Department of Distance and

Continuing Education
University of Delhi

Master of Business Administration (MBA)

Semester - II
Course Credit - 4.5
Core Course - MBAFT - 6205
Editorial Board
Dr. Rishi Taparia
Dr. Kumar Bijoy

Content Writers
Dr. Rishi Taparia, Dr. Priyanka Ahluwalia,
CA. Vishal Goel, CA Kritee Manchanda,
Dr. Vijay Lakshmi, Dr. Sanjana Monga,
CA. Mannu Goyal, Ms. Shalu Garg,
Mr Jigmet Wangdus

Academic Coordinator
Mr. Deekshant Awasthi

© Department of Distance and Continuing Education

ISBN: 978-81-19169-12-2
1st edition: 2023
e-mail: [email protected]
[email protected]

Published by:
Department of Distance and Continuing Education under
the aegis of Campus of Open Learning/School of Open Learning,
University of Delhi, Delhi-110 007

Printed by:
School of Open Learning, University of Delhi
Disclaimer

DISCLAIMER

This book has been written for academic purposes only.Though every
effort has been made to avoid errors yet any unintentional errors
might have occurred . The authors ,the editors,the publisher and the
distributor are not responsible for any action taken on the basis of this
study module or its consequences thereof.

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INDEX

Lesson – 1: Cost Concepts in Accounting…………………..………………………....1

1.1 Learning Objectives
1.2 Introduction
1.3 Nature of Management Accounting
1.4 Scope of Management Accounting
1.5 Classification of Costs
1.6 Snapshot of Management Accounting, Financial Accounting and Cost Accounting
1.7 Reconciliation of Cost and Financial Accounts
1.8 Summary

Lesson-2: Elements of Costs……….……………………………………...……….…26

2.1 Learning Objectives
2.2 Introduction
2.3 Elements of Cost
2.4 Material Cost and Control
2.5 Labour Cost
2.6 Overhead Cost and Control
2.7 Summary

Lesson-3: Job, Batch and Contract Costing…….……………………………………57

3.1 Learning Objectives
3.2 Introduction
3.3 Job Costing
3.4 Advantages of Job Costing
3.5 Limitations of Job Costing
3.6 Batch Costing
3.7 Differentiate Between Job Costing and Batch Costing
3.8 Contract Costing
3.9 Differentiate Between Job Costing and Contract Costing
3.10 Some Special Terms Used in Contract Costing And Their Treatment
3.11 Treatment of Various Financial Elements Involved In Contract Costing
3.12 Summary
\
Lesson-4: Process Costing……………………………………………………………...81
4.1 Learning Objectives
4.2 Introduction – Meaning, Concept and Accounting
4.3 Wastages: Normal Loss and Abnormal Loss/Gain
4.4 Valuation of Work in Progress (WIP)
4.5 Joint Products and By Products
4.6 Summary

Lesson-5: Cost concepts in Decision Making……………………………..…………107

5.1 Learning Objectives
5.2 Introduction
5.3 Cost Concepts in Decision Making
5.4 Objectives of a Costing System
5.5 Marginal Costing
5.6 Advantages of Marginal Costing
5.7 Limitations of Marginal Costing
5.8 Difference between Marginal costing and Absorption costing
5.9 Cost-Volume-Profit analysis
5.10 Break Even analysis
5.11 Various decision-making problem
5.12 Summary

Lesson-6: Standard Costing and Variance Analysis.……………………..…….…..149

6.1 Learning Objectives
6.2 Introduction
6.3 Standard Cost
6.4 Standard Costing
6.5 Classification of Variances
6.6 Summary

Lesson-7: Budget and budgetary Control ……………………………..……….….. 184

7.1 Learning Objectives
7.2 Introduction
7.3 Meaning of Budget and Steps in Budgetary Control
7.4 Types of Budgets
7.5 Zero-Based Budgeting
7.6 Summary

Lesson - 8: Cost Management…….……….…………………………………………207

8.1 Learning Objectives
8.2 Introduction
8.3 Cost Management, Cost Control and Cost Reduction
8.4 Strategies for Cost Management
8.5 Activity Based Costing
8.6 Accounting and The Theory of Constraints (TOC)
8.7 Throughput Accounting
8.8 Target Costing
8.9 Value Chain Analysis
8.10 Life Cycle Costing
8.11 Just-In-Time (JIT)
8.12 Backflush Costing
8.13 Summary

Lesson - 9: Performance Measurement – Balanced Scorecard……………………238

9.1 Learning Objectives
9.2 Introduction
9.3 Performance Measurement
9.4 Balanced Scorecard
9.5 Performance Drivers and Weighting Performance Measures
9.6 Summary

Lesson - 10: Inventory Management ………………………………………………269

10.1 Learning Objectives
10.2 Introduction
10.3 Inventory Management
10.4 Cost associated with Goods for Sales
10.5 Tools and Techniques of Inventory Management and Control
10.6 Economic Order Quantity (EOQ) Decision Model
10.7 Just in Time (JIT)
10.8 Method of Inventory Valuation
10.9 Solved Practical Questions
10.10 Summary

Lesson - 11: Performance Measurement and Evaluation ………………………304

11.1 Learning Objectives
11.2 Introduction
11.3 Responsibility Centres and Its Performance
11.4 Performance Management System
11.5 Divisional Performance Measures
11.6 Pros and Cons of the use of Performance Measures
11.7 Financial Performance Measures
11.8 Economic Value Added (EVA)
11.9 Limitations of EVA
11.10 Non - Financial Performance Measures
11.11 Balanced Scorecard
11.12 Performance Pyramid
11.13 The Building Block Model
11.14 Performance Prism
11.15 Triple Bottom Line (TBL)
11.16 Summary
Management Accounting

LESSON 1
COST CONCEPTS IN ACCOUNTING

Dr. Rishi Taparia

Director – Management Studies
IAMR Ghaziabad
[email protected]

STRUCTURE

1.1 Learning Objectives

1.2 Introduction
1.3 Nature of Management Accounting
1.4 Scope of Management Accounting
1.5 Classification of Costs
1.6 Snapshot of Management Accounting, Financial Accounting and Cost Accounting
1.7 Reconciliation of Cost and Financial Accounts
1.8 Summary
1.9 In-text Questions
1.10 Self-Assessment Questions
1.11 References
1.12 Suggested Readings

1.1 LEARNING OBJECTIVES

After having studied the first module, the student will be acquainted with the fundamentals
and will be able to:
• Explain basic concept of Management accounting
• Understand various objectives of Management Accounting
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• Appreciate how management accounting information can assist management in

planning, monitoring performance, controlling and making decisions in, their area of
responsibility
• Understand different managerial decisions in relation to Management Accounting
• Identify the information needs and produce financial analyses for a range of decisions

1.2 INTRODUCTION

In basic terms, "Management Accounting is intended for use by managers". It begins where
Financial Accounting ends. Management Accounting supports the managerial tasks at all levels
by equipping managers with the necessary data for efficient policy formulation, control, and
decision-making. It is also considered the branch of accounting that supports managers with
performance evaluation, cost management, and cost determination for financial reporting. In
brief, Management Accounting is concerned with data collection from internal and external
sources, analysing, processing, interpreting, and communicating the information for use within
the organisation so that management can plan, make decisions, and control the organisation
more efficiently. To better understand the concept, a definition may be the most useful tool.
Management accounting is defined by CIMA [UK] as:
Management Accounting is an integral part of management concerned with identifying,
presenting, and interpreting information utilized for formulating strategy, planning and
controlling activities, decision making, optimizing the use of resources,
1. disclosure to shareholders and other external entities,
2. disclosure to employees,
3. safeguarding ‘assets

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Management Accounting

Some definitions of Management Accounting

“Management Accounting is concerned with accounting information that is useful to management.”

Robert N. Anthony
“Management accounting for profit control includes income accounting, cost accounting and budgetary,
planning and control; of these, cost accounting is the keystone.”
W. Keller and Ferrara
“Management accounting is “any form of accounting which enables a business to be conducted more
efficiently.”
The Institute of Chartered Accountants of England and Wales
“Management accounting is a more intimate merger of the two older professions of management and
accounting, wherein the informational needs of the manager determine the accounting means for their
satisfaction.”
V. Smith
“Management accountancy is the term used to describe the accounting methods, systems, and
techniques which, coupled with special knowledge and ability, assist management in its task of
maximizing profits or minimizing losses.”
Batty
“Accounting, which serves management by providing information as to the cost or profit associated with
some portion of the firm’s total operations, is called managerial accounting.”
Shillinglaw
“Management Accounting is the process of identification, measurement, accumulation, analysis,
preparation, interpretation, and communication of financial information used by the management to
plan, evaluate, and control.”
Management Accounting Practices Committee (MAPC) of the United States

Thus, management accounting is accounting for decision-making. It gives data to aid

management in formulating policies and administering the organization daily.
Management accounting relates to accounting primarily for management (i.e., accounting that
provides the necessary information to management, enabling key personnel to discharge their
functions).
Planning, organizing, directing, and controlling are these functions. Accounting for
management offers the information required for management to exercise effective and efficient
control over the firm.
To ensure that the decision-making process is straightforward, simple, and efficient,
management accounting was developed to integrate these pieces of data.

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1.3 NATURE OF MANAGEMENT ACCOUNTING

Any concept's nature or features are derived from its meaning and definitions. Consequently,
the nature of management accounting may be deduced from its definition and aims.
1. Oriented toward the future: Although financial accounting provides historical
information, that information is used to make plans and important decisions.
2. Raising productivity: Concepts such as responsibility accounting, cost centres, etc.,
are helpful in increasing productivity and regulating employee performance.
3. Management accounting investigates the relationship between cause and effect when
assessing the rationale for a loss or profit.
4. Flexible: Management accounting does not adhere to specific standards or formats,
such that the procedure to be followed and the way the result is assessed is left to the
discretion of the data user.
5. It gives only information, not decisions: Management accounting provides only
information, which must be studied and correctly interpreted by management to reach
a conclusion.
6. Tools and techniques: A variety of statistical and mathematical tools and techniques
are used to present the data.
7. Utilizes accounting information: It uses financial information in a manner that meets
the needs of planning, controlling, and decision-making.

1.4 SCOPE OF MANAGEMENT ACCOUNTING

It has a broad scope as it transcends the bounds of cost and financial accounting and
encompasses a variety of sectors, including:
1. A solid and well-designed financial accounting system is required for a successful and
effective management accounting system.
2. Several cost accounting methods, such as marginal costing, standard costing,
budgeting, etc., are utilised by management accounting systems for decision-making.
3. A management accounting system is incomplete without appropriate cost management
procedures.
4. Management accounting utilises statistical tools, including tables, graphs, and charts,
to provide findings and reports.
5. Management accounting provides a reliable method for reporting to top management.
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Management Accounting

6. Tax management is only possible when a solid management accounting system is in

place.
7. Budgeting and budgetary control play a crucial role in the decision-making process.
8. The management accountant is required to utilise the internal audit report to evaluate
performance at all levels.
9. Management accountants are expected to maintain and direct office services such as
filing, copying, communication, and other auxiliary services.

1.5 CLASSIFICATION OF COSTS

The different bases of cost classification are:

1. By time (Historical, Pre-determined).
2. By nature or elements (Material, Labour and Overhead).
3. By degree of traceability to the product (Direct, Indirect).
4. Association with the product (Product, Period).
5. By Changes in activity or volume (Fixed, Variable, Semi-variable).
6. By function (Manufacturing, Administrative, Selling, Research and development, Pre-
production).
7. Relationship with accounting period (Capital, Revenue).
8. Controllability (Controllable, Non-controllable).
9. Cost for analytical and decision-making purposes (Opportunity, Sunk, Differential,
Joint, Common, Imputed, Out-of-pocket, Marginal, Uniform, Replacement).
10. Others (Conversion, Traceable, Normal, Avoidable, Unavoidable, Total).
1.5.1 Classification based on Time
i. Historical Costs: These expenses are determined after the fact. Such expenses are only
available once the production of a given item has been completed. They are objective
and verifiable through reference to actual operations.
ii. Pre-determined Costs: These costs are calculated in advance based on a specification
of all cost-influencing factors. Such fees may include:
a. Estimated costs: Costs are estimated prior to the production of items; naturally, these are
less precise than standards.
b. Standard costs: This is a specific notion and method. This strategy entails: • establishing
established criteria for each element of cost and each product; • comparing actual to standard
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to identify deviations; • pinpointing the causes of such deviations and taking corrective action;
and • implementing corrective measures. Obviously, standard costs, though pre-determined,
are arrived with much greater care than estimated costs.
1.5.2. Classification by Nature or Elements
There are three broad elements of costs:
(1) Material: The substance from which the product is made is known as material. It can be
direct as well as indirect.
Direct material: It refers to those materials which become a major part of the finished product
and can be easily traceable to the units. Direct materials include:
(i) All materials specifically purchased for a particular job/process
(ii) All material acquired, and latter requisitioned from stores
(iii) Components purchased or produced
(iv) Primary packing materials like cartoons and boxes
(v) Material passing from one process to another
Indirect material: All material that is used for purposes ancillary to production and which can
be conveniently assigned to specific physical units is termed as indirect materials. Examples,
oil, grease, consumable stores, printing, and stationary material etc.
(2) Labour: Labour cost can be classified into direct labour and indirect labour.
Direct labour: It is defined as the wages paid to workers who are engaged in the production
process whose time can be conveniently and economically traceable to units of products. For
example, wages paid to compositors in a printing press, to workers in the foundry in cast iron
works etc.
Indirect labour: Labour employed for the purpose of carrying tasks incidental to goods or
services provided, is indirect labour. It cannot be practically traced to specific units of output.
Examples, wages of store-keepers, foreman, time-keepers, supervisors, inspectors etc.
(3) Expenses: Expenses may be direct or indirect.
Direct expenses: These expenses are incurred on a specific cost unit and identifiable with the
cost unit. Examples are cost of special layout, design or drawings, hiring of a particular tool or
equipment for a job; fees paid to consultants in connection with a job etc.

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Management Accounting

Indirect expenses: These are expenses which cannot be directly, conveniently and wholly
allocated to cost centre or cost units. Examples are rent, rates and taxes, insurance, power,
lighting and heating, depreciation etc.
It is to be noted that the term overheads has a wider meaning than the term indirect expenses.
Overheads include the cost of indirect material, indirect labour and indirect expenses.
overheads may be classified as
(a) production or manufacturing overheads, (b) administration overheads, (c) selling
overheads, and (d) distribution overheads.
The various elements of cost can be illustrated by the following chart:

Total expenditure may therefore be analysed as follows:

Materials cost = Direct materials cost + Indirect materials cost

+ + +
Labour cost = Direct labour cost + Indirect labour cost
+ + +
Expenses = Direct expenses + Indirect expenses
________________ ___________________ ___________________
Total cost = Direct cost/prime cost + Overhead cost
================ ================= ===================

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Q. Which of the following costs would be charged to the product as a prime cost?
A. Component parts
B. Part-finished work
C. Primary packing materials
D. Supervisor wages
Answer
A, B and C
A, B and C are all examples of direct material costs. The prime cost includes direct material, direct labour and
direct expenses. D is an indirect labour cost.

1.5.3 Classification by Degree of Traceability to the Products

Cost can be distinguished as direct and indirect.
Direct Costs: The direct costs are those which can be easily traceable to a product or costing
unit or cost center or some specific activity, e.g. cost of wood for making furniture. It is also
called traceable cost.
Indirect Costs: The indirect costs are difficult to trace to a single product or it is uneconomic
to do so. They are common to several products, e.g. salary of a factory manager. It is also called
common costs.
Costs may be direct or indirect with respect to a particular division or department. For example,
all the costs incurred in the Power House are indirect as far as the main product is concerned
but as regards the Power House itself, the fuel cost or supervisory salaries are direct. It is
necessary to know the purpose for which cost is being ascertained and whether it is being
associated with a product, department or some activity.
Direct cost can be allocated directly to costing unit or cost center. Whereas Indirect costs have
to be apportioned to different products, if appropriate measurement techniques are not
available. These may involve some formula or base which may not be totally correct or exact.
1.5.4 Classification by association with the Product
Cost can be classified as product costs and period costs.
Product Costs: Product costs are those which are traceable to the product and included in
inventory values.
In a manufacturing concern it comprises the cost of direct materials, direct labour and
manufacturing overheads. Product cost is a full factory cost. Product costs are used for valuing

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Management Accounting

inventories which are shown in the balance sheet as asset till they are sold. The product cost of
goods sold is transferred to the cost of goods sold account.
Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc., include
many selling and administrative costs essential to keep the business running. Though they are
necessary to generate revenue, they are not associated with production, therefore, they cannot
be assigned to a product.
They are charged to the period in which they are incurred and are treated as expenses.
Selling and administrative costs are treated as period costs for the following reasons:
(i) Most of these expenses are fixed in nature.
(ii) It is difficult to apportion these costs to products equitably.
(iii) It is difficult to determine the relationship between such cost and the product.
(iv) The benefits accruing from these expenses cannot be easily established.
The net income of a concern is influenced by both product and period costs. Product costs are
included in the cost of the product and do not affect income till the product is sold. Period costs
are charged to the period in which they are incurred.
Consider a retailer who acquires goods for resale without changing their basic form. The only
product cost is therefore the purchase cost of the goods. Any unsold goods are held as
inventory, valued at the lower of purchase cost and net realisable value and included as an asset
in the statement of financial position. As the goods are sold, their cost becomes an expense in
the form of 'cost of goods sold'. A retailer will also incur a variety of selling and administration
expenses. Such costs are period costs because they are deducted from revenue without ever
being regarded as part of the value of inventory.
Now consider a manufacturing firm in which direct materials are transformed into saleable
goods with the help of direct labour and factory overheads. All these costs are product costs
because they are allocated to the value of inventory until the goods are sold. As with the
retailer, selling and administration expenses are regarded as period costs.
1.5.5 Classification by Changes in Activity or Volume
Costs can be classified as fixed, variable and semi-variable cost.
Fixed Costs: The Chartered Institute of Management Accountants, London, defines fixed cost
as “ the cost which is incurred for a period, and which, within certain output and turnover limits,
tends to be unaffected by fluctuations in the levels of activity (output or turnover)”.
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These costs are incurred so that physical and human facilities necessary for business operations,
can be provided. These costs arise due to contractual obligations and management decisions.
They arise with the passage of time and not with production and are expressed in terms of time.
Examples are rent, property taxes, insurance, supervisors’ salaries etc.
It is wrong to say that fixed costs never change. These costs may vary depending on the
circumstances. The term fixed refers to non-variability related to the relevant range. Fixed cost
can be classified into the following categories for the purpose of analysis:
(a) Committed Costs: These costs are incurred to maintain certain facilities and cannot be
quickly eliminated. The management has little or no discretion in this cost, e.g., rent, insurance
etc.
(b) Policy and Managed Costs: Policy costs are incurred for implementing particular
management policies such as executive development, housing, etc. Such costs are often
discretionary. Managed costs are incurred to ensure the operating existence of the company
e.g., staff services.
(c) Discretionary Costs: These are not related to the operations and can be controlled by the
management. These costs result from special policy decisions, new research etc., and can be
eliminated or reduced to a desirable level at the discretion of the management.
(d) Step Costs: Such costs are constant for a given level of output and then increase by a fixed
amount at a higher level of output.
Variable Cost: Variable costs are those costs that vary directly and proportionately with the
output e.g. direct materials, and direct labour. It should be kept in mind that the variable cost
per unit is constant but the total cost changes corresponding to the levels of output. It is always
expressed in terms of units, not in terms of time.
Management decisions can influence cost behaviour patterns. The concept of variability is
relative. If the conditions upon which variability was determined change, the variability will
have to be determined again.

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Management Accounting

Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable elements. Because
of the variable element, they fluctuate with volume and because of the fixed element; they do
not change in direct proportion to output. Semi-variable costs change in the same direction as
that of the output but not in the same proportion. Depreciation is an example; for two shifts
working the total depreciation may be only 50% more than that for single shift working. They
may change with comparatively small changes in output but not in the same proportion.
1.5.6 Functional Classification of Costs
A company performs a number of functions. Functional costs may be classified as follows:
(a) Manufacturing/production Costs: It is the cost of operating the manufacturing division
of an undertaking. It includes the cost of direct materials, direct labour, direct expenses,
packing (primary) cost and all overhead expenses relating to production.
(b) Administration Costs: They are indirect and covers all expenditure incurred in
formulating the policy, directing the organisation and controlling the operation of a concern,
which is not related to research, development, production, distribution or selling functions.
(c) Selling and Distribution Cost: Selling cost is the cost of seeking to create and stimulate
demand e.g. advertisements, market research etc. Distribution cost is the expenditure incurred
which begins with making the package produced available for dispatch and ends with making
the reconditioned packages available for re-use e.g. warehousing, cartage etc. It includes
expenditure incurred in transporting articles to central or local storage. Expenditure incurred in

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moving articles to and from prospective customers as in the case of goods on sale or return
basis is also distribution cost.
(d) Research and Development Costs: They include the cost of discovering new ideas,
process, products by experiment and implementing such results on a commercial basis.
(e) Pre-production Cost: When a new factory is started or when a new product is introduced,
certain expenses are incurred. There are trial runs. Such costs are termed as pre-production
costs and treated as deferred revenue expenditure. They are charged to the cost of future
production.

1.6 MANAGEMENT, COST & FINANCIAL ACCOUNTING

Basis Management Financial Cost Accounting

Accounting Accounting
Meaning Concerned with Concerned with Concerned with the
accounting recording, ascertainment,
information useful to classifying and allocation and
the management for summarizing the distribution of costs
decision making business transactions
Objective Information is To determine the It's objective is to
provided to company’s ascertain cost,
formulate plans and profitability and control cost,
to achieve desired financial position evaluate
objective of during a financial performance and
management year take remedial
measures
Nature Futuristic in nature Historical in Deals with historic
data but also
Nature
futuristic in nature
Users of Management Internal as well as Majorly
information external users like management

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Management Accounting

owners,
management, banks
& FIs etc.
Dependence MA depends on Independent Independent but
consider
both financial
figures from
accounting and
financial
cost accounting
accounting
Units of Can be expressed Expressed only in Expressed in both
measurement both in monetary monetary and
monetary units
and physical units physical units.
Accounting system Not restricted to any Based on double Follows few
specific accounting principles
entry system and
system and develop a
follows uniform
costing system best
accounting rules and
suited to its
regulations
individual needs
Emphasis Emphasis is on Emphasis is on Emphasis is on cost
planning and profit/loss ascertainment, cost
controlling
determination control and cost
reduction

1.7 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

The financial accounts are maintained to ascertain profit & loss of the company as a whole
entity as well as financial position for a particular financial year. The financial accounts
primary objective is to record, classify and summarisation of business transactions and finished
with the preparation of financial statements i.e. Trading & Profit & Loss Account and Balance
Sheet.
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Whereas, Cost accounting deals with the ascertainment of cost of product, absorption of
overheads into product cost, ascertainment of division-wise or product – wise profitability. The
accounting principles, methods, and practices applicable under these two systems of accounting
are different.
The maintenance of different sets of accounts with different objectives will show different
figures of profit or loss and thus it becomes necessary to reconcile the two accounts periodically
and a statement of reconciliation is prepared to show the reasons for difference in profit or loss
shown by cost and financial accounting. The cost and financial accounts are maintained in
different forms or follow different methods, principles and approaches and it will naturally
result in different profit or loss ascertained in cost and financial accounts which necessitates
the reconciliation of both accounting to identify the reasons for deviation.
Reasons for necessity of Reconciliation
The important reasons necessitating the reconciliation of cost and financial accounts as follows:
1. To ascertain the reasons for the difference in profits or loss as shown by cost accounts
and financial accounts
2. To ensure the accuracy of cost accounting methods and practices followed by the
companies like absorption and recovery of overheads, depreciation allowance,
inventory valuation and is verified with the financial accounts
3. To ensure the reliability of cost accounting data and financial accounting data
4. To promote coordination and co-operation between the financial accounting and cost
accounting departments in generating accurate and reliable accounting data for meeting
statutory requirements and generation of data for managerial decision-making
5. To explain the difference in profit or loss shown in cost accounting and financial
accounting and any mistakes in preparation of accounts are brought out and ensures in
arithmetical accuracy of both sets of accounts
6. To help in standardisation of policies like inventory valuation, overhead absorption,
depreciation provision etc. for better internal control
Reasons for Disagreement
The difference in profit or loss ascertained in cost accounting and financial accounting is due
to the following reasons:
Certain items only shown in Financial Accounting that are not shown in Cost Accounting:
• Profit or loss on sale of fixed assets
• Discount on issue or redemption of shares and debentures
• Capital issue expenses
• Preliminary expenses written off

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Management Accounting

• Cash discounts and bad debts

• Distribution of dividend
• Payment of income tax
• Donations
• Transfer of profits to reserves
• Goodwill written off
• Lay off wages and retrenchment compensation
Certain items only shown in Cost Accounting that are not shown in Financial Accounting
• Notional rent on premises owned
• Notional interest on capital
Disagreement due to under or over absorption of overheads items:
In financial accounting the actual overheads incurred are recorded and accounted for. But, in
cost accounting for ascertainment of cost of production and profitability of cost unit,
predetermined overhead absorption rates like machine hour rate, direct labour hour rate,
percentage of direct material, direct labour, prime cost, factory overhead, factory cost etc. are
used for absorption of overheads.
The absorption of overheads in cost accounting may be over or under recovered than the actual
overheads incurred.
Difference due to use of different methods of stock valuation:
• In financial accounting, the stocks of raw materials are valued at cost or market value,
whichever is lower. Whereas, in cost accounting, stock may be valued under FIFO,
LIFO, weighted average price method etc.
• The finished goods are valued under absorption costing method in financial accounts.
But, in preparation of cost accounting, the finished stock may be valued under
absorption costing, marginal costing, standard costing etc.
Difference due to use of different rates of depreciation
In financial accounting, the amount of depreciation is charged as per rates given in the
Companies Act, 2013. But, in cost accounting, appropriate and suitable method is used for
calculation of the amount of depreciation
Methods of Reconciliation -
The cost accounting and financial accounting are reconciled by preparing any of the following:
(1) Memorandum Reconciliation Account
(2) Reconciliation statement

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1. Memorandum Reconciliation Account

It is an account not being a part of double entry system of book-keeping. It is a method by
which a record can be made of differences in cost accounting and financial accounting.
Memorandum Reconciliation Account, basically, is the presentation of reconciliation statement
in ‘T’ shape account form.
Steps in preparation of Memorandum Reconciliation Account
Four basic steps of preparing the Memorandum Reconciliation Account are encapsulated in the
following lines:
Step 1. Profits as per cost account is placed on the credit side of the account and loss the debit
side of the memorandum reconciliation account.
Step 2. All items which are to be added for reconciliation purpose will be shown on the credit
side of the account. For instance, if we are starting from costing book's profits, the following
items will be shown on the credit side :
(a) Purely financial incomes included in financial accounts
(b) Over-absorption of overheads in cost accounts
(c) Over-valuation of opening stock in cost accounts
(d) Under valuation of closing stock in cost accounts.
Step 3. All those items which are to be subtracted from base profit figure will be shown on the
debit side of Memorandum Reconciliation Account. A list of the items to be shown on debit
side in case, we start the procedure from profits as per cost accounts is given below :
(a) Purely financial charges (as listed in the preceding section) excluded from cost
accounts.
(b) Under absorption of overheads in cost accounts
(c) Over-Valuation of closing stock in cost accounts
(d) Under-Valuation of opening stock in cost accounts.
Step 4. Placing the balancing figure: If sum of credit side items > sum of debit side, items,
balancing figure is profit. If sum of debit side > sum of credit side items, balancing figure is
loss, as per financial accounts.

DR. Memorandum Reconciliation A/c

CR.
Particulars Amount Particulars Amount
(Rs.) (Rs.)

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Management Accounting

To Loss as per cost accounts By profits as per cost accounts

To pure financial charges By pure financial income
• Discount on issue of shares • Rent Received
written off
• Preliminary expenses • Interest Received
written off
• Underwriter's Commission • Profits on sale of fixed
assets
• Fines & Penalties • Dividend
• Donation • Transfer fee received
• Bank interest By items charged in cost
accounts only.
• Interest on own capital
• Rent on own building
To depreciation under charged in By Excess of depreciation
cost a/cs charged in cost books.
To under-absorption of overheads By over-absorption of
overheads
To under-valuation of opening By over-valuation of opening
stock in cost a/cs stock in cost a/cs.
To over-valuation of closing stock By under-valuation of closing
in cost a/cs stock in cost a/cs.
To profits as per financial a/cs By Loss as per financial a/c.
(Balancing figure when sum of (Balancing figure when sum
credit items > sum of debit of Debit items > sum of credit
items) items)

Illustration 1:
PQR Limited has closed its accounts for the year ended March 31, 2021. The profit shown in
financial accounting is Rs.3,72,000 and for the same period, cost accounting showed a profit
of Rs.4,10,000.On comparison of both accounts, the following stock balances appeared:

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MBA

Stock Value Cost Accounting Financial

Accounting
Raw Material Opening Stock 1,36,000 1,45,000
Closing Stock 1,10,000 1,03,000
Finished Goods Opening Stock 2,66,000 2,58,000
Closing Stock 2,29,000 2,23,000

Additional information appearing the financial accounting:

Loss on sale of machine Rs.35,000
Dividends received Rs.7,000
Interest received Rs.4,000
You are required to prepare Memorandum Reconciliation Account
Solution:
Memorandum Reconciliation A/c
Particulars Amount Particulars Amount
(Rs.) (Rs.)
To loss on sale of machine 35,000 By Profit as per Cost 4,10,000
Accounting
To undervaluation of 9,000 By Dividend Received (not 7,000
opening stock of raw credited in cost accounting)
materials in cost accounting
To over valuation of closing 7,000 By Interest received (not 4,000
stock of raw materials in cost credited in cost accounting)
accounting
To over valuation of finished 6,000 By over valuation of opening 8,000
goods closing stock in cost stock of finished goods in
accounting cost accounting
To Net Profit as per financial 3,72,000
accounting
4,29,000 4,29,000

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Management Accounting

2. Reconciliation Statement:

In preparation of reconciliation statement, profit shown by one set of accounts is taken as base
profit and items of difference are either added to it or deducted from it to arrive at the figure of
profit shown by other set of accounts.
Procedure of Preparing reconciliation Statement
1. Start with profit shown by any one set of accounts (profit as per financial accounts or
profit as per cost accounts). Take this profit as a ‘base profit’.
2. All expenditures not taken into account in arriving at the base profit should be
deducted from it
3. All expenditures taken into account for arriving at the base profit but not
considered for profit shown by other set should be added back to base profit
4. The amount of expenditures undercharged in arriving at the base profit should be
reduced from it
5. All income taken into account for arriving at ‘base profit’ but not considered for profit
shown by other set should be reduced from it
6. Amount of understated income for arriving at the base profit should be added back
7. Amount of overstated income for arriving at the base profit should be reduced from it
8. Income not taken into account for arriving at the base profit but considered for profit
shown by other set should be added to base profit
9. Consider in isolation with the factors, the effect of differences in valuation of opening
stock on base profit. If base profit has been overstated due to difference in valuation of
opening stock, it should be reduced. If base profit has been understated due to difference
in valuation of opening stock, the amount of difference should be added to it.
Proforma Reconciliation Statement - Suppose we start taking the profits as per cost accounts
as base profits figure, the reconciliation statement can be exhibited / presented as given below.
Proforma Reconciliation Statement
(When profits as per Cost Accounts is taken as Starting point or base figure).
Particulars Amount Amount
(Rs.) (Rs.)
A. Profits as per cost accounts
B. Add : items having the effect of higher profits in
financial accounts

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(a) over-absorption of factory, office and selling and

distribution over-heads
(b) Items charged in cost accounts only e.g.
- Notional Rent
- Notional Interest or Salaries
(c) Over-valuation of opening stocks in cost a/cs
(d) Under-valuation of closing stocks in cost a/cs
(e) Purely financial incomes excluded from cost a/cs
- Interest & dividends received
- Rent or transfer fees received
C. Less : items having the effect of lower profits in
financial accounts
(a) Under absorption of factory, office and selling and
distribution overheads
(b) Under-valuation of opening stock in cost a/cs
(c) Over-valuation of Closing stock in cost a/cs
(d) Purely financial charges excluded from cost a/cs egg
Legal charges, donations, preliminary expenses
written off
(e) Depreciation under- charged in cost accounts
D. Profits as per financial accounts.

Note :
In cases we have losses in cost accounting records then the figure of loss as a starting point can
be put as ‘minus’ or ‘-ive’ figure. The implication of this will be that sum of ‘+’ items (items
to be added) will be deducted and sum of ‘-’ items (items to be subtracted) will be added to the
base figure of loss to arrive at the resultant figure (which is the profit/loss as per financial
books).
Illustration2:
The financial accounts for ABC Limited indicate a net profit of ₹ 77,348 whereas the cost
accounts indicate ₹ 102,600 for the same year. Prepare a statement of reconciliation to reconcile
both the earnings from the following data:
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Management Accounting

(i) Depreciation charged in financial accounts ₹ 6500

while recovered in cost accounts ₹ 6520
(ii) Works overheads under absorbed in cost accounts ₹ 1650
(iii) Office overheads over-recovered in cost accounts ₹ 580
(iv) Interest on loans (credit) not included in cost accounts ₹ 4000
(v) Loss due to obsolescence charged in financial accounts ₹ 2580
(vi) Bank interest and dividends received ₹ 573
(vii) Income-Tax paid ₹ 15,020
(viii) Loss due to depreciation in inventories charged in financial accounts ₹ 5733
(ix) Stores adjustment credited in financial accounts ₹ 732
Reconciliation Statement
Solution
Particulars Amount Amount
(₹) (₹)
Profits as per cost books 102,600
Add:
1. Excess of depreciation charged in cost a/cs (6520 - 6500) 20
2. Over absorption of office overheads 580
3. Interest on loans (Credit) 4,000
4. Bank interest and dividend received 573
5. Stores adjustment 732 5,905
Less:
1. Under absorption of works overheads 1,650
2. Obsolescence charged in financial books 2,580
3. Income tax paid 15,020
4. Loss on depreciation of inventories (charged in financial 5,733 24,963
books)
Profit as per financial books 83,542

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MBA

1.8 IN-TEXT QUESTIONS

Indicate whether the following statements are true or false:
1. Cost and financial accounting are reconciled under non-integral
accounting
2. Rent on owned building is not included in cost accounts
3. Costing P&L A/c includes all items of financial nature (like interest)
which are not included in cost ascertainment
4. Dividend received but not included in cost accounts is to be added
back to costing profit in reconciling profit with financial profit
5. Income tax is provided in cost accounting only
6. The need of reconciliation arises only under integrated accounting
system
7. There is only one figure of profit under integral accounting system
8. Over-absorption of production overheads in cost accounts are
deducted to costing profit to reconcile it with profit as per financial
book
9. Loss on the sale of capital assets is not included in accounts under
integral system
10. No accounts of debtors and creditors are opened in integrated
accounts
[Ans: True – 1, 4, 7 False: 2, 3, 5, 6, 8, 9, 10]

1.9 SUMMARY

• The financial accounting deals with recording, classification and summarisation of

business transactions and prepares financial statements i.e. Income Statement and
Balance Sheet
• The cost accounting deals with ascertainment of cost and profitability pf products,
divisions, centres etc.

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Management Accounting

• Different accounting principles, methods, and practices are followed under financial
accounting and cost accounting systems
• The two sets of accounts show different figures and financial results and it requires
periodical reconciliation of both the accounts
• The reconciliation promotes the integrity of both the systems of accounting and helps
in standardisation of policies
• The difference in profit as shown in cost accounting and financial accounting may relate
to the reasons like some expenses are only shown in financial accounting like
preliminary expenses, capital issue expenses,; certain items of expenses are shown only
in cost accounting like interest on capital, notional rent, overheads absorbed in cost
accounts difference in valuation of stock and WIP, difference s in rates of depreciation
charged etc.
• The cost accounting and financial accounting are reconciled by preparation of either
Memorandum Reconciliation Account or Reconciliation Statement

1.10 SELF-ASSESSMENT QUESTIONS

1. State the need for reconciliation of cost and financial accounts.

2. There is generally a divergence between ‘financial profits’ and ‘cost profits’. Explain
this statement and give reasons for such divergence.
3. What are the reasons for disagreement of profits as per financial accounts and cost
accounts? Discuss.
4. Mention four items of expenses or incomes which will appear in one set of accounts
but not the other.
5. The financial records by Modern Industries Limited reveal the following data for the
year ended March 31, 2022:

Particulars Amount
(Rs. in
‘000)
Sales (20,000 units) 4,000
Materials 1,600
Wages 800
Factory Overheads 720

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Office and Administrative Overheads 416

Selling and Distribution Overheads
Closing Stock of finished goods (1230 units)
Work-in-progress (Closing)
Materials 48
Labour 32
Factory Overheads 32 112
Goodwill written off 320
Interest on Capital 32

In the costing records, factory overhead is charged at 100% of wages, administration

overhead at 10% of works cost and selling and distribution overhead at Rs.16 per unit
sold.

Prepare a statement reconciling the profit as per cost records with the profit as per
financial records of the company. All workings should form part of your answer.

6. Prepare Cost Sheet Profit & Loss Account from the following information and
reconcile:

Particulars Amount (in Rs.)

Material consumed 20,000
Wages 18,000
Works Overhead Charges 15,000
Office Overhead Charges 16,000
Selling Overhead 4,000
Sales 1,00,000

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Management Accounting

In cost records, works overhead charges are recovered at 100% on direct wages, and
office overhead charges are recovered at 25% on works cost. Selling expenses are
charged at 10% on sales.
In financial records, debenture interest paid Rs.5,000, preliminary expenses written off
Rs.3,000.

1.11 REFERENCES

• Saxena, V.K. and Vashist, C.D.. Cost Accounting – Textbook. Sultan Chand & Sons
• Kishore, Ravi M. Cost & Management Accounting. Taxmann
• Arora, M. N. Cost and Management Accounting-Principles and Practice. Vikas
Publishing House, New Delhi.
• Jain, S.P., and K. L. Narang. Cost Accounting: Principles and Methods. Kalyani
Publishers, Jalandhar.
• Lal, Jawahar & Seema Srivastava. Cost Accounting. McGraw Hill Publishing Co., New
Delhi.
• Maheshwari, S. N., & S. N. Mittal. Cost Accounting. Theory and Problems. Shri
Mahabir Book Depot, New Delhi.

1.11 SUGGESTED READINGS

• "Cost Accounting: A Managerial Emphasis" by Charles T. Horngren, Srikant M.

Datar, and George Foster
• "Cost and Management Accounting" by Colin Drury
• "Cost Accounting: Principles and Practice" by M.N. Arora
• "Cost Accounting: An Introduction to Managerial Accounting" by Eric W. Noreen
and Peter C. Brewer
• "Managerial Accounting" by Ray H. Garrison and Eric W. Noreen

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LESSON 2
MATERIAL, LABOUR AND OVERHEAD COST & CONTROL
Dr. Priyanka Ahluwalia
Email-Id [email protected]

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Elements of Cost
2.4 Material Cost and Control
2.4.1 Direct Material Costs
2.4.2 Indirect Material
2.4.3 Objectives of Material Control
2.4.4 Material Cost control
2.5 Labour Cost
2.5.1 Direct Labour Cost
2.5.2 Indirect Labour Cost
2.5.3 Labour Cost Control
2.6 Overhead Cost and Control
2.7 Summary
2.8 Solved Numerical Questions
2.9 MCQ
2.10 Self-Assessment Questions
2.11 References & Suggested Books

2.1 LEARNING OBJECTIVES

After studying this lesson, you will be able:
• To understand the major cost drivers
• To know the basis of cost identification and understand the key elements of cost.
• To effectually use the cost data for effective managerial decision and control analysis
• To enumerate the factors affecting the quality of management decisions and policies.

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Management Accounting

2.2 INTRODUCTION
As discussed in the last section, cost forms an integral part of laying the foundation for
estimating the revenues and profitability of any economic activity. Commonly, the expenditure
incurred on an item is termed as “cost”. However, this is a very generic meaning of the word
“cost”. Cost is not as simple as being generally understood, its understanding is subjective to:
a) The subject application
b) The industry, sector or the business characteristics

For example, the cost of land for a manufacturing business is a substantial expense,
which will support the entire manufacturing process over a very long tenure, thus will
be identified as a capital expenditure. However, the same cost of land for a real estate
business is a direct cost because of the nature of the business as it deals with buying
and selling of real estate assets only. Thus, it can be clearly stated, that the same cost
might indicate different aspects subject to varying situations.
This dynamic feature of the cost concept makes it imperative for the managers to
understand the business model and use due diligence to understand and accurately
identify the various cost heads. This shall give a true picture of the cost structure and
lay down the significance of each cost element.

2.3 ELEMENTS OF COST

Broadly, there are three major elements of cost:
• Material
• Labour
• Overheads

2.4 MATERIAL COST AND CONTROL

Any item used to make a product to satisfy the demand in the economy can be termed as
material. The material used may be raw, semi-processed or finished material, which can be
further processed in the value chain for manufacturing or developing a new product. The
material cost can also be classified as direct or indirect material cost.

2.4.1 Direct Material Costs

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Direct material costs are those raw material and item costs which are incurred directly in the
making of a product. The materials must be simply distinguishable from the ensuing product.
For example, the direct materials for chocolate making are cocoa powder, sugar, oil,
flavourings etc.
The direct material costs are identified and observed for various financial analysis to
understand the magnitude and impact of each cost on the final product. This also supports a
better understanding to establish a justified selling price. Consequently, it enables the
management of the company to establish the key cost drivers.
The key elements of the direct material costs can be enumerated as under:
• Raw material costs – The substances that are transformed by losing their identity
during the process of production, and become an integral part of the product are the raw
materials. For example: Steel used in car manufacturing units, can be termed as raw
material for the Original Equipment Manufacturer (OEM).
• Packing costs: The packing material used for the storage and safe transportation of the
products to the end user is a direct material cost. Material such as bubble wrap,
cardboard, cartons etc are included under this category.
• Freight and storage expenses: Transportation costs and storage costs are a function
of the final product features such as perishability, fragility, size, geographical location
gap between the manufacturer and the end customer etc. This cost must be considered
while calculating the direct material cost as this function bridges the gap between the
manufacturer and the end user.
• Indirect Taxes
With the new tax regime in the country, Value added tax (VAT) and goods and services
tax (GST) is levied almost on all materials. However, the tax rates vary on the basis of
the material category and the geographical location.
With the help of the following examples, we can clearly understand the direct material
costs;
 Fabric is a direct material cost for a readymade clothing business
 The stitching machinery, buttons, zips etc will also be considered as
components of direct material costs.
 The wood and steel used in furniture manufacturing business is a direct
material cost.
 The plastic used in the toy manufacturing business is also a direct
material cost.
Thus, direct material costs can be easily understood by relating it to real life
examples.
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Management Accounting

2.4.2 Indirect Material

Indirect materials are goods are those which are part of the overall manufacturing process
however, are not transformed during the process. These materials are consumed to support the
manufacturing process and generally, the outgo on these materials is comparatively lesser than
the direct materials. It is also tedious to allocate these costs in specific quantities to the finished
product. For example, consumables such as tapes, gloves, protective gears, stationary etc. can
be termed as indirectmaterialsl whichise significant for the smooth production process but do
not lose their original form during the production process.

The calculation of direct material cost can be understood as under:

Illustration 2.1 Intech Ltd is a pen manufacturing company. The finance manager wishes to
understand the total direct costs of the company.
The cost elements of Intech Ltd for December, 2021are as under:
Cost of raw material purchased: Rs. 109,000
Indirect taxes: Rs.15,200
Wages paid to the employees: Rs 43,000
Packing and container costs incurred: Rs. 2,000
Inward Freight charges: Rs. 950
You are required to calculate the direct material cost for the company on behalf of the finance
manager.
Solution:
Particulars Amount (Rs.)
Material Cost (a) 1,09,000
Indirect Taxes (b) 15,200
Packing and Container costs (c) 2,000
Inward Freight Charges (d) 950
Total Direct Costs (a+b+c+d) 1,27,150

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Further, the total direct cost per unit can also be computed as follows:
Let us assume: Total number of pens manufactured during the month of December, 2021 is
10,000.
Therefore,
The Direct cost per unit shall be estimated as under:
Total Direct costs / No. of units manufactured
Thus, the direct cost per pen = Rs. 1,21,750 / 10,000 = Rs. 1.2175
Significance - Direct Materials cost
As discussed earlier, direct material costs are substantial costs incurred during the production
process and thus must be considered by the cost accountant and the management to take well-
informed decisions for the smooth and successful functioning of the business.
• The direct material costs form a significant portion of the total costs and are crucial for
setting the final product pricing, thus it is worth taking the cost of each item, that is
being used to develop the final product.
• The direct material cost also supports a comparative cost analysis vis a vis the
realization per unit, thereby, establishing the profits generated by each product.
• It supports the managers to understand the supplier cost structure and make a market-
wide analysis in terms of the quality and pricing of the raw material procured. Thus,
this information can be effectively used by the managers for price negotiations with the
suppliers.
• It helps managers to understand the costing and pricing bottlenecks and further helps
them develop an effective cost control and review system. This shall also result in
efficient utilisation of resources and better supply management.

Thus, direct material cost analysis allows the managers to take improvised business decisions
backed by an in-depth understanding of the cost elements and profits generation capacity of
the business.

This cost control and review system supports better product development at effective costs,
thereby enhancing the product acceptability by the end consumers which in turn leads to better
growth prospects for the business.

For a break down free production process, the manufacturing unit always requires an
uninterrupted supply the raw materials, stores and spares and machines. The purchase

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Management Accounting

department plays a key role in procuring the required quantity and quality of taw materials.
Further, the procured raw materials are stored efficiently and safely by the stores’ department
and released to the production department on requisition raised. This calls for well-coordinated
efforts between the various departments. Thus, material control can be defined as the timely
availability of the optimum quantity at the best quality possible at the least cost possible. This
calls for minimum stock maintenance to avoid raw material shortage yet maintain the least
possible storage cost and thereby, avoiding any cost of damage to the input materials.

Thus, in order to avoid stock-out costs, high-cost procurement of raw materials and stock
damage costs, most of business organisations maintain a production planning and control
department whose endeavour is to coordinate between the various organisational functions
such as purchase, production, sales and marketing departments etc. It also acts to keep the costs
at the minimum level while maintaining the quality and continuity of the production and sales
department.

2.4.3 Objectives of Material Control

As discussed in the earlier section, it is very crucial to keep the costs under check to operate at
the most efficient level. The material control system supports to achieve the following aims:

1. To fix the reorder level of raw materials: For efficient inventory management, it is
imperative to fix the quantity of the raw material at which it should be reordered. It is
also required to set a limit for minimum quantity, optimum quantity and maximum
quantity of the materials to monitor the overall costs.
2. To keep a track of the material stock levels: Material control helps to facilitate
updated information about the availability and the quantity of the materials. This
facilitates the timely raising of requisitions for the purchase of the required quantity, to
support the uninterrupted manufacturing process. It also helps in identifying the levels
of re-purchase of stocks.
3. Ensures availability of Quality products: Every manufacturing organisation needs a
specific quality of materials in order to keep the costs at the estimated level yet meet
the customer specifications for the final product. Any change in the quality of the raw
materials will either effect the cost structure adversely or product quality, thereby,
making the product unsuitable either in terms of final pricing or quality of the end user.
Thus, keeping a check on the quality of input materials, yet maintaining the costs within
the permissible limits is of key significance.
4. To monitor the wastage levels: In order to keep a check on the wastage of the input
due to breakage, theft, obsolescence etc, efficient storage facilities for various materials
are maintained. This helps in keeping the wastage at a bare minimum level and requires
an efficient controlling and monitoring system in place.

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5. Effective purchasing costs: As material control supports maintaining the optimum

levels of stocks and also provides information about the timely reorder levels, the
materials can be procured at the right price as, there is no sudden requirement to procure
materials. With this efficient material planning system in place, the materials can be
purchased at competitive prices. This also enables management to establish long-term
relationships with the suppliers, thereby ensuring quality consistency too. This cost-
effectiveness percolates to better profitability for the organisation.
6. Avoidance of Over-Stocking or Under-Stocking: As conferred in the above
discussion, understocking of materials might lead to production breakdowns and
overstocking might lead to higher storage and wastage costs. Overstocking might also
be impacted obsolescence. Both these situations are likely to put profitability under
pressure. Thus, in order to manage the overstocking or understocking costs, efficient
material control systems are necessary.

2.4.4 Material Cost Control

Requisition order of materials: The first step to effectively control the material costs is to
estimate the adequate quantity of raw materials, components and other stores. Based on the
best estimates, the purchases are made by the purchasing department of the organisation. The
purchase requisition also mentions the quality of the material directed to be procured within
the stipulated time frame.

Reliable material vendors: The purchase department on the basis of the quality and the best
pricing shortlists a few vendors for each material procurement. On the basis of the purchase
requisition, the vendor is selected considering the time lag between the order and supply of the
materials. The vendors are continuously reviewed with a view to maintaining the quality and
striking a fine balance between the price and the right time of procurement.

Issue of Letters Inviting Quotations: After a careful selection of the vendors, the quotations
are invited from the vendors with clear specifications regarding the price, quantity, quality,
delivery time etc. This enables the purchasing department to make a prudent decision on the
basis of the comparative analysis of the quotations made by the vendors. As these quotations
clearly specify the expected deal terms and conditions, any risk of future mismatch in terms of
quality, quantity or timeliness is mitigated substantially.

Placing the Purchase Order: On the careful selection of the vendor on the basis of the order
details, the purchase order is placed with the vendor. The purchase order indicates the quantity,
quality, the delivery schedule for the materials. In some cases, the penalty clause is also inserted
to avoid any delivery delays. It acts as a deterrent and the transfer of risk of loss due to stock
out to an extent.

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Management Accounting

Quality checks and Approval of Invoices: Post the delivery of the materials, the quality check
inspections are conducted by the quality control department. This practice helps in minimising
the wastage cost due to any substandard quality as in case of any deviations from the agreed
features of the material, the issue is taken up with vendor, the payments for the material ate
stalled.

Method of Material Pricing Issues

After the materials are issued to the production department, the companies face issues in regard
to the pricing at which the materials issued need to be charged. The companies purchase the
same type of material at different prices at different times in different lots. There are various
methods of pricing material and they may be categorised as below:
I. Cost Price Methods
• First-in-First-out Method (FIFO)
• Last-in-First-out Method (LIFO)
• Highest-in-First-out Method (HIFO)
II. Average Price Method
• Simple Average
• Weighted Average Price Method
• Periodic Simple Average
• Moving Simple Average
• Weighted Moving Average
III. Notional Price Methods
• Standard Price
• Inflated Price
• Market Price
First-in First-out (FIFO) Method
As per FIFO, materials which are purchased first are issued first. The value of the closing stock
is valued at the price of the latest purchases.
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MBA

Advantages:
i. Inventory Management System is effective as the oldest units are consumed first
and inventory comprises the latest stock.
ii. This method is logical.
iii. Easy to understand and operate.
iv. Facilitates inter-firm and intra-firm comparisons.
v. Inventory Valuation and cost of finished goods are regular, perpetual and
realistic.
Disadvantages:
i. Involves lot of calculation work
ii. Cost of production is not linked to the current prices.
iii. For pricing one requisition, more than one price may have to be adopted
iv. In a period of fluctuating prices, the cost of issues do not represent market price

v. The pricing of material returns is not easy.

vi. Cost comparisons among two batches of production become difficult when issues
are priced differently.

