UNIT-1

CONCEPTS OF MANAEMENT ACCOUNTING

LEARNING OBJECTIVES:

 To understand different branches of Accounting with their limitations

 To conceptualize the meaning, definition, nature, scope and objectives of Management

Accounting

 To analyze the importance/role of Management Accounting

 To differentiate between Management Accounting, Financial Accounting and Cost

Accounting

 To know the role of Management Accounting in modern business

 To acquaint with the tools and techniques of Management Accounting

CHAPTER PLAN:

1.1 Introduction
1.2 Definition of Management Accounting
1.3 Nature/Characteristics of Management Accounting
1.4 Scope of Management Accounting
1.5 Objectives of Management Accounting
1.6 Importance/Functions of Management Accounting
1.7 Role of Management Accounting
1.8 Role of Management Accountant
1.9 Distinction between Management Accounting, Financial Accounting & Cost Accounting
1.10 Role of Management Accounting in Modern Business
1.11 Tools and Techniques of Management Accounting
1.12 Limitations of Management Accounting
1.13 Glossary
1.14 Review Questions
1.1 INTRODUCTION:

Accounting is the process of recording, classifying, summarizing, analyzing and interpreting the
financial transactions of the business for the benefit of management and those parties who are
interested in business such as shareholders, creditors, bankers, customers, employees and
government. Thus, it is concerned with financial reporting and decision making aspects of the
business.

Branches of Accounting

Accounting can be groupedinto three categories:

1. Financial Accounting

2. Cost Accounting, and

3. Management Accounting

1.1.1 Financial Accounting

The term ‘Accounting’ unless otherwise specifically stated always refers to ‘Financial
Accounting’. Financial Accounting is commonly carried on in the general offices of a business.
It is concerned with revenues, expenses, assets and liabilities of a business house.

Financial Accounting has two-fold objectives, viz.

1. To ascertain the result of the business in terms of earning of profits or suffering of losses, and

2. To know the financial position of the concern.

The following are the functional aspects of financial accounting:

1.Dealing with Financial Transactions

2. Recording of information

3. Classification of Data

4. Summarizing Group of Information

5. Analyzing

6. Interpreting the Financial Information

7. Communicating the Results

Financial Accounting is like a post-mortem report. At the most it can reveal what has happened
so far, but it does not have any control over the past happenings.

The limitations of financial accounting are as follows:

1. It records only quantitative information.

2. It records only the historical cost. The impact of future uncertainties has no place in financial
accounting.

3. It does not take into account price level changes.

4. It provides information about the whole concern. Product-wise, process-wise, department-

wise or information of any other line of activity cannot be obtained separately from the financial
accounting.

5. Cost figures are not known in advance. Therefore, it is not possible to fix the price in advance.
It does not provide information to increase or reduce the selling price.

6. As there is no technique for comparing the actual performance with that of the budgeted
targets, it is not possible to evaluate performance of the business.

7. It does not tell about the optimum or otherwise of the quantum of profit made and does not
provide the ways and means to increase the profits.

8. In case of loss, whether loss can be reduced or converted into profit by means of cost control
and cost reduction? Financial Accounting does not answer such question.

9. It does not reveal which departments are performing well? Which ones are incurring losses
and how much is the loss in each case?

10. It does not provide the cost of products manufactured

11. There is no means provided by financial accounting to reduce the material losses, i.e.
wastage, scrap, spoilage and defectives.

12. Can the expenses be reduced which results in the reduction of product cost and if so, to what
extent and how? There is no answer to these questions in financial accounting.

13. It is not helpful to the management in taking strategic decisions like replacement of assets,
introduction of new products, discontinuation of an existing line, expansion of capacity, etc.

14. It provides ample scope for manipulation like overvaluation or undervaluation. This
possibility of manipulation reduces the reliability.
15. It is technical in nature. A person not conversant with accounting has little utility of the
financial accounts.

1.1.2 Cost Accounting

The Institute of Cost and Works Accountants, India defines cost accounting as, “the technique
and process of ascertainment of costs. Cost Accounting is the process of accounting for costs,
which begins with recording of expenses or the bases on which they are calculated and ends with
preparation of statistical data”.

To put it simply, when the accounting process is applied for the elements of costs (i.e.,
Materials, Labour and Other expenses), it becomes Cost Accounting.

The main objectives of cost accounting are as follows:

1. Cost Ascertainment

2. Cost Control

3. Cost Reduction

4. Fixation of Selling Price

5. Providing information for framing Business policy.

Limitations of Cost Accounting

i)GroundedonEstimation: As cost accounting relies heavily on predetermined data, it is not

reliable.

ii)No StandardizedProcedure:As there is no uniform procedure, with the same information

different results may be arrived by different cost accountants.

iii)Conventions and Estimates: There are number of conventions and estimates in preparing
cost records such as materials are issued on an average (or) standard price, overheads are charged
on percentage basis, Therefore, the profits arrived from the cost records are not true.

iv) Formalities: Many formalities are to be observed to obtain the benefit of cost accounting.
Therefore, it is not applicable to small and medium firms.

v) Expensive: Cost accounting is expensive and requires reconciliation with financial records.

vi) AdditionalTool: Cost Accounting is an additional tool not an essential tool and an enterprise
can survive even without cost accounting.
vii) Secondary Data: Cost Accounting depends on financial statements for a lot of information.
The errors or short comings in that information creep into cost accounts also.

1.1.3 Management Accounting

Management Accounting is comprised of two words ‘Management’ and ‘Accounting’. It means

the study of managerial aspect of accounting. The emphasis of management accounting is to
redesign accounting in such a way that it is helpful to the management in formation of policy,
control of execution and appreciation of effectiveness.

Management Accounting can be viewed as Management-oriented Accounting. Basically it is

the study of managerial aspect of financial accounting,i.e.“accounting in relation to management
function". It is developed mainly to help the management in the discharge of its functions and for
taking various decisions. The primary task of management accounting is, therefore, to redesign
the entire accounting system so that it may serve the operational needs of the firm. It furnishes
definite accounting information-past, present or future, which may be used as a basis for
management action. The financial data are so devised and systematically developed that they
become a unique tool for management decision.Hence, Management Accounting involves the
study of accounting information and techniques that managers use in analyzing information.

Management Accounting is not a specific system of accounts, but could be any form of
accounting which enables a business to be conducted more effectively and efficiently.
Management Accounting, therefore, appears as the extension of the horizon of cost accounting
towards emerging areas of management. Management Accounting is largely concerned with
providing economic information to managers for achieving organizational goals.Managers use
management accounting information to choose strategy to communicate it and to determine how
best to implement it. They use management accounting information to coordinate their decisions
about designing, producing and marketing a product or service.

1.2 DEFINITION OF MANAGEMENT ACCOUNTING:

Anglo-American Council of Productivity: “ManagementAccounting is the presentation of

accounting information in such a way as to assist the management in creation of policy and the
day to day operation of an undertaking".

Institute of Chartered Accountants of England and Wales: “Any form of accounting which
enables a business to be conducted more efficiently can be regarded as Management
Accounting”.

American Accounting Association: “It includes the methods and concepts necessary for
effective planning for choosing among alternative business actions and for control through the
evaluation and interpretation of performances.”
Institute of Cost and Management Accountants, London: “Management Accounting is the
application of professional knowledge and skill in the preparation of accounting information in
such a way as to assist management in the formulation of policies and in the planning and control
of the operation of the undertakings”.

Institute of Management Accountants (IMA): "Management Accounting is a profession that

involves partnering in management decision making, devising planning and performance
management systems, and providing expertise in financial reporting and control to assist
management in the formulation and implementation of an organization's strategy"

J. Batty: “Management Accountancy is the term used to describe the accounting methods,
systems and techniques which, with special knowledge and ability, assist management in its task
of maximizing profit or minimizing losses.”

Brown and Howard: “Management Accounting is that aspect of accounting which is concerned
with the efficient management of a business through the presentation of management of such
information as will facilitate efficient and opportune planning and control.”

Robert Anthony: “Management Accounting is concerned with accounting information which is

useful to management”

CIMA, London: “Management Accounting is an integral part of management concerned with

identifying, presenting and interpreting information used for: (a) formulating strategy; (b)
planning and controlling activities; (c) decision taking; (d) optimizing the use of resources; (e)
disclosure to shareholders and others external to the entity; (f) disclosure to employees; (g)
safeguarding assets”.

1.3 NATURE /CHARACTERISTICS OF MANAGEMENT ACCOUNTING:

1. Grounded onAccounting Information

Management Accounting is based on accounting information. Management Accounting is a

service function and it provides necessary information to different levels of management.
Management Accounting involves the presentation of information in a way that suits the
managerial needs. The accounting data collected by accounting department is used for reviewing
various policy decisions.

2. Cause and Effect Analysis

The role of financial accounting is limited to find out the ultimate result, i.e., profit and loss,
whereas management accounting goes a step further. Management Accounting discusses the
cause and effect relationship. The reasons for the loss are probed and the factors directly
influencing the profitability are also analyzed. Profits are compared to sales, different
expenditures, current assets, interest payables, share capital, etc. to give meaningful
interpretation.

3. Use of Special Techniques and Concepts

Management Accounting uses special techniques and concepts according to necessity, to make
accounting data more useful. The techniques usually used include financial planning and
analyses, standard costing, budgetary control, marginal costing, project appraisal etc.

4. Aids in Taking Important Decisions

It supplies necessary information to the management which may be useful for its decisions. The
historical data is studied to see its possible impact on future decisions. The implications of
various decisions are also taken into account.

5. Aims at Achieving Objectives

Management Accounting uses the accounting information in such a way that it helps in
formatting plans and setting up objectives. Comparing actual performance with targeted figures
will give an idea to the management about the performance of various departments. When there
are deviations, corrective measures can be taken immediately with the help of budgetary control
and standard costing.

6. No Fixed Norms

No specific rules are followed in management accounting as that of financial accounting. Though
the tools are the same, their use differs from concern to concern. The deriving of conclusions
also depends upon the intelligence of the management accountant. The presentation will be in the
way which suits the concern most.

7. ImprovesEfficiency

The purpose of using accounting information is to increase efficiency of the concern. The
performance appraisal will enable the management to pin-point efficient and inefficient spots.
Efforts are made to take corrective measures so that efficiency can be improved. The constant
review will make the staff cost conscious.

8. DeliversInformation and not Decision

Management accountant is only to guide to take decisions. The data is to be used by the
management for taking various decisions. ‘How is the data to be utilized’ will depend upon the
caliber and efficiency of the management.
9. Involvedin Forecasting

The management accounting is concerned with the future. It helps the management in planning
and forecasting. The historical information is used to plan future course of action. The
information is supplied with the object to guide management for taking future decisions.

1.4 SCOPE OF MANAGEMENT ACCOUNTING

The advancement in information technology and the ever growing appetite of information
consumers in this information age has broadened the scope of management accounting to include
things that were not included in the discipline some ten years ago.Management Accounting has
moved from a mere information gathering and processing system to an all-encompassing
business solution box.

Management Accounting is concerned with presentation of accounting information in the most

useful way for the management. Its scope is, therefore, quite vast and includes within its fold
almost all aspects of business operations. However, the following areas can rightly be identified
to be within the ambit of management accounting:

(i) Financial Accounting: Management Accounting is mainly concerned with the

rearrangement of the information provided by financial accounting. Hence, management cannot
obtain full control and coordination of operations without a properly designed financial
accounting system.

(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential
costing and other cost techniques play a useful role in operation and control of the business
undertaking.

(iii) Revaluation Accounting: This is concerned with ensuring that capital is maintained intact
in real terms and profit is calculated with this fact in mind.

(iv) Budgetary Control: This includes framing of budgets, comparison of actual performance
with the budgeted performance, computation of variances, finding their causes, etc.

(v) Inventory Control: It includes control over inventory from the time it is acquired till its
final disposal.

(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other
statistical methods make the information more impressive and intelligible.

(vii) Interim Reporting: This includes preparation of monthly, quarterly, half yearly income
statements and the related reports, cash flow and funds flow statements, scrap reports, etc.

(viii) Taxation: This includes computation of income in accordance with the tax laws, filing of
returns and making tax payments.
(ix) Office Services: This includes maintenance of proper data processing and other office
management services, reporting on best use of mechanical and electronic devices.

(x) Internal Audit: Development of a suitable internal audit system for internal control.

(xi)Management Information System [MIS]: Management Accounting serves as a centre for

collection and dissemination of information.MIS is an essential part of Management Accounting.

1.5 OBJECTIVES OF MANAGEMENT ACCOUNTING

The fundamental objective of management accounting is to enable the management to maximize

profits or minimize losses. The evolution of management accounting has given a new approach
to the function of accounting. The main objectives of management accounting are as follows:

1. Planning and Policy Formulation

Planning involves forecasting on the basis of available information, setting goals, framing
polices, determining the alternative courses of action and deciding on the programme of
activities. Management accounting can help greatly in this direction. It facilitates the preparation
of statements in the light of past results and gives estimation for the future.

2. Interpretation Process

Management Accounting is to present financial information to the management. Financial

information is technical in nature.

Therefore, it must be presented in such a way that it is easily understood. It presents accounting
information with the help of statistical devices like charts, diagrams, graphs, etc.

3. Assists in Decision-Making Process

With the help of various modern techniques, management accounting makes decision-making
process more scientific. Data relating to cost, price, profit and savings for each of the available
alternatives are collected and analyzed and thus it provides a base for taking sound decisions.

4. Controlling

Management Accounting is a useful tool for managerial control. Management Accounting tools
like standard costing and budgetary control are helpful in controlling performance. Cost control
is affected through the use of standard costing and departmental control is made possible through
the use of budgets. Performance of each and every individual operation is controlled with the
help of management accounting.
5. Reporting

Management Accounting keeps the management fully informed about the latest position of the
concern through reporting. It helps management to take proper and quick decisions. The
performances of various departments are regularly monitored and reported to the top
management.

6. Facilitates Organizing

Since management accounting stresses more on Responsibility Centres with a view to control
costs and fixation of responsibilities, so it also facilitates decentralization to a greater
extent.Thus, it is helpful in setting up effective and efficient organization framework.

7. Facilitates Coordination of Operations

Management Accounting provides tools for overall control and coordination of business
operations. Budgets are important means of coordination.

1.6 IMPORTANCE/FUNCTIONS OF MANAGEMENT ACCOUNTING

The basic function of management accounting is to assist the management in performing its
functions effectively. The functions of the management are planning, organizing, directing and
controlling. Management Accounting helps in the performance of each of these functions in the
following ways:

(i) Provides Data: Management Accounting serves as a vital source of data for management
planning. The accounts and documents are a repository of a vast quantity of data about the past
progress of the enterprise which are a must for making forecasts for the future.

(ii) Modifies Data: The accounting data required for managerial decisions is properly compiled
and classified. For example, purchase figures for different months may be classified to know
total purchases made during each period product-wise, supplier-wise and territory-wise etc.

(iii) Analyses and Interprets Data: The accounting data is analyzed meaningfully for effective
planning and decision-making. For this purpose the data is presented in a comparative form.
Ratios are calculated and likely trends are projected.

(iv) Serves as a Means of Communicating: Management Accounting provides a means of

communicating management plans upward, downward and outward through the organization.
Initially, it is a means of identifying the feasibility and consistency of the various segments of the
plan. At later stages it keeps all parties informed about the plans that have been agreed upon and
their roles in these plans.

(v) Facilitates Control: Management Accounting helps in translatinggiven objectives and

strategy into specified goals for attainment by a specified time and secures effective
accomplishment of these goals in an efficient manner. All this is made possible through
budgetary control and standard costing which is an integral part of management accounting.

(vi) Uses also Qualitative Information: Management Accounting does not restrict itself to
financial data for helping the management in decision making but also uses such information
which may not be capable of being measured in monetary terms. Such information may be
collected form special surveys, statistical compilations, engineering records, etc.

1.7 ROLE OF MANAGEMENT ACCOUNTING

The role of management accounting can be summarized in following points:

1. Helping Forecast the Future:

Forecasting aids decision-making and answering questions, such as: Should the company invest
in more equipment? Should it diversify into different markets? Should it buy another company?
Management Accounting helps in answering these critical questions and forecasting the future
trends in business.

2. Helping in Make-or-Buy Decisions:

Is it cheaper to procure materials or a product from a third party or manufacture them in-house?
Cost and production availability are the deciding factors in this choice. Through management
accounting, insights will be developed which will enable decision-making at both operational
and strategic levels.

3. Forecasting Cash Flows:

Predicting cash flows and the impact of cash flow on the business is essential. How much cost
will the company incur in the future? Where will its revenues come from and will the revenues
increase or decrease in the future? Management Accounting involves designing of budgets and
trend charts, and managers use this information to decide how to allocate money and resources to
generate the projected revenue growth.

4. Helping Understand Performance Variances:

Business performance discrepancies are variances between what was predicted and what is
actually achieved. Management Accounting uses analytical techniques to help the management
build on positive variances and manage the negative ones.

5. Analysing the Rate of Return:

Before embarking on a project that requires heavy investments, the company would need to
analyse the expected rate of return (ROR). If given two or more investment opportunities, how
should the company choose the most profitable one? In how many years would the company
break-even on a project? What are the cash flows likely to be? These are all vital questions that
can be answered through management accounting.

1.8 ROLE OF MANAGEMENT ACCOUNTANT

The management accountant, often referred to as controller, is the managers of accounting

information used in planning, control and decision making areas. He is responsible for collecting,
processing and reporting information that well help managers in their planning, controlling and
decision making activities. He participates in all accounting activities within the organization.

The following are the Roles of Management Accountant:

1. Participating in Management Process: The management accountant occupies a pivotal

position in the organization. He performs a staff function and also has line authority over the
accountant and other employees in his office. He educates executives on the best use of
accounting information.

2. Maintaining optimum Capital Structure: Management accountant has a major role to play
in raising of funds and their application. He has to decide about maintaining a proper mix of debt
and equity. The raising of funds through debt is cheaper because of tax benefits and a proper
leverage leads to trading on equity.

3. InvestmentOpportunities: A management accountant can assist either person or a firm

regarding the investment in different ways. He can suggest how, when and where the investment
should be made so that an investor or the firm canearn maximum return.

4. Financial Investigations: A management accountant can assist the management about the
financial investigations which is extremely desired to determine the financial position for the
interested parties. Relating to issue of shares, amalgamation or mergers, or reconstructions etc to
ascertain the reason of decreasing profit or increasing costs, it so happened.

5. Long-term and Short –term Planning: Management accountant plays an important role in
forecasting future business and economic events for making future plans i.e., short term and
long-term plans, formulating corporate strategy, market study etc.

6. Participating in Management Process: The management accountant occupies a pivotal

position in the organization. He performs a staff function and also has line over the accountant
and other employees in his office. He educates executives on the need for collecting information
and on the ways of using it. He shifts relevant information from the irrelevant and reports the
same in a clear form to the management and sometimes to interested external parties.

7. Decision Making; Management accountant provides necessary information to management in

taking short-term decision e.g. optimum product mix, make or buy, lease or buy, pricing of
product, discontinuing a product etc. and long-term decisions e.g., capital budgeting,investment
appraisal, project financing. However, the job of management accountant is limited to the
adequacy of required information, both in a comprehensive as well as reliable form for decision
making purposes.

8. Control: The management accountant analyses accounts and prepares reports e.g., standard
costs, budgets, variance analysis and interpretation, cash and funds flow analysis, management of
liquidity, performance evaluation and responsibility accounting etc. for control.

