kg &abour; &E:.. NFF -roduction overheads 1FF L of labour

9ormal losses are 1F percent of input in the process, and without further processing any losses can be sold as scrap for F.2F cents per kg. $he output for the period was 2,NFF kg from the process.

$here was no work in progress at the beginning or end of the period.

61

.<

/hat value will be credited to the process account for the scrap value of the normal lossO %. #. C. . &E:. 2FF &E:. H2F &E:. PNF &E:.0,F10

/<

/hat is the value of the abnormal lossO %. #. C. . &E:.KF &E: 0PK &E: 12F &E:.13H

0<

/hat is the value of the outputO %. #. C. . &E:.2,G13 &E:.3,2GF &E:.3,KHH &E:.3,PFF

62

Practice >uestions 01<

ata concerning process 1 last month was as follows;

$ransfer from process 0 Materials added Conversion costs Output to finished goods Output scrapped 9ormal loss

3FF kg at a cost of 2,FFF kg

&E:. 1,0HF &E:. K,01F &E:. 1,233 1,NFF kg 3FFkg 0F percent of materials added in the period

$he scrapped units were complete in materials added but only HF percent complete in respect of conversion costs. %ll scrapped units have a value of &E:.. 1 each.
63

$here was no opening work in progress, but 1FF kg were in progress at the end of the month, at the following stages of completion;

NF L complete in materials added 3F L complete in conversion costs

Cou are re(uired to write up the accounts for the process.

0)< $he following information is available for -rocess 2 in June.

egree of completion and cost <nits Cost &E:. Opening stock Closing stock 0FF NF KP1 -rocess 1 input L 0FF 0FF &E:. 0GK Materials added in -rocess 2 L KF GF &E:. 2FF Conversion costs L 2F HH &E:. 10K

64

Input costs; Input from process 1 PFF

&E:. 0,KFF 2,1P3 3,0PF

Materials added in process 2 Conversion costs

9ormal loss is 0F percent of input from process 16 GF units were scrapped in the month, and all scrap units realise &E:. F.1F each.

Output to the next process was NHF units. Cou are re(uired to complete the account for process 2 in June.

0.< <thayan Company has maintained three manufacturing processes and the information related to process 1 for the month of ecember 1F0F is as follows. Input from process 0 :aw materials added irect labour -roduction overhead %ctual loss ? ? ? ? ? H,FFF kg M &E:. 20.KF &E:. PFK,FFF &E:. KH3,FFF &E:. 30K,FFF &E:. NFF kg

/ork in progress at the beginning of the month was KFF kg and it was completed as follows -ercentage completed :aw materials transferred from process 0 :aw materials added irect labour
65

Cost 7&E:.8 0GH,GFF 3G,HHF 3P,GFF

0FFL KFL 2FL

-roduction overhead

2FL

0N,FFF

/ork in progress at the end of the month was 0,FFF kg and it was completed as follows. -ercentage completed :aw materials transferred from process 0 :aw materials added irect labour -roduction overhead 0FFL GHL 3FL 1FL

9ormal loss is 0FL of active units and scraps can be sold M &E:.. HF.' per unit. Cou are re(uired to prepare process 1 account and other relevant accounts.

0/<
J-Q Company produces the product % through three manufacturing processes. Information related to process 0 for the month of 9ovember 1F0F is given below. irect material irect labour -roduction overhead 9ormal loss %ctual output %ctual loss *inished stock as the end of the month ? ? ? ? ? ? ? 1,FFF kg M &E:.. 0P1.HF &E:.. 1KG,GHF &E:.. 0KG,FFF HL of input 0,3FF kg 03Fkg 3KFkg

Closing work in progress stock was completed as follows. irect material irect labour -roduction overhead +crap unit can be sold at a rate :s HF.' %ssuming the scrap unit are identified at the end of the process prepare process 0 account and other related accounts for the month of 9ovember 1F0F.
66

0FFL GHL HFL

00<
$he following information is available for process 1 in October egree of completion and cost <nits Cost &E:. Opening stock Closing stock Input costs; Input from process 0 Materials added in process 1 Conversion costs 3FFF KFF 2HF 0,3NF -rocess 0 input L 0FF 0FF &E:. K1NF 20FP 3KPN &E:. N0F Materials added in -rocess 1 L NF PF &E:. 3HF Conversion costs L 3F 2F &E:. 11F

9ormal loss in HLof input from process 0 2FF units were scrapped in the month. $he scrapped units had reached the following degrees of completion. Material added PFL Conversion cost KFL %ll scrapped units reali4ed &E:. 0 each Output to the next process was 2PHF units. Cou are re(uired to complete the account for process 1 and for the abnormal loss or gain in October

06< %#C &td. manufactures a product called Qeer which will go through three se(uential processes namely -0, -1 and -2 before producing the final product. %s per the industry norms and past experience %#C &td. has set the following normal loss levels on the inputs. -0 9ormal loss 0FL 0FL -1 HL -2

67

*ollowing information was recorded for the month ended 20 ecember 1F00. -0 7:s8 irect material introduced 701,FFF kg8 Other material added 7ignore the weight 8 0H,FFF irect wages 0N,FFF irect expenses 1F,H1F +crap value Output per month 7kg8 G,NFF Company has budgeted production overheads of :s. 0NF,FFF per month, absorbed as a percentage of direct wages for each process. <sing the information given above prepare the accounts for processes -0, -1, and -2. 0 P,KFF 2 P,3FF H K,FFF 3,NNF N,FFF 0F,FFF P,FFF 0F,FFF 2F,FFF -1 7:s8 ?? -2 7:s8 ??

07< $he following data pertain to -rocess % for March, 1F0F of %lpha $extiles &td.

Opening work in progress 0,HFF units for egree of completion Materials 0FF L, labour and overheads 22.22L Input of materials 0N,HFF units at irect labour Overheads Closing work in progress H,FFF units
68

&E:.0H,FFF

&E:.H1,FFF &E:.03, FFF &E:.1N,FFF

egree of completion Materials PF L , labour and overheads 2F L 9ormal process loss is 0F L of total input 7Opening work in progress units > <nits put in8 +crap value &E:. 1.FF per unit. <nits transferred to the next process 0H,FFF units. *I*O method is used by the company.

You are re=uire( to+ 7a8 compute e(uivalent units of production 7b8 compute cost per e(uivalent unit for each cost element 7c8 prepare the process and other accounts.

0'7 Foint Pro(ucts In a certain production process if it is produced more than one output in similar nature it is known as )oint products. 5g; -etrol, iesel and Eerosene produced in oil refinement.
69

%ccording to the inherent nature of )oint products it can not be identified until the )oint products are split off separately. $his point is called separation point or split off point. %ccordingly the cost incurred up to the point of separating )oint products is known as )oint cost. $his )oint cost should be apportioned among )oint products on a reasonable basis. $he goods identified at the point of separation can be sold at that point or can be sold at a higher price after further processing. 0'8 A ortionment of t"e Foint Cost to Foint Pro(ucts

$o apportion )oint cost among )oint products two bases are mainly used. 0. -hysical . production <nits #asis 1. +ales Ialue #asis

0'8'1 P"#sica! A ro(uction Dnits Basis

Joint cost is apportioned among )oint products on the basis of units produced from each )oint product. $his method is used only if all )oint products can be measured in e(ual physical units. Sa!es 5a!ue Basis %s sales value I. II. III. *inal sales value +ales value at split ? off point Or, 9et realisable value can be considered. 4ina! sa!es 3a!ue *inal sales value means the value that can be obtained from the sale of final output of the process of )oint product.