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Management Accounting

Inventory Valuation using FIFO

Date Opening Balance Purchase Issue Balance
Units Rate Total Amt. Units Rate Total Amt. Units Rate Total Units Rate Total
Amt. Amt.
01-01- 0 0 0
2022
01-01- 100 30 3000 100 30 3000
2022
15-01- 50 30 1500 50 30 1500
2022
01-02- 200 40 8000 200 40 8000
2022
15-02- 50 30 1500
2022
15-02- 50 40 2000 150 40 6000
2022
20-02- 100 40 4000 50 40 2000
2022
01-03- 150 50 7500 150 50 7500
2022
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15-03- 50 40 2000
2022
50 50 2500 100 50 5000

So the value of closing stock is Rs.5,000

2. Last-in-First Out
This method is based on the assumption that the last items purchased are issued first. The
closing stock is valued at the prices of the earliest purchase.
Advantages:
i. LIFO helps company in avoiding tax
ii. It conforms to the principle that cost should be related to current price levels
iii. The cost of material is stated at current market price and thus, unrealised
inventory profits are not reflected in the accounts
iv. Unlike FIFO method, LIFO does not result into unrealised profit due to
inflationary trends
Disadvantages:
i. This method is not acceptable to income tax authorities
ii. This method is useful if the items of materials to be priced are few in number
iii. Under falling prices, issues are priced at lower prices and stocks are valued at
higher prices
iv. Cost of different batches vary greatly, making inter-firm and intra-firm
comparison difficult.
Inventory Valuation using LIFO

Date Opening Balance Purchase Issue Balance

Units Rate Total Units Rate Total Units Rate Total Units Rate Total
Amt. Amt. Amt. Amt.
01-01- 0 0 0
2022

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Management Accounting

01-01- 100 30 3000 100 30 3000

2022
15-01- 50 30 1500 50 30 1500
2022
01-02- 200 40 8000 200 40 8000
2022
15-02- 100 40 4000 50 30 1500
2022
15-02- 100 40 4000
2022
20-02- 100 40 4000 50 30 1500
2022
01-03- 150 50 7500 150 50 7500
2022
15-03- 100 50 5000 50 30 1500
2022
50 50 2500

Value of Closing 50 30 1500

Stock
50 50 2500
4000

Weighted Average Price Method

Under WAP, weighted average price is calculated by dividing the total cost of material
purchased during an accounting period by the total quantity of material purchased during that
period.
WAP = Total Cost of purchases during an accounting period / Total quantity purchased during
an accounting period
Advantages:
i. Simple to operate
ii. This method averages out the effect of price fluctuation
iii. Used in process industries
Disadvantages:
i. Cannot be used in job order industry where each individual order must be priced
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at each stage upto completion

ii. The costing of material issues gets delayed up to the end of the period and this
results in heavy burden on the staff
iii. The closing stock does not correspond to the conventional method of valuting
stock i.e. cost or market value, whichever is lower.
Inventory Valuation using Weighted Average Price

Date Opening Balance Purchase Issue Balance

Units Rate Total Units Rate Total Units Rate Total Units Rate Total
Amt. Amt. Amt. Amt.
01-01- 0 0 0
2022
01-01- 100 30 3000 100 30 3000
2022
15-01- 50 30 1500 50 30 1500
2022
01-02- 200 40 8000 200 40 8000
2022
15-02- 100 40 4000 50 30 1500
2022
15-02- 100 40 4000
2022
20-02- 100 40 4000 50 30 1500
2022
01-03- 150 50 7500 150 50 7500
2022
15-03- 100 50 5000 50 30 1500
2022
50 50 2500

Value of Closing stock = Rs.4,000

Normal Loss of Material Vs Abnormal Loss of Material
Material loss arises due to handling, storage or during manufacturing. Material loss is
categorised into two i.e. normal loss and abnormal loss.
Normal loss is that loss which has necessarily incurred and thus is unavoidable. Examples:

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• Loss due to evaporation

• Loss occurring due to loading and unloading
• Loss resulting from breaking the bulk, etc.
Normal loss of material cannot be completely avoided but can be controlled to a limited extent.
The term "abnormal loss" refers to losses caused by inefficiency in operations, mischief,
negligence, etc. Examples –
• Theft or pilferage
• Breakage
• Fire, accident, flood, etc.
• Use of inaccurate instruments
• Improper storage, etc.
Materials losses may arise in the form of waste, scrap, spoilage or defectives.
Waste consists of invisible loss, visible loss that cannot be collected, and the percentage of
recovered loss that cannot be sold. Waste is not factored into production quantity. Wastes
include smoke, dust, gases, slag, etc.
Scrap is the non-usable loss that can be sold. It is a residue that can be measured and has a
negligible value. It may be caused by the processing of materials, outdated stock, or defective
parts. Metal scrap may consist of turnings, borings, filings, etc.; sawdust in the timber sector;
and off-cuts and cut pieces in the leather business.
Spoilage refers to damaged materials or components that cannot be repaired or reconditioned
during the manufacturing process. Some spoilage may be sold as seconds. If they have
deteriorated significantly, they can be sold as garbage or scrap.
Defectives are the portion of process loss that can be transformed into finished goods by
investing additional material and labour costs. The additional expenses are added to the
manufacturing cost, and the rectified units are added to the overall number of units.
Substandard materials, poor craftsmanship, inadequate inspection, a lack of blueprints, etc. can
all result in flaws.

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2.5 LABOUR COST

The raw material needs to process at different stages to convert the input materials into a
finished product. This needs human intervention i.e. the human skills; knowledge and efforts
are put in to manufacture a finished product. These human efforts are to be compensated in
monetary terms and this is called the labour cost. The cost of labour comprises a variety of
charges related to employees. These can be direct monetary payments to employees like basic
wages, dearness allowance, bonuses, etc., deferred monetary benefits like employer
contributions to provident funds, gratuities, pensions, etc., and fringe benefits like employer
contributions to the Employees' State Insurance scheme, subsidized food, and housing, leave
travel concessions, medical and vacation home facilities, libraries, and other welfare measures.
Like material cost, labour costs might be direct or indirect in connection to the task or the final
output.
2.5.1 Direct Labour Cost
Direct labour cost is the part of a factory's prime cost that is allocated to paying employees who
worked there directly on the creation or manufacture of the items. The amount that is paid to
labour for each unit they produce or for each hour they work on a project can also be referred
to as the cost of direct labour.
Direct labour costs can be located and assigned to a particular job process or product. Examples
of direct labour cost are as follows:
Wages: The amount which is paid by company to labourer for production of products. This is
example of direct labour cost.
Payment of Subsidized Food: The amount which is paid by company for providing the food
at subsidized rates to laborers will be the example of direct labour cost.
Subsidized Housing: If company is getting less rent from worker for providing homes,
different between actual rent and taken rent will be the example of direct labour cost.
Educational Benefits to Children of Workers: All educational benefit's price which is being
given to the children of workers will be the example of direct labour cost.
Other Benefits: In order to indicate the true prime cost in the cost sheet, bonus, allowances
and other parks or benefits are added in the direct labour cost.

2.5.2 Indirect Labour Cost:

The amount given to employees who aren't directly involved in the manufacturing of goods is
referred to as indirect labour cost. It is impossible to identify and assign the indirect labour cost
to a specific cost centre or cost unit.

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Indirect labour costs are typically spread evenly. Maintenance workers, managers, supervisors,
sweeping crews, etc. are all examples of indirect labour costs. Nonetheless, they indirectly
contribute to the manufacturing of products.

Examples of indirect labour are as follows: Production manager, Marketing, Security, and
Human Resources

Direct and indirect labour costs must be distinguished for the following reasons:

• to calculate accurate labour costs and thus provide a basis for strict control;

• to facilitate calculation of labour efficiency;

• to ensure proper allocation of overheads;

• to implement incentive schemes;

• to facilitate inter-unit comparison; and

• to estimate total labour costs.

What distinguishes indirect labour from direct labour?

The price associated with the production of goods and services is direct labour. The number of
hours of labour required to produce a product for a consumer is used by businesses to determine
the cost of direct labour. Employees that support other departments within the company are
only taxed for indirect labour, which is not used in the manufacturing process.
Direct Labour Cost forms part of PRIME COST whereas Indirect Labour Cost becomes part
of OVERHEAD.
2.5.3 Labour Cost Control
Employees have a crucial part in an organization's growth and productive operations because
they are its most valuable asset. The systematic and efficient use of the organization's human
resources has a stronger impact on the development and advancement of the company. In the
same comparison, it is certain that its manufacturing and marketing activities will be slowed
down if this resource is not correctly exploited.

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The management is concerned with keeping labour costs under control. Labour cost control
involves such systems, procedures, techniques and tools used by the management in order to
keep the labour cost of the product or job as minimum as possible. Labour cost control includes
the process of developing various forms, studying and recording the activities and performance
of workers, calculating the correct amount of wages and making payment in time. For planning
and decision-making, it also includes the process of assessing and reporting labour costs to
management.

• Provide employees with predictable work schedules.

• Reduce pay overages.
• Reduce labor costs by optimizing schedules.
• Reduce employee turnover and increase productivity.
• Incentivize performance.

Labour cost management is essential

• To employ labour in the industrial process economically.

• To produce the most output possible using the fewest materials and resources possible.
• To produce better-quality work with the least amount of time and effort from the workforce.
• To decreases the cost of production of products created or services delivered.
• By fostering a positive work atmosphere in the factory, one may guarantee the contentment
of the employees.
• To implement a just system of wage payment and to reduce employee turnover.
• Controlling labour costs is useful in reducing worker waste of resources, idle time, and
atypical overtime work.
• To maintain a secure workplace atmosphere.
• Controlling labour costs is crucial for maintaining accurate personnel records and providing
management with data on employee availability, productivity, utilization, and absenteeism.
• To make the organisation more profitable and competitive.

Factors for labour-cost control

While planning the system, the following elements for labour-cost control should also be taken
into consideration:

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Management Accounting

Production-Planning: Production should be organised to utilize labour as efficiently and

effectively as possible. Production planning is made up of the engineering of the product and
the process, programming, routing, and direction.

Setting up of standards: The setup of time study and motion study for industrial activities is
made possible by work study. A comparison is made between the standard labour cost that has
been defined and the actual labour cost, and any discrepancies are examined.

Use of labour budgets: A labour budget is created using the production budget as a guide. The
Labour budget accounts for the type and quantity of workers required for the output as well as
the cost of labour. This budget is a plan for labour costs and is based on historical data taken
into account in the context of the future.

Analysis of the effectiveness of wage policy: How much does the compensation provided by
departments under incentive plans aid in managerial control over labour and labour cost
management?

Labour Performance Reports: The reports on labour usage and efficiency, which are
acquired on a regular basis from the departments, are useful for managing labour and regulating
labour costs.

Minimization of labour cost through control does not necessarily mean paying less to the
employees. It entails getting the most out of the workers by giving them all the amenities, both
financial and non-financial. The result is that the business is able to generate more profit. On
the other hand, if labour costs are not adequately managed, it will negatively affect both cost
savings and profit.
Illustration 2.2
From the details given below, you are required to calculate the direct labour cost to PRIM
corporation for the month of October, 2022
Particulars Amount (Rs.)
Wages paid to labourers 1,65,000
Raw material 7,00,000
Health insurance premium paid for direct labours 15,000

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Wages paid to employees indirectly involved in manufacturing 1,30,000

process

Direct Labour Cost = Wages Paid to labourers +

Health insurance premium paid for direct labourers.
= Rs. 1,65,000+15,000
= Rs. 1,80,000
Note:
The raw material cost is the direct material cost
The wages paid to other employees is an indirect labour cost

2.6 OVERHEAD COST AND CONTROL

Overhead costs are those costs which are incurred over and above the direct material, direct
labour and direct expenses. The overhead expenses are those costs which cannot be directly
recognised to the final product. Thus, overhead costs are a blanket term for indirect material,
indirect labour and indirect expenses.
There are mainly three functions in a manufacturing unit.
a) Manufacturing unit
b) Office and Administrative services
c) Selling and Distribution function
The overheads can be categorised on the following basis:
1. Functional Analysis
2. Behavioural Analysis
1. Functional Classification
Overheads can be divided into the following categories on functional basis:

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Management Accounting

a) Manufacturing or Production or Factory Overhead – These overhead costs are

manufacturing overhead costs such as factory rent and taxes, indirect wages etc.
b) Office and Administrative Overhead– These are non-manufacturing overheads such as
office staff salary, stationery etc.
c) Selling and Distribution Overhead – These expenses are indirect overheads which are
incurred to enhance the sales of the product such as sales performance bonus, sale
promotion expenses etc.

Behavioural Classification

Based on Behavioural patterns, overhead costs can also be categorised as Variable overheads,
Semi -Variable overheads and Fixed overheads.

Variable overheads are directly proportional to the manufacturing scale and thus is a dynamic
cost which increases with the higher production and vice versa. For example, performance
bonus is a variable cost.

Fixed overheads are not linked to the change in the output quantity and is fixed irrespective
of the production scale. For example, Factory rent is a fixed cost.

Semi Variable overheads are those costs which varies with the production level but not in a
linear relation. For example: Power and fuel is a semi variable overhead.

Methods of segregating semi-variable overheads

Semi-variable overheads can be segregated into variable and fixed overheads can be done by
applying the following methods:

i. Scattergraph Method: This is a statistical method, where a line is fitted to a series of data by
observation.

Illustration 1: From the following information, draw the line of best fit
Month Output Units Cost (Rs.)
January 1,500 6,000
February 1,800 6,600
March 2,100 7,200
April 2,820 8,640
May 2,220 7,440

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Month Output (units) Costs (Rs.) Variable Cost (Rs.) Fixed Cost (Rs.)
January 1500 6000 2000 3000
February 1800 6600 3600 3000
March 2100 7200 4200 3000
April 2820 8640 5640 3000
May 2220 7440 4440 3000

ii. High and Low Points Method

Under this method, levels of highest and lowest expenses are compared with one another and
related to output attained in those periods.

Illustration 2: Considering the following information, segregate semi-variable costs into fixed cost
and variable cost.

Month Output (Rs.) SVC (Rs.)

January 5,000 25,000
February 6,000 28,000
March 7,000 31,000
April 9,400 38,200

Considering the highest and lowest levels of output:

Highest (April) 9,400 38,200

Lowest (January) 5,000 25,000
Difference 4,400 13,200
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Management Accounting

Variable Cost per unit = Change in Costs / Change in Output = Rs.13,200 / 4,400 = Rs.3/unit

Month Output (Rs.) SVC (Rs.) VC (Rs.) FC (Rs.)

January 5,000 25,000 15,000 10,000
February 6,000 28,000 18,000 10,000
March 7,000 31,000 21,000 10,000
April 9,400 38,200 28,200 10,000

Thus, VC per unit = Rs.3 per unit and Fixed Cost is Rs.10,000 at all levels of output

Steps of Overhead Costing:

The overhead costs allocation involves the following procedure:

i. Collection of factory overhead costs: Firstly, the overhead costs are assimilated from
the various documents such as the invoices issued, payrolls, distribution details etc. for
the varying sources of overhead costs.
ii. Allocation and distribution of overhead costs: Each overhead cost should be
identified to a specific cost centre. This allocation of cumulative overhead costs to a
particular cost unit is called cost allocation.

However, when the cost centre identification is tedious or impractical, the overhead cost is
allocated based on relevance and rationality. This approach of cost distribution over multiple
cost units is called cost apportionment. There are few generally accepted and practiced basis
of distribution in the industry. The below mentioned list enumerates some of this basis of
apportionment.

i) Rent, rates and taxes i) Area occupied/Floor space

ii) Insurance of Stock ii) Value of Stock
iii) Insurance of other fixed assets iii) Value of fixed assets
iv) Stores overhead iv) Value of materials
v) Indirect wages v) Direct wages
vi) Indirect materials vi) Direct materials
vii) Lighting/Electricity expenses vii) wattage x working hours or
No. of light points
viii) Power viii) K w x working hours
ix) Canteen expenses ix) No. of workers
x) Supervisor’s salary x) No. of workers
xi) Employee welfare expenses xi) No. of workers

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xii) Workers’ compensation insurance xii) Direct wages

xiii) General expenses xiii) Working hours or direct
wages
xiv) Repair & maintenance of assets xiv) Value of assets

iii) Allocation of service function cost to the manufacturing function- This

distribution of service costs to the other cost units is called secondary distribution.
For example, the repairs and maintenance cost might be allocated to the various
cost units on the basis of the asset’s value .

Let us discuss the distribution of overheads and re-distribution of service department cost
to production department with an illustration.

Illustration 2.3 PQR Ltd is a manufacturing company with three production departments
P, Q and R, and two service departments A and B. The following is the forecasted budget
for March, 2023:

Total
Rs
Rent and rates 15,000
General lighting 600
Indirect wages 1,500
Power 3,000
Depreciation of machinery 2,0000
Sundry expenses 10,000

Additional information: P (Rs) Q (Rs) R (Rs) A (Rs) B (Rs)

Area (sq.m) 200 250 300 200 50

Value of machinery (Rs) 60,000 80,000 1,00,000 5,000 5,000
Machine hour 100 200 4000 100 100
Light points (nos) 10 15 20 10 5
Direct wages 30,000 20,000 30,000 15,000 5,000
H.P. of machines 60 30 50 10 ---
Working hours 5,326 3,048 2,048 --- ---

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Management Accounting

You as the cost accountant of the company are required to prepare a statement showing the
apportionment of overheads.

Solution :2.3
Statement showing the distribution of overheads
Item of Basis of Total Production Deptt Service Deptt
expenses apportionmen (Rs)
t
P Q R A B
Rent and Floor Space 15,000 3000 3750 4500 3000 750
rates
General Light points 600 100 150 200 100 50
Lighting
Indirect Direct wages 1,500 450 300 450 225 75
wages
Power H.P. of 3,000 1200 600 1000 200 --
machine -
Depreciation Value of 20,000 4800 6400 8000 400 400
machine
Sundries Direct wages 10,000 3000 2000 3000 1500 500
TOTAL 50,100 12550 13200 17150 6925 2275

Apportionment of the Overhead Costs

The basis for the apportionment of the overhead costs are as follows:
• Adequacy: The overhead rate should reflect an unbiased distribution of overhead costs
• Suitability: The overhead rate should be convenient and easy to comprehend and apply
the same.
• Time factor: The time taken to complete a task should be well defined and the overhead
cost should be in line with the time consumed for the specific job.
• Manual or machine work: The overhead should vary on the basis of the type of work
such as manual or mechanised as both involves different resource. The availability and
cost of each process lays the basis for the average overhead rate.
• Diverse Overhead Rates: In an event of varying characteristics of work done,
distinguished overhead rates should be ascertained.

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• Information: The data availability affects the overhead cost selection criteria.
Overhead cost control systems:
Similar to the overhead cost allocation and apportionment, the overhead cost control method
is complex. The overhead cost control requires the management to plan the cost budget
objectively. Further, for monitoring purposes, well defined yardsticks should be laid down.
These yardsticks provide a foundation for the review of the check points. Thus, cost control is
a continuous process and requires dedicated resources to work effectively.
With the alteration in production processes, there is a change in the overhead costs, that needs
to be recognized and considered to reflect the true profitability prospects of the company.
As it has been clearly established that overhead costs are difficult to be recognised under a
product or manufacturing activity, the control even is more complicated as needs to be looked
for minutely, otherwise it might go unnoticed.
Steps to Control Overhead Expenses
The overhead costs can substantially be controlled by proactive cost management. The
management should look for the following key areas to control and reduce the major overhead
costs.
• With the effective working capital management, the overhead costs can be controlled
to a great extent.
• Implementation of total quality management in order to curb the unnecessary and
wasteful expenditure can also help the management in achieving the cost control goal.
• Reducing the logistics costs by optimising the transportation expenses should be
carefully executed, as it is one of the major components of the overheads cost in most
of the supply chain.
• By proper and regular check-ups of the machinery and the production infrastructure,
the maintenance overheads can be kept under control.
• The sales expenses can be minimised by directing the sales force efforts not only to
push sales, but the team should also be trained to work towards the profit maximisation.
The sales incentives should be offered and linked to the profits of the business.

2.7 SUMMARY

The primary goal of a business is to generate profits for all the interested parties. In most simple
terms, profits are the difference between the revenues and cost. Thus, it is very crucial for any
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organisation to study the cost structure of manufacturing the final product. In order to
understand the cost structure, the costs have broadly been classified as three main elements
discussed in this section. The main elements of cost for any manufacturing unit are Material,
Labour and Overheads. The Material and Labour can be directly recognised with the final
product. However, an in-depth study is required for the allocation of overheads to various
manufacturing processes. This cost identification and allocation helps the management to keep
a watch on the key components of the cost structure. This follow up and review process,
enhances the management efficiency in controlling costs and thereby enhancing the
profitability of the organisation.

2.8 SOLVED NUMERICAL QUESTIONS

Question 1 The following is an extract from the accounting records of PAM Corporation for
the 3QFY22 i.e (Oct, 1st to 31st December, 2021)
Cost of Raw Material on October 1, 2021 15,000
Raw material purchases during the quarter 2,25,000
Labour cost paid during the period 1,15,000
Factory Overheads 46,000
Cost of work- in-progress on October 1, 2021 6,000
Cost of raw materials on December 31, 2021 7,500
Cost of stock of finished goods on October 1, 2021 30,000
Cost of stock of finished goods on December 31, 2021 27,500
Selling and Distribution expenses 10,000
Administrative Overheads 15,000
Sales 4,50,000
Prepare the cost sheet
Solution :
Statement of cost
For the period (1st Oct ,2021 – 31st Dec, 2021)
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Particulars Amount (Rs.)

Opening stock of raw 15,000
materials
Add: Purchases 2,25,000
Less: Closing stock of raw 7,500
materials
Cost of raw materials 2,32,500
consumed
Labour cost paid 1,15,000
Direct costs 3,47,500
Factory Overheads 46,000
3,93,500
Add: Opening stock of Work 6,000
in Progress
Less: Closing stock of Work NIL
in Progress
Factory Costs 3,99,500
Add: Administration 15,000
Overhead
Cost of Goods produced 4,14,500
Add: Opening stock of 30,000
finished goods
Less: Closing stock of 27,500
finished goods
Cost of production of goods 4,17,000
sold
Add: Selling and 10,000
Distribution

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Management Accounting

Cost of sales 4,27,000

Profit (Balancing Figure) 23,000
Sales 4,50,000

Questions for Practice:

Q1. From the following you are required to prepare a statement showing the issues made nder
FIFO and LIFO method:
Date
1 Opening Balance 100 units at Rs.10 each
1 Received 200 units at Rs.10.50 each
2 Received 300 units at `10.60 each
4 Issued 400 units
6 Issued 120 units
7 Received 400 units at Rs.11 each
10 Issued 200 units
12 Received 300 units at Rs.11.40 each
13 Received 200 units at Rs.11.50 each
15 Issued 400 units
Q2. Myra Industries Limited is a single product organization having a manufacturing capacity
of 6,000 units per week of 48 hours. The output data vis-à-vis different elements of cost for
three consecutive weeks are given below:

Units Direct Material Direct Labour Total Factory

Overheads
(Variable + Fixed)
2,400 4,800 6,000 37,200

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2,800 5,600 7,000 38,400

3,600 7,200 9,000 40,800

As a cost accountant, you are asked by the company management to work out the selling price
assuming an activity level of 4,000 units per week and a profit of 20% on selling price.

2.9 MCQ

1) The process of charging costs directly to a cost centre is called

i) Absorption
ii) Apportionment
iii) Allocation
iv) Allotment
2) The labour rate is used in an event when
i) Majority of work is done by machines
ii) Majority of work is done by labours
iii) The work is distributed amongst different labour groups
iv) One machine operator works on several machines
3) Direct labour is a
i) Variable Expense
ii) Fixed Cost
iii) Opportunity cost
iv) Sunk Cost
4) Basic objective of cost accounting is
i) Financial analysis
ii) Statutory audits
iii) Tax regulations
iv) Cost ascertainment
5) Material, labour and Overhead expenses are three vital …………. of costs
i) Methods
ii) Segments
iii) Elements
iv) Process
6) The synonym for direct wages is
i) Direct output
ii) Direct Material

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iii) Indirect Labour

iv) Direct Labour
7) Indirect material, indirect labour and indirect expense is collectively known as
i) Material expense
ii) Direct wages
iii) Total cost
iv) Overheads

Answers: 1(iii), 2 (ii), 3(i), 4(iv), 5(iii), 6(iv), 7(iv)

2.10 SELF-ASSESSMENT QUESTIONS

1. Cost management is futuristic in nature. Comment
2. Allocation and apportionment are interchangeable. Do u agree with the statement. Give
rationales.
3. Enumerate the key elements of cost. Discuss the significance of each element.
4. Prepare a cost sheet based on the following information provided to you.
Apca Ltd is a manufacturing firm. You are required to prepare a cost sheet for the period
of January ,2023.
Particulars Amount (Rs.)
Opening stock of raw material 25,000
Raw material purchases during the month 2,72,000
Closing stock of raw material 17,000
Labour cost 108,000
Factory overheads (50% of labour cost)
Office and administrative overhead 10% of works cost
Selling and Distribution expenses 52,000

2.11 REFERENCES & SUGGESTED BOOKS

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• Moore & Jaidicke, Managerial Accounting, Chapter 7

• Horngren, Charles, Cost Accounting: A Managerial Emphasis, Chapter 2 and 3
• Maheshwari S.N. and Mittal, SN., Cost Accounting – Theory and Problems, Twenty –
sixth Edition, chapter 2.

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Management Accounting

LESSON 3
JOB, BATCH AND CONTRACT COSTING
CA. VISHAL GOEL
(CA, CFA, PGDBA, M.Com, CS, UGC-NET)
Adjunct Faculty- AMITY University
Ex- Associate Professor- IILM University
Email-Id: [email protected]

STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 Job Costing
3.4 Advantages Of Job Costing
3.5 Limitations Of Job Costing
3.6 Batch Costing
3.7 Differentiate Between Job Costing And Batch Costing
3.8 Contract Costing
3.9 Differentiate Between Job Costing And Contract Costing
3.10 Some Special Terms Used In Contract Costing And Their Treatment
3.11 Treatment Of Various Financial Elements Involved In Contract Costing
3.12 Summary
3.13 Glossary
3.14 Answers to In-Text Questions
3.15 Self-Assessment Questions
3.16 References
3.17 Suggested Readings

3.1 LEARNING OBJECTIVES

● To Understand Job Costing method.
● To calculate the cost under Job Costing.

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● To Understand Batch Costing methods.

● To calculate the cost for a batch
● To Differentiate between Job Costing and Batch Costing.
● Ascertain the cost of a contract
● To Understand concepts of Value of work certified, Cost of Work not certified.
● Compute Notional or Estimated profit from a contract.
● To Differentiate between Job and contract costing

3.2 INTRODUCTION
In past few chapters you have studies various element of cost. And how cost of a product is
calculated in general, now we will discuss how the cost accounting information can be
presented and used according the needs of the management. To cater to the need of the different
users of the cost accounting information, different methods of costing are developed. These
costing methods enable the users to have customized information of any cost object according
to their need and suitability.
Different methods of costing have been developed as per the needs and nature of industries.
For this purpose, industries can be broadly classified under two basic categories i.e. Industries
doing job work (Customised as per needs of the particular customer) and industries engaged in
mass production of a single product or identical products. For eg. If a particular Kind of a
Furniture item is to be produced for a customer or may be a batch of chairs of a particular size
for a customer’s office than Job Costing is a suitable method to calculate their cost. But for a
company producing Soaps on a mass scale Process costing may be more suitable method as all
are following same production process repeatedly.

3.3 JOB COSTING

Job Costing refers to a system of costing in which costs are ascertained in terms of specific
jobs or orders which are not identical or comparable with each other. This kind of Costing
method is followed in industries where production is not highly repetitive and, in addition,
consists of different jobs or lots so that material and labour costs can be identified by order
number . Industries where this method of costing is generally applied are automobile repair
shop, Printing Press, interior designing, construction, etc. In all these cases A separate cost

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Management Accounting

sheet or an account is opened for each job and all appropriate expenditure is charged thereto
to calculate total cost of that particular job.
Steps in Job Costing:
• Prepare a separate cost sheet for each job
• Charge full cost of materials issued for the job
• Charge full labour costs incurred (on the basis of Job Cards or time cards)
• Charge Direct expenses of that particular job done as per customers instructions.

• When job is completed, charge proportionate overhead also to ascertain total Cost.

3.4 ADVANTAGES OF JOB COSTING

(i) It helps management to find out cost of all resources involved in completing that particular
job. As total cost of that particular job is known so management will try fix a price to
customer which will cover that cost and a desired profit.
(ii) Since overheads rates are to be predetermined for their absorption in job costing, it will
necessitates the application of a system of budgetary control of overheads with all the
advantages.
(iii) Spoilage and defective work can be easily identified with specific jobs or products so
that responsibility may be fixed on particular departments or individuals.
(iv) Job costing is particularly suitable for cost plus and such other contracts where selling
price is determined directly on the basis of costs and to be quoted to the customer.

3.5 LIMITATIONS OF JOB COSTING

(i) This system of costing is too time consuming and requires detailed record keeping. This
makes the method very expensive as compared to other method.
(ii) Inefficiencies of a particular department or organization may be charged to a job making
price quoted on cost plus basis to be less competitive.
(iii) As lot of clerical process is involved the chances of error is more.
Example 1
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Following information has been extracted from costing records of Khushi Industries
manufacturing Chairs as per customised order in respect of particular job :

Materials Rs. 1500 per unit

Wages:
Department A 6 Hours @ Rs. 30 per hour
Department B 4 Hours @ Rs. 20 per hour
Department C 2 Hours @ Rs. 40 per hour
Overheads for the three departments are estimated as follows:
Variable Overheads:
Department A Rs. 40, 000 for 4, 000 direct labour hours
Department B Rs. 30, 000 for 1, 500 direct labour hours
Department C Rs. 10, 000 for 500 direct labour hours
Fixed Overheads:
Estimated at Rs. 1,00, 000 for 10000 normal working hours

You are required to calculate the cost of a chair and calculate the price to be charged so as
to give a profit of 20% on cost.

Solution:
Cost Sheet for a chair
Particulars Amount Amount
Direct Materials 1500
Direct Wages:
Department A – 6 hrs @Rs. 30 per hour 180
Department B – 4 hrs @Rs. 20 per hour 80
Department A – 2 hrs @Rs. 40 per hour 80 340
Variable Overheads
Department A – 6 hrs @Rs. 10 per hour 60
Department B – 4 hrs @Rs. 20 per hour 80

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Department A – 2 hrs @Rs. 20 per hour 40 180

Fixed Overheads 12 normal working hours 120
(6+4+2) @ Rs. 10 per hour
Total Cost 2,140
Profit @ 20% of Cost 428
Sale Price to be quoted 2,568

Working Notes
Variable Overhead rates have been arrived as follows:

Department A = Amount of Overheads / No. of direct labour hours

= Rs. 40000 / 4000 hours
= Rs. 10 per hour
Department B = Amount of Overheads / No. of direct labour hours
= Rs. 30000 / 1500 hours
= Rs. 20 per hour
Department C = Amount of Overheads / No. of direct labour hours
= Rs. 10000 / 500 hours
= Rs. 20 per hour

Fixed Overhead rate has been arrived as follows:

Amount of Fixed Overheads / Normal Working Hours

= Rs. 100000 / 10000
= Rs. 10 per hour

Example 2
Anjana Fabricators Ltd specialises in Providing customised Furniture to its clients their cost
data of 2022is given below
Cost of Raw material 6,00,000 Selling and Distribution overheads 3,64,000
Wages 5,00,000 Office and Admin Overheads 4,20,000
Factory Overheads 3,00,000 Profit 25% of cost

They received a work order in 2023 and estimated expenses are

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Material Rs. 10,000, Wages Rs, 5000, What selling price must be quoted to earn same rate of
profit as in 2022, if company has a policy of absorbing Factory overheads on basis of wages,
Office and admin overheads on the basis of factory cost and Selling and distribution overheads
on the basis of Cost of Production. Also extra Packing & Transport cost for home delivery to
customer expected to be Rs 10,000.This to be recovered from customer as part of total cost.

Solution:
Step1 Let us first prepare cost sheet of year 2022
Particulars Amount (Rs.)
Materials 6,00,000
Wages 5,00,000
Prime cost 11,00,000
Add Factory Overheads 3,00,000
Factory or Works cost 14,00,000
Office and admin Overheads 4,20,000
Cost Of Production 18,20,000
Selling and Distribution overheads 3,64,000
Total Cost/ Cost of Sales 21,84,000
Profit @25% of cost 5,46,000
Sales 27,30,000

Step 2: Calculate Overhead Absorption rates

Factory overheads as a % of Wages = (3,00,000/5,00,000)*100
= 60%

Office and Admin Overheads as a % of Factory Cost = (4,20,000/14,00,000)*100

=30%
Selling And Distribution overheads as a % of Cost of production= (3,64,000/18,20,000)*100
= 20%
Step 3 Cost Sheet for Work Order in 2023
Particulars Amount (Rs.)
Materials 10,000
Wages 5,,000

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Prime cost 15,000

Add Factory Overheads @60& of wages 9,000
Factory or Works cost 24,000
Office and admin Overheads @30% of factory cost 7,200
Cost Of Production 31,200
Selling and Distribution overheads @20% of cost of Production 6,240
Extra Packing and Transport charges 10,000
Total Cost/ Cost of Sales 47,440
Profit @25% of cost 11,860
Selling price to be quoted 59,300
So A selling price of Rs. 59,300 to be Quoted to customer for this work order.

3.6 BATCH COSTING

Batch Costing is a type of specific job order costing where articles are manufactured in fixed
predetermined lots, known as batch. Under this costing method, the cost object for cost
determination is a batch rather than a single unit as in job costing method.
A batch consists of certain number of identical units which are processed simultaneously in a
manufacturing operation. Since a large number of them are manufactured together and pass
through the same process of manufacture, it is convenient to collect their cost of manufacture
together. A separate job cost sheets are maintained for each batch of products. Material
requisitions are prepared batch wise, the direct labour is engaged batch wise and the overheads
are also absorbed batch wise. Cost of each unit manufactured in the batch is then determined
by dividing the total cost of the batch by the number of units manufactured.
For example, in Soap manufacturing industry, it would be tough to calculate cost of one soap
at a time Also it will be very costly to manufacture one particular soap to meet the demand of
one customer. On the other hand, the production, of say 10,000 soaps, of the same design will
reduce the cost to a sizeable extent.So the cost of a batch of whole 10,000 soaps will be
calculated and then divided by no of units i.e. 10,000 to get the cost of 1 unit.
So Batch costing is suitable for industries manufacturing same product in large no which are
identical in nature It is used in industries manufacturing soaps , pens and tyre & tube etc.
Steps in Batch Costing:
• One number is allotted for each batch & Prepare a separate cost sheet for each Batch
• Charge full cost of materials issued for the Batch
• Charge full labour costs incurred on basis of time devoted to produce a full batch.
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• Charge Direct expenses of that particular batch as per customers instructions.

• When batch is completed, charge proportionate overhead also to ascertain total Cost.
• Calculate cost of each unit by dividing total cost of batch by no of units in batch.

. Cost per unit = Total Batch Cost

Total Units in Batch

3.7 Differentiate between Job Costing and Batch Costing

Basis Job Costing Batch Costing

Suitability It is suitable for the products It is suitable for the industries

which are to be custiomised as per producing homogeneous products
customers order and having mass production

Cost determination Cost is determined for each Cost is determined for a batch
product

Individuality of a Each job is separate and different Products are homogeneous and
product from others. and cant be distinguished from
each other

Example 3:

VGA Limited manufactures Pens which are embossed with the customers’ own
logo. A customer has ordered a batch of 500 pens. The following is the cost
structure for a batch of 100 pens.`
Particulars Cost per batch of 100
Direct materials 800
Direct labour 400
Machine set up 100
Design and art work 200
Total Prime cost 1500

VGA Limited absorbs production overheads at a rate of 25% of direct labour

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cost. Selling and Distribution overheads absorbed @10 % of total production cost of
each batch. VGA Limited requires a profit margin of 25% on cost.

Calculate the sale value of full batch of 500 as well selling price of each pen.

Solution:
Particulars Cost of Cost of
batch of batch of
100 500
Prime cost ( 800+400+100+200) 1500 7500
Production Overheads ( 25 % of labour cost) 100 500
Production cost 1600 8000
Selling, distribution and admin overheads @ 1 0 % o f P r o d u c t i o n 160 800
cost
Total cost 1760 8800
Profit @ 25 % of total cost 440 2200
Selling price 2200 11000

So the sales value of batch of 500 pens is Rs 11000 and cost of 1 pen can be
calculated by dividing the total sales value by no of units produced in a batch

Selling price per pen = 11000/500 = Rs 22

3.8 CONTRACT COSTING

Contract costing is a form of job order costing where job undertaken is relatively large and
normally takes period longer than a year to complete. Just like in job costing ,in contract costing
too, each contract is treated as a cost unit and costs are ascertained separately for each contract.
Contract costing is usually adopted by the contractors engaged in any type of contracts like
construction of building, road, bridge, erection of tower, setting up of plant etc. Usually, there
is a separate account for each contract and the contract account is debited with all direct and
indirect expenditure incurred in relation to the contract. It is credited with the amount of
contract price on completion of the contract. The balance represents profit or loss made on the
contract and is transferred to the costing profit and loss account. In the case, the contract is not
completed at the end of the accounting period, a reasonable amount of profit, out of the total
profit made so far on the incomplete contract, may be transferred to profit and loss account.

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So after analyzing the above definitions we can conclude that Contract costing have few
distinct features which are as follows:
1. The cost unit in contract costing is the contract itself.
2. The Major expenses incurred by the contractor are considered as direct as they are incurred
in relation to a particular contract
3. The few indirect expenses mostly consist of office expenses, stores and works and are
absorbed proportionately on basis of some predetermined overhead absorption rates.
4. A separate account is usually maintained for each contract.
5. The major part of the work in connection with each contract is ordinarily carried out at the
site of the contract.

As mentioned above a contract usually takes multiple accounting period to complete and the
exact result of the contract, whether it is a profit or loss and how much is the profit or loss can
be known only after the completion of the contract.
Still in order to have a better control over the contract and cost, it is necessary to have an idea
of profitability of contracts at regular intervals or at least once every year. For this purpose, a
contractor needs to calculate expected profit or notional profit for a contract. It also helps in
comparison of profit for a period with that of another period and provide a good basis for
performance measurement and evaluation of those employees or departments who are engaged
in the contract. A suitable portion of expected or notional profit in respect of each contract in
progress is transferred to the costing profit and loss account for the year to determine overall
profitability of the contractor’s business entity.

3.9 Differentiate between Job Costing and Contract Costing

Basis Job Costing Contract Costing

Cost Allocation The cost is first allocated to cost
In contract costing, most of the
centers and then to a particular
expenses are of direct nature so
jobs directly charged to that particular
contract Account
Place of In Job Costing generally In Contract costing Most of the work
Production production carried out in is carried out on site
factory
Determination of In Job costing Price is largely In contract costing Price is generally
Selling Price influenced by Market determined on basis of Cost plus

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conditions apart from cost of mark up or negotiation between Both

product Parties

3.10 Some Special Terms used in Contract Costing and their treatment

(i) Work-In-Progress:
Work-in-progress in contract costing refers to the The cost of the contract which is not
complete at the reporting date. In Contract Accounts, the value of the work-in-progress
consists of the cost of work completed, both certified and uncertified.

(ii) Cost Of Work Certified:

Since a contract is a continuous process, to know the periodic work done and to know
the cost of work completed as on a particular date; a periodic assessment of the work
is carried out by an expert, based on his assessment, the expert certifies the work
completion in terms of percentage of total work. This value is known as Cost of work
certified.
Value of Work Certified = Value of Contract × Work certified (%)

Cost of Work Certified = Cost of work to date – (Cost of work uncertified

+ Material in hand + Plant at site)

(iii) Cost Of Work Uncertified:

In every Contract there always will be some work which has been carried out by the
contractor but has not been certified by the expert as its degree of completion cant be
ascertained or too low. It is always shown at cost price. This is known as Cost of work
uncertified.

Cost of Work uncertified = Cost of work to date – (Cost of work certified

+ Material in hand + Plant at site)
(iv) Progress Payment:
Since, a contract takes longer period to complete and requires large investment in
working capital, hence it is desirable by the contractor to have periodic payments from
the contractee against the work done to avoid working capital shortage. For this the
contactor enters into an agreement with the contractee and agrees on payment on some
reasonable basis, which is generally calculated as a percentage of work certified. After
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every period the Contractor will gets payments for work done on a contract based on
work certified
Progress payment = Value of work certified – Retention money – Payment made till date

(v) Retention Money:

The Contractor will never be paid full amount as mentioned by expert to be work
certified. To have a cushion against any defect or undesirable work detected in future,
the contractee upholds some money payable to contractor. This security money upheld
by the contractee is known as retention money.
Retention Money = Value of work certified – cash paid

(vi) Cash Received:

It is ascertained by deducting the retention money from the value of work certified
Cash received = Value of work certified – Retention money

(vii) Notional Profit:

It represents the difference between the value of work certified and cost of work
certified.
Notional profit = Value of work certified – Cost of work certified

(viii) Estimated Profit:

It is the excess of the contract price over the estimated total cost of the contract.
Estimated profit on contract = Contract price - Total expenditure to date -Estimated
Further expenditure to complete the contract(including
Reserve for contingencies)
(ix) Escalation Clause:
As we know A contract generally takes longer period to complete so there is a great
probability that the cost which was estimate at the start of the contract undergoes a big
change and which is beyond the control of contractor to manage. For ex some items
like cement, iron are integral elements of cost of any contruction contract and their
prices are sometimes either controlled by regulator or affected largely due to external
factors too. So, to safeguard his interest contractor request for a clause in the contract
which will allow him to raise contract price, by a suitable percentage, to bear this
increase in cost beyond a certain limit. In other words As per this clause, the contractor

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increases the contract price if the cost of materials, employees and other expenses
increase beyond a certain limit.

(x) Cost-Plus Contracts

There are few contracts in which its difficult to accurately estimate the cost of contract
at the very beginning of the contract due to the nature of ingredients used in contract
or the ongoing unstable economic environment. In such cases Cost Plus contract is
preferred by the contractors to safeguard their economic interest.
Cost-plus contract is a contract in which the contract price is determined by adding a
specified amount or percentage of profit to the costs incurred in the contract. In such
contract agreements, the contractee undertakes to pay to the contractor the actual cost
of contract plus a stipulated profit. It can be mutually decided that the profit to be added
to cost may be either a fixed amount or a specified percentage of cost.

Cost-plus contracts are usually entered into for executing special type of work, like
construction of dam, powerhouse, newly-designed ship, etc., where each project is so
unique that accurate cost estimation is difficult. Government often prefers to give
contracts on ‘cost-plus’ terms.

Cost-plus contracts are beneficial To the Contractor as he will never suffer loss on
such contracts and he is protected from the risk of fluctuations in market prices of
material, labour, etc. but at the same time it is disadvantageous to him as he is deprived
of the advantages which would have accrued due to reduced market prices of material
wages atc. Also he has no motivation for working more efficiently as profit is already
fixed.

3.11 Treatment of various financial elements involved in contract costing

a. Material.
Materials may be purchased in bulk and kept in store for supply to various contract
undertaken by contractor, as and when required, or these may be purchased and directly
supplied to the contract on site. Whatever be the case the cost of material issued or
supplied for a particular contract would be debited to the contract account. In case
certain materials previously charged to contract are returned to stores, the same will be
credited to the contract account. If certain Materials stolen or destroyed by fire or other
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reasons, the respective cost will be transferred to profit and loss account and finally
Materials in hand/ at site at the end of the year will appear on the credit side of the
contract account.

b. Labour.
All labour employed at the contract site should be regarded as direct labour and charged
direct to the contract concerned irrespective of the kind of work they perform. If large
number of contracts are carried on and workmen are made to divide their time between
two or more contracts, it would be necessary to prepare analysis sheets of labour, for
charging to each contract in such case a seperate job card for each workman need to be
prepared to keep record of time devoted by him on a particular contract.

c. Direct expenses.
All expenses other than material and labour are charged to individual contracts as and
when they are incurred e.g. design charges , setup charges, architect’s fee.

d. Overhead costs:
Though minimal in nature , still some part of general and admin overhears need to be
absorbed in each contract as support services are provided by the back offices too to
each contract. Such costs in case of a contract will be in the nature of wages paid to
storekeeper, men engaged as supervisor, lorry drivers and stationery, central
administrative office lighting, heating etc. These have to be allocated over several
contracts on some suitable basis e.g. as a percentage of material or labour or total cost
of contract excluding such overheads.

e. Plant used in a contract:

The value of plant used on a contract may be either debited to the contract and the
written down value thereof at the end of the year entered on the credit side for closing
the contract account, or only a charge for use of the plant (depreciation) may be debited
to the contract account.

f. Profit on incomplete contracts:

This is perhaps most debated and trick part of contract cost accounting. Since contract
takes longer period to complete so every year a notional profit is determined to judge
the periodic performance. And also to transfer a suitable profit figure to Profit and loss

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account from each contract. At the end of an each accounting period it may be found
that certain contracts have been completed while others are still in process and will be
completed in the coming years. The profit on completed contracts may be safely taken
to the credit of the profit and loss account. In the case of incompleted contracts there
are unforeseen contingencies which may lead to heavy fluctuations in costs and profit.
At the same time it does not also seem desirable to consider the profits only on
completed contracts and ignore completely incomplete ones as this may result in heavy
fluctuations in the future for profit from year to year.

Therefore, profits on incomplete contracts should be considered, of course, after

providing adequate sums for meeting unknown contingencies. There are no hard and
fast rule regarding calculation of the figures for profit to be taken to the credit of profit
and loss account.

However, the following rules may be followed in absence of any clear guidelines:
(i) Profit should be considered in respect of work certified only, work uncertified
should always be valued at cost.
(ii) No profit should be taken into consideration if the amount of work certified is
less than 1/4th of the contract price.
(iii) If the amount of work certified is 1/4th or more of contract price but less than
1/2 of the contract price, 1/3rd of the profit disclosed as reduced by the percentage of
cash received from the contractee, should be taken to the profit and loss account

Profit to be transferred =1/3 * Notional Profit * (Cash received / Work certified)

The balance be allowed to remain as a reserve.

(iv) If the amount of work certified is 1/2 or more of the contract price but less than
90% of the contract price, 2/3rd of the profit disclosed, as reduced by the percentage
of cash received from the contractee, should be taken to the profit and loss account.
Profit to be transferred = 2/3 *Notional Profit *(Cash received / Work certified)

The balance should be treated as reserve.

(v) In case the contract is very much near to completion i.e. work certified is more

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than 90 % of contract price , if possible the total cost of completing the contract should
be estimated. The estimated total profit on the contract then can be calculated by
deducting the estimated cost from the contract price. The profit and loss account should
be credited with that proportion of total estimated profit on cash basis, which the work
certified bears to the total contract price.

Profit to be transferred =Estimated profit *(Work certified / Contract price)* (cash received/
work certified)

The balance should be treated as reserve.

(vi) In case there is a loss the whole loss, should be transferred to the profit and loss
account.

For Example: If the Notional profit on a contract for Rs.30,00,000 is Rs.600,000 and
the contract is 70% complete and has been certified accordingly. The retention money
is 25% of the certified value, then the amount of profit that can be prudently credited
to Profit and Loss Account may be calculated as follows

Notional profit Rs 6,00,000

2/3rd of this is ordinarily suitable for transfer to Profit Rs. 4,00,000
and Loss Account (Since the Work certified is more
than 50%)
The percentage of cash received to certified value is 4,00,000*75/100
75% (as retention money is 25%) so The amount of =3,00,000
profit determined on cash basis being suitable for
transfer to Profit and Loss Account

or Alternatively it can be calculate on a different basis on basis of value of work

certified
6,00,000*(75/100)* (70/100)=3,15,000

when contract is incomplete

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Contract A/c
Particulars Amount Particulars Amount
Open W/P Material returned
Certified Plant returned
add uncertified P & L (Mat/Plant Lost) (book
Less Reserve value)
Material Material in hand (net)
Wages Plant in hand (net)
Direct expenses Cost of Contract c/d (Bal. Fig )
Overhead allocated
Plant
Profit
Cost of Contract b/d Closing w/p
Notional Profit c/d certified
+ uncertified
P & L a/c Notional Profit b/d
closing WIP (reserve)

Contractee’s A / C
To balance C/ d By cash A/c

When contract is complete

Contract A/C
To open w/p By plant returned
Material By material returned
Wages By P & L (Mat/ Plant Lost) (book
Overheads (o/h) value)
Plant By Material in hand (net)
P & L A/C By Plant in hand (net)
By Contractee’s A/C
(contract price)

Contractee’s A / C
Contract A / C by balance b/d
by Cash

Example 4

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Homemakers Construction Company Ltd., obtained a contract for the construction of a small
shopping complex. Construction started in April, 2022. The contract was Rs.90,00,000. On
31st March 2023, the end of the financial year, the cash received on account was
Rs.36,00,000, being 80% of the amount on the surveyor’s certificate.
Rs.
Materials issued to contract 24,00,000
Materials in hand at site as at 31st March, 2023 75,000
Wages 18,60,000
Plant purchased specially for the contract and to be depreciated at 10% per 3,00,000
annum 2,90,000
Direct expenses incurred 1,00,000
General overheads allocated to the contract 3,45,000
Work finished but not yet certified
You are required to prepare contract account for period ending31st March 2023, indicating
what proportion of the profit, the company would be justified in taking to the credit of the
profit and loss account.

Solution:
Homemakers Construction Co. Ltd.
Contract account for the year
Dr. ended 31st March 2023 Cr.
Rs. Rs.
To Material issued 24,00,000 By Materials in hand c/d
To wages 18,60,000 By Plant ( less deprecation ) on 75,000
To Direct expense 2,90,000 site 2,70,000
To Plant purchased 3,00,000 Cost of contract c/d 46,05,000
To General overheads 1,00,000
49,50,000 49,50,000
Cost of contract b/d 46,05,000 By Work-in-progress c/d:
Notional Profit c/d 2,40,000 Work certified
45,00,000 48,45,000
Work not certified
3,45,000
48,45,000 48,45,000
31.3.07 by Notional profit b/d
To profit & Loss A/c 1,28,000 2,40,000
To Work – in- progress c/d
(profit in reserve ) 1,12,000
2,40,000 2,40,000
Since cost of work certified is 50% of contract price so profit transferred will be 2/3rd

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of notional profit as reduced by the proportion of cash received as against work

certified
Profit to be transferred = 2,40,000 * 2/3 * 80/100 = 1,28,000

Example 5:
Altitude contractors began to operate on 1st April, 2022, the following was the expenditure
on a contract for Rs.4,50,000.
Rs.
Materials issued to contract 76,500
Plant used for contract 22,500
Wages 1,21,500
Other expenses 7,500
st
Cash received on account 31 March, 2023 amounted to Rs.1,92,000 being 80% of the work
certified.
Of the plant and material charged to the contract, plant which costed Rs.4,500 and materials
costing Rs.3,750 were lost.
On 31st March 2023 plant costing Rs.3,000 was returned to stores; the cost of work done but
uncertified was Rs.1,500 and materials costing Rs.3,450 were in hand. Charge 15%
depreciation on plant. Prepare contract account from the above particulars.

Solution.
Contract Account for the year ending 31st Dec., 2023
Rs. Rs.
To Materials 76,500 By Costing profit and loss A/c
To Wages 1,21,500 Rs.
To Plant 22,500 Plant lost
To Expenses 7,500 4,500 8,250
Material lost
3,750
By plant and machinery A/c 2,550
Plant returned 3,450
3,000 12,750
Less: Depreciation 2,01,000
450
By Materials at site
By Plant at Site*
By Cost of Contract c/d
2,28,000 2,28,000
To cost of contract b/d 2,01,000 By Work-in-progress : Work 2,40,000
Notional Profit c/d 40,500 certified 1,500
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Work
uncertified

2,41,500 2,41,500
To P & L A/c Notional Profit b/d 40,500
21,600
(40,500 * 2/3 * 80/100) 40,500
To Reserve
18,900
40,500 40,500

* Value of the plant at the end has been calculated as under Rs.
Cost of plant 22,500
Less : Plant lost 4,500
(Assume that plant was lost in the beginning of the year)
Plant returned to stores (at cost) 3,000 7,500
15,000
Less : Depreciation @ 15% p.a. 2,250
Plant at site 12,750

IN-TEXT QUESTIONS
1. A costing system where cost is determined for each job based on its specific
requirements is known as
a) Batch costing b) Service costing
c) Job costing d) Operating costing
2. Contract costing doesn’t have following feature
a) Long duration b) It’s a type of job costing
c) Work performed at site d) all contracts are same

3. Which of the following terms are relevant in contract costing

a) Work Certified b) Notional Profit
c) Escalation Clause d) all Of the above

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3.12 SUMMARY
Job Costing refers to a system of costing in which costs are ascertained in terms of specific
jobs or orders which are not identical or comparable with each other. This kind of Costing
method is followed in industries where production is not highly repetitive and, in addition,
consists of different jobs or lots so that material and labour costs can be identified by order
number .
Steps in Job Costing:
• Prepare a separate cost sheet for each job
• Charge full cost of materials issued for the job
• Charge full labour costs incurred (on the basis of Job Cards or time cards)
• Charge Direct expenses of that particular job done as per customers instructions.
• When job is completed, charge proportionate overhead also to ascertain total Cost.
Batch Costing is a type of specific job order costing where articles are manufactured in fixed
predetermined lots, known as batch. Under this costing method, the cost object for cost
determination is a batch rather than a single unit as in job costing method.
A batch consists of certain number of identical units which are processed simultaneously in a
manufacturing operation. Since a large number of them are manufactured together and pass
through the same process of manufacture, it is convenient to collect their cost of manufacture
together.
Steps in Batch Costing:
• One number is allotted for each batch & Prepare a separate cost sheet for each Batch
• Charge full cost of materials issued for the Batch
• Charge full labour costs incurred on basis of time devoted to produce a full batch.
• Charge Direct expenses of that particular batch as per customers instructions.
• When batch is completed, charge proportionate overhead also to ascertain total Cost.
• Calculate cost of each unit by dividing total cost of batch by no of units in batch.
. Cost per unit = Total Batch Cost
Total Units in Batch

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Contract costing is a form of job order costing where job undertaken is relatively large and
normally takes period longer than a year to complete. Just like in job costing ,in contract
costing too, each contract is treated as a cost unit and costs are ascertained separately for each
contract. Contract costing is usually adopted by the contractors engaged in any type of
contracts like construction of building, road, bridge, erection of tower, setting up of plant etc.
Contract costing have few distinct features which are as follows:
1. The cost unit in contract costing is the contract itself.
2. The Major expenses incurred by the contractor are considered as direct as they are incurred
in relation to a particular contract
3. The few indirect expenses mostly consist of office expenses, stores and works and are
absorbed proportionately on basis of some predetermined overhead absorption rates.
4. A separate account is usually maintained for each contract.
5. The major part of the work in connection with each contract is ordinarily carried out at the
site of the contract.
Cost-Plus Contracts
There are few contracts in which its difficult to accurately estimate the cost of contract
at the very beginning of the contract due to the nature of ingredients used in contract
or the ongoing unstable economic environment. In such cases Cost Plus contract is
preferred by the contractors to safeguard their economic interest.