9.Developing Management Information System: The routine reports as well as reports for long
term decision making are forwarded to managerial personnel at all levels to take corrective
action at the right time and also uses these reports for taking important decisions.

10. Stewardship Accounting: Management accountant designs the framework of cost and
financial accounts and prepares reports for routine financial and operational decision making.

11. CorporatePlanning: He can assist management for long-term planning and advise
management regarding amalgamation or mergers or reconstructions including financial planning
to see whether effective utilization of resources is made or not. Thus, the role of management
accountant cannot be ignored. As such, his services are primarily desired for the efficient
management of an undertaking.

1.9 DISTINCTION BETWEEN MANAGEMENT ACCOUNTING, FINANCIAL

ACCOUNTING, COST ACCOUNTING

1.9.1 DIFFERENCE BETWEEN COST ACCOUNTING AND FINANCIAL ACCOUNTING

Sl No Basis Cost Accounting Financial Accounting

1 Purpose: The main purpose of Cost The main purpose of Financial
Accounting is to analyze, Accounting is to record financial
ascertain and control costs transactions and prepare financial
statements.

2 Decision The Cost Accounts are basically Financial accounts are of limited
Making: designed to facilitate decision use in decision making.
making in the areas of
production, purchase, sales etc.
3 Analysis of The Cost Accounting shows the Financial Accounting shows the
Cost and detailed cost and profits for each overall profit/loss of the entire
Profit: product, process, job, contract organization.
etc.
4 Transactions Cost Accounting keeps records Financial Accounts keep records
Recorded: of both external and internal of only external transactions with
transactions. outsiders.

5 Access: In Cost Accounting the outsiders In Financial Accounting anybody

generally have no access to cost can have access to Financial
records. Statements of Companies.

6 Control: Cost Accounting Control all Financial Accounting does not

elements of Costs. exercise adequate control over
material, labour and overhead
costs.

7 Profit or Loss Cost Accounting determines the Financial Accounting determines

profit or loss of each product, the profit or loss of the entire
process, job and department. business.

8 Units Cost Accounting records both Financial Accounting records only

monetary and physical units monetary units in the books of
such as labour hour, machine accounts.
hour etc.
9 Valuation of Closing Stock is valued at cost In Financial Accounting Closing
Closing price only in Cost Accounting. Stock is valued at cost or market
Stock price {Net Realizable value}
whichever is lower.

10 Audit Cost Accounting need not be Financial Accounting needs a

followed by a system of external system of independent audit of the
audit. financial records by an external
auditor.

11 Tax Cost Accounting does not form a Financial Accounting forms a

Assessment basis for tax assessment. basis for determination tax
liability of the business.

12 Parties Cost Accounting serves the Financial Accounting serves the

information needs of the information needs of owners,
management. creditors, employees and the
society at large.

13 Mandatory Installing a costing system is Maintaining Financial Accounting

purely optional. is mandatory.
14 Lack of There are no fixed rules and There are fixed rules and
Uniformity: regulations in Cost regulations in Financial
Accounting.Therefore different Accounting.
cost accounting system may be
followed by different firms in
the same industry which makes
comparison difficult.
1.9.2DIFFERENCE BETWEEN COST ACCOUNTING AND MANAGEMENT
ACCOUNTING

The important differences between Cost Accounting and Management Accounting are as
follows:

Sl No Basis Cost Accounting Management Accounting

1 Purpose: The purpose of Cost Accounting The purpose of Management
is the ascertainment of cost at Accounting is to provide
each stage of production. information to the management
for decision making.
2 Basis: Cost Accounting is prepared Management Accounting purely
mainly on the basis of past and aims at the future based on the
less emphasis is given for the past information.
future.
3 Preparation: Cost Accounting is prepared on Management Accounting is
the basis of some rules and prepared without adopting any
regulations prescribed by the specific and rigid rules. It may be
ICAI (Institute of Cost prepared according to the will of
Accountants of India). the managerial personnel.

4 Reports: The Reports of the Cost The reports of the Management

Accounting are subject to Accounting are not subject to
statutory audit. statutory audit.

5 Useful: The reports of the Cost The reports of the Management

Accounting are useful both to Accounting are useful only for the
the internal and external parties. internal parties.

6 Scope: Cost Accounting does not Management Accounting includes

include tax planning and tax tax planning and tax accounting.
accounting.

7 Evolution: Cost Accounting evolves due to Management Accounting evolves

the limitation of financial due to the limitations of cost
accounting, accounting. It is the managerial
aspects of financial accounting
and cost accounting.
8 Maintenance The maintenance of records is The maintenance of records is
of Records: compulsory for complying the purely voluntary and for internal
statutory requirements in use of management of the
selected industries as notified by Company.
Govt. from time to time.
9 Planning Cost Accounting is mainly Management Accounting is
Aspect: concerned with short-term concerned with short term as well
planning. as long term planning of the
organization.

10 Installation Cost Accounting can be installed Management Accounting system

of System: without the help of the cannot be properly installed
Management Accounting in the without a proper cost accounting
organization. system.

11 Derivation of Cost Accounting data are Management Accounting data are

Data: derived basically from financial derived from both Cost Accounts
accounts. as well as from Financial
Accounts.

12 Status: The status of the Cost The status of the Management

accountant in the organization accountant is higher than Cost
comes after the management accountant in the organization due
accountant. to direct participation in decision
making process.

1.9.3DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

Sl No Basis Financial Accounting Management Accounting

1 Objective Financial Accounting aims at The aim of Management
recording business transaction Accounting is to prepare various
systematically to ascertain profit statements for managerial
or loss and financial position at planning, control and decision
the end of the financial year. making.

2 Time Period In Financial Accounting the InManagement Accounting the

accounts are prepared for a reports are prepared from time to
particular period. time to update with the changing
business environment.
3 Audit In Financial Accounting under InManagement Accounting audit
Company law Financial is optional..
accounts are subject to
compulsory Audit.
4 Principles Financial Accounting is In Management Accounting no set
prepared as per Generally of standing principles are
Accepted Accounting principles followed.
(GAAP).

5 Nature Financial Accounting is The Management Accounting is

concerned with historical data. It concerned with both historical
records only those transactions data and estimated data.
which have already taken place.
Thus, the accounts prepared here
are like post-mortem report.
6 Publication In Financial Accounting, In Management Accounting the
Financial Statements are statements and reports are not
published annually for external published. They are meant for
parties interested in the internal use of the management.
accounting information.
7 Quickness In Financial Accounting, In Management Accounting,
reporting is slow and time reporting is very quick as it is
consuming. Hence, one has to meant for decision making.
wait till the end of the
accounting year to get the
financial statements.
8 Nature of Financial Accounting is Management Accounting is
Information concerned with quantitative concerned with both qualitative
information expressed in terms and quantitative information.
of money.
9 Reporting In Financial Accounting, InManagement Accounting, the
Financial reports are prepared reports are prepared for internal
not only for the organization but use only.
for others interested in the
accounting information of the
business.
10 Legal Preparation of financial accounts Management Accounting is not
Compulsion is mandatory to comply with compulsory.
statutory requirements.

1.10 ROLE OF MANAGEMENT ACCOUNTING IN MODERN BUSINESS:

Management Accounting is required to satisfy the demands of the current economic

environment. There is a need for more innovative and useful management accounting techniques
to improve productivity, to reduce costs, to improve quality, to determine accurate product costs
to satisfy managerial needs of planning, decision making and control.

1. Activity-Based Costing (ABC) and Management:

The demand for more accurate and relevant management accounting information has led to the
development of activity-based costing and activity-based management. Activity-based costing
improves the accuracy of assigning costs by first tracing costs to activities and then to products
or customers that consume these activities. Process value analysis, on the other hand, emphasizes
activity analysis— trying to determine why activities are performed and how well they are
performed.
The objective is to find ways to perform necessary activities more efficiently and to eliminate
those that do not create customer value. Activity-based management is a system- wide,
integrated approach that focuses management’s attention on activities with the objective of
improving customer value and the resulting profit. Activity-based management emphasizes
Activity- Based Costing (ABC) and process value analysis.

2. Increasing Customer Value:

Globalisation has brought a wave of change in the way business operates and creates value for
the customer. Now the market is not firm-centric but customer-centric. Customer value is a key
focus of every firm. Firms can establish a competitive advantage by creating better customer
value for the same by reducing cost than that of competitors with value addition to the product.

Customer value is the difference between what a customer receives (customer realization) and
what the customer gives up (customer sacrifice). Increasing customer value means increasing
customer realization or decreasing customer sacrifice, or both.

Increasing customer value to create a sustainable competitive advantage is achieved through

selection of strategies. Cost information plays a critical role in this process and does through a
process called as strategic cost management. Strategic cost management is the use of cost data to
develop and identify superior strategies that can produce a sustainable competitive advantage. A
focus on customer value ensures that the management accounting system should produce
information about both realization and sacrifice.

3. Cross-Functional Perspective:

Management Accounting has a cross-functional perspective and management accountant must

understand all functions of the business, from manufacturing to marketing and customer service.
When customer value is attempted to be increased, all the functions of a business become
interrelated; a decision affecting one, affects others as well.

A cross-functional perspective helps us to see the forest, not just one or two of the trees. This
broader vision allows managers to increase quality, reduce the time required to serve customers
and improve efficiency. In this perspective, management accounting helps other business
functions through providing useful information and analysis.

4. Total Quality Management (TQM):

Continuous improvement is fundamental for establishing a state of manufacturing excellence.

Manufacturing excellence is the key to survival in today’s world-class competitive environment.
A philosophy of total quality management, in which manufacturers strive to create an
environment that will enable workers to manufacture perfect (zero-defect) products, has replaced
the “acceptable quality” attitudes of the past.
Quality cost measurement and reporting are key features of a management accounting system for
both manufacturing and service industries. In both cases, the management accounting system
should be able to provide both operational and financial information about quality, including
information such as the number of defects, quality cost reports, quality cost trend reports and
quality cost performance reports.

5. Enhancing Efficiency and Reducing Time:

Improving efficiency in business activities is of vital concern in all business enterprises. Both
financial and non-financial measures of efficiency are needed. Cost is a critical measure of
efficiency. Trends in costs over time and measure of productivity changes can provide important
measures of the efficiency of continuous improvement decisions. (Output measured in relation to
the inputs).

Reducing time in all phases of production cycles, selling and distribution should be an important
target for all business houses. Firms should deliver products or services quickly by eliminating
non-value-added time and time of no-value to the customer. Decrease in non-value added time
has correspondence with increase in quality.

Now-a-days, the technological innovation has increased for many industries and the life of a
particular product can be quite short. Managers must be able to respond quickly and decisively to
changing market conditions. Information to allow them to accomplishthis must be available from
a management accounting information system.

6. Electronic Business (E-Business):

E-business is doing business transaction through information and communication technology. E-

commerce is buying and selling products using information and communication technology.
Business firms can expand sales and lower costs through e-business compared to paper-based
transactions. Management accounting plays significant role in e-business through providing
relevant cost information about its benefits, risks and opportunities. For example, business
managers need to know the cost per electronic transaction versus cost per paper transaction.

1.11TOOLS AND TECHNIQUES USED IN MANAGEMENT ACCOUNTING

Some of the important tools and techniques used in management accounting are briefly
explained below.

1. Financial Planning

The main objective of any business organization is maximization of profits. This objective is
achieved by making proper or sound financial planning. Hence, financial planning is considered
as best tool for achieving business objectives.
2. Financial Statement Analysis

Profit and Loss account and Balance Sheet are important financial statements. These statements
are analysed for different period. This type of analysis helps the management to know the rate of
growth of business concern. This analysis is done through comparative financial statements,
common size statements, ratio analysis and trend analysis.

3. Cost Accounting

Cost Accounting presents cost data in product wise, process wise, department wise, branch wise
and the like. These cost data are compared with predetermined one. This comparison of two
costs enables the management to decide the reasons responsible for the difference between these
costs.

4. Funds Flow Analysis

This analysis finds out the movement of fund from one period to another. Moreover, this analysis
is very useful to know whether the fund is properly used or not in a year when compared to the
previous year. The net working capital changes and funds lost from operation are also found out
through this analysis.

5. Cash Flow Analysis

The movement of cash from one period to another can be found out through this analysis.
Besides, the reasons for cash balance and changes between two periods are also found out. It
studies the cash from operation and the movement of cash in a period under the distinct heading
of operating activities, financing activities and investing activities.

6. Standard Costing

Standard cost is predetermined cost. It provides a yard stick for measuring actual performance. It
is used to find the reasons for the variances if any.

7. Marginal Costing

Marginal costing technique is used to fix the selling price, selection of best sales mix, best use of
scarce raw materials or resources, to take make or buy decision, acceptance or rejection of bulk
order and foreign order and the like. This is based on the fixed cost, variable cost and
contribution.

8. Budgetary Control

Under Budgetary control techniques, future financial needs are estimated and arranged according
to an orderly basis. It is used to control the financial performances of business concern. Business
operations are directed in a desired direction.
9. Revaluation Accounting

The fixed assets are revalued as per the revaluation accounting method so that the capital is
properly represented with the assets value. It helps to find out the fair return on capital employed.

10. Decision-Making Accounting

A business problem can be solved by choosing any one of the best and most profitable
alternatives. To select such alternative, the relevant costs are compared. Thus, accounting
informationare used to solve the business problem which are arising out of increasing complexity
of nature of business.

11. Management Information System (MIS)

Free flow of communication within the organization is essential for effective functioning of
business. Hence, the management can design the system through which every employee of an
organization can assess the information and used for discharging their duties and taking quality
decisions.

12. Statistical Techniques

There are a lot of statistical techniques used in removing management problems. Methods of
least square, Regression analysis, Correlation analysis, Time series analysis and Statistical
quality control etc. are some examples of statistical techniques.

13. Management Reporting

The management accountant is preparing the report on the basis of the contents of profit and loss
account and balance sheet and submit the same before the top management. Thus, management
reports disclose the strength and weakness indifferent areas of operating activities and financial
activities. These identifications are highly useful to management in exercising control and taking
appropriate decision.

14. Ratio Analysis

It is used by management in the discharge of its basic functions of forecasting, planning,

coordination, communication and control. It paves the way for effective control of business
operations by undertaking an appraisal of both the physical and monetary targets.

Summary of Tools and Techniques of Management Accounting:

1. Based on Financial Accounting Information

 Analysis of Financial Statements through Ratio Analysis.
 Analysis of Financial Statements through Comparative statements,Common size
statements, Trend, Graph and Diagram.
 Funds flow and Cash flow analysis.
 Return on Capital Employed Techniques.

2. Based on Cost Accounting Information

 Marginal costing (including cost-volume-profit analysis).
 Differential costing.
 Standard Costing.
 Analysis of Cost Variances.

3. Based on Mathematics
 Operation Research.
 Linear Programming.
 Network Analysis.
 Queuing theory and Game Theory.
 Simulation Theory.

4. Based on Future Information

 Budgetary Control.
 Business Forecasting.
 Project Appraisal or Evaluation.

5. Miscellaneous Tools
 Managerial Reporting.
 Integrated Auditing.
 Financial Planning.
 Revaluation Accounting.
 Decision Making Accounting.
 Management Information System.

1.12 LIMITATIONS OF MANAGEMENT ACCOUNTING

Management Accounting, being comparatively a new discipline, suffers from certain limitations
which limits its effectiveness. These limitations are as follows:

1. Limitations of Basic Records: Management Accounting derives its information from

financial accounting, cost accounting and other records. The strength and weakness of the
management accounting, therefore, depends upon the strength and weakness of these basic
records. In other words, their limitations are also the limitations of management accounting.

2. Persistent Efforts: The conclusions drawn by the management accountant are not executed
automatically. He has to convince people at all levels because people by nature are resistant to
change. In other words, he must be an efficient salesman in selling his ideas.

3. Management Accounting is only a Tool: Management Accounting cannot replace the

management. Management accountant is only an adviser to the management. The decision
UNIT-3
ABSORPTION COSTING AND MARGINAL COSTING
Chapter Outlines
2.0 Learning Objectives
2.1 Introduction
2.2 Meaning of Marginal Cost
2.3 Marginal Costing
2.4 Absorption Costing
2.5 Special Terms for Marginal Cost
2.5.1 Contribution
2.5.2 Cost Volume Profit Analysis
2.5.3 Break-Even Point
2.5.4 Angle of Incidence
2.5.5 Margin of Safety
2.5.6 Key or Limiting factor
2.5.7 Assumptions underlying CVP Analysis / Break - Even Charts
2.6 Managerial Application of CVP Analysis.
2.7 Summary
2.8 Key Terms
2.9 Questions and Exercises
2.0 LEARNING OBJCTIVES
After studying this chapter, you should be able to understand:
 Explain concept of absorption and marginal costing.
 Distinguish between absorption costing and marginal costing.
 Explain the managerial application of CVP analysis.
 Explain the concept of angle of incidence.
2.1 INTRODUCTION
In cost accounting, cost of production per unit of the goods produced or services provided is
calculated with the help of the various methods such as Unit Costing Method, job costing, Batch Costing
contract Costing or Process Costing. Marginal costing is not a method of calculating the cost of
production as the above given methods are but it is a technique applicable to the existing methods to find
out the effect on profits if changes are made either in the volume of output or in the type of output. Thus
marginal costing is a technique which helps the management in taking various routine and special or
crucial decisions for running the organisational activities like (i) To continue with a product or not, (ii) To
change the selling price as per the market conditions, (iii) To change the method of production, (iv) To
make or buy decision, (v) To decide about sales mix.
2.2 MEANING OF MARGINAL COST
(i) According to I.C.M.A. London, marginal cost is defined as “The amount at any given volume of
output by which aggregate costs are changed if the volume of output is increased or decreased by
one unit. In practice this is measured by the total variable attributable to one unit.” In this context, a
‘Unit’ may be single article, a batch of articles, an order, a stage of production capactiy, a man-
hour, a process or a department.
(ii) According to Blocker and Weltmore, “Marginal cost is the increase or decrease in the total cost
which result from producing or selling additional unit of a commodity or from a change in the
method of production or distribution.”
Marginal cost is the aggregate of variable costs. It is the cost of producing one additional unit. The
marginal cost concept is based on the distinction between fixed and variable costs. Marginal cost is the
total of variable costs only and fixed costs only and fixed costs are ignored.
So, after analysing the definition we can say that with the increase in one unit of output, the total
cost is increased and this increase in total cost from the existing to the new level is known as ‘Marginal
Cost’.
For example, for the production of 1,000 units of product, the variable costs per unit is `5 and fixed
costs are `5,000 per annum. If the production is increased by one unit, the marginal cost will be:
Total cost of 1, 000 units:
Fixed costs = ` 5,000
Variables costs (1, 000 units × 5) = ` 5,0000
Total cost = Fixed Costs + Variables Costs
= `5,000 + ` 5,000 = ` 10, 000
10, 000
Per unit costs = = `10/-
1, 000
Total cost of 1,001 units:
Fixed costs ` 5,000
Variable costs (1, 001 units × 5) `5,005
Total costs `10,005
Marginal cost = ` 10,005 – ` 10,000 = ` 5
Hence, marginal cost is `5. This is the change in total cost due to change in one unit of output.
2.3 MEANING OF MARGINAL COSTING
According to the Institute of cost and management accountants, London, Marginal costing is
defined as “The ascertainment of marginal cost and of the effect on profit of changes in volume or type of
output by differentiating between fixed costs and variable costs. In this technique of costing only variable
cost are charged to operations, processes or products, while the fixed costs are to be written off against
profits in the period in which they arise.”
Thus, in this context, we can say that marginal costing is a technique which is concerned with the
changes in costs and profits result from changes in volume of output. Marginal costing is also known as
‘Variable Costing’.
2.4 ABSORPTION COSTING / TOTAL COSTING
Absorption costing is the total cost technique. It is the practice of charging all costs, both variable
and fixed, to operations, processes or products. Under absorption costing all costs whether variable or
fixed are treated as product cost. Absorption costing is also known as full costing technique.
This method employs highly arbitrary way of apportionment of overheads which reduces the
practical utility of cost data for controlling purposes.
Illustration 2.1
The following information relates to a company:
Production 40, 000 units
Sales 40, 000 units
Selling Price ` 30 per unit
Direct Material ` 5 per unit
Direct Labour `4 per unit
Overheads :
Variables `3 per unit
Fixed ` 1,00, 000
Calculate net profit under :
(a) Absorption Costing Method : (b) Marginal Costing Method.
Solution:
Income Statement (Absorption Costing)
Sales Particulars ` `
Sale (40,000 units `30) 12,00,000
Less : Cost of goods sold :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Overheads :
Variable (40,000 × 3) 1,20,000
Fixed 1,00,000 5,80,000
Net Profit 6,20,000
Income Statement (Marginal Costing)
Particulars ` `
Sale (40,000 × `30) 12,00,000
Less : Variable Cost :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Variable Overheads (40,000 × 3) 1,20,000 4,80,000
Contribution 7,20,000
Less : Fixed Cost 1,00,000
Net Profit 6,20,000
Illustration 2.2
The following information relates to a company:
Production 40,000 units
Sales 30,000 units
Selling Price `30 per unit
Direct Materials ` 5 per unit
Direct Labour R
Factory Overheads:
Variable `3 per unit
Fixed `1, 00,000
Selling and Distribution overheads:
Variable `1 per unit
Fixed ` 45,000
Calculate:
(i) Net Profit under Absorption Costing Method.
(ii) Net Profit under Marginal Costing Method.
Solution:
Income Statement (Absorption Costing)
Sales Particulars ` `
Sale (30,000 × 30) 9,00,000
Less : Cost of Sales :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Factory overheads :
Fixed 1,00,000
Variable (40,000 × 3) 1,20,000
Less : Closing Stock  5,80, 000 10, 000 units  5,80,000
 40, 000 
 