Sa!es 3a!ue at s !it , off oint

$his means the value that can be obtained from the sales of )oint products at split off point.
70

Net Rea!isa%!e 5a!ue :NR5< 9:I means the value that may receive after deducting further processing cost from the final sales value of )oint products.

*inal sales value *urther . %dditional -rocessing Cost 9et realisable value

xxx 7xx8 xxx

E*am !e+ , 1 5NS -lc produces three )oint products %, # and C through a production process. *ollowing information is provided for the month of July 1F00.

+ales price at the point of split off +ales price after further processing Cost of further processing Output units Joint cost is &E:.. 0FF,FFF .'

% 1F 3F HF,FFF 2,HFF

# 13 HK 3F,FFF 1,HFF

C 2H KF GF,FFF 1,FFF

Cou are re(uired to apportion )oint cost among )oint product made each of following basis. 0. -hysical units basis 1. #asis of sales value at the point of split off 2. *inal sales value basis 3. 9et sales value basis.

0'@ Deci(ing $"et"er t"e -oint ro(uct are %eing furt"er rocesse( or not

/hether the )oint products are sold at the point of separation or it is sold at a higher price after further processing is depending on the profit that can be obtained at each situation.
71

%ccordingly, if more profit can be obtained after further processing than the profit that can be obtained by selling it at the point of separation, selling after further processing will be benefited.

$his profit can be computed in two main methods. 1' Com uting tota! rofit t"at $i!! arise at eac" situation ,ere, final decision is taken after computing the profit at the point of separation and the profit that can be earned after further processing. )' Com uting incrementa! or a((itiona! rofit

,ere decision is taken after comparing the further processing cost with the additional income that can be earned after processing.

E*am !e+ %ssuming )oint cost of 5xample 0 above is apportioned among )oint products on the basis of physical units, determine.

0. /hich product should be further processed and which product should be sold at the point of separation. 1. Calculate the profit that the business can earn according to your decision.

72

E*am !e+ ABC Company carry out its manufacture through two processes. 9ormal loss of each process is 0F L. Output of process 0 is transferred to process 1 and output of process 1 is processed as )oint products of - and R to the market.

Output volume of - and R is at a ratio of 1;0 and )oint cost is apportioned between two products on the basis of output volume. Opening and closing stock was not available and also work in progress was not available at the end of the month. +elling price of - and R is &E:.. 01F and &E:.. 00F respectively. $here is possibility of producing super - after further processing. 9ormal loss of that process is 3F L. $o produce super - additional cost of :s. 0HF,FFF .' per month should be born. $he selling price of super - is :s. 1HF .'. *ollowing information is relevant for the month of 1 ecember 1F0F related to process &E: Input from process 0 70F,FFF kg8 %dditional raw materials irect labour -roduction overhead HFF,FFF 1FF,FFF 0HF,FFF HF,FFF

Cou are re(uired 0. $o prepare process 1 account. 1. $o determine whether the production of super - is profitable to the company. 2. $o compute profit for the month of ecember if the total output is sold.

73

0'10 B# Pro(ucts In a manufacturing process once the main or most valuable outputs are produced from the )oint process the remaining products of )oint process are called subsidiary products or by products. <sually the sales value of by product is less than the value of main products. $herefore it is not necessary to adopt complex accounting system when the by products are accounted. 5g; Manufacturing alcohol from sugar processing -reparing carpets using the waste of garment factory

If it is necessary to bear additional cost for further processing of by products it does not identified separately and it is deducted from the sales value of by product to obtain net sales value.

A!ternati3e s#stems t"at can %e use( in accounting for %# ro(ucts

0. 9et sales value of by product is credited to the relevant process account. $hat means it is deducted from the )oint cost of the process. <nit cost of main product will be reduced then. 1. 9et sales value of by product is credited to cost profit and loss account treating it is as additional income. 2. /hen the sales value of by product is material accounting may be done treating it as )oint product. ,ere the )oint cost should also be allocated to the by product.

Dsua!!# met"o( 1 a%o3e in fo!!o$e( in accounting for %# ro(ucts'

E*am !e+
74

#C+ Company produces )oint products = and C and by product : is through common production process. Information relevant to the month of May 1F00 is given below.

&E:. irect material cost 71F,FFF kg8 irect labour cost -roduction overhead cost 9ormal loss of process is H L Output for the month is as follow <nit = C : 0F,FFF N,FFF 0,FFF 0P,FFF +elling prices of =, C and : are &E:.HF, &E:.3F and &E:. 01 respectively. Joint cost is apportioned on the basis of output ratio. -acking cost of by product is &E:. 1 per unit and scrap can be sold at &E:. H per unit. $reat there is no opening or closing finished goods stock or work in progress and abnormal losses or gains. Cou are re(uired to prepare for the month of May 1F00. 2FF,FFF 0GH,FFF NF,FFF

0. -rocess account. 1. #y product account 2. -rofit of each product and the total profit.

E*am !e+

75

HYJ manufactures three products x, y and 4 through common process and following data are extracted from the company records. -roduct <nits produced $otal sales value at split off 7&E:.8 P,FFF,FFF 3,NFF,FFF ? *urther processing costs 7&E:.8 KFF,FFF 3FF,FFF HFF,FFF +ales value after further processing 7&E:.8 P,1FF,FFF K,FFF,FFF H,HFF,FFF

= C D

1H,FFF 01,FFF 0F,FFF

-roduct D does not have a readily available market without further processing. Joint production costs up to the point of splitting were &E:. P,3HF,FFF .' for the period. $he common process also results in a byproduct - and during the period H,FFF units of - were produced and sold at a price of &E:.0H.' per unit after incurring &E:.. H .' per unit as further processing costs.

You are re=uire( to&

7a8 7b8

etermine how the )oint costs are allocated to each product using physical measurement method. etermine the allocation of )oint costs to each product using sales value at split off point.

7c8 :ecommend which product7s8 should be further processed to maximi4e net contribution to profit and determine the gross profit margin of each product if )oint costs are allocated using physical measurement method

76

CHAPTER 06 BREA;,E5EN ANALYSIS AND SHORT, RDN DECISION MA;INE

Learning outcomes After com !eting t"is c"a ter #ou $i!! %e a%!e to& <nderstand the uses and assumptions of #reak even or cost volume profit analysis Enow the main CI- analysis formulae. Enow how marginal costing can assist short run decision making <nderstand how to identify key factors

6'1 Intro(uction Marginal costing is an accounting techni(ue which ascertains marginal cost by differentiating between fixed or period and variable costs. $he marginal cost of a product is its variable cost, that is, it includes direct labour, direct materials, direct expenses and the variable part of overheads. It can be defined formally as, Aa costing principle whereby variable costs are charged to cost units and the fixed cost attributable to the relevant period is written off in full against the contribution for that periodB. $he term !contribution" mentioned in the formal definition is the term given to the difference between +ales and Marginal cost. M%:QI9%& CO+$'I%:I%#&5 CO+$' I:5C$ &%#O<: > I:5C$ M%$5:I%& > I:5C$ 5=-59+5+ > I%:I%#&5 OI5:,5% +
77

CO9$:I#<$IO9' +%&5+ ? M%:QI9%&CO+$.