3.13 GLOSSARY
Job Costing refers to a system of costing in which costs are ascertained in terms of specific
jobs or orders which are not identical or comparable with each other.
Batch Costing is a type of specific job order costing where articles are manufactured in fixed
predetermined lots, known as batch.
Contract costing is a form of job order costing where job undertaken is relatively large and
normally takes period longer than a year to complete.
Work-in-progress in contract costing refers to the The cost of the contract which is not
complete at the reporting date.
Cost Of Work Certified: the expert certifies the work completion in terms of percentage of
total work. This value is known as Cost of work certified.
Cost Of Work Uncertified: In every Contract there always will be some work which
has been carried out by the contractor but has not been certified by the expert as its

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degree of completion cant be ascertained or too low. It is always shown at cost price.
This is known as Cost of work uncertified.

Progress Payment: the contactor enters into an agreement with the contractee and agrees on
payment on some reasonable basis, which is generally calculated as a percentage of work
certified.
Retention Money: This security money upheld by the contractee is known as retention
money.
Cash Received: It is ascertained by deducting the retention money from the value of
work certified

Notional Profit: It represents the difference between the value of work certified and
cost of work certified.

Estimated Profit: It is the excess of the contract price over the estimated total cost of
the contract.

Escalation Clause:As per this clause, the contractor increases the contract price if the
cost of materials, employees and other expenses increase beyond a certain limit.

Cost-plus contract is a contract in which the contract price is determined by adding a

specified amount or percentage of profit to the costs incurred in the contract. In such
contract agreements, the contractee undertakes to pay to the contractor the actual cost
of contract plus a stipulated profit.

3.14 Answer to in-text questions

1. c) Job costing
2. d) all contracts are same
3. d) all Of the above

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3.15 SELF-ASSESSMENT QUESTIONS

1. Differentiate between Job Costing and Contract Costing
2. What is cost plus contract? What are its advantages and limitations for the contractor?
3. What is an escalation clause?
4. How is Profit transferred from an incomplete contracts?

3.16 REFERENCES
• Study Material of Institute of Chartered Accountants of India
• Study Material of Institute of Cost and management Accountant of India

3.17 SUGGESTED READINGS

• S.N. Maheshwari , Suneel Maheshwari , Sharad K. Maheshwari - A Textbook Of
Accounting For Management, Vikas Publishing House Pvt. Limited

• Asish K Bhattacharyya- Principles and Practice of Cost Accounting ,PHI learning

Private Limited

• R.S.N. Pillai, V. Bagavathi -Management Accounting , S. Chand and Company

Limited.

• M.Y. Khan P.K. Jain - Management Accounting: Text, Problems and Cases , Mc Graw
Hill Education

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LESSON 4
PROCESS COSTING
CA Kritee Manchanda
Assistant Professor
Keshav Mahavidyalaya
Email-Id: [email protected]

STRUCTURE
4.1 Learning Objectives
4.2 Introduction – Meaning, Concept and Accounting
4.3 Wastages: Normal Loss and Abnormal Loss/Gain
4.4 Valuation of Work in Progress (WIP)
4.5 Joint Products and By Products
4.6 Summary
4.7 Glossary
4.8 Answers to In-Text Questions
4.9 Self-Assessment Questions
4.10 References
4.11 Suggested Readings

4.1 LEARNING OBJECTIVES

● To understand the meaning, concept and accounting of process costing
● Calculation and treatment of normal loss, abnormal loss/gain.
● Understanding the calculation/valuation of work in progress (WIP) using the concept
of equivalent production
● Understand the concept and valuation of Joint Product and By Product

4.2 INTRODUCTION

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In a manufacturing business, products that are homogeneous can be produced in bulk by

undergoing series of steps known as processes. As the goods are identical and standard, bulk
units are passed through different processes. For example, cement can be manufactured in four
stages or processes, crushing and grinding, blending, burning and grinding. Likewise,
industries like pharmaceuticals, chemicals, FMCG, bottling and canning companies etc. are
using process costing. When each of the process is clearly identified, costs attributable to each
process are calculated using the concept of ‘process costing’.
4.2.1 Meaning of Process Costing:
According to CIMA, “Process costing is defined as the costing method which is applicable on
goods or services that result from a sequence of continuous or repetitive operations or
processes. The costs are averaged over the units produced during the period, being initially
charged to the operation or process.” Thus, process costing is used in those industries where
the raw material passes through several processes to become finished goods.
4.2.2 Features of Process Costing:
i. Applicable if the product products are homogeneous, passes through series of stages
and the production is continuous
ii. Process wise costs are identifiable and accumulated before going to the subsequent
process.
iii. Output of current process becomes input of subsequent process.
iv. There might be normal or abnormal losses during the processes.
v. Process accounts are maintained in T shape account with ‘Dr’ and ‘Cr’ sides.
4.2.3 Steps in Process Costing:
1. Identify the stages/ processes of manufacturing activities and prepare the process
account.
2. Identify and calculate various costs associated with each process and record them in
process accounts. All the input costs and expenses are taken on the debit side while
output values of each process are identified on the credit side.
3. Output value of current process is transferred to input value of next process
4. Identify the cost of finished goods by calculating output cost of the last process.

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Dr Process
Process
A A/c
A A/c Cr Dr Process B A/c Cr

To Input Cost By Output t/d to To input t/d from By Finished Goods

Process B A/c Process A A/c

Illustration 1:
From the following information, calculate cost per unit of output at each process if total units
produced are 500.

Particulars Process I Process II Process III

Material 1,00,000 44,000 24,000

Labour 85,000 1,00,000 1,55,000

Other Expenses 36,000 84,000 25,000

Indirect Expense amounting to Rs 85,000 can be apportioned on the basis of labour expense.
Solution:

Dr Process I A/c Cr
Particulars Amount Particulars Amount

Material 1,00,000 Process II A/c 2,42,250

Labour 85,000

Other Expense 36,000

Indirect Expense 21,250

2,42,250 2,42,250
Cost per unit = 2,42,250/500 = Rs 484.50

Dr Process II A/c Cr
Particulars Amount Particulars Amount

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Process I A/c 2,42,250

Material 44,000 Process III A/c 4,95,250

Labour 1,00,000

Other Expense 84,000

Indirect Expense 25,000

4,95,250 4,95,250
Cost per unit = 4,95,250/500 = Rs 990.50

Dr Process III A/c Cr

Particulars Amount Particulars Amount

Process II A/c 4,95,250

Finished Goods
Material 24,000 A/c 7,38,000

Labour 1,55,000

Other Expense 25,000

Indirect Expense 38,750

7,38,000 7,38,000
Cost per unit = 7,38,000/500 = Rs 1,476/-

Note: Indirect Expense can be apportioned in the ratio of 85,000:1,00,000:1,55,000 = Rs.

21,250 in Process I, Rs 25,000 in Process II and Rs. 38,750 in Process III.

4.3 WASTAGES: PROCESS LOSSES

During the manufacturing process, there may be material loss at different stages known as
process loss. Process loss may be in the form of weight loss, as in the case of preparing powder
sugar from crystals or may be due to wastage during the consumption of material in the process.
Such expected, regular and unavoidable losses may be considered normal. The management
considers this loss as a part of cost of production. There might be losses which are may not be
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regular, uncertain and avoidable due to inefficiency of labour, theft or fire etc. Such losses are
abnormal losses. Such losses are not considered while calculating cost of production. Hence,
following types of losses may occur during the course of processing operations:
(1) Normal Process Loss: Normal Process loss or normal wastage due to evaporation, weight
loss or scrap are routine of process and hence can be anticipated by the management. These
losses cannot be avoided and are expected to occur under normal conditions. The cost of
production of normal loss units is added to the cost of production of good units produced under
the process. Thus, any amount, if realized by the sale of normal loss units, should be deducted
from total cost of production of good units and credited to the process account thereby reducing
the burden of loss on good units.
Following accounting treatment may be done
Normal Loss A/c …Dr
To Process A/c
(With the amount of scrap realised)

(2) Abnormal Process Loss: Abnormal loss, as the name suggests, is the loss over and above
the normal loss. It is avoidable and does not occur under the normal conditions. It may be may
be caused by abnormal conditions such as breakdown of machinery, inefficiencies, lack of
effective supervision, substandard materials etc. The cost of an abnormal process loss unit is
not absorbed by good units while calculating cost of production. Therefore, cost per unit of
abnormal loss is equal to per unit cost of production of good unit after normal loss. The
calculated value of abnormal loss is transferred and credited to the process account. This cost
of abnormal loss is taken to the debit of Costing Profit and Loss Account.
Computation of Abnormal Loss:
Value of Abnormal Loss = Cost of production per unit after normal loss x Units of abnormal
loss
Where:
Quantity of Abnormal Loss = Total Quantity after normal loss – Actual Quantity
= Input - Normal Loss – Actual Quantity
Following accounting treatment may be done
Abnormal Loss A/c… Dr

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To Process A/c
(with amount computed above)
Bank A/c… Dr (with amount of scrap realised)
Costing Profit & Loss A/c… Dr (with difference in the value)
To Abnormal Loss A/c (with amount computed above)

(3) Abnormal Process Gain: Sometimes, due to better and improved conditions, actual output
generated is more than normal output. Thus, when actual loss during production is less than
normal loss, it gives rise to abnormal gain. Abnormal gain is defined as unexpected gain of
units during production under normal conditions. The value of abnormal gain is calculated in
the same manner as abnormal loss i.e. cost of production per unit of good units multiplied by
abnormal gain units. The process account is debited with abnormal gain as accounting
treatment.
Process A/c… Dr
To Abnormal Gain A/c
(Amount calculated on the basis of cost of production of units after normal loss)

Abnormal Gain A/c…Dr (with amount calculated above)

To Normal Loss A/c (with the amount of scrap value)
To Costing Profit & Loss A/c (difference in the above values)

Illustration 2: (Normal Loss) A product passes through Process- I and Process- II. Materials
issued to Process- I amounted to Rs 45,000, Wages Rs 32,000 and manufacturing overheads
were Rs 26,000. Normal loss anticipated was 6% of input and net output was transferred-out
from Process-I. Input raw material issued to Process I were 10,000 units. You are required to
Prepare Process- I account if (a) Scrap has no realisable value (b) scrap have realisable value
of Rs 2.20 per unit.

Particulars Process I (in Rs.)

Material 45,000
Wages 32,000
Manufacturing Expenses 26,000
Normal Loss 6%
Normal Loss (units) 600
Input units 10,000

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(a)

Dr Process I A/c Cr
Particulars units Amount Particulars units Amount

Material 10,000 45,000 Process II A/c 9,400 1,03,000

Wages 32,000 Normal Loss 600 NIL

Manufacturing Expense 26,000

10,000 1,03,000 10,000 1,03,000

Cost per unit = 1,03,000 ÷ (10,000 – 600) = Rs 10.96
(b)

Dr Process I A/c Cr
Particulars units Amount Particulars units Amount

Material 10,000 45,000 Process II A/c 9,400 1,01,680

Wages 32,000 Normal Loss 600 1,320

Manufacturing Expense 26,000

10,000 1,03,000 10,000 1,03,000

Cost per unit = (1,03,000 – 1,320) ÷ (10,000 – 600) = Rs 10.82
Illustration 3: (Normal Loss, Abnormal Loss, Abnormal Gain) Product Zinga passes through
three processes namely, Process A, Process B and Process C. Output of process A is the input
of process B and output of Process B is input of Product C. Following information is
considered:

Particulars Process A Process B Process C

Materials issued 51,000 32,000 11,200

Labour 7,200 4,800 1,200

Manufacturing Expenses 11,800 10,200 16,400

Output 14,000 13,300 12,000

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Normal Loss 3% 6% 9%

Calculate the value of Zinga if 15,000 units have been issued to the Process-A and Rs 1.50 per
unit can be realised from scrap.
Sol.

Dr Process A A/c Cr
Particulars units Amount Particulars units Amount

Material issued 15,000 51,000 Process B A/c 14,000 66,704

Normal Loss
Labour 7,200 (3% of 15000) 450 675

Manufacturing Expense 11,800 Abnormal Loss 550 2,621

15,000 70,000 15,000 70,000

Cost per unit of completed units and abnormal loss:
= (Total Cost – Scrap Value of Normal Loss) ÷ (Total units – Normal Loss)
= (70,000 - 675) ÷ (15,000 – 450) = Rs 4.76

Dr Process B A/c Cr
Particulars units Amount Particulars units Amount

Process A A/c 14,000 66,704

Material issued 32,000 Process C A/c 13,300 1,13,641
Labour 4,800 Normal Loss 840 1,260
Manufacturing Expense 10,200
Abnormal Gain 140 1,196

14,140 1,14,901 14,140 1,14,901

Cost per unit of completed units and abnormal loss:
= (Total Cost – Scrap Value of Normal Loss) ÷ (Total units – Normal Loss)
= (1,13,704 – 1,260) ÷ (14,000 – 840) = Rs 8.54

Dr Process C A/c Cr
Particulars units Amount Particulars units Amount

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Process B A/c 13,300 1,13,641

Material issued 11,200 Finished Goods A/c 12,000 1,39,448

Labour 1,200 Normal Loss 1,197 1,796

Manufacturing
Expense 16,400 Abnormal Loss 103 1,197

13,300 1,42,441 13,300 1,42,441

Cost per unit of completed units and abnormal loss:
= (Total Cost – Scrap Value of Normal Loss) ÷ (Total units – Normal Loss)
= (1,42,441 – 1,796) ÷ (13,300 – 1,197) = Rs 11.62

Dr Normal Loss A/c Cr

Particulars units Amount Particulars units Amount
Abnormal Gain (Process
Process A A/c 450 675 B) 140 210

Process B A/c 840 1,260 Bank (Scrap Process A) 450 675

Process C A/c 1,197 1,796 Bank (Scrap Process B) 700 1,050

Bank (Scrap Process C) 1,197 1,796

2,487 3,731 2,487 3,731

Dr Abnormal Loss A/c Cr

Particulars units Amount Particulars units Amount

Process A A/c 550 2,621 Bank (Scrap Process A) 550 825.0

Process C A/c 103 1,197 Bank (Scrap Process C) 103 155

Costing P&L A/c 2,838

653 3,817 653 3,817

Dr Abnormal Gain A/c Cr

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Particulars units Amount Particulars units Amount

Normal Loss A/c 140 210 Process B A/c 140 1,196

Costing P&L A/c 986

140 1,196 140 1,196

Dr Costing P&L A/c Cr

Particulars units Amount Particulars units Amount

Abnormal Loss A/c 2,838 Abnormal Gain A/c 986

- 2,838 - 986

4.4 VALUATION OF WORK IN PROGRESS

In the manufacturing industries, simultaneous processes are run for meeting continuous
production demands. At the end of a reporting period, there may be certain units which are
either completely processed into finished goods or there may be raw materials left unused.
Apart from these two categories, some goods are in the incomplete stage. They are no more the
raw material as process has already started on them, but they could not be completed into final
good. Such units are known as Work in Progress. The calculation of cost of work-in-progress
is a challenging task as units are in different stages of completion. Though material, directly
attributable in the process is identified on actual basis, but bifurcation of labour and other
expenses might lack some degree of accuracy. To ascertain appropriate value, we may use the
concept of equivalent production units that converts partly finished units into equivalent
finished units. For instance, 50% of work done on four units is equivalent to 100% of work
done on two equivalent units.
Equivalent Units: are the incomplete production units converted into their equivalent
completed units by multiplying the percentage of completion with total units introduced in
reference to the elements of costs classified into material, labour and overheads.
The formula is
Equivalent Completed Production Units = Actual number of units in the process x Percentage
(Degree) of Work completed
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For example,
200 units of material were introduced in the process. 60% of the work is completed and 40%
is still under progress. Work completed is equivalent to 200 x 60% = 120 units of complete
finished goods.
Valuation of WIP can be done by either of the methods
1. First in First Out (FIFO) Method – In case of FIFO, value of WIP in the beginning is
calculated to the extent of work done in the given period. It is added to the total cost to
calculate cost per unit. The value added in the current period is added to the to the
opening value of WIP to get the final value of WIP.
2. Weighted Average Method – The cost of WIP in the beginning and current cost are
aggregated and not considered separately.
Step 1: (FIFO)
Calculation of equivalent units can be done by using the table below:
Input Units Output Units Equivalent Units
Details Particulars
Material Labour Overheads

% Units % Units % Units

A B C=AxB D E=AxD F G=AxF

Opening WIP Xxx Opening WIP xxx Xxx xxx xxx xxx xxx xxx

Units Xxx Finished Output xxx Xxx xxx xxx xxx xxx Xxx
Introduced (from current
units)

Normal Loss xxx - - - - - -

Abnormal Loss/ xxx Xxx xxx xxx xxx xxx Xxx

Gain

Closing WIP xxx Xxx xxx xxx xxx xxx xxx

Total Xxx Total xxx xxx xxx xxx

Step 2:

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Calculation of Cost per Equivalent Unit of Production = Total Cost ÷ Equivalent Production
units
Step 3: Statement of Evaluation (FIFO)

Particulars Equivalent Units Cost per unit Amount

(Q) (Rs per unit) (in Rs)

Opening WIP completed during the Xxx xxx xxx

period
xxx
Add: Cost of WIP in the beginning

Completed cost of WIP xxx

Completely processed units Xxx xxx xxx

Abnormal Loss Xxx xxx xxx

Closing WIP Xxx xxx xxx

Illustration 4:
M/s ABC Ltd is manufacturing product P by passing through process A and process B. The
following information is available in respect of Process A for April, 2022.
i. Opening stock of work in progress: 800 units at a total cost of Rs 4,000.
ii. Degree of completion of opening work in progress – Materials 100%, Labour 65%,
Overheads 65%
iii. Input of materials at a total cost of Rs 36,800 for 9,200 units.
iv. Direct wages incurred Rs 16,440.
v. Production overhead Rs 8,220.
vi. Units scrapped 1,200 units. The stage of completion of these units was: Materials 100%,
Labour 75%, Overheads 75%
vii. Closing Work in Progress is 900 units. The stage of completion of these units was
Materials 100%, Labour 60%, Overheads 60%
viii. 7,900 units were completed and transferred to the next process.
ix. Normal loss is 8% of the total input (opening stock plus units put in)
x. Scrap Value is Rs 4 per unit.

You are required to:

a. Compute equivalent production
b. Calculate cost per unit for each element

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c. Calculate cost of abnormal loss/gain, WIP, and units transferred to the next process
using FIFO and weighted average method
d. Prepare Process Account.

Solution: FIFO Method

Statement of Equivalent Production

Inputs Units Output Units Equivalent Production
Material Labour Overhead
% units % units % units

Opening WIP 800 Opening WIP 800 0 0 35 280 35 280

Raw Material 9200 Completed units 7100 100 7100 100 7100 100 7100
Normal Loss 800 0 0 0
Abnormal Loss 400 100 400 75 300 75 300
Closing WIP 900 100 900 60 540 60 540
Total 10000 10000 8400 8220 8220

Statement of Cost
Element of Equivalent Cost per Equivalent
Cost Cost Production unit

Material 36800
Less: Scrap
Value 3200 33600 8400 4
Labour Cost 16440 8220 2
Overhead 8220 8220 1

Statement of Evaluation
Particulars Units Cost per unit Cost Total Cost
Opening WIP
Material 0 4 0
Labour 280 2 560
Overhead 280 1 280 840
Opening Value 4000
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4840
Completed Units
Material 7100 4 28400
Labour 7100 2 14200
Overhead 7100 1 7100 49700
Abnormal Loss
Material 400 4 1600
Labour 300 2 600
Overhead 300 1 300 2500
Closing WIP
Material 900 4 3600
Labour 540 2 1080
Overhead 540 1 540 5220

Dr Process A A/C Cr
Particulars Units Amount Particulars units Amount
Opening WIP 800 4000 Normal Loss 800 3200
Material 9200 36800 Abnormal Loss 400 2500
Labour 16440 Completed and transferred 7900 54540
to next process
Overhead 8220 Closing WIP 900 5220
10000 65460 10000 65460

Notes:
1. Normal Loss units are not considered for the purpose of calculation of equivalent
production units.
2. Units completed and transferred to next process include 800 units of opening WIP and
7100 units of current stock, according to FIFO.
3. Value of completed units in Process A/c = Value of opening WIP + Value of current
completed units.

Average Method

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Statement of Equivalent Production

Inputs Units Output Units Equivalent Production
Material Labour Overhead
% units % units % units

Opening WIP 800 Completed units 7900 100 7900 100 7900 100 7900

Raw Material 9200 Normal Loss 800 0 0 0

Abnormal Loss 400 100 400 75 300 75 300
Closing WIP 900 100 900 60 540 60 540
Total 10000 10000 9200 8740 8740

Statement of Cost
Element of Equivalent Cost per Equivalent
Cost Cost Production unit
Material 40800
Less: Scrap
Value 3200 37600 9200 4.086957
Labour Cost 16440 8740 1.881007
Overhead 8220 8740 0.940503

Statement of Evaluation
Cost per Total
Particulars Units unit Cost Cost
Completed
Units
Material 7900 4.09 32286.96
Labour 7900 1.88 14859.95
Overhead 7900 0.94 7429.98 54576.89
Abnormal Loss
Material 400 4.09 1634.78
Labour 300 1.88 564.30
Overhead 300 0.94 282.15 2481.24
Closing WIP
Material 900 4.09 3678.26
Labour 540 1.88 1015.74
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Overhead 540 0.94 507.87 5201.88

Dr Process A A/C Cr

Particulars Units Amount Particulars units Amount

Opening WIP 800 4000 Normal Loss 800 3200
Material 9200 36800 Abnormal Loss 400 2481.236
Completed and
transferred to next
Labour 16440 process 7900 54576.89
Overhead 8220 Closing WIP 900 5201.876
10000 65460 10000 65460

Notes:
1. Normal Loss units are not considered for the purpose of calculation of equivalent
production units.
2. Units completed and transferred to next process are 7900 units (irrespective of being
WIP or new units). The value of opening WIP is added to the cost of material
introduced. The final cost per unit has average cost of material.

4.5 JOINT PRODUCT AND BY PRODUCT

4.5.1 Joint Products: Joint products are the multiple products produced simultaneously
in the same process from the use of same raw material. Joint Products are generally
equally important. However, the core product which is under the process resulting
in several other products is known as joint product. For example, crude oil refining
leads to petrol, kerosene, oil tar etc. which can be considered as joint-products.
Characteristics of Joint Products
Joint products have following important features:
(1) Same set of raw materials are used to produce joint products.
(2) They are produced in common manufacturing process.
(3) The values of joint products are almost equal
(4) They may undergo further processing after their separation

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Methods of Apportionment of Joint Products

Some of the important methods mentioned below are used for apportionment of joint costs upto
the point of separation
i. Average Unit Cost Method - Average cost per unit of the finished product is calculated
and used as weightage to apportion the joint cost to the respective products, under this
method.
Average costs = Total joint costs up to the point of separation ÷ total production of all
the products or outputs.
ii. Physical Unit Method – Physical units of output for each joint product such as weight,
volume or quantity of products (till the split-off occurs) are considered for joint costs
apportionment. It is suitable if joint products can be measured in the same units. If not,
joint products must be converted to the denominator common to all the units produced.
iii. Survey Method – or Points Value Method considers points value or percentage assigned
to each products as a result of survey or technical evaluation to allocate the joint costs.
Share of joint costs = physical quantities of each product x weightage points.
iv. Contribution Margin Method - or "Gross Margin Method" is based on calculation of
contribution each product. Contribution is the excess of sales over variable costs. Under
this method, joint costs are bifurcated as fixed and variable costs. Contribution of each
product will be considered for ratio of apportioning Fixed Joint costs whereas units of
goods are considered for variable portion of joint costs.
v. Standard Cost Method – Standard costs are determined on the basis of experience,
efficiency, cost factors and technical issues etc. Joint costs, under this method, are
apportioned on the basis of standard costs.
vi. Market Value Method – or "Relative Sales Value Method" or simply Sales Value
method follows allocation of joint production costs on the basis of final market value
of products. Market value can be calculated by multiplying number of units of each
product manufactured by the product's selling price. The portion of total joint costs
allocated to each product is, apparently, proportional to the sales value of each product.
Market value methods can be sub classified as:
(a) Market Value at Separation Point: As the name says, market value of the joint
products at the split off point is identified and used to allocate the joint production cost.
The quantities of each product are taken as weightage.
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(b) Market Value After Further Processing: Final Selling Price is considered for
bifurcation of joint costs in this method.
(c) Net Realizable Value: or the "Reverse Cost Method" is the one in which reverse
calculation is done on sales value by deducting estimated profit, selling and distribution
expenses and after split off processing costs of each joint products. Based on the ratio
of value derived, the total costs before separation point is apportioned.
4.5.2 By Products:
It refers to the products which have comparatively less value than the main product
being incidentally manufactured during the production process. By products are also
known as "Minor Products." The value of by products is significantly low from the
main product, however they are jointly manufactured with the main products. By
products remain inseparable and are produced alongwith the main product till the split
off point or point of separation.
Illustration 5:
Azba Ltd, a manufacturing company purchases a raw material that is processed to make
three products namely, Am, El and Bt. In February, 2023, the Company purchased
12,000 kg of the raw materials at the cost of Rs.17,50,000 and company has incurred
additional joint conversion costs of Rs.4,50,000. February, 2023 sales and production
information are as follows:
Units of output Price at Split Further Eventual Sale
Produced Off point (per Processing Price
unit) Cost per unit
Am 6,000 Rs 270 - -
El 4,000 Rs 210 - -
Bt 2,000 Rs 180 Rs 40 Rs 400
For the products, Am and El, they can be sold to other manufacturing companies at the
split off point. But for the product, Bt, it undergoes two options, either can be sold at
the split-off point or may be processed further and packaged for sale as an advanced
level of product Bt.
You are required to: (i) allocate the joint costs of the three products by using
a. the Physical Units Method,

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b. the Sales Value at Split-off Method and

c. the Net Realizable Value Method.
(ii) Suppose that in half of the month of February, 2023, manufacturing of El could be
further processed and mixed with the whole of Am, to make a new product namely, EA.
Further processing costs amounts to Rs.2,62,000. The selling price of EA is fixed at
Rs.400 per unit.
As an analyst you are required to suggest, if the manufacturing company shall further
process Am into EA. Assume that 6,000 unit as the resultant quantity of EA must be
produced.
Solution:
(i) Total Joint Cost that is required to be allocated = Rs. 17,50,000 + Rs. 4,50,000
= Rs. 22,00,000
Physical Units Method
Product Units of Output Proportion of Joint Cost Allocation
Produced Joint Cost on the
basis of output
units
Am 6,000 6,000 ÷ 12,000 = 0.5 x 22,00,000 =
0.5 11,00,000
El 4,000 4,000 ÷ 12,000 = 0.333 x 22,00,000 =
0.333 or 1/3rd 7,33,333
Bt 2,000 2,000 ÷ 12,000 = 0.167 x 22,00,000 =
0.167 or 1/6th 3,66,667

Sales Value at Split Off Point Method

Product Units of Sale Sales Proportion Joint Cost
Output Price Value = of Joint Cost Allocation
Produced per Output x on the basis
unit Price of sale value

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Am 6,000 270 16,20,000 16,20,000 ÷ 0.5745 x

28,20,000 = 22,00,000 =
0.5745 12,63,900
El 4,000 210 8,40,000 8,40,000 ÷ 0.2979 x
28,20,000 = 22,00,000 =
0.2979 6,55,380
Bt 2,000 180 3,60,000 3,60,000 ÷ 0.1276 x
28,20,000 = 22,00,000 =
0.1276 2,80,720

Net Realisable Value Method

Product Units of Net Net Proportion Joint Cost
Output Realisable Realisable of Joint Allocation
Produced Value per Value = Cost on the
unit Output x basis of
NRV pu NRV
Am 6,000 270 16,20,000 16,20,000 ÷ 0.5094 x
31,80,000 22,00,000
= 0.5094 =
11,20,680
El 4,000 210 8,40,000 8,40,000 ÷ 0.2642 x
31,80,000 22,00,000
= 0.2642 = 5,81,240
Bt 2,000 400-40 = 7,20,000 7,20,000 ÷ 0.2264 x
360 31,80,000 22,00,000
= 0.2264 = 4,98,080

(ii) For the Joint costs are not relevant to this decision. Instead, following costs may
be considered - further processing costs and the opportunity cost of the lost
contribution margin on the El diverted to Am purification.
Incremental Revenues (Rs.400 - Rs.270) x 6000 units = Rs. 7,80,000

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Less: Further processing cost of Am Mixture = (Rs. 2,62,000)

Less: Contribution margin lost on El
(2000 kg & Rs. 210) = (Rs.4,20,000)
Increased Net Income Rs. 98,000
Alternatively
Existing Revenue
El = 2000 kg x Rs.210 = Rs. 4,20,000
Am = 6000 kg x Rs.270 = 16,20,000 Rs. 20,40,000
Proposed Income
EA = 6000 units x Rs.400 = 24,00,000
Less: Processing Cost = 2,62,000 21,38,000
Increased Income 98,000
Alternatively
Joint cost
- 6,000 kg of Am Rs. 12,63,900
- 2,000 kg of El (half of Rs. 6,55,380) = Rs 3,77,690
(at the point of split off ): Rs. 16,41,590
We will get 6,000 units of EA after incurring additional Rs. 2,62,000 of further
processing cost.
On 6,000 units of EA, the total sale revenue earned is Rs. 24,00,000. Hence the
profit can be calculated as Rs. 24,00,000 – Rs 16,41,590 – Rs 2,62,000 =
4,96,410.
If 6,000 kg of Am and 2,000 kg of El were sold at the split off point, total profit
earned (Rs. 16,20,000 + 4,20,000 - Rs. 16,41,590) = Rs. 3,98,410.
As the amount of profit on making EA of Am increases by Rs. 98,000, therefore,
company must consider the proposal and accept it.

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IN-TEXT QUESTIONS
1. Fill in the blanks
(a) _______________is defined as the type of costing procedure which can be
used for calculation of cost of product in continuous or mass production
industries.
(b) Cost for units lost through _____________ is absorbed by the remaining
"good" units produced during the period.
(c) The _______________ is the number of complete units that could have been
obtained from the materials, labour and overheads that went into the partially
completed units.
(d) The difference between actual loss and normal loss is termed as
________________.
2. Chose the correct options
(a) Two or more products produced simultaneously from the same raw materials
less important than main product are known as
(i) Joint Product (ii) Finished Product (iii) By Product (iv) Raw Materials
(b) Which of these is not a method of calculating value of joint cost
(i) Physical Units Method
(ii) Average Cost Method
(iii) Net Realisable Value Method
(iv) Budgeted Cost Method
(c) Which of the following is not a process loss
(i) By Products
(ii) Normal Loss
(iii) Wastage
(iv) Scraps
(d) Which of these is not a feature of process costing
(i) Products pass through different processes
(ii) Cost of materials, labour and overheads are calculated for each process.
(iii) Products produced are heterogeneous and differential.
(iv) Output and value of output of each process is transferred to the next
process until the finished good is completed.

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IN-TEXT QUESTIONS

Q3. Following information relating to the cost of X product passes through three
processes. During the month of March, 1000 units were produced. Prepare the
process accounts and calculate per unit cost of each process.
Process I Process II Process III
Raw Materials 40,000 20,000 10,000
Wages 20,000 15,000 15,000
Direct Expense 6,000 2,000 4,000
Rs. 10,000 are the overhead expenses that can be apportioned on the basis of
wages.

Q4. For MN Ltd, the product Generator passes through three processes namely Alpha,
Beta and Gamma. The output of each process is passed as the input in the next
process. Following information is considered:

Particulars Process Process Beta Process

Alpha Gamma

Materials issued 31,000 22,000 7,500

Wages 6,300 4,500 800

Production Expenses 9,800 8,200 12,600

Output 19,000 18,000 16,000

Normal Loss 3% 6% 9%

Calculate the cost of the final product if 20,000 units have been issued to the Process-
Alpha and Rs 2 per unit can be realised from scrap.

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4.6 SUMMARY
Process Costing is the method of costing in which costs are compiled process wise for the
standard products. Cost of one process is transferred to the cost of next process as input. During
the production, each process may generate wastes alongwith goods. Process Loss including
wastes, scraps, defectives may be normal loss, abnormal loss or abnormal gains. In case of raw
material that is under production but not completed yet as finished goods are known as work
in progress. Calculation of value of work in progress is done by calculating equivalent units of
production. Two or more products which are formed during the same process are either joint
products or by products.

4.7 GLOSSARY
• Costs – price paid for something

• Scrap – waste material from manufacturing process

• Valuation – judgement on worth of something

• Equivalent Production - converting icompleted production into equivalent level of

completed units

• Split Off Point- location in the production process where jointly manufactured products
will be henceforth manufactured separately;

4.8 ANSWERS TO IN TEXT QUESTIONS

1. (a) Process Costing 2. (a) (iii) By Products
(b) Normal Loss (b) (iv) Budgeted Cost Method
(c) Equivalent Units (c) (i) By Product
(d) Abnormal Loss. (d) (iii) Products produced are
heterogeneous and differential.

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4.9 SELF-ASSESSMENT QUESTIONS

(i) Explain Process Costing. Mention the advantages and limitations of process costing.
(ii) Differentiate between joint products and by products with example. Briefly explain the
methods used in accounting of the same.
(iii) Distinguish between normal loss and abnormal loss. Explain how to treat the losses in
the process accounting.
(iv) 500 kgs of raw material was introduced in Process I at the rate of Rs 100. Direct Labour
and Other manufacturing expenses amount to Rs 25,000 and Rs 10,000 respectively.
Normal loss is 10% and the net output generated is 420 kgs. Prepare a ledger account
of Process I, if the scrap realises Rs 12 per unit.
(v) Product Alpha passes through three processes during the month of January. If 2000
units of alpha was produced, prepare the process accounts and calculate per unit cost of
each process.
Process M Process N Process O
Raw Materials 70,000 60,000 30,000
Wages 30,000 25,000 25,000
Other Expense 12,000 20,000 26,000
Overhead expenses amounting to Rs. 16,000 can be apportioned on the basis of wages.
(vi) For Gabra Ltd, the product passes through three processes I, II and III. The output of
each process is passed as the input in the next process. Following information is
considered:

Particulars Process I Process II Process III

Cost of Materials consumed (Rs) 51,000 32,000 10,500

Labour (Rs) 6,700 4,800 5,100

Manufacturing Expenses (Rs) 12,800 10,200 9,600

Finished Goods (units) 2,800 2,700 2,400

Normal Loss 3% 6% 9%

Calculate the cost of the final product if 3,000 units have been issued to the Process-I and Rs
2.50 per unit can be realised from scrap.

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4.10 REFERENCES

• Arora, M.N. A Textbook of Cost and Management Accounting,12th ed., Vikas Publishing
House Pvt. Ltd
• Maheshwari, S.N. and Mittal, S.N. Cost Accounting: Theory and Problems Shree Mahavir
Book Depot
• Dr. P. Periasamy, A Textbook Of Financial Cost And Management Accounting, Himalaya
Publishing House
• ICAI Study Material

4.11 SUGGESTED READINGS

• Datar, S.M. & Rajan, M.V., (2017), Horngren's Cost Accounting: A Managerial Emphasis (16th
Edition) Pearson.

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LESSON 5
COST CONCEPTS IN DECISION MAKING

CA. VISHAL GOEL

(CA, CFA, PGDBA, M.Com, CS, UGC-NET)
Adjunct Faculty- AMITY University
Ex- Associate Professor- IILM University
Email-Id: [email protected]

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Cost Concepts in Decision Making
5.4 Objectives of a Costing System
5.5 Marginal Costing
5.6 Advantages of Marginal Costing
5.7 Limitations of Marginal Costing
5.8 Difference between Marginal costing and Absorption costing
5.9 Cost-Volume-Profit analysis
5.10 Break Even analysis
5.11 Various decision-making problem
5.12 Summary
5.13 Practical Problems
5.14 Glossary
5.15 Answers to In-Text Questions
5.16 Self-Assessment Questions
5.17 References
5.18 Suggested Readings

5.1 LEARNING OBJECTIVES

After reading this lesson student should be able to understand:
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● Various cost concepts involved in Decision making.

● Concepts of Relevant, differential, incremental and Opportunity costs.
● Objectives of various costing systems
● Concepts of marginal costing.
● Advantages & limitations of marginal costing.
● Difference between absorption and marginal costing,
● Break-even analysis and its uses for decision making.
● Concept of CVP analysis and its practical application in various decision making
process like make or buy decisions, selection of a suitable product mix, effect of change
in price, Shut down or continue, maintaining a desired level of profit.

5.2 INTRODUCTION
Meaning of Managerial Decision-Making:
In simple words Managerial decision making is the process of deciding the particular
course of action from among various alternatives course of action available in present scenario.
For every managerial problem, generally there are various course of actions available, the
manager has to choose from among them that course of action which he / she believes or
considers to be most effective in solving that particular problem. In deciding this he/she has to
consider all the given resources and other internal and external factors which are relevant and
can impact the decisions like Govt. Policies, laws of the country, Policies of the competitors.
Since all decisions are futuristic in nature, so involve lot of forecast on what could occur
in future. Due to this reason in all managerial decision manager try to build in the concept of
probability. Larger is the period of forecast, greater is the degree of analysis required. Decisions
can be routine in nature like how much of goods to be produced next week to achieve desired
level of sales, such decisions can be taken with little consumption of time and efforts as degree
of uncertainty is less.
On the other hand some non-routine decisions like to shut down a plant or not due to
very little demand of product is a major decision and may involve lot of calculations, analysis
and forecasting by managers as it will have major financial and non-financial implications. So
while taking such decision manager has to spend lot of time in discussions with various
departments involved and to be impacted by this decision.

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5.3 Cost Concepts in Decision Making

RELEVANT AND IRRELEVANT COSTS:
To take correct managerial decisions managers must always be aware about the fact that which
costs are relevant for that particular decision and which are irrelevant.
Relevant costs are the costs which would be impacted by managerial decisions. They are the
future cost whose magnitude will be effected by a decision. While Irrelevant costs are those
which would not be effected by the decision.
For example, if a manager is considering closing down of a factory for 1-2 year due to low
demand of the goods produced in that factory, wages payable to the workers of the factory are
relevant in this connection as they will not be paid on closing down of the factory so result in
cost saving, but prepaid rent for the factory will be irrelevant costs as it will not be refunded so
it must be ignored.
DIFFERENTIAL COST: (Incremental and Decremental costs)
Quite often managers are confronted with 2 or more alternatives which have different cost
implications and he/she has to choose one out of them keeping in mind all relevant factors.
When one alternative is chosen over the other it is bound to have impact on total cost , either
total cost will be increased or decreased.
The difference in total costs between two alternatives is termed as Differential Costs.
Differential cost is the increase or decrease in total costs resulting out of:
(a) Producing a few more or few less of products
(b) A change in the method of production
(c) An addition or deletion of a product in product mix
(d) The selection of an additional sales channel.
Differential costs can be very useful in planning and decision making and helps manager to
choose the best alternative among all options available. It helps management to know the
additional profit that would be earned if a particular alternative is selected over another one.
In case the choice of an alternative results in increase in total costs, such increased costs are
known as Incremental Costs. In case the choice results in decrease in total costs, such
decreased costs are termed as Decremental Costs.

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For example: Suppose cost of Raw material supplied by our current Supplier A is Rs 6 per
unit while cost of material supplied by supplier B is Rs.8 per Unit and we need 10000 units of
such raw material. If Manager decides to choose supplier B over the current supplier A as B
is giving better quality material Than The differential cost will be Rs. 20000 (2*10000) Also
since there is an increase in cost due to the decision so it will be called as incremental cost.
OPPORTUNITY COST
Opportunity cost is a very important concept in decision making. It represents the best
alternative that is foregone in taking the decision. The opportunity cost emphasises that
decision making is mainly concerned with alternatives and that the cost of taking one
decision is the profit or benefit foregone by not taking the next best alternative.
In other words This cost means the value of benefit sacrificed in favour of an alternative
course of action.
Example: if the owner starts a business and invests money in buying plant and machinery. He
has to foregone the interest he was earning while this money was in Fixed deposits from
where it is withdrawn. The loss of interest that would have been earned is the opportunity
cost.
Opportunity costs are not recorded in the books as no cash payment is involved but It is
important in decision making and comparing various alternatives.It is also known asputed
cost.

5.4 Objectives of a Costing System

From the discussion in the previous section, now you are aware that there are different type of
costs and we need to carefully examine whether a particular cost is to be considered for decision
making or not.
Some costs are direct in nature while others are indirect, direct costs can be associated to a
specific product/ service but indirect costs are the ones which can not be associated to specific
product/ services as there is no direct relation between there occurrence and the production
activity, So all different costs need to be allocated on some objective and rational basis for
calculating the total cost of a particular product or service and thereby do the pricing which can
be justifiable to customers.
Costing Systems are the systematic allocation of cost to products by following one or the other
available and suitable technique. It can be used for planning and decision making. Since costing

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is mostly done in advance for goods or services to be produced and delivered in future so
generally forecasted/Budgeted figures are used.
Objectives of A Costing System
Whatever costing system we follow as per suitability in that particular industry or type of
product, basic objectives of costing system remains same and they are:
1. Ascertainment of cost :
This is the primary objective of cost accounting. The cost of each product, job or service is
ascertained.
2. Determining selling price.
All Business entities operate with profit making as one of major objective. So it is expected
that the revenue should be greater than the costs incurred in producing goods and services. Cost
system should be so designed that it provides complete information regarding the cost to
produce and sell such goods or services.
3. Cost Control and Cost Reduction.
It must assist in cost control. Budgets should be prepared well in advance. The standards for
each item of cost can be determined, the actual costs are compared with the standard costs and
variances to be calculated along with the causes of variances. The aim of a good costing system
is not only to control cost but also provide important information to assist in cost reduction
without compromising on the quality of goods or services.
4. Providing data for managerial decision-making:
Cost data must provide information for various managerial decisions for eg.:
(a) Introduction of a new product,
(b) Utilization of unused plant capacity,
(c) Making components in house or buying components from outside suppliers.
(d) Shut down or continue.
(e) Selling below total cost in special orders.

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IN-TEXT QUESTIONS
1. The benefit which is foregone due to a particular managerial decision is known as
_________________ cost.

2. The cost which will be impacted by managerial decisions is known as

________________ cost.

5.5 Marginal Costing

Marginal costing is the process of ascertaining marginal (additional) costs and the effect of
changes in volume of output on profit
This is done by differentiating between fixed costs and variable costs. Several other terms are
used synonymously in place of marginal costing like direct costing, variable costing, and
incremental costing.
Marginal costing can also be defined as a process whereby each costs element is analysed and
is classified into fixed cost and variable cost and with after this division managerial decisions
are taken to be more effective. Variable costs are the one which vary with volume of production
or output, whereas fixed costs are the ones which remains unchanged irrespective of changes
in the volume of production or output.
In other words per unit variable cost remains same at different levels of output and total variable
cost changes in direct proportion with the number of units. On the other hand, total fixed cost
remains same for all levels of output, while per unit fixed cost keep changing with change in
number of units, more the number of units produced lesser will be the per unit fixed cost.

5.6 ADVANTAGES OF MARGINAL COSTING

1. It Helps in determining the volume of production:
Marginal costing helps in determining the level of output which is most profitable for a running
concern. The production capacity, therefore, can be utilized to the maximum possible extent.
2. Maximisation of Profit:

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It helps, in determining the most profitable relationship between cost, price and volume in the
business, which helps the management in fixing appropriate selling price for its products thus,
maximization of profit can be achieved.
3. Helps in selecting optimum production mix:
The techniques of Marginal costing helps in determining the most profitable production mix
by comparing the profitability of different products. With analysis of data it can help in deleting
the less profitable products from the portfolio of products and adding new more profitable new
products thereby creating a optimum product mix products.
4. Helps in deciding whether to Make or Buy:
The decision whether a particular product should be manufactured in the factory or to be bought
from out side supplier can be taken. In case the purchase price is lower than the marginal cost
of production, it will be advisable to purchase the product from outside rather than
manufacturing it in the factory.
5. Help in deciding method of manufacturing:
In case a product can be manufactured by two or more alternative methods, ascertaining the
marginal cost of manufacturing the product by each method will be helpful in deciding as to
which method should be adopted for maximum cost saving.
6. Helps in deciding whether to shut down or continue:
In the periods when company is suffering losses due to lower demand for its products Marginal
costing helps in deciding in whether the production in the plant should be temporarily
suspended or continued.
There are numerous other managerial decisions in which marginal costing will be very helpful
by providing the relevant data.

5.7 Limitations of Marginal Costing

1. Artificial Classification:-
Marginal costing assumes that all expense can be classified into fixed and variable expenses.
But in real life scenario it is difficult to analyse and classify all costs into fixed and variable
elements. Some elements of costs are partly fixed and partly variable and their separation is
mostly based on assumption and not on facts. In reality all costs are variable in the long run.
2. Faculty Decision:-
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In marginal costing most decisions are taken based on variable costs that’s why it is also
sometimes referred as variable costing but if fixed costs are completely ignored, decisions
taken by management can be deceptive in certain circumstances. For eg. With the introduction
of costly automatic machine, the importance of fixed costs in increasing day by day.
3. Marginal costing ignores time factor and investment:-
The marginal cost of two jobs may be the same but the time taken for their completion and the
cost of machines used may differ. The true cost of a job which takes longer time and uses
costlier machine would be higher. This fact is not covered by marginal costing.
4. Controllability of Fixed cost:-
In Marginal costing the importance of controlling fixed costs in completely ignored. No doubt,
fixed costs can also be controlled in short term but by placing them in a separate category and
by accepting them as fixed and completely non controllable, the importance of controllability
of fixed cost is undermined.
5. Difficult to apply:-
The technique of marginal costing is difficult to apply in industries such as ship building, and
other construction based industries where due to long operating cycle the value of work in
progress is generally high in relation to turnover.
6. Stock is understated:-
Under marginal costing stocks and work in progress are valued at variable cost only so their
value is bound to be understated.
7. No Basis for Cost control or reduction:-
Marginal costing does not provide any standard for the evaluation of performance. A system
of budgetary control and standard costing provides more effective tools and basis for cost
control than the one provided by marginal costing.

5.8 Difference between Marginal costing and Absorption costing

Absorption costing :-
The process of charging all costs, both variable and fixed, to operations, products or process is
known as absorption costing. So in other words absorption costing is a method of costing in
which all direct costs and appropriate overheads are absorbed/charged in cost of the product or
services for finding out the total cost of production.

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STOCK VALUATION under Absorption costing Vs Marginal Costing

Inventories are over-stated in absorption costing as it includes one extra cost element in
inventory value than under marginal costing, i.e the fixed manufacturing cost.
Inventory value under absorption costing
= Direct material+ Direct labour +variable manufacturing costs+ Fixed manufacturing costs
Inventory value under marginal costing
= Direct material+ Direct labour +variable manufacturing costs
From the Discussion so far one can easily understand that there are some basic differences in
basic premise on which cost are ascertained in absorption costing and marginal costing. The
main difference is in treatment of fixed cost among the two. While in absorption costing it is
treated in same manner as variable cost and form part of total cost based on which stock is
valued but on the other hand in marginal costing only variable costs are considered in decision
making and valuing the stock.
Following are various points of difference between Absorption costing and Marginal Costing
Basis of Difference Absorption costing Marginal costing
Classification of Costs are not classified Costs have to be classified into fixed
Costs into variable and fixed. costs and variable costs. To establish
cost-volume-profit relationship.
Treatment of Fixed Fixed production Fixed production costs are regarded as
Production overheads are charged to period cost and are charged to revenue
overheads the product. It is included along with the selling and
in cost per unit. administration expenses, i.e., they are
not included in cost per unit.

Calculation of Profit Profit is the difference Under marginal costing first

between sales and cost of contribution is ascertained by
goods sold. subtracting variable cost from total
revenue. After that we deduct therefrom
the total fixed expenses to calculate
profit.

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Effect of valuation If inventories increase If inventories increase during a period,

of inventory on during a period, this this method generally reports less profit
Profit method will reveal more than absorption costing but when
profit than marginal inventories decrease this method reports
costing. When inventories more profit. As closing stock is valued
decrease, less profits are at lower cost as compared to absorption
reported because under costing
this method closing stock
is valued at higherfigures
as it includes absorbed
fixed cost also.
Over/under Arbitrary apportionment Since fixed costs are excluded, there is
absorption of of fixed costs may result in no question of arbitrary apportionment
Overheads under or over absorption of fixed overheads and thus no under or
of overheads. over absorption of overheads.

Let’s understand with the help of an example how profit is calculated under absorption costing
and Marginal costing. Before that understand the format for income statement under both
methods.
Income Statement under Absorption Costing
Particulars Amount
Rs.
Sales (A) XXX
Variable (Direct Material Cost) X
Variable (Direct Labour Cost) X
Variable (Direct Expenses) X
Variable Factory Overhead X
Fixed Factory Overhead absorbed X
(units produced x standard rate per unit )
Total manufacturing cost of Quantity Produced XXX

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Add:- Opening FG X
Less:- Closing FG X
Total manufacturing cost of Quantity Sold XXX
Add:- Variable Office & Admin Overhead X
Fixed Office and Admin Overhead X
Variable Selling & Distribution Overhead X
Fixed Selling & Distribution Overhead X
Add:- Under absorbed Overhead(Actual Overhead incurred – Overhead X
absorbed) X
Less:- Over absorbed Overhead (Overhead absorbed – Actual Overhead incurred)
Total Cost of Sales (B) XXX
Profit (A-B) XXX

Income Statement Under Marginal Costing

Particulars Amount Rs.
Sales XXX
Less Variable Cost
Direct Material Cost X
Direct Labour Cost X
Direct Exp. X
Variable Factory Overhead X
Variable Office & Admin Overhead X
Variable Selling & Dist. Overhead X
Contribution XXX
Less Fixed Cost
Fixed Factory Overhead X

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Fixed Office & Admin Overhead X

Fixed Selling & Dist. Overhead X
Profit XXX

Example 1 VGA Ltd. Produces a single product and normal level of production is 18000 units.
Information for last accounting year is provided below:
Production 20000 units sales 16000 units
Particulars Rs
Selling Price per unit 30
Production cost:
Direct material cost per unit 7
Direct labour cost per unit 6
Variable Overheads per unit 4
Fixed Overhead incurred 54,000
Variable Selling and administration overheads per unit 4.5
Fixed Selling and administration overheads 25,000
There was no opening stock of finished goods.
Income statement under Absorption costing method
Particulars Amount Amount
(Rs.) (Rs.)
Sales (A) 4,80,000
Production cost:
Direct material cost (20000*7) 1,40,000
Direct labour cost (20000*6) 1,20,000
Variable Overheads (20000*4) 80,000
Fixed Overhead incurred 60,000 4,00,000

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Add: Opening stock Nil

Less: Closing stock (4000*20) (80,000)
Total Production cost 3,20,000
Less: over absorbed overheads (2000*3) (6,000)
Adjusted Production Cost 3,14,000
Variable Selling and administration overheads (16000*4.5) 72,000
Fixed Selling and administration overheads 25,000 97,000
Total Cost of Sales (B) 4,11,000
Profit (A-B) 69,000

Fixed production overheads given are Rs. 54,000 for budgeted 18000 units so it comes down
to Rs.3 per unit (54000/18000)
Fixed production overheads absorbed for current production of 20,000 units is Rs. 60,000
(20000*3)
Therefore over absorbed fixed production overheads 6000 (60000-54000)

Income statement under Marginal costing

Particulars Amount Amount
Rs. Rs.
Sales 4,80,000
Less Variable Cost
Direct Material Cost 1,40,000
Direct Labour Cost 1,20,000
Variable Factory Overhead 80,000
Total Variable cost of production 3,40,000
Add Opening Stock Nil

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Less: Closing Stock (4000*17) (68,000)

2,72,000
Add: Variable Selling and Administration overheads 72,000 3,44,000
Contribution 1,36,000
Less Fixed Cost
Fixed Production Overhead 54,000
Fixed Selling & Admin Overhead 25,000 79,000
Profit 57,000

So it can be observed that there is a difference of Rs. 12,000 Between profits under two method,
this is the same amount as difference between value of closing stock. Since closing stock under
Absorption is valued at Rs. 80,000 (Full Cost of production) while in Marginal costing it is
valued at Rs. 68,000 (Variable cost of Production)

5.9 COST-VOLUME-PROFIT ANALYSIS

Cost-Volume-Profit (CVP) analysis is the systematic study of relationship between cost of the
product, volume of activity and the resultant profit. Since all these three factors are interrelated
so its very important to study their relationship and how a change in one can effect the other as
well. For eg. Cost of the product will provide the base on which selling price will be determined
and accordingly profit will be calculated. If we change selling price it might impact volume of
sales and volume of production and thereby will impact the cost .
So CVP analysis is very important technique used in managerial decision making and achieving
the desired results.
Assumptions in CVP Analysis:
1. Any Changes in the levels of revenues (Sales) and costs arise only because of changes in the
number units produced and sold – for example, the number of Cars produced and sold by
Maruti Suzuki or the number of Passengers travelling in a bus.
2. Total costs can always be separated into two elements or parts i.e a fixed element which does
not change with the level of output and a variable element which changes with level of output.