1,45,000
4,35,000
Add : Selling and Distribution Overheads :
Fixed 45,000
Variable (30,000 × 1) 30,000 5,10,000
Net Profit 3,90,000
Note : Closing stock value of Total Cost.
Income Statement (Marginal Costing Method)
Particulars ` `
Sale (30,000 × 30) 9,00,000
Less : Variable Cost :
Direct Material (40,000 × 5) 2,00,000
Direct Labour (40,000 × 4) 1,60,000
Factory Overheads (40,000 × 3) 1,20,000
 4,80, 000 
Less: Closing Stock  10, 000 units  4,80,000
 40, 000 
1,20,000
3,60,000
Add: Selling and Distribution (30,000 × 1) : 30,000 3,90,000
Contribution 5,10,000
Less: Fixed Cost:
Factory Overheads 1,00,000
Selling and Distribution Overheads 45,000 1,45,000
Net Profit 3,65,000
Note: Closing stock value of Variable Cost.
2.5 SPECIAL TERMS FOR UNDERSTANDING MARGINAL COST
(i) Contribution
(ii) Profit Volume Ratio (P/V ratio)
(iii) Break Even Analysis
(iv) Break Even point (BEP)
(v) Break Even Graph
(vi) Angle of Incidence
(vii) Sales for Desired Profit
(viii)Margin of Safety (M/S)
2.5.1 Contribution
Contribution is the difference between Sales and Variable Cost or marginal cost. In other words,
contribution is defined as the excess of sales over variable cost. Contribution first contributes to fixed cost
and then to profit. Higher contribution means more profit and lower contribution means less profit. So the
management of an organisation tries to increase contribution for higher earning.
Contribution can be represented as :
1.Contribution  Sales  Variable Cost(Marginal Cost)
2. Contribution   per unit   Selling price per unit  Variable cost per unit
3. Contribution  Fixed Cost  Profit / Loss
or C  F  P / L
4. Contribution  Sales  P / V Ratio
For example, if the selling price of a product is R 100 per unit and its variable cost is R 60 per unit,
contribution per unit is `40 (`100 – ` 60).
2.5.2 Profit Volume Ratio
The profit/volume ratio, also called the ‘contribution ratio’ or ‘marginal ratio’, is defined as the
relationship between contribution and sales. In other words, profit/volume ratio is a ratio of contribution
to sales and it can be expressed as under:
Contribution per unit
P / V Ratio 
Sales per unit
Contribution C
(i) P / V Ratio  100 or  100
Sales S
Sales  Variable Cost
(ii) P / V Ratio   100
Sales
Fixed Cost+Profit F+P
(iii) P/V Ratio= ×100 or = ×100
Sales S
Change in profit contribution
(iv) P / V Ratio   100
Change in sales
(v) P / V Ratio  1  var iable Cost Ratio
Example: If selling price of product is ` 100 and the variable cost is `75 per unit, then P/V ratio is :
Marginal costing and Break Even Analysis
100  75 25
P / V Ratio  100  100  25%
100 100
2.5.3 Cost-Volume-Profit (CVP) Analysis or Break Even Analysis
CVP analysis is the relationship among cost, volume and profit. In CVP analysis, an attempt is
made to measure variations of costs and profit with volume of production. In other words, it is a technique
of management accounting which determines profit, cost and sale volume at different levels of
production. When volume of production increases, cost per unit decreases because fixed cost remains
constant. Again, with the increase in volume of output there are chances of decrease in cost per unit and
increase in profit per unit. Thus, cost–volume profit analysis helps the management in profit planning
because we can determine the amount of profits at different levels of activity and the volume of sales to
earn desire profit can also be determined. In this regard, Herman C.Heiser rightly said ‘the most
significant single factor in profit planning of the average business is the relationship between the volume
of business, costs and profits.”
The study of cost – volume – profit analysis is also known as break-even analysis because break-
even analysis refers to the study of relationship between costs, volume and profit at different levels of
production or sales.
2.5.4 Break-even Point:
Break-even point may be defined as the point of sales volume at which total revenue equals total
costs. It is the point of no profit, no loss. When the total sales of a business is equal to its total costs, it is
known to break-even point. At this point, contribution is equal to fixed costs. If a business is producing
more than the break-even point there shall be profit to the business organisation otherwise it would suffer
a loss. The detailed study of Break-even point is known as Break-even Analysis.
2.5.5 Break-even Chart: Graphic Method
Break-even chart is a tool of presentation of the information relating to production quantity, sales
and profits of a business organisation. With the help of this chart the break-even point can be known as
well as the amount of profit or loss at the various levels of output and margin of safety can be found out.
It also provides us the knowledge about the relationship between fixed and variable costs as well as the
contribution and profit-volume(P/V) relationship. Break-even chart shows the relationship between cost,
volume and profit. Break-even point is the most important information out of the all above information
and due to this reason, it is known as break-even chart.
Methods of Drawing a Break-even chart
For drawing a break-even chart, one should have information regarding production capacity,
variable costs and fixed costs of a business organisation.
Firstly, a table is prepared to know about the fixed cost, total costs and total sales at various levels
of output.
First Method (BEP Chart) :
(i) Volume of production/output or sales (in units/rupees) is plotted on X-axis (horizontal axis).
(ii) Cost and sales revenue are shown in Y-axis (vertically).
(iii) On Y-axis, fixed costs are shown first. A parallel line to X-axis
is drawn which means that fixed costs remain constant at each
level of input. Total cost line is drawn upward from the starting
point of fixed cost line. To draw total cost line, the total costs
points are plotted at various levels of output with the help of
table and a line is drawn thereafter joining all these points. This
line is called total cost line.
(iv) Sales values at various levels of output are plotted and a line is
drawn joining these points. This line is called total revenue line.
(v) The point at which total cost line and total revenue line
intersect each other is called break-even point.
(vi) A perpendicular is drawn, from this point, to X-axis to know the break-even point in units and sales
revenue at break-even point can be known by a perpendicular Y-axis from this point.
(vii) The area on the left of break-even point represent the loss area and on the right of BEP indicates the
profit area.
(viii) The angle between sales or total revenue line and total cost line in profit area is called ‘angle of
incidence’. The wider the angle the greater is the profit and vice-versa.
(ix) Difference between the present sales and Break-even sales on the graph shows the margin of safety.
Second Method (BEP Chart) :
In this method, variable costs are shown first and fixed cost line
is drawn parallel and upward to the variable cost line. The fixed cost
line drawn represents the total cost of various levels of output. With
the help of this chart, contribution can be known at various levels of
output by the differences between total sales (revenue) line and
variable cost line.
Third Method (Contribution Chart):
In this method, fixed cost line is drawn parallel to X-axis. The
contribution line is drawn from the origin point which increases with the increase in the output. The
contribution line and fixed cost line inter sects each other that points are called break-even point:
2.5.6 Angle of Incidence:
The angle formed at the intersection of the total sales curve
and the total cost curve is known as angle of incidence. Bigger the
angle of incidence higher will be the profits and smaller the angle of
incidence the lower will be the profits. To improve this angle
contribution should be increased either:
(i) By raising the selling price or
(ii) By reducing Variable cost or
(iii) By both the way.
Illustration 2.3
Plot the following data on a graph and determine break-even point: selling price = ` 20 per unit,
Variable Cost = ` 10 per unit, Fixed Cost ` 20,000.
Output Variable Cost Fixed Expenses Total Cost Total Sales Contribution Pr ofits
 in units  10 per unit 
0 0 20, 000 20, 000 0 0 20, 000
1, 000 10, 000 20, 000 30, 000 20, 000 10, 000 10, 000
2, 000 20, 000 20, 000 40, 000 40, 000 20, 000 
3, 000 30, 000 20, 000 50, 000 60, 000 30, 000 10, 000
4, 000 40, 000 20, 000 60, 000 80, 000 40, 000 20, 000
5, 000 50, 000 20, 000 70, 000 1, 00, 000 50, 000 30, 000
First Method

B.E.P. = 2,000 units or `40,000

Second Method

B.E.P. = 2,000 units or `40,000

Third Method

B.E.P. = 2,000 units or `40,000

Calculation of Break-even point: Algebraic Method
1. Break-even Point in units : It can be calculated with the help of following formula:
Fixed Cost
Break  even po int (in units) 
Selling P r ice per unit  Variable Cost per unit
Fixed Cost
or B.E.P. 
Contribution per unit
or B.E.P.  F C / C

2.Break-even point in terms of money value :

Fixed Cost  Sales
Break  even po int (Rupees) 
Sales  Variable Cost
Fixed Cost  Sales
or B.E.P. 
Contribution
With the help of P / V ratio, B.E.P can be calculated as follows :
Fixed Cost
B.E.P. 
P / V Ratio
New Break-even Point :If the selling price of a product changes, contribution will be changed. As
a result, new Break-even point will be as follows:
Fixed Cost
(i) New B.E.P. (in units) 
New Selling Pr ice  Variable Cost
FC
or 
New Contribution
Fixed Cost
(ii) New B.E.P. (Rupees) 
New P / V Ratio
Calculation of selling price when Break-even point is shifted
When break-even point is shifted, selling price will be calculated in the following manner:
Fixed Cost
New Contribution=
New BEP (in units)
Sales=New Contribution+Variable cost
Illustration 2.4
From the following information, calculate:
(i) BEP (in units)
(ii) BEP (in `)
Sales of 50,000 units @ `6
Variable Costs @ ` 4
Total Fixed Costs ` 80,000
Solution:
Fixed Costs 80, 000
(i) B.E.P. (in units) =   40, 000 units
Contribution Per unit 2(6  4)
Contribution = selling price – Variable Cost
or C=S–V
C=`6–`4=`2
(ii) B.E.P. (in Rs) = Fixed Cost  Sales
Sales  Variable Cost
80, 000  (50, 000  6) 80, 000  3, 00, 000
 
(50, 000  6)  (50, 000  4) 3, 00, 000  2, 00, 000
80, 000  3, 00, 000 = `2,40,000

1, 00, 00
or with the help of P/V ratio, BEP is :
Fixed Costs
BEP (in `) =
P / V Ratio
Contribution C
P / V Ratio   100   100 [C  S  V]
Sales S
Marginal Costing and Break Even Analysis
and C = Selling Price per unit – Variable Cost
= ` 6 – `4 = ` 2
2
 P/V Ratio =  100  33.33%
6
Fixed Costs 80, 000 100
BEP (in `) =   `2,40,000
P / V Ratio 33.33
2.5.7 Sales for Desired Profit
Marginal Costing technique can be applied for maintaining a desired level of profit. Due to
competition, the price of the products may have to be reduced. The change in sales price affects the
profitability of a concern. Marginal costing helps the management to know how many units have to be
sold to maintain the desired level of profits. In order to achieve the desired level of profit the required
sales can be calculated by the following formula:
(a) When total amount of desired profit is given :
Fixed Cost  Desired Pr ofit
(i) Required sales to earn desired profit (in units) 
Contribution per unit
Fixed Cost  Desired profit
(ii) Re quired sales to earn desired profit 
P / V Ratio
(b) When desired profit per unit is given :
Fixed Cost
(i) Sales (in units) 
Contribution per unit  profit per unit
Fixed Cost
(ii) Sales (in Rs)   Selling Pr ice Per unit
Contribution per unit  Pr ofit per unit
Illustration 2.5
Following data are collected from the record of a manufacturing unit of scooter :
Selling price of a scooter is ` 32,000
Fixed cost of a scooter is ` 2,000
Variable cost of a scooter is ` 23,000
In the given period 1000 scooters were sold.
Calculate break -even point of the company and how many scooters should be sold to earn the same
profit, if company reduces the selling price of scooter by ` 2000 per scooter?
Solution:
Total Fixed = ` 2000 × 1000 = ` 20,00,000
Fixed Cost
Break  even po int 
Contribution per unit
20, 00, 000
  222.22 [C= SV=`32,00 `23,000 = `9,000 ] or = 222 Scooters.
9, 000
The present profit of the company is as follows:
Variable cost per scooter `23,000
Fixed cost per scooter `2,000
Total cost per scooter _________
`25,000
Selling price of a scooter is ` 32,000
Profit of the company per scooter is `32,000 – ` 25,000 = ` 7,000
Total profit is (`7,000 × 1,000) = ` 70,00,000
To earn the same profit with a reduced price by ` 2000, the number of scooters can be found out as
follows:
New Selling Price = `32,000 – ` 2,000 = ` 30,000
Fixed Cost = `20,00,000
Described profit = `70,00,000
New contribution per unit = `30,000 – ` 23,000
= `7, 000
FC  Desired profit 20, 00, 000  70, 00, 000
Sales  
Cost per unit 7, 000
= 1,285.71 or = 1,286 scooters.
2.5.8 Margin of Safety:
Margin of safety is the difference between actual sales and sales at break-even point. For example,
if actual sales of a company is `10,00,000 and the sales at break-even point is `4,00,000 the difference
between these two figures `6, 00, 000 (10,00,000 – 4,00,000) is margin of safety. Margin of safety can be
calculated by the following formulae:
(i) Margin of safety (in units)  Actual sales (in units)  sales at B.E.P.(in units)
(ii) Margin of sales(in Rupees)  Actual sales(in Rupees)  sales at B.E.P.(in Rupees)
Pr ofit
(iii) Margin of safety   100
P / V Ratio
Margin of Safety
(iv) Margin of safety(%)   100
Actual Sales
Illustration 2.6
The data below relate to a company:
Sales `1,50,000
Fixed Cost `45,000
Profit `15,000
Calculate:
(i) P/V ratio at present
(ii) P/V ratio, if selling price is increased by 10%.
(iii) P/V ratio, if selling price is decreased by 20%.
Solution:
Sales(S) = `1,50,000.
Fixed Cost(FC) = ` 45,000
Profit(P) = `15,000
S – V = FC + P
`1,50,000 – V = ` 45,000 + ` 15,000
or V = `1,50,000 – `60,000 = ` 90,000
(i) P/V ratio at present is:
C 1, 50, 000  90, 000
Since P/V ratio =  100   100  C  S  V
S 1, 50, 000
60, 000
=  100  40%
1,50, 000
(ii) Calculation of P/V Ratio, if selling price is increased by 10%:
Sales Value = `1,50,000 + ` 1,50,000 × 10
100
= ` 1,50,000 + 15,000 = ` 1,65,000
SV 1, 65, 000  90, 000
P/V ratio =  100   100
S 1, 65, 000
75, 000
=  100  45.45%
1, 65, 000
(iii) Calculation of P/V ratio, if selling price is decreased by 20%:
In this case, sale value would be ` 1,50,000 – ` 30,000 = ` 1,20,000
SV
P/V Ratio =  100
S
1, 20, 000  90, 000 30, 000
=  100   100  25%
1, 20, 000 1, 20, 000
Illustration 2.7
Following information is available from the records of a company:

Year Sales (`) Profit/Loss (`)

I 5,00,000 2,000 (Loss)
II 7,00,000 2,000 (Profit)