6'1'1 Dses of Margina! Costing+, $here are two main uses for the concept of marginal costing. a8 %s a basis for providing information to management for planning and decision making. It is particularly appropriate for short run decisions involving changes in volume or activity and the resulting cost changes. b8 It can also be used in the routine cost accounting system for the calculation of costs and the valuation of stocks. 6'1') Brea?e3en or cost,3o!ume, rofit ana!#sis' Cost?volume?profit 7CI-8 analysis is defined in CIM%"s Official $erminology as Athe study of the effects on future profit of changes in fixed cost, variable cost, sales price, (uantity and mixB. % more common term used for this type of analysis is breakeven analysis. $he focus of the analysis is the breakeven point? that is, the level of activity that produces neither profit nor loss. $he scope of CI- analysis is much wider than this, as indicated in the definition. ,owever, you should be aware that the terms !breakeven analysis" and !CI- analysis" tend to be used interchangeably. 6'1'. Ca!cu!ating t"e %rea?e3en oint' $his is the breakeven point where neither profits nor losses are made. #reakeven point in units ' *ixed costs Contribution per unit #reakeven point in :upees ' *ixed costs Contribution per unit ' or *ixed costs x 0 C.+ ratio

x +ales -rice per unit

78

E*am !e+ , 1< +uppose that an organi4ation manufactures a single product, incurring variable costs of &E:.2F.' per unit and fixed costs of :s 1F,FFF.' per month. If the product sells for &E:. HF.' per unit. Calculate the breakeven pointO

6'1'/ T"e margin of safet#' $he margin of safety is the difference between the expected level of sales and the breakeven point. $he larger the margin of safety, the more likely it is that a profit will be made.

E*am !e+ , )< In the above example 0, if forecast sales are 0,GFF units per month. Calculate the margin of safetyO 6'1'0 T"e contri%ution to sa!es :CAS< ratio' $he contribution to sales ratio is usually expressed as a percentage. C.+ ratio ' Contribution per unit x 0FF +ales price per unit E*am !e+ , .< In the above example 0, calculate the C.+ ratioO &evel of +ales to result in target profit 7in units8 &evel of +ales to result target profit 7:s sales8 ' *ixed cost > $arget -rofit Contribution per unit. ' 7*ixed cost > $arget -rofit8 Contribution per unit. x +ales price per unit in

6'1'0 Dra$ing a %asic %rea?e3en c"art' 6'1'0'1 Tra(itiona! %rea?e3en c"art' % basic breakeven chart records costs and revenues on the vertical axis and the level of activity on the hori4ontal axis. &ines are drawn on the chart to represent costs and sales revenue. $he breakeven point can be read off where the sales revenue line cuts the total cost line. /e shall use our basic example to demonstrate how to draw a breakeven chart. $he data is;
79

+elling price Iariable cost *ixed costs *orecast sales

&E:.HF per unit &E:. 2F per unit &E:.1F,FFF per month 0,GFF units per month

raw the basic breakeven chartO

6'1'0') T"e contri%ution %rea?e3en c"art' % contribution breakeven chart is based on the same principles but it shows the variable cost line instead of the fixed cost line. $he same lines for total cost and sales revenue are shown so the breakeven point and profit can be read off in the same way as with a conventional chart. ,owever, it is also possible to read the contribution for any level of activity

6'1'0'. T"e rofit,3o!ume c"art %nother form of breakeven chart is the profit?volume chart. $his chart plots a single line depicting the profit or loss at each level of activity. $he breakeven point is where this line cuts the hori4ontal axis. $he vertical axis shows profits and losses and the hori4ontal axis is drawn at 4ero profit or loss. T"e a(3antage of t"e rofit,3o!ume c"art' $he main advantage of the profit? volume chart is that it is capable of depicting clearly the effect on profit and breakeven point of any changes in the variables. 5xample; ? % company manufactures a single product that incurs fixed costs of &E:. 2F,FFF per annum. %nnual sales are budgeted to be GF,FFF units at a sales price of &E:. 2F per unit. Iariable costs are &E:.1N.HF per unit. 7a8 point. raw a profit? volume graph, and use it to determine the breakeven

$he company is now considering improving the (uality of the product and increasing the selling price to &E:. 2H.' per unit. +ales volume will be unaffected, but fixed costs will increase to &E:. 3H,FFF.' per annum and variable costs to &E:.22.' per unit. 7b8 raw, on the graph as for part 7a8, a second profit? volume graph and comment on the results.
80

6'1'6

T"e !imitations of %rea?e3en :or C5P< ana!#sis

$he limitations of the practical applicability of breakeven analysis and breakeven charts stem mostly from the assumptions that underlie the analysis a8 b8 c8 d8 e8 f8 Costs are assumed to behave in a linear fashion. +ales revenues are assumed to be constant for each unit sold. $here is assumed to be no change in stocks. It is assumed that activity is the only factor affecting costs, and factors such as inflation are ignored. %part from the unrealistic situation described above of a constant product mix, the charts can only be applied to a single product or service. $he analysis seems to suggest that as long as the activity level is above the breakeven point, then a profit will be achieved.

6'1'7 Assum tions %e"in( t"e Brea?, e3en Ana!#sis 0. %ll costs can be classified as fixed and variable. 1. Iariable costs vary proportionately with the production and the fixed cost will remain constant to a certain level of activity. 2. Iariable cost per unit and selling price per unit remain unchanged with in the level of activity concerned. ,ence, contribution per unit also will not be changed. 3. +tocks are valued at variable cost. H. $he technology, production efficiency and production methods, etc, remain unchanged at every level of activity. 6'1'8 4actors affecting to increase t"e rofit 3o!ume ratio 0. Increase in selling price per unit. 1. ecrease in variable cost per unit. 2. $he speed of increasing the selling price per unit is greater than the speed of increasing the variable cost per unit. 6'1'@ A(3antages of rofit %rea? 9e3en ana!#sis 0. $he profit or loss in relation to the given capacity level can be easily determined and the relative profitability of each product is shown by the profit volume ratio. 1. $he break? even point and the margin of safety provide a hint about the business risk and it helps to promote sales and production. 2. +ince revenue and cost are depicted graphically even managers who have not enough knowledge about the costing can easily understand. /'
81

Eg+ +ales Managers -roduction managers 6'1'10 Dsing costs for (ecision,ma?ing Most management decisions involve a change in the level, method or mix of activities in order to maximi4e profits. $he only costs that should be considered in decision? making are those that will be altered as a result of the decision. $hose costs that will be affected by the decision may be referred to as relevant costs, while others are non? relevant and should be ignored in the analysis. It is often the case that variable costs are relevant whereas fixed costs are not, unless the decision affects the cost structure of the organi4ation. $hus, information for decision? making should always be based on marginal costing principles, since marginal costing focuses on the variable costs and is not concerned with arbitrary apportionment of fixed costs that will be incurred anyway.