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3. Selling price per unit, variable cost per unit, and total fixed costs are known and constant.
(Mind it, Total sales and total variable cost will keep changing with level of output).
4. It is assumed that company is either selling a single product or that the proportion of different
products will remain constant as the level of total units sold changes i.e. sales mix remains
constant.
Before we proceed further, let us briefly discuss various concepts & symbols used in marginal
costing and CVP analysis.

Total Fixed cost (TFC):

It remains constant or same at all levels of output.
Total Variable Cost (TVC):
It will be 0 at zero level of activity and increases proportionately with the volume of activity.
Total Cost (TC):
It is a combination of Fixed cost and variable cost so it will start from the level of fixed cost
and keep increasing following the variable cost.
Total Sales (S): It represents the total amount received as revenue by selling the goods
produced
Profit (P) : It represents the difference between Total sales and Total Cost.
Basic equation:
Total sales = Total Fixed Cost + Total variable Cost + Total Profit
TS = FC +VC + P
Contribution (C): When only Variable cost is subtracted from Sales the resultant figure is
called Contribution. Since in Marginal costing it is assumed that fixed cost will remain same
at least in short run for all levels of production activity. So, contribution is an important concept
to help in decision making in marginal costing.
Contribution =Total Sales – Total Variable Cost
OR Contribution=Fixed Cost + Profit
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Standard Marginal Cost Statement (Simplified)

Particulars Amount (Rs.)

Sales (S) XXX

Less Variable cost (VC) XXX

Contribution (C) XXX

Less Fixed Cost (FC) XXX

Profit (P) XXX

Concepts Used in Marginal costing for Decision Making

1. Profit Volume (P/V) Ratio :
This ratio helps in knowing the profitability of the operations of a business. It establishes the
relationship between Contribution and sales. Since Fixed cost do not change with the level of
output so any increase in contribution will leads to increase in profit.
So Profitability of the different Goods produced by a company can be ascertained by comparing
their P/V ratio. Higher the P/V ratio higher the profit of that particular product and vice-versa.
P/V ratio is also known as Contribution Margin Ratio or Contribution to Sales Ratio.
P/V Ratio = Contribution X 100
Sales

Or Contribution per unit X 100

Sales per unit

Or Change in contribution X 100

Change in sales

Or Change in profit X 100

Change in sales

Let us see how all of these formulas will give same result for a given set of information.
Example 2 Khushi Enterprises shares with you their cost data for 2 years

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Particulars Year 1 Year 2 Change

Production 5000 units 8000 units 3000 units

Sales @5 per unit 25000 40000 15000

Variable cost @ 3 per Unit 15000 24000 9000

Contribution @2 per unit 10000 16000 6000

Fixed cost 4000 4000 0

Profit 6000 12000 6000

Lets check P/V ratio with all Formulas mentioned above

P/V Ratio = Contribution X 100 For Year 1 (10000/25000)*100 = 40%
Sales

Or Contribution per unit X 100 For year 1 (2/5)*100 = 40%

Sales per unit

Or Change in contribution X 100 (6000/15000)*100 = 40 %

Change in sales

Or Change in profit X 100 (6000/15000)*100 = 40%

Change in sales

So, that’s the benefit of this formula that as per given information we can use any of its
version still getting same answer.

5.10 BREAK EVEN ANALYSIS

Though many believes that there is no difference in CVP analysis and Break even analysis and
they refer to same concept others believe that CVP is a broader term and include Break even
analysis But if we carefully observe concepts used in them we can say that Break-even analysis
is a actually a method to apply the CVP analysis in decision making process by including many
more related concepts into it.

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Break even point:

Break-even point is production and sales level where there will be no profit and loss i.e. total
cost (TC) is equal to total sales revenue (S)
or Sales = Total Fixed Cost + Total Variable cost & Profit = 0
Break-even Point can be calculated both in units and Rs. When calculated in Terms of Rs. It is
also referred as Break even sales.
Let us calculate Break-even point for the given set of data we used in CVP analysis above

Particulars Year 1 Year 2 Change

Production 5000 units 8000 units 3000 units

Sales @5 per unit 25000 40000 15000

Variable cost @ 3 per Unit 15000 24000 9000

Contribution @2 per unit 10000 16000 6000

Fixed cost 4000 4000 0

Profit 6000 12000 6000

Break even point (in units) = BEP = Fixed costs

Contribution per unit

So For given set of values Break Even Point = (4000/2) = 2000 units
We can Cross check this by simple calculations
Suppose we produce 2000 units and selling price is 5 per unit so total sales 10000
Variable cost @ 3 per unit will be (2000 *3) = 6000 so contribution will be 4000 and fixed
cost given is 4000 so profit will be 0

3. Break even Point (in Rs.) = BES = Fixed cost X Sales per unit
Contribution per unit

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Or BEP in units * Selling Price per unit or Fixed Cost

P/v ratio

In our example BES = 2000 * 5 = 10000 Rs. Or 4000/40% = 10000 Rs.

Lets see few other related concepts which further help in decision making
Break Even Point With Desired Profits: BEP with DP (in units)
Since no business entity would like to settle at Break even point , their main objective of
existence is to earn profit for shareholders or owners so it makes sense to calculate particular
level of units to be produced and sold to earn desired profits.
4. BEP with DP (in units) = Fixed cost + Desired profit
Contribution per unit

And following the same concept which we discussed for BEP in Rs. , BEP with desired
profit in Rs can also be calculated in similar manner

5. BEP with DP (In Rs) = BES with DP = Fixed cost + Desired profit x Sales per unit
Contribution per unit

Or BEP with DP in units * Selling Price per unit

Or Fixed Cost + Desired Profit

P/V ratio

Let us assume in our example shareholders have given a target of Rs. 24000 Profit to be earned
So BEP With DP in Units = (4000 + 24000)/2 = 14000 units
BEP with DP in Rs. = 14000 *5 = Rs.70000 or (4000 + 24000)/40% = Rs. 70000
This can be verified with following calculations

Production 14000 units

Sales @5 per Unit 70000

Variable cost Per unit @3 per unit 42000

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Contribution @2 Per unit 28000

Fixed Cost 4000

Profit 24000

So it can be clearly observed that by producing and selling 14000 units The revenue will be
Rs. 70000 and a profit of Rs 24,000 is expected be achieved.

Margin Of Safety (MOS):

Margin of safety is the difference between actual sales and Break even sales It can be expressed
in absolute terms or as a % of Actual sales
6. MOS (Absolute) = Actual Sales – Break Even Sales
MOS Can also be calculated with following Formula
MOS = Profit/P/V ratio
7. MOS (%) = MOS/ Actual sales
So in our example, if we calculate Margin of Safety for 2nd year it will be
MOS (Absolute) Actual Sales- BES = 40000-10000 = Rs 30000
MOS = 12000/40% = Rs.30000
MOS (%) = MOS/Actual Sales = 30000/40000 = 0.75 or 75%
Let us see with few more examples that with the minimal information given how we can
calculate all these components which will help in decision making process to a great extent
Example 3 Homemakers Pvt Ltd. Gives you following data

Particulars Amount in Rs.

Sales 500000 units 15,00,000

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Fixed Cost 4,50,000

Profit 3,00,000

You need to find BEP, MOS

Solution:
Since All marginal costing concepts revolve around contribution and P/V ratio lets first
calculate that
Contribution = Fixed Cost + Profit
= 4,50,000 + 3,00,000 = 7,50,000
P/V Ratio = (Contribution/Sales)*100
= (7,50,000/15,00,000)*100 = 50%
BEP in Rs (In Sales) = Fixed Cost / P/V ratio
= 4,50,000/50% = 9,00,000
BEP in Units = BEP in sales/ Selling Price per unit
= 9,00,000/3 = 3,00,000 units
(note: Selling price per unit = sales/ no of units = 15,00,000/5,00,000 = 3 per unit)
Margin of Safety (in Rs.) = Actual sales – Break even sales
= 15,00,000 - 9,00,000 = Rs. 600000
Margin of safety (in %) = MOS/ Actual Sales
= 6,00,000/15,00,000 = .0.4 or 40%
Angle of Incidence
The angle which the Total Sales Line makes with the Total Cost Line is known as the Angle
of Incidence.
The angle indicates the profit-earning capacity of the company over the break-even point.
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A large angle of incidence indicates a high margin of profit and a mall angle of incidence
indicates earning of low margin of profit.

Let us see with a few more examples that with the minimal information given how we can
calculate all these components which will help in the decision-making process to a great extent.
Example 4 Mrs Anju is running a business named “AHAAR” for supplying packed foods to
near by offices. She supplied you the following information and ask for answers to few
questions.

Particulars Year 1 Year 2

Sales 20,00,000 30,00,000

Profit 2,00,000 4,00,000

Answer the following:

1. P/V ratio
2. Variable cost for year 1
3. Fixed Cost
4. BEP
5. Sales to earn a Profit of Rs 6,00,000
6. Profit When sales are 50,00,000
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7. MOS for a Profit of 6,00,000

Solution:
1. P/V ratio = (Change in Profit/ Change in Sales)*100
= (2,00,000/10,00,000)*100 = 20%
2. Variable cost in 1st year = Sales - Contribution
Contribution in year 1 = Sales *P/V ratio
= 20,00,000* 20% = 4,00,000

Therefore Variable cost = 20,00,000 - 4,00,000 = 16,00,000

3. Fixed Cost = Contribution – Profit
= 4,00,000 – 2,00,000 = Rs 2,00,000
4. BEP = FC/ P/V ratio
= 2,00,000/20 % = 10,00,000
5. Sales to earn a profit of 6,00,000
BEP with DP = (FC +DP)/ P/V ratio
= (2,00,000 + 6,00,000)/20%
= Rs. 40,00,000
6. Profit when sales are 50,00,000
Contribution = Sales * P/V ratio
= 50,00,000*20%
= 10,00,000
Profit = Contribution – fixed cost
= 10,00,000 – 2,00,000 = Rs. 8,00,000
7. MOS for a profit of 6,00,000
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MOS = Profit/ P/V ratio

= 6,00,000/20%
= 30,00,000

5.11 VARIOUS DECISION-MAKING PROBLEM

In every organisation Management uses marginal costing and CVP analysis concepts for
making various decisions. Generally, short-term decisions are related with temporary gaps
between demand and supply for available resources.
In this section, we will learn how the concepts of marginal costing and CVP is applied for
analysis of identified options for short-term decision making. Some of the Decision problems
faced are as follows:
1. Problem of Limiting Factor (Key Factor)
2. Processing of Special Order
3. Local vs Export sale
4. Make or Buy/ In-house-processing vs Outsourcing
5. Shut-down or continue decision etc.
1. Limiting Factor (Key Factor)
In normal circumstances, the company will always prioritise the product to be produced which
will give the greatest contribution. To maximise profit, resources should be mobilised towards
that product which gives the maximum contribution. But in real life, there may be several
factors which may put a limit on the number of units to be produced even if the products give
a high contribution . These factors limit the volume of output at a particular point of time or
over a period. these are called key factors, scarce factors, limiting factors.
The limiting factors may be, raw material available, labour hours available ,Machine hours
available, availability of capital etc. For e.g., for a factory in a remote location, labour may be
a key factor or the factory in a location with limited power supply may have limited machine
hours for production. Contribution per unit of key factor should be considered and that
particular course of action should be adopted which gives the highest contribution per unit of
key factor.

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Example 5
You are given the following information in respect of products X and Y of Altitude. Ltd.
Product X Product Y
Selling price 55 35
Direct material 10 5
Labour hours (2 Rs per hour) 5 hours 10 hours
Variable overheads 20% of Direct wages
Show which product is more profitable during labour shortage. Also If Labour hours available
are 25000 hours and demand for X and Y is 2000 and 3000 units respectively
Solution :
Particulars Product X Product Y
Selling price per unit in 37 49
Direct Material per unit in 10 5
Labour cost per unit ( Hrs *2 per hour) 10 20
Variable overhead (20% of Labour Cost) 2 4
Total Variable Cost per unit 22 29
Contribution per unit 15 20
Since Labour is in shortage so it will be treated as Key factor and the product which is
generating higher contribution per unit of labour hour will be produced first.
Contribution per Unit 15 20
Number of Hrs required per unit 5 10
Contribution per labour hour: 3 2
So You can see that though contribution per unit is higher for Y but contribution per labour
hour for product X is higher so product X is more profitable in the case labour hours are limited

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So we will first use labour hours for producing X to maximum possible extent i.e. 2000 units
in our case as demand is only for 2000 pieces remaining labour hours will be used for Y
Total labour hours available 25000
Labour hours for X (2000*5) 10000
Remaining labour hours 15000
Maximum Production of Y possible is 15000/10(labour hr per unit for Y)
So only 1500 units of Y can be produced with remaining labour hour
Now we can calculate Total Contribution by multiplying the unit produced with the per unit
contribution.
X (2000*15) = 30000
Y(1500*20) = 30000
Total = 60000
2. Processing of Special Order/ Accepting export order
Sometimes company is faced with a situation that it receives an order to supply goods below
its normal selling price. In that case if company has additional idle capacity, only additional
cost in producing and processing such order shall be compared with additional revenue to be
generated. In simple words Only Marginal cost to be considered and if it is less than the price
offered by exported or new local customer than it can be accepted, if its not going to impact
current selling price of local market.
Example 6
Anjana Industries manufacture and sell toys and has following cost structure for each unit of
Product
Particulars Amount
Rs.`
Materials 10.00
Labour 8.00
Variable expenses 10.00
Fixed expenses 17.00
Total cost 45.00

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Per Unit Selling Price of the product is Rs 52.00.

The company’s normal capacity is 1,00,000 units. The figures given above are for
70,000 units. The company has received an offer for 20,000 units @ Rs. 40 per unit
from a customer in USA.

Advice the manufacturer on whether the order should be accepted. Also give your
advice if the order is from a local merchant.

Solution:

Marginal cost for additional 20,000 units

Per unit For 20,000

units
` `
Material 10.00 2,00,000
Labour 8.00 1,60,000
Variable expenses 10.00 2,00,000
Marginal cost/ variable cost 28.00 5,60,000
Additional revenue to be realised 40 8,00,000
Marginal cost 5,60,000
Net additional contribution) 2,40,000

The offer should be accepted because it gives an additional contribution of Rs.

2,40,000. The total profit will also increase by Rs 2,40,000 because fixed expenses
have already been recovered from the local market.

As regarding answer to 2nd part of question, the order from the local customer should
not be accepted at Rs. 40 per unit or at any rate below the normal price i.e., Rs. 52
because it will result in the general reduction of selling prices of the product.

Note: If circumstances are such that acceptance of the additional order is

beyond the present capacity of the organization than in that case, some fixed
expenses may also go up substantially. If there is an increase in fixed expenses,
the increase should also be considered by including it in the total additional cost
and than it shall be compared with the additional revenue.

3. Make or Buy decision

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Sometimes company is faced with a decision whether to buy a component or part, required for
its product from outside supplier or manufacture it on its own.
In such cases, Marginal cost of Producing that item internally shall be compared with Purchase
price to come to a conclusion.
Example 7: SAANVI Automobile Ltd manufactures 20,000 units of Part UVW each year. At
current level of activity, the cost per unit follows:
Direct materials Rs. 4.80
Direct labor Rs. 7.00
Variable manufacturing overhead Rs. 3.20
Fixed manufacturing overhead Rs. 10.00
Total cost per part UVW Rs.25
An outside supplier has offered to sell 20,000 units of Part UVW each for Rs. 22 per part. And
You Are Required to advice which option is better
Solution:
Total Marginal Cost of Producing the Part in Factory
Direct materials Rs. 4.80
Direct labour Rs. 7.00
Variable manufacturing overhead Rs. 3.20
Total Marginal cost of manufacturing Rs. 15
Total cost of purchase Rs 22
It is advisable to manufacture in our own factory as cost saved by not manufacturing is less
than the purchase price. It is assumed that Fixed cost will still need to be incurred.
4. Product Profitability
In the event that a company produces multiple products, the issue of the product mix that
maximises profitability will arise. Due to a lack of resources or capabilities, the company must
deal with this issue. A company should use a combination of sales that results in higher profit

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or maximum contribution. The key or limiting component should also be taken into account
while choosing the profitable blend.
For example- The following describes a company's sales/production mix:
1. The company produce 500 units each of Product A and Product B.
2. 1500 units of product C.
3. 300 units each of product B and C, and 500 units of product A.
Particulars Product A (Rs.) Product B (Rs.) Product C (Rs.)
Direct Material 5 5 6
Direct Labour 3 5 4
Variable Cost 4 4 3
Fixed Cost 1500 1500 1500
Selling Price 20 30 25

Determine the profitable product mix.

Solution- First of all let us calculate the contribution per unit. Formula to calculate
Contribution per unit = Selling Price – (Direct material + Direct Labour + Variable cost)
Contribution per unit Product A = 20 – (5+3+4) = Rs. 8 per unit
Contribution per unit Product B = 30 – (5+5+4) = Rs. 16 per unit
Contribution per unit Product C = 25 – (6+4+3) = Rs. 12 per unit
Then, evaluate different alternative one by one:
Alternative 1: The company produce 500 units each of Product A and Product B.
Total Contribution = (Contribution per unit Product A x No. of units of Product A) +
(Contribution per unit Product B x No. of units of Product B)
= (Rs.8 per unit x 500 units) + (Rs. 16 per unit x 500 units)
= Rs. 4000 + Rs. 8000 = Rs. 12,000
Profit = Total Contribution – Fixed cost
= 12,000 – 1500
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= Rs. 10500

Alternative 2: 1500 units of Product C.

Total Contribution = (Contribution per unit Product C x No. of units of Product C)
= (Rs.12 per unit x 1500 units)
= Rs. 18000
Profit = Total Contribution – Fixed cost
= 18,000 – 1500
= Rs. 16500
Alternative 3: 300 units each of product B and C, and 500 units of product A.
Total Contribution = (Contribution per unit Product A x No. of units of Product A) +
(Contribution per unit Product B x No. of units of Product B) +
(Contribution per unit Product C x No. of units of Product C)
= (Rs.8 per unit x 500 units) + (Rs. 16 per unit x 300 units) +
(Rs. 12 per unit x 300 units)
= Rs. 4000 + Rs. 4800 + Rs. 3600 = Rs. 12,400
Profit = Total Contribution – Fixed cost
= 12,400 – 1500
= Rs. 10900
Conclusion: As a result of its larger profit of Rs. 16500, product mix 2 is more profitable than
the other product mixes.
5. Dropping a product line
When a company produces multiple products and needs to stop one of them, management
should make a decision based on the product's contribution, the impact on sales of other
products, the plant's capacity, etc. Using the marginal costing technique, management can
decide whether to add or remove a product or product line. The product that contributes the
least should be discontinued.

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Since the goal of every corporate organisation is to maximise profits, the company can think
about the efficiencies of doing away with unproductive items and replacing them with more
lucrative ones (s).
In such circumstances, the company may have two options, as follows:
(a) To discontinue the unprofitable product and not use the available capacity.
(b) To stop producing the unprofitable product and use the available resources to start
producing a more lucrative product.
For choosing whether to add or remove a product line the contribution technique is used for
this purpose, accounting for the following elements:

• Contribution from a product that isn't viable (i.e. Sale Revenue Less Variable Costs)

• Specific unprofitable product fixed costs that can now be avoided or minimised.

• Contribution from a different profitable product that would be produced using all
available capacity.
The following considerations should be made into account whenever a decision is made on
whether or not the capacity will be increased.

• Additional fixed costs will be incurred.

• Possibility of a drop in selling price as a result of increased output.

• Whether there is enough demand to accommodate the extra production.

• The cost schedule will be developed based on the aforementioned points.

• The division of fixed expenses and the marginal contribution cost must be considered
while considering whether to shrink the firm.
Example: XYZ Ltd. manufactures three products:
A — 500 units @ Selling price Rs. 25 Per unit;
B — 400 units @ Selling price Rs. 30 Per unit;
C — 300 units @ Selling price Rs. 28 Per unit;

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The company decides to stop producing one product, which will result in a 50% increase in the
production of other products. The others details are as follow:

Particulars Product A (Rs.) Product B (Rs.) Product C (Rs.)

Direct Material 5 6 7
Direct Labour 4 7 6
Variable cost 6 5 4
Fixed cost 8 7 9

You must determine which product needs to be discontinued.

Solution: First of all, let us calculate the contribution per unit. Formula to calculate
Contribution per unit = Selling Price – (Direct material + Direct Labour + Variable cost)
Contribution per unit Product A = 25 – (5+4+6) = Rs. 10 per unit
Contribution per unit Product B = 30 – (6+7+5) = Rs. 12 per unit
Contribution per unit Product C = 28 – (7+6+4) = Rs. 11 per unit
Situation 1: Now let us suppose that, production of products B and C will each be boosted by
50% if product A is discontinued. 600 units of B and 450 units of C would be produced,
respectively.
Total Contribution = (Contribution per unit Product B x No. of units of Product B) +
(Contribution per unit Product C x No. of units of Product C)
= (Rs.12 per unit x 600 units) + (Rs. 11 per unit x 450 units)
= Rs. 7200 + Rs. 4950 = Rs. 12,150
Total Fixed Cost= (Fixed Cost per unit Product B x No. of units of Product B) +
(Fixed cost per unit Product C x No. of units of Product C)
= (Rs.7 x 600) + (Rs. 9 x 450)
= Rs. 4200 + Rs. 4050
= Rs. 8250
Profit = Total Contribution – Fixed cost

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= 12,150 – 8250
= Rs. 3900
Situation 2: Now let us suppose that, production of products A and C will each be boosted by
50% if product B is discontinued. 750 units of A and 450 units of C would be produced,
respectively.
Total Contribution = (Contribution per unit Product A x No. of units of Product A) +
(Contribution per unit Product C x No. of units of Product C)
= (Rs.10 per unit x 750 units) + (Rs. 11 per unit x 450 units)
= Rs. 7500 + Rs. 4950 = Rs. 12,450
Total Fixed Cost= (Fixed Cost per unit Product A x No. of units of Product A) +
(Fixed cost per unit Product C x No. of units of Product C)
= (Rs.8 x 750) + (Rs. 9 x 450)
= Rs. 6000 + Rs. 4050
= Rs.10050
Profit = Total Contribution – Fixed cost
= 12,450 – 10,050
= Rs. 2400
Situation 3: Now let us suppose that, production of products A and B will each be boosted by
50% if product C is discontinued. 750 units of A and 600 units of B would be produced,
respectively.
Total Contribution = (Contribution per unit Product A x No. of units of Product A) +
(Contribution per unit Product B x No. of units of Product B)
= (Rs.10 per unit x 750 units) + (Rs. 12 per unit x 600 units)
= Rs. 7500 + Rs. 7200 = Rs. 14,700
Total Fixed Cost= (Fixed Cost per unit Product A x No. of units of Product A) +
(Fixed cost per unit Product B x No. of units of Product B)
= (Rs.8 x 750) + (Rs. 7 x 600)

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= Rs. 6000 + Rs. 4200

= Rs.10200
Profit = Total Contribution – Fixed cost
= 14,700 – 10,200
= Rs. 4500
Conclusion: If product C is discontinued, production of products A and B will each be boosted
by 50%. As a result of its larger profit of Rs. 4500, this product mix is more profitable than the
other product mixes.
6. Shut Down Vs. Continue Operations
When a corporation decides to shut down, it signifies that production will stop temporarily.
That indicates that the company will restart production in the future. Reasons of shut down
production include- decline in demand; financial difficulty; high tax rates and technological
change; inadequate raw material availability a market downturn and mismanagement.
In general, all businesses should have greater revenue than total cost (Revenue > Total Cost)
in order to remain in operation. But in the short run, all businesses disregard fixed costs; as a
result, Revenue must be equal to or higher than variable cost.
If the items are helping to pay for fixed costs, or if the selling price is higher than the marginal
cost then it is preferable to continue because the losses are kept to a minimum.
Shut Down Point determines whether to shut down. The shutdown point describes the precise
point at which a company's revenue and variable costs are equal. labour costs, supplies for
production, and other varying costs. It describes the precise point at which a company's revenue
and variable costs are equal. A corporation is said to be operating at a shutdown point when
there is no advantage to continuing such operations. in order to decide to temporarily or, in
certain situations, permanently shut down.
Depending on the nature of the industry, certain fixed expenses can be avoided by pausing
production while other fixed expenses may go up.
The contribution must be more than the difference between fixed expenses incurred during
normal operation and fixed expenses incurred during plant shutdown before a decision can be
made. The formula below can be used to determine the shutdown point.
Shutdown point is calculated as Total Fixed Cost – Shutdown Cost = Contribution per unit
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1. A short-run criterion
Depending on the company, the short-run is for a finite amount of time, such as quarterly, half-
yearly, or yearly. For choosing whether to stop or continue in short run, only variable cost is
taken into account during the short-term outage. In other words, we analyze whether or not the
business can cover its variable costs for the short period during which sales occur. Otherwise,
the Firm must close.
As an illustration, suppose a company's income is Rs. 500 and its variable cost is Rs. 400. then
the contribution will be Rs. 100. There is no need to turn the product off in this case. However,
the corporation must discontinue that product if the variable cost exceeds the sales.
2. Long-term criterion
Depending on the sort of business, the long run may be annually or more frequently than
annually. Both fixed and variable costs are taken into account when considering a long-term
shutdown. As an illustration, let's say a corporation sells for Rs. 500, with Rs. 450 in variable
costs and Rs. 100 in fixed costs. Then a loss of Rs. 50 occurs.
That suggests that while the business won't last in the long run, it will likely survive in the short
term.
Marginal costs is useful when a department or product is being discontinued. The marginal
costing technique demonstrates how each product affects the profit at fixed costs. If a
department or product makes the smallest contribution, it may be closed or its production may
be stopped. It implies that just the product with the highest level of contribution should be used,
and the rest should be discarded.

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IN-TEXT QUESTIONS
Following information is available of Anvi enterprises for year ended June, 2022
Fixed cost Rs. 3,00,000
Variable cost Rs. 12 per unit
Selling price Rs. 15 per unit
Output level 1,50,000 units
3. P/V Ratio is
a) 80% b) 20% c) 100% d) 33.3%

4. BEP in Units
a) 200000 b) 100000 c) 600000 d) 300000

5. BEP in Rs.
a) 10,00,000 b) 12,00,000 c) 15,00,000 d) 20,00,000

6. Sales Required To earn Profit Of Rs. 6,00,000

a)30,00,000 b) 45,00,000 c) 60,00,000 d) 20,00,000

5.12 SUMMARY

Costing Systems are the systematic allocation of cost to products by following one or the other
available and suitable technique. It can be used for planning and decision making. Objectives
of A Costing System
1. Ascertainment of cost :
2. Determining selling price.
3. Cost Control and Cost Reduction.
4. Providing data for managerial decision-making:
a) Introduction of a new product,
b) Utilization of unused plant capacity,
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c) Making components in house or buying components from outside suppliers.

d) Shut down or continue.
e) Selling below total cost in special orders.
Marginal costing is the process of ascertaining marginal (additional) costs and the effect of
changes in volume of output on profit
Advantages of Marginal Costing
1. It Helps in determining the volume of production:-
2. Maximisation of Profit:
3. Helps in selecting optimum production mix:-
4. Helps in deciding whether to Make or Buy:-
5. Help in deciding method of manufacturing:-
6. Helps in deciding whether to shut down or continue:-
Limitations of Marginal Costing
1. Artificial Classification:-
2. Faculty Decision:-
3. Marginal costing ignores time factor and investment:-
4. Controllability of Fixed cost:-
5. Difficult to apply:-
6. Stock is understated:-
7. No Basis for Cost control or reduction:-
Marginal Costing Vs Absorption Costing
The main difference is in treatment of fixed cost among the two. While in absorption costing
it is treated in same manner as variable cost and form part of total cost based on which stock is
valued but on the other hand in marginal costing only variable costs are considered in decision
making and valuing the stock.

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Cost-Volume-Profit (CVP) analysis is the systematic study of relationship between cost of

the product, volume of activity and the resultant profit. Since all these three factors are
interrelated so its very important to study their relationship and how a change in one can effect
the other as well.
Decision Making Problems
In this section, we have learned how the concepts of marginal costing and CVP is applied for
analysis of identified options for short-term decision making. Some of the Decision problems
faced are as follows:
1. Problem of Limiting Factor (Key Factor)
2. Processing of Special Order
3. Local vs Export sale
4. Make or Buy/ In-house-processing vs Outsourcing
5. Shut-down or continue decision etc.

5.13 PRACTICAL PROBLEMS

1. Two competing companies HERO Ltd. And ZERO Ltd. Sell the same type of product in
the same market. Their forecasted profit and loss accounts for the year ending December 2022
are as follows:

Particulars Hero Ltd. Zero Ltd.

Sales Rs.5,00,000 Rs. 5,00,000
Less: Variable Costs Rs.4,00,000 Rs.3,00,000
Less: Fixed Costs Rs.50,000 Rs.50,000
Forecasted Profit Rs.50,000 Rs.50,000

You are required to state which company is likely to earn greater profits in conditions of:
a) Low demand
b) High demand

2. Two manufacturing companies which have the following operating decides to merge:

Particulars Company A Company B

Capacity Utilization (%) 90 60
Sales (Rs. in lacs) 540 300
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Variable Costs (Rs. in lacs) 396 225

Fixed Assets (Rs. in lacs) 80 50

Assuming that the proposal is implemented, calculate:

a) Break-even sales of the merged plant and the capacity utilization at that stage
b) Profitability of the merged plant at 80% capacity utilization
c) Turnover of the merged plant to earn a profit of Rs.75 lacs
d) When the merged plant is working at a capacity to earn a profit of Rs.75 lacs, what
percentage increase in selling price is required to sustain an increase of 5% in fixed
overheads

3. Croma manufactures and sells four types of products under the brand names A, B, C and D.
The sales mix in value comprises of 33-1/3%, 41-2/3%, 16-2/3% and 8-1/3% of A, B, C and
D respectively. The total budgeted sales are Rs.60,000 per month.

Operating costs of the company are as follows:

Product % of sale price

A 60%
B 68%
C 80%
D 40%

Fixed Cost is Rs.14,700 per month.

The company proposes to change the sales mix for the next month as follows and it is estimated
that total sales would be maintained at the same level as the current month:

Product Sales mix

A 25%
B 40%
C 30%
D 5%

You are required to calculate:

a) Break-even point for the products on an overall basis for the current month.
Break-even point for the products on an overall basis for the next month assuming that the
proposal is implemented

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5.14 GLOSSARY
Relevant costs are the costs which would be impacted by managerial decisions. They are the
future cost whose magnitude will be effected by a decision.
Irrelevant costs are those which would not be effected by the decision.
Differential Costs The difference in total costs between two alternatives is termed as.
Opportunity Cost This cost means the value of benefit sacrificed in favour of an alternative
course of action.
Costing Systems are the systematic allocation of cost to products by following one or the
other available and suitable technique.
Marginal costing is the process of ascertaining marginal (additional) costs and the effect of
changes in volume of output on profit
Absorption costing The process of charging all costs, both variable and fixed, to operations,
products or process is known as absorption costing.
Cost-Volume-Profit (CVP) analysis is the systematic study of relationship between cost of
the product, volume of activity and the resultant profit.
Break-even analysis is a actually a method to apply the CVP analysis in decision making
process by including many more related concepts into it.

All Formulas at a Glance

1. Basic Cost equation:
Total sales = Total Fixed Cost + Total variable Cost + Total Profit
TS = FC +VC + P
2. Contribution =Total Sales – Total Variable Cost
OR Contribution=Fixed Cost + Profit
3. P/V Ratio = Contribution X 100
Sales

Or Contribution per unit X 100

Sales per unit

Or Change in contribution X 100

Change in sales

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Or Change in profit X 100

Change in sales

4. Break even point (in units) = BEP = Fixed costs

Contribution per unit

5. Break even Point (in Rs.) = BES = Fixed cost X Sales per unit
Contribution per unit

Or BEP in units * Selling Price per unit or Fixed Cost

P/v ratio
6. BEP with DP (in units) = Fixed cost + Desired profit
Contribution per unit

7. BEP with DP (In Rs) = BES with DP = Fixed cost + Desired profit x Sales per unit
Contribution per unit

Or BEP with DP in units * Selling Price per unit

Or Fixed Cost + Desired Profit

P/V ratio
8. MOS (Absolute) = Actual Sales – Break Even Sales
MOS Can also be calculated with following Formula
MOS = Profit/P/V ratio
9. MOS (%) = (MOS/ Actual sales)*100

5.15 Answers to in-text Questions

1. Opportunity 4. b) 1,00,000
2. Relevant 5. c) 15,00,000
3. b)20% 6. b) 45,00,000

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5.16 SELF-ASSESSMENT QUESTIONS

Q1 What are various Cost concepts involved in managerial decision making?

Q2 What is Marginal Costing ? How is it Different From Absorption Costing?
Q3 What is CVP analysis and what are is uses?
Q4 What are Advantages of Marginal Costing?

5.17 REFERENCES
Study Material of Institute of Chartered Accountants of India
Study Material of Institute of Cost and management Accountant of India

5.18 SUGGESTED READINGS

S.N. Maheshwari , Suneel Maheshwari , Sharad K. Maheshwari - A Textbook Of Accounting
For Management, Vikas Publishing House Pvt. Limited

Asish K Bhattacharyya- Principles and Practice of Cost Accounting ,PHI learning Private
Limited

R.S.N. Pillai, V. Bagavathi -Management Accounting , S. Chand and Company Limited.

M.Y. Khan P.K. Jain - Management Accounting: Text, Problems and Cases , Mc Graw Hill
Education

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Management Accounting

LESSON 6
STANDARD COSTING AND VARIANCE ANALYSIS

Dr. Vijay Lakshmi

Assistant Professor
Ramanujan College
University of Delhi
[email protected]

STRUCTURE

6.1 Learning Objectives

6.2 Introduction
6.3 Standard Cost
6.4 Standard Costing
6.4.1 Meaning
6.4.2 Purpose of Standard Costing
6.4.3 Establishing the Standard Cost
6.4.4 Kinds of Standards
6.4.5 Process of Standard Costing
6.4.6 Types of Variances
6.5 Classification of Variances
6.6 Summary
6.7 Glossary
6.8 Answers to In-text Questions
6.9 Self-Assessment Questions
6.10 Suggested Readings

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6.1 LEARNING OBJECTIVES

After this chapter, learners will be able to:-

•
To understand the standard costing and its relevance.
•
Learn the pre requirements for the success of the standard costing in the
company.
• Analysis the classification of the overhead variances.
Develop an understanding and examining the reasons behind the variances within the
actual and planned results.

6.2 INTRODUCTION

The business organisation’s success depends upon how effectively and efficiently it is able to
control the costs. In a wider context the cost can be calculated and reported through
predetermined costing and historical costing. Where the historical cost refers to identification
and reporting of the actual cost that has been incurred postproduction. Moreover, efficiently
ascertaining and controlling the cost is one of the essential goal of cost accounting.
Historical costing has not been considered as an efficient method for exercising the cost control
since it is not applicable as per plan of action. Also, it is unable to furnish any benchmark which
may be utilised for gauging the actual performance. Hence on the basis of these shortcomings
of historical costing, it is considered important to understand before the production phase
begins what costs should be examined for finding the exact cause of failures (if any) for
achieving the target and fixation of responsibility thereupon. Therefore, standard costing has
been considered as an essential equipment that helps management for planning and controlling
the operations of the business. In standard costing each costs are determined beforehand, where
a comparison is made between these pre-determined costs and actual costs. Moreover, the
difference in between these two costs (predetermined and actual) has been named as Variance.
And these variances are informed to the management of the company for taking the corrective
measure so that actual costs adhered to the pre-determined costs.
Accordingly, in historical costing, actual costs are evaluated once they were incurred. These
costs have been not considered useful to the management for decision purposes and controlling
of costs. As a result, standard costing is being considered as a useful technique to plan, make
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various decisions and controlling the business operations. In this unit you are going to study
about the standard costing and variance analysis.

6.3 STANDARD COST

Standard costs are the costs which have been pre-determined and used as benchmark for
measuring the effectiveness on the basis of which the actual costs were incurred under the given
situations. For instance, the quantum of raw material needed for producing one unit of a product
can be ascertained and the cost can be estimated for that raw material. This became the standard
material input. As per official terminology of C.I.M.A (Chartered Institute of Management
Accountants), standard cost comprises of unit cost of a product, component or service planned
by an organisation. This cost could be evaluated on various number of base. Its utility lies in
measuring performance, valuation of stock, control and formulating selling price. Hence it can
be said that standard cost is:-
 Planned
 Decided upon single or several bases

6.4 STANDARD COSTING

Standard Costing is a costing technique used by the company’s management as a tool of control.
Where controlling is function of the management besides other functions of management such
as directing, staffing and planning. Each company sets a target and for achieving it the
management of the company has to make plans, thereafter, get them in execution and oversee
the work for checking any deviation (comparison of actual with that standard) from the planned
one.
6.4.1 Meaning :
Standard costing is a method employed for determining the standard cost and making
comparison between them and actual costs in order to ascertain the reasons behind such
differences, for taking any remedial measures that must be taken with immediate effect.
According to Chartered Institute of Management Accountants (C.I.M.A)¸ standard costing has
been defined as “the preparation of standard costs and applying them to measure the
variations from actual costs and analysing the causes of variations with a view to maintain
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maximum efficiency in production”. Hence it is a method of the cost accounting for comparing
the standard cost for every product with that of the actual cost, for determining the operation’s
efficiency. So, standard costing includes the subsequent steps:-
a) Determining the standard costs of several elements for costs.
b) Documenting the actual costs.
c) Making a comparison in between actual costs and standard costs for finding variances.
d) Examining the causes of the variances.
e) Informing the management on the variance analysis in order to take corrective steps
where required.

6.4.2 Purpose of Standard Costing:

a) Controlling of costs – It has been one of the essential aims of standard cost whereby it
assists the management in the controlling of all the costs.
b) Creating an environment of awareness on cost – This objective helps to make an
environment of consciousness about costs in the organisation. This further helps to
ensure that employees recognize the significance of the efficiency in the business
operations wherein the cost can be optimized because of combined efforts of all.
c) Management plans – Standard costing is appropriate for budgetary plans made by the
company on several stages since it has been made in a prudent way by considering all
the technicality related in the business.
d) Developing policies and setting of prices – It intends to support the management in
policies formulation and determination of the prices involved in the operations of the
business.

6.4.3 Establishing the Standard Cost:

The accuracy and trustworthiness determine the successfulness of a standard costing
system. Hence, each operation must be considered during setting the standards. The
standard costs have made for every component of the cost namely: -
 Direct labour
 Direct Material and

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 Overheads

Standards are determined both in: - Physical manner and Monetary manner for every element
of cost.
 Physical Standards – It refers to recording of the standards in hours or units. At this
point the standard hours and quantity have been fixed for a specific service or product.
The intent of fixing the standards is to achieve the economies of scale in the production
stage and setting the price for quoting it. During the process of setting the standards the
following things must be considered:-
• Company’s Budget.
• Production of final output.
• Where multiple inputs are there then the material’s proportion that has
to used must be determined.
• Specification of the material in terms of quality and quantity as required.
• Availability and skills of the workers.
• Production method.
• Internal and external factors.
• Working conditions
• Material quantity standards - The process for setting up of material quantity standard have
been enumerated as follows: -
a. Products standardization – In this stage decision has been on the products to be made
on the basis of the plan of production and customers orders. Normally questions to
name a few – what has to produce, how many products to be made and what type of the
product has to be made are answered during this stage.
b. Study of the product – The production and development of the product requires its
thorough analysis. This analysis is being carried by the specialized departments or
product experts. During this stage the answers to questions like how product can be
produced, what are preconditions, what type of material has to be used, how to make
the acceptability of the product in markets, etc. have been addressed.
c. Formulating the specification list – Once product has been studied thereafter a list of
the materials is made specifying the quantity as well as the quality of the material that
has to be utilized, preconditions, procedure to be used, necessary conditions, expected
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wastage etc.
d. Sample runs – The trial runs with specific circumstances must be conducted and the
sample is being tested of the desirable quantity and quality.
• Labour time standards – The steps for determining the labour quantity standards
are as follows:-
a. Product standardization and its study as conducted in case of material quantity
standards.
b. Labour description – In this type and time of labour has been mentioned. Time
specification of labour has been established from the past records along with
considering the normal time wastage.
c. Process standardization – Selecting the appropriate machine to be used for correct
sequence and modalities of operations.
d. Manufacturing framework – A design of operation of every product enlisted and
required in operations has to be made.
e. Motion & time study – This study helps to select best path required in the completion
of a motion or job that worker will execute along with considering the standard
time required to take by an average worker for every job.
f. Training – Training must be provided to workers for doing their work and time used
up during dry run.
• Quantity standards/overheads time – Indirect costs are known as overheads. Variable
overhead quantity/time is ascertained on the basis of specification as required by the specific
departments. These variable overheads are based on labour hour or direct material quantity.
• Fixed overhead time has been based on the budgeted volume of production.
Challenges associated with the setting up of physical standards:-

The issues faced when fixing physical standards might differ from one industry to another
and are as follows: -

• In case of introduction of a new product line, a company has to employ workers with
minimal or no experience of the job at times. In such situations setting of the standard
time involves a problem as requisite adjustments have to be made on timely basis for the
workers with less/no experience.
• Where changes in the technology have to be made new machinery are being installed.
Under such scenario exact valuation of the output as well as efficiency in standards might
be an issue and requires a considerable time and work.
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• On account of diversification of the product line, the issue also arises because of
redefining the production facilities.
• Unavailability of the materials also poses problems in the establishment of the standards.

Difference between Standard Cost and Estimated Cost

Standard Costs and estimated costs are the predetermined costs which vary in their objectives.
The differences between the two are:
Standard Cost Estimated Cost
It aims at what the cost should be. It gives an estimate of what the cost would be.
These costs are developed scientifically.
These costs are based on past averages and
future anticipations.
Standard costs are used only with the These costs are used in any organisation
standard costing system. working with a historical costing system.
The objective is to control costs. The objective is to provide a basis for price
fixation.
These costs are usually entered in the These costs do not enter the accounting system.
accounting system and used in variance
computation and analysis.

Difference between Standard Costing and Budgetary Control

Both Standard costing and budgetary control are cost-control techniques involving the
comparison of predetermined costs with the actuals and further followed with corrective action.
However, the two techniques differ from each other in many aspects:

Standard Costing Budgetary Control

Standard costing is based on scientific It is based on past performance and future
calculations. anticipations.

The standard costing system is mainly used Budgetary control is used in various
by the manufacturing division. departments like production, sales, finance
etc.
It is used to measure efficiency. It is used for forecasting.

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Its main objective is the ascertainment of It’s mainly concerned with the profitability
costs and cost control. of the business.

Standard costing is a projection of cost It’s a projection of financial accounts.

accounts.

It is intensive in the application and requires It is extensive in the application and does not
a detailed analysis of variances. call for rigorous analysis of deviations.

Rate or Price Standards – Generally, such standards are set on following ways: -

• Normal prices anticipated to persist during cyclical seasons for several years.
• Average actual price anticipated to prevail within upcoming time.

Material Price Standards – The prices of the material used in manufacturing are not in the
manufacturer’s control entirely. At the same time an approximation can be made by the
purchase department after knowing the requirement of production quantities from their
understanding of the present market trends. It will further help in stating the sufficiently the
price accuracy of the constituent elements. The following factors must be considered generally
for setting standards for material prices provided fluctuations in prices are minimal and not
significant: -
a. In hand materials stock along with the prices upon which they were held.
b. Expected price fluctuations.
c. Minimal support price determined by the competent authority.
d. The prices of future material deliveries for which orders have been place already.

Wage Rate Standards – The labour type required for doing a particular work is an essential
element in fixing the wage rate for workers. The wage rate standards for unskilled and
skilled workers are determined as per following grounds: -
a. Piece rate or time prevalent in the industry and it can be learned from the fellows.

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b. The wage agreement in between the workers union and management.

c. Time which has been taken by workers for completing a single production unit.
d. Laws prevalent in the operation area such as Payment of Bonus Act, payment of
minimum wages act, etc.

Overhead Expense Standard – For ascertaining the standards for overhead expenses,
deliberation must be made on the output level and budgeted expenses. The budget representing
the output level which is examined for reaching the standards for overhead expenses might be
on the basis of average capacity of sales or budgeted capacity to be employed in the following
year. Post choosing one bases for the computation of the level of output, then expenses perhaps
budgeted with respect to variable and fixed categories. Hence the standards for overhead
expenses are fixed by ascertaining the optimal output level for production unit and then
preparing a budget considering variable and expenses that has been incurred this level. A
flexible budget can be prepared for seasonal production or during fluctuations in a year which
facilitates comparison in between actual expenditure and target for the period.
6.4.4 Kinds of Standards
The significance and exactness for stating the standard cost rests on the credibility for the
standards that are being established. For setting standards, it is important to identify the level
of certainty with the proximate standards with that of actual outcome. Therefore, the following
standards are enumerated as follows: -
a) Ideal Standard – It denotes the performance level which can be attained when labour
and material prices are utmost favourable and when the maximum output is realized
from the best layout as well as tool and where highest efficiency by utilizing the
resources leads to maximization of output with minimal cost. However, these standards
are subject to following criticisms: -
• As standards are not attainable so they are not taken seriously by anyone.
• The variances reported are the one from that of ideal standards. Hence do not
reflect the extent to avoid them in a reasonable manner.
• Absence of rational way to dispose these variances.
b) Normal Standard – Such standards are achievable under the normal operating
circumstances. The normal work is being defined as number of the standard hours that
will produce at the normal level of efficiency which will be adequate in meeting the

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average demand of sales over the period of years. Though they are difficult to determine
since they need a forecasting level. In case of actual performance is abnormal, then it
could result into larger variances, and it requires standards revision.
c) Basic Standard - They are used when standards are probably to remain fixed or
constant over longer time. In this a base year is selected for comparing. These standards
are suitable for small products range and are set for a longer term with less revisions.
In these variances are not estimated and actual cost has been stated in percentage of the
basic cost and current cost is also expressed similarly, thereafter a comparison is made
in these two percentages to ascertain how far the current standards deviated from actual
cost. And the percentages are then compared with that of former periods for establishing
trend of current and actual standard from the basic cost.
d) Current Standard – Such standards represent the anticipation of the management on
actual costs for the current period and these costs are the one which business will make
in case expected prices have been paid for goods as well as services and usage appear
to be believed necessary for the production of planned level of output.
6.4.5 Process of Standard Costing
Following is the procedure for standard costing:
Standards setting
Ascertaining actual cost
Compairing standard cost and actual cost
Variances analysis
Variances disposal

6.4.6 Types of Variances

The difference in the actual and standard cost or the deviation from the standard performance
is known as Variance. The primary purpose of variance computing and analysing variance is
to enable the management to find out reasons for deviation from the budgeted profit. In other
words, variance analysis helps the management to know the responsibility centres which can
be held accountable for various variances.

According to CIMA London, “Variance Analysis is the process of computing the amount
of variance and isolating the causes of variance between actual and standard.”

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Management Accounting

For achieving the objective of the standard costing, a report on variance analysis is prepared to
show the actual cost, standard cost, and the variances (along with the causes) and submitted to
the management for further action. The report is prepared to indicate the direction (favourable
or unfavourable), nature (controllable or uncontrollable) and the quantum of variance. The
variances may be cost variances or sales variances.

In the case of cost variances, when the actual cost is less than the standard cost, the variance is
favourable and vice versa. Both favourable and unfavourable variances need analysis.
Favourable variance not always implies efficiency. It may be due to certain favourable external
factors or the standards are loosely set. In the same way, an unfavourable variance does not
always mean inefficiency. Controllable variances are those variances which can be or are
within the influence of a particular responsibility centre or a particular individual.
Uncontrollable variances are to be disposed of by apportioning to the unit of the finished good
and work in progress.
The aim of standard costing involves investigation of the causes behind important variances
with a view to find the issues and taking remedial actions. The following are the types of
variances:-
a) Controllable and Uncontrollable Variances – The variances which are controllable
by the department are known as controllable variances while those variances beyond
the control of the department are termed as uncontrollable. Controllability has been
considered as a subjective thing and differs as per the situations. In case the
uncontrollable variances have been of a significant kind and are continuous, then it calls
for revision in the standards.
b) Favourable and Adverse Variances – The variances which provide profits to the
company are considered as favourable variances and those variances that drives
losses have been categorized as adverse variances. In the computation of cost
variances, the favourable variances are standard cost minus actual cost. While
adverse variances are where actual cost is in excess of the standard cost. The
situation is inverse in case of sales variance. Favourable variance occurs when actual
exceeds the budgeted and adverse variances are when actual lowers the budgeted.
They have been credited and debited in costing profit & loss account respectively.

‘F’ denotes the favourable variance and ‘A’ represents the adverse variance.

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In text Questions
Q1) State in case the statements mentioned below are True or False:-
a) The standard hour can be considered as a hypothetic hour representing the
quantum of the work to be performed in an hour given subject to specific
situations.
b) Standard cost can be utilised as a benchmark for measuring the effectiveness
on the basis of which actual costs are being incurred.
c) Generally, standards are fix for long time and being revised on annual basis.
d) For controlling the costs either budgetary controls or standard costing can be
employed and not both of the methods.
e) Standard costs project the cost accounts however budgeting projects the
financial accounts.
Q2) Select one of the options and mark () the correct answers
a) Standard costing includes the determination of
 Actual Costs
 Standard Costs
 Budgeted Costs
 Estimated Costs
b) The difference in between the standard costs and actual costs has been
considered as
 Variances
 Loss
 Profit
 Historical Costs
c) The aim of standard costing
 Measuring efficiency
 Controlling prices
 Reducing costs
 Examining the variances
Q3) Mark the following statements as correct or wrong:-
a) Standard costing is suitable for those companies where products are repetitive
and standardised.
b) It is important for a standard costing system to be accurate and trustworthy in
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c) ©Budgeting
Departmentinvolves preparation
of Distance of theEducation,
& Continuing plans for Campus
the future
of events of a company.
Open Learning,
d) Expected standards are the figures of the past average
School of Open Learning, University of Delhi performances after
considering the cyclical/seasonal changes.
Management Accounting

6.5 CLASSIFICATION OF VARIANCES

Variances can be broadly classified into – Revenue Variance and Cost Variance. Revenue
Variance can be calculated by comparing the actual sales with budgeted (standard) sales. The
Cost side variances, on the other hand, gets reflected in the cost components.
Computation of Variances: As mentioned earlier variances can be classified into two parts.
Hence, we will begin the discussion with all the components of cost side and then move to
labour side variance.
(a) Material Cost Variance: It is the difference between the standard cost and actual cost.
Mathematically, it can be written as below:
MCV = (SQ × SP) – (AQ × AP)
Where
MCV = Material Cost Variance
SQ = Standard Quantity
SP = Standard Price
AQ = Actual Quantity
AP = Actual Price
Reasons: The Material cost variance results from – (a) difference in the material as
well standard price, (b) variation between material and standard consumption else may
be due to both causes. Material cost variance evaluation could be obtained by – Material
Price variance and Material Usage variance.