Selling price is given ` 100 per unit

Calculate:
(i) Fixed Cost
(ii) Break-even point in units
(iii) Sale in units for desired profit of ` 28,000.
Solution:
Change in profit / Contribution 4000
P/V Ratio =  100   100  2%
Change in Sales 2, 00, 000
(i) Fixed Cost:
S × P/V Ratio = P + FC
2
I Year: ` 5, 00, 000   FC  ( 2, 000)
100
` 10,000 = Fc – 2,000
FC =` 10,000 + ` 2,000 = ` 12,000
2
II Year: 7, 00, 000   FC  2, 000
100
` 14,000 = FC + ` 2,000
FC = `14,000 – ` 2,000 = `12,000
FC 12, 000
(ii) B.E.P. =   100  `6,00,000
P / V Ratio 2
6, 00, 000
B.E.P.(in units) =  6, 000 units
100
(iii) Sale of units for a profit of ` 28,000:
FC  DP 12, 000  28, 000
Sale =   100
P / V Ratio 2
40, 000
=  100  `20,00,000
2
20, 00, 000
Sales (in units) =  20, 000 units
100
2.6 MANAGERIAL APPLICATION OF CVP ANALYSIS
2.6.1 Fixation of Selling Price:
Fixation of selling price is an important function of management. Under normal circumstances, the
price is fixed to cover the fixed as well as variable cost and to earn the profit. But under other
circumstances, the product may be sold at a price below the total cost. These circumstances may arise due
to stiff competition, trade depression, for accepting additional orders, for exporting, etc. In such
circumstances, the price should be fixed on the basis of marginal cost in such a manner so as to cover the
marginal cost and contribute something towards the fixed costs. In the following circumstances
production may be continued even if the selling price is below the marginal cost:
(i) To dispose of surplus stocks.
(ii) To eliminate the competitor from the market.
(iii) To utilise idle capacity.
(iv) To explore new markets.
(v) To explore foreign markets in order to earn foreign exchange.
(vi) when company deals with perishable products.
(vii)when company wants to introduce a new product in the market.
(viii) when the labour cannot be retrenched.
(ix) when company wants to avoid extra losses by closing down the business.
Illustration 2.8
The P/V Ratio of a company is 75%. Marginal cost of the product is `50. Determine the selling
price of the product.
Solution:
If selling price is `100
Variable cost will be ` 25
and contribution is `75
Selling price of the product, when the marginal cost is `50, will be:
100
=  50  `200
25
Assumptions Underlying Break-Even Charts
There are a number of assumptions which are made while drawing a break-even chart, such as :
(i) All costs can be separated into fixed and variable costs.
(ii) Fixed costs remain constant at all levels of activity.
(iii) Variable cost fluctuates directly in proportion to changes in the volume of output.
(iv) Selling prices per unit remain constant at all levels of activity.
(v) There is no opening or closing stock.
(vi) There will be no change in opening efficiency.
(vii) Product mix remains unchanged or there is only one product.
(viii) The volume of output or production is the only factor which influences the cost.
Advantages Or Uses of Break-Even Charts
Computation of break-even point or presentation of cost, volume and profit relationship by way of
break-even charts has the following advantages:
1. Information provided by the break-even chart is in a simple form and is clearly understandable
even to a layman. The whole idea of the problem is presented at a glance.
2. The break-even chart is very useful to management for taking managerial decisions because the
chart studies the relationship of cost, volume and profit at various levels of output. The effects of
changes in fixed costs and variables costs at various levels of output and that of changes in the
selling price on the profits can be depicted very clearly by way of break-even charts.
3. The break-even charts help in knowing and analysing the profitability of different products under
various circumstances.
4. A break-even chart is very useful for forecasting (the costs and profits), planning and growth.
5. The break-even chart is a managerial tool for control of costs as it shows the relative importance of
fixed cost in the total cost of a product.
6. Besides determining the break-even point, profits at various levels of output can also be determined
with the help of break-even charts.
7. The break-even charts can also be used to study the comparative plant efficiencies of business.
Limitations of Break–Even Charts
Despite many advantages, a break-even chart suffers from the following limitations:
1. A break-even chart is based upon a number of assumptions, discussed above, which may not hold
good under all circumstances. For example, fixed costs do not remain constant after a certain level
of activity; variable costs do not always vary in direct proportion to changes in the volume of
output because of the laws of diminishing and increasing returns; selling prices do not remain the
same forever and for all levels of output due to competition and changes in general price level; etc.
2. A break-even chart provides only a limited information. We have to draw a number of charts to
study the effects of changes in the fixed costs, variable costs and selling prices on the profitability.
In such cases, it becomes rather more complicated and difficult to understand.
3. Break-even charts present only cost-volume profit relationships but ignore other important
considerations such as the amount of capital investment, marketing problems and government
policies, etc.
4. A break-even chart does not suggest any action or remedies to the management as a tool of
management decisions.
5. More often, a break-even chart presents only a static view of the problem under consideration.
2.6.2 Maintaining a Desired Level of Profit
Marginal Costing techniques can be applied for maintaining a desired level of profit. Due to
competition, the price of the products may have to be reduced. The change in sales price, variable cost
and product mix affects the profitability of a concern. Marginal costing helps the management to know of
profit the sales can be ascertained by the following formula;
Fixed Cost  Desired Pr ofit
Sales =
P / V Ratio
Illustration 2.9
The price structure of a cycle made by a company is as follows:
Per Cycle `
Materials 600
Labour 200
Variable overheads 200
1000
Fixed overheads 500
Profit 500
Selling price 2,000
This is based on the manufacture of one lakh cycles per annum. The company expects that due to
competition they will have to reduce selling prices, but they want to keep the total profit intact. How
many cycles will have to be made to get the same amount of profit if:
(a) the selling price is reduced by 10%.
(b) the selling price is reduced by 20%.
Solution:
Total Fixed Costs = 500 × 1 lakh = 500 lakhs
Total Present Profit = 500 lakhs
Fixed Cost  Desired Pr ofit
Sales =
Contribution per unit
(a) If selling price is reduced by 10%: Use
New selling price = (2,000 – 10 % of 2,000)
= 2,000 – 200 = ` 1,800
500  500
Sales =
1,800  1, 000
1000
=  1, 00, 000 = 1,25,000 Cycles
800
(b) If selling price is rescued by 20%:
New selling price = (2,000 – 20 % of 2,000)
= 2,000 – 400 = `1,600
500  500
Sales =
1, 600  1, 000
1000
=  1, 00, 000 = 1,66,667 Cycles
600
2.6.3 Key or Limiting Factor:
A key factor or limiting factor is a factor which limits or puts a restriction on production or sales
and restricts a company from making unlimited profits. Limiting factors may be availability of raw
material, labour, sales finance, plant capacity, etc. When contribution and key factors are known, the
profitability of a product can be measured as under:
Contribution
Profitability =
Key Factor
For example:
(i) When limiting factor is the availability of labour:
Contribution
Profitability =
Key Hours
(ii) When limiting factor is raw material:
Contribution
Profitability =
Materials in Kg
Illustration 2.10
A company is producing two products A and B. The particulars of the company are as follows:
Product A Product B
(`per unit) (` per unit)
Sales 75 80
Material Cost 15 20
Labour Cost 20 15
Direct Expense 10 12
Variable overheads 10 15
Machine Hours used 3 hrs 2 hrs
Consumption of material 2 kg 3 kg
Comment on profitability of each product, if both use the same raw material, when:
(i) Total sales potential in units is key factor.
(ii) Total sales potential in values is key factor.
(iii) Raw material is in short supply.
(iv) Production Capacity (in terms of machine hrs.) is the key factor.
Solution:
Product A Product B
(`per unit) (` per unit)
Sales 75 80
Marginal Cost
Materials 15 20
Wages 20 15
Direct expense 10 12
Variable overheads 10 15
Total Marginal Cost 55 62
Contribution (Sales – Total marginal cost) 20 18
Contribution (per ` of Sales) 20/75 18/80
(Contribution/Sales) = ` 0.266 =` 0.225
Material consumed contribution per kg of materials 20/2kg 18/3kg
= ` 10 `6
Contribution per hour 20/3 hrs 18/2 hrs
= `6.6 `9
Comments:
(i) When total sales potential in units is limited, product A is more profitable as its contribution per
unit is more than that of product B.
(ii) When total sales potential in value is limiting factor, product A is more profitable as it has more
contribution as per sales in rupees than that of product B.
(iii) Product A is more profitable than product B, when raw material is in short supply.
(iv) Product B is more profitable that product A, when production capacity in terms of machine hours is
the key factor.
2.7 SUMMARY
 Marginal cost is the aggregate of variable costs. It is the cost of producing one additional unit.
 Absorption costing is the total cost technique. It is the practice of charging all costs, both variable
and fixed, to operations, processes or products.
 Contribution is the difference between Sales and Variable Cost or marginal cost.
 Break-even chart is a tool of presentation of the information relating to production quantity, sales
and profits of a business organisation.
 The angle formed at the intersection of the total sales curve and the total cost curve is known as
angle of incidence.
 Marginal Costing techniques can be applied for maintaining a desired level of profit.
 Fixation of selling price is an important function of management. Under normal circumstances,
the price is fixed to cover the fixed as well as variable cost and to earn the profit.
2.8 KEY TERMS
Marginal cost -Marginal cost is the aggregate of variable costs.
Marginal costing- marginal costing is a technique which is concerned with the changes in costs and
profits result from changes in volume of output.
Absorption Costing- Absorption costing is the total cost technique. It is the practice of charging all
costs, both variable and fixed, to operations, processes or products.
Higher contribution- Higher contribution means more profit
Break-even Analysis- In CVP analysis, an attempt is made to measure variations of costs and profit
with volume of production.
Break-even point- Break-even point may be as the point of sales volume at which total revenue
equals total costs.
2.9 QUESTIONS AND EXERCISES
1. What is ‘cost and profit’? Bring out its importance.
2. ‘Profit-Volume analysis’ is a technique of analysing the costs and profits at various ‘level of
volume’. Explain how such analysis helps management.
3. (a) Your boss is looking over a Break-even Chart which you have constructed to portray the cost
volume profit relationship of proposed plan of operations. He comments ‘The chart only tells
me more we sell more profits we make’. What is your reply?
(b) What are the limitations of a break even chart.
4. Explain the technique of marginal costing and state its importance in decision-making.
5. (a) State distinction between Marginal Costing and Absorption Costing as regards valuation of
finished goods inventories.
(b) State the circumstances in which ‘contribution approach to price is most suitable’. If this
approach is adopted, what are the special items of cost or revenue that have to be considered
when quotation for an export order is made ?
6. (a) What benefits are gained from Marginal Costing ? Are there any pitfalls in the application of
Marginal Costing ? Discuss these matters critically.
(b) Give a brief account of practical application of marginal costing which you consider sound
from a policy point of view.
7. What is Break-even Analysis ? Discuss its assumptions and uses.
8. State the implications of selling the product of a multiple firm at a price less than the marginal cost.
When would you advocate selling below the marginal cost ?
9. ‘Cost-Volume-Profit’ relationship provides the management with a simplified framework for an
organization which is thinking on a number of its problems. Discuss.
10. ‘The proper treatment of fixed costs presents a problem in full cost pricing’. Explain this statement.
Give suitable illustrations.
11. Explain with suitable illustrations the following statements:
(a) ‘In the very long run all costs are differential’.
(b) ‘In the long run profit calculated under absorption costing will be the same as that under
variable costing’.
12. State four different methods of finding out the break-even point graphically.
13. Explain how semi-variable costs could be split into fixed and variable costs.
14. What is meant by differential cost? Explain the practical utility of differential cost analysis.
15. What is meant by break-even analysis? Explain the important assumptions and practical
significance of break-even analysis.
16. What are the uses of break-even analysis and direct costing?
17. Mention the types of problems which a Management Accountant can expect to solve with break-
even analysis.
18. ‘Marginal Costing is an administrative tool for the management to achieve higher profits and
efficient operation’. Discuss.
19. Explain under what circumstances marginal costing plays important role in price fixation ?
20. Explain how marginal costing technique is useful in day-to-day decision making.
21. What are the cheif advantages of break-even analysis ? Outline the assumptions behind this
analysis.
22. Write briefly about Cost-Volume-Profit Analysis’.
23. Examine the concept of ‘Margin of Safety’ and give its uses for decision-making.
24. Explain the concept of BEP and CVP. Explain as to how are they useful for the managers for their
decision-making.
25. What are the limitations of marginal costing? Explain.
26. Distinguish between Marginal Costing and Total Costing techniques of cost Analysis. How are the
Profit Statements under the two techniques Present ?
27. Mention any four important factors to be considered in Marginal Costing Decisions.
28. Discuss the relationship between Angle of Incidence, Break-even and Margin of Safety.
UNIT 4
BUDGETARY CONTROL
Chapter Outlines

5.0 Learning Objectives

5.1 Introduction
5.2 Meaning of Budget
5.2.1 Meaning of Budgetary Control
5.2.2 Budgetary Control as a Management Tool
5.2.3 Limitations of Budgetary Control
5.2.4 Forecasts and Budgets.
5.3. Budgetary Control System
5.3.1 Installation of Budgetary Control System.
5.3.2 Kinds of Budgets.
5.3.3 Functional Budgets.
5.3.4 Flexibility Budgets
5.3.5 Period Budgets
5.3.6 Condition Budgets
5.4 Zero-Base Budgeting Strategy
5.5 Balanced Scorecard
5.6 Summary
5.7 Key Terms
5.8 Questions and Exercises
5.0. LEARNING OBJECTIVES
After studying this chapter, you should be able to understand:
 Explain Budget, Budgeting.
 Explain Budgetary control and distinguish between Budget and forecast.
 Explain precautions in Budgeting.
 Explain the advantages of Budgetary control.
 Explain kinds of Budgets.
 Explain the advantages and disadvantages of zero-Base Budgeting.
5.1 INTRODUCTION
Budgetary Control is an important tool for the management to make optimum use of limited business
resources and to maximize the profits of business. In order to maximize the profits of business effective
control on cost is must. In budgetary control, plans are made in advance for various business activities
like purchases, sales and productions, etc. These plans are termed as budget and the actual results are
compared with the budgets and the variance are discussed and analyzed.
5.2 MEANING OF BUDGET
“ Budget is a financial and/or quantitative statement, prepared prior to defined period of time , of the
policy to be pursued during that period for the propose of attaining a given objective . It may include
income, expenditure and the employment of capital.” -I.C.M.A London
5.2.1 Meaning of Budgetary Control:-
(i) “Budgetary control is the establishment of budgets relating to the responsibilities of
executives to the requirement of a policy and continuous comparison of actual with budget
results, either to secure by individual action of objectives of that policy to provide a solid
basis for its revision.”
(ii) “Budgetary control is the planning in advance of the various functions of a business so that
the business as a whole can be controlled.” -Wheldon
5.2.2 Budgetary Control as a Management Tool
• Advantages of Budgetary Control
(i) Definite Objectives: Under budgetary control, every department is given a target to be
achieved. The efforts are made to achieve the specific aims.
(ii) Reduction in Cost of Production: In budgetary control, the various departments prepare the
budgets and this results in reduction in cost of production. Moreover, every businessmen tries to
reduce the cost of production and opts for more profitable combinations of products.
(iii) Coordination: The working of different departments is properly coordinated and a 'Master
Budget is prepared for effective coordination and cooperation among various departments of the
organisation.
(iv) Maximum Profits: Under budgetary control, the resources are utilised efficiently in an
organisation as each person is aware of his task and the best way by which it is to be
performed,
(v) Reduces Uncertainty: Under budgetary control, the managers are forced to map out future
courses of action clearly. Thus, uncertainty is reduced to minimum.
(vi) Determining Weaknesses: The deviations in budgeted and actual performance will enable the
determination of weak spots. By pin-pointing responsibility for inefficient performance, budgetary
control helps managers trace weak spots early and take remedial steps.
(vii) Economy: The planning of expenditure will be systematic and there will be economy in
spending. The resources are used to the best advantage. The benefits derived for the enterprise will
ultimately extend to industry and then to national economy.
(viii) Adoption of Standard Costing: The use of performance standards in financial matters and
operational activities help the adoption of standard costing.
(ix) Optimum use of Resources: The resources of the organisation are used to the best
advantage as the objectives are clear and each level of management is aware of its task. It
directs enterprise activity towards maximisation of efficiency, productivity and profitability.
(x) Effective Control: It is a very important tool for effective control because under it the actual
performance is compared with the budgets and remedial steps are taken in case of deviation, if any.
(xi) Successful Planning: Budgets are based on plans and all the departmental managers are
informed about the expectations from them. The extent of expenditure that they can incur is [aid
down in the budget alongwith the expected profits of their department. The departmental managers
make their utmost effort to achieve the target and thus much help is obtained in the success of the
plans.
(xii) Inculcates the feeling cost consciousness: Budgetary control inculcates the feeling of cost
consciousness among workers. Thus, it increases productivity and operating economy.
(xiii) Introduction of Incentive schemes: Budgetary control system also enables the introduction of
incentives schemes of remuneration. The comparison of budgeted and actual performance will
enable the use of such schemes. Thus, efficient workers become more efficient and
inefficient workers start becoming efficient.
Thus it can be said that "Budgetary control improves planning, aids in coordination and helps in having
comprehensive control.
5.2.3 Limitations of Budgetary Control
To maximise the profit of the business and industry budgeting control is an important managerial technique but
the technique of the budgetary control has following limitations:
(i) Based on Estimates: Budgets are based on estimates regarding an event the success of
budget depends upon experience and estimates. Thus, these estimates cause the failure of
budgetary control system.
(ii) Co-operation: The success of the budgetary control system depends upon the co-operation
and co-ordination among the various levels of the management. The lack of co-ordination and
co-operation at the operating level results into failure of budgetary control.
(iii) Time Effect: The world is changing everyday like change in price, change in demand, change
in government policies, create problems in achieving the budgetary targets. So, budget needs
revision for their success but this revision is a very costly affair.
(iv) Excessive Cost of Budgetary System: To apply and implement budgetary control system
successfully needs heavy expenditure, which may not be possible for small scale organisations.
(v) Internal Disputes: Each and every departmental head wants more and more financial outlay for
their respective departments which becomes a cause of contention (dispute) among the various
departments of the organisation.
(vi) Opposition of Budgets: Employees and Managerial personnel are of the view that budgetary
control will reveal their efficiency and inefficiency at the various levels and hence because of
fear of inefficiency they oppose the implementation of budgetary control system.
(vii) Pressure Devices: Budgets are perceived by the work force as pressure devices imposed by top
management. This can have an adverse effect on labour relations.
(viii) Success Depends Upon the Support of Top Management: If the top management is dynamic
and enthusiastic then it will bring success to the budgetary control. On the other hand, if the top
management is dull and lethargic then the system will collapse.
5.2.4 Difference between Budget and Forecast

Basis Budget Forecast

Concept It relates to planned events and is the It is the estimate or inference about
quantitative expression of business plans and the future probable events which
policies for the future. may or may not be accurate.
Control It is an important control device for the It represents a probable event over
management. which no control can be exercised.
device
Provision The difference between actual Here, there is no such provision-
performance and budgeted performance can be
for found out under budgetary control and necessary
correction steps taken to rectify the deficiencies, if any.
Period It is prepared separately for each It may covers a long period.
accounting period.
Sequence Budgeting begins where forecasting ends. Forecasting provides a logical basis
for preparing budgets.
Scope Budgets have limited scope. It can be made of Forecasts are wider in scope and it
phenomenon capable of being can be made in those spheres also
where budgets cannot interfere
expressed quantitatively.
5.3 BUDGETARY CONTROL SYSTEM
5.3.1 Precautions in Budgeting/Budget Administration/Essentials/Installation of Budgetary
Control system
For the successful implementation of the budgetary control system, the following steps should be
considered:
(i) Objectives and Policy of Business: The budget is prepared for the achievement of the business
objectives. Therefore, the objectives of the business should be clear. Business policy is made to attain
the business objectives.
(ii) Budget Period: Budget period refers to the period of time for which the budget is prepared. The
budget period depends on the various factors such as nature of business, timing of availability of
finance, period required for manufacturing the products, etc. Generally there are two types of budget -
short term and long term budgets, cash budget, sales budget, income and expenditure budget are short
term budgets whereas capital expenditure budget, research and development budget are long term
budget.
(iii) Budget Committee: Budget committee will have the managers of various departments like
production, marketing, sales, finance, etc. The managers of each department prepare budgets for their
own department and submit it to the committee. The main functions of this committee are as follows:
(a) To provide previous years data to departmental managers for making budgets,
(b) To determine business policy regarding budgets.
(c) To prepare master budget.
(d) To review the departmental budgets and to establish coordination among them, etc.
(iv) Budget Centres: It is that part of the organisation which is selected for budgetary control such as sales
department, purchase department, production department, etc. Each budget centre prepares a
separate budget. A budget centre must be clearly demarcated to facilitate the formulation of various
budgets with the help of concerned departmental heads.
(v) Budget Manual: A budget manual helps in knowing in writing the role of every employees and the
ways of undertaking various tasks. It helps in avoiding ambiguity in time. Any problem arising from the
operation of a budgetary controls system can be settled through the budget manual. Thus, Budget
manual is a written document or booklets which covers the following matters:
(a) It states the functions of various officials connected with the formulation of budgets.
(b) Duties, responsibilities' of various officials connected with the preparation of budgets.
(c) Objectives and benefits of budgetary control system.
(d) Length of various budget periods.
(e) Specimen forms and number of copies for preparing budget report.
(vi) Budget Key Factor: A factor which sets a limit to the total activity is known as budget factor / key
factor / limiting factor. There may be a limitation on the quantity of goods a concern may sell. In
this case, sales will be a key factor and all other budgets will be prepared by keeping in view the
amount of goods the concern will be able to sell. The raw material supply may be limited; so,
production, sales and cash budgets will be decided according to raw materials budget. Similarly,
plant capacity may be a key factor if the supply of other factors is easily available. The key factors
may not necessarily remain the same. The sales may be increased by adding more salesmen and
advertisement. The raw material supply may be limited at one time and it may be easily
available at another time.
(vii) Organisation for Budgetary Control: For the successful preparation of budgets, a proper
organisation is a must. There must be cooperation among all the departments. Therefore,
keeping in mind the cooperation and coordination, an organisation chart is prepared
(viii) Budget Officer: The chief executive appoints some person as budget officer. The budget
officer works as a coordinator among different departments. He determines the deviations
between actual performance and budgeted and takes necessary step to rectify the deficiencies. He also
informs the top management about the performance of different departments.
5.3.2 Kinds of Budgets
(A) (B) (C) (D)
According to Functions According to Flexibility According to Period According to Condition