6') S"ort, term (ecision , ma?ing Re!e3ant cost Cost that should be used in decision making is called as relevant cost. %ccordingly, relevant cost can be described as the cost that is specially incurred so as to take some management decisions. ,ence, two costs can be identified in short term decision making. 0. Incremental cost 1. Opportunity cost Incrementa! cost It is the cost which is incremental as to the relevant management decision. $hough, more fre(uently the incremental cost includes variable costs, the fixed cost may also be included. O ortunit# cost

$he income lost 7foregone8 by not using a resource which can be used in the best available alternative method. E*am !e+ , /< % summary of a manufacturing company"s budgeted profit statement for its next financial year, when it expects to be operating at GH percent of capacity, is given below.

82

&E:. +ales P,FFFunits at &E:. 21 &ess; irect materials irect wages -roduction overhead fixed Iariable Qross profit &ess; admin and selling ?fixed ?varying with sales volume 9et profit 2K,FFF 1G,FFF H3,FFF G1,FFF 31,FFF 0N,FFF

&E:. 1NN,FFF

0NK,FFF 0F1,FFF

K2,FFF 2P,FFF

It has been estimated that; 7i8 If the selling price per unit were reduced to :s 1N, the increased demand would utili4e PFpercent of the company"s capacity without any additional advertising expenditure6 7ii8 $o attract sufficient demand to utili4e full capacity would re(uire a 0H percent reduction in the current selling price and a :s H,FFF special advertising campaign. You are re=uire( to+ 7a8 Calculate the breakeven point in units, based on the original budget6 7b8 Calculate the profits and breakeven points that would result from each of the two alternatives and compare them with the original budget. 6')'1 >ua!itati3e factors in Decision Ma?ing 0. 1. 2. 3. H. K. G. N. P. %vailability of money Inflation 5mployees Customers Competitors +uppliers *easibility -olitical pressure &egal constraints

83

<sing the above relevant cost short term decision is taken in the following nature. 0. &imiting factors analysis 1. Make or #uy decisions 2. %ccept or :e)ect decisions 3. +hutdown decisions H. 5xtra shifts decisions. 6')') Limiting factor (ecision 9ma?ing % limiting factor is any factor that is in scarce supply and that stops the organi4ation from expanding its activities further that is it limits the organi4ation"s activities.

$he limiting factor for many trading organi4ations is sales volume because they cannot sell as much as they would like. ,owever, other factors may also be limited, especially in the short term. *or example, machine capacity or the supply of skilled labour may be limited for one or two periods until some action can be taken to alleviate the shortage. $he main factor that limits the business activity 5g; :aw materials, +killed &abour, Machine Capacity, Market emand, etcV..

6')'.

Decisions in3o!3ing a sing!e !imiting factor

If an organi4ation is faced with a single limiting factor, for machine capacity, then it must ensure that a production plan is established that maximi4es the profit from the use of the available capacity. %ssuming that fixed costs remain constant, this is the same as saying that the contribution must be maximi4ed from the use of the available capacity. $he machine capacity must be allocated to those products that earn the most contribution per machine hour.

$his decision rule can be stated as !maximi4ing the contribution per unit of limiting factor".

$he following steps are carried out,

0. Identify the limiting factor.

84

1. 2. 3. H.

Contribution per unit is computed for each product. Compute the re(uired (uantity from limiting factor for each product. Compute the contribution per limiting factor. -lan the production based on the se(uential order of highest contribution per limiting factor. K. Maximum production should be the maximum demand for the relevant product. E*am !e+ 0< Iariable cost per unit of product x and y of %#C company are as follows. = 7&E:.8 irect material cost irect labour cost 7:s. H.' per each hour8 Iariable overhead 1F 0F 1F HF C 7&E:.8 2F 0H 1H GF

+elling price per unit for x and y are &E:.. NF.' and &E:..0FF.' respectively. $he number of labour hours available for the month of July 1F0F is restricted to 0N,FFF.5xpected sales for the month for x and y are 2,FFF and H,FFF units respectively. Cou are re(uired to, 0 -repare a production plan which maximi4es the profit. 1 if the fixed cost for the month is &E:. 00F,FFF.', compute the profit for the month of July 1F0F in terms of the above production plan.

85

E*am !e+,6< &M9 -lc manufactures the products &,M and 9. $he company that supplies the two raw materials that are used in all three products has informed &M9 that their employees are refusing to work overtime. $his means that supply of the materials is limited to the following (uantities for the next period; Material % Material # 0F2F kg 011F kg

9o other source of supply can be found for the next period Information relating to the three products manufactured by &M9 ltd is as follows;

& Ruantity of Material used per unit manufactured Material % 7kg8 Material # 7kg8 Maximum sales demand 7units8 Contribution per unit sold 1 H 01F &E:..0H

0 2 0KF

3 G 00F &E:.0G.H

&E:.01

Owing to the perishable nature of the products, no finished goods sticks are held. Re=uirements+ a8. :ecommend a production mix that will maximi4e the profits of &M9 ltd for the forthcoming period. b8. &M9 ltd has a valued customer to whom they wish to guarantee the supply of HF units of each product next period. /ould this alter your recommended production planO

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6')'/ Ma?e or Bu# Decisions ,ere, the relevant decision is taken in comparison with the relevant cost of the product which manufactured within a firm and the supplier"s price. $he relevant cost of the product which manufactured within the firm is included, 0. Incremental cost i Iariable cost ii 5xtra fixed cost

1. Opportunity cost $he opportunity cost is that the product which is manufactured within the firm and its lost the opportunity to produce other products by using such resources and thereby lost the contribution. It becomes a cost of the product concerned.

#efore make the relevant final decision, the following (ualitative factors should also be considered. 0. +upplier"s credibility such as capacity of supplying the relevant products on time, the (uality of the product etc. 1. /hat is the period of time the present price are remain unchanged. E*am !e+,7< % company manufactures two models of a pocket calculator. $he basic model sells for &E:. H, has a direct material cost of &E:.0.1H and re(uires F.1H hours of labour time to produce. $he other model, the +cientist, sells for &E:.G.HF, has a direct material cost of &E:.0.K2 and takes F.2GH hours to produce. &abour, which is paid at the rate of &E:. K per hour, is currently very scarce, while demand for the company"s calculators is heavy. $he company is currently producing NFFF of the basic model and 3FFF of the +cientist model per month, while fixed costs are &E:. 13FFF per month. %n overseas customer has offered the company a contract, worth :s.2HFFF, for a number of calculators made to its re(uirements. $he estimating department has ascertained the following facts in respect of the work; $he labour time for the contract would be 01FF hours
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$he material cost would be &E:. PFFF plus the cost of a particular component not normally used in the company"s models $hese components could be purchased from a supplier for &E:. 1HFF or alternatively, they could be made internally for a material cost of &E:.0FFF and an additional labour time of 0HF hours. Re=uirement+ %dvise the management as to the action they should take. Ma?e or Bu# Decisions $it" Limiting 4actors E*am !e+,8< C#- company produces 2 products %,# and C by using same type of machines. It is expected to produce 3FFF units of each product and sell next week. $he information related to a unit is as follows. Machine hours % # C 2 1 3 Iariable cost 7&E:.8 1F 2K 13 +elling price 7&E:..8 2H 3H 3F

$he number of machine hours during the next year is restricted to 1F,FFF.
SPV Company agreed to supply each product n accordance ! th the "ollo! ng pr ce#

&E:. % # C 1P 3F 23

You are re=uire( toI 0. etermine the production plan which maximi4es the profit of the company. 1. If the fixed cost of the company for a week is :s. KF,FFF.', compute the maximum profit for a week.