(i) Material Price Variance: estimates the variance that arises in the material cost
due to the difference in actual material purchase price and standard material
price. Mathematically, it can be written as below:
Material Price Variance = Actual Quantity* × (Standard Price – Actual
Price)
Or
MPV = AQ × (SP – AP)

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*In this the actual quantity denotes actual quantity of the material that has been
purchased. In case the question does not mention the material purchase then it
is equavalent to the material consumed.

Material Price Variance is also calculated by taking the material utilised as the
actual quantity rather than material that has been purchased. This technique is
correct as well however, it does not serve the purpose of computation of
variance. Material Price Variance can arise due to many reasons – some of them
can be controlled and some cannot be controlled by the purchase department. If
the price variance arises from the inefficiency of the purchase department or
due to any other reason which is well within control of the organisation, in that
case it is essential to inform about this variance at the earliest and it is done by
taking the purchase quantity as actual quantity for the computation of price
variance.

Responsibility: Generally, the purchase department purchases the material from

market. Purchase department must perform its functions prudently so that the
company does not incur any losses because of the inefficiency. Purchase
department is made accountable if any adverse price variance results from the
factors that could have been controlled by the department.

(ii) Material Usage Variance: measures the variance that arises in the material cost
due to consumption/usage of the materials. Mathematically, it can be written as:
Material Usage Variance (MUV) = Standard Price(Standard Quantity – Actual
Quantity*)

*where Actual Quantity is actual quantity of the material that has been used.

Responsibility: The purchase department has the onus of the Material Usage,
and it is held accountable for the adverse usage variance.
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Reasons of the Material Usage Variance: Actual Market consumption can differ
with the standard quantity because of either the variation in usage of the
proportion from that of standard proportion or because of the difference in the
actual yield from standard yield. Material usage variance has been divided into
2 categories- (a) Material Usage Mix variance, (b.) Material Yield variance.

(a) Material Mix Variance: Variations in the material consumption arise

because of difference in the proportion that has been used in real terms from
standard proportion/mix. It is due to the reason(s) in case two or more inputs
are being used in the manufacturing of the product. Therefore,

Material Mix Variance (MMV) = (Revised Standard Quantity–Actual

Quantity)×Standard Price

where,
Revised Standard Quantity (RSQ) =
Standard Quantity of one material × Total of actual quantities of all materials
Total of standard quantities of all materials

(b) Material Yield Variance or Material Sub-usage Variance: Variances

in the material consumption that occurs because of the yield or productivity of
the inputs. It can arise due to using the below average quality of the materials,
workers inefficiency or because of the inaccurate processing.

Material Revised Usage Variance (MRUV)

= (Standard Quantity – Revised Standard quantity) × Standard Price
Or
Material Yield Variance (MYV)
= (Actual Yield – Standard Yield)×Standard output price

Note: MRUV can be referred as Material Sub – Usage Variance.

Where there is only 1 variance i.e., either Material Yield or Material Revised Usage
Variance.

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Verification of the formulae:

Material Cost Variance = Material Usage Variance + Material Price Variance*
Or Material Cost Variance = (Material Mix Variance + Material Revised Usage
Variance) + Material Price Variance
*In case where material consumed quantity as well as material purchase quantity
are one and same

Meaning of the terms used in the formulae:

TERMS MEANING
Standard Quantity (SQ) Quantity of the input that has to be used for
producing actual output.
Actual Quantity (AQ) Quantity of input used in real terms for
producing the actual output.
Revised Standard Quantity (RSQ) In case actual total quantity of the input are
being used in the standard proportion.
Actual Yield (AY) It denotes the Actual Output
Standard Yield (SY) It signifies the Actual output when input is
being used in the standard ratio
Standard Output Price (SOP) It refers to Standard material cost for the
actual output

Illustration 1 Calculate material cost variance from the given actual and standard amount for
the product “ABC” are as follows: -

Particulars Standard Actual

Quantity of material 60 units 50 units

Price per unit of material 3.00 2.00

Answer:
(a) Material cost variance (MCV)= SC – AC = 180 – 100 = ₹80 (F)
(b) Price variance (PV) = AQ (SP – AP) = 50 (3 – 2) = ₹50 (F)
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(c) Usage variance (UV) = SP (SQ – AQ) = 3(60 - 50) = ₹20 (F)

Illustration 2 Calculate the material mix variance and yield variance from the following
information:
The information for producing 1 unit of the product is:
Material Units Rate per unit

X 55 13

Y 70 19

Z 90 24

But in the month of May, 10 units had been produced as well as consumed and the information
was as follows:
Material Units Rate per unit

X 600 15.50

Y 875 17.50

Z 730 21

Answer:

Material Standard for 10 units Actual for 10 units

Unit(s) Rate Amount Unit(s Rate Amount
X 550 13 7130 600 15.50 9300
Y 700 19 13300 875 17.50 15312.50
Z 900 24 21600 730 21 15330
Total 2150 42030 2205 39942.5

(a) Material cost variance (MCV) = Standard cost (SC) – Actual cost (AC) = 42030 –
39942.5 = ₹2087.5 (F)

(b) Material Price variance (MPV) = Actual quantity (standard price – actual price)
X = MPV= 600 (13 - 15.50) = ₹1500 (A)
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Y = MPV = 875 (19 – 17.50) = ₹1312.5 (F)

Z = MPV = 730 (24 – 21) = ₹2190 (F)

(c) Material Usage variance (MUV) = Standard price (standard quantity – actual quantity)
X = MUV = 13 (550 - 600) = ₹650 (A)
Y = MUV = 19 (700 - 875) = ₹3325 (A)
Z = MUV = 24 (900 – 730) = ₹4080 (F)

(d) Material Mix variance (MMV) = Standard price (Revised standard quantity – Actual
quantity)
X = MMV = 13 (566.5 - 600) = ₹435.5(A)
Y = MMV = 19 (721 - 875) = ₹2926(A)
Z = MMV = 24 (927 - 730) = ₹4728(F)

Revised standard quantity has been calculated for all the three material:
X = (2205/2150)550 = 566.5
Y = (2205/2150)700 = 721
Z = (2205/2150)900 = 927

(e) Material yield variance

In order to calculate material yield variance, certain calculations are required –
Standard yield variance = Actual usage of the material/Standard usage per unit of output
= 2205/215 = 10.26 units
Standard material cost per unit (SOP) = 42030/10 = ₹4203
Material yield variance = (Actual yield – Standard yield) Standard material cost per
unit
= (10 – 10.26) 4203 = ₹1092.78(A)
[Note – Actual yield is the actual output]

Material revised usage (sub-usage) variance (MRUV) = (Standard quantity – Revised

standard quantity)Standard
price

Any of the one can be calculated i.e., Material mix variance or Material revised sub-usage
(usage) variance, as both are always equal.

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Management Accounting

Illustration 3: X chemical ltd. manufactures chemical X using three kinds of raw material A,
B and C. The company uses standard costing system and furnishes following information about
manufacturing of chemical X. Compute all material cost variances.

Standard price of raw material A ₹ 100 per kg

Standard price of raw material B ₹ 50 per kg
Standard price of raw material C ₹ 60 per kg
Actual price of raw material A ₹ 90 per kg
Actual price of raw material B ₹ 60 per kg
Actual price of raw material C ₹ 70 per kg
Standard quantity of raw material A to produce 1 tonne 300 kg
of chemical X
Standard quantity of raw material B to produce 1 tonne 400 kg
of chemical X
Standard quantity of raw material C to produce 1 tonne 500 kg
of chemical X
Actual quantity of raw material A used to produce 3,50,000 kg
chemical X
Actual quantity of raw material B used to produce 4,20,000 kg
chemical X
Actual quantity of raw material C used to produce 5,30,000 kg
chemical X
Actual output of chemical X 1000 tonnes

Solution:

Given,
SP of A = ₹100, B = ₹50, C= ₹60
AP of A=₹ 90, B = ₹60, C = ₹70

SQ = Standard quantity of material required for actual output

A= 300 × 1,000 = 3,00,000 kg
B= 400 × 1,000 = 4,00,000 kg

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C= 500 × 1,000 = 5,00,000 kg

AQ = Actual quantity of material used for actual output

A= 3,50,000 kg
B= 4,20,000 kg
C= 5,30,000 kg

RSQ = Revised standard quantity based on actual quantity of material used in standard ratio
3
A= × 13,00,000 =3,25,000 kg
12
4
B= × 13,00,000 =4,33,333 kg
12
5
C= × 13,00,000 = 5,41,667 kg
12

1
Standard Yield for actual input = 1300000 × =1083.33 tonnes
1200
Standard cost per unit of output = (300× 100) + (400 × 50) + (500 × 60) = ₹80000

Material Cost Variance 𝑀𝑀𝑀𝑀𝑀𝑀 = (𝑆𝑆𝑆𝑆 × 𝑆𝑆𝑆𝑆) − (𝐴𝐴𝐴𝐴 × 𝐴𝐴𝐴𝐴)

Material A 𝑀𝑀𝑀𝑀𝑀𝑀 = (300000 × 100) − (350000 × 90) = 1500000 (A)
Material B 𝑀𝑀𝑀𝑀𝑀𝑀 = (400000 × 50) − (420000 × 60) = 5200000 (A)
Material C 𝑀𝑀𝑀𝑀𝑀𝑀 = (500000 × 60) − (530000 × 70) = 1500000 (A)
MCV=13800000 (A)

Material Price Variance 𝑀𝑀𝑀𝑀𝑀𝑀 = 𝐴𝐴𝐴𝐴 × (𝑆𝑆𝑆𝑆 − 𝐴𝐴𝐴𝐴)

Material A 𝑀𝑀𝑀𝑀𝑀𝑀 = 350000 × (100 − 90) = 3500000 (F)
Material B 𝑀𝑀𝑀𝑀𝑀𝑀 = 420000 × (50 − 60) = 4200000 (A)
Material C 𝑀𝑀𝑀𝑀𝑀𝑀 = 530000 × (60 − 70) = 5300000 (A)
MPV= 6000000 (A)

Material Usage Variance 𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑆𝑆𝑆𝑆 × (𝑆𝑆𝑆𝑆 − 𝐴𝐴𝐴𝐴)

Material A 𝑀𝑀𝑀𝑀𝑀𝑀 = 100 × (300000 − 350000) = 5000000 (A)
Material B 𝑀𝑀𝑀𝑀𝑀𝑀 = 50 × (400000 − 420000) = 1000000 (A)
Material C 𝑀𝑀𝑀𝑀𝑀𝑀 = 60 × (500000 − 530000) = 1800000 (A)
MUV= 7800000 (A)
Material Mix Variance 𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑆𝑆𝑆𝑆 𝑋𝑋(𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐴𝐴𝐴𝐴)
Material A 𝑀𝑀𝑀𝑀𝑀𝑀 = 100 × (325000 − 350000) = 2500000 (A)
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Material B 𝑀𝑀𝑀𝑀𝑀𝑀 = 50 × (433333 − 420000) = 666650 (F)

Material C 𝑀𝑀𝑀𝑀𝑀𝑀 = 60 × (541667 − 530000) = 700020 (F)
MMV=11,33,330 (A)
Material Sub Usage Variance 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑆𝑆𝑆𝑆 𝑋𝑋(𝑆𝑆𝑆𝑆 − 𝑅𝑅𝑅𝑅𝑅𝑅)
Material A 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 100 × (300000 − 325000) = 2500000 (A)
Material B 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 50 × (400000 − 433333) = 1666650 (A)
Material C 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 60 × (500000 − 541667) = 2500020 (A)
MSuV=66,66,670 (A)
Material Yield Variance
𝑀𝑀𝑀𝑀𝑀𝑀 = ( 𝐴𝐴𝐴𝐴 − 𝑆𝑆𝑆𝑆) × 𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
(1000-1083.34) × 80000 = 6666670 (A)

Material Yield Variance = Material Sub Usage Variance

(b) Labour Cost Variance: It is the variation between actual labour cost as well as
standard cost . Hence,
Labour Cost Variance (LCV)
= (Std. hours for actual output × Std. rate per hour) – (Actual hours × Actual rate per
hour)

Reason: Because of the differences in labour cost that results either due to the
differences in actual labour rate from standard rate or difference in the numbers of
hours worked from standard hour. Labour Cost Variance has been divided into the
two categories - (i) Labour Rate Variance (LRV) and (ii) Labour Efficiency
Variance(LEV).

(i) Labour Rate Variance: It occurs because of differences in actual rate which
is being paid and standard rate. It is very similar to the material price variance.
It is being calculated as follows:-
Labour Rate Variance (LRV) = Actual time*(Std. rate – Actual rate)
*In this the Actual Time refers to the time where wage is being paid.

Responsibility: Normally labour rate is being impacted due to external factors

which are not in the control. But personnel manager can be held responsible
for negotiating the labour rate.

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(ii) Labour Efficiency Variance (LEV): It occurs because of digression in the

hours of working from standard(s) set.

Labour efficiency Variance = Standard rate (Standard hour for actual output
– Actual hour*)
*Actual time which is being worked

Responsibility: The variance in efficiency arises because of unsuitable team

the of workers, production manager’s or foreman’s inefficiency etc.
However, production manager may hold accountable in case of any of the
adverse variances which can be controlled.

LEV can be further divided into the following variances:

(a) Idle Time Variance (IDV)
(b) Labour Mix Variance (LMV) or Gang variance (GV)
(c) Labour Yield Variance (LYV) or Labour Revised-efficiency
Variance(LREV)

(a) Idle Time Variance: It is being estimated for the labour hours which were
considered as unproductive. In this the idle time refers to the idle time of
labour which occurs because of the abnormal causes. It can be calculated as:

Idle Time Variance (ITV) = Idle hours × Standard Rate

(b) Labour Mix Variance: It occurs because of either change in the

proportion or the combination of different skill set, i.e., skilled worker, semi-
skilled worker as well as unskilled worker.

Labour Mix Variance (LMV)= (Revised standard hour – Actual

hour)×Standard rate

(c) Labour Revised Efficiency Variance (LREV) or Labour Yield

Variance (LYV): It occurs because of the productivity of the workers.

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Labour Revised Efficiency Variance (LREV) = (Standard hour for the

actual output - Revised standard
hour) × Standard rate
Or

Labour Yield Variance (LYV) = (Actual yield – Standard yield from the
actual input) × Standard labour cost per unit of
output
Verification:
Labour Cost Variance (LCV) = Labour Rate Variance (LRV) + Labour
Efficiency Variance (if hour paid as well as hour
worked are same)

Or

Labour Cost Variance (LCV) = Labour Rate Variance (LRV) + Idle Time
Variance (ITV) + Labour Efficiency Variance (in
case idle time exists)

Labour Efficiency Variance (LEV) = Labour Mix Variance (LMV) + Labour

Yield Variance (LYV)

Illustration 4: From the following information on an organisation.:-

Standards:- Standard time for work 900 hours
Standard rate on hourly basis for work ₹1
Actuals:- Actual time for work 700 hours
Actual rate to be paid for work ₹300
Calculate –
a) Labour cost variance (LCV)
b) Labour rate variance (LRV)
c) Labour efficiency variance (LEV)

Answer
Std. labour cost (900 hours @ ₹1 per hour) = ₹900
Actual wages to be paid ₹300
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Actual rate on hourly basis (300/700) = ₹0.43

LRV = Actual time (Std. rate – Actual rate) = 700 (1 – 0.43) = ₹399(F)
LEV = Std. rate per hour (Standard time – Actual time) = 1 (900 - 700) = ₹200(F)
LCV= Std. labour cost – Actual labour cost = 900 – 300 = ₹600(F)

Illustration 5: X Ltd.is a cement manufacturing company using standard costing system. It

furnishes following information about manufacturing of cement in tonnes. Compute all labour
cost variances.

Standard rate of labour per hour ₹ 50

Actual rate of labour per hour ₹ 45
Standard hours required to produce one tonne of cement 15
Actual hours 15300 hours
Actual output 1000 tonnes

Solution:

Given,
SR = ₹ 50
AR =₹ 45

ST = Standard hours of labour required for actual output = 15 × 1000 = 15000 hours
AT = Actual hours of labour = 15300hours

Labour Cost Variance

𝐿𝐿𝐿𝐿𝐿𝐿 = (𝑆𝑆𝑆𝑆 × 𝑆𝑆𝑆𝑆) − (𝐴𝐴𝐴𝐴 × 𝐴𝐴𝐴𝐴𝑝𝑝 )
𝐿𝐿𝐿𝐿𝐿𝐿 = (50 × 15000) − (45 × 15300)
𝐿𝐿𝐿𝐿𝐿𝐿 = 750000 − 688500
𝐿𝐿𝐿𝐿𝐿𝐿 = 61500 (𝐹𝐹)

Labour Rate Variance

𝐿𝐿𝐿𝐿𝐿𝐿 = (𝑆𝑆𝑆𝑆 − 𝐴𝐴𝐴𝐴) × 𝐴𝐴𝐴𝐴
𝐿𝐿𝐿𝐿𝐿𝐿 = 15300 × (50 − 45)
LR𝑉𝑉 = 76500 (𝐹𝐹)

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Labour Efficiency Variance

𝐿𝐿𝐿𝐿𝐿𝐿 = (𝑆𝑆𝑆𝑆 − 𝐴𝐴𝐴𝐴) × 𝑆𝑆𝑆𝑆
𝐿𝐿𝐿𝐿𝐿𝐿 = 50 × (15000 − 15300)
𝐿𝐿𝐿𝐿𝐿𝐿 = 50 × −300
𝐿𝐿𝐿𝐿𝐿𝐿 = 15000 (𝐴𝐴)

Verification:
LCV= LRV+ LEV
61500 (F) = 76500 (F) + 15000 (A)

Labour mix variance, labour revised efficiency variance and Idle time variance are not
computed as only one type of labour used and no information about idle time is given.

Illustration 5: X Ltd.is a steel pipe manufacturing company using standard costing system. It
furnishes following information about manufacturing of steel pipes for work scheduled to be
completed in 30 hours in a week. Compute all labour cost variances and verify them.

Particulars Unskilled Semi-skilled Skilled

Standard number of 9 15 26
workers in one group
Actual number of 8 18 24
workers employed
Standard wage rate 100 200 400
per week
Actual wage rate per 120 180 400
week
During the week, the gang produced 1600 standard labour hours.

Solution:

Type of Standard Actual

workers
Hours Rate Amount Hours Rate Amount
Skilled 780 400 312000 720 400 288000
Semi- 450 200 90000 540 180 97200
skilled
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Unskilled 270 100 27000 240 120 28800

1500 429000 1500 414000

429000
Standard cost of actual output = × 1600 = 457600
1500
Labour Cost Variance
𝐿𝐿𝐿𝐿𝐿𝐿 = Standard cost of actual output − 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐿𝐿𝐿𝐿𝐿𝐿 = 457600 − 414000
𝐿𝐿𝐿𝐿𝐿𝐿 = 43600 (𝐹𝐹)

Labour Rate Variance

𝐿𝐿𝐿𝐿𝐿𝐿 = (𝑆𝑆𝑆𝑆 − 𝐴𝐴𝐴𝐴) × 𝐴𝐴𝐴𝐴
Skilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (400 − 400) × 720 = 0
Semi-skilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (200 − 180) × 540 = 10800 (F)
Unskilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (100 − 120) × 240 = 4800 (A)
LRV = 6000 (F)

Labour Efficiency Variance

𝐿𝐿𝐿𝐿𝐿𝐿 = (𝑆𝑆𝑆𝑆 − 𝐴𝐴𝐴𝐴) × 𝑆𝑆𝑆𝑆
Skilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (832 − 720) × 400 = 44800 (F)
Semi-skilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (480 − 540) × 200 = 12000 (A)
Unskilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (288 − 240) × 100 = 4800 (F)
LEV = 37600 (F)
ST= Standard hours for actual output
1600
Skilled = × 780 = 832
1500
1600
Semi-skilled = × 450 = 480
1500
1600
Unskilled = × 270 = 288
1500

Labour Mix Variance

𝐿𝐿𝐿𝐿𝐿𝐿 = (𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐴𝐴𝐴𝐴 ) × 𝑆𝑆𝑆𝑆
Skilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (780 − 720) × 400 = 24000 (F)
Semi-skilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (450 − 540) × 200 = 18000 (A)
Unskilled 𝐿𝐿𝐿𝐿𝐿𝐿 = (270 − 240) × 100 = 3000 (F)
LEV = 9000 (F)

Labour Yield Variance

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𝐿𝐿𝐿𝐿𝐿𝐿 = ( 𝐴𝐴𝐴𝐴 − 𝑆𝑆𝑆𝑆) × 𝑆𝑆𝑆𝑆

𝐿𝐿𝐿𝐿𝐿𝐿 = ( 1600 − 1500) × 286 = 28600(F)

429000
SC= Standard rate per hour of work = = 286
1500

Verification:
LCV= LRV+ LEV
43600 (F) = 6000 (F) + 37600 (F)

LEV = LMV+LYV
37600(F) = 9000(F) + 28600 (F)

Overhead Variance – Overhead involves the indirect labour, indirect material and indirect
expenses. The overhead variances have been classified into variable overhead and fixed
overhead.
Variable Overheads Cost Variance (VOCV): Variable Overhead involves the expenses other
than that of direct material as well as direct labour expense which varies with level of the
production. VOCV has been divided into two parts – (i) Variable Overhead Expenditure
Variance (VOEV) and (ii) Variable Overhead Efficiency Variance (VOEV).
Variable Overhead Cost Variance (VOCV) = Std. Cost – Actual Cost
OR
(Std. Rate × Std. Hour) – (Actual Rate × Actual Hour)
(i) Variable Overhead Expenditure Variance (VOEV)
= Actual Hour(Standard Rate – Actual Rate)
(ii ) Variable Overhead Efficiency Variance (VOEV)
= Standard Rate(Standard Hours – Actual Hour)

Fixed overhead cost variance (FOCV): It occurs because of differences in Absorbed Fixed
Overhead and Actual Fixed Overhead. Fixed Overhead consists of two parts – Fixed Overhead
Expenditure Variance (FOEV) and Fixed Overhead Volume Variance (FOVV).

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Fixed Overhead Cost Variance (FOCV) = Absorbed Fixed Overhead – Actual Fixed
Overhead
or
= (Standard hour for the actual output × Standard fixed overhead rate) – Actual Fixed
Overheads

(i) Fixed Overhead Expenditure Variance (FOEV) = Budgeted Fixed Overhead (BFO) –
Actual Fixed Overheads (AFO)
or
= (Standard hour for actual output × Standard fixed overhead rate) – Actual Fixed Overhead
(ii) Fixed Overhead Volume Variance (FOVV) = Absorbed Overheads – Budgeted
Overheads
= Std. Rate (Std. hour for the actual output – Budgeted hour)

Fixed Overhead Volume Variance (FOVV) are divided under three variances:
(a) Efficiency Variance (b) Capacity Variance (c) Calendar Variance
(a) Fixed Overhead Efficiency Variance (FOEV) = (Absorbed fixed overheads – Standard
fixed overheads)
= (Standard hour for the actual output – Actual hour) × Standard fixed overhead rate
(b) Fixed Overhead Capacity Variance (FOCV) = (Std. fixed overheads – Budgeted
Overheads)
= (Actual Hour – Budgeted Hour) × Standard Fixed Overhead Rate
(c) ) Fixed Overhead Calendar Variance (FOCV) = (Actual number of working days –
Standard number of working days) × Standard
fixed rate per day
or = (Revised Budgeted Hour – Budgeted hour) × Standard fixed rate per hour
Where,
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Revised Budgeted Hours = (Actual days × [Budgeted Hours/Budgeted Days])

Illustration 6: The information has been extracted from the GHJ company. Estimate the
overhead variances using the information provided below:-

Particulars Budget Actual

Output given in units 20000 22000
Hours 20000 23000
Fixed overhead 55000 60000
Variable overhead 70000 78000
Number of working days 24 25

Answer:
Standard hours per unit = Budgeted hours/Budgeted Units = 20000/20000 = 1 hr.
Standard hours (SH) for the actual output = 22000 × 1 = 22000

Standard overhead (SO) rate per hour = Budgeted overhead/Budgeted hour

In case of the fixed overheads = 55000/20000 = ₹2.75
In case of the variable overheads = 70000/20000 = ₹3.50

Standard fixed overheads rate per day = 55000/25 = ₹2200

Recovered overheads = Standard hour for the actual output × Standard rate
In case of the fixed overheads = 22000 × 2.75 = ₹60500
In case of the variable overheads = 22000 × 3.50 = ₹77000

Standard overhead (SO) = Actual hour × Std. rate

In case of the fixed overheads = 23000 × 2.75 = ₹63250
In case of the variable overheads = 23000 × 3.50 = ₹80500

Revised budgeted hour = (Budgeted hour/Budgeted day) × Actual day

= (20000/24) × 25 = 2083.3 hours
Revised budgeted overheads for fixed overheads = 2083.3 × 2.75 = ₹5729.08
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Calculation of fixed overhead variance:-

(i) Fixed overhead cost variances = Recovered overhead (RO) – Actual overhead (AO) =
60500 - 60000
= ₹500 (F)
(ii) Fixed overhead expenditure variances = Budgeted overheads – Actual overheads
= 55000 – 60000 = ₹5000 (A)
(iii) Fixed overhead volume variances = Recovered overheads – Budgeted overheads
= 60500 – 55000 = ₹5500 (F)
(iv) Fixed overhead efficiency variances = Recovered overheads – Standard overheads
= 60500 – 63250 = ₹2750 (A)
(v) Fixed overhead capacity variances = Standard overheads – Revised budgeted overheads
= 63250 - 5729.08 = ₹57520.92 (F)
(vi) Calendar variance = (Actual days – Budgeted days) × Std. rate per day
= (25-24) × 2200 = ₹2200 (F)

Calculation of the variable overhead variance:-

(i) Variable overhead cost variances = Recovered overheads – Actual overheads
= 77000 – 78000 = ₹1000 (A)
(ii) Variable overhead expenditure variances = Standard overheads – Actual overheads
= 70000 – 78000 = ₹8000 (A)
(iii) Variable overhead efficiency variances = Recovered overheads – Standard
overheads
= 77000 – 80500 = ₹3500 (A)
Sales variances - Those variances that occur because of change in the actual sales price and
the actual quantity of sold units from what it was budgeted have been termed as sales
variance(s).
Sales value variance = Actual sale(s) – Budgeted sale(s)
= (Actual price × Actual quantity) – (Budgeted price × Budgeted quantity)
In case variances have been given on the basis of margin then
Sales margin variance = Actual margin – Budgeted margin
Actual margin = Actual sale price per unit – Std. cost per unit
Budgeted margin = Budgeted sales price per unit – Std. cost per unit

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Management Accounting

The sales value variance has been divided into sales price variances and sales volume variances
(i) Sales price variance = Actual quantity (Actual price – Budgeted price)
In case variance have given on margin basis
Sales price variance = Actual quantity (Actual margin – Budgeted margin)
(ii) Sales volume variance = Budgeted price (Actual quantity – Budgeted quantity)
In case variances have given on margin basis
Sales margin volume variance = Budgeted margin (Actual quantity – Budgeted
:quantity)

Illustration 7: Ascertain the sales variances from the following information:-

Service Budgeted Quantity Budgeted price Actual quantity Actual price

(BQ) (BP) (AQ) (AP)

A 3000 2 2600 2.50

B 2500 5.50 2000 4

C 1000 8 900 7.50

Answer:

Service BQ × BP AQ × AP AQ × BP

A 6000 6500 5200

B 13750 8000 11000

C 8000 6750 7200

Total 27750 21250 23400

(i) Sales price variance = AQ (AP – BP) = (AQ × AP) – (AQ × BP) = (21250 – 23400)
= ₹2150 (A)
(ii) Sales volume variance = BP (AQ – BQ) = (BP × AQ) – (BP × BQ) = (23400 – 27750)
= ₹4350 (F)
(iii) Total variance = Actual sales – Budgeted sales = 21250 – 27750 = ₹6500(F)

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6.6 SUMMARY

Standard costing refers to the pre specified costs used as benchmark for measuring efficiency
where actual costs must be incurred under the given situations. Further, analysis of variances
involves measuring the deviations of the actual performance from that of desired performance,
and then gauging the reasons of those deviations with a view to take remedial actions on timely
basis. Variance are bifurcated on the basis of cost variances and sales variances. Moreover, as
labour is also involved into the business operations, which call for measuring labour variances
which is another form of variances. Overhead variances have been categorised in two parts –
fixed and variable. Variable overhead varies directly with the production on the other hand
fixed overheads are dependent on the activity level or volume and any changes in the activity
level leads to changes in overhead rates as well.

6.7 GLOSSARY

• Standard cost : Pre specified cost of any product or service.

• Standard costing : A method of cost accounting that compares each product pr service
standard cost with that of the actual cost for determining the effectiveness of a company.
• Standard hour : The output quantity that must be produced in an hour.
• Ideal standard : It is a standard that has been fixed under ideal circumstances.
• Fixed overhead variance : It is variation between the standard fixed overhead and the
actual fixed overhead.
• Variable overhead variance : The variation in between the actual overhead and
standard variance overhead.
• Sales value variance : It is the difference between actual overhead variances sales and
budgeted sales.
• Variances : The difference between the actual costs and the pre-determined costs.

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6.8 ANSWERS TO IN-TEXT QUESTIONS

Ans 1) – a) True, b) True, c) False, d) False, e) True

Ans 2) – a) Standard Costs, b) Variances, c) Measuring efficiency
Ans 3) - a) True, b) True, c) True, d) False

6.9 SELF-ASSESSMENT QUESTIONS

1. Explain your understanding on standard costing.

2. Mention the purpose of standard costing.
3. You are working in a company as team leader for setting up standard costing system.
In lieu of this state how would you assure success of this system?
4. Describe how the standards are fixed?
5. Explain briefly the following terms:-
a) Normal Standard
b) Ideal Standard
c) Basic Standard
d) Standard Hour
6. From the following information of the Reliance group evaluate the material usage,
price and total cost of variance (considering quantity of 1,000 kg).
The 10kg of sanitizer, the requirement of standard raw materials X and Y are:
Material Quantity Per kg rate

X 10 9

Y 7 5

However, because it is being anticipated by the company that demands for sanitizer
might increases leading to production of 1,000kg of sanitizer. This makes the actual
consumption as:
Material Quantity Per kg rate

X 500 10

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Y 350 8

7. From the following provided by the TCZ company, you are required to calculate the
following labour variances: -
a) Labour cost variances
b) Labour rate variances
c) Labour efficiency variances
d) Labour mix variances

Type of workers Standard wages Actual wages

Skilled worker 85 workers @ ₹1.50 per hours 78 workers @ ₹2 per hours
Unskilled worker 73 workers @ ₹4 per hours 75 workers @ ₹1 per hours
Budgeted hours 1100 Actual hours 950

8. The information provided has been obtained from the AXC company records. Since
you are working as a Cost accountant in this company, so you wanted to know the
position of the overhead variances. Hence in this respect estimate the following: -
a) Fixed overhead variances
b) Variable overhead variances
Particulars Standard Actual
Production 2000 units 1500 units
Number of working days 10 12
Fixed overhead 30000 27000
Variable overhead 10000 9000

9. Compute the sales value variances, sales price variance and sales volume variance as
per the details provided from the records of GYT company: -
Product Budgeted Quantity Budgeted price Actual Actual price
(BQ) (BP) quantity (AQ) (AP)

X 2200 5 3000 4

Y 3400 2.50 1400 6.25

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Management Accounting

Z 1100 4 3700 5

T 3200 7.45 4750 3.75

6.10 REFERENCES & SUGGESTED READINGS

• Maheshwari, S. N., & Mittal, S. N. Cost Accounting: Theory and Problems. Shree
Mahavir Book Department.
• Arora, M.N. Cost Accounting-principles and practice. Vikas Publishing House.
• Maheshwari, S. N., Maheshwari, S. K., Mittal, S.N. Cost Accounting: Principles &
Practice. Shree Mahavir Book Depot.
• Nigam, B. M .Lal & Jain, I. C. Cost Accounting: Principles and Practice. PHI
Learning.
• Mitra. Cost and Management accounting. Oxford University Press.
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LESSON 7
BUDGETS AND BUDGETARY CONTROL

Dr. Rishi Taparia

Director – Management Studies
Institute of Advanced Management &
Research
[email protected]

STRUCTURE

7.1 Learning Objectives

7.2 Introduction
7.3 Meaning of Budget and Steps in Budgetary Control
7.3.1 Meaning of Budget, Budgeting and Budgetary Control
7.3.2 Objectives and Functions of Budgeting
7.3.3 Advantages of Budgeting
7.3.4 Disadvantages of Budgeting
7.3.5 Steps in Budgetary Control
7.4 Types of Budgets
7.4.1 Sales Budget
7.4.2 Production Budget
7.4.3 Raw Material Consumption Budget
7.4.4 Raw Material Purchase Budget
7.4.5 Overheads Budget
7.4.6 Cash Budget
7.4.7 Master Budget
7.4.8 Fixed and Flexible Budget
7.5 Zero-Based Budgeting
7.6 Summary
7.7 Practical Problems
7.8 Glossary
7.9 Answers to In-text Questions
7.10 Self-Assessment Questions

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7.11 References
7.12 Suggested Readings

7.1 LEARNING OBJECTIVES

After studying this chapter, the students will be able to understand:

• Meaning of Budget, Budgeting and Budgetary Control

• Distinction between Budget and Forecast
• Objectives and functions of the Budget
• Advantages and disadvantages in budgeting
• Budgeting Process
• Steps involved in Budgetary control.
• Various types of Budgets.
• Distinction between Fixed and Flexible Budgeting.
• Zero Based Budgeting and its comparison with Traditional Budgeting

7.2 INTRODUCTION

Every company makes plans. Some plans are more formal than others and some companies
plan more formally than others but all make same attempt to consider the risk and opportunities
that lie ahead and how to face them. In most businesses this process is formalised in short-term
with considerable effort put into preparing annual budgets and monitoring performance against
those budgets. Budgeting is a management tool used for short-term planning and control.
For effective running of a business, management must know:

• Where it intends to go i.e. organizational objectives

• How it intends to accomplish its objectives i.e. plans
• Whether individual plans fit in the overall organizational objective i.e. coordination and
• Whether operations conform to the plan of operations relating to that period i.e. control.
Budgetary Control is the device that a company uses for all these purposes.

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7.3 MEANING OF BUDGET AND STEPS IN BUDGETARY

7.3.1 Meaning of Budget, Budgeting and Budgetary Control:

Budget: CIMA has defined a Budget as “a financial and/or quantitative statement,
prepared and approved prior to a defined time, of the policy to be pursued during that
period for the purpose of attaining a given objective”

A budget is necessary to plan for the future, to motivate the staff associated, to
coordinate the activities of different departments and to control the performance of
various persons operating at different levels.

ACTIVITY
Suppose you are planning to travel with your friends, You are required to prepare
a Budget including all the expected expenditures keeping in mind the following:
1. Budget has to be in monetary terms.
2. It should only consider quantitative aspect.
3. It has to be for defined period of time

Budgeting
Budgeting is the whole process of designing, implementing and operating budgets. The main
emphasis in this is short-term budgeting process involving the provision of resources to support
plans which are being implemented.
Budgetary Control
CIMA has defined Budgetary Control as “the establishment of budgets relating the
responsibilities of executives to the requirements of a policy, and the continuous comparison

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of actual with budgeted results, either to secure by individual action the objective of that policy
or to provide a basis of its revision”.
Difference between Budget and Forecast

S. No. Forecast Budget

1 an estimate of what is likely to Depicts the policy and programme to be
happen. It is a statement of probable followed in a period under planned
events conditions
2 Forecasts, being statements of future A budget is a tool of control since it
events, do not connote any sense of represents actions that can be shaped
control according to will so that it can be suited
to the conditions which may or may not
happening
3 Forecasting is a preliminary step for It begins when forecasting ends.
budgeting. It ends with the forecast Forecasts are converted into budgets
of likely events.
4 Forecasts are wider in scope Budgets have limited scope

7.3.2 Objectives and Functions of Budgeting:

The following are the various objectives and functions of budgeting:
a) Planning: Planning is an important managerial function. Budgeting allows us to
plan ahead of time what to do, how to do it, when to do it, and who will do it.
Planning enables managers to anticipate and plan for contingencies in order to
achieve their goals. Budget preparation motivates managers to plan ahead of time.
Thus, budgeting is an important planning device.
b) Coordination: To coordinate is to harmonise all the activities of a company so as
to facilitate its working and its success. Coordination will lead to following results:
• Each department will work in harmony with others
• Each department will know their specific role to play in the accomplishment
of overall organizational objectives
• Overlapping of activities and wastage of time and labour could be avoided
by the sequential arrangement of activities of different departments
c) Communication: Budgets effectively communicate the information to the
employees within the organization. Budgets keep different sections of the
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organization informed about the contribution of different sub-units in the attainment

of overall organizational objective.
d) Control: Budgets act as a great tool to control various activities within the
organization. Many 'adjustments' are made to make functional budgets align with
organisational goals.
e) Performance Evaluation: Budgets assist businesses in determining variances by
comparing budgeted, estimated, or anticipated activity against actual activity.
Budgets also aid in reviewing employee performance to determine whether or not
they have met the business's objectives.
7.3.3 Requirements of a Good Budgeting System:
Following are the requirements of a good budgeting system.

• Budgeting process should be backed and well supported by the CEO of an organization
• The organizational goal should be quantified and clearly stated
• The organizational goal must be divided in functional goals
• All employees should mentally accept the exercise of budget preparation
• The persons responsible for the execution of budget should participate in budget
preparation
• The budget should be realistic and attainable
• The budgeting should be a continuous process
• Periodic reports should be prepared to compare the actual results with the budgeted one
to find out the deviations
7.3.3 Advantages of Budgeting:
The following advantages of budgeting are:
1. A budget forces management to plan ahead sp that long-term objectives are achieved
2. It establishes a basis of internal audit by regularly evaluating departmental results
3. All members of top management participate in budget committee. For this reason even
planning at departmental level gets benefit of experience of seasoned executives
4. All functional heads are complelled to make plans in harmony with the plans of other
departments
5. Only reporting information which has not gone according gto plan, it economises on
managerial time and maximises efficiency. This is called ‘Management By Exception’
reporting

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Management Accounting

6. Scarce resources should be allocated in an optimal way, thus controlling expenditure

7. Communication increased throughout the company and coordination also improves
8. Areas of efficiency and inefficiency are identified. Remedial measures are taken with
the help of variance analysis
9. People are made responsible for items of cost and revenue
10. It facilitates periodic self-analysis of the organisation
11. It helps in obtaining bank credit
7.3.4 Disadvantages of Budgeting:
Budgeting has numerous benefits, but it also has some drawbacks. The following are some of
the drawbacks of budgeting:
1. Budgeting is based on estimation. As a result, it is subjective in nature, and those
involved in budgeting exercise their discretion. As a result, budgeting based on
inaccurate estimates is pointless.
2. The circumstances are changing constantly and therefore, budgets and budgetary
techniques will not be useful, till they are continually adapted
3. Budgeting could only be successful only when there is coordination and cooperation
among all the departments, management, and employees and thus, the organization will
be able to achieve its goals and objectives.
4. Budgeting is just a tool to control the business activities and can only help in achieving
the objectives of the company only when all managerial functions are performed
efficiently and effectively
5. Preparing a budget is time-consuming and requires great amount of effort
6. Management places a lot of pressure on lower-level employees to achieve goals, which
causes them to offer inaccurate information to upper-level management.
7. When upper level employees see that the expenses that have occurred are far less than
those that were intended, they have an urge to spend more extravagantly, resulting in a
decrease in the company's revenues.
7.3.5 Steps in Budgetary Control:
The following steps are to be followed in budgetary control:
1. Standards are established
2. Actuals are measured
3. Comparison of standards with the actual ois done
4. Finding out deviations
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5. Remedial measures taken

Features of budgetary control:
1. Establishment of budgets for each purpose of the business.
2. Revision of budget in view of changes in conditions.
3. Comparison of actual performances with the budget on a continuous basis.
4. Taking suitable remedial action, wherever necessary.
5. Analysis of variations of actual performance from that of the budgeted
performance to know the reasons thereof.

IN-TEXT QUESTIONS
1. A quantitative expression of management objectives is a (n) ________
2. Is budget futuristic in nature? Yes / No
3. Budgeting system __________ key managerial functions.
4. Budget is prepared for a _______ period of time.
5. The first step in Budgetary control is to______.

7.4 TYPES OF BUDGETS

To achieve the overall companys’ objectives, the company makes various types of budgets. Let
us study few of them.

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Sales
Budget
Producti
Flexible
on
Budget
Budget

Raw
Fixed Material
Budget Consumpti
on Budget

Raw
Master Material
Budget Purchase
Budget
Cash
Budget Overhead
s Budget

7.4.1 Sales Budget

The sales budget is the most common functional budget. If sales figure is incorrect, practically
all functional budgets and consequently the master budget will get affected. Sales budget can
be prepared showing sales under any one or combination of the following headings:

1. Product
2. Territory
3. Types of customers
4. Salesman
5. Month, quarter, week
The exercise of preparing sales budget can be broadly divided into two categories:
1. Sales Forecast
2. Evaluating Sales Forecast
7.4.2 Production Budget
After having established sales budget, production budget is made as it shows the quantities to
be produced for achieving sales targets and keeping sufficient inventories. Budgeted

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production is equal to projected sales plus closing inventory of finished goods minus opening
stock of finished goods. Thus, production budget is based on sales budget and desired inventory
levels. Production budget is prepared in physical units.
Units to be produced= Budgeted Sales (+) Desired Closing Stock (-) Opening Stock

Illustration 1:
The Rama & Company plans to sell 1,08,000 units of a certain product line in 1st quarter,
1,20,000 units in 2nd quarter, 1,32,000 in 3rd quarter, 1,56,000 units in 4th quarter and 1,38,000
units in the 1st quarter of the following year. At the beginning of the 1st quarter of the current
year, there are 18,000 units in stock. At the end of each quarter the company plans to have an
inventory equal to 1/6th of the sale for the next quarter. How many units must be manufactured
in each quarter of the current year?
Solution:
Production = Sales + Closing Stock – Opening Stock
Rama & Company Production Budget

Particulars 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.

(Units) (Units) (Units) (Units)
Sales Budget 1,08,000 1,20,000 1,32,000 1,56,000
+ Closing Inventory 20,000 22,000 26,000 23,000
Total 1,28,000 1,42,000 1,58,000 1,79,000
- Opening Inventory 18,000 20,000 22,000 26,000
Estimated Production 1,10,000 1,22,000 1,36,000 1,52,000

7.4.3 Raw Material Budget

Direct Materials budget is prepared to compute standard material cost per unit. The Raw
Material Budget budget shows the projected quantity of all raw materials and components
required for the production budgeted. This budget serves the following purposes:

• It helps the purchasing department to plan purchase schedule to avoid default in

delivery of material
• It forms basis for purchase cost budget
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• It forms basis for determination of minimum and maximum levels of inventory of

material and components
7.4.4 Purchase Budget
Purchase budget sets out ‘purchase’ plan of the company during the budget period. Material
budget only gives an idea of the material requirements of the company during the budget. For
preparing purchase budget, it is also necessary to know the level of inventories to be
maintained. The purchase budget can be expressed in terms of both quantity and monetary
value. The governing points for preparation of purchase budget are:
1. Opening stock of different types of materials and components
2. Closing stock of different types of materials and components
3. Orders already placed
4. Storage space available
5. Economic Order Quantity
6. Price to be paid
7. Seasonal discounts that can be availed of
8. Finance available

7.4.5 Cash Budget

A cash budget is a concise statement of a company's expected cash revenues and payments over a given
time period. A cash budget projects cash inflows and outflows over some specified period of time. The
basis is mostly the sales forecast and the level of assets that will be required to meet those forecasts. A
cash budget can be created for any interval but firms typically use a monthly cash budget for the coming
year, mostly for planning purposes and a daily or weekly budget for actual cash control.
A typical cash budget consists of three sections:

• Sales and Expenses worksheet that summarizes the firm’s sales income and expenses incurred
in purchasing materials
• Cash Gain or Loss section that indicates the cash inflows and outflows with the ‘bottom line’
indicating either a gain or loss
• Cash surplus or Loan requirement (Net Cash Balances) section that summarizes the firm’s
surplus cash held or total loans needed.
This will be estimated by deducting total expenses for a given period e.g. a month from the total cash
receipts for that period. The result will either indicate a surplus or deficit.
-In case of surplus, it can be invested in bonds, equities or in savings accounts
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- In case of a deficit, it can be bridged by:

1. Borrowing short-term funds e.g. through overdrafts.
2. Delaying capital expenditures until the firm’s cash position improves.
3. Requesting suppliers for a longer credit period.
4. Delay payment of taxes.
5. Postpone payment of dividends.
Note: Since the cash budget represents a forecast, all the values shown are expected values.

• If the firm’s inflows and outflows are not uniform over the budget interval, the cash budget for
that period will overestimate or underestimate the firm’s cash needs.
• A cash budget can be used to help set the firm’s target cash balance i.e. the desired cash balance
that a firm plans to maintain in order to conduct business. The target balance can be adjusted
over time depending on the size of the firm’s operations during various business cycles
• Even though depreciation amounts do not appear directly in the budget, they still affect the
amount of taxes shown

Advantages of Cash Budget

1. Helps determine future cash flows thus enabling the company to plan for its financing.
2. Helps management know when to borrow and how much to borrow.
3. Helps in determining when there will be a cash surplus so management can plan for its use i.e.
whether to pay dividends or invest in short-term securities.
4. Helps management to control expenditure based on the forecasted income and expenditure.
5. Assists management in planning for its obligations and knowing when and how to meet those
obligations.
6. Strengthens the liquidity position of a company since it helps a company know its accurate cash
position and what measures to take depending on its position.

Disadvantages of Cash Budget

1. Uncertainty – It assumes that everything remains constant while in reality, anything can
actually happen.
2. Forecasting budgets isn’t always accurate since one can predict expenses but can’t accurately
predict income / sales
3. Requires highly skilled personnel to forecast and prepare a cash budget
4. If there is any deviation from the fixed budget, a new budget has to be designed again.

Format of Cash Budget

Particular January February March
Opening Cash Balance ‐ ‐ ‐
Add: Cash Receipts:

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Cash Sales ‐ ‐ ‐
Receipts from Debtors ‐ ‐ ‐
Interest received ‐ ‐ ‐
Dividend Received
Sale of fixed assets / Investments ‐ ‐ ‐

Bank Loan ‐ ‐ ‐
Issue of Equity Shares ‐ ‐ ‐
Issue of Debenture
Others cash receipts ‐ ‐ ‐
Total Receipts (A) ‐ ‐ ‐
Less: Cash Payments
Cash Purchases ‐ ‐ ‐
Payment to creditors ‐ ‐ ‐
Salaries paid ‐ ‐ ‐
Wages paid
Administrative expenses ‐ ‐ ‐
Selling expenses ‐ ‐ ‐
Dividend paid ‐ ‐ ‐
Purchase of long-term assets ‐ ‐ ‐
Repayment of Loan ‐ ‐ ‐
Taxes Paid ‐ ‐ ‐
Total Payments (B) ‐ ‐ ‐
Closing Balance (A ‐ B) ‐ ‐ ‐

7.4.6 Master Budget

The Master Budget is consolidated summary of the various functional budgets. Master Budget
is defined as “a summary of the budget schedules in capsule form made for the purpose of
presenting, in one report, the highlights of the budget forecast”.
The master budget is prepared by the budget committee on the basis of co-ordinated functional
budgets and becomes the target for the company during the budget period when it is finally
approved by the committee. This budget summarises functional budgets to produce a Budgeted
Profit & Loss Account and a Budgeted Balance Sheet as at the end of the budget period.
Advantages of the Master Budget are as follows:
1. A summary of all functional budgets in capsule form is available in one report
2. The accuracy of all the functional budgets is checked because the summarised
information of all functional budgets should agree with the information given in the
master budget
3. It gives an overall estimated profit position of the company for the budget period

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The Master Budget

Cost of goods
Sales Production sold and ending
forecast schedule inventory
budgets

Budgeted
financial Capital Operating
budgets: expenditures expense
 cash
budget budgets
 income
 balance sheet

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

7.4.7 Fixed and Flexible Budget

FIXED BUDGET: A fixed budget is a budget that does change during the budget period. It is
prepared for a particular activity level and it does not change with actual activity level being
higher or lower budgeted activity level. This budget does not highlight the ‘activity variance’.
In this budget, there is no absolute difference between budgeted figures and actual figures.
Following are the advantages of fixed budget:
1. It is misleading
2. It is inadequate for control purposes
3. It violates logic

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FLEXIBLE BUDGET: A flexible budget is a budget which is designed to change as volume

of output changes – CIMA. The flexible budget is also known as a variable budget because it
keeps on fluctuating. A flexible budget takes into account the cost classification into fixed,
variable, and semi-variable.
A flexible budget may be more effective in the following circumstances:
• When the level of activity varies from one period to the next.
• Where the firm is new and forecasting demand is tough.
• Where the organisation is experiencing a scarcity of any production element. For example,
material, labor, and so on, as the amount of activity is determined by the availability of
such a thing.
• Where the nature of the business is such that sales fluctuate.
• Where changes in fashion or trend have an impact on production and sales.
• Where the organisation frequently offers new products or changes the patterns and styles
of its products.
• When a significant portion of output is destined for export.
Format of Flexible Budget

Particulars Capacity Utilization

50% 70% 90%
Sales xxx xxx Xxx
Less: Variable
Overheads
Contribution
Less: Fixed
Overheads
Profit

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Difference between Fixed Budget and Flexible Budget

S. No. BASIS FIXED BUDGET FLEXIBLE BUDGET

1. Activity level Based on one single activity Based on different levels of

activity

2. Nature of the Static in nature thus is rigid. Dynamic in nature and thus
budget That means this budget does not flexible. This means this budget
change with the level of output changes with the level of output
achieved

3. Difficulty in True picture is not depicted on True picture is shown on

comparing. comparing the actual level of comparing the actual level of
output with the budgeted level output with the budgeted level
of output of output

4. Working Assumes that the business Assumes that the business

conditions of conditions remain the same and situations keeps on changing
the business does not consider this fact. and takes this fact into
consideration.

5. Differentiation Does not consider the difference Consider the difference

in cost between fixed cost, variable between fixed cost, variable
cost, and semi-variable cost cost, and semi-variable cost

6. Cost Correct cost ascertainment is Correct cost ascertainment is

ascertainment difficult as business working easy as the budget changes with
conditions are not static the volume of output

7. Tool for cost It has a limited application and It has more applications and
control is ineffective as a tool for cost can be used as a tool for
control effective cost control

8. Price fixation If the budgeted and actual It helps in fixation of price and
activity levels vary, the correct submission of tenders due to
cost ascertainment and fixation correct cost ascertainment
of prices become difficult

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IN-TEXT QUESTIONS

6. The production budget is determined by the sales budget. True or false?

7. The budget that specifies the amount of raw materials that will be utilised
during the manufacturing process is called as _______________.
8. The raw material consumption budget and the raw material purchasing budget
are the same. Yes/No
9. The _______ budget includes cash inflows and outflows.
10. A budget that is a compilation of all budgets is termed as ____________.

7.5 ZERO-BASED BUDGETING

ZBB may be better termed as ‘De nova budgeting’ or budgeting from the beginning without
any reference to any base-past budgets and actual happening. Zero-Based Budgeting is a
subset of budgeting. As the name implies, we start budget preparation from zero. In basic
terms, we begin budget preparation from the sctach, that is, from the beginning. Zero Base
Budgeting is:
1. A technique of planning and decision-making.
2. Reverses the working process of traditional budgeting.
3. In traditional incremental budgeting, departmental managers need to justify only
increases over the previous year budget. This means what has been already spent is
automatically sanctioned.
4. In the case of ZBB, no reference is made to the previous level of expenditure. Every
department function is reviewed comprehensively and all expenditures rather than only
increases are approved.

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5. ZBB is a technique, by which the budget request has to be justified in complete detail
by each division manager starting from the Zero-base. The Zero-base is indifferent to
whether the total budget is increasing or decreasing.
Advantages of Zero Base Budgeting:
1. Results in efficient allocation of resources as it is based on needs and benefits
2. Drives managers to find out cost effective ways to improve operations
3. Detects inflated budgets
4. Useful for service departments where the output is difficult to identify
5. Increases staff motivation by providing greater initiative and responsibility in decision-
making
6. Increases communication and coordination within the organization
7. Identifies and eliminates wastage and obsolete operations.
8. Identifies opportunities for outsourcing.
9. Forces cost centers to identify their mission and their relationship to overall goals.
Disadvantages of Zero Base Budgeting:
1. Difficult to define decision units and decision packages, as it is very time-consuming
and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D department is threatened
whereas the production department benefits.
3. Necessary to train managers. ZBB should be clearly understood by managers at various
levels otherwise they cannot be successfully implemented. Difficult to administer and
communicate the budgeting because more managers are involved in the process.
4. In a large organization, the volume of forms may be so large that no one person could
read it all. Compressing the information down to a usable size might remove criticaly
important details.
5. Honesty of the managers must be reliable and uniform. Any manager that is prone to
exaggeration might skew the results.