1. Sales Budget 1. Fixed Budget 1. Long Period Budget 1. Basic Budget

2. Production Budget 2. Flexible Budget 2. Short Period Budget 2. Current Budget
3. Materials Budget
4. Labour Budget
5. Plant Budget
6. Overhead Budget
7. Research & Development Budget
8. Cash Budget
9. Master Budget
5.3.3 Functional Budgets
According to Functions
(1) Sales Budget: A sales budget is an estimate of expected sales during a budget period. It is
the most important budget and it is called the backbone of the enterprise. A sales budget
is the starting point on which other budgets are based.
In sales, budget expected sales are expressed in quantity as well as in value. A sales
manger is made responsible for preparing sales budget. The following factors should be
taken into account while preparing a sales budget:
(i) Past sales figures and facts; (ii) Availability of raw materials; (iii) Seasonal
fluctuations; (iv) Plant capacity; (v) State of competition in the market; (vi) Availability of
finance; (vii) Government policy; (viii) Selling price and quality of the products of
competitors; (ix) Development of market.
The following informations can be obtained with the help of sales budget:
(i) Sales target; (ii)Possibility of sales in different areas; (iii) What efforts should be made for
increasing sales in new areas? (iv) How much amount is required to increase the sales?
Illustration 5.1
A company manufactures two types of products A and B and sells them in the markets of Ambala and
Panchkula. The following information is made available for the current year:
Market Budgeted Sales Actual Sales
Ambala :A 400 units at ` 9 each 500 units at ` 9 each
:B 300 units at`21 each 200 units at ` 21 each
Panchkula :A 600 units at ` 9 each 700 units at ` 9 each
:B 500 units at `21 each 400 units at ` 21 each
Market studies reveal that product A is popular as it is under priced. It is observed that if its price
is increased by 11 it will get a ready market. On the other hand, product B is overpriced and market could
absorb more sales if its selling price is reduced to `20. The management has agreed to give effect to the
above price changes.
On the above basis, the following estimates have been prepared by sales manager:
Percentage increase in Sales over Current Budget
Product Ambala Panchkula
A + 10% + 5%
B + 20% + 10%
With the help of an intensive advertisement campaign, the following additional sales above the
estimated sales:
Product Ambala Panchkula
A 60 units 70 units
B 40 units 50 units
You are required to prepare a budget for sales incorporating the above estimates.
Solution:
Sales Budget
Market Product Budget for Current Period Actual Sales Budget for Future
Qn. Price(`) Value (`) Qn. Price(`) Value(`) Qn. Price(`) Value(`)
Ambala A 400 9 3.600 500 9 4,500 50 10 5,000
B 300 21 6,300 200 21 4,200 0 20 8,000
Total 700 — 9,900 700 — 8,700 40
900 — 13.000
Panchkula AB 600 9 5,400 700 9 6,300 700 10 7,000
500 21 10,500 400 21 8,400 0 20 12,000
Total 1,100 15,900 — 60
14,700 1,300 19,000
0
Budgeted Sales for the future has been calculated as under:
Ambala Panchkula
Product A Product B Product A Product B
400 600 500
(10% of 400) 40 (20% of 300) 60 (5% of 600) 30 (10% of 500) 50
440 360 630 550
60 40 70 50
500 400 700 600

(2) Production Budget: Production budget is a forecast of production and cost of production for a
budget period. A production manager is made responsible for preparing production budget. A
production budget is prepared on the basis of sales budget. The sales budget presents demand
while the production budget makes adequate arrangements for the fulfilment of this demand.
The object of this budget is to manufacture the product at the minimum cost. A proper production
planning is essential for preparing the production budget.
The following factors should be taken into account while preparing production budget:
(i) The optimum plant capacity utilization
(ii) Avoidance of bottlenecks due to shortage of materials and labour
(iii) Key factors
(iv) Quantity of different products
(v) Opening stock, closing stock and estimated sales
(vi) Availability of physical resources
Example of Production Budget is as follows:
Production Budget

Products
Stock on 31st Dec. 2014
A B C
Add: Budgeted Sales Units Units Units
5,000 10,000 15,000
50,000 60,000 70,000
Estimated Stock on 1st Jan., 55,000 70,000 85,000
2014 Production requirement 4,000 6,000 8,000
51,000 64,000 77,000
Illustration 5.2
From the following data, prepare a Production Budget for a company: Stocks for the budget period:
Product as on 1st January 2014 as on 30th June 2014
A 8000 10,000
B 9000 8,000
C 10,000 14,000
Requirement to fulfill sales programme:
A 60,000 units
B 50,000 units
C 80,000 units
Solution:
Production Budget

Products
A B C
Units Units Units
Sales 60,000 50,000 80,000
Add: Stock on 30th June, 2014 10,000 8,000 14,000
70,000 58,000 94,000
Less: Stock on 1st January, 2014 8,000 9,000 10,000
Production requirement 62,000 49,000 84,000
(3) Materials Budget: Material budget is prepared for determining the requirement of raw material
for production. This budget depends upon sales and production budget. The materials are
purchased as per the requirements of production department. The number of units to be produced
multiplied by the rate of consumption of raw materials will give the figure of materials required.
The units of materials required multiplied by the rate per unit of raw material will give a figure of
material cost.
Total material required = (Quantity of material required per unit)(Budgeted output)
Material cost = (Units of material required) (Rate per unit of Raw material)
The raw materials budget will enable the fixation of minimum stock level, maximum level and re-
ordering level.
(4) Labour Budget: The labour required for manufacturing the product is known as direct labour and
the labour which cannot be specified with production is called indirect labour. Labour budget is
prepared for making possible the continuous availability of labour for attaining the production
targets. This budget is useful for anticipating labour time required for production.
Labour Cost is determined as under:
Labour Cost = Labour hours  Rate of pay per hour
Labour budget provides the following information:
(i) Number and types of workers required,
(ii) Rate of remuneration payable to the workers of different categories and availability of them.
(iii) Time and cost of training to be provided to the labourers.
(iv) The number of workers to be required more in the year.
(5) Plant Budget: In big enterprises where plants are valuable and most of the production is carried
out with the help of machinery, preparation of plant budget becomes essential. Plant budget
provides the following informations:
(i) Department wise the number of machines.
(ii) Original cost, depreciation and current value of machineries.
(iii) Work for which each machine is to be used.
(iv) Need to purchase new machines and amount required thereof.
(v) Production capacity of machines.
(vi) Remaining life of machines, etc.
(6) Overheads Budget: Overheads budget is prepared for the estimation of indirect
expenses related to production, i.e., indirect material, indirect labour and other indirect expenses.
This budget is classified into following parts:
(i) Factory overheads Budget
(ii) Financial overheads Budget
(iii) Sales overheads Budget
(iv) Administrative Overheads Budget
(7) Research and Development Budget: It is a long term budget. It is prepared for the
expansion of business and to adopt new techniques of production. In this budget, the
estimates are made for expenses on current research programmes. Development starts where
research ends and development ends where actual production commences. Thus, development
is the stage between research and actual production.
(8) Cash Budget: Cash budget is a statement of estimates of cash position for the budget period.
It is a plan of estimated receipts and payments of cash for the budget period. It can be
prepared for any time period. Normal time period of cash budget is half year which is
further sub-divided into the months. It helps in planning and control of the financial
requirements of the organisation. Cash budget ensures that cash is available in time for carrying
out business activities and meeting financial obligations. If there is any shortage of cash, then
time by arrangements can be profitability used in temporary investments. In cash budget,
estimate regarding each item of cash receipt and payment is made at the time of its preparation.
Cash-receipts items: Cash sales, credit sales having regard to credit collection policy, interest,
dividend, the amount received on shares and debentures, bank loan, the amount of tax
refund, rent receivable, etc.
Cash-payments items: Cash purchase of raw materials, payment made to suppliers of credit
purchases of raw materials, wages, salaries, manufacturing expenses, administrative
expenses, selling and distribution expenses, research and development expenses, repayment
of bank loans and public deposits, redemption of preference shares and debentures, payment
of taxes, interest and dividends.
•Importance of Cash Budget
The importance of preparing a cash-budget are as follows:
1. It serves as a device for planning and controlling of receipts and payments of cash to ensure
availability of cash in an adequate amount.
2. It enables the management to prepare borrowing and repayment schedule will in advance.
3. It enables the management to take advantages of cash discount.
4. It enables the management to plan for financing a new project and expansion modernization of
an existing project.
5. It enables the management to plan for dividend payment.
•Methods of Preparation of Cash Budget
(I) Receipt and Payment Method
(II) Adjusted Profit and Loss Account Method
(III) Projected Balance Sheet Method
(I) Receipt and Payment Method: In this method, estimated cash receipts and payments are taken into
consideration. Cash receipts and cash-payment items we have discussed earlier.
Illustration 5.3
Prepare a cash budget for the month of May, June and July 2014 on the basis of the following
information:
(1) Income and Expenditure Forecasts:
Months Credit Credit Wages Manufac- Office Selling
Sales Purchases (`) turing Expenses Expenses
(`) (`) Expenses (`) (`)
(`)
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
(2) Cash balance on 1st May, 2014 `8,000.
(3) Plant costing `16,000 is due for delivery in July and payable 10% on delivery and the
balance after 3 months.
(4) Advance tax `8,000 each is payable in March and June.
(5) Period of credit allowed (i) by supplier - two months and (ii) to customers-one month.
(6) Lag in payment of manufacturing expenses – ½ month.
(7) Lag in payment of office and selling expenses - one month.
Solution:
Cash Budget
Particulars May 2014 June 2014 July 2014
(`) (`) (`)
Opening Balance 8,000 13,750 12,250
Add: Receipts
Credit Sales 62,000 64,000 58,000
70,000 77,750 70,250
Less: Payment
Credit Purchase 36,000 38,000 33,000
Wages 10,000 8,500 9,500
Manufacturing Expenses 3,750 4,000 3,750
Office Expenses 1,500 2,500 2,000
Selling Expenses 5,000 4,500 3,500
Plant - Payment on delivery — — 1,600
Advance Tax — 8,000
Total 56,250 65,500 53,350
Closing Balance 13,750 12,250 16,900
Working Notes:

(i) Since the period of credit allowed by suppliers is two months, the payment for credit
purchases in March will be made in May and so on.
(ii) Since the period of credit allowed to customers is one month, the receipt for credit sales in April
will be in May and so on.
(iii) One half of the manufacturing expenses of April and one half of May will be paid in May, i.e.,
(1/2 of ` 3,000) + (1/2 of `4,500) = `3,750 and so on.
(iv) Office and selling expenses of April shall be paid in May and so on.
(v) Opening balance of cash for the month of June has been ascertained after finding out closing
balance of May and for July after closing balance of June.
(ii) Adjusted Profit and Loss Method: In this method, the cash balance and net profit
disclosed by Profit and Loss Account and Balance Sheet does not represent the fair amount of
cash, since some such items take place in Profit and Loss Account which do not affect the outflow
and inflow of the cash. Therefore, all such non-cash items are to be adjusted just to get the correct
estimate of real cash. The formula for calculating closing cash balance is given below:
Opening Cash Balance + Net Profit + Non - Cash expenses + Decrease in Current Assets+
Increase in Current Liabilities + Sales of Fixed Assets of Issue of Shares and Debentures -
Increase in Current Assets - Decrease in Current Liabilities - Payment of Tax and Dividend-
Purchase of Fixed assets – Redemption of Shares and debentures etc. = Closing Cash Balance.
(iii) Balance Sheet Method: Under this method, a forecasted or budgeted balance sheet is prepared
at the end of the budget period. In this method, all assets and liabilities (except Cash and Bank
Balance) are shown. If the amount of budgeted liabilities exceeds the budgeted assets, the
difference will be cash or bank balance at the end of budget period. If the amount of budgeted
assets are in excess of liabilities, the difference will be bank overdraft.

Illustration 5.4
From the following information prepare a Cash Budget by the Adjusted Profit and Loss Method,
for ABC Limited:
BALANCE SHEET
(as on 31st December, 2013)

Liabilities Amount Assets Amount

(`) (`)
Equity Share Capital 50,000 Cash 7,360
Debentures 29,400 Stock 24,760
Creditors 26,920 Debtors 19,600
ACC Depreciation 20,000 Investments 40,000
Profit & Loss A/c 53,400 Plant 88,000
1,79,720 1,79,720
Forecasted Profit and Loss Account

Particulars Amount Particulars Amount

(`) (`)
To ACC Depreciation A/c 8,800 By Gross Profit b/d 80,000
To Income Tax 2,000 By Profit on sale of Investment 800
To Interest 1,200 By Interest 4,000
To Admn. & Selling Exp. 4,000
To Loss on Sale of Plant 3,200
To Net Profit c/d 65,600
84.800 84,800
To Dividend 4,000 By Net Profit b/d 65,600
To Balance c/d 61 ,600
65,600 65,600

Additional Information:

(i) Investment Costing `4,000 were sold for ` 4,800.

(ii) New Plant Costing `32,000 was purchased during the year.
(iii) An old plant costing `24,000 and accumulated depreciation of `16,800 was sold for
`4,000.
Balance on 31st December, 2014:

Stock `37,000; Debtors ` 33,280;

Creditors v 40,000; Debentures `20,000;

Equity shares issued during the year`20,000

Solution:
CASH BUDGET
(Adjusted Profit and Loss Method)
Particulars Amount(`) Amount (`)
Opening Cash Balance 7,360
Add: Budgeted Net Profit 65,600
Depreciation written off 8,800
Increase in Creditors 13,080
Loss on sale of Plant 3,200
Sale of Investment 4,800
Issue of Shares 20,000
Sale of old Plant 4,000 1,19,480
1,26,840
Less: Purchase of Plant 32,000
Redemption of Debentures 9,400
Payment of Dividend 4,000
Profit on sale of Investment 800
Increase in Debtors 13,680
Increase in Stock 12,240 72,120
Closing Balance of Cash 54 720

Illustration 5.5

By using the data of Illustration 5.4, prepare a Cash Budget showing Cash at Bank on 31st
December, 2014, under 'Balance Sheet Method'.
Solution:
Budgeted Balance Sheet
(On 31st December, 2014)

Liabilities Amount Assets Amount

(`) (`)
Equity Share Capital 70,000 Plant Investment Stock 96,000
Profit and Loss A/c (53,400 + 61 1,15,000 Debtors Cash at Bank (Bal. 36,000
,600) Debentures Ace. 20,000 Figure) 37,000
Depreciation (20,000 + 8,800 - 16,800) 12,000 33,280
Creditors 40,000 54,720
2,57,000 2,57,000
9. Master Budget: A master budget is prepared for the business as a whole, combining all the budgets
for a period into this budget. It is the summary of all subsidiary functional budgets, prepared by the
concern. Before preparing a master budget, it is necessary to prepare sales budget, purchase budget,
cash budget, production budget, overheads budget, etc. Thus, the master budget is a summary
budget which incorporates all functional budgets in a capsule form. It shows budgeted income
statement for the budget period and budgeted balance sheet at the end of the budget period. The
master budget requires the approval of the budget committee before it is put into action. The master
budget co-ordinates the budgets of all the departments.