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6')'0 Acce t or Re-ect S ecific Or(ers % special order is the special (uantity of demand made by a special customer to the firm in addition to the existing market demand. $his is mainly in two forms. 0. %bility to complete the order within the normal production capacity of the firm. 1. Inability to complete the order within the normal production capacity of the firm. $hat is the necessity of an extra production capacity to complete the order. E*am !e+,@< :athnayake company manufactures product x and sells at :s. KF.' per unit. Iariable cost per unit is &E:.3F.'.

Qa)anayaka company placed a special order of 0,FFF units for product x and agreed to pay &E:. 3H.' per unit.

,owever, it is noted that if this special order is accepted the present demand of the company is brought down by 1FF units. Cou are re(uired to decide whether the special order should be accepted.

6')'6

S"ut(o$n Decisions

,ere, the decision is taken by comparison of the sales revenue receives by making a relevant product or by maintaining the relevant division with the relevant cost by making a relevant product or by maintaining the relevant division.

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%ccordingly, the relevant cost in relation to maintaining of the relevant division or the manufacturing of the relevant product is to be included,

0. Incremental cost i variable cost ii *ixed cost

1. Opportunity cost.

$he opportunity cost is the lost of contribution by instance where buildings, e(uipments and staff could have to be used for other purposes since the relevant division is maintained the lost of contribution by avoiding the opportunity to manufacturing of other products by using the resources already utili4ed for the relevant product.

E*am !e+,10< JEC Company consists of 3 divisions and the information of the company for the year 1F0F is as follows.

&E:. +ales value Cost of sales cost Qross profit Other expenses 9et profit N,KFF,FFF 7H,221,FFF8 2,1KN,FFF 71,H21,FFF8 G2K,FFF

$he directors are considering about the winding up the division % of the company.

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$herefore, the gross profit percentage of division % is as half of the gross profit percentage of the company, generally earned. If sales are 0FL of the sales of the company. &E:.20K,FFF.' is fixed cost out of the cost of sales of the relevant division. +imilarly, other expenses of the division % is &E:.. 0HK,FFF.' and all of them are fixed cost. $he company expenses of :s. 2N,FFF.' has been absorbed and included in this other expenses.

If sales are made by division %, it will be affected to drop the sales of other division of the company. #y this, it is expected to lost a contribution of &E:.01F,FFFF.' per annum.

Cou are re(uired to decide whether the division % of the company should be winded up or not.

6')'7 E*tra S"ifts Decisions

,ere, the comparison should be made with the relevant cost of working of a extra shift and the sales income available by working of a extra shift.

,ere, the relevant cost of a extra shift is to be included,

0. Incremental cost i Iariable cost ii 5xtra fixed cost

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1. %dditional cost

E*am !e+,11< Qunawardene Company produces product - by working only a single shift. $he relevant information for the first half of the year 1F0F is as follows.

&E:. +ales 70F,FFF units8 irect material cost irect labour cost Iariable overhead cost Contribution *ixed cost -rofit 701F,FFF8 70FF,FFF8 71F,FFF8

&E:. 2KF,FFF

713F,FFF8 01F,FFF 71F,FFF8 0FF,FFF

% demand for the additional unit of K,HFF at the present price is available and it is expected to work an extra shift for this purpose. ,owever, in implementing this extra shift, an extra fixed cost of &E:. N,FFF.' is to be incurred. +imilarly,, it is expected to incur a cost of 01FL of the labour cost incurred for the production of a unit in the first shift. #ut, it could be obtain a HL of discount on the purchase of extra raw materials since incurred (uantity of units is purchased.

Cou are re(uired to decide whether the extra shift should be implemented or not.

Test #our ;no$!e(ge+

0. In decision making, costs which need to be considered are said to be relevant costs. /hich of the following are characteristics associated with relevant costsO

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7i8 7ii8 7iii8 7iv8

*uture costs <navoidable costs Incremental costs ifferential costs

% C

7i8 and 7iii8 only 7i8 , 7iii8 and 7iv8 only

7i8 and 7ii8 only %ll of them

1.

$he most relevant costs to be used in decision making are

% # C

costs already incurred which are known with certainty current costs estimated future costs notional costs

2.

/hich of the following is not a relevant costO

% C

ifferential cost out of pocket cost

Committed cost Incremental cost

3.

% company makes a single product and incurs fixed costs of :s. 2F,FFF per month. Iariable cost per unit is :s. H and each unit sells for :s. 0H. Monthly sales demand is G,FFF units. $he breakeven point in terms of monthly sales units is;

% C

1,FFF units 3,FFF units

#. .

2,FFF units K,FFF units

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H.

% company manufactures a single product for which cost and selling price data are as follows.

+elling price per unit Iariable cost per unit *ixed costs per month #udgeted monthly sales

&E:.01 &E:.FN &E:.PK,FFF 2F,FFF units

$he margin of safety, expressed as a percentage of budgeted monthly sales, is 7to the nearest whole number8;

%. 1F L C G2L

#. 1H L . 01H L

Practice =uestions
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01<

;umar Lt( ma?es t"ree ro(uctsI using t"e same mac"ineI $"ic" is a3ai!a%!e for 00I000 "ours for ne*t erio(' T"e stan(ar( costs of t"e ro(uctI er unitI are+
Pro(uct A L;R' GF 3N 2K 0H3 1FF 2,FFF Pro(uct B L;R' 3F 21 3F 001 0HN 1,HFF Pro(uct C L;R' NF HK 31 0GN 113 H,FFF

irect materials Direct !a%our+ Machinists 7&E:' N per hour8 %ssemblers 7&E:' K per hour8 $otal variable cost +elling price per unit Maximum demand 7units8 *ixed costs are &E:. 2FF,FFF per period. Re=uirements+ i8 ii8 iii8 0)<

Calculate the deficiency in machine hours for the next period. etermine the production plan that will maximi4e Eumar &td"s profit for the next period. Calculate the profit that will result from your recommended production plan.

+ales and profit of the QCE Company in respect of two years are as follows.

+ales 7&E:.8 Cear 0 Cear 1 H,FFF,FFFF G,HFF,FFF

-rofit 7&E:.8 HFF,FFF 0,FFF,FFF

$he selling price was not changed during the two years and also the fixed cost of the company was not changed.

Cou are re(uired to calculate the followings. 0. #reak?even sales value of the company. 1. :e(uired sales value in order to obtain a profit of &E:.0.H M 2. -rofit earning when sales of the company is &E:.K M
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0.<
% company manufactures and sells a single product that has the following cost and selling price structure; <nit. &E:. +elling -rice irect Material irect labour Iariable Overhead *ixed Overhead 11 2K 03 01 N3 -rofit per unit 2K <nit. &E:. 01F

$he fixed overhead absorption rate is based on the normal capacity of 1,FFF units per month. %ssume that the same amount is spent each month on fixed overheads. #udgeted sales for next month are 1,1FF units. You are re=uire( to ca!cu!ate+ 7i8 7ii8 7iii8 7iv8 the breakeven point, in sales units per month6 the margin of safety for next month6 the budgeted profit for next month6 the sales re(uired to achieve a profit of :s PK,FFF.' in a month.