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Traditional budgets are based on historical performance and costs from the previous accounting
period. However, with Zero-Based Budgeting, we do not take anything from the prior
accounting period.
We focus on the goals and objectives that we need to achieve in zero-based budgeting, and the
rest of the budgeting technique is the same as we do in traditional budgeting.
Comparison of ZBB from Traditional Budgeting is as follows:

TRADITIONAL BUDGETING ZERO-BASED BUDGETING

It takes into consideration the previous It does not take into consideration the
accounting period’s data to make the new previous accounting period’s data for
budget. making the new budget, rather it starts from
scratch.

It has a major focus on money. It has a major focus on the attainment of

goals and objectives.

It does not consider different approaches. It takes different approaches to achieve

similar results.

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IN-TEXT QUESTIONS
11. Zero base Budgeting means starting from the _____.
12. Zero base Budgeting takes into consideration previous accounting
period’s data. True/False
13. Zero base Budgeting is time-consuming. Yes/No
14. Traditional Budgeting takes into consideration previous accounting
period’s data. True/False
15. The primary emphasis of Zero-based Budgeting is on ____ and
___________.
16. Following tools can be used to create interest among the learners:
a) Jargons b) complex language
c) Pictures d) repetitive sentences
17. Fill up the blanks:
a. Budget is drawn for_________ .
b. Key factor is also known as ___________ .
c. ____________requires classifications of cost as fixed, variable and
semi-variable.
d. Flexible budget is drawn for _____________level of activity.
e. ____________budget is prepared for a longer period.
f. _____________ is a summary of all the functional budgets.
g. _____________shows estimate of sales in future.
h. Flexible budget is useful for _____________ .
i. Budget defines _________________of a concerned manager.
j. ______________shows budgeted receipts and payments.

[Ans.: a. Future, b. Limiting factor, c. Flexible budget, d. Fixed, e. Capital, f.

Master budget, g. Sales budget, h. Control, i. Responsibility j. Cash budget.]

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7.6 SUMMARY

In a nutshell, a budget is a financial statement that is based on estimates. And if there are any
differences between the intended level of activity and the activity achieved, these are referred
to as deviations, and corrective procedures can be implemented to address them. The budget
serves as a regulating tool and aids in the achievement of the organisation's goals and
objectives. Budgets are classified into several types, including sales budgets, production
budgets, raw material consumption budgets, raw material purchase budgets, cash budgets,
master budgets, fixed budgets, and flexible budgets. There is also the idea of zero-based
budgeting, which indicates that no data from prior accounting periods is used and the budget
is created from start.

7.7 PRACTICAL PROBLEMS

1. Bharat Forging Limited manufactures a single product for which market demand exists for
additional quantity. Present sales of Rs.60,000 per month utilises only 60% capacity of the
plant. Marketing Manager assures that with the reduction of 10% in the price he would be
able to increase the sale by about 25% to 30%.
The following data are available:
Selling Price Rs.10 per unit
Variable Cost Rs.3 per unit
Semi-variable Cost Rs.6,000 fixed + 50 paise per unit
Fixed Cost Rs.20,000 at present level estimated to be
Rs.24,000 at 80% Output
You are required to prepare the following statements:
a) The operating profits at 60%, 70% and 80% levels at current selling price, and
b) The operating profits at proposed selling price at the above levels

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2. A factory is currently running at 50% capacity and produces 5,000 units at a cost of Rs.90/-
per unit as per details below:

Material Rs.50

Labour Rs.15

Factory Overheads Rs.15 (Rs.6 fixed)

Administrative Overheads Rs. 10 (Rs.5 fixed)

The current selling price Rs.100 per unit.

At 60% working, material cost per unit increases by 2% and selling price per unit falls by
2%
At 80% working, material cost per unit increases by 5% and selling price per unit falls by
5%
Estimate profits of the factory at 60% and 80% working and offer your comments.
3. Based on the following information, prepare a Cash Budget for the three months ending 30th
June, 2022

Month Sales Materials Wages Overheads

February Rs.14,000 Rs.9,600 Rs.3,000 Rs.1,700

March Rs.15,000 Rs.9,000 Rs.3,000 Rs.1,900

April Rs.16,000 Rs.9,200 Rs.3,200 Rs.2,000

May Rs.17,000 Rs.10,000 Rs.3,600 Rs.2,200

June Rs.18,000 Rs.10,400 Rs.4,000 Rs.2,300

Credit Terms are:

• Sales / Debtor – 10% sales are on cash, 50% of the credit sales are collected next
month and the balance in the following month.

• Creditors: Materials 2 months, Wages ¼ month, Overheads ½ month

• Cash and Bank Balance on 1st April, 2022 is expected to be Rs.6,000

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Other relevant information is:

• Plant & Machinery will be installed in February 2022 at a cost of Rs.96,000. The
monthly installments of Rs.2,000 is payable from April onwards.

• Dividend @ 5% on Preference Share Capital of Rs.2,00,000 will be paid on 1st June.

• Advance to be received for sale of vehicles Rs.9,000 in June

• Dividends from investments amounting to Rs.1,000 are expected to be received in

June.

• Income Tax (advance) to be paid in June is Rs.2,000

7.8 GLOSSARY

• Deviation: It shows the amount of difference between the two things.

• Remedial Action: The corrective action which needs to be taken in the case of
deviation.
• Attain: To attain anything is to achieve something.
• Target Audience: A group of people who will become our potential customers.
• Allocation of expenses: It means assigning a particular expense to a particular unit.
• Aggregation: It is the sum total of all.
• Ascertainment: It means to find out something.

7.9 ANSWERS TO IN-TEXT QUESTIONS

1. Quantitative Statement 9. Cash budget

2. False 10. Master budget
3. Yes 11. Scratch or zero
4. Defined 12. False
5. Set Standards 13. Yes
6. True 14. True
7. Raw material consumption budget 15. Goals and Objectives
8. No

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7.10 SELF-ASSESSMENT QUESTIONS

1. Define budgetary control.

2. Define budget and budgetary control. State the advantages of budgetary control in an
organization.
3. Distinguish between cost control and cost reduction.
4. Distinguish between fixed and flexible budget. Briefly state the circumstances in which
flexible budgets are used.
5. Write short note on Zero Based Budgeting?

7.11 REFERENCES

• Arora, M. N. (2016). Cost And Management Accounting, Penguin Random House.

• Saxena & Vashist, Cost Accounting, Sultan Chand & Sons

• Ravi M Kishore, Cost & Management Accounting, Taxmann

• Jain S P & Narang K L, Cost and Management Accounting, Kalyani Publishers

7.12 SUGGESTED READINGS

• Pandey, I M, Management Accounting, Vikas Publishing

• Khan M Y & Jain P K, Theory and Problems of Management and Cost Accounting,

McGraw Hill Education

• Horngren C T, Cost and Management Accounting - A Managerial Emphasis, Pearson

Education

**************LMS Feedback: [email protected]**************

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Management Accounting

LESSON 8
COST MANAGEMENT

Ms. Sanjana Monga

Sessional Faculty
Niagara College, Toronto, Canada
Email-Id: [email protected]

STRUCTURE

8.1 Learning Objectives

8.2 Introduction
8.3 Cost Management, Cost Control and Cost Reduction
8.4 Strategies for Cost Management
8.5 Activity Based Costing
8.6 Accounting And The Theory Of Constraints (TOC)
8.7 Throughput Accounting
8.8 Target Costing
8.9 Value Chain Analysis
8.10 Life Cycle Costing
8.11 Just-In-Time (JIT)
8.12 Backflush Costing
8.13 Summary
8.14 Glossary
8.15 Self-Assessment Questions
8.16 References
8.17 Suggested Readings

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8.1 LEARNING OBJECTIVES

● d
Learning objectives of this unit are:
● Explain the concept of cost management, cost control and cost reduction
● Describe activity based costing in detail
● Concept of value chain analysis
● Target costing and life cycle costing
● Modern accounting techniques like throughput and backflush costing

8.2 INTRODUCTION

The business environment has changed considerably over last few decades. Many of the
organisations have already adopted automated modes for most of their operations following
the lean business model resulting in decrease in direct labour but increase in indirect overheads.
Therefore, direct labour is no more considered a good base or predictor for overheads
allocation. Besides that, increased competition in the market has led to emergence of
organisations that are manufacturing multiple types of products or services. Diverse nature of
manufactured products or services generally consume resources or overheads in different
proportion and it is not possible to correctly capture this diversity by following traditional
costing systems.

8.3 COST MANAGEMENT, COST CONTROL AND COST

REDUCTION
Companies utilise cost reduction analysis as a method to lower their expenses and boost
earnings. Depending on the goods or services they provide, many businesses adopt various
strategies. Every choice made during the product development process has an impact on the
price.
Companies frequently launch new products without concentrating on how much value there
will be. However, the importance of pricing changes drastically when market rivalry rises and
prices of goods and services become a significant point of differentiation.

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The action is regulated by cost management to maintain the cost components within the
predetermined bounds. Contrarily, cost reduction refers to a real, long-term decrease in the unit
price. Understanding the distinction between cost reduction and cost control will be helpful.

8.3.1 Control of Costs

The goal of cost control is to rationalise overall value through the use of competitive analysis.
The goal of this technique is to keep the real price in line with the specified policy. The
operational costs must not exceed the budgeted amount, thus this must be ensured.
Cost control encompasses a number of tasks, beginning with the creation of the budget for the
operation, evaluation of the performance, computation of the differences between the actual
costs and the budgeted value, and identification of the causes of those differences. The final
task is carrying out the appropriate corrections to address the discrepancies.
Importance of Cost Control and Cost Reduction

• Better utilization of resources

• To prepare for meeting a future competitive position

• Reasonable prices for the customers

• Firm standing in domestic and export markets

• Improved methods of production and use of latest manufacturing techniques which

have the effect of rising productivity and minimizing cost

• Improves rate of return on investment

• Improves the image of the company for long-term benefits

8.3.2 What Distinguishes Cost Reduction from Cost Control?

The distinction between the two can be summed up as follows: cost management ensures that
costs are within defined criteria; cost reduction focuses on trying to continuously improve costs
while ignoring any standards.
The key advantages of cost reduction initiatives are that they can improve an organization's
cash flow and profitability. The essential components and variables for programme design and
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implementation are presented. The results of a cost-cutting programme can also be guaranteed
to align with the organization's beliefs and aims. The fact that a corporation must implement a
cost reduction programme is widely understood, especially given the abundance of options
available to managers who are cost-conscious. Last but not least, a comprehensive tax reduction
programme can lessen the heavy financial obligations that can stabilise a business's growth and
can free up valuable capital that can result in the long-term advantage of the organisation.
S.No. Cost Control Cost Reduction

1 This process undertakes the competitive This process finds out the substitute by
analysis of actual results with established finding new ways or methods
norms

2 Under this method, variances are Under this process, necessary steps are
appraised and reported and necessary taken for further modification in the
course of action will be taken to revise method
norms, standards

3 It starts from established cost standards It challenges the standards forthwith and
and attempts to keep the costs of attempts to reduce cost on a continuous
operation of a process in line with those basis
of materials

4 It is a preventive function It is a corrective function

5 The main stress is on the present and past The emphasis is partly on the present costs
behaviour of costs and largely on future costs

8.4. STRATEGIES FOR COST MANAGEMENT

Businesses generally use different strategies to cut costs. The techniques include Just in Time
(JIT), Activity-Based Costing (ABC), Value Engineering (VE) , Target Costing (TC) and Life
Cycle Costing. Some more advanced techniques like Throughput Costing and Backflush
Costing.

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Management Accounting

8.5. ACTIVITY BASED COSTING

Consider the cost computation of manufacturing a product. It is not difficult to trace the cost
of direct materials and labour on the cost object. Problem arises for overheads that are difficult
to trace and need to be allocated taking some suitable and rational measure. The accuracy of
allocation of overhead relates to how well the consumption of labour by the production activity
tracks the incurrence of the overhead cost. If the incurrence of overhead is unrelated to
consumption of direct labour, the allocation of overheads to the cost of object using direct
labour as the base of allocation can cause significant errors. It should be made clear that choice
of any base for allocation will be prone to some errors because the correlation between the
overhead cost incurrence and the use of allocation base will be less than perfect. It can be
considered a fundamental challenge when costs are not directly traceable while computing
production cost. It produces the concept of activity based costing (ABC) as an alternative
approach for cost allocation with aim to enhance the accuracy in overhead allocation by
providing reliable estimates of product cost.
Activity Based Costing is a method of cost allocation that attempts to assign overheads cost to
cost objects more accurately than the traditional costing methods. The basic idea underlying
concept of ABC is that every order from a client or customer for a service or products triggers
to number of activities; a number of different types of resources are required to carry out these
activities; and money is involved in using these resources. Through activity based costing , an
attempt is made to trace these costs directly to the activities causing them. The activities are
believed to be drive the cost, that’s the reason they are called cost drivers.

CIMA defines ABC as “cost attribution to cost units on the basis of benefit received from
indirect activities like ordering, setting-up, assuring quality”.
ABC has been defined as “the collection of financial and operational performance
information tracing the significant activities of the firm to product costs”.
Definition of terms:
Cost Objects: The products under consideration for computing cost are generally cost
objects. But with the widening of the scope of managerial consideration for numerous
purposes besides computing cost, customers or clients, services that are being provided
or even the area or territory can also be cost objects.
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Activities: The most common term used in concern of ABC is "activity". An activity may be
defined as the aggregation of various tasks or functions that are being performed concerning
the cost objects. Activities can again be of two different types. It can be either any support
activity or it can be any activity that is related to the process of production. Activities that are
grouped under support activities need to be performed before or after the production process.
For example, deciding about the schedule of production, setting up of machine, queuing the
customer orders, an inspection of different items, etc., while activities performed during the
process of production like using machines or assembling are called production process
activities.

Cost pool: The cost centre described above may also sometimes be termed a Cost pool. Hence
cost pool is nothing but the other name of the cost centre.

Cost Drivers: The reason or cause due to which some overhead occurs or is incurred, is known
as a cost driver. In other words, cost drivers can be termed as the factor because of which the
cost of production gradually changes. With the change in the level of cost driver, the level of
the total cost of production also changes. Some examples of cost drivers are the setup of
machines, an inspection of quality, scheduling of production orders, receiving material,
shipments, units of power consumed, etc.

The activity measure expresses the carried out part of activity i.e. volume of activity. This
activity measure is generally used as base for allocation of overheads to product and service
cost. For example, number of complaints received from customers can be a natural choice of
an activity measure for the activity handling customer’s complaints.

Each activity has its own activity rate that is used to apply cost of overheads.

Predetermined Activity Rate = Estimated activity costs / Estimated activity volume

For example, the activity maintenance would be having their own activity cost pool. If we
assume that total cost in this pool is ₹ 100,000 and total expected activity is 1000 hours, the
activity rate will be ₹ 100 per maintenance hour. This amount calculated for activity rate is
not dependent on number or size of job. Whether the job is big or small, all will be charged at
the same rate per maintenance hour.

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Objectives of ABC:
The primary objectives of ABC system are as follows:
a. To improve the accuracy of product costs by carefully changing the type and number
of factors used to assign costs, and
b. To use this information to improve product mix and pricing decision

The other important objectives of ABC systems are as below:

• To identify value-added activities in transactions
• To chalk out ways to eliminate non-value added activities
• To distribute overheads on the basis of activities
• To ensure accurate product costing of decision-making process
• To focus the high cost activities
• To identify the opportunities for improvement and reduction of costs

8.5.1 Steps Involved In Designing Activity Based Costing System

Designing of activity based costing system requires commitment and time from almost all
levels of managers and involves the following seven steps, which sometimes vary from
organisation to organisations. These are general steps that are expected to be followed while
implementing activity based costing (ABC). These steps are:

1. Identification of activities and creation of activity dictionary.

2. Creation of pools of activity cost.
3. Identification of consumed resources by individual activity cost pools.
4. Identification of activity measures for each cost pool.
5. Estimation of total activity volume for each cost measure.
6. Computation of predetermined activity rate for each activity cost pool.
7. Allocation of cost to the desired cost objects.
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Step 1: Identification of activities and creation of activity dictionary

In most of the organisations, overheads are caused due to hundreds or even thousands of
activities. For example taking calls over telephone, making invoices, ordering materials,
training of staff, packaging and dispatching orders, etc. It may be extremely difficult to
design and maintain a complex costing system that can include and record every activity.
The main challenge faced while designing the activity based costing system may be
identification of activities that are manageable and able to explain the variations in
overhead costs. The simplest and most common way to do this is interviewing the broad
range of managers to identify activities that they think are most relevant and consumes
major portion of resources. This list may be more refined by consulting top managers;
activities that are related can be combined that can help in reducing cost of keeping details
and records. At the end of this process, an activity dictionary will be created that defines
all the activities and how to measure them.

Step 2 : Creation of pools of activity cost

In manufacturing organisations, it is not necessary that all the activities mentioned in
activity directory are performed every time whenever additional units are produced. Some
activities may require to perform every time an additional unit is manufactured, but others
may not be. To have more clarity regarding this aspect of activities, generally
manufacturing units divide all activities into four groups

a. Unit level activities, performed every time a unit is produced.

b. Batch level activities, that consist of tasks that are required to be performed every
time a batch or a lot is processed.
c. Product level activities, that are related to specific products and must be performed
every time regardless of number of batches oy units produced.
d. Facility level activities, also sometimes called as organisation sustaining activities
and are regularly performed regardless of which products or how many batches are
being manufactured. These are generally related to administration like salary,
insurance etc., are combined into single cost pool and then allocated taking some
arbitrary base such as direct labour-hours.

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Exhibit 8.1 Activities and Activity measures in a Manufacturing organisation

Activity type Activity Activity Measure
Unit level Assembly Direct labour- hours
Machining Machine hours
Batch level Production Scheduling Number of orders
Material Receipts Number of receipts
Product Testing Number of tests
Product level Administration of Parts Number of parts numbers
Facility level Factory general Direct labour hours
administration

Using such a classification allows the designer of ABC system to examine whether the
activities can be combined in a meaningful manner so that system is simplified and proper
activity measure can be identified to allocate cost to different cost objects.

Step 3: Identification of consumed resources by individual activity cost pools

Next important step after creation of cost pool is identifying the total cost that is consumed by
each of the cost pool. For example to identify the resources consumed by a activity cost pool
testing of products, expenses like time taken by tester, depreciation of testing equipment,
supplies used during testing procedure are traceable and directly allocated to the cost pool. But
other costs like rent of building, electricity, maintenance of building that are common across
all of the activities cost pools, must be allocated to individual cost pools taking some suitable
base, like rent of building can be allocated on the basis of percentage area allotted to testing
activity. Other example for taking base for common expenses may be:

• Fringe benefits of employees - Direct labour hours

• Electricity – Number of machine Hours
• Maintenance of Equipment – Number of machine hours
• Maintenance of Factory – Area in Sq. Feet

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Step 4: Identification of activity measures for each cost pool

After the determination of assigned amount of cost to each cost pool, the next is to assign the
cost of the pool to the cost objects by using an activity cost measure. For example, once the
total cost assigned to testing activity is determined, the next is to identifying the activity
measure that will be used to allocate the cost of this cost pool to the final cost object, like
number of testings’ done on a particular cost object.

Step 5: Estimation of total activity volume for each cost measure

Remaining of the steps are related to designing the mechanism of activity pool cost allocation
to final cost objects. Like in example of product testing activity, the activity volume will be the
estimated numbers of tests conducted in a given period of time. Because testing of products
generally is a batch level activity, it is dependent on volume of the estimated number of batches
produced and policy of testing (like testing 10 batches per day), what will be the volume of
activity measure.

Step 6: Computation of predetermined activity rate for each activity cost pool
The activity measure expresses the carried out part of activity i.e. volume of activity. This
activity measure is generally used as base for allocation of overheads to product and service
cost. For example, number of complaints received from customers can be a natural choice of
an activity measure for the activity handling customer’s complaints. Each activity has its own
activity rate that is used to apply cost of overheads.
Predetermined Activity Rate = Estimated activity costs / Estimated activity volume

Step 7: Allocation of cost to the desired cost objects

At this stage, costs obtained from different cost pools are finally allocated to different cost
objects using the activity rate and volume of activity measure consumed by this cost object.
For example, if the activity rate per test is ₹ 55, and production of a particular product requires
100 test to be performed, 55*100, i.e. 5500 will be assigned to this product. Here it is necessary
to mention that the information regarding number of tests required must be gathered. Such
information again can prove a tool to manage and control cost which might not be necessary
under traditional costing system, and is generally considered a key plus point of ABC system.

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Different categories of Cost Pools and its Cost Drivers

Cost Pools Cost Drivers

Customer Order Processing No. of customers

No. of order source
No. of orders by quantity
No. of orders by value
No. of customer visits

Material Planning / Acquisition No. of items / parts / components

No. of deliveries
No. of material receipts
No. of material orders
No. of stock shortages / discrepancies
No. of material transactions
No. of material movements

Inspection and Quality Control No. of inspections

No. of rejections
No. of product changes
No. of set-ups
Batch sizes

Production Control No. of product changes

No. of parts operational
No. of production hours
No. of machine changes
No. of schedule changes
No. of machine layout changes
No. of set-ups

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No. of work orders

Maintenance No. of set-ups

No. of machine break-downs
No. of defects
Capital Expenditure
Maintenance schedule

Research & Development No. of research projects

Technical complexities of projects

Customer Service No. of service calls

No. of products serviced
No. of hours spent on servicing products

8.5.2. Accounting -Based Vs Traditional Costing

Assume the Busy Ball Company makes two types of bouncing balls; one has a hollow center
and the other has a solid center. The same equipment is used to produce the balls in different
runs. Between batches, the equipment is cleaned, maintained, and set up in the proper
configuration for the next batch. The hollow center balls are packaged with two balls per
package, and the solid center balls are packaged one per package. During the year, Busy Ball
Material Purchased 4,00,000
Expenses on machine set up 7,00,560
Packaging expenses 6,00,000
Testing expenses 5,40,000
Maintenance 5,77,080
Total overheads cost 28,17,640
expects to make 2,000,000 hollow center balls and 4,000,000 solid center balls. The overhead
costs incurred have been allocated to activity pools as follows:

Amount (in ₹)

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After analysing the activity pools, cost drivers are identified, total units to be produced for each
product are estimated and unit cost for each cost driver is calculated:

Activity Cost driver Total Total cost (2) Unit cost per
estimated units cost driver
for cost driver (3)= (2) / (1)
(1)
Material Purchased Number of 200 4,00,000 2,000
purchase orders
Expenses on machine Number of set 504 7,00,560 1,390
set up ups
Packaging expenses Number of 50,00,000 6,00,000 0.12
containers filled
Testing expenses Number of tests 6,000 5,40,000 90
Maintenance Number of runs 504 5,77,080 1,145

Following table shows activity by product:

Activity Cost Driver Unit Hollow Solid Hollow Solid

cost center center center center
(3) (4) (5) (3)*(4) (3)*(5)
Material Number of 2,000 100 100 2,00,000 2,00,000
Purchased purchase orders
Expenses on Number of set 1,390 252 252 3,50,280 3,50,280
machine set ups
up
Packaging Number of 0.12 10,00,000 40,00,000 1,20,000 4,80,000
expenses containers filled
Testing Number of tests 90 2,000 4,000 1,80,000 3,60,000
expenses
Maintenance Number of runs 1,145 168 336 1,92,360 3,84,720
Total 10,42,640 17,75,000

Further, for the purpose of calculating per unit overhead rate under activity based costing, the
total cost that have been assigned to each product is divided by number of units manufactured.
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Overhead cost assigned to hollow centre balls = 10,42,640 = ₹ 0.521

Number of hollow centre balls 20,00,000

Overhead cost assigned to solid centre balls = 17,75,000 = ₹ 0.444

Number of solid centre balls 40,00,000

If following traditional costing, total overhead cost will be allocated on basis of direct labour
cost , where total of overheads will be divided by total combined labour cost for both types of
balls. Estimated direct labour cost for the year is ₹ 30,24,000 out of which 7,56,000 is for
hollow center balls and 22,68,000 is for solid center balls. The per unit direct labour cost will
be for hollow centre ball ₹ 0.378 ( 7,56,000/20,00,000) and ₹ 0.567 for Solid center balls
(22,68,000/40,00,000).

Step 1: Calculation of overhead per direct labour hour

Total overhead cost = 28,17,640 = 0.932

Total direct labour hours 30,24,000

Step 2: Allocation of overhead

Overhead cost per direct labour hour * per unit direct labour hours
Hallow center balls = 0.932*0.378 = ₹ 0.352 overhead per unit
Solid center balls = 0.932*0.576 = ₹ 0.528 overhead per unit

A comparison of the overhead per unit calculated using the ABC and traditional methods often
shows very different results:

ABC Traditional
Hollow center ball Rs. 0.52 Rs. 0.35
Solid center ball Rs. 0.44 Rs. 0.53

In above example, as per ABC, overheads are ₹ 0.52 per hollow ball, much higher than the ₹
0.35 that is calculated using traditional costing. The cost calculated using ABC is more accurate
while pricing the production. Fir the balls with solid center, cost of overheads per unit is ₹ 0.44
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under ABC method while it is ₹ 0.53 under traditional costing. The reason behind this is under
traditional costing, overheads have been allocated on the basis of direct labour cost, so the
product having high direct labour cost gets higher of the overheads cost as well.

8.5.c. Advantages of ABC:

I. Gives accurate manufacturing costs for particular products.

II. More properly allocates manufacturing costs to the activity's user-facing products and
processes.
III. Identifies wasteful procedures and aims to improve them
IV. More correctly calculates product profit margins
V. Identifies the procedures with wasteful and excessive expenditures.
VI. Provides a better explanation and defense of manufacturing overhead costs.

8.5.d. Limitations of ABC:

I. Data preparation and collection take time.

II. Information gathering and analysis are more expensive sources of data aren't always
easily accessible from standard accounting reports
III. It is not usually possible to utilize ABC reports for external reporting because they don't
always follow widely accepted accounting rules.
IV. Data generated by ABC could be at odds with managerial performance standards that
were previously established using conventional costing methodologies.
V. For businesses where overhead is low relative to total operating costs, it might not be
as helpful.

8.6. ACCOUNTING AND THE THEORY OF CONSTRAINTS

The principles of the Theory of Constraints are used to clarify decisions after throughput
accounting has laid the groundwork for a more straightforward approach to operational
accounting.
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When some of the limiting factors prevent production, this is referred to as a theory of
constraint situation. Production plans must be managed in accordance with these limits because
they can also be referred to as bottlenecks or scarce resources.
The Theory of Constraints, developed by Eliyahu M. GOLDRATT and popularised by his best-
selling book "The Goal" and other works, led to the introduction of throughput accounting in
the 1980s.
The foundation of management by constraints is the idea that the major constraint—typically
represented by a bottleneck close to or directly at the entry of the constrained resource—limits
the amount of money that can flow out of an industrial or commercial structure.

8.7. THROUGHPUT ACCOUNTING

Businesses utilise throughput accounting as a clever production planning tool. Profit

maximisation is the goal of employing this accounting strategy. When producing several
products, this idea is relevant if there is a particular constraint. So it's more about manufacturing
and production planning.
Consider the possibility that you may need to use raw materials (the bottleneck) in a variety of
your company's goods. A bottleneck is a material or any other element that lowers your
production capacity. Any production-related factor, such as a limited supply of raw materials,
manpower, or machine hours, may be the bottleneck.
Only the following situation makes this style of accounting appropriate.

• There is a bottleneck in your company.

• Your company makes more than one product, and each product uses bottleneck
resources differently.

In this case, throughput accounting can assist in creating a production schedule that maximises
your business's profits.

8.7.a. Process Of Throughput Accounting

Step 1: Knowing your production facility is important for identifying bottleneck resources.
Consequently, this stage entails a thorough study of the production stages. For various
enterprises, there may be various bottlenecks. An example of a scarce resource would be labour
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hours, machine hours, raw materials, or any other production factor. Understanding the actual
source of the problem is therefore more important when finding constrained resources.
Step 2: Calculate the contribution for each product, per unit. It involves using the product in
some math. Just subtract all variable expenses from revenue.
Step 3: Divide the contribution per unit by the scarcity of the resource Again, simple math
requires dividing the contribution per unit by the limited resource. Throughput value is the
name of it.
Step 4: Rank the values from step 3 in order of importance. The step three throughput value's
top-ranked values show the highest use of scarce resources to produce profit. Simply said, we
have found a product that makes the most contribution while utilising the fewest scarce
resources. Therefore, the top-ranked products should be prioritised. The maximum demand for
each product should, however, be taken into account while developing a product plan.
The product that uses the least amount of a scarce resource to provide the most contribution
has been identified. We have also graded products according to how well they use limited
resources. Consequently, a production plan with the maximum overall contribution can be
created using this information.
8.7.b Throughput Ratio:

Throughput accounting ratio is equal to throughput value divided by fixed cost per unit, where
contribution / unit of a scarce resource determines throughput value.
If the value determined is more than one, the throughput value can pay for the fixed cost. A
throughput ratio of less than one, on the other hand, indicates that the business's fixed costs are
not covered by the throughput value. Consequently, knowing if it is profitable to produce a
product may be useful to the firm.

8.8. TARGET COSTING

Target Costing is defined as “as a cost management tool for reducing the overall cost
of a product over its entire life cycle with the help of the production, engineering, R&D”.
Target costing is a market-driven design methodology and involves estimating a cost for
a product and then designing the product to match the cost.

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Target costing is a cost management tool for reducing product costs over its entire life
cycle. It becomes an important reference point for cost management. Target costing
includes actions management must take to establish reasonable target costs, develop methods
for achieving those targets and develop means by which to test the cost effectiveness of
different cost-cutting scenarios.

Sakurai discusses the most important procedure of target costing as follows:

1. To plan and design high quality products that meet customers’ needs
2. To set a target cost for the products through the use of value engineering

3. To attain the target cost at the production stage by use of standard costs

How does Target Costing work?

Target costing is more than simply a way of costing; it is also a management technique in which
prices are set by the market, taking into account a number of variables, including homogeneous
product offerings, the intensity of competition, the cost of switching for the end user, etc.
Management seeks to keep expenses under control when these elements are present since they
have limited or no control over the selling price. Target costing is used to manage expenses
prior to the company incurring any manufacturing expenditures, which saves a significant
amount of time and money. Target costs can also be continuously employed to keep costs under
control throughout the whole production life cycle.
The following may be construed as the components in the product target costing:

• Type of product

• Technical specifications

• Technical requirements

• Customer

• Resource consumption (acquisition price)

• Resource consumption (cost

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Formula for Target Cost:

Where the profit margin is based on selling price, target total cost can be calculated as follows:
Target cost = Selling Price – Required Profit

Required Profit = (Gross Profit / Sales) × Selling Price

Where the profit margin is based on cost, target cost can be found as follows:

Target Cost = Selling Price

1 + Profit Percentage

Targets can be set for each individual cost component based on the standard costing.

Example
M&M is a dress manufacturer that operates in extreme competition. It sells dresses to different
resellers market dresses under their own brands. M&M can only charge ₹ 5 per meter. If the
company’s intended profit margin is 25% on cost, calculate the target cost per unit. If 20% of
the cost per meter of dress is related to direct materials, what’s the target cost per unit for direct
materials.

Solution

M&M wants to earn a margin of 25% on cost, so the following formula need to be applied to
get the total target cost per unit.

Target cost per unit = ₹ 5 per meter = ₹ 4

1+ 25%
M&M has to keep its cost per unit below ₹ 4 in order to generate 25% profit margin on cost.

If 20% of the unit cost is related to direct materials, target cost for direct materials shall be ₹
0.80 (0.2*Rs.4).

If M&M wants to earn 25% on selling price, the total target cost per unit shall be worked out
as follows:

Target cost per unit = ₹ 5* (1 – 25%) = ₹ 3.75

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Target costing has the advantages listed below:

• By using ABC, target costing offers a better way to test various cost scenarios and
specific information on the expenses associated with developing a new product.

• Target costing shortens the product development cycle.

• Target costing significantly boosts the profitability of new products by encouraging

cost-cutting while preserving or enhancing quality. Target price also encourages
consumer demands, which makes it more well-liked than competing products.

• Target costing is also used to project future costs and offers encouragement to hit cost
targets.

• Target costing is used to manage expenses prior to the company incurring any
manufacturing expenditures, which saves a significant amount of time and money.
Target costs can also be continuously employed to keep costs under control throughout
the whole production life cycle.

With highly competitive environment, the organizations are aiming to be ‘customer driven’ i.e.
customer satisfaction is priority one. One of the key tool in the hands of the management to
achieve this aim is value chain analysis.

Value Chain Analysis ‘is a strategic managerial tool to assess and review the various business
functions in which utility is added to the products or services’.
Michael Porter first proposed the concept of a value chain in 1985 to illustrate how customer
value builds up along a chain of processes that result in a final good or service.
The internal procedures or actions carried out by a business "to create, produce, promote,
distribute, and support its product," according to him, comprise the value chain. According to
him, "a firm's value chain and the manner in which it carries out certain operations are a
reflection of its history, its strategy, its method to achieving its plan, and the underlying
economics of the activities themselves."
Porter divided business activities into two categories: primary, line, and support activities. The
conversion of inputs into outputs, as well as delivery and post-sale support, are the main
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operations. In other words, they cover tasks like order processing, distribution, and the
transformation of inputs into finished goods. They also cover communication, pricing, and
channel management, as well as installation, maintenance, and part replacement.
The activities that assist primary activities are known as support activities. They include the
following and are handled by the organization's staff functions:
1. Procurement—acquiring assets as well as raw materials, suppliers, and other consumables.
2. Each value chain activity requires specific technical knowledge, processes, and inputs.
3. Human resource management, including hiring, promoting, and placing employees as well
as providing them with feedback and rewards.
4. The organisational framework of the company, including general management, planning,
finance, accounting, legal, public affairs, and quality management.

The value chain for a typical organization is shown in Figure 8.1.

New product Marketing Distribution

Operations
development and Sales services

Figure 8.1 Value Chain Analysis for a Business

Support Activities may be Human Resource; Finance; Information

Technology
The value chain breaks down the company into each of its unique strategic activities. Value
chain analysis looks at how customer value can be increased or expenses can be reduced across
the company's operations, from new product creation to distribution.
The main inquiries are:
I. Is it possible to minimise expenditures in this activity while keeping revenue value
constant?
II. Is it possible to raise profits while maintaining the same costs in this activity?
III. Is it possible to minimise assets while maintaining costs and profits in this activity?
IV. Most crucially, is it possible to complete steps 1, 2, and 3 all at once?

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The business unit can get a competitive edge in terms of cost and revenue differentiation by
methodically analysing expenses, revenues, and assets in each activity.
All of the aforementioned roles play a part in carrying out a company's competitive strategy,
and each must create its own strategy in order to do so. Here, a process' or function's strategy
refers to what it will specifically strive to accomplish. A company's planned portfolio of new
items is laid out in a product development strategy. Additionally, it determines whether the
development work will be done internally or externally. A marketing and sales strategy outlines
the market segmentation, product positioning, pricing, and promotion plans. The type of raw
material procurement, material transportation to and from the business, product manufacture
or operation to provide the service, and distribution of the product to the customer are all
determined by a supply chain strategy, along with any follow-up services and a specification
of whether these processes will be carried out internally or externally. Given that businesses
are rarely fully vertically integrated, it is crucial to understand that the supply chain strategy
outlines both the internal processes that the business should optimise and the roles that each
supply chain entity should perform. The overall structure of the supply chain as well as what
are commonly referred to as "supplier strategy," "operations strategy," and "logistics strategy"
are all included in supply chain strategy.

8.10. LIFE CYCLE COSTING

Every cost matters when you run a small business. If you make bad choices about what to buy,
it can cost your business more money than it needs to and hurt your bottom line over time. Life
cycle costing is something you should do before buying new assets for your business.
The life cycle cost, also called the whole-life cost, of an asset affects how a business budgets,
prices its products, and makes decisions.
What is costing over the life cycle?
Life cycle costing, also called whole-life costing, is a way to estimate how much you will spend
on an asset over the course of its useful life. Whole-life costing takes into account the costs of
an asset from the time you buy it until you get rid of it.
When you buy an asset, you are making a financial commitment that goes beyond the price
tag. Think about a car as an example. The price of the car is only one part of how much it will
cost over its whole life. You also need to think about the costs of car insurance, interest, gas,
oil changes, and any other repairs the car might need. If you don't plan for these extra costs, it
can set you back.

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Costs add up when you buy, use, and take care of a business asset. Whether you're buying a
car, a copier, a computer, or stock, you should think about and plan for how much the asset
will cost you in the future. Costing for the whole life cycle refers to getting a better idea of how
much a new asset will cost your business when you do a life cycle cost assessment.
Lifecycle costing example:
Your business needs a new copier.
• Price of copier: ₹ 2,500.
• Installation and delivery cost: ₹ 75.
• Operating cost: You expect to spend ₹ 1,000 on ink cartridges and paper during its
lifetime. You estimate ₹ 300 in copier electricity use.
• Maintenance: You estimate ₹ 450 to fix the copier.
• Financing: Your store credit card charges 3.5% per month for the copier. Next month,
you pay off the printer, owing ₹ 87.50 in interest (Rs.2,500 X 3.5%).
• Depreciation: You estimate ₹ 150 in annual copier depreciation.

• Disposal: You estimate that an independent contractor will charge ₹ 100 to remove the
copier from your firm.

The copier costs ₹ 2,500, but its life cycle might cost your organisation over ₹ 4,500.
Product Life Cycle Costing
The innovation of a new product and its degeneration into a common product is termed as the
‘life cycle of a product’. Following are the five distinct phases in the life cycle of a product:
• Introduction
• Growth
• Maturity
• Saturation
• Decline

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Project Life Cycle Costing

The term ‘project life cycle cost’ has been defined as ‘it includes the costs associated with
acquiring, using, caring of physical assets, including the feasibility studies, research, design,
development, production, maintenance, replacement and disposal, as well as support, training
and operating costs generated by acquisition, use, maintenance and replacement of permanent
physical assets’.
The project life cycle costs of a capital asset can be grouped into three broad categories:
• Initial costs
• Operating costs
• Disposal costs

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Project Life Cycle Cost Iceberg

8.11. JUST-IN-TIME (JIT)

With a just-in-time (JIT) inventory system, a business receives products as close as feasible to
the moment they are actually required. As a result, if an auto assembly facility wants to install
airbags, it doesn't maintain a supply on hand; instead, it gets them as the cars are put together.
Schonberger defines JIT as “to produce and deliver finished goods just in time to be sold, sub-
assemblies just in time to be assembled into finished goods, fabricated parts just in time to go
into sub-assemblies and purchased materials just in time to be transformed into fabricated
parts”.
The just-in-time (JIT) inventory system reduces stock and boosts productivity. Because
manufacturers receive supplies and parts as needed for manufacturing and do not incur storage
costs, JIT production techniques reduce inventory costs. Furthermore, in the event that an order
is cancelled or not filled, manufacturers are not left holding extra inventory.
A vehicle manufacturer that runs with minimal inventory levels but significantly relies on its
supply chain to deliver the parts it needs to produce automobiles on an as-needed basis is one
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example of a JIT inventory strategy. As a result, the manufacturer only places an order for the
parts needed to assemble the automobiles after receiving one. Companies need consistent
production, excellent workmanship, faultless plant machinery, and trustworthy suppliers for
JIT manufacturing to flourish.
Features of JIT:
The main features of JIT are as follows:

• Operates as a ‘pull’ system, producing on demand i.e. ‘making to order’

• Uses small lot sizes and therefore, frequent production runs

• Aims to minimize set-up time

• Take steps to reduce process time

• Use a ‘kanban’ system to drive the usage of parts and control the flow of materials

• Uses planned production systems

• Uses process capability analysis

• Adopts TQM approach

Kaplinsky and Hoffman highlighted seven key elements of JIT as:

• Demand-driven production

• Multi-skill and multi-task work

• Flexibility in product and process

• Just in time production (Minimum inventory)

• Zero defect policies

• Giving responsibility back to the worker

• Worker involvement in technical improvements

8.11.a. Benefits of JIT Inventory Systems:
JIT inventory systems have a number of benefits over conventional methods. Short production
runs enable firms to switch swiftly from one product to another. This technique also lowers
expenses by reducing the requirement for warehousing space. Additionally, businesses spend

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less on raw materials because they only purchase what they need to produce the products that
have been requested.
8.11.b. Drawbacks of JIT Inventory Systems:

• The risk for supply chain disruptions is one of JIT inventory systems' drawbacks.

• The entire manufacturing line might be stopped if a supplier of raw materials

experiences a problem and is unable to deliver the products on time.

• The delivery of finished items to customers may be delayed by an unforeseen sudden

order for goods.

8.12. BACKFLUSH COSTING

Backflush accounting focuses on "post production issuing."

Backflush accounting is defined as ‘a cost accounting system which focuses on the output of
the organization and then work backwards to allocate costs between cost of goods sold and
inventory”
Product costing is postponed until things are finished under a Just-In-Time (JIT) operational
environment. Backflush accounting records expenses after the events, then uses standard costs
to "flush" out manufacturing costs. This eliminates expense tracking. Standard costs are used
to assign costs to units when journal entries to inventory accounts are made. The backflushing
procedure has two steps: one reports the created part to raise its amount on hand, and the other
relieves the inventory of all component parts. Component part numbers and quantities-per are
from the standard bill of material (BOM). This saves a lot compared to the old technique of a)
issuing component parts one at a time, usually to a discrete work order, b) receiving the finished
parts into inventory, and c) returning any unused components to inventory.
8.12.a. Features:
I. Backflush costing is an accounting technique created to track expenditures under
particular circumstances.
II. Backflush costing is often referred to as backflush accounting.
III. Companies that typically have short production cycles, commoditized products, and
low or constant inventories use backflush costs.
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IV. Backflush costing can be challenging to execute, and not all businesses can qualify to
perform it.

The thorough tracking of expenses, such as raw material and labour costs throughout the
manufacturing process, which is a component of traditional costing systems, is eliminated
when costs are "flushed" to the end of the production run. This enables the company to
streamline its expense tracking procedures, saving money on administrative and process costs,
but it may also limit the amount of detail that the organisation retains regarding specific
production and sales prices.
At the conclusion of the procedure, the entire cost of a production run is documented.
Therefore, businesses that use backflush costing typically work backward, figuring out how
much a product costs after it is sold, finished, or shipped. Businesses do this by putting a set
price on the products they make. Companies must eventually acknowledge the variations
between standard costs and actual costs because costs can occasionally vary.
The cost of a product is typically determined at numerous points along the production cycle.
Backflush costing is intended to streamline accounting procedures while reducing costs for
firms by getting rid of work-in-process (WIP) accounts.
8.12.b. Backflush Costing's pros and disadvantages
Theoretically, backflushing seems to be a reasonable solution to sidestep the numerous
challenges posed by ascribing costs to goods and inventory. Companies can save time and
money by not documenting costs during the various production steps. Backflush costing is an
accounting technique that businesses may utilise when looking for methods to cut their bottom
lines, but it isn't always simple to put into practise.
Backflushing, however, is not always an option for businesses and can be difficult to execute.
Additionally, backflush costing organisations lack a sequential audit record and may not always
adhere to generally accepted accounting principles. These are two major drawbacks of this
costing system.
Businesses that employ backflush costing should typically fit all three criteria:
Short production cycles: Products that require a lot of time to manufacture shouldn't be costed
backwards. It is harder and harder to appropriately assign standard costs as time goes on.

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Customized goods: Since the fabrication of customised goods necessitates the development
of a distinct bill of materials for each item created, the technique is not appropriate for this task.
Low or stable amounts of material inventory are present: The majority of production
expenses will flow into the costs of goods sold when inventories, or the variety of finished
items maintained by a company, are low rather than being postponed as inventory charges.

8.13. SUMMARY

• The unit covers Activity based costing, Target costing, Value chain Analysis,
Throughput costing, Life Cycle Costing, Backflush costing
• Value chain analysis assesses customer value.
• A corporation must price a new product based on comparable products on the market.
• Target costing lets a corporation set product prices, costs, and margins in advance.
• Theory of constraints fosters dialogue and appreciation for cost-cutters, who are
typically seen as reactionary and non-value-adders.
• Life cycle costing costs the cost object—product, project, etc.—over its predicted
lifespan. It describes a system that tracks and collects costs and revenues and attributes
to cost objects from inception to abandonment.
• Traditional cost accounting systems report cost object profitability weekly, quarterly,
and yearly. Life cycle costing does not. Life cycle costing tracks product-by-product
cost and revenue over numerous calendar months.
• Backflush accounting focuses on "post production issuing."

8.14. GLOSSARY

• Activity-based costing (ABC) assigns overhead and indirect costs—such as salaries

and utilities—to products and services.
• Backflushing is used in perpetual inventory systems. Periodic inventory management
is still used by small organisations with few goods.
• Cost management estimates, allocates, and controls project costs.
• JIT inventory management connects supplier raw-material orders with production
schedules.
• Life Cycle Costing Life cycle costing costs the cost object—product, project, etc.—
over its predicted lifespan. Describes a system that tracks and aggregates cost object
costs and profits from inception through abandonment.

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• Target costing Market-driven design entails calculating a product's cost and designing
it to match it.
• Tooling: Tooling up for production can entail establishing a production line costing
several millions of rupees, manufacturing expensive jigs, buying special purpose
machine tools, or otherwise making a substantial expenditure.
• Traditional cost accounting reports cost object profitability regularly, quarterly, and
annually.
• Value Chain Analysis: The value chain is a company's internal procedures to "create,
develop, sell, deliver, and support its product".

8.15. SELF ASSESSMENT QUESTIONS

1. Briefly explain the main difference between a job-order cost system and a process cost
system.
2. What is Activity based costing? Give examples of cost drivers commonly used to
allocate overhead costs to products and services.
3. What do you mean by Value chain analysis?
4. Explain the main differences between traditional and activity-based costing systems?
5. What are advantages of JIT inventory system? How does JIT helps decision making?
6. What is Target costing? How does it benefit? What are the stages of target costing?
7. Write short notes on:
• Theory of constraints
• Backflush costing
• Throughput accounting

8.16. REFERENCES
• Bhar. K.B. (2008) Cost Accounting, Methods & Problem, Academic Publishers.
• Lal, Jawahar & Srivastava, Seema (2009) Cost Accounting, 4th Edition, Tata
McGraw- Hill Education.
• Nigam, Lal B.M. & Jain I. C. (2001) Cost Accounting: An Introduction, PHI
Learning Pvt. Ltd.
• Thakur. S.K, (2009). Cost Accounting: Theory and Practice, Excel Books.

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• https://fundamentalsofaccounting.org/what-is-throughput-costing/
• https://efinancemanagement.com/costing-terms/backflush-costing

8.17. SUGGESTED READINGS

• Anthony, R.N., Hawkins, F.D., & Merchant, K.A. (2013).Accounting: Text and Cases
(13th Ed.).Tata McGraw Hill.
• Horngren, T.C., Datar, S.M., & Rajan, M.V. (2017). Horngren's Cost Accounting: A
Managerial Emphasis (16th Ed.). Pearson.
• Horngren, T.C.,Sundem, G.L., Schatzberg, J., & Burgstahler, D. (2014).Introduction to
Management Accounting (16th ed.).Pearson.
• Spiceland, D.,Thomas, W.M., &Herrmann, D. (2018). Financial Accounting (5th Ed.).
McGrawHill.
• Horngren, T.C., Datar, S.M., &Rajan, M.V. (2014). Cost Accounting, Student Value
Edition (15th Ed.). Pearson.

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LESSON 9
PERFORMANCE MEASUREMENT- BALANCED SCORECARD

Ms. Shalu Garg

Assistant Professor
University of Delhi
[email protected]

STRUCTURE

9.1 Learning Objectives

9.2 Introduction
9.3 Performance Measurement
9.3.1 Traditional Performance Measurement Techniques
9.3.2 Strategic Management Model
9.4 Balanced Scorecard
9.4.1 Meaning of Balance in Balanced Scorecard
9.4.2 Balanced Scorecard Example
9.4.3 Characteristics of Good Balanced Scorecards
9.4.4 Requisites of Balanced Scorecards
9.4.5 Perspectives or Factors in Balanced Scorecards
9.5 Performance Drivers and Weighting Performance Measures
9.6 Summary
9.7 Glossary
9.8 Answers to In-text Questions
9.9 Self-Assessment Questions
9.10 References
9.11 Suggested Readings

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9.1 LEARNING OBJECTIVES

In this lesson we will learn the concept of performance measurement, various traditional
performance measurement techniques and the limitations of these techniques. We will also be
going to learn the meaning of balanced scorecard, perspectives of scorecard. This chapter will
also teach us the characteristics of good balanced scorecards and requisites of the balanced
scorecards.
After studying this lesson, students will be able to:

• Understand the Performance Measurement.

• Explain the Traditional Performance Measurement Techniques.
• Get acquainted with Strategic Management Model.
• Explain the meaning, characteristics, requisites, factors, or perspectives of Balanced
Scorecards.
• Learn Performance Drivers and Weighting Performance Measures.

9.2 INTRODUCTION

Performance measurement is observing the spending plans or focusing on genuine

outcomes to lay out how well the business and its workers are working overall and as
individuals. Performance measurements can connect with short-term goals (for example cost
control) or long-term measures (for example consumer loyalty).
A balanced scorecard is an essential organization’s performance management that helps
organizations distinguish and work on their internal operations to help in improving their
external outcomes. It estimates past execution information and furnishes organizations with
criticism on the most proficient method to pursue better choices later.

9.3 PERFROMANCE MEASUREMENT

Comparing performances to established criteria in companies is how performance

measurement is defined. Performance evaluation is the methodical procedure used to assess an

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organization's efficiency and effectiveness. Measurements serve as the yardsticks that inform
us of our performance and motivate us to improve. Measuring involves observing how people
move and rating their performance in order to continuously improve. Performance
measurement is prepared to embrace change that helps organisations achieve the necessary
level of quality. Although measurement sounds simple and uncomplicated, it is a challenging
and time-consuming process.
D.S. Sink in his article 'Accomplishing World Class Quality and Productivity
Management; the Role of Measurement remarks:
Measuring is an art. In the long term, the vast majority of people who analyse the task of
developing measuring frameworks come to this conclusion. In fact, despite a worrying fact,
even those who are regarded as experts quickly admit that measurement is hard. Measurement
is difficult, disappointing, challenging, important, and handled improperly.
9.3.1 Traditional Performance Measurement Techniques:
The customary way to deal with performance depends on data and procedures
accessible in financial accounting, cost accounting and management accounting. The
conventional methods utilized by organizations are basically financial measures like ROI, RI,
net benefit, EPS, and so forth. The conventional methods are backward looking. That is, they
focus around past financial performance rather than on how administrators are making future
shareholder value.

Limitations of Traditional Performance Measurement:

a) Short-term Focused- Every activity is directed towards the present moment. Many
organisations collect information that is purely functional and financial. Numerous
financial and functional measurements can be found in all enterprises. We can
understand the organization's overhead costs, salaries, and benefits, as well as a few
other numbers derived from the accounting system. One of the reasons
organizations struggle to endure over an extended period of time is their singular
attention on the present. These organizations succeed for a brief period of time before
failing and eventually going out of business. Any organisation should think about the
following long-term measures:
i. Consumer loyalty
ii. Employee satisfaction

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iii. Item/administration quality

iv. Public responsibility measures

b) Outdated and Irrelevant Principles- The requirements of the modern business

environment must be taken into consideration because all traditional measures are
frequently based on out-of-date and unnecessary criteria.

c) Focus on Cost and Revenue Data, Less on Process- Performance measures place
more emphasis on cost and revenue data while putting less emphasis on the process. It
frequently provides irrelevant or false information. Financial outcomes that are the
primary focus of performance measures have passed the point at which meaningful
corrective action can be taken.
d) Lack Activity and Process Analysis- Performance measures lack the examination
of movement and interaction that is essential to choose worth-added and non-worth-
added movement and interaction. Business companies must determine whether
processes are capable of meeting customer requirements repeatedly.

e) Based on Tracking Single Dimensions of Performance- Performance measures are

dependent on the following discrete performance components and do not provide an
integrated or thorough understanding of performance. Administrators frequently learn
that they are ill-equipped to assess the effectiveness of their system implementation
since performance is only reviewed in clearly defined areas.

f) Encourage Competition and Discourage Teamwork- Traditional performance

measurements promote rivalry and discourage cooperation. Instead of comparing each
specialty unit's performance to its own performance and goals, performance reports
typically compare the performances of two specialty units. This is a common technique
to discourage teamwork. The individual in charge takes pride in their position and has
no desire to share any information with the other specialist units or sectors because they
like their job. When employees are informed of their position in respect to their co-
workers, the biggest threat arises. Teamwork is destroyed when people try to measure
themselves against others, whether they are ranked one or fifteen.