5.3.4 Flexibility Budgets

On the basis of flexibility, budgets can be classified as follows:
(1) Fixed Budget: According to I.C.M.A., London, "Fixed budget is a budget which is
designed to remain unchanged irrespective of the level of activity attained."
It does not change with the change in level of activity actually attained. It is prepared for a given level
of activity and does not take note of changes in the circumstances. Therefore, it becomes useless
for comparison with actual performance when level of activity changes.
(2) Flexible Budget; According to I.C.M.A., London, "A flexible budget is a budget
designed to change in accordance with the level of activity actually attained."
A flexible budget provides budgeted costs at different levels of activity. It varies with the level of
activity attained. Flexible budget is desirable in the following cases:-
(i) Where the business is new or estimation of demand is not possible.
(ii) Where the business is subject to the vagaries of nature such as soft drinks, etc.
(iii) Where sales are unpredictable.
(iv) Where the demands for the product keep changing due to change in fashion and tastes of
customers.
(v) Where production cannot be estimated due to irregular supply of necessary material and
labour.
Illustration 5.6
Prepare a Flexible Budget for the production at 80% and 100% activity on the basis of following
information:
Production at 50% capacity 5,000 units
Raw Material ` 80 per unit
Direct labour ` 50 per unit
Direct Expenses `15 per unit
Factory Overhead `50,000 (50% fixed)
Administration Overhead ` 60,000(60% variable)
Solution:
Flexible Budget
Particulars 50% 80% 100%
Capacity Capacity Capacity
5,000 units 8,000 units 10,000 units
(`) (`) (`)
Per unit Total Per unit Total Per unit Total
Raw Material 80 4,00,000 80 6.40.000 80 8,00,000
Direct Labour 50 2,50,000 50 4,00,000 50 5,00,000
Direct 15 75,000 15 1,20,000 15 1,50,000
Expenses 145 7,25,000 145 11,60,000 145 14.50,000
Prime Cost
Factory
Expenses: 5 25,000 3.125 25.000 2.50 25,000
(Fixed 50%) 5 25,000 5 40.000 5 50,000
(Variable 50%)
Works Cost 155 7,75,000 153.125 12,25,000 152.50 15,25,000
Administration Exps.
Fixed (40%) 4.80 24,000 3.00 24,000 2.40 24,000
Variable (60%) 7.20 36,000 7.20 57,600 7.20 72,000
Total Cost 167 8,35,000 163.325 13,06,600 162.10 16,21,000
Note: 1. Variable cost per unit and total fixed costs remain constant irrespective of changes on activity
levels.
2. Total variable cost and fixed cost per unit vary with the changes in the activity levels.
5.3.5 Period Budgets
(i) Long Period Budgets: Long period budgets are those budgets which incorporate planning for
five to ten years and even more. Research and development budget is an example of long period
budget.
(ii) Short Period Budgets: Short period budgets are prepared for the period less than one year.
Material budget, Cash budget, etc. are the examples of short period budgets.
5.3.6Condition Budgets
(i) Basic Budget: A basic budget is one which is established for use unaltered over a long period of
time. Current circumstances are not considered while preparing this budget.
(ii) Current Budget: A current budget is one which is established for use over a short period of
time and it is related to current conditions. This budget is more useful than basic budget.
Illustration 5.7
ABC Ltd. prepared the budget for the production of one lakh unit of the one type of commodity
manufactured by them for a costing period as under:-
Raw Material Z 2.52 per unit
Direct Labour ? 0.75 per unit
Direct Expenses ? 0.10 per unit
Works overheads (60% Fixed) ? 2.50 per unit
Admn. overheads (80% Fixed) ? 0.40 per unit
Selling overheads (50% Fixed) ? 0.20 per unit
Actual production during the period was only 60,000 units. Calculate the budget cost per unit.
Solution:
Flexible Budget
1,00,000 Units 60,000 Units
Particulars Per unit Amount (`) Per unit Amount (`)
Raw Material 2.52 2,52.000 2.52 1,51,200
Direct Labour 0.75 75,000 0.75 45,000
Direct expenses 0.10 10,000 0,10 6,000
Prime Cost 3.37 3,37,000 3.37 2,02,200
Works Cost: (60% Fixed) 1.50 1,50,000 2.50 1,50,000
(40% Variable) 1.00 1 ,00,000 1.00 60,000
Admn. Overheads: (80% Fixed) 0.32 32,000 0.53 32,000
(20% Variable) 0.08 8,000 0.08 4,800
Cost of Production 6.27 6,27,000 7.48 4,49,000
Selling Overheads:
50% Fixed 0.10 10,000 0.17 10,000
50% Variable 0.10 10,000 0.10 6,000
Total Cost 6.47 6,47,000 7.75 4,65,000
•/ Programme Budgeting
Programme budgeting was firstly used by Department of Defence in U.S.A. in 1961. It focuses on
process of allocating funds.
5.4 ZERO-BASE BUDGETING STRATEGY (ZBB)
Zero-base budgeting is also known as "De nova budgeting", i.e., budgeting from beginning. In other
words, it is beginning from zero base, assuming that nothing is happened in the past. The concept of zero
base budgeting can be applied from a home budget to the national budget. In a home budget, a housewife
prepares the budget of next month after ignoring the current and past budget (expenditures) altogether.
1. According to Certified Institute of Management Accountants, London, "Zero
base budgeting is a method of budgeting whereby all activities are re-evaluated each time
a budget is set. Discrete levels of each activity are valued and a combination chosen to
match funds available."
2. According to Peter A Pyher, "A planning and budgeting process which requires each
manager to justify his entire budget request in detail from scratch (hence zero base) and
shifts the burden of proof to each manager to justify why he should spend money at all. The
approach requires that all activities be analysed in decision packages which are evaluated by
systematic analysis and ranked in order of importance." Peter Pyher is known as the father of
Zero Base Budgeting as he introduced ZBB at Texas Instruments in USA in 1969.
Thus we can say that in zero base budgeting, every year is taken as a new year and previous year is not
taken as a base. It starts from a “Zero base” and every function within an organization is analysed for its
needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of
whether the budget is higher or lower than the previous one.
Steps Involved in the Process of Zero Base Budgeting
For implementing zero base budgeting, following necessary steps are taken
1. Determining the objectives of zero base budgeting.
2. Developing decision unit i.e., a department of an organization where decisions are taken.
Decision units are developed for cost benefit analysis.
3. Development decision packages: Decision package summaries the scope of work requirement,
anticipated benefits, time schedule etc.
4. Ranking of decision packages on the basis of benefits to the organization.
5. Allocation of resources on the basis of ranking of decision packages.
Advantages of Zero-Base Budgeting
1. Efficient allocation of resources, as it is based on needs and benefits rather than history.
2. It helps in identifying and eliminating wasteful and obsolete operations.
3. It helps in detecting inflated budgets.
4. It increases communication and coordination within the organization.
5. It enables the management to find cost effective ways to improve operations.
6. Responsibility and accountability are more specifically fixed under zero based budgeting as
compared to traditional budgeting.
7. It increases staff motivation by providing greater initiative and responsibility in decision making.
8. It is useful in Government department where all expenditure are incurred on the basis of budgets.
9. It focuses on cost benefit analysis to reach on maximization of profit of the company.
10. It can be used for implementation of “Management by objective’ (MBO). Thus it can be used not
only for fulfillment of the objective, but also for variety of the purpose.
11. It identifies activities involving wasteful expenditure.
12. It involves rational decision making.
13. It promotes operating efficiency.
Limitations of zero-Base Budgeting
1. It is more time consuming than traditional budgeting as every single item is paid attention to
afresh.
2. It requires specific training due to increased complexity as compared to traditional budgeting.
3. It increases paper work.
4. Cost of preparing the decision package may be very high.
5. There is a problem in defining decision units and decision packages.
6. Wrong cost-benefit analysis may hamper the future growth of the organization. For example,
cutting present advertisement cost may effect future sales. Similarly, cutting research and
development cost may effect the future growth and cost effectiveness of the organization.
7. The concept ZBB needs clarity at top management level otherwise conflict among departments
may affect the overall profitability of the organizations.
ZBB is highly relevant in ‘continuous improvement’ environment because of its nature of
continuous evaluation of costs and benefits. This technique is relevant for effective utilization of
resources and increasing the profitability of the organizations. So ZBB can be implemented as a
planning device in the overall corporate strategy.

SELF-ASSESMENT QUESTION

1. What do you understand by “Budgeting” ? Mention the type of budget that the Management of a
big industrial concern would normally prepare.
2. What is budget ? What is sought to be achieved by Budgetary Control.
3. Has ‘Budgetary Control’ any significance with management accounting ?
4. Outline a plan for sales budget and purchases budget. What considerations are necessary in the
preparation of such budgets ?
5. Mr. Managing Director is surprised that his profit every year is quiet different from what be wants
or expects to achieve. Someone advised him to install a formal system of budgeting. He employs a
fresh accountant to do this. For two years, the accountant faithfully makes all budgets based on
previous year’s accounts. The problem remains unsolved. Advise Mr. Managing Director and the
Accountant on what steps they should take. Make assumption about what is lacking.
6. (a) What do you mean by budgetary control with reference to manufacturing-cum-selling
enterprise.
(b) What factors would influence the selection of budget period between two firms carrying on
diverse activities ?
(c) What do you mean by flexible budget allowance ? How is it ascertained ? Explain with a
cogent example.
7. (a) What do you mean by budgetary control ? Explain the objectives of budgetary control with
special reference to a large manufacturing concern.
(b) Explain what is meant by flexible budget and its utility. Prepare a proforma of flexible budget
of a manufacturing concern for their imaginary activity, levels in a suitable form.
8. (a) What do you understand by budget and budgetary control ? Give example of five budgets that
may be prepared and employed by a manufacturing concern.
(b) What is the principal budget factor ? Give a list of such factors and explain how you would
proceed to prepare budgets in the case of a manufacturing company.
9. Are you in agreement with the view that Budgeting should better be called profit planning and
control.
10. ‘Why do responsible people in an organization agree to accept budgetary control in theory but
resist in practice’ ? Explain.
11. ‘If the sales forecast is subject to error then there is no basis of budgeting’. Do you agree ? Also
explain how flexible budget can be used to help control cost.
12. Explain the procedure you would follow to prepare a projected Profit and Loss Account and
Projected Balance Sheet. Explain also use of these statements.
13. ‘Budgetary control improves planning, aids in coordination and helps in having comprehensive
control’. Elucidate this statement.
14. Describe in brief the modus operandi for the purpose of preparation of a production budget. What
are the principal considerations involved in budgeting production ?
15. What do you understand by budget and budgetary control ? How far is a budgetary control a tool in
the hands of management ?
16. What is ‘zero-base budgeting’ ?
17. What do you understand by the terms ‘Budget’ and ‘Budgetary Control’ ? What are the advantages
of ‘budgetary control’ ?
18. What is the mechanism of master budget ?
Discuss the difficulties which arise and how are they overcome in forecasting sales and preparing
sales budget in a jobbing concern.
19. (a) What is master budget ? How is it prepared ?
(b) Explain zero-based budgeting.
20. Write an essay on zero-based budgeting and highlight its procedure, norms and superiority over
functional budgeting.
21. What are different types of functional budgets which are prepared by a large scale manufacturing
concern ?
UNIT-4

STANDARD COSTING

Standard Costing: Meaning

Standard costing is a system of accounting that uses predetermined standard costs for direct
material, direct labor, and factory overheads. Standard costing is the second cost control
technique, the first being budgetary control. It is also one of the most recently developed
refinements of cost accounting. The standard costing technique is used in many industries due to
the limitations of historical costing. Historical costing, which refers to the task of
determining costs after they have been incurred, provides management with a record of what has
happened. For this reason, historical costing is simply a post-mortem of a case and has its own
limitations. For managers within a company, exercising control through standards and standard
costs is a creative program aimed at determining whether the organization’s resources are being
used optimally.

Standard costs are typically determined during the budgetary control process because they are
useful for preparing flexible budgets and conducting performance evaluations. The use of
standard costs is also beneficial in setting realistic prices. Along with this, standard costs help to
identify any production costs that need to be controlled. Importantly, comparison of actual
cost with standard cost shows the variance. When correctly analyzed, this shows how to correct
adverse tendencies. The current category “Standard Costing and Variance Analysis” discusses
the technique of standard costing and variance analysis, which is aimed at profit improvement
mainly by reducing materials, labor, and overhead costs.

Standard Cost: Definition

There are different definitions of standard costing, all of which emphasize the use and
determination of standard cost. Hence, it is useful to understand the meaning of standard cost. A
standard cost is one that a company expects at the outset of a year under a normal level of
operational efficiency. Standard costs are used periodically as a basis for comparison with actual
costs. Standard costs may be termed commonsense costs. This reflects the view that a standard
cost represents the best judgment of management about what costs the business operations will
involve when undertaken efficiently. According to Brown & Howard, “standard cost is a pre-
determined cost which determines what each product or service should cost under given
circumstances.”

Blocker defined standard cost as follows:

A pre-determined cost based upon engineering specifications and representing highly efficient
production for quality standard with a fixed amount expressed in terms of dollars for materials,
labor, and overhead for any estimated quantity of production.
The Institute of Cost and Management Accountants (ICMA) defined standard cost in the
following way:

A pre-determined cost which is calculated from management’s standards of efficient operation

and the relevant necessary expenditure. It may be used as a basis for price fixation and for cost
control through variance analysis.

In ICMA’s definition of standard cost, the phrase “management’s standards of efficient

operation” is important. This is because standard cost is ascertained on this basis.

The standard of efficient operation is decided based on previous experience, research findings, or
experiments. The standard is generally defined as that which is attainable but only after
substantial effort. Standard cost serves as a measure against which actual cost is compared. If
actual cost does not exceed standard cost, performance is treated as fully efficient.

Standard cost also plays a role in evaluating staff performance. For example, by analyzing the
difference between actual costs and standard costs, management can identify the factors leading
these differences.Standard costs also assist the management team when making decisions about
long-term pricing.

Features of Standard Costing System

1. Standard cost is a predetermined cost. It is based on past experience and is referred to as

a common sense cost, reflecting the best judgment of management.

2. Standard cost relates to a product, service, process or an operation. It is also determined for a
normal level of efficiency of operation.

3. Standard cost is used to measure the efficiency of future production or future operations. For
this reason, it provides a useful basis for cost control.

4. Also, standard cost may be expressed in terms of money or other exact quantities.

Advantages of Standard Cost

This section highlights the most important advantages of standard cost.

1.First, standard costs serve as a yardstick against which actual costs can be compared.The
difference between standard cost and actual cost are called variances. For proper control and
performance measurement in an organization, variances should be measured and analyzed. This
also ensures that regular checks are made on expenditures.
2. The second advantage is that if immediate attention is taken, control over costs is greatly
facilitated. A proper standard costing system assists in achieving cost control and cost reduction.

3. Standard cost also helps to motivate employees. This is because the system can be used to
provide an incentive scheme wherein variance is minimized.

4. Production and pricing policies are formulated with certainty when standard cost systems are
in place. This helps to keep costs in check.

5. The last advantage of using standard cost is that even when other standards and guidelines are
constantly being revised, standard cost serves as a reliable basis for evaluating performance and
control costs.

Nature and Purpose of Standard Costing System

The main purpose of standard cost is to provide management with information on the day-to-day
control of operations.

1. Standard costs are predetermined costs that provide a basis for more effectively controlling
costs. Standard cost offers a criterion against which actual costs incurred by the business can be
measured and analyzed.

2. The difference between actual costs and standard costs is known as variance. Variance is
identified and carefully analyzed, and it is reported to managers to inform suitable corrective
actions.

Applicability of Standard Costing

Standard costing is applicable under diverse conditions. It requires the following:

 There should be an output or the production of a sufficient volume of a standard product

 The methods, operations, and processes of production should be capable of
standardization
 The costs should be controllable
Standard costing techniques have been applied successfully in all industries that produce
standardized products or follow process costing methods.

Examples of such industries include sugar, fertilizers, cement, footwear, breweries and
distilleries, and others.

Public utilities such as transport organizations, electricity supply companies, and waterworks can
also apply standard costing techniques to control costs and increase efficiency.
In jobbing industries, as well as industries that produce non-standardized products, it is not
possible to apply the technique advantageously.

Objectives of Using Standard Costing System

Within an organization, there are several objectives that a standard costing system may be
established to help achieve.

1. First, a standard costing system may be used to control costs, which is achieved mainly by
setting standards for each type of cost incurred: material, labor, and overhead.

2. This also helps to analyze variance and, hence, enables managers to be effective in controlling
the costs for which they are held responsible.

3. The second objective that a standard costing system may be used to achieve is to help in
setting budgets. Third, such a system may be used to provide useful and detailed information for
managerial planning and decision-making.

4. Fourthly, a standard costing system may be used to assess the performance and efficiency of
staff and management.

5. Finally, standard costing is a control technique that follows the feedback control cycle.
Therefore, the feedback system may help to eliminate unwanted costs in the future, leading to a
potential reduction in costs.

Preliminaries to Consider Before Using a Standard Costing System

When deciding whether to use standard costing in a business, several preliminaries have to be
considered. These preliminaries are:

1. Establishing cost centers

2. Classification and codification of accounts
3. Types of standards
4. Setting the standards

1. Establishing Cost Centers

A cost center is a location, person, or item of equipment (or a group of these) for which costs
may be ascertained and used for the purpose of cost control. Cost centers may be personal cost
centers or impersonal cost centers. Personal cost centers are related to a person, while impersonal
cost centers are related to a location or item of equipment. Establishing cost centers is needed to
allocate responsibilities and define lines of authority.
2.Classification and Codification of Accounts

Classification or grouping of accounts is essential for standard costing.

Accounts should be classified in such a way that the cost elements of every cost center are
clearly and precisely reflected. Codes and symbols are assigned to different accounts to make the
collection and analysis of costs more quick and convenient.

Types of Standards

A standard is a predetermined measure relating to materials, labor, or overheads. It is a reflection

of what is expected, under specific conditions, of plant and personnel.

A standard is essentially an expression of quantity, whereas a standard cost is its monetary

expression (i.e., quantity multiplied by price). It shows what the cost should be.

In setting standards, the key question is to decide on the type of standard to be used in fixing the
cost. The main types of standards are ideal, basic, and currently attainable standards.

1. Ideal Standards

Ideal standards, also called perfection standards, are established on a maximum efficiency level
with no unplanned work stoppages.

They are tight standards which in practice may never be obtained. They represent the level of
attainment that could be reached if all the conditions were perfect all of the time.

Ideal standards are effective only when the individuals are aware and are rewarded for achieving
a certain percentage (e.g., 90%) of the standard.

2. Basic Standards

Basic standards are long-term standards and they remain the same after being computed for the
first time. They are projections that are rarely revised or updated to reflect changes in products,
prices, and methods.

Basic standards provide the basis for comparing actual costs over time with a constant standard.
They are used primarily to measure trends in operating performance.
3. Currently Attainable Standards

A currently attainable standard is one that represents the best attainable performance. It can be
achieved with reasonable effort (i.e., if the company operates with a “high” degree of efficiency
and effectiveness).

These standards make proper allowances for normal recurring interferences such as machine
breakdown, delays, rest periods, unavoidable waste, and so on.

It is assumed that these are unavoidable interferences and are a fact of life. However, allowances
are not made for any avoidable interference with output.

The currently attainable standard is the most popular standard, and standards of this kind are
acceptable to employees because they provide a definite goal and challenge to them.

Setting the Standards or Establishing a Standard Costing System

Establishing a standard costing system for materials, labor, and overheads is a complex task,
requiring the collaboration of a number of executives.

For this purpose, a Standards Committee is established. The Standards Committee generally
consists of:

 Production Manager
 Purchase Manager
 Personnel Manager
 Production Engineer
 Sales Manager
 Cost Accountant
The Budget Committee and Standards Committee can be combined into one committee.

The Standards Committee is responsible for fixing standards. It also assists in the effective
application of standards, as well as making necessary changes as new circumstances render
previous standards obsolete. Before fixing standards, a detailed study of the functions involved
in the manufacturing of the product is necessary. While fixing standard costs, the fundamental
principle to be observed is that the set standards are attainable so that these are taken as
yardsticks for measuring the efficiency of actual performances. The setting up of standard costs
requires the consideration of quantities, price or rates, and qualities or grades for each element of
cost that enters a product (i.e., materials, labor, and overheads).