0/<
% company"s sales and profit for two consecutive years are given below; Cear 0 1 +ales 7&E:.8 0F,FFF,FFF 0H,FFF,FFF -rofit 7&E:.8 0,FFF,FFF 1,FFF,FFF

uring the two years the company did not change its selling price and there were no changes in the fixed cost of the company as well. You are re=uire( to+
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i< ii< iii<

Calculate the break even point of the company. Calculate the amount of sales re(uired to generate a profit of :s. 3 million. Compute the profit when the sales of the company reach :s.01 million

00<
%n engineering company manufactures two different main products namely x and y. $hey also manufacture the two main components of the products namely x 0 and y0. One unit of x0 is re(uired to manufacture a unit of x and one unit of y0 is re(uired to manufacture a unit of y. *ollowing are the budgeted costs of each item for the next year. &E:.per unit Components x0 irect materials irect labour Iariable overhead *ixed overhead $otal 11.HF 1F.FF 0F.FF 1H.FF GG.HF y0 2P.FF K.FF 2.FF G.HF HH.HF x 0FF.FF KF.FF 2F.FF GH.FF 1KH.FF -roducts y 0KN.FF 033.FF KG.FF 0NH.FF HK3.FF

It is possible to purchase component x0 and y0 from the open market for &E:.KF.' and &E:.3H .' per unit respectively. ue to the economic meltdown anticipated selling prices of the two products, x and y, have fallen to &E:.. 1HF.' and &E:.H3F.' per unit respectively. :i< %dvise the company whether; 7a8 It should purchase any of the above components in the open market. 7b8 It should discontinue production of any of the above main products. :ii< $here is a possibility that the company could obtain some additional orders for the components. $he demand for the components x0 and y0 for next year will be G,HFF and K,FFF units respectively while the demand for products x and y would be H,FFF and 3,FFF units respectively. $he company uses a special
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machine to manufacture these two components and two main products and the average capacity of the machine is 0HF,FFF hours per annum. $he re(uired number of machine hours for each unit is as follows. Component x0 y0 ? 0F hours ? 3 hours

-roduct

x y

? N hours ? 03 hours

%dvise the company, if additional orders are available, how they should manufacture.

06<
E'; Limite( manufactures and sells a single product, which has the following cost and selling price structure.

&E:. +elling price per unit Cost per unit irect material irect labour Iariable overhead *ixed overhead -rofit 11.FF 2K.FF 03.FF 01.FF

&E:. 01F.FF

7N3.FF8 2K.FF

$he fixed overhead absorption rate is based on the normal capacity of 3,FFF units per month. %ssume that the same amount is spent in each month for fixed overheads. #udgeted sales for the next month are 3,1FF units.

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Cou are re(uired to calculate the; i. ii. iii. #reak? even point in sales units per month. Margin of safety for next month 7in units8 +ales re(uired to achieve a profit of :s. PK,FFF.' in a month 7in units8.

CHAPTER 07 MODERN COSTINE 9 ACTI5ITY BASED AND EN5IRONMENTAL COSTINE Learning outcomes
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After com !eting t"is c"a ter #ou $i!! %e a%!e to& iscuss activity based costing as compared with traditional marginal and absorption costing methods

%pply principles of environmental costing in identifying relevant internalised costs and externalised environmental impacts of the organisation"s activities. 7'1 Mo(ern ro(uction en3ironments Modern producers have changed the way that they produce so that they have; Much more machinery and computerised manufacturing systems +maller batch si4es &ess use of !direct" labour

$his has had the following im act on ro(uction costs+

More indirect overheads 7for example, insurance and depreciation of the machines and computers8 &ess direct labour costs

$his means that the traditional methods of costing 7marginal and absorption8 produce standard cost cards that are less useful due to inaccurate product costs;

$he largest cost of production is indirect overheads but these are categorised together in one figure that lacks detail and is not useful to management.

#ecause management does not know what the components are of the largest production cost 7indirect overheads8 they cannot implement proper cost control. the costs are often allocated between products on the basis of direct labour hours ? despite the fact that direct labour is becoming a smaller proportion of product costs and does not fairly reflect the relationship between the products and the indirect overheads
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because costs are inappropriately or inaccurately shared between products it means that the total production cost can be wrong which can lead to poor pricing and production decisions

%ctivity based costing :ABC< "as %een (e3e!o e( to so!3e t"e ro%!ems that traditional costing methods create in these modern environments. 7'1'1 Acti3it# 9 %ase( costing %ctivity based costing 7%#C8 is an alternative approach to product costing. It is a form of absorption costing, but, rather than absorbing overheads on a production volume basis it firstly allocates them to cost oo!s before absorbing them into units using cost (ri3ers' A cost oo! is an activity that consumes resources and for which overhead costs are identified and allocated. *or each cost pool, there should be a cost driver. A cost (ri3er is a unit of activity that consumes resources. %n alternative definition of a cost driver is a factor influencing the level of cost.

7'1' ) I(entif#ing acti3ities an( (ri3ers If a business decides to adopt activity?based costing to measure the costs and profitability of its products or services, it must identify the key activities that consume resources and the cost driver for each of those activities. $here might be a large number of different activities, but in an accounting system it is usually necessary to simplify the overhead cost analysis and select a fairly small number of activities. If a large number of activities are identified and used in %#C, the task of analy4ing costs becomes more complex and time?consuming, and the value of the additional accuracy might not )ustify the cost and effort. *or any activity there might be )ust one cost driver or several different cost drivers. /here there are several cost drivers, it is necessary to select )ust one for the purpose of %#C analysis.

7'1'. I(entif#ing acti3ities $he main activities that consume overhead resources differ from one type of business to another. % useful approach to identifying suitable activities within a business is to consider four different categories of activity or transaction; Logistica! transactions' $hese are activities or transactions concerned with moving materials or people, and with tracking the progress of materials or work through the
101

system. Ba!ancing transactions' $hese are concerned with ensuring that the resources re(uired for an operation are available. *or example, the buying department has to make sure that raw materials are available to meet production re(uirements.

>ua!it# transactions' $hese are concerned with ensuring that output or service levels meet (uality re(uirements and customer expectations. Inspections and handling customer complaints are both examples of (uality transactions.

C"ange transactions' $hese are activities re(uired to respond to changes in customer demand, a change in design specifications, a scheduling change, a change in production or delivery methods, and so on.

*or any business, there could be important resource?consuming activities in each of these categories.

7'1'/ I(entif#ing cost (ri3ers

*or each selected activity, there should be a cost driver. $he chosen cost driver must be;

Re!e3ant' In other words, there should be a connection between the cost driver and the consumption of resources for the activity.

Eas# to measure' Measuring the units of cost driver and identifying the products or services to which they relate needs to be a fairly easy and straightforward process.