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The majority of performance appraisal frameworks also include elements that

encourage competitiveness while discouraging representative groupings from working
together. In many systems, people, not groups, are judged. Additionally, individuals, not
organisations, receive promotions and raises. A typical but harmful strategy in an organisation
seeking to promote a sense of participation and sharing is focusing solely on individual
performance proportions.
Johnson and Kaplan (1987) have voiced their concern as follows:
The organization's financial detailing framework generates the current administration
accounting data, which is beyond the point of no return, excessively collected, and too
deformed to even comprehend being applicable for the preparation and control decisions of the
chiefs.
Afterward, Kaplan refers explicitly to current business conditions which utilize
standards such as TQM, JIT, Design for Manufacture (DFM) and Flexible Manufacturing
System (FMS) finished up:
Existing frameworks for cost and performance estimation gave little inspiration to help
organizations' attitude to incorporate TQM, JIT, DFM, and FMS ideas into ongoing, continuous
improvement exercises. In certain occurrences, the customary financial exhibition measures
hindered the improvement exercises.

This worry demonstrates the dire requirement for taking a gander at better approaches
for finding progress wherever it is made without fundamentally evaluating any result in
financial terms.
Qualities of this new way to deal with estimating organizational performance are ideas
like the accompanying:
a) Less is better - focus on estimating the crucial few key factors as opposed to the numerous
variables.
b) Measures ought to be connected to the variables required for progress: key business drivers.
c) Measures ought to be a blend of past, present, and future to guarantee that the organization
is worried about each of the three viewpoints.
d) Measures ought to be based on the necessities of clients, investors, and other key partners.

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e) Measures ought to begin at the top and stream down to all degrees of workers in the
organization.
f) Various records can be consolidated into a solitary list to give a superior in the general
evaluation of performance.
g) Measures ought to be changed or possibly changed as the climate and methodology change.
h) Measures need to have targets or objectives laid out that depend on research as opposed to
inconsistent numbers.

9.3.2 Strategic Management Model:

In performance measurement, the challenge is estimating the appropriate variables and learning
to ignore other interesting data that does not help us advance to the next level in the model. To
start, we characterize what an organisation does and what the future goal is. The firm should
then identify the techniques and crucial success variables it needs to concentrate on to stand
out from rivals. The organisation also determines key business requirements on which it should
concentrate at this stage in order to maintain its success.
Company basics are typically matters on which all business organisations must concentrate,
such as benefit, development, or guidelines. A fundamental component of a business system is
selecting the main achievement elements for a company so that it can concentrate on the
designated performance areas. These may be advantages they will continue to exploit or flaws
that need to be fixed. The actions, or metrics, are derived from the major success factors and
business fundamentals. Clear objectives or goals should be established for each measurement
once the organization has identified the significant measures on its overall scorecard.
Research-based objectives should help the organisation realise its overarching goal. It is
important to check that each aim is cohesively related to the others so that a strong showing on
one metric doesn't result in a decline in performance on another. Following the identification
of the objectives or targets, activity plans that will enable their accomplishment should be
identified. Finally, to ensure that the exercises and performance are in line with the objectives
and aims, they must be monitored and controlled. It is also anticipated that performance reports
and follow-up reports contain relevant and useful information.

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IN-TEXT QUESTIONS
6. The performance measurement is the systematic assignment of numbers to the
_____ and results in the organization.
7. The traditional performance measurement is short-term focused. True/False.
8. Performance measures focus more on cost and revenue data. Yes/No.
9. Traditional performance measurement is not outdated. True/False.
10. Traditional performance measures encourage ________ and discourage
teamwork.

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9.4 BALANCED SCORECARD

Balanced Scorecard is a procedure of performance estimation created by Robert Kaplan, a

Harvard Professor and David Norton, an expert.
Kaplan and Norton remark on Balanced Scorecard (BSC) as follows:
The Balanced Scorecard (BSC) gives managers the tools they need to look for future significant
accomplishments. The Balanced Scorecard translates an organization's strategy and mission
into a comprehensive set of performance projections that provide the groundwork for a key
projection and the board framework. The fair scorecard places a strong emphasis on reaching
financial objectives while also taking into account the presentation-related factors that
influence these objectives. According to four adjusted points of view—financial, client,
internal business processes, and learning and development—the scorecard measures
authoritative performance. The BSC gives organisations the ability to monitor financial results
while also monitoring their progress in developing the capacities and acquiring the illusive
resources they require for long-term growth.
9.4.1 Meaning of Balance in Balanced Scorecard:
As per Atkinson, Banker, Kaplan, and Mark Young', to be adjusted, performance measurement
frameworks should meet two necessities:
1. In other words, the performance measurement framework should screen both the
organization's presentation and what the board accepts are the drivers of performance on the
organization's essential goals. They should reflect the comprehension organization might
interpret reasons for the successful performance of the organization's essential goals. This is
the most important aspect of adjustment.
2. The most fundamental views or distinguishing characteristics of organisational performance
should be quantified by the performance measurement framework. These viewpoints offer the
organisation its remarkable abilities to achieve its primary objective. This is the general
requirement for adjustment.
The balanced scorecard's main component is a set of performance estimates that
businesses use to monitor their progress toward both mandatory and optional goals. In this
view, the planning and procedure of the company characterise the focus and scope of the fair

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scorecard as well as the connections the business should forge with its personnel, suppliers,
and the community in order to achieve long-term success with its targeted clients.
9.4.2 Balanced Scorecard Example:
System: To continuously improve and adapt to our present environment in order to be the
leading organisation in our sector. Regarding the development of investor and client esteem,
employee learning and development, and our outstanding corporate citizenship, we shall
evaluate progress.
Balanced Scorecard Example:

9.4.3 Characteristics of Good Balanced Scorecards:

For balanced scorecards to be effective and helpful, the following traits must be present:
a) Focus on Cause-and-Effect Relationship- A balanced scorecard should highlight an
organization's process by putting an emphasis on the circumstances and logical linkages
between the results. Accept that Hindustan Unilever Ltd. wants to spend as little as possible
while advancing development. The balanced scorecards should specify clear objectives and
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gauge performance from a "learning and development point of view" that could advance
internal business procedures. Thus, they would lead to greater consumer loyalty, a larger
market share, higher worker wages, and greater shareholder profit.
b) Strategy translated to Coherent and linked set of Understandable and Measurable
Operational Targets- By converting the process into a logical and connected set of
understandable, achievable, and quantifiable functional targets, balanced scorecards should aid
in the communication of the methodology developed to all members of a company. In order to
implement the organization's system, directors and representatives take actions while taking
the scorecard into consideration. It is preferable over fostering scorecards at the division and
office levels to work with decisions and actions as per scorecards.
c) Emphasis on Financial Objectives and Measures- When evaluating how well a company
is performing financially, the balanced scorecard focuses a significant emphasis on financial
measurements and objectives. Although development, quality, and customer loyalty are
frequently prioritised by business executives, they may not always result in tangible benefits.
Non-financial indicators are seen as an essential component of a strategy or plan to attain and
enhance future financial performance in a balanced adjusted scorecard. When correctly paired
in modified scorecards, a variety of non-financial performance criteria serve as predictors of
future financial performance.
d) Critical Measures Only- The balanced scorecard reduces the number of measures used by
focusing only on the most fundamental ones. Avoiding a proliferation of measures focuses on
those that are essential for the successful execution of procedure.
e) Suboptimal Trade-offs- The scorecard illustrates the sub-optimal trade-offs that managers
may make if they don't take both functional and financial indicators into account. For instance,
a company that prioritises innovation could achieve unmatched short-term financial results by
cutting back on R&D expenditures. A balanced adjusted scorecard would demonstrate that
decisions may have been made that harmed the future in order to achieve the short-term
financial performance. Financial performance on the basis that R&D spending and R&D yield,
a proactive aspect of that presentation, have decreased.
9.4.4 Requisites of Balanced Scorecards:
In order to fit the organization's primary goals, a balanced scorecard requires a suitable
organising structure and an understanding of organisational processes. However, developing
and incorporating balanced scorecards for performance measurements are challenging tasks.

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Prior to adopting the balanced scorecard, organisations must meet the requirements listed
below.
a) Management should Define Organization’s Goals and Objectives- The executives
should describe the main objectives of the company. This is often advantageous because
the majority of benefit-seeking businesses have a clear objective in mind, namely to grow
shareholder value. The board should describe how leaders should accomplish each of these
goals in order to find companies that have fundamental aims that include both social and
owner wealth goals. Legislative bodies are examples of non-profit organisations where the
board should clearly state its objectives.

b) Organization’s understanding about Stakeholders and Processes- The company needs

to understand how stakeholders and processes contribute to its key objectives. Many
managers admit that this is dangerous. For instance, it is unclear from the organisational
behaviour literature if increased employee motivation actually results in improved worker
and benefit performance. Even if they work on large, high-quality projects, many
businesses genuinely don't understand how value affects performance and prefer to speak
in platitudes, such as "quality isn't a problem; you need quality just to play the game."

c) Development of Secondary Objectives by the Organization- The company should

support a number of secondary objectives that drive the achievement of primary objectives.
Perhaps the most challenging and important stage in implementing the balanced scorecard
is this one. This assignment must be completed with matching processes and results. The
organization should invest resources to support the methods it believes will produce results.
This project seeks answers to questions like how much should be invested on consumer
loyalty, representative preparedness, quality improvement, or superior strategy
frameworks. Such decisions should be made in light of an understanding of how increased
expenditure further develops process outcomes, such as further established customer
loyalty, which in turn improves the performance of the organization's key objectives.

d) Development of set of Measures to Monitor Performance on both Primary and

Secondary Objectives- The organisation should develop a number of metrics to monitor
performance on both primary and secondary goals. This is management accounting's
typical task. The question of where to find the relevant variable is brought up in this phase.
How does the organisation gauge the model's commitment or inspiration to the

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organisation? These performance indicators are crucial because they bring methodology
into sharp focus because the acts that people are instructed to supervise are what will
determine their performance. If the organisation chooses a bad set of policies, it will lead
to poor performance. Consider, for example, that the company, lacking the ability to assess
motivation, equates motivation with lavish incentive money and measures inspiration by
the amount of motivator compensation it provides to employees. However, compensation
for motivational forces may actually have a negligible long-term effect on inspiration.

e) Development of set of Processes with the Attendant Implicit and Explicit Contracts
with Stakeholders- To achieve those crucial objectives, the organisation should support a
number of processes and the associated implicit and explicit contracts with partners. The
balanced scorecard's suggested level of complexity is much higher than what is typically
done, despite the fact that this administrative necessity is unquestionably acknowledged.
For instance, many managers adopted the maxim "value at any cost" in light of the events
of the 1980s. Directors would evaluate the costs and benefits of proposals to go to the next
level of excellence under the balanced scorecard.

f) Specific and Public Statements must be made by Organizations- The

organization should express its beliefs about how processes lead to results in a clear and
open manner. Responsibility is based on public pronouncements, specific commitments to
courses of action, and anticipated outcomes. They address a part of the management risk in
this way since the board's shortcomings can be scrutinized more closely. This level of risk
can bother a lot of top managers. However, owners might find these candid statements
enlightening.

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CASE STUDY
A Case Study of a National Bank
A national bank believed a few years ago that the Internet would revolutionize the
way banks dealt with their customers and would force the bank to become a more agile
and customer-focused organisation. As a result, the bank replaced its previous scoring
system, which was 90% geared toward financial execution, with a fair scorecard.
Three "mark of appearance" metrics were highlighted on the scorecard, and these were
(i) Customer Fulfilment List and a Proportion of Consumer Loyalty.
(ii) A percentage of representative opinion and confidence is listed under employee
relations.
(iii) Comparative execution of a competitive position-conveyance strategy.
Required: Why did the bank include non-financial indicators and a fair scorecard in its
new execution estimation framework?

9.4.5 Perspectives or Factors in Balanced Scorecards:

The balanced scorecard consists of a number of performance goals and outcomes that
relate to the four performance components of financial, customer, internal process, and
innovation. It believes that businesses depend on a variety of partner groups, including
employees, suppliers, clients, local communities, and investors. The balanced scorecard
displays how well a firm does at setting goals and interacting with shareholders. Shareholders
can occasionally have a range of needs. Employees, for instance, depend on an organisation
for their business. Investors depend on a company to keep up with their bets. The company
needs to balance such conflicting needs. Therefore, the purpose of a balanced scorecard is to
assess how well a business is performing in light of the needs of its stakeholders.
The majority of firms use four points of view or four categories of performance
measures. The organization's system and activities are evaluated from a financial standpoint to

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Management Accounting

see if they benefit investors. The financial perspective shows how well the approach and
activities help to work on the organization's financial well-being for companies that try not to
have investors. The perspective of the client shows how the organization's methods and
endeavours benefit clients. The internal business and creation process viewpoint displays the
ability of the internal business processes to raise client value and further the development of
investor wealth. The framework for development and long-term development is strong, as
shown by the learning and development perspective. Through its four perspectives, the
balanced scorecard system demonstrates its power by providing a comprehensive view of
corporate value.
These four viewpoints have been briefly discussed underneath:

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ACTIVITY
Produce is transported by Mahindra & Mahindra Trucking from farms to
markets. According to the entity's mission statement, "We strive to be the
industry leader in cost-effective and timely supply of produce," its managers
made the decision to establish a balanced scorecard. For each of the four
perspectives in the balanced scorecard for Mahindra & Mahindra Trucking,
provide two alternative performance measurements.

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i) Financial Perspective

Since for-profit firms use financial execution measures like net gain and return on
investment, the balanced scorecard makes use of these. Financial performance indicators
provide a common vocabulary for analysing and examining businesses. Financial
institutions and investors are two examples of people that donate assets to businesses, and
they heavily rely on financial execution criteria when deciding whether to lend money or
provide reserves. Financial measures that are properly developed can provide a
comprehensive view of an organization's success.

Financial indicators by themselves do not provide progress-motivating forces. Financial

measures are vital but cannot serve as a guide or aid in adding value to performance because
they only reflect the past and not the future.

As per Brown,' a sound way to deal with financial estimation is to ensure that your
information base incorporates three sorts of data:
i. Historical Data: How did we in all actuality do last month, last week, this year,
last year, etc?
ii. Current Data: How are we doing at present, today?
iii. Future Data: How will we be doing in the following couple of months or years?

From a financial perspective, a business exists to generate wealth for its owners. A
company can monitor who is winning and how successfully it is generating wealth by using
yield metrics or other verifiable financial measures. Because they are based on events that
have already occurred, this information is always past tense: our net profit for the year
compared to last year, our deals income this year compared to last year, and our usual offer
value this month compared to last month. These are historical indicators of company
performance. Any financial information that is included in a report for investors or other
partners would typically be considered to be authentic information.

The amount of money the company has on hand or the total value of its resources in relation
to its liabilities are additional aspects of financial data. This accounts for a respectable
amount of an organization's overall financial health. These financial metrics should provide
an answer to the question, "How are we performing today?"

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The third type of financial data needed for a comprehensive set of measurements is used to
predict how the company will display its finances in the future. These projections are used to
project future asset and responsibility needs. The amount invested in innovative work relative
to deal income or benefit is another typical future-focused financial assessment. Organizations
usually cut back on these expenses during difficult times, which can make them contract their
future for the aim of short-term financial profits. If the company intends to expand into
untapped or emerging market segments, growth in deals from a certain region or industry may
also be a financial indicator for the future.

ACTIVITY
Imagine a car dealership decided to stop paying sales commissions to employees
and instead offer a salary with bonuses for good customer satisfaction ratings.
What issues could arise financially for the dealership, in your opinion?

CASE STUDY
A business manager delivers the following phrase: "The alliance enhances the
worth of investors, as shown by the financial perspective of the decent scorecard. I work
with two organisations: a sanctuary believe that does not have investors and a private
firm that is an organisation. Although the fair scoring seems fine to me, the financial
perspective is plainly unnecessary for these two associations."

Required: How would you respond to this claim?

ii) Customer Perspective

Managers understand the client and market segments in which the specialty unit will
compete as well as the proportions of the specialty unit's performance in these targeted
segments from the perspective of the client as seen through the lens of the Balanced

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Scorecard. This viewpoint frequently includes a few fundamental or traditional indicators

of the effective outcomes from a thoroughly developed and applied process. Consumer
loyalty, client maintenance, gaining new clients, client benefit, and market share in targeted
areas are all included in the key result measures.

However, the customer's perspective should also include details of the offers that the
company will provide to customers in particular market segments. The target specific
drivers of core client results speak to the essential elements that influence a client's decision
to switch providers or remain loyal to their current ones. Clients may value, for example,
short lead times and timely delivery, a steady flow of innovative goods and services, or a
supplier prepared to anticipate their changing needs and capable of developing new goods
and strategies to meet those demands. The client point of view gives specialist unit
managers the ability to describe the market- and client-based methodology that will
produce the majority of future financial returns.

In many businesses, the primary measurement group of client outcomes is standard. The
primary estimation category includes indicators of:
i. Share of the overall industry
ii. Client maintenance
iii. Client procurement
iv. Consumer loyalty
v. Client benefit

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CASE STUDY
A Case Study of Household Products Division, a maker of kitchen dishwashers
The Household Products Division, which manufactures kitchen dishwashers, is
led by Ashok Dhawan, who just saw the division's fair rating for 2016. Amit, the
division's administrative bookkeeper, is summoned right away to his office for a
meeting. "I believe that the consumer loyalty and representational fulfilment
percentages are very low. These figures are based on an erratic sample of emotional
assessments conducted by various supervisors and client delegates. My personal
experience is that we are doing particularly well in both of these areas. I believe that by
revealing such low scores for representative and customer loyalty, we are doing our
organisation and ourselves harm until we do a thorough assessment of employees and
clients at some point in a year. At the division commanders' meeting in a month, these
results will make us seem bad. We wish to increase these figures. Even though Amit is
aware that the representative and customer loyalty scores are hypothetical, his method
for the current year was the same as his past methods. He was aware from the comments
that he had asked that the scores take into account the suffering of representatives due to
the most recent work regulations and the despair of clients due to delayed deliveries. He
also understood that these problems will be resolved in due course.
Required:
1. How about the Household Products Division's respectable scorecard include random
measurements of representative fulfilment and customer loyalty? logically explain.
2. How should Amit to react?

Source: Lal, J. (2017). Advanced Management Accounting (Text, Problems & Cases)

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Management Accounting

iii) Internal Business Process Perspective-

Managers understand the fundamental internal business processes that the organisation needs
to flourish from this perspective. These procedures give commercial entities the ability to:
• Communicate the offers that will entice and retain customers in specific market categories.
• Meet investor expectations for great financial returns.
Any firm can achieve greatness if its processes are managed to produce reliable products and
services. The correct procedures being followed correctly results in consistent levels of product
and service quality. Finding the proper process components to measure and establishing
guidelines that are appropriate for the performance levels of each process measure are difficult
tasks. Edge estimations that are even more present-focused are driven by process and functional
measurements. These are the measurements that are frequently and probably regularly
observed.
Even some interaction elements are observed to ensure the development and supervision of
great goods and services. Excellent process or functional measure execution results in high-
quality goods and services, which, in turn, produce thrilled or satisfied customers, who then
encourage repeat business and support an organization's long-term survival and success.
Process measures provide the data necessary to predict and manage the nature of goods and
services. When a problem with products or services arises, the root cause is typically found by
looking at the process data.
For all organisations, results and outcomes matter. Truth be told, they might be
overwhelmingly important. However, it is also important to consider how those achievements
are achieved in the process measures.
According to Brown, successful companies gauge their operational outcomes and business
processes in the following ways:
a) Cycle Time- Process duration for all key cycles is estimated.

b) Rework Time- Revise time as well as expenses are followed for key creation and
administration conveyance processes.

c) Key Measures of Productivity- Key proportions of efficiency are recognized and followed
for significant process in the organization.

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d) Identification of Key Measures- Key processes have been recognized in each unit,
capability, and division of the organization, and handle measures have been characterized
for each vital process.

e) Correlation of Process Measures- Process measures furnish with the information

expected to foresee and control the quality of items and administrations.

f) Setting of Standards or Goals- Guidelines or objectives are set for all key process
measures, and those norms depend on benchmark organizations and client prerequisites.

g) Preventive Approach- Process measures elevate a preventive way to deal with

accomplishing reliably high-quality products and services.

h) Development of Safety Index- The organization has fostered a general security record that
is followed no less than once a month and comprises of a few result estimates like lost-time
mishaps, as well as various preventive or social measures.

i) Future-Oriented Process- A couple of future-situated process measures are followed that

will assist with guaranteeing long-term survival and achievement.

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Management Accounting

iv)Learning and Growth Perspective

For incentive purposes, the learning and growth viewpoint concentrates on the abilities
of individuals. Managers would be liable for creating worker capacities. Key measures for
assessing managers' performance would be worker satisfaction, worker maintenance, and
employee efficiency.

a) Employee Satisfaction: Employee fulfilment perceives the significance of worker

assurance for further developing efficiency, quality, consumer loyalty, and
responsiveness to circumstances. Managers can measure employee fulfilment by
sending reviews, talking with workers, or on the other hand noticing employees at work.

b) Employee Retention: Firms focused on holding workers perceive that employees

develop organization-specific intellectual capital and give an important non-monetary
resource to the organization. Moreover, firms cause costs when they should find and
recruit great ability to replace individuals who leave. Firms measure worker
maintenance as the inverse of employee turnover-the percent of individuals who leave
every year.

c) Employee Productivity: Employee efficiency perceives the significance of output per

employee. Employees make actual results (i.e., miles driven, pages delivered, or lawns
cut), or monetary results (i.e., income per employee or benefits per worker). The
number of credits handled per credit official each month would give a straightforward
proportion of efficiency for loan officers at a bank.

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ACTIVITY
Government agencies and social service organisations, for example, have
financial systems that budget expenses as well as track and manage actual
spending. Explain why these organisations ought to think about creating a
balanced scorecard of metrics for performance monitoring and reporting. What
other viewpoints should this balanced scorecard of measurements include?

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Management Accounting

CASE STUDY
A Case Study of Hero Honda Bikes Company
The phrase "The financial point of view Hero Honda Bikes (HHB) needs to
carry out a competent scorecard" is provided by a business manager. Its mission
statement is, "We manufacture top-notch, durable bicycles at rock-bottom prices." The
substance's rigorous process entails continuously improving the utility, dependability,
and quality of its bicycles while holding competition-level demonstrations. The material
now produces three different types of trailblazing bicycles through three separate units
that are coordinated around the product offered for each type. Engineers are now
making progress on the designs for the assembly system for the fourth bicycle line
improvement, which includes a finished blueprint. HHB operates an online store where
bicycle shops can place orders for customised items and sells directly to them.
Required:
(a) Describe the fair scorecard's execution cycle at HHB.
(b) Describe the four perspectives of the fair scorecard and list at least one execution
goal for each perspective that HHB should consider.
(c) Choose one execution goal for each viewpoint, while keeping in mind that there may
be two or more potential measures. Understand the relationship between each activity
and the work done on the financial execution.
(d) Outline the benefits and drawbacks of implementing a fair scorecard for HHB.

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IN-TEXT QUESTIONS

11. The External Business perspective is a part of balanced scorecard. True/False

12. Employee retention, employee productivity and employee_____ is the part of
learning and growth perspective.
13. The Financial perspective is a part of balanced scorecard. True/False
14. In Internal perspective of balanced scorecard _____time for all key process are
measured.
15. Financial perspective of balanced scorecard studies historical data, current data
and ____data.

9.5 PERFROMANCE DRIVERS AND WEIGHTING PERFORMANCE

MEASURES

Performance Drivers:
Results metrics and performance drivers should be mixed in a well-balanced scorecard.
Without execution drivers, result measures cannot explain how the results are to be achieved.
They also don't provide a quick indication of how well the strategy is being used. However,
performance drivers such as process lengths and Part-Per-Million (PPM) imperfection rates
without result measures might enable the specialty unit to achieve short-term functional
improvements but will fail to reveal whether the functional improvements have been translated
into increased business with both current and new clients and, in the end, to improved financial
execution. The results (incidental results) and execution drivers (driving marks) of the
specialist unit's process should be properly balanced in a balanced scorecard.

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ACTIVITY
The "Balanced Scorecard" strategy attempts to give management information to
aid in the creation and implementation of strategic policy. It emphasises the
necessity of giving the user a set of data that covers all pertinent performance
areas impartially and objectively.
Requirements:
(i) Describe in basic terms the primary type of information that a manager would
need to use this method of performance measurement;
(ii)Comment on three specific examples of performance metrics that might be
utilised by a business in the service sector, such a consulting firm.

Four Perspectives: Are they Sufficient

The reasonable scorecard's four points of view should be viewed as a layout rather than
a restriction. There is no quantitative hypothesis to show that four points of view are both
necessary and sufficient. The organization's owners and capital contributors are identified on
each scorecard through financial goals and metrics. Since customers are essential to achieving
the financial goals, client measures are also included on each scorecard (from the client's
perspective). When exceptional performance along this aspect can prompt advancement
execution for clients and investors, objectives and measures for workers appear on the
reasonable scorecard.
Organizations almost never employ less than four points of view, although in some cases, at
least one additional viewpoint may be necessary due to market conditions, a speciality unit's
system, and other factors. For instance, some managers take into account the interests of other
important partners, such as suppliers and the neighbourhood. The internal business process
viewpoint of the company should be combined with result and execution driver metrics for
provider connections at the point when connections are crucial for the strategy driving forward
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client and financial execution. Targets and metrics for that perspective also become an essential
component of an organization's scorecard when exceptional natural and local area performance
is the system's focal point.

Weighting Performance Measures:

For each of the four points of view or elements, the organisation using a reasonable
scorecard will construct three to five performance metrics. The actions are then linked to the
organization's method for advancement. The method for weighing various performance
estimations is problematic for those who create adjusted scorecards. Assigning a set weight to
each presentation metric (for example, 15% of the overall presentation score will be based on
customer loyalty) ignores adaptability when assessing performance and fails to take into
account challenges that arise unexpectedly during the display period.
For instance, while it is typical for planners to give consumer loyalty a weight of 15%,
a particular division did outstanding work to increase consumer loyalty. Such execution should
be rewarded by senior administration more than the 15% weighting suggests. According to
research, the use of adaptability might lead to concerns about bias. For instance, shifting
workloads to execution measurements after the exhibition time frame and combining emotional
execution assessments are two examples.

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CASE STUDY
A Case Study of Rastogi & Co.
New Delhi's Rastogi & Co. is a legal practise. The company has a very informal
and laid-back management style that has previously worked effectively for it. Rastogi &
Co., however, has not been gaining new customers as quickly as more competitive legal
firms. Mahesh, the managing partner, learned about the balanced scorecard when he
recently attended a conference on performance monitoring in legal companies. He
believed it might be a useful tool for Rastogi & Co., one that would let the company
maintain its ethos while still acting more fiercely to attract new clients. The following
strategic objectives were determined by Mahesh to be compatible with the firm's score
values and to offer a framework for monitoring the firm's progress toward its objectives:
Financial
(a) To steadily increase the firm's revenues and profits.
Customer
(a) To understand the firm's customers and their needs.
(b) To value customer service over self-interest.
Internal Business Process
(a) Encourage knowledge sharing among the legal staff.
(b) To communicate with each other openly, honestly, and often.
(c) To empower staff to make decisions that benefit their clients.
Organisation Learning
(a) To maintain an open and collaborative environment that attracts and retains the best
legal staff.
(b) To seek staff diversity.
Required:
(i) Develop at least one measure for each of the strategic objectives listed.
(in) Explain how Rastogi & Co. can use this balanced scorecard to evaluate staff
performance.
(ii) Should staff compensation be tied to the scorecard performance measures? Why or
why not?

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IN-TEXT QUESTIONS
17. A good balanced scorecard is the one which have outcome measures. True/False
18. The balanced scorecard contains ____ number of perspectives.
19. A good balanced scorecard is not necessarily contained performance drivers.
True/False.
20. Customer ______ plays a huge role in weighting performance measures.
21. The four perspectives of the balanced scorecars should be considered as a
template. Yes/No.

9.6 SUMMARY

We have learned about balanced scorecards and performance measurement in this lesson. The
reasonable scorecard is a management tool designed to turn an organization's primary goals
into a series of hierarchical performance goals that can then be estimated, checked, and
modified as necessary to ensure that an organization's primary goals are achieved.
The monetary accounting measurements that businesses often use to monitor their
primary goals are insufficient to keep businesses on track, which is a key justification for the
balanced scorecard approach. Financial results provide information about what has already
happened, not about where the business is or should be heading. By adding additional variables
that evaluate performance in areas like customer loyalty and product development to monetary
indicators, the reasonable scorecard framework hopes to provide partners with a more
comprehensive picture.

9.7 GLOSSARY

Correlation: The relationship between two factors or variables under study.

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9.8 ANSWERS TO INTEXT QUESTIONS

1. Performances 9. Cycle
2. True 10. Future
3. Yes 11. True
4. False 12. Four
5. Competition 13. False
6. False 14. Satisfaction
7. Satisfaction 15. Yes
8. True

9.9 SELF-ASSESSMENT QUESTIONS

6. In what way customer perspective is important in balanced scorecard? [Source:

Lal, J. (2017). Advanced Management Accounting (Text, Problems & Cases)]
7. What problems arise if any, from monitoring and rewarding senior executives
by a combination of financial and non-financial measures? [Source: Lal, J. (2017).
Advanced Management Accounting (Text, Problems & Cases)]
8. When implementing balanced scorecard, why do some managers use a different
term to describe it. [Source: Lal, J. (2017). Advanced Management Accounting (Text,
Problems & Cases)]
9. Discuss the importance of balanced scorecard for a not-for-profit organization.
[Source: Lal, J. (2017). Advanced Management Accounting (Text, Problems & Cases)]

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9.10 REFERENCES

• F. (2021, May 6). Where Performance Measurement Fits Into a Small Business. Small
Business Success in Wilmington, NC! https://small-business-success-
wnc.com/performance-measurement-fits-into-small-businesses
• Veyrat, P. (2019, May 3). 3 Balanced Scorecard Examples and their Application in
Business. HEFLO BPM. https://www.heflo.com/blog/balanced-scorecard/balanced-
scorecard-examples/
• Getz, A. (2020). Balanced Scorecard Defined. BI / DW Insider. https://bi-
insider.com/business-intelligence/balanced-scorecard-defined/
• Dudic, Z. (2019). The Innovativeness and Usage of the Balanced Scorecard Model in
SMEs. MDPI. https://www.mdpi.com/2071-1050/12/8/3221
• Todd, R. J. (2021). From Net Surfers to Net Seekers: The WWW, Critical Literacies
and Learning Outcomes. IASL Annual Conference Proceedings, 231–242.
https://doi.org/10.29173/iasl8173
• Stamoulis, K., & Mark Spearing, S. (2004). Influence of Macro- and
Nanotopography, Thin Film Thermomechanical Behavior and Process Parameters on
the Stability of Thermocompression Bonding. MRS Proceedings, 854.
https://doi.org/10.1557/proc-854-u9.11
• Evolute Consulting. (2018). A. https://evolute.be/reviews/bsc.html

9.11 SUGGESTED READINGS

• Lal, J. (2017). Advanced Management Accounting (Text, Problems & Cases). S

CHAND & Company Limited.

• Arora, M. N. (2016). COST AND MANAGEMENT ACCOUNTING. Penguin Random

House.

**************LMS Feedback: [email protected]**************

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Management Accounting

LESSON 10
INVENTORY MANAGEMENT
Jigmet Wangdus
Assistant Professor
DDCE/SOL/COL
University of Delhi
[email protected]

STRUCTURE

10.1 Learning Objectives

10.2 Introduction
10.3 Inventory Management
10.3.1 Meaning and Types of Inventories:
10.3.2 Meaning of Inventory Management
10.3.3 Significance of holding inventory
10.3.4 Objectives of Inventory Management
10.3.5 Factors affecting the level of Inventory

10.4 Cost associated with Goods for Sales

10.5 Tools and Techniques of Inventory Management and Control
10.5.1 Determination of Stock Levels
10.5.2 ABC Analysis
10.6 Economic Order Quantity (EOQ) Decision Model
10.7 Just in Time (JIT)
10.7.1 Features of JIT
10.7.2 Elements involved in JIT
10.7.3 Advantages of JIT
10.7.4 Disadvantages of JIT
10.8 Method of Inventory Valuation
10.8.1 Cost Price Method
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10.8.2 Average Price Method

10.8.3 Notional Price Methods
10.9 Solved Practical Questions
10.10 Summary
10.11 Answers to In-Text Questions
10.12 Self-Assessment Questions
10.13 References
10.14 Suggested Readings

10.1 LEARNING OBJECTIVES

After studying this lesson, you will be able to understand:

● Meaning and definition of Inventory
● Objective and Management of Inventories
● Tools and techniques of Inventory management and control
● Method of Inventory valuation.

10.2 INTRODUCTION

In this lesson we will understand the meaning of inventory and inventory management, the
need and the objective of holding inventories, factors affecting the level of inventory, tools and
techniques of inventory management and methods of inventory valuation. Every organization
which is into production, trading, sale and service of a product will necessarily hold stock of
various physical resources to aid in future consumption and sale. The organizations hold
inventories for various reasons, e.g. speculative purposes, functional purposes, physical
necessities etc.

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10.3 INVENTORY MANAGMENT

10.3.1 Meaning and Types of Inventories:

Inventory is the assets a business intends to sell to customers for profit. Inventory describes the
stockpile of the item(s) a business is selling as well as the individual items that make up the
item. To put it another way, the inventory is utilised to indicate the total amount of the tangible
assets that are:
• held for sale normally as part of operations.
• in the production phase for such a transaction.
• To be currently consumed in the production of goods or services to be available for
sale
The inventory may be classified into three categories:
Raw materials and supplies: It refer to the unfinished goods used in the process of
manufacturing.
Work in Progress: It describes semi-finished goods which are not 100% complete but some
work has been done on them.
Finished Goods: It refers to the goods on which all work has been completed and they are
ready for sale.
10.3.2 Meaning of Inventory management:
Inventory management is the technique of managing and controlling the ordering, storage, and
use of components that a business employs in the production of the goods it sells. Inventory
management is a part of supply chain management which regulates the movement of products
from producers to warehouses and from these locations to points of sale. Inventory control
entails effectively managing the money spent on supplies, raw materials, work-in-progress, and
finished goods.
10.3.3 Significance of holding inventory:
One of a company's most valuable assets is regarded as its inventory. Inventory management
must be precise, effective, and proactive. Every business need inventory to guarantee that the
production process runs smoothly, to lower the ordering cost of inventory, to take advantage
of quantity discounts, to avoid missing out on sales opportunities, to maximise and optimise
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plant capacity, and to reduce the total price. As a result, inventory must be maintained in an
appropriate quantity and is therefore necessary. However, the idea of Just In Time (JIT), which
is an inventory strategy used by businesses to boost productivity and cut waste by acquiring
products only as they are required in the production process, is gaining popularity. JIT lowers
the inventory costs but require producers to forecast demand accurately.
10.3.4 Objectives of Inventory Management
Maintaining right level of inventory is the objective of inventory management to prevent excess
or shortfall of inventory. Inventory management systems reduce the cost of carrying inventory
and guarantee a steady supply of raw materials and finished goods throughout the cycle of
business operations. The objectives can be separated into the two categories listed below:
• Operating objectives: They are related to the operating activities of the business like
purchase, production, sales etc.
a. To ensure a steady supply of materials.
b. To guarantee a continuous flow of production.
c. To reduce the risks and losses incurred due to inventory shortages.
d. To ensure enhanced customer services.
e. Reducing the risk of stockouts.
• Financial Objectives:
a. To reduce the capital investment in the inventory.
b. To reduce the cost of inventories.
c. Economy in the purchase.
Inventory management places a strong emphasis on reducing the negative effects of
having excess inventory in addition to the goals. The following effects resulted from
holding surplus inventory:
• Unnecessary investment of funds and reduction in profit.
• Increase in holding costs.
• Loss of liquidity.
• Deterioration in inventory

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10.3.5 Factors affecting the level of inventory

The level of inventory should be appropriate. There are several factors which determine
the appropriateness level of inventory. Some of the important factors are explained
below:
• Nature of Business: Whether a retail business, a wholesale business, a
manufacturing business, or a trading business, the level of inventory will depend
on the nature of business.
• Inventory turnover: Inventory turnover discusses the quantity and frequency of
sales of inventory. It directly affects the amount of inventory a businesses need
to maintain.
• Product type: The goods sold by the businesses could be either durable or
perishable goods. Consequently, maintaining the inventory is required.
• Economics of production: The volume of inventory retained is also influenced
by the size at which manufacturing is done. A company might operate on a huge
scale to take advantage of the economies of production.
• Inventory Costs: The business will incur additional operating expenses as more
inventory is kept on hand. Inventory retained must be balanced against the entire
cost of inventory, which includes purchase cost, ordering cost, and holding cost.
• Financial position: The supplier's credit terms can occasionally be rigid and
the credit period can be quite short. The inventory must then be maintained in
accordance with the company's financial status.
• Duration of Operating cycle: If the operating cycle duration is long, it will also
take a long time to realise the money from the sale of inventory. As a result, the
managed inventory should match the operational cycle's time and the need for
working capital.
• Management Attitude: The top management may embrace the idea of zero
inventories or hold a high level of inventories. Accordingly, the inventory
policy will be designed for the business.

10.4 COST ASSOCIATED WITH GOODS FOR SALES

Companies must effectively manage costs that fall into the following six categories in order to
effectively manage inventories and increase net income:

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• Purchasing costs include the price of incoming freight as well as the price of goods
purchased from suppliers. Generally, the largest cost category for goods for sale is
comprised of these costs. Purchase costs are impacted by discounts for different
purchase order sizes and supplier payment terms.
• Ordering costs occur during the preparation and issuance of purchase orders, the
acquisition and inspection of the ordered goods, and the matching of invoices
received, purchase orders, and delivery records to determine payments. The price of
getting purchase approvals is included in the ordering costs, along with any additional
fees for special processing.
• Carrying costs arise while holding an inventory of good for sale. The opportunity cost
of the investment tied up in inventory and the other cost associated with storage such
as insurance, rent of warehouse, obsolescence and spoilage all are included in carrying
costs.
• Stockout costs arises when a business runs out of a specific item that customers are
demanding. In order to satisfy that demand, the business must act quickly to replenish
inventory or suffer the costs of not meeting it. In order to address a stockout, a business
may expedite an order from a supplier, which can be costly due to additional ordering
and transportation costs. Or the stockout might result in the company losing sales. The
opportunity cost of the stockout in this instance consists of the contribution margin lost
on the unrealized sale as well as any contribution margin lost on upcoming sales as a
result of unfavourable customer behaviour.
• Quality costs incurs when a product or service's features and characteristics do not
meet customer requirements. The four types of quality costs are as follows: (prevention
costs, appraisal costs, internal failure costs, and external failure costs)
• Shrinkage Cost are caused by employee fraud, theft by outsiders, misclassifications,
and clerical errors. Shrinkage is measured by the difference between the cost of the
inventory when physically counted and the cost of the inventory recorded on the books
in the absence of theft and the other incidences. Shrinkage is a key indicator of
management effectiveness.

10.5 TECHNIQUES OF INVENTORY MANAGEMENT AND CONTROL

An efficient control system for inventories is necessary for effective inventory management.
Proper inventory management not only aids in resolving the urgent liquidity issue, but also

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boosts profits and significantly lowers the company's need for working capital. The following
are crucial methods and tools for managing and controlling inventory:

1. Determination of Stock Levels.

2. Determination of Economic Order Quantity
3. A.B.C. Analysis
4. VED Analysis
5. Just in Time Inventory
10.5.1 Determination of Stock Levels:
Both carrying too much, and too little inventory is detrimental for the business organisation. A
low inventory level will result in frequent stock-outs and high ordering costs, while a high
inventory level will result in unnecessary capital ties up. A company must therefore maintain
an ideal level of inventory to ensure that inventory costs are kept to a minimum while also
preventing stock-outs, which could lead to sales loss or a halt in production. Different stock
levels are discussed in this circumstance.

(a) Minimum Level: This represents the amount that must always be on hand. The work will
stop due to a lack of supplies if stocks fall below the minimum level. When determining the
minimum stock level, the following factors are taken into consideration.
Lead Time: A purchasing company needs some time to process the order, and a supply
company needs time to carry out the order. Lead time refers to the period of time needed
to process the order before it is executed.

Rate of Consumption: It is the average consumption of materials in the factory.

Utilizing past performance and production plans, the rate of consumption will be
determined.

Nature of Material: The minimum level is also influenced by the nature of the
inventory. A minimum amount of stock is not necessary for materials that are only
needed for special orders from customers.

Minimum stock level = Re-ordering level-(Normal consumption x Normal Re-

order period).

(b) Re-ordering Level: A new order is sent to obtain materials when the quantity of materials
reaches a specific level. Prior to the materials reaching the minimum stock level, the order is
sent. The level of reordering is fixed between the minimum and maximum level. When
determining the reorder level, the rate of consumption, the number of days needed to replenish
the stock, and the maximum amount of material needed on any given day are all taken into
consideration.
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Re-ordering Level = Maximum Consumption x Maximum Re-order period.

(c) Maximum Level: It is the quantity of materials beyond which a firm should not exceed its
stocks. Overstocking occurs if the quantity exceeds the maximum level allowed. Overstocking
should be avoided by a business as it will increase material costs.

Maximum Stock Level = Re-ordering Level+ Re-ordering Quantity -(Minimum

Consumption x Minimum Re-ordering period).

(d) Danger Level: It is the level beyond which materials should not fall in any case. If danger
level arises then immediate steps should be taken to replenish the stock even if more cost is
incurred in arranging the materials. If materials are not arranged immediately there is
possibility of stoppage of work.

Danger Level = Average Consumption x Maximum reorder period for emergency

purchases.

(e) Average Stock Level

The average stock level is calculated as such:
Average Stock level = Minimum Stock Level +½ of re-order quantity

Illustration 1:
In a manufacturing company, a material is used as follows:
Re-order quantity = 3,600 units
Maximum consumption = 900 units per week
Minimum consumption = 300 units per week
Normal consumption = 600 units per week
Re-order period = 3 to 5 week

Calculate: a) Re-order level; b) Minimum stock level; c) Maximum stock level.

Solution:
Reorder level = Maximum consumption × Maximum re-order period
= 900 × 5 = 4,500 units
Minimum Stocks level = Re-order level – (Normal consumption × Normal re-order
period)
= 4500-(600× 4) = 2100 units
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Note: Normal re-order period is the average period.

Maximum Stock Level = Re-order level + re-order quantity – (Minimum consumption×

Minimum re-order period)
= (4500 + 3600) – (300 × 3) = 7,200 units.

Illustration 2:
In a manufacturing company, a material is used as follows:
Maximum consumption - 12,000 units per week
Minimum consumption - 4000 units per week
Normal Consumption - 8000 units per week
Re-order quantity - 48000
Time required for delivery - Minimum : 4 weeks, Maximum : 6 weeks
Calculate : a) re-order level, b) Minimum level, c) Maximum level; d) Danger level and
e)Average stock level.

Solution:
Reorder level = Maximum consumption × Maximum re-order period
= 12000 × 6 = 72,000 units
Minimum Stocks level = Re-order level – (Normal consumption × Normal re-order period)
= 72,000 - (8000× 5) = 32,000 units
Maximum Stocks level = Re-order level + Re-order quantity + (Minimum consumption ×
minimum re-order period)
= 72,000 – 48,000-(4000 ×4) = 1,04,000 units
Danger Level = Average consumption × Maximum re-order period for
emergency purchases
= 8000 × 2 week = 16000 units
Average Stock Level = Minimum level + ½ (48000) = 56,000 units

10.5.2 ABC Analysis

ABC (Always Better Control) analysis is believed to have originated in General Electric
Company of America. It is based upon the classification of inventory for selection control. It
measures the monetary value i.e., cost significance of each inventory/material in relation to
total cost and inventory value. The logic behind this kind of analysis is that the management
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should study each item of stock in terms of its usage, lead time, technical or other problems
and its relative money value in the total investment in inventories. Critical, or high value, items
require very close attention, while low valu
e items require the least amount of expense and effort when it comes to inventory control.

Under ABC analysis, the various stock items can be ranked according to their average material
investment or according to their annual rupee usage. Materials segregation or inventory control
involve several crucial steps, including:
(i) Find out how much of each stock item will actually be used in the future for the review
and forecast period.
(ii) Determine the price per unit for each item.
(iii) Determine the total project cost of each item by multiplying its expected units to be
used by the price per unit of such item.
(iv) Beginning with the item with the highest total cost, arrange different items in order of
their total cost as computed under step (iii) above.
(v) Express the units of each item as a percentage of total costs of all items.
(vi) Compute the total cost of each item as a percentage of total costs of all items.

If it is convenient different items may be classified into only three categories and labelled as
A, B, and C respectively depending upon whether they are high value items, middle value items
or low value items. If need be, percentage of different items may be plotted on a chart. The
entire working of ABC analysis may be explained with the help of the following simplified
example:

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VED Analysis: Vital, Essential, and Desirable (VED) analysis states that highest control must
be over vital items, medium control over essential items and least control is inferred over
desirable items.
SDE Analysis: SDE stands for Scarce, Difficult and Easy. Highest control is exercised over
scarce items, medium control over difficult items and least control over easily available items.

10.6 ECONOMIC ORDER QUANTITY [EOQ]

Economic Order Quantity [EOQ]

The two fundamental problems in material control are how much of a given item should be
ordered at once and when to place the next order. The objective is to determine the ideal order
size before choosing an economical ordering quantity. Considerations like material carrying
costs and the ordering cost associated with placing purchase orders must be taken into
consideration while determining the ideal order size; the total cost (ordering + storing cost) be
minimised. The costs associated with carrying material include interest on the capital used to
purchase the material stores, rent for the storage space, salaries and wages for the department
in charge of keeping the stores, any loss from theft and deterioration, costs associated with
store insurance, stationery and other supplies used by the stores, taxes on inventories, etc.

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Ordering costs may include the rent for the office space that purchasing department occupies,
the salaries and wages of its employees, the depreciation on its equipment and furniture,
postage, telegraph, and telephone bills, the stationaries, and other consumables it needs, any
travel expenses incurred, the costs of inspection etc.
Assumption of Economic Order Quantity
The following formula determines the economic ordering quantity, which is the quantity for
which the cost of holding plus the cost of purchasing is minimum:
• The EOQ model assumes only ordering and carrying cost.
• At each reorder point, same quantity is ordered.
• Consumption, ordering costs, and carrying costs are all well known. It is also certain
how long it will take to fulfil a purchase order from the time it is placed.
• The order quantity has no impact on the purchasing cost per unit. Due to the assumption
that the purchase price is the same regardless of the order size, purchasing costs are
irrelevant when determining EOQ.
• There are no stockouts. This assumption is based on the idea that managers keep enough
inventory to prevent stockouts because the costs of stockout are so high.
• Managers only take quality and shrinkage costs into account when determining the size
of a purchase order to the extent that these costs have an impact on ordering or carrying
costs.
Calculation of EOQ
EOQ is that quantity at which total relevant cost is minimum
Total relevant costs = Relevant ordering costs + Relevant carrying costs
We use the following notion:
D = Total demand in units for a specific period (e.g., 1 year)
Q = Size of each order
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑖𝑖𝑖𝑖 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 (𝑜𝑜𝑜𝑜𝑜𝑜 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦) 𝐷𝐷
Number of purchase orders per period (one year) = =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒ℎ 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑄𝑄

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𝑄𝑄
The average inventory in units = , because each time the inventory goes down to 0, an order
2
0+𝑄𝑄
for Q units is received. The inventory varies from Q to 0 so the average inventory is
2

P = relevant ordering cost per purchase order

C = Relevant carrying cost of one unit in stock for the time period used for D (one year)

For any given quantity Q

The EOQ model is solved using calculus but the key intuition is that relevant total costs are
minimized when relevant ordering costs equal relevant carrying costs.
To solve EOQ we set

2𝑄𝑄 2DP
Multiplying both sides by = we get Q2 =
𝐶𝐶 C

2𝐷𝐷𝐷𝐷
Q= �
𝐶𝐶

Where,
Q = EOQ
D = Annual units’ consumption during the year
P = Cost of placing an order (Ordering costs).

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C = Annual cost of storage of one unit (Carrying costs).

The above formula indicates that EOQ increases with increase in D (Annual consumption)
and/or P (Ordering Cost).
The graphical representation of EOQ is given below:

Figure 10.1
In the figure 10.1 ordering cost, carrying cost and total cost are plotted on y-axis and quantity
on x-axis. The EOQ is achieved when the Ordering Cost is equal to Carrying Cost. At EOQ
level the total inventory cost is minimum.
Example 10.1: ABC Ltd is an independent stationary store that sells pen. ABC Ltd purchases
the pen from XYZ Ltd at Rs 14 a package (each package contains 20 pens). All the incoming
freight is bear by XYZ Ltd. No inspection is necessary at ABC Ltd because XYZ Ltd supplies
quality pens. ABC Ltd annual demand is 13,000 packages, at a rate of 250 packages per week.
ABC Ltd requires a 15% annual rate of return on investment. The purchase-order lead time is
two weeks. Relevant ordering cost per purchase order is Rs. 200. Other relevant cost of
insurance, materials handling. Breakage, shrinkage and so on pe year is 3.10.
Solution
Weekly consumption = 250
Cost of placing an order = 200
Annual carrying cost (per unit) = required annual return on investment + other relevant carrying
cost =0.15*14 + 3.10 = 5.20

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Calculate the EOQ.

Solution
2𝐷𝐷∗𝑃𝑃
EOQ = �
𝑆𝑆

Where U = Annual Consumption in units = 250*52 = 13,000

P = Cost of Placing an order = 200
S = Annual Carrying cost per unit = 5.20
2(13000)∗200
EOQ = � = 1000 units.
5.20

13000
Calculation of number of orders in a year = = 13 orders
1000
𝐷𝐷 𝑄𝑄
Calculation of Relevant Total Cost: = � × 𝑃𝑃� + � × 𝐶𝐶�
𝑄𝑄 2

13000×200 1000
=� �+� 5.20�
𝑄𝑄 2

= 2600+2600 = 5200.

10.7 JUST IN TIME (JIT)

Using a just-in-time (JIT) inventory system, suppliers can place orders for raw materials that
are directly in line with production schedules. By only ordering the goods they actually need
for the production process, businesses can cut down on inventory costs while increasing
efficiency and reducing waste. With this strategy, producers must precisely forecast demand.
The "nervous system" of lean JIT production, kanban regulates inventory movement and work-
in-progress production. When it comes to reducing manufacturing waste brought on by
overproduction, kanban is essential.

Push inventory tactics are used in more conventional mass production techniques and are based
on the anticipated quantity of sales. The pull approach used by Kanban allows for greater
production floor flexibility because a business can only generate items in response to genuine
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customer requests. On a factory floor, Kanban uses cards—either paper or digital—to monitor
the status of output. Kanban cards track the flow of inventory through the manufacturing
process and can indicate when it's time to place an order for additional stock.
10.7.1 Features of JIT
• The just-in-time (JIT) inventory system is a management technique that reduces
inventory and boosts efficiency.
• JIT manufacturing is also known as Toyata Production system (TPS) because Toyota,
a car manufacturer, adopted JIT system in the 1970s
• To prevent work-in-process overcapacity, JIT is frequently used in conjunction with
the scheduling system known as kanban.
• The JIT production process depends on consistent output, excellent craftsmanship, no
equipment failures, and trustworthy suppliers for its success.
• The Motorola and IBM terms for the JIT system are short-cycle manufacturing and
continuous-flow manufacturing, respectively.

10.7.2 Elements involved in JIT

Continuous improvements:
• Addressing core issues and everything that does not improve the product.
• Creating mechanisms to locate issues with manufacturing and related problems.
• A layout focused on the product such that movement of materials and parts consume
minimum time.
• Quality control at source to ensure every worker is solely responsible for the quality of
their own produced output.
Eliminating waste:
One of the primary goals of the Just In Time system is waste reduction. This requires efficient
inventory management across the whole supply chain. There are seven types of waste:
• Waste from product defects.
• Waste of time.