VARIANCE ANALYSIS

Variances may be classified into:

(i) Favourable and Unfavourable Variances, and
(ii) Controllable and Uncontrollable Variances
(i) Favourable and Unfavourable Variances: When the actual cost incurred is less than the
standard cost, the deviation is known as 'favourable variance' whereas, when the actual cost
incurred is more than the standard cost, the variance is treated as 'unfavourable* or
'adverse*. A favourable variance reflects the efficiency while unfavourable variance indicates
inefficiency. Favourable variance is also known as positive ( + ) or credit variance and viewed
only as profits whereas adverse variance is known as negative (-) or debit variance and is
viewed as losses. In other words, any variance which increases the actual profit is favourable
variances and any variance which decreases the actual profit is unavoidable variable. Favourable
variance is designated by (F) and unfavourable or adverse by (A).
(ii) Controllable and Uncontrollable Variances: A variance is said to be controllable if primary
responsibility of a specified person or department can be identified. For example, excess
usage of materials by production department is controllable being the responsibility of the
foreman of the said department. On the other hand, when variance is due to the factors beyond
the control of the concerned person, it is said to be uncontrollable. For example, increase in
wage rate of workers on account of strike or government policy, etc. No individual person or
department can be held responsible for uncontrollable variances.
Variance analysis is a process of analysing variances by sub-dividing the total cost variance in such a way
that the management of the concern can assign the responsibility for off standard performance. It also leads to
ascertain the magnitude of each of the variances and reasons thereof. In variance analysis, the attention of the
management is drawn not only to the monetary value of unfavourable and favourable managerial performance
but also the responsibility and reasons for the same.
Material Variances
Material forms a very high percentage of the total cost. It is very important to study its cost variance. Material
variances consist of the following variances:
(1) Material Cost Variance (MCV)
(2) Material Price Variance (MPV)
(3) Material Usage/Quantity/Volume Variance (MQV)
(4) Material Mix Variance (MMV)
(5) Material sub-usage Variance/Revised Material Quantity Variance {RMQV}
(6) Material Yield Variance (MYV)
Classification of Cost Variances
(1) Material Cost Variance (MCV): "Material cost variance is the difference between the
standard cost of materials specified for the actual output and actual cost of materials
used." — I.C.M.A., London
It is expressed as:
MCV= Standard Cost of Material for Actual Output — Actual Cost of Material
or (SQ  SP) - (AQ AP)
SQ stands for Standard Quantity for Actual Output
SP stands for Standard Price
AQ stands for Actual Quantity
AP stands for Actual Price
Standard Quantity for Actual Output is computed as follows
Standard Quantity
 Acual output
Standard Output
(2) Material Price Variance (MPV): Material price variance is the portion of the Material Cost Variance
which arises due to the difference between the standard price specified and actual price paid. It can be
expressed as:
Material Price Variance - Actual Quantity (Standard Price - Actual Price) or MPV = AQ (SP - AP)
The reasons for the material price variance may be the following:
(i) Change in market price
(ii) Change in quantity of purchase
(iii) Change in quality of material purchased
(iv) Emergency purchases leading to higher prices
(v) Discounts not availed
(vi) Rush order to meet shortage of supply, etc.
(3) Material Usage/Quantity/Volume Variance: Material usage variance is the difference
between the standard quantity specified and the actual quantity used. This variance may arise due to the
following reasons:
(i) Use of inferior material
(ii) Poor inspection of material
(iii) Lack of due care in the handling of materials
(iv) Abnormal wastage, theft, pilferage of materials
(v) Setting of improper standards
(vi) Improper maintenance of machine, etc.
It may be expressed as:
Material Usage Variance = Standard Price (Standard Quantity for Actual Output- Actual Quantity)
or MUV = SP(SQ-AQ)
Relationship among MCV, MPV and MUV:
MCV = MPV + MUV
Illustration 4.1
The standard material required for production is 5,200 kg. A price of `2 per kg has been fixed for
the materials. The actual quantity of materials used for the product is 5,600 kg. A sum of ` 14,000 has
been paid for the materials.
Calculate: (a) Material Cost Variance; (b) Material Price Variance; (c) Material Usage Variance.
Solution:
Standard Quantity = 5,200 kg
Standard Price = ` 2 per kg
Actual Quantity = 5,600 kg
Actual Price = 14, 000 = ` 2.50 per kg
5, 600
(a) Material Cost Variance (MCV):
MCV = (SQ  SP)  (AQ  AP)
= (5,200 2)  (5,600  2.50)
= ` 10,400  `14,000 = `3,600 (Adverse)
(b) Material Price Variance (MPV):
MPV = AQ{SP - AP} = 5,600 {2-2.50}= 5600(-0.50) = `2,800 (Adverse)
(c) Material usage variance (MUV):
MUV =SP(SQ-AQ)
= 2(5,200-5,600)
= 2(-400) = `800 (Adverse)
Verification:
MCV =MPV + MUV = `3,600(Adv.) = 2,800 (Adv.) + 800 (Adv.)
Illustration 4.2
In a brass foundry, the standard mixture consists of 60% Copper and 40% Zinc. The standard loss
of production is10% on input. From the actual production in a month calculate the Material Cost
Variance and analyse it:
Copper 50kg@`30 per kg (standard 60kg)
Zinc 50 kg@`20per kg (Standard 40 kg)
Actual Output: 86 kg
SP and AP are the same
Solution:
Standard Mix Actual Mix
SQ(kg) SP(`) Std. Cost(`) AQ(kg) AP(`) Actual Cost(`)
Copper 60 30 1800 50 30 1,500
Zinc 40 20 800 50 20 1,000
100 2,600 100 2,500
Less (10%) 10 14
(Loss) 90 86

Material Cost Variance (MCV) = (Std. Cost – Actual Cost)

Std. Cost – (SQ for Actual Output SP)
SQ for Actual Output will be computed as follows:
60
Copper   86  57.33
90
40
Zinc   86  38.22
90
Now, MCV for Copper =  57.33  30   50  30  ` 220 (Fav.)
MCV for =  38.22  20   50  20  ` 236 (Adv.)
= `16 (A|dv.)
This is explained by
(i) Material Price Variance = Nil
(ii) Material Mix Variance = (SQ-AQ)SP
Copper =  60  50  30 = `300 (Fav.)
Zinc =  40  50  20 = `200 (Fav.)
= `100 (Fav.)
(iii) Material Yield Variance = (AY -SY)SC per unit
 86  90  28.89*
= `116 (Adv.)
2600
*SC   `28.89
90
Verification
MCV = MPV + MMV + MYV
`16 (Adv.) = Nil + `100 (Fav.) + `116(Adv.)
`16 (Adv.) = `16(Adv.)
Note: Since SPO and AP are the same and Standard Total Quantity and actual Total Quantity are
the same, there will be no Material Price variance and Material Usage Variance.
Illustration 4.3
The standard material cost for a normal mix of one tonne of chemical Z is based on:
Chemical Usage (Kg) Price Per Kg. (`)
A 240 6
B 400 12
C 640 10
During a month, 12.5 tonnes of Z were produced from:
Chemical Consumption (Tonnes) Cost (`)
A 3.2 22,400
B 4.8 60,000
C 9.0 94,500

Analyse the Variances:

Solution:
(i) SQ for Actual output:
A = 24012.5 = 3,000 Kg
B = 400  12.5 = 5,000 Kg
C = 640  12.5 = 8,000 Kg
Total SQ = 16,000Kg
(ii) Total AQ = 3.200 + 4,800 + 9,000 = 17,000 Kg.
(iii) RSQ
3, 000
A  17, 000  3,187.5 Kg.
16, 000
5, 000
B  17, 000  5, 312.5 Kg.
16, 000
8, 000
C  17, 000  8, 500 Kg.
16, 000
Computation of Material Cost Variances
Material SQ for SP(`) SQ + AQ AP(`) AQ RSQ RSQSP(`)
AQ SP(`) AP(`)
A 3,000 6 18,000 3,200 7.0 22,400 3,187.5 19,125
B 5,000 12 60,000 4,800 12.5 60,000 5,312.5 63,750
C 8,000 10 80,000 9,000 10.5 94,500 8,500.00 85,000
16,000 17,000
Loss 3,500 4,500

12,500 1,58,000 12,500 1,76,900 1,67,875

(1) Material Cost Variance (MCV) = (SQ SP) – (AQAP)

= `1,58,000 – `1,76,000
= `18,000 (A)
(2) Material Price Variance (MPV) = AQ (SP – AP)
A = 3,200(6-7) = `3,200 (A)
B = 4,800 (12–12.5) = `2,400 (A)
C = 9,000 (10–10.5) = `4,500(A)
MPV = `10,100(A)
(3) Material Usage Variance (MUV) = SP (SQ- AQ)
A = 6 (3,000 – 3,200) = `1,200 (A)
B = 12 (5,000–4,800) = `2,400(F)
C = 10 (8,000 – 9,000) = `10,000(A)
MUV = 8,800(A)
(4) Material Mix Variance (MMV) = SP (RSQ-AQ)
A = 6(3,187.5 – 3,200) = `75(A)
B = 12(5,312.5 – 4,800) = `6,150 (A)
C = 10(8,500 – 9,000) = 5,000 (A)
MMV = `1,075(F)
(5) Material Yield Variance (MYV)
MYV = (Actual Yield – Std. Yield) SC per unit
Actual Yield = 12,500
Standard Yield = (12,500/16,000)17,000 = 13,281
Standard Cost = 1,58,000/12,500 = 12.64
MYV = (12,500 – 13.281)  12.64 = `9,875 (A)
Alternatively, MYV = SP(SQ – RSQ)
MYV = (SQSP) – (RSQSP)
= (1,58,000 – 1,67,875)
= `9,875 (A)
Verification:
1. MCV = MPV + MUV
18,900 (A) = 10,100(A) + 8,800 (A)
18,900(A) = 18,900 (A)
2. MUV = MMV + MYV
8,800(A) = 1,075(F) + 9,875 (A)
8,800 (A) = 8,800 (A)
Labour Variances
These may be two main reasons of the occurrence of deviations in cost of direct labour:
(i) Difference in actual rates and standard rates of labour and
(ii) The variation in the actual time taken by the workers and standard time allowed to them for
performing a job or an operation.
The various labour variances may be arranged as follows:

(1) Labour Cost Variance (LCV): It is the difference between the standard labour cost and
actual labour cost of the product.
LCV = (Standard Rate  Standard Time for Actual Output*)-(Actual Rate  Actual Time)
Standard Time
*  Actual output
Standard Output
LCV  SR  ST    AR  AT 
Labour cost variance may be analysed further as (i) Labour rate variance, and (ii) Labour efficiency
variance.
(2) Labour Rate Variance (LRV): It is that portion of labour cost variance which is due to the
difference between the standard rate specified and the actual rate paid. It would occur due to the following
reasons:
(i) Employment of one or more workers of different grade than the standard grade,
(ii) Excessive overtime,
(iii) Overtime work in excess of that provided in the standard,
(iv) New workers not being allowed full wage rates, etc. The formula for calculating LRV is as
under: Labour Rate Variance (LRV) = Actual Time x {Standard Rate - Actual Rate)
or LRV=AT  SR-AR 
(3) Total Labour Time/Efficiency Variance (TLEV): It is that portion of labour cost
variance which arises due to the difference between the Standard Labour hours specified and
the actual labour hours spent. It may arise due to the following reasons:
(i) Wrong selection of workers,
(ii) Higher labour turnover,
(iii) Lack of supervision,
(iv) Poor working conditions,
(v) Defective machinery, tools and equipment,
(vi) Use of non-standardised materials,
(vii) Inefficiency of workers, etc.
TLEV = Standard Rate x {Standard Time for Actual Output* - Actual Time)
Standard Time
*  Actual output
Standard Output
TLEV = SR  (ST - AT) TLEV can be divided into three parts:
(i) Simple LEV = SR x (ST for Actual output - AT worked*)
* AT Allowed - Idle Time - Holiday Time
(ii) Idle Time Variance* = Idle Time x SR
Note: Idle time is always adverse,
(iii) Holiday/Calendar Variance - Holiday Time x SR
Note: Holiday/Calendar Variance is always adverse.
TLEV = SLEV + Idle Time Variance + Holiday Variance
Labour Idle Time Variance: It is that portion of labour efficiency variance which may arise due to
abnormal wastage of time on account of strikes, power out, non-availability of raw-material, breakdown
of machinery etc.
Idle Time Variance = Idle Time (Hours)  Standard Rate
(4) Labour Mix Variance (LMV): Where workers of two or more than two types are engaged in the
difference between the standard composition of workers and the actual gang (or group) of workers is
known as ‘Labour Mix Variance’. It is calculated as under:
LMV  Labour Mix Variance (LMV)= SR(RST-AT)
Standard Time
Revised Standard Time (RST) =  Total Actual Time
Total Standard Time
(5) Labour Yield Variance (LYV): It is that portion of labour efficiency variance which arises due to the
difference between actual output of worker and standard output of worker specified. It is calculated as
follows:
(LYV) = SC(Actual Yield – Revised Standard Yield*)
SC stands for standard cost of Labour per unit of standard output
SC is calculated as follows:
Standard Cost of Labour
SC 
Standard Output
*Revised Standard Yield = Standard Yield Actual mix of Labour before

Standard Mix of Labour Idle and Holiday Time
before Idle and Holiday Time
Illustration 4.4
From the following information, compute labour cost variance, labour efficiency variance and labour rate
variance.
Standard
Workers Hours Rate per hour (`) Total Amount (`)
A 10 3.00 30.00
B 15 4.00 60.00
Actual
A 20 3.00 60.00
B 5 4.50 22.50
Solution:
(a) Labour Cost Variance (LCV):
LCV = (STSR) – (ATAR)
Worker A = (10  3) – (20  3) = `30 (Adv.)
Worker B = (15  4) – (5  4.50) = `37.50 (Fav.)
= `7.50 (Fav.)
(b) Labour Efficiency Variance (LEV):
LEV = (ST - AT) SR
A = (10 - 20)  3 = `30 (Adv.)
B = (15 - 5)  4 = `40 (Fav.)
= `10 (Fav.)
(c) Labour Rate Variance (LRV)L
LRV = (SR – AR) AT
A = (3 - 3) 20 = 0
B = (4 – 4.50)  5 = `2.50 (Av.)
= `2.50 (Adv.)
Verification:
LRV = LEV + LRV
7.50 (Fav) = 10 (Fav.) + 2.50 (Adv.)
`7.50 (Fav.) = `7.50 (Fav.)
Illustration 4.5
Calculate Labour Variance from the following information:
Labour Rate = `1 per hour
Hours as Standard per unit = 12 Hours
Actual Date:
Units Produced = 1,000
Actual Labour Cost = `10,000
Hours Worked actually = 12,500 Hours
Solution:
Standard Time (ST) = 100012 = 12,000 Hours
Standard Cost = 12,0001 = `12,000
Labour Cost Variance (LCV) = (Standard Cost – Actual Cost)
= (12,000 – 10,000)
= `2,000 (Fav.)
Labour Rate Variance (LRV)= (SR – AR) AT
1.00  0.80   12, 500 = `2,500 (Fav)
10, 000
Actual Rate= = `0.80 per hour
12, 500
Labour Efficiency Variance (LEV): (ST – AT) AT
LEV = (12,000 – 12,500) 1
= `500 (Adv.)
Verification:
LCV = LRV + LEV
`2,000(Fav.) = `2,500 (Fav.) + `500 (adv.)
`2,000 (Fav.) = `2,000(Fav.)
Illustration 4.6
From the following information, calculate labour variance
Standard wages:
Grade X : 90 Labourers at `2 per hour
Grade Y: 60 Labourers at `3 per hour
Actual Wages:
X: 80 Labourers at `2.50 per hour
Y: 70 Labourers at `2.00 per hour
Budgeted Hours = 1,000
Actual Hours = 900
Budgeted Gross Production = 5,000 units
Standard Loss = 20%
Actual loss = 900 units
Solution:
Standard Actual
Grade Time (Hours) Rate (`) Amount(`) Time (Hours) Rate (`) Amount (`)
(80900)
X(901000) 90,000 2 1,80,000 72,000 2.50 1,80,000
Y(601,000) 60,000 3 1,80,000 63,000 2.00 1,26,000
(70900)
1,50,000 3,60,000 1,35,000 3,06,000

(i) Labour Cost Variance (LCV):

Standard Cost for actual production – actual Cost
Here actual production = 5,000 – 900 =4,100 units
So, Standard cost for actual Production:
3, 60, 000
 4,100  `3,69,000
4, 000
Standard Production (SP) = 5,000- 1,000 = 4,000 units
LCV = `3,69,000 - `3,06,000
= `63,000 (Fav.)
(ii) Labour Rate Variance (LRV): AT (SR – AR)
Grade X = 72,000 (2 – 2.50) = `36,000 (Adv.)
Grade Y = 63,000 (3 – 2.00) = `63,000 (Fav.)
= 27,000(Fav.)
(iii) Labour Efficiency Variance (LEV):
SR (ST for actual Output – Actual Time)
90, 000
ST for Grade X=  4,100  92, 250 hrs
4, 000
60, 000
ST for Grade Y =  4,100  61,500 hrs
4, 000
LEV:
Grade X = 2(92,250 – 72.000) = `40,500 (Fav.)
Grade Y = 3(61,500 – 63,000) = `4,500 (Adv.)
= 36,000 (Fav.)
Labour efficiency Variance can be further analysed as follows:
(iv) Labour Mix Variance (LMV): SR (RST – Actual Time)
Standard Time
RST =  Total Actual Time
Total Standard Time
90, 000
Grade X =  1, 35, 000  81, 000 hrs
1, 50, 000
60, 000
Grade Y =  1, 35, 000  54, 000 hrs
1, 50, 000
LMV:
Grade X = 2(81,000 – 72,000) = `18,000 (Fav.)
Grade Y = 3(54,000 – 63,000) = `27,000 (Adv.)
= `9,000 (Adv.)
(v) Revised Efficiency Variance (REV):
SR (ST for actual Output – RST)
Grade X = 2(92,250- 81,000) = `22,500 (Fav.)
Grade Y = 3(61,500 – 54,000) = `22,500 (Fav.)
= `45,000 (Fav.)
Verification:
1. LEV = LMV + REV
`36,000 (Fav.) = `9,000 (Adv.) + `45,000(Fav.)
`36,000 (Fav.) = `36,000 (Fav.)
2. LCV = LRV + LEV
`63,000 (Fav.) = `27,000 (Fav.) + `36,000 (Fav.)
`63,000 (Fav.) = `63,000 (fav.)
Note: Revised Efficiency Variance (REV) is equal to Labour Yield variance:
Labour Yield Variance = Standard Cost per unit  (Standard Output for Actual Mix – Actual Output)
3, 60, 000
Here, Standard Cost per unit =  `90
4, 000
standard Output
Standard Output for Actual Mix =  Acutal Mix
Standard Mix
4, 000
  1, 35, 000  3, 600
1, 50, 000
Labour Yield Variance = 90 (4,100 – 3,600) = `45,000 (Fav.)
Overhead Variances
Overhead variance is the difference between the standard overhead specified and actual overhead
incurred.
Overhead variance is divided into:
(A) Variable Overhead variance.
(B) Fixed Overhead Variance
(A) Variable Overhead Variance
Variable cost varies in proportion to the level of output, while cost is fixed per unit. As such the
standard cost per unit of these overheads remains the same irrespective of the level of output attend.
(1) Variable Overhead Cost Variances. The variable overhead cost variance represents the
difference between the standard cost of variable overhead for actual output and the actual
variable overhead incurred during the period.
Variable Overhead Cost Variance
= (Actual Output  St. Variable Overhead Rate per unit) - Actual Variable Overhead Cost
Or
= (St. Hours for Actual Output  St. Variable Overhead Rate per Hour)
Actual Variable Overhead Cost
(2) Variable Overhead Expenditure Variance. It is the difference between the actual
variable overhead rate per hour and standard variable overhead rate per hour multiplied
by the actual hours worked. It is also known as 'Budget Variance'.
Variable Overhead Expenditure Variance
= (St. Variable Overhead Rate x Actual Hours) - Actual Variable Overheads
Or
= Recovered Variable Overheads - Actual Variable Overheads
(3) Variable Overhead Efficiency Variance. The variable overhead efficiency variance is
calculated by taking the difference in standard output and actual output multiplied by the
standard variable overhead rate.
Variable Overhead Efficiency Variable = St.Variable Overhead Rate  (St. Quantity  Actual
Quantity) Or
= SVOR  (SHAO  AH)
Where SVOR = Standard Variable Overhead Rate per hour; SHAO = Standard Hours for
Actual Output;
AH = Actual Hours. Confirmation:
Variable Overhead Variance = V.O. Expenditure Variance + V.O. Efficiency Variance
Illustration 4.7
From the following information, calculate: (a) Variable Overhead Variance, (b) Variable Overhead
Expenditure Variance, and (c) Variable Overhead Efficiency Variance.
1. Standard hours per unit: 3; Variable Overhead per hour: `5
2. Actual Variable Overhead incurred: ` 4,20,000
3. Actual Output: 30,000 units
4. Actual Hours worked: 1,00,000 hours.
Solution:
(a) Variable Overhead Variance = Standard Variable Overhead - Actual Variable Overhead
= (3  ` 5  30,000 units) `4,20,000
= `4,50,000  ` 4,20,000 = ` 30,000 (F)
(b) Variable Overhead Expenditure Variance
= Standard Variable Overhead for Actual Time - Actual Variable Overhead = (Standard
Overhead Rate  Actual Hours) - A.V.O.
= (` 5  1,00,000 hours) - `4,20,000
= ` 5,00,000  ` 4,20,000 = `80,000 (F)
(c) Variable Overhead Efficiency Variance = Standard Variable Overhead on Actual Production
 Standard Variable Overhead for Actual Time
= (3  `5 30,000units)-( `51,00,000 hours)
= ` 4,50,000-`5,00,000 = ` 50,000 (A)
Confirmation:
Variable Overhead Variance = V.O. Expenditure Variance + V.O. Efficiency Variance.
` 30,000 (F) = ` 80,000 (F) + ` 50,000 (A)
` 30,000 (F) = ` 30,000 (F).
(B) Fixed Overhead Variance
Fixed overhead variance reveals all items of expenditure which are more or less remain constant
irrespective of level of output or number of hours worked. Fixed overhead variance depends upon
two factors, which are: (i) fixed expenses incurred and (ii) volume of production obtained.
The volume of production depends upon (a) capacity at which the factory works, (b) number of
days factory works, and (c) efficiency at which factory works.