Often, the cost driver is the number of transactions relating to the activity. *or example; the cost of setting up machinery for a production run might be driven by the number of set?ups Qobs or batches produced8. the cost of running machines might be driven by the number of machine hours for
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which the machines are running the cost of order processing might be related to the number of orders received the cost of dispatch might be related to the number of orders dispatched or to the weight of items dispatched the costs of purchasing might be related to the number of purchase orders made the costs of (uality control might be related to the number of inspections carried out, or to the incidence of re)ected items.

7'1' 0 Ca!cu!ating t"e fu!! ro(uction cost er unit using ABC $here are five basic steps to calculating an activity based cost; Ste 1+ Erou ro(uction o3er"ea(s into acti3itiesI accor(ing to (ri3en' "o$ t"e# are

% cost pool is the grouping of costs relating to a particular activity which consumes resources and for which overhead costs are identified and allocated. *or each cost pool, there should be a cost driver. Ste )+ I(entif# cost (ri3ers for eac" acti3it#I i'e' $"at causes t"ese acti3it# costs to %e incurre(' % cost driver is a factor that influences 7or drives8 the level of cost. Ste .+ Ca!cu!ate a cost (ri3er rate for eac" acti3it#' $he cost driver rate is calculated in the same way as the absorption costing O%:. ,owever, a separate cost driver rate will be calculated for each activity, by taking the activity cost and dividing by the cost driver information. Ste /+ A%sor%K t"e acti3it# costs into t"e ro(uct' $he activity costs should be absorbed by applying the cost driver rate into the individual products. Ste 0+ Ca!cu!ate t"e fu!! ro(uction cost an( Aor t"e rofit or !oss' +ome (uestions ask for the production cost per unit and . or the profit or loss per unit.W Other (uestions ask for the total production cost and . or the total profit or loss. E*am !e+, % manufacturing business makes a product in two models6 model M 0 and model M1, details of the two products are as follows.

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%nnual sales 9umber of sales orders +ales price per unit irect material cost per unit irect labour hours per unit irect labour rate per hour +pecial parts per unit -roduction batch si4e +etups per batch -roduction batch si4e

Mo(e! M1 N,FFF units KF H3 00 1.F hours N 1 1,FFF units 0 0

Mo(e! M) N,FFF units 1HF G2 10 1.H hours N N 0FF units 2 lW

&E:. +etup costs Material handling costs +pecial part handling costs Invoicing Other overheads $otal overheads PG,KFF 31,FFF HF,FFF 20,FFF 0FN,FFF 21N,KFF

Cost driver 9umber of setups 9umber of batches 9umber of special parts 9umber of sales orders irect labour hours

% customer has indicated an interest in placing a large order for either model M0 or M1, and the sales manager wished to try to sell the higher? priced model M1. :e(uired; 7a8 Calculate the profit per unit for each model, using %#C. 7b8 <sing the information above identify which product the sales manager should try to sell on the basis of the information provided by your %#C analysis. 7'1'6 C"en is ABC re!e3antL %#C is a more expensive system to operate than traditional costing, so it should only be introduced when it is appropriate to do so. %ctivity?based costing could provide much more meaningful information about product costs and profits when; Indirect costs are high relative to direct costs -roducts or services are complex -roducts or services are tailored to customer specifications +ome products or services are sold in large numbers but others are sold in small numbers.
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In these situations, %#C will often result in significantly different product or service overhead costs, compared with traditional absorption costing. 7'1'7 A(3antages an( (isa(3antages of ABC ABC "as a num%er of a(3antages+ It provides a more accurate cost per unit. It provides much better insight into what drives overhead costs. %#C recogni4es that overhead costs are not all related to production and sales volume. It can be applied to derive realistic costs in a complex business environment. %#C can be applied to all overhead costs, not )ust production overheads. %#C can be used )ust as easily in service costing as in product costing.

isadvantages of %#C %#C will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a small proportion of the overall cost. It is impossible to allocate all overhead costs to specific activities. $he choice of both activities and cost drivers might be inappropriate. %#C can be more complex to explain to the stakeholders of the costing exercise. $he benefits obtained from %#C might not )ustify the costs.

7'1'8 T"e im !ications of s$itc"ing to ABC $he use of %#C has potentially significant commercial implications; -ricing can be based on more realistic cost data. ?-ricing decisions will be improved because the price will be based on more accurate cost data +ales strategy can be more soundly based. ?More realistic product costs as a result of the use of %#C may enable sales staff to; ?target customers that appeared unprofitable using absorption costing but may be profitable under %#C ?stop targeting customers or market segments that are now shown to offer low or negative sales margins. ecision making can be improved.
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:esearch, production and sales effort can be directed towards those products and services which %#C has identified as offering the highest sales margins. -erformance management can be improved. -erformance management should be enhanced due to the focus on selling the most profitable products and through the control of cost drivers. . %#C can be used as the basis. of budgeting and longer term forward planning of overhead costs. $he more realistic budgeted overhead cost should improve the system of performance management. 7') En3ironmenta! management accounting T"e im ortance of En3ironmenta! management Organi4ations are beginning to recogni4e that environmental awareness and management are not optional, but are important for long?term survival and profitability. %ll organi4ations; are faced with need increasing legal customersW and regulatory re(uirements relating environmental management environment to meet needs and concerns relating to the need to demonstrate effective environmental management to maintain good public image need to manage the risk and potential impact of environmental disasters can make cost savings by improved use of resources such as water and fuel are recogni4ing the importance of sustainable development, which is the meeting of current needs without compromising the ability of future generations to meet their needs. 7')'1 T"e contri%ution of en3ironmenta! management accounting :EMA< 5M% is concerned with the accounting information needs of managers in relation to corporate activities that affect the environment as well as environment?related impacts on the corporation. $his includes; identifying and estimating the costs of environment?related activities identifying and separately monitoring the usage and cost of resources such as water, electricity and fuel and to enable costs to be reduced ensuring environmental considerations form a part of capital investment decisions assessing the likelihood and impact of environmental risks including environment?related indicators as part of routine performance monitoring benchmarking activities against environmental best practice.

7')'. En3ironmenta! management an( effect on financia! erformance $here are a number of ways in which environmental issues can have an impact on the
106

financial performance of organi4ations. Im ro3ing re3enue -roducing new products or services which meet the environmental needs or concerns of customers can lead to increased sales. It may also be possible to sell such products for a premium price. Improved sales may also be a conse(uence of improving the reputation of the business. It is possible that in the future, rather than good environmental management resulting in improved sales, poor management will lead to losses. %ll businesses will be expected to meet a minimum standard related to environmental issues. Cost re(uctions -aying close attention to the use of resources can lead to reductions in cost. Often simple improvements in processes can lead to significant costs savings Increases in costs $here may be increases in some costs, for example the cost of complying with legal and regulatory re(uirements, and additional costs to improve the environmental image of the organi4ation. ,owever some of these costs may be offset by government grants and this expenditure may save money in the long?term as measures taken may prevent future losses. Costs of fai!ure -oor environmental management can result in significant costs, for example the cost of clean? up and fines following an environmental disaster.