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• Transportation waste.
• Inventory waste.
• Waste from overproduction.
• Processing waste.
10.7.3 Advantages of JIT
• The manufacturers can easily move from one product to another
• JIT reduces the costs by minimizing the warehouse needs.
• The businesses spend less on raw materials because they only purchase what they need
to produce the products that have been ordered.
• Less working capital is needed because, with this management approach, only essential
stocks needed for manufacturing are acquired.
• By setting a minimum reorder level and only placing orders for new stock when that
level is reached, this approach also benefits inventory management.
• The organisations' overall ROI (Return On Investment) is high as a result of the
aforementioned low level of stocks held.
• Since this strategy relies on a demand-pull model, all goods produced would be sold,
making it simple to account for unforeseen changes in demand.
• Due to the erratic and unstable nature of market demand today, JIT is appealing.
• In order to reduce rework costs and inspection costs, JIT places a strong emphasis on
the "right-first-time" principle.
• JIT can lead to higher productivity and higher-quality products.
• A JIT system promotes better communication along the manufacturing chain.
10.7.4 Disadvantages of JIT
• The JIT approach states that there should be ZERO tolerance for errors, which makes
rework challenging in practise because inventory is kept to a minimum.
• JIT implementation requires a high reliance on suppliers, whose performance is out of
the manufacturer's control.

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• JIT lacks buffers, which can lead to production line idling and downtime, which would
be detrimental to both the financial situation and the production process.
• Given that there won't be any extra finished goods on hand, the odds of failing to fulfil
an unexpected rise in orders are quite high
• Depending on the frequency of transactions, transaction charges would be relatively
significant.
• Due to the frequent delivery, JIT may have some unfavourable environmental
implications because more transportation would be needed, which would increase the
use and cost of fossil fuels.
Example of JIT
Toyota Motor Corporation, which is renowned for its JIT inventory system, only orders parts
in response to new car orders. The company started using this technique in the 1970s, but it
took 20 years to get it just right. Sadly, a fire at the Japanese-owned automotive parts supplier
Aisin severely damaged its ability to produce P-valves for Toyota's vehicles in February 1997,
threatening to put an end to Toyota's JIT inventory system. Toyota had to halt production for a
few days because Aisin is the only supplier of this component, and its weeks-long shutdown
caused that.
As a result, other Toyota parts vendors were forced to temporarily close their doors because
the automaker was no longer in need of their components. This fire consequently cost Toyota
160 billion yen in revenue
JIT in Service Industries
It is possible to use JIT purchasing and production processes in the service sector as well. For
instance, more than a third of the expenses at most hospitals are related to inventory, supplies,
and the labour costs. Eisenhower Memorial Hospital in Palm Springs, California, decreased its
inventory and supplies by 90% in just 18 months by introducing a JIT purchasing and delivery
system. To produce hamburgers, McDonald's has utilised JIT production techniques.
Previously, McDonald's precooked a batch of hamburgers that were kept warm under heat
lamps until orders were placed. The discarding of the hamburgers in cases where it didn't sell
within a specified time period resulted in significant inventory holding costs and spoiling costs.
Also, the longer the hamburgers lay beneath the heat lamps, the worse their quality became.
Finally, clients who ordered a hamburger with a particular request (such one without cheese)
had to wait for the burger to cook. Today, McDonald's is able to cook hamburgers just when

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they are ordered, considerably decreasing inventory holding and spoilage costs. This is made
possible by the use of new technology (including an inventive bun toaster) and JIT production
processes. Most significantly, JIT has increased consumer satisfaction by enhancing hamburger
quality and slashing the time required for special orders.
Kanbans = D.L(1+ α)/EOQ
Where D = Daily Demand
L = Lead Time
Α = Safety Stock
Illustration 3:
Calculate the number of Kanbans needed at the ABC company for the following two products, produced
in a factory that works eight hours per day, five days per week.

Product 1 Product 2
Usage 300/week 150/week
Lead time 1 week 2 week
Container size 20 units 30 units
Safety Stock 15 percent 0

Solution
Product 1 Product 2
Daily Demand (D) 300/5 150
Lead time (L) 5 days 10 days
EOQ 20 units 30 units
Kanbans = D.L(1+ α)/EOQ
17.25 = 18 Cards 50 Cards
Total number of Kanban in the system 18+50 = 68 Cards

10.8 METHOD OF INVENTORY VALUATION

When materials are issued to production department, a difficulty arises regarding the price at
which materials issued are to be charged. The same type of material may have been purchased
in different lots at different times at several different prices. This means that actual cost can
take on several different values and same method of pricing the issue of materials must be
selected.
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There are numerous methods of pricing issues. They may be classified as follows:

10.8.1 COST PRICE METHOD

a) Specified Price (Identifiable Method)

Sometimes materials are bought to be used in a specific job or problems can be found with
a specific receipt. The actual purchase price may be levied in these circumstances. When
prices are stable or when the materials are covered by price control orders, this method can
be used. This technique only has a few applications.

b) First-in First-out (FIFO) Method

It is based on the assumption that materials issued first are those that were purchased first. It
uses the price of first batch of materials purchased for all issues until all units from this batch
have been issued and so, the materials in stock are valued at the cost of the most recent
purchases since they are issued at the oldest cost price listed in the store's ledger account.
Although normally materials would be expected to move out of stock on approximately a
FIFO basis because oldest stocks are typically used up first, it should be noted that the
assumption of FIFO is only for accounting purposes, i.e., the physical flow of materials need
not necessarily be in the order of the flow of costs.

Example:
Receipts: 12 March 100 kgs. @ Rs 10.00 per kg.
22 March 150 kgs. @ Rs 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
100 kgs. @ Rs 10.00 per kg.

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100 kgs. @ Rs 9.00 per kg.

Balance 50 kgs @ 9.00 per kg.

Advantages:
• This approach is beneficial because it prioritises the oldest units while keeping
inventory up to date.
• This method is logical along with easy to use and understand.
• This method helps in inter and intra-firm comparisons
• Valuation of inventory and cost of finished goods is consistent and realistic
Disadvantages:
• The cost of production is independent to the current prices.
• The production cost is underestimated if prices are rising. However, if the rate
of stock turnover is high, the inventory will reflect current prices The effect of
current market prices is not revealed in issues when prices are rising.
• When multiple lots are bought at different levels of price, the true picture is not
presented. Calculation became challenging.
• The pricing of material returns is difficult.
• High inflation makes it difficult to replace used materials; FIFO does not
address this issue.
• Usually more than one price has to be adopted for a particular issue.
• Cost comparisons between two batches of production becomes difficult when
issues are priced differently.

c) Last -in First out (LIFO) Method

The principle adopted is that the production only uses materials that have recently been
purchased. The inventory is valued using the oldest costs. As the method applies the current
cost of materials to the cost of units, it is also known as the replacement cost method. This
method is crucial for matching costs and revenues in the process of determining income.

Example:
Receipts: 12 March 100 kgs. @ Rs 10.00 per kg.
22 March 150 kgs. @ Rs 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
150 kgs. @ Rs 9.00 per kg.
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50 kgs. @ Rs 10.00 per kg.

Balance 50 kgs @ 10.00 per kg.

Advantages:
• When there are few transactions, it is easy to use.
• It is a good method of avoiding tax.
• It is a systematic method. It matches current costs with current revenues in a better way.
• It illustrates real income during periods of price inflation
• It minimises unrealised inventory gains and losses and tends to stabilise reported
operation profits especially when the industry is prone to sharp price fluctuations.

Disadvantages:
• When rates of material receipts are highly fluctuating, the method becomes
complicated.
• More than one price may have to be adopted for an issue.
• Cost of different batches vary greatly, making inter-firm and intra-firm comparison
difficult.
• The stocks require to be adjusted during falling prices.
• Unless purchases and sales occur in equal quantities the current costs cannot be easily
matched with current revenue.
• The company can time the purchases to cause high or low costs thus changing reported
income at will.
• Existing profit sharing and bonus can be affected by an accounting change. Employees
will have difficulty in understanding the cause for these changes.

d) Highest in First-out Method

The inventory is valued at the lowest feasible price, and the most expensive materials
are issued first. The procedure calls for thorough documents. It is typically applied to
cost-plus contracts or monopoly goods. The creation of a hidden reserve occurs when
stocks are undervalued.

e) Base Stock Method

A certain minimum stock of a material is always carried and is priced at the original cost
(usually at the lowest purchase price). The portion of stock above this level is issued and
priced under any one of the methods.
The disadvantage of this method is that the stock may be undervalued and hence the
computation of return on capital will not be reliable.

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10.8.2 Average Price Method

a. Simple Average Method
The simple average is the average of prices ignoring the quantities involved. It can be used
when the prices are normally stable and the stocks purchased are in equal quantities or the stock
value is small. It is calculated by dividing the total rates of materials by the number of rates of
prices. A new average is worked out after every receipt.

Example:
Receipts: 12 March 100 kgs. @ Rs 10.00 per kg.
22 March 150 kgs. @ Rs 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
200 kgs. @ Rs 9.50 [(10+9)/2] per kg.
Balance 50 kgs @ 9.50 per kg.

b. Weighted Average Method

In this approach, the average price is determined after accounting for both total quantities and
total costs. Every time a purchase is made, it is calculated by multiplying the cost of the
purchase by the cost of the stock on hand, then adding the quantity received to the stock on
hand. To calculate the value, divide the total cost by the total quantity. This approach prevents
price changes, minimises the number of calculations, and provides a stock price that is
reasonable.
Example:
Receipts: 12 March 100 kgs. @ Rs 10.00 per kg.
22 March 150 kgs. @ Rs 9.00 per kg.
Issues 23 March 200 kgs. Will be valued as follows:
200 kgs. @ Rs 9.40 [(10*100 + 9 *150)/250] per kg.
Balance 50 kgs @ 9.40 per kg.
Advantages:
• It is rational and consistent.
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• The issues and inventory are not affected by changes in the prices.
• The values of the inventory reflect the actual costs.
Disadvantages
• It requires a significant amount of clerical work.
• It is cumbersome and difficult when prices vary frequently
• It is not realistic as it is not the actual price.
(c) Periodical Simple Average Method
Some business may price materials by taking average of the prices of all receipts during a
period, e.g., a month, a week, etc. for the subsequent period. Only those prices - relevant to the
period is taken into account. Both closing stock and purchases made during the time are
considered.

Illustration 4:

The prices of the receipts during the week are Rs 8, Rs 9, Rs 10, Rs 11. The periodic simple
average will be:

= Total Prices of Material/ Total number of Price

= (8+9+10+11)/4 = Rs 9.5

Disadvantages:
(i) Pricing of issues ignores heavy fluctuations in price during the current period.
(ii) it is not an exact cost method.
(iii) It involves heavy clerical work.

(d) Periodic Weighted Average Method

The average price is calculated periodically and not every time the material is received. It is
computed by dividing the total amount purchased by the total value of materials purchased
over the course of a period.

Example: If the total receipt during a week is 100 kg. costing Rs 2500, the periodic weighted
average will be
= Rs 2,500/100 = Rs 25 per kg.

Advantages:
(i)It reduces the Clerical costs
(ii) It is useful in process costing.
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(iii) The issue price is not affected by short-term fluctuations.

Disadvantages:
(i) At the end of the accounting period, heavy clerical work is involved.
(ii) Violent fluctuations are ignored till the end of the period.
(iii) Closing stock can be erroneously valued and nil stock may have a residual value.

(e) Moving Simple Average Method

In this method, periodic simple average prices are further averaged. The moving average is
calculated by dividing periodic average prices by the total number of periods taken. The period
chosen should cover the period in which the material is issued. The closing stock's value could
be overvalued or undervalued. In times of rising prices, the issue price calculated is lower than
the period's average prices, and vice versa.

Example:

Moving Average
Month Periodic Average Price Price
April 2.50
May 2.60 2.60
June 2.70 2.72
July 2.85 2.85
August 3.00 3.03
September 3.25

(f) Moving weighted Average Method

The material issue price is computed by dividing the total of the periodic weighted average
prices for a number of periods by the total number of such periods.

10.8.3 Notional Price Methods

(a) Standard Price Method

For a given time period, the price of issues for each item is predetermined, taking into account
all the variables that affect price, such as market trends and transportation costs. For each
material, standard prices are determined. The standard price is maintained for all issues and
inventories. Periodically, these should be revised. Standard could be basic or current standard.
The basic standard is set for an extended period of time and provides the best price. It aids in
planning ahead. The current standard keeps product costs updated to reflect current market

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trends. Contrarily, basic standards support the analysis of production cost trends over time
period.

The difference between standard and actual is transferred to the purchase price variance
account.

Advantages:
(i) It simplifies accounting as only quantities are recorded.
(ii) Inconsistency is avoided since only one rate is adopted.
(iii) It helps to determine purchase efficiency. If actual cost is more than the standard than there
is unfavourable purchasing efficiency and vice versa.
(iv) It is simple to operate.
(v) It provides stability to the costing system.

Disadvantages:
It does not reflect the actual or expected cost but only a target.

(b) Inflated Price Method

The inflated price includes carrying costs, evaporation losses, etc. It seeks to recover the full
cost of the materials purchased.

(c) Market Price Method

Materials may be provided at replacement price. The price of identical materials in the market
at any given time is the replacement cost.

Advantages:
(i) It measures results correctly and accurately as current revenues are matched against
current costs.
(ii) It differentiates between holding gains and operating gains.
(iii) A realistic and competitive selling price can be determined.

Disadvantages:
(i) In the absence of a market price, replacement price cannot be determined.
(ii) As it is not based on actual cost, they may increase the confusion and complication in
accounting.

The replacement price is used in respect of items used in manufacturing whereas the realisable
price is used for items kept in stock. The realisable price is useful for calculating the issue price
of obsolete and slow-moving stores. If issues are priced at current market price, price reduced
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due to bulk purchases, are not reflected. The market price method introduces elements of
uncertainty and involves excessive classical labour to maintain records of latest prices for
various items.

IN-TEXT QUESTIONS
(True/False)
1. In ABC technique, A items are those which are used in largest quantities
2. Value of closing stock under FIIFO and LIFO methods is the same.
3. Reorder level is equal to normal consumption * normal reorder period.
4. When the price are showing a raising tendency, FIFO method results in
higher profits
5. There is an inverse relationship between carrying cost and ordering cost.
6. The JIT production process depends on consistent output, excellent
craftsmanship, no equipment failures, and trustworthy suppliers for its
success.

10.9 SOLVED PRACTICAL QUESTIONS

Q.1 Following is the information by ABC Ltd. Related to first week of December 2013:
The transactions in connection with the materials are as follows:

Days Receipts Issues

Rate per
Units (units)
unit
1st 40 15
2nd 20 16.5
3rd - 30
4th 50 17.1 -
5th - 20
6th - 40

Calculate the cost of materials issued under (i) FIFO METHOD; (ii) LIFO method; and (iii) Weighted
average method of issue of materials and value of closing stock under the above methods.

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Solution:

(i) Cost of materials issued and value of closing stock under FIFO Method

Rs. Rs.
December 3, 2013. issued 30 units @ Rs 15 per unit 450
December 5, 2013: issued 10 units @ Rs 15 150
issued 10 units @ Rs 16.50 165 315
December 6, 2013: issued 10 units @ Rs 16.50 165
Issued 30 units @17.10 513 678
Closing stock: 20 units @ 17.10 342

(ii) Cost of materials issued and value of closing stock under LIFO Method:

Rs. Rs.
December 3, 2013. issued 20 units @ Rs 16.50 330
issued 10 units @ Rs 15.00 150 480
December 5, 2013: issued 20 units @ Rs 17.10 342
December 6, 2013: issued 30 units @ Rs 17.10 513
Issued 10 units @15.00 150 663
Closing stock: 20 units @ 15.00 300

(iii) Cost of materials issued and value of closing stock under Weighted Average Method:

Q.2 From the following you are required to prepare a statement showing the issues made under
LIFO method:
Date Opening Balance 100 units at `10 each
1 Received 200 units at `10.50 each

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2 Received 300 units at `10.60 each

4 Issued 400 units to Job A vide MR No. 3
6 Issued 120 units to Job B vide MR No. 4
7 Received 400 units at `11 each
10 Issued 200 units to Job C vide MR No. 5
12 Received 300 units at `11.40 each
13 Received 200 units at `11.50 each
15 Issued 400 units to Job D vide MR No. 6
Solution:

Receipts Receipts Balance

M.R.
Date P.O. No Qty Rate Amt Date No Qty Rate Amt Qty. Rate Amt
100 10.00 1000
1st 200 10.50 2100 100 10.00 1000
200 10.50 2100
100 10.00 1000
2nd 300 10.60 3180 200 10.50 2100
300 10.60 3180
4th 3 (400)
300 10.60 3180 100 10.00 1000
100 10.50 1050 100 10.50 1050
6th 4 (120)
100 10.50 1050 80 10.00 800
20 10.00 200
7th 400 11.00 4400 80 10.00 800
400 11.00 4400
10th 5 200 11.00 2200 80 10.00 800
200 11.00 2200
12th 300 11.40 3420 80 10 .00 800
200 11.00 2200
300 11.40 3420
13th 200 11.50 2300 80 10.00 800
200 11.00 2200

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300 11.40 3420

200 11.50 2300
15th 6 (400) 80 10.00 800
200 11.50 2300 200 11.00 2200
200 11.40 2280 100 11.40 1140
CLOSING STOCK : 380 Units, Value: 4140
Q3. Prepare a statement showing the pricing of issues, on the basis of (a) Simple Average, and (b)
Weighted Average Methods from the following information pertaining to material ‘X’.

Date

1 Purchased 100 units @ `10.00 each.

2 Purchased 200 units @ `10.20 each.

5 Issued 250 units to Job A vide MR No. 1

7 Purchased 300 units @ `10.50 each

10 Purchased 200 units @ `10.80 each

13 Issued 200 units to Job B vide MR No. 2

18 Issued 200 units to Job C vide MR No. 3

20 Purchased 100 units @ `11.00 each.

25 Issued 150 units to Job D vide MR No. 4

Solution:

a. Simple Average Method

Receipts Receipts Balance

Dat P.O. Qt Rat Am Dat M.R. Qt Am Qty
e No y e t e No y Rate t . Amt
10.0
1st 100 0 1000 100 1000
10.2 3040
2nd 200 0 2040 300
th
5 1 240 (10+10.20)/2 2525 50 515
10.5 3665
7th 300 0 3150 350
10.8 582
10th 200 0 2160 150 5

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3725
13th 2 200 (10.2+10.5+10.8)/3 2100 350
1595
18th 3 200 (10.5+10.8)/2 2130 150
11.0 2695
20th 100 0 1100 250
(10.80+11.00)/ 1060
25th 4 150 2 1635 100

Closing Stock : 100 units, Value Rs 1060

b. Weighted Average Method

Receipts Receipts Balance

Date P.O. No Qty Rate Amt Date M.R. No Qty Rate Amt Qty. Rate Amt
1st 100 10 1000 100 10.00 1000
2nd 200 10.2 2040 300 10.31 3040
5th 1 240 10.13 2533.30 50 10.31 515
7th 300 10.5 3150 350 10.45 3665
10th 200 10.8 2160 150 10.58 5825
13th 2 200 10.58 2116.00 350 10.58 3725
18th 3 200 10.58 2116.00 150 10.58 1595
20th 100 11 1100 250 10.74 2695
25th 4 150 10.74 1611.00 100 10.74 1060

Closing Stock: 100 Units Value 1073.70

Note: Rate1 = 3040/300 = 10.13, Rate2 = 3656.70/350 = 10.45
Rate3 = 5816.70/550 = 10.58, Rate4 = 2684.70/240 = 10.74
Q4. The following data pertain to material X:
Supply period 4 6o 8 months
Consumption rate:
Maximum 600 units per month
Minimum 100 units per month

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Normal 300 units per month

Yearly 3600 units
Storage costs are 50% of stock value, ordering costs are Rs 400 per order, price per unit of
material Rs 64
Compute: i) Re-order level ii) Minimum stock level. iii) Maximum stock level
iv) Average stock level.
Solution

2𝐷𝐷∗𝑃𝑃
EOQ = �
𝑆𝑆

Where U = Annual Consumption in units = 3600

P = Cost of Placing an order = 400
S = Annual Carrying cost per unit = 0.5*64 =32
2(3600)∗400
EOQ = � = 300 units.
32

Reorder level = Maximum consumption × Maximum re-order period

= 600 × 8 = 4,800 units
Minimum Stocks level = Re-order level – (Normal consumption × Normal re-order
period)
= 4800-(300× 6) = 3000 units
Note: Normal re-order period is the average period.= (4+8)/2 = 6 months

Maximum Stock Level = Re-order level + re-order quantity – (Minimum consumption×

Minimum re-order period)
= (4800 + 300) – (100 × 4) = 4,700 units.
Average Stock Level = (minimum level + maximum level)/2 = (3000+4700)/2 =3850 units

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10.10 SUMMARY

• Inventory control is the systematic control and regulation of purchase, storage and usage of
materials in such a way as to maintain an even flow of production and at the same time avoiding
excessive investment in inventories.
• ABC analysis is a value based system of material control, in which materials are analysed
according to their value so that costly and more valuable materials are given greater attention
and care.
• Economic Ordering Quantity (EOQ) is that size of the order which gives maximum economy
in purchasing any material and ultimately contributes towards maintaining the material at the
optimum level and at minimum cost.

• The just-in-time (JIT) inventory system is a management technique that reduces

inventory and boosts efficiency.
• JIT manufacturing is also known as Toyata Production system (TPS) because Toyota,
a car manufacturer, adopted JIT system in the 1970s
• Materials are issued to production department on cost price, average price or notional price
methods.

10.11 ANSWERS TO INTEXT QUESTIONS

1. False 4. True
2. False 5. True
3. False 6. True

10.12 SELF-ASSESSMENT QUESTIONS

5. XYZ Ltd requires 10,000 units of a product during the year. The cost of ordering is Rs.
50 and the carrying cost per unit is Rs 3 per year. Lead time of an order is 7 days and
the company will keep a safety stock of three days usage.
You are required to calculate the following:
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a. Minimum Inventory
b. Maximum Inventory
c. Average Inventory
d. Re-order Point
e. Economic Order Quantity

6. Laxmi enterprise manufacture a product “ABC” The following particulars are collected
for the year 2016:
a. Annual demand of ABC – 1000 units
b. Cost of placing an order Rs. 100
c. Annual carrying cost per units Rs. 10
d. Normal Usages 100 units per week
e. Minimum usage 50 units per week
f. Maximum usages 150 units per week
g. Re-order period 2 to 6 weeks
Calculate the following:
a. Re-order Quantity
b. Re-order Level
c. Minimum Level
d. Maximum Level
e. Average stock level.
7. What do you mean by minimum level, maximum level and re-order level? How are
they fixed?
8. Discuss the advantages and disadvantages of FIFO and LIFO methods of pricing. Under
condition of rising prices which of these methods would you recommend and why?
9. Briefly describe the various methods of pricing the material issues.
10. Explain the weighted average method of pricing. How it is different form normal
average method.
11. X Ltd. has purchased and issued the materials in the following order:
Unit Unit Cost `

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1st January Purchased 300 3

4th January Purchased 600 4
6th January Issued 500
10th January Purchased 700 4
15th January Issued 800
20th January Purchased 300 5
23rd January Issued 100

Ascertain the quantity of closing stock as on 31st January and state what would be its value (in each
case) if issues were made under the following methods: (i) Average cost. (ii) First-in First-out. (iii) Last-
in First-out. (Weighted average = `2,218/-; FIFO `2,300/-; LIFO `1,900/-)

10.13 REFERENCES

• Cost and Management Accounting, Study Material Module 1 Paper 2, The institute of
Company Secretaries of India
• Arora, M. N. (2016). Cost And Management Accounting, Penguin Random House.

10.14 SUGGESTED READINGS

• Arora, M. N. (2016). Cost And Management Accounting, Penguin Random House.

• Maheshwari, S. N., &; Mittal, S. N. Cost Accounting: Theory and Problems. Shree
Mahavir Book Department.

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LESSON 11
PERFORMANCE MEASUREMENT AND EVALUATION

CA. Mannu Goyal

[email protected]

Mr. Jigmet Wangdus

Assistant Professor
SOL/COL
University of Delhi
[email protected]

STRUCTURE

11.1 Learning Objectives

11.2 Introduction
11.3 Responsibility Centres and Its Performance
11.4 Performance Management System
11.5 Divisional Performance Measures
11.6 Pros and Cons of the use of Performance Measures
11.7 Financial Performance Measures
11.8 Economic Value Added (EVA)
11.9 Limitations of EVA
11.10 Non - Financial Performance Measures
11.11 Balanced Scorecard
11.12 Performance Pyramid
11.13 The Building Block Model
11.14 Performance Prism
11.15 Triple Bottom Line (TBL)
11.16 Summary
11.17 Self-Assessment Questions
11.18 Practical Problems
11.19 Suggested Readings

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11.1 LEARNING OBJECTIVES

After studying this chapter, you will be able to:

• Describe how performance measurement and control systems contribute to the creation
of value, the implementation of strategies, and the monitoring of performance to
enhance strategies.
• Examine both conventional and unconventional methods of performance measurement.
• Determine non-financial performance indicators, interpret them, and make suggestions
for ways to raise the performance
• Explain the causes and issues caused by short-termism and the financial manipulation
of results, and offer strategies to promote a long-term perspective.
• Compute and evaluate performance measures relevant in a divisionalized
organisational structure, including return on investment, residual income, and economic
value added.
• Examine and assess performance, and make recommendations for ways to enhance both
financial and non-financial performance.

11.2 INTRODUCTION

It is essential to measure and evaluate performance because it enables management to

assess how well the business is performing in relation to both prior years and its
competitors.
Responsibility accounting is the process of gathering, compiling, and disclosing
financial information in which each manager is responsible for particular costs, revenue,
or assets of the company. The information is about the decision centers throughout the
organization. It is also known as profitability accounting or activity accounting.
Responsibility accounting is appropriate where top management has delegated
decision-making authority. According to the principle of responsibility accounting, a
manager's effectiveness should be assessed based on how effectively they handle the
matters that fall under their direct control. Performance measurement is directly linked
to the organisational structure of a business.

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11.3 RESPONSIBILITY CENTRES AND ITS PERFORMANCE

According to Deakin and Maher ‘a responsibility centre is a specific unit of an organisation

assigned to a manager who is held responsible for its operation and resources’.
CIMA London has defined Responsibility Accounting as “a system of management accounting
under which accountability is established according to the responsibility delegated to various
levels of management and management information and reporting system instituted to give
adequate feedback in terms of the delegated responsibility. Under this system, division of units
of an organization under specified authority in a person are developed as a responsibility centre
and evaluated individually for their performance. A good system of transfer pricing is essential
to establish at the performance and results of each responsibility centre. Responsibility
accounting is thus used as a control technique:”.
To enhance the application of responsibility accounting in decision-making, it is essential for
an organisation to attach a level of responsibility (decentralised power/s) to different
divisions/departments and designate as either of cost, profit, revenue or investment centre.
Cost or Expense Centres
Cost or Expense Centres are responsibility centres where the manager ‘has control over the
costs’ (other than those of capital nature) owning to function, for which he/ she is responsible.
For example, the paint department in an automobile firm. Performance report of cost centre is
focused on budgeted and actual costs (cost in term of quantity of input resource (may be money,
material, man- hours) to appraise the performance. Cost variances are relevant measures.
Revenue Centres
Revenue Centres are the responsibility centres where the manager has ‘control over the
generation of revenue from operation’ with no responsibility for costs. To illustrate, booking
counter of any Airline Company is revenue centre.
The key measures used to appraise performance are sales variances.
Profit Centres
Profit Centres are the responsibility centres where the manager of such a centre or division has
‘control on both revenue and costs’ (other than those, which are of capital nature) earned out
of and incurred on Thus, performance is measured in terms of the difference between the

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Management Accounting

revenues and costs.assets assigned to the division respectively. To illustrate, the facility of
canteen can be considered as the profit centre.
Investment Centres
Investment Centres are the responsibility centres where the manager has responsibility for not
just the revenues and costs relating to the centre, but also the assets that cause these costs and
generate these revenues and the investment decisions relating to disposal and acquisit ion of
assets.
The performance of an investment centre can be measured by appraising profit/return in
relation to investment base of centre, ROI, RI, and EVA are some prominent financial
performance measures.
Investment centre can be referred to as strategic business units (SBUs). Mind it each division
is not SBU. For being SBU capabilities to work independently and in isolation are essential.

11.4 PERFORMANCE MANAGEMENT SYSTEM

Performance management shall be considered as an essential aspect of management

accounting. Performance management may be seen as four-stage solution to take any
organisation towards sustainability.
Aspects related to the first two phases are already covered in the previous heading, now it’s
turn to study the performance measure (both financial and non-financial), based upon which
performance can be measured.

11.5 DIVISIONAL PERFORMANCE MEASURES

Performance management system plays a key role in deploy strategy, but it has a prerequisite
and that is; measure the existing performance. As already mentioned in the first section of this
chapter that performance measurement is directly linked to the organisational structure. If
organisation is divisionalised then performance also needs to be measured at the division level
for each division. It is obvious, that to measure the performance of division certain performance
measures or indicators need to be established.

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The division can be on the basis of functional, geographical, enterprise, geographical &
functional.

It is important here to note that if any organisation opt for divisional structure, then there are
verities of issues, which need to be addressed while establishing performance measures to
determine performance. These issues are such as inter-dependence of divisions, goal
congruence, allocation of costs of shared services or head office, and internal transfer pricing
policy and etc. These factors affect the divisional performance substantially.
A good performance measure should–

• Provide the divisional manager a justifiable incentive to make decisions that are in the
best interests of the entire business (goal congruence).
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• Only include elements for which the divisional manager is liable.

• Recognise both short-term and long-term organizational goals.
The issues of evaluating the performance of divisions in multinational companies arises due
to:

• The differences in economic, legal, political, social, and cultural environments in

different countiries.
• In some nations, the government may impose restrictions and set a ceiling on product
prices.
• Costs of materials, labour, and infrastructure, as well as the availability of skilled labour
and materials, may vary widely between nations.
• Divisions that operate in various nations maintain track of their performance in various
currencies.

11.6 PROS AND CONS OF THE USE OF PERFORMANCE

David Otley, Jane Broadbent, and Anthony Berry suggest the pros and cons of the use of
performance measures the benefits are–

• Develops agreed measures of activity.

• Define and clarifies the objectives of the organization.
• Helps in the setting targets for managers.
• Greater understanding of the process.
• Facilitate comparison between divisions.
• Promotes accountability to stakeholders.
Poorly designed performance management system (where performance measures are not
appropriately chosen and applied) may result in wrong signaling. Wrong signals may lead to
inappropriate action and decisions; hence it is important to identify and overcome the problems
associated with the use of performance measures.

11.7 FINANCIAL PERFORMANCE MEASURES

In order to be a sustainable business, the essentials are profitability, survival, and growth. Since
the financial performance measures/indicators, can be considered as best indicators of
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profitability and easy indicators of growth and survival (solvency and liquidity); hence must
be part of performance measurement metrics. These are–
Return on Investment Method (ROI)
The American company DuPont was the first to recognise the importance of taking into account
the level of investment as well as the income from such investment when evaluating the
performance of the investment centre in the 1920s. Since then, many businesses have begun
focusing on a division's return on investment (ROI) rather than just its absolute size of profits.
The DuPont technique emphasises that any action that boosts return on sales or investment
turnover leads to a rise in ROI. When keeping the other two variables constant, ROI rises with:
1. increases in revenues,
2. decreases in expenses, or
3. declines in investments
“ROI expresses divisional profit as a percentage of the assets employed in the division. Assets
employed can be defined as total divisional assets, assets controllable by the divisional manager
or net assets.”
ROI is a widely used metric, making it the perfect tool for comparing corporate divisions of
similar size and operating in related industries. But it also has limitations. It's possible that
divisional ROI can be increased by actions that will lower the overall ROI of the company, and
vice versa, actions that decrease divisional ROI may improve the situation for the company as
a whole.
In other words, evaluating divisional managers on the basis of ROI may not encourage goal
congruence. (it’s already mentioned in the beginning of topic ‘Divisional Performance
Measures’ that certain issues will arise due to establishing measures at a divisional level which
need to be addressed and goal congruence is one among these)
ROI = (Profit margin / Investment) x 100
ROI = (Net Profit / Sales) x (Sales / Capital Employed) x 100

Division A Division B

Available Investment Project ₹40 lacs ₹40 lacs

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Controllable Contribution ₹4.4 lacs ₹3.2 lacs

Return on the Proposed Project 11% 8%

Presently the ROI of Divisions 14% 6%

Overall Cost of Capital is 9%

The manager of division "A" is unwilling to invest the additional Rs. 40 lacs because
the proposed project's return is 11%, which would cause a decrease of the current ROI of 14%.
The manager of division "B," on the other hand, would like to invest the Rs. 40 lacs. because
the proposed project's 8% return is higher than the division's current ROI of 6% and would
boost the divisions ROI.
Decisions made by the managers of the two divisions would not be in the company's best
interests. Only projects with a ROI greater than the cost of capital (9%) should be approved by
the company; however, the manager of division "A" would reject a potential return of 11%,
while the manager of division "B" would accept a potential return of 8%.
Residual Income Method (RI)
To overcome some of the dysfunctional consequences of ROI (lack of goal congruence), the
residual income approach can be used for the purpose of evaluating the performance of
divisional managers.
“Residual income is excess of controllable profit over a predetermined organisation-wide
minimum hurdle rate (cost of capital charge) on the investment controllable by the divisional
manager. So higher the residual income means better the performance.”
Residual income can be characterised as the divisional profit contribution less a cost of capital
charge on the total amount invested in assets used by the division for assessing the division's
economic performance.
There is a greater probability that managers will be encouraged to act in the company's best
interests as well as their own if residual income is used to gauge the managerial performance
of investment centres.
A typical divisional residual income statement is shown below:

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Particulars Details Amount (Rs.)

Sales xxx

Less: Variable Costs xxx

CONTRIBUTION xxx

Less: Controllable fixed costs xxx

Controllable Profit xxx

Less: Interest on controllable investment xxx

Controllable residual income xxx

Less: Uncontrollable cost (allocated head office charges) xxx xxx

Less: Interest on uncontrollable investment xxx xxx

Net Residual Income xxx

Returning to our previous example in respect of the investment decision for divisions A and B,
the residual income calculations are as shown further;
Division A (in ₹ lacs) Division B (in ₹ lacs)

Proposed Investment ₹40.00 ₹40.00

Controllable Contribution ₹4.40 ₹3.20

Cost of Capital (9%) ₹3.60 ₹3.60

Residual Income ₹0.80 – ₹

0.40

If both managers accept the project, this calculation shows that division "A" residual income
will increase and division "B" residual income will decrese. As a result, the manager of division
"A" would make an investment, as opposed to the manager of division "B," who would not.
The best interests of the business as a whole are served by these actions.

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The residual income cannot be used as a comparison tool for divisional performances of various
sizes because it is an absolute measure. It is obvious that a large division is more likely than a
small division to generate a higher residual income.
For each division, targeted or budgeted residual income levels that are in line with asset size
and market conditions should be established in order to make up for this shortfall.
Advantages of Residual Income

• When investments that generate returns above the cost of capital are made and those
that generate returns below the cost of capital are eliminated, the residual income will
increase.
• Due to the ability to apply a different cost of capital to investments with various risk
profiles, residual income is more adaptable.
Disadvantage of Residual Income
The drawback of Residual Income is that it does not facilitate comparisons between investment
centres, nor does it relate the size of a centre's income to the size of the investment.
Differences between ROI and RI are shown below:

Particulars ROI RI

Emphasis Percentage Ratio Money Amount

Involves same rate of return for all Yes No

assets?

Profit / Loss Relates to capital It is residual

Example ROI vs RI
The department A of XYZ Ltd has the following profit, capital employed and imputed interest
charges of 13% on the operating asssets.

Operating profit 30000

Operating assets 100000
Imputed interest (13%) 13000
Return on investment 30%
Residual Income 17000
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Lets’ assume that the department has proposed an additional investment of 10000, which will
increase the operating income in department A by 1500 . The effect of the investment would
be:

Operating profit 31500

Operating assets 110000
Imputed interest (13%) 14300
Return on investment 28.64%
Residual Income 17200

The manager A is made responsible for the performance of department A. He would be

interested for additional investment of 10,000 if he had to judge on the basis of Residual Income
as there would be marginal increase of 200 from 17,000 to 17,200, but if the same investment
is judged on ROI basis then he would resist the additional investment as ROI is reduced by
1.36% from 30% to 28.64%.
The marginal investment offers a return of 15% (1,500 on the additional investment of 10,000),
which is above the cut-off rate of 13%. The overall divisional performance will be reduce as
the the original ROI was 30%. To summarize, any additional investment which offers an annual
accounting rate of return of less than 30% would reduce the overall performance.

11.8 ECONOMIC VALUE ADDED (EVA)

EVA is a performance measurement system that aims to overcome the limitations of other
divisional performance measures which are based upon accounting profit. The major
shortcomings of relying upon accounting profit include–

• Profit disregards the cost of equity capital. Companies can only become wealthy when
they produce a return greater than the return demanded by equity and debt investors.
The cost of debt financing is considered in the financial statements when calculating
profit, but the cost of equity financing is not taken into account.

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• Profits calculated in accordance with accounting standards are susceptible to

manipulation by accountants and do not accurately reflect the wealth that has been
created..
An alternate to accounting profit is economic profit and EVA is a measure of economic profit.
Calculation of EVA
Economic profit is measured by economic value added. The Economic Value Added is
calculated as the difference between the Net Operating Profit After Tax (NOPAT) and
Opportunity Cost of Invested Capital. This opportunity cost is calculated by multiplying the
capital employed by the Weighted Average Cost of Debt and Equity Capital (WACC).
EVA = NOPAT – WACC × Capital employed
Where- NOPAT means net operating profit after tax. This profit figure shows profits before
taking out the cost of interest.
Two approaches to adjusting for interest are taken.

• Subtract the adjusted tax charge from the operating profit. Since the tax charge includes
the interest tax benefit, it should be adjusted. Since the interest is a tax-deductible item,
having interest in the income statement means that the tax charge is lower. Since we
are taking the cost of interest out of the income statement, it is also necessary to subtract
the tax benefit of it from the tax charge. To do this, multiply the interest by the tax rate,
and add this to the tax charge, or
• Start with profit after tax, and add back the net cost of interest. This is the interest charge
multiplied by (1 – rate of corporate tax).

11.9 LIMITATIONS OF EVA

• EVA is also, an absolute measure hence not free from shortcomings like comparison
between performances of enterprises of different size is not possible, and
• Largely based upon historical data.

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11.10 NON - FINANCIAL PERFORMANCE MEASURES

Financial measures, as previously mentioned, have a number of flaws that make them
unsuitable for a system of effective performance management, especially when used in
isolation. These flaws include a short-term orientation, historical nature, internal focus only
(which does not comprise the entire picture), and window dressing. A balance between
financial and non-financial measures must be maintained because profitability is crucial in
relation to stability (so that financial performance can be measured, but in the context of long
-term viability).
The following non-financial control measures should also be considered for evaluation of
divisional:

• Market position
• Productivity
• Product leadership
• Personnel department
• Employee attitudes
• Public responsibility
• Balance between short-range and long-range goals
Tools like balanced scorecard, performance pyramid, building block model, and performance
prism is capable to serve the purpose because these encompass non-financial performance
measures apart from financial performance measures.

11.11 BALANCED SCORECARD

Information has become a crucial component in the business world today, and it is essential for
gaining a competitive edge over competitors. A company cannot survive in the information
age's competitiveness by making only huge capital investments in cutting-edge technology for
its physical assets or by exercising excellent financial asset and liability management. Both
manufacturing and service entities need new capabilities to succeed in the information age. An
organisation must be able to mobilise and exploit its intangible or invisible assets in order to
succeed. This is because managing and investing in physical, tangible assets alone is not
sufficient.

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Intangible assets enable an organisation to:

• Maintain and further development in customer relationships to maintain the loyalty of

current clients and to effectively and efficiently serve new client/market segments.
• Introduce goods and services in accordance with the preferences of the targeted market
and customer segments
• Produce personalised, high-quality goods and services economically in a short period
of time.
• Mobilise employee skills and motivation in order to improve and maintain consistency
in the evaluation of process capabilities, quality, and response times.
• Implement data bases, information technology, and efficient management information
systems.
Balanced scorecard is a method that divides an organization's performance into four categories:
financial, customer, internal, and innovative. The four dimensions take into account both long-
term and short-term objectives while recognising the interests of shareholders, customers, and
employees.
Kaplan and Norton classified performance measures into four business ‘perspectives’:
Financial Perspective: “How Do We Look to Shareholders?”
In this step, the manager of a division or unit connects the division's or unit's business objectives
to the company's overall corporate strategy. Financial performance measures exhibit whether
the company's execution of its strategy is generating revenue and profits. Managers inquire
"How do we look to shareholders" during strategic planning to identify key performance
measures from this perspective.
Corporate strategy and strategic initiatives are examined from the financial perspective to see
feasibility of these initiatives of being met. The financial objectives chosen at the onset of the
balanced scorecard implementation should serve two purposes:

• To provide definite performance that was expected at the time of strategies selection.
• To provide a focus for objectives and appropriate measures in each of the other three
perspectives.
Customer Perspective: “How Do Customer View Us?”
Companies identify the markets and customer segments in which they compete as well as the
ways in which they add value to these markets and customers during this stage. Managers
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recognise the distinguishing characteristics that set one business unit or product apart from
others. Depending on the market segment or the customer, the lead indicator may change. For
instance, on-time delivery becomes a lead indicator if a customer values it. Various customer
considerations, such as the following, are examples of lead indicators:

• On-time delivery
• On-site service
• After sales support
• Defects per order
• Cost of the product
• Free shipments etc.
By delivering quality as per the customer demand and need, business units can improve
outcome measures such as customer satisfaction, retention, acquisition and loyalty.
Internal Business Perspective: “At What Must We Excel?”
Companies identify at this stage the procedures and actions required to accomplish the set
objectives at the stage of the financial and customer perspectives. By reevaluating the value
chain and making the necessary adjustments to the current operating activities, these goals may
be accomplished. If a company's financial goal is to maintain net earnings and after-sales
service can boost customer retention, internal business perspective must improve after-sales
services to meet customer demands in order to preserve net earnings. For instance, offering
toll-free customer support lines and establishing service centres in all major cities are two ways
to accomplish this goal.
Learning and Growth Perspective: “How Do We Continue to Improve and Create Value?”
The learning and growth perspective helps businesses identify the initiatives and support
systems needed to foster long-term growth and meet the goals outlined in the first three
perspectives. The three main sources of organisational learning and growth are as follows:

• People i.e. employee capabilities

• Systems i.e. information system capabilities and
• Organisational procedures i.e. motivation, empowerment and alignment.
Since the balanced scorecard aims to boost long-term performance, managers may invest in
short-term resources, but this shouldn't have an impact on the performance of the business unit.

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An improved long-term financial performance should be the end result of using the balanced
scorecard strategy. Since the scorecard accords equal weight to relevant non-financial
measures, it ought to deter short-termism, which results in spending reductions on new product
development, human resource development, etc., all of which are ultimately harmful to the
company's future prospects.
Why Balanced Scorecard fails to provide for the desired results?
The following are some reasons why Balanced Scorecards sometimes fail to provide for the
desired results–

• Managers mistakenly think that since they already use non – financial measures, they
already have a Balanced Scorecard.
• Senior executives misguidedly delegate the responsibility of the Scorecard
implementation to middle level managers.
• Company’s try to copy measures and strategies used by the best companies rather than
• developing their own measures suited for the environment under which they function.
• There are times when Balanced Scorecards are thought to be meant for reporting
purposes only. This notion does not allow a Business to use the Scorecard to manage
Business in a new and more effective way.

11.12 PERFORMANCE PYRAMID

K. F. Cross and R. L. Lynch, in the year 1989 publish an article ‘The SMART way to define
and sustain success.’ In this article they suggest Strategic Measurement Analysis and Reporting
Technique (SMART) which is popularly known as performance pyramids due to 4 level
hierarchy applied in the framework.

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The attractiveness of this framework is that it integrates the business’ strategic objective with
operational performance dimensions, consider the internal efficiency vis-à-vis external
effectiveness. Performance pyramid contains the hierarchy of financial and non-financial
performance measures divided in following four levels–

Through corporate vision, organisation defines how the long-term success & competitive advantage will be
L- 1
attained.

In order to achieve corporate vision, the initial focus is on the attainment of CSFs relatedto market and
L-2
finance at SBU or division level.

Market and financial strategies become a guiding force to achieve a strategic objective,which includes
L-3
Customer Satisfaction, Increased Flexibility and High Productivity.

Operational performance dimensions such as Quality, Delivery, Cycle Time and Wasteetc. will be used
L- 4
as status check to strategic objective designated at level 3.

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11.13 THE BUILDING BLOCK MODEL

Fitzgerald and Moon proposed a Building Block Model which suggests the solution of
performance measurement problems in service industries. But it can be applied to other
manufacturing and retail businesses to evaluate business performance. It is based on the three
building blocks of dimensions, standards, and rewards.

Dimensions- Dimensions are the goals for the business, i.e. the CSFs and suitable measures
must be developed to assess each performance dimension. They are further divided into two
sub-categories.
Determinants-These are performance areas which influence the results. These are.

• Quality- Consistently delivering goods and services is what quality is. The eyes of the
customer should be used to evaluate quality. The level of benefits that customers
anticipate from a product is its quality. A product's quality ought to be adequate for the
price paid.

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• Flexibility: This quality refers to the ability to adapt to changes in the factors affecting
business performance. For instance, the capacity to handle a spike in sales demand.
• Innovation- The ability of a company to create new goods and methods of operation.
like environmentally friendly (recyclable) product packaging.
• Resource Utilization- It is the capacity to utilise resources to accomplish business goals.
Business assets should be used in the best possible way and for the intended purpose.
For instance, only loading delivery vans with approved goods and using them to their
fullest capacity.
Results- It reflects the success or failure of determinants identified above.

• Financial Performance- In monetary terms, financial performance provides a quick

indication of the state of the business as a whole. You can use these to indentify area
of strengths and weaknesses. It might also highlight other previously noted areas that
are important for business success.
• Competitive Performance- How do they compare to their rivals? How do they differ
from their rivals? For instance, offering products with higher quality than rivals and
products with unique features from rival products.
Standards- These are the measures used, i.e. the KPIs, should have the following
characteristics:
Equity- All areas of the business should have performance measures that are equally
challenging. A business division receiving relaxation causes the perception of unfair treatment,
which reduces productivity.
Ownership- Everyone should be able to accept the performance measure. Instead of forcing
measures upon employees, they should be identified with them. Ownership in this context
refers to taking accountability for the outcomes.
Achievable- Performance measure should be realistic. Ex, using actual results for the
competitors to set as target. Employee will not be motivated to achieve targets if consider them
impossible.
Rewards- To ensure that employees are motivated to meet standards, the standards need to be
clear and linked to controllable factors. Reward schemes should possess the following
characteristics:

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Motivation- The design of the reward scheme should encourage employees to meet the
company's objectives. If sales growth is desired than bonuses can be tied to performance
indicators, such as an increase in the number of units sold over the previous year.
Clear- Employees should be informed in advance of the rewards programme. How will their
performance be evaluated and what kind of performance will be rewarded?
Controllability- Employees should only be rewarded or penalized of the result over which they
have some control or influence.

11.14 PERFORMANCE PRISM

The creators of Performance Prism, Andy Neely and Chris Adams, noted that the more well-
known Balanced Scorecard framework only pays attention to shareholders and customers. An
approach to performance management called the Performance Prism aims to successfully
satisfy the needs and demands of all stakeholders. This is in contrast to value-based
management, which puts the needs of shareholders first, as well as the performance pyramid,
which tends to focus on customers and shareholders.

• Instead of using the organization's strategy as the foundation for developing

performance measures, it starts with the needs of the stakeholders.
• It recognises the need to work with stakeholders to ensure that their needs are met.
There are five ‘interrelated facets’ to the Performance Prism which lead to key questions for
strategy formulation and measurement design:
Stakeholders Satisfaction: The businesses needs to concentrate on who the stakeholders are?.
What are the stakeholders' needs and desires.
Strategies: What strategies will the businesses need to implement in order to satisfy the needs
and wants of the stakeholders?
Processes: What are the necessary processes required for satisfying the above strategies?
Capabilities: What capabilities is the businesses going to need in order to run and improve the
process?
Stakeholders Contributions: It also considers what the management needs from its
stakeholders in terms of contributions.
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Comprehensiveness of Performance Prism

The Performance Prism enables organisations to create strategies, operational procedures, and
performance measure geared to the unique requirements of all significant stakeholder groups.
The Performance Prisma enables an organisation to more directly address the risks and
opportunities in its business environment by adopting a broad stakeholder perspective that
includes regulators and business communities. It is easier to communicate with stakeholders
and implement a strategy when measures are developed using the PP for each important and
relevant stakeholder.

11.15 TRIPLE BOTTOM LINE (TBL)

British business author John Brett Elkington in year 1994 coined the term TBL. But the origin
of concept actually lies in Brundtland report by World Commission on Environment and
Development, (now known as Brundtland Commission) published in year 1987, in which
Sustainable Development is explained as is development that meets the needs of the present
without compromising the ability of future generations to meet their own needs.
It is also important here to note that United Nations Conference on Environment and
Development taken place in year 1992, gave stress on sustainable development.

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School of Open Learning, University of Delhi
Management Accounting

To measure performance of business decision in economic terms we consider only one bottom
line i.e. profit, but to consider sustainability of business decision there are three bottom lines
i.e. People, Planet and Profit (also known as dimensions of TBL).

TBL truly extends the scope of traditional accountancy, to transform it into modern day
sustainability reporting (which is beyond financial reporting because it considers social and
environmental performance too). Some organisations even have separate business
sustainability reporting system and they apply the standard of sustainability reporting
pronounced by Global Reporting Initiative, Which is the independent, international
organization that helps businesses and other organizations take responsibility for their impacts,
by providing them with the global common framework (standards) to report those impacts.
Dimension (sets) of TBL
Planet, the environmental bottom line measures the impact on resources, such as air, water,
ground and emissions to determine the environment impact and ecological footprints.
People, the social equity bottom line relates to corporate governance, motivation, incentives,
health and safety, human capital development, human rights and ethical behaviour.
Profit, the economic bottom line refers to measures maintaining or improving the company’s
success in term of adding value to shareholders.

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School of Open Learning, University of Delhi
MBA

11.16 SUMMARY

Responsibility accounting is defined as the collection, summarization, and reporting

of financial information where the accountability of certain costs, revenue or assets of
firm is held by individual manager.
Cost or Expense Centres are responsibility centres where the manager ‘has control over the
costs’ (other than those of capital nature) owning to function, for which he/ she is responsible.
Revenue Centres are the responsibility centres where the manager has ‘control over the
generation of revenue from operation’ with no responsibility for costs.
Profit Centres are the responsibility centres where the manager of such a centre or division
has ‘control on both revenue and costs’ (other than those, which are of capital nature) earned
out of and incurred on.
Investment Centres are the responsibility centres where the manager has responsibility for
not just the revenues and costs relating to the centre, but also the assets that cause these costs
and generate these revenues and the investment decisions relating to disposal and acquisit ion
of assets.
Financial Performance Measures
• Return on Investment (RoI)

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School of Open Learning, University of Delhi
Management Accounting

• Residual Income (RI)

• Economic Value Added (EVA)
Non - Financial Performance Measures
• Balanced Scorecard
• Performance Pyramid
• The Building Block Model
• Performance Prism
• Triple Bottom Line (TBL)

11.17 SELF-ASSESSMENT QUESTIONS

1. Explain the concept of Responsibility Accounting.

2. What are different Responsibility Centres.
3. Explain the different Financial Performance Measures.
4. Write a short note on:
i. Economic Value Added (EVA)
ii. Balanced Scorecard
iii. Performance Pyramid
iv. The Building Block Model
v. Performance Prism
vi. Triple Bottom Line (TBL)

5. Supply the missing data in the following table:

Particulars Division A Division B Division C
Sales Rs.60,000 Rs.75,000 Rs.1,00,000
Operating Income (a) Rs.25,000 (e)
Operating Assets Rs.30,000 ( c) Rs.50,000
Return on Investments (ROI) 15% 10% 20%
Minimum required rate of return 10% (d) (f)
Residual Income (RI) (b) Rs.5,000 0

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School of Open Learning, University of Delhi
MBA

11.18 REFERENCES & SUGGESTED BOOKS

• Maheshwari, S. N., & Mittal, S. N. Cost Accounting: Theory and Problems. Shree
Mahavir Book Department.
• Arora, M.N. Cost Accounting-principles and practice. Vikas Publishing House.
• Maheshwari, S. N., Maheshwari, S. K., Mittal, S.N. Cost Accounting: Principles &
Practice. Shree Mahavir Book Depot.
• Nigam, B. M .Lal & Jain, I. C. Cost Accounting: Principles and Practice. PHI
Learning.
• Mitra. Cost and Management accounting. Oxford University Press.
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