Classification of Fixed Overhead Variances

(1) Fixed Overhead Cost Variance. It shows the difference between the standard cost of
fixed overheads recovered for actual output and actual cost of fixed overheads incurred.
Fixed Overhead Cost Variance = Standard Fixed Overheads - Actual Fixed Overheads
Or
= (Actual Output x Standard Fixed Overhead Rate)  Actual Fixed Overheads Fixed Overhead
Cost Variance may be classified as:
(a) Fixed Overhead Expenditure Variance;
(b) Fixed Overhead Volume Variance.
(2) Fixed Overhead Expenditure Variance. It is that part of fixed overhead cost variance
which arises due to the difference between budgeted fixed overhead expenditure and the
actual fixed overhead expenditure relating to a specified period.
Fixed Overhead Expenditure Variance = Budgeted Fixed Overheads - Actual Fixed Overheads
Or

= (Standard Overhead Rate x Budgeted Output) - Actual Overhead Rate x Actual Output)

(3) Fixed Overhead Volume Variance. This variance reveals the difference between fixed overhead
recovered on actual output and fixed overheads on budgeted output. It is the result of difference in
volume of production multiplied by the standard rate. Fixed Overhead Volume Variance =
Recovered Fixed Overheads - Budgeted Fixed Overheads
Or
= (Actual Output x Standard Overhead Rate) - (Budgeted Output x Standard Overhead Rate) Fixed
overhead volume variance can further be analysed as (a) Fixed Overhead Efficiency Variance, (b)
Fixed Overhead Capacity Variance and (c) Fixed Overhead Calendar Variance
3 (a) Fixed Overhead Efficiency Variance. It is that part of fixed overhead volume variance which is
due to the difference between the budgeted efficiency of production and the actual efficiency
attained. The actual quantity produced and standard quantity fixed might be different because of
higher or lower efficiency of workers employed in manufacturing of goods. Fixed Overhead
Efficiency Variance = Recovered Fixed Overheads - Standard Overheads
Or
= Standard Overhead Rate (Actual Quantity - Standard Quantity)
3 (b) Fixed Overhead Capacity Variance. The variance which is related to the over or under
utilisation of plant capacity is known as fixed overhead capacity variance. Strikes, lock-out, idle
time, etc., lead to under-utilisation and overtime, extra shift, etc., lead to over-utilisation. Fixed
Overhead Capacity Variance = Standard Overhead Rate per unit (Revised Budgeted Output -
Budgeted Output)
Or
Hours = Standard Rate per hour (Revised Budgeted Hours - Budgeted Hours) Whereas, Revised
Budgeted Nos. = Actual Working days x Budgeted Hrs. per Day.
3 (c) Fixed Overhead Calendar Variance. It is that part of volume variance which arises due to the
difference between the number of working days anticipated in the budget period and the actual
working days in the budget period. The number of working days in the budget are arrived at by
dividing the number of annual days by twelve. But the actual days of a month may be more or less
than the standard days and with the result there may be calendar variance. Fixed Overhead
Calendar Variance = possible Fixed Overheads - Budgeted Fixed Overheads
Or
= (Standard Rate of Overhead per hour x Possible Hours)
(Standard Overhead Rate per hour x Budgeted Hours)
Possible Hours = Standard Working hours per day x Actual Number of Working days.
Or Fixed Overhead Calendar Revised Variance = (Standard Rate per hour/day)  (Excess or
Deficit Hours/Days Worked)
Fixed Overhead Capacity Revised Variance = Standard Overhead - Possible Overhead

Illustration 4.8
From the following data calculate Fixed Overhead Variances
Budgeted Actual
Output 20,000 units 18,000 units
Number of Working Days 25 28
Fixed Overheads `40,000 `41,000
There was an increase of 10% in capacity
Solution:
Standard Fixed Overheads
Standard Overhead Rate =
Standard Output
40,000
=  `2.00
20,000 Units
(a) Fixed Overhead Cost Variance
= Standard Fixed Overheads - Actual Fixed Overheads
= (Actual Output x Standard Fixed Overhead Rate)
- Actual Fixed Overheads
FOCV = (18,000 units  ` 2.00)  ` 41,000 = ` 36,000  ` 41,000
= ` 5,000 (A)
(b) Fixed Overhead Expenditure Variance
= Budgeted Fixed Overheads - Actual Fixed Overheads
FOEV = ` 40,000  ` 41,000 = `1,000 (A)
(c) Fixed Overhead Volume Variance
= Recovered Fixed Overheads - Budgeted Fixed Overheads
= (Actual Output x Standard Overhead Rate)
- (Budget Output x Standard Overhead Rate)
= (18,000 units  ` 2.00) (20,000 units x `2.00)
FOW = ` 36,000  ` 40,000 = ` 4,000 (A)
(d) Fixed Overhead Efficiency Variance
= Standard Overhead Rate (Actual Quantity - Standard Quantity)
Standard Quantity (without increase) = Budgeted Quantity
=20,000 units
Increase in Capacity @ 10% = 2,000 units
 Standard Production = 22,000 units
(+) Standard Production for 3 days
 22, 000units 
i.e.,  28  25 days   3 days   2640 units
 25days 
Thus, Standard Quantity after Increase of Capacity = 24.640 units
. F.O.E.F.V = `3.00 (18,000 units  24,640 units) =` 13,280 (A)
(e) Fixed Overhead Capacity Variance
= Standard Overhead Rate (Standard Output for Actual Time  Budgeted Output)
= Standard Overhead Rate (Revised Budgeted units  Budgeted units)
10
= `2.00 [(20,000 + 20,000  ) = 20,000 units]
100
 F.O.C.V = `2.00 (22.000 units - 20,000 units) = ` 4,000
(F)
(f) Fixed Overhead Calendar Variance
= Increase or Decrease in production due to more or less working days
 Standard Overhead Rate per unit with the increase in capacity
 F.O.C.V = 2,640 units  ` 2 = ` 5,280 (F)
Confirmation:
Fixed Overhead Cost Variance = F.O. Expenditure Variance + F.O. Volume Variance
` 5,000 (A) = `1,000 (A) + ` 4,000 (A)
` 5,000 (A) = ` 5.000 (A)
Fixed Overhead Volume Variance
= F.O. Efficiency Variance + F.O. Capacity Variance +F.O. Calendar Variance
`4,000 (A) = `13,280(A) + ` 4,000 (F) + ` 5,280 (F)
` 4,000(A) = ` 13,280 (A) + `9,280 (F)
` 4,000 (A) = ` 4,000(A)

Illustration 4.9
Ankita Ltd. has furnished you the following data:
Budgeted Actual (July, 2014)
Number of Working Days 25 27
Production ( in units) 20,000 22,000
Fixed Overheads (in `) 30,000 31,000
Budgeted Fixed Overhead Rate is `1.00 per hour. In July, 2014, the actual hours worked were 31,500.
Calculate the following variances: (i) Efficiency Variance; (ii) capacity Variance; (iii) Calendar Variance;
(iv) Volume Variance; (v) Expenditure variance; (vi)Total Overheads Variance.
Solution:
Working Notes:
St. Hrs. for Actual Output =  22, 000  30, 000  = 33,000 hrs
 20, 000 
Budgeted Overheads = `30,000
Budgeted Overhead Rate per hour = `1.00
30, 000
Budgeted Hours =  30,000
1.00
Budgeted Output = 20,000 units
30, 000
St. Time per unit of Output =  1.5 hrs
20, 000
1.5Hours
St. Rate per unit of Output =  `1.50
1.0
Budgeted Days = 25
30, 000
Budgeted Hrs. Worked per day = =1200 Hrs
25
Calculation of First Overhead Variances:
(1) Efficiency Variance = St. Rate per hour (St. Hours – Actual Hours)
EV = `1.00 (33,000- 31,500) = `1,500 (F)
(2) Capacity Variance = St. Rate per hour (Actual Hours – Revised Budgeted Hours)
CV = `1.00 (31,500  27 1.200)= `900 (A)
Budgeted Overheads
(3) Calendar Variance =  (actual No. of Working Days
Budgeted Working Days
- Budgeted No. of Working Days)
30, 000
 CIV   27  25   `2,400 (F)
25
(4) Volume variance = Standard Rate per unit (Actual Output Budgeted Output)
VV = `1.50 (22,000 – 20,000) = `3,000
(5) Expenditure Variance = Budgeted Overheads Actual Overheads
Exp. V = ` 30,000 - `31,000 = ` 1,000 (A)
(6) Total Overhead Variance = (Actual Output x Standard Rate per unit) Actual Overheads
= (22,000 units x `1.50}` 31,000
TOV = `33,000  `31,000 - ` 2,000 (F)
Confirmation:
Total Overhead Variance = Expenditure Variance + Volume Variance
`2,000 (F) = `1,000 (A) + ` 3,000 (F)
`2,000 (F) = `2,000 (F)
Volume Variance = Efficiency Variance + Capacity Variance + Calendar Variance
`3,000 (F) - `1,500 (F) + ` 900 (A) + `2,400 (F)
`3,000 (F) = ` 3,000 (F)
Illustration 4.10
The following information is available from the cost records of a company for January, 2014:
(`)
Materials Purchased: 20,000 pieces 88,000
Materials Consumed: 19,000 pieces
Actual Wages Paid: 4,950 Hours 24,750
Factory Overheads Incurred 44,000
Factory Overheads Budgeted 40,000
Units Produced: 1,800
Standard Rates and Prices are:
Direct Material Rate `4 per piece
Standard Input 10 pieces per unit
Direct Labour Rate `4 per hour
Standard Requirement 2.5 hours per unit
Overhead `8 per labour hour
Required:
(a) Show the Standard Cost Card.
(b) Compute all Material, Labour and Overhead Variances for January, 2014.
Solution:
(a) Standard Cost Card

Per Unit m
Direct — 10 pieces @ ` 4 per piece 40
Material — 2.5 hrs @ `4 per hour 10
Direct — 2.5 hrs @ ` 8 per hour 20
Labour Total Standard Cost 70
Overheads
(b) Computation of Variances:
I. Material Variances
(1) Total Material Cost Variance = Standard Cost of Material for Actual Output
- Actual Material Cost
 19, 000 
 1, 800  10 pieces ` 4    ` 88, 000  
 20, 000 
TMCV = `72,000` 83,600 =` 11600 (A)
(2) Material Price variance = Actual Qty. (St. Price - Actual Price)
 ` 88, 000 
MPV = 19,000 pieces  ` 4  
 20, 000 
= 19,000 pieces (`4 – `4.40) = `7,600 (A)
(3) Material Usage Variance = St. Price (St. Qty. – A. Qty.)
MUV = `4.00 (18,000  19,000) = ` 4,000 (A)
Confirmation:
TMCV = MPV + MUV
` 11,600 (A) = ` 7,600 (A) + ` 4,000 (A)
` 11,600 (A) = ` 11,600 (A)
II. Labour Variances
(1) Total Labour Cost Variance — St. Cost of Labour for Actual Output
- Actual Labour Cost
= (` 1,800  2.5 hrs x ` 4)  ` 24,750
LTV = ` 18,000  ` 24,750 = ` 6,750 (A)
(2) Labour Rate Variance = Actual hrs. (St. Rate per hour - Actual Rate per hour)
 ` 24, 750 
= 4,950 hrs.  ` 4  
 4, 950 
= 4,950 hrs. (`4 - `5)
LRV = ` 4,950 (A)
(3) Labour Efficiency Variance = St. Rate per hour (St. hrs. - A. hrs.)
= ` 4 [(1800 x 2.5 hrs) - 4,950 hrs.]
=` 4 (4,500 hrs. - 4,950 hrs.)
LEV = ` 1,800 (A)
Confirmation:
TLCV = LRV + LEV
`6,750 (A) = `4,950 (A) + `1,800 (A)
`6,750 (A) = `6,750 (A)
III. Fixed Overhead Variances
(1) Total fixed Overhead Cost variance = Overhead Recovered on Actual Output
- Actual Factory Overheads
= (1,800 units 2.5 hrs 8) – 44,000
 TFOC = ` 36,000 - `44,000 = ` 8,000 (A)
(2) Fixed Overhead Expenditure Variance
- Budgeted Fixed Overheads - Actual Fixed Overheads
 F.O. Exp. V. = ` 40,000 - ` 44,000 = `4,000 (A)
(3) Fixed Overhead Efficiency Variance = St. F.O. Rate per hour
(St. hrs, for Actual Output - Actual hrs.)
= ` 8 [(2.5 hrs.1,800)4,950 hrs.]
F.O. Eff. V. = ` 8 (4,500 hrs. 4,950 hrs.)
= ` 3,600 (A)
(4) Fixed Overhead Capacity Variance = St. F.O. Rate per hour (Actual Capacity hrs.
- Budgeted Capacity hrs.)
 Rs. 40, 000 
 Rs.8  4, 950hr  
 8 

= ` 8(4,950 hrs.  5,000 hrs.)

F.O.C.V = ` 400 (A)

Confirmation:

TFOCV = F.O. Exp. V. + F.O. Capacity V

` 8,000 = ` 4,000 (A) + ` 3,600 (A) + ` 400 (A)
`8.000(A) = ` 8,000 (A)
4.3.1 Evaluation of cost and sales variances
Sales Variances
Some companies are interested in calculating only cost variances relating to materials, labour and
overheads. These variances are of great significance to the business enterprises. But in order to obtain the
full advantages of standard costing system, many companies also calculate safe variances. Sales variances
affect a business in terms of changes in revenue.
Sales variances can be calculated by two methods:
(A) The Value or the Turnover Method, (B) The Profit or the Margin Method.
• (A) The Value or the Turnover Method
Under this method, variances are calculated with reference to their effect on sales or sales value.
Classification of Sales Variances Based on Turnover

(1) Sales Value Variance (SVV): It shows the difference between the actual sales and the
budgeted sales. If the actual sales exceed the budgeted sales the variance is treated as
favourable and vice-versa.
Sales Value Variance (SVV) = Actual Value of Sales - Budgeted Value of Sales
or
SVV - (Actual Quantity  Actual Selling Price) 
(St. Quantity  St. Selling Price)
(2) Sales Price Variance (SPV): It is the that part of Sales Value Variance which arises due
to the difference between actual price and standard price of sales. If the actual price
attained is more than the standard price, the variance shall be favourable and vice-versa.
Sales Price Variance {SPV) = Actual Quantity (Actual Selling Price - St. Selling Price)
(3) Sales Volume Variance (S.Vlm. V): It is that part of Sales Value Variance which arises
due to the difference between the actual quantity sold and the standard quantity of sales.
Sales Volume Variance (S. Vim. V) = St. Selling Price (Actual Quantity of Sales
St. Quantity of Sales)
Sales Volume Variance can be further divided into:
3 (a) Sales Mix Variance (SMV): It is that part of Sales Volume Variance which arises due to the
difference between standard and actual composition of the sales mix. This variance arises only
when the business firm deals in more than one product. Sales Mix Variance (SMV) = St.
Value of Actual Mix - St. Value of Revised St. Mix
or
SMV = St. Selling Price (Actual Qty. - Revised St. Qty.)
3 (b) Sales Quantity Variance (SQV): It is that part of Sales Volume Variance which is due to the
difference between standard value of a actual sales at standard mix and the budgeted sales.
Sales Quantity Variance (SQV) = Revised Standard Sales Value - Budgeted Sales Value
or SQV — Standard Selling Price per unit (Standard Proportion for
Actual Sales Quantity - Budgeted Quantity of Sales)
or SQV — St. Selling Price per unit (Revised St. Mix - St. Mix)
Illustration 4.11

The budgeted sales for one month and the actual results achieved are as under :

Product Budget Actual

Quantity Rate (`) Amount (`) Quantity Rate (`) Amount (`)
(units) (units)
M 1,000 10.00 10,000 1,200 (`)
12.50 15,000
N 700 20.00 14,000 800 15.00 12,000
O 500 30.00 15,000 600 30.00 18,000
P 300 50.00 15,000 400 60.00 24,000
Total 2,500 54,000 69,000
You are required to calculate in respect of each product, the Sales Variances.

Solution:
(1) Sales Value Variance = Actual Value of Sales - Budgeted Value of Sales
 SVV = ` 69,000  ` 54,000 = ` 15,000 (F)
(2) Sales Price Variance = Actual Qty. (Actual Selling Price - St. Selling Price)
M = 1200 (` 12.50  ` 10.00) = ` 3,000 (F)
N = 800 (` 15.00  ` 20.00) = ` 4,000 (A)
O = 600 (` 30.00  ` 30.00) = Nil
P = 400 (` 60.00 ` 50.00) = ` 4000 (F)
 Total Sales Price Variance = ` 3.000 (F)
(3) Sales Volume Variance = St. Selling Price (Actual Qty. - St. Qty.)
M = ` 10.00 (1200 - 1000) = ` 2,000 (F)
N = ` 20.00 (800 - 700) = ` 2,000 (F)
O = ` 30.00 (600 - 500) = ` 3,000 (F)
P = ` 50.00 (400 - 300) = ` 5,000 (F)
 Total Sales Volume Variance = ` 12.000 (F)
3 (a) Sales Mix Variance = (St. Value of Actual Mix - St. Value of Revised St. Mix)
or SMV = St. Selling Price (Actual Qty.  Revised St. Qty.)

Total Actual Mix of Sales

Whereas, Revised St. Qty. =  St.Qty.
Total St. Mix of Sales
3, 000
Revised St. Qty. for product M =  1000 = 1,200 units
2, 500
3, 000
Revised St. Qty. for product N =  700  840 units
2,500
3, 000
Revised St. Qty. for product O =  500  600 units
2,500
3, 000
Revised St. Qty. for product P =  300 = 360 units
2,500
Sales Quantity Variance M = ` 10.00 (12001200) = Nil
N = ` 20.00 (800  840) = ` 800 (A)
O = ` 30.00 (600  600) = Nil
P = ` 50.00 (400  360) = ` 2,000 (F)
Total Sales Mix Variance = ` 1,200 (F)
3 (b) Sales Quantity Variance - St. Selling Price (Revised St. Qty. - St. Qty.
M = ` 10.00 (1200  1000) = ` 2,000 (F)
N = ` 20.00 (840700) = ` 2,800 (F)
O = ` 30.00 (600 500) = ` 3.000 (F)
P = ` 50.00 (360 300) = ` 3,000 (F)

 Total Sales Quantity Variance = ` 10.800 (F)

Confirmation:

Sales