7')'/ I(entif#ing an( accounting for en3ironmenta! costs Interna! an( e*terna! en3ironmenta! costs Management are often unaware of the extent of environmental costs and cannot identify opportunities for cost savings. 5nvironmental costs can be split into two categories; Interna! costs $hese are costs that directly impact on the income statement of a company. $here are many different types, for example; improved systems and checks in order to avoid penalties.fines
107

waste disposal costs product take back costs 7i.e. in the 5<, for example, companies must provide facilities for customers to return items such as batteries, printer cartridges etc. for recycling. $he seller of such items must bear the cost of these Xtake backs8

regulatory costs such as taxes 7e.g. companies with poor environmental management policies often have to bear a higher tax burden8 upfront costs such as obtaining permits 7e.g. for achieving certain levels of emissions8 back?end costs such as decommissioning costs on pro)ect completion

E*terna! costs $hese are costs that are imposed on society at large but not borne by the company that generates the cost in the first instance. *or example, carbon emissions usage of energy and water forest degradation health care costs social welfare costs

7')'0 En3ironmenta! acti3it# 9 %ase( accounting In %#C, environmental costs are removed from general overheads and traced to products and services. $his means that cost drivers are determined for these costs and products are charged for the use for these environmental costs based on the amount of cost drivers that they contribute to the activity. $his should give a good attribution of environmental costs to individual products. A(3antages of en3ironmenta! costing Y Y better.fairer product costs improved pricing ? so that products that have the biggest environmental impact reflect this by having higher selling prices . better environmental cost control facilitates the (uantification of Disa(3antages Y Y time consuming expensive to implement

determining accurate costs and appropriate costs drivers is difficult external costs not experienced

Y
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cost savings from Xenvironmentally?friendlyX measures Y should integrate environmental costing into the strategic management process reduces the potential for cross? subsidi4ation of environmentally damaging products Y

by the company 7e.g. carbon footprint8 may still be ignored.unmeasured some internal environmental costs are intangible 7e.g. impact on employee health8 and these are still ignored a company that incorporates external costs voluntarily may be . at a competitive disadvantage to rivals who do not do this

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CHAPTER 08 INTRODDCTION, 5ARIANCE

Learning outcomes After stu(#ing t"is c"a ter #ou $i!! %e a%!e to+ efine +tandard Costing and +tandard Cost Calculate basic Material, &abour and Overhead variances

8'1 Stan(ar( costing (efine( +tandard costing is a techni(ue which establishes predetermined estimates of the costs of products and services and then compares these predetermined costs with actual costs as they are incurred. $he predetermined costs are known as standard costs and the difference between the standard cost and actual cost is known as a variance. $he process by which the total difference between actual cost and standard cost is broken down into its different elements is known as variance analysis. 8') Stan(ar( cost $his can be formally defined as W$he planned unit cost of the products, components or services produced in a period. $he standard cost may be determined on a number of bases 7see standard8. $he main uses of standard costs are in performance measurement, control, stock valuation and in the establishment of selling prices.W 8'. 5ariance ana!#sis (efine( % variance is the difference between standard cost and actual cost. $he term variance is rarely used on its own. <sually it is (ualified in some way, for example6 direct materials cost variance, direct labour efficiency variance and so on. $he process by which the total difference between standard and actual costs is sub?divided is known as variance analysis which can be defined as: $he evaluation of performance by means of variances, whose timely reporting should maximi4e the opportunity for managerial action. Iariances arise from differences between standard and actual (uantities and.or differences between standard and actual prices. $hese are the causes of variances6 the reasons for the differences have to be established by management investigation. Iariances may be adverse 7%8 , ie where actual cost is greater than standard, or they may be favourable 7*8, ie where actual cost is less than standard. %lternatively they may be known as minus or plus variances respectively.

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8'/ T"e %asic materia!s 3ariances $his paragraph deals with the irect Materials $otal Iariance, the irect Materials -rice Iariance and the irect Materials <sage Iariance. % particular problem arises with Materials variances in that materials can be charged to production at either actual prices or standard prices. $his affects when the price variance is calculated, ie either at the time of purchase or at the time of usage. %lthough both these approaches are possible, the procedure where materials are charged to production at standard price has many advantages and will be adopted in this book. $his method means that variances are calculated as soon as they arise 7ie a price variance when the material is purchased8 and that they are more easily related to an individualWs responsibility 7ie a price variance would be the buyerWs responsibility8. %ccordingly for materials variances 7and %&& other variances8, price variances are calculated first and thereafter the material is at standard price. $he individual material variances can now be considered; 8'/'1 Direct materia!s tota! 3ariance 9 (efinition+ % measurement of the difference between the standard material cost of the output produced and the actual material cost incurred 7standard material cost of output produced ? actual cost of material purchased8 where the (uantities of material purchased and used are different, the total variance should be calculated as the sum of the usage and price variances. 8'/') Direct materia!s rice 3ariance 9 (efinition+ $he difference between the actual price paid for purchased materials and their standard cost. 77actual (uantity of material purchased x standard price8 ? actual cost of material purchased8. 7$his variance may be calculated at the time of purchase or the time of usage. It is generally preferable to calculate the variance at the time of purchase.8 8'/'. Direct materia!s usage 3ariance 9 (efinition+ Measures efficiency in the use of materials by comparing standard material usage for actual production with actual material used, the difference is valued at standard cost. 7actual production x standard material per unit ? actual material usage8 x standard cost per kg, litre, other8. 8'0 La%our 3ariances $his paragraph deals with the irect &abour $otal Iariance, the irect &abour :ate Iariance 7the Wprice varianceW8 and the irect &abour 5fficiency Iariance 7the WusageW variance8.
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$he formulae are given below and it should be noted that they follow a similar pattern to the material variances described in the previous paragraph. $hese are defined as follows; 8'0'1 Direct !a%our tota! 3ariance , (efinition Indicates the difference between the standard direct labour cost of the output. which has been produced and the actual direct labour cost incurred 77standard hours produced x standard direct labour rate per hour8 ? 7actual hours paid x actual direct labour rate per hour88. 8'0') Direct !a%our rate 3ariance 9 (efinition Indicates the actual cost of any change from the standard labour rate of remuneration 77actual hours paid x standard direct labour rate per hour8 ? 7actual hours paid x actual direct labour rate per hour88. 8'0') Direct !a%our efficienc# 3ariance 9 (efinition Indicates the standard labour cost of any change from the standard level of labour efficiency 77actual production in standard hours ? actual hours worked8 x standard direct labour rate per hour.8 E*am !e+, Stan(ar( cost car( +tandard cost . unit :aw materials HF kgs M :s. 1.HF . kg irect labour G hrs M &E:.. P.HF . hour %ctual result for January -roduction irect material purchases G,FFF kgs at a cost of Opening stock direct material Closing stock direct material /ages paid 70,F0F hrs8 Cou are re(uired to calculate what variances have arisen. &E:. 01H.FF KK.HF 0P0.HF 0HF units &E:.0N,1FF.' 0,2FF kgs NHF kgs :s. P,NPN.'

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E*am !e+, $he standard mix of a product is as follows; Material = C D L of input 2F L HF L 1F L +tandard cost per Eg 7&E:.8 0.1F 1.PH 0.0H

$he standard process loss is 0H L of input weight. uring a period 1,3HF Egs of good output were produced from the following inputs6

Material = C D

Input Egs N0H 0,HFF HNH

-rice per Eg 7&E:..8 0.1H 1.PF 0.0H

You are re=uire( to ca!cu!ate t"e re!e3ant 3ariances'

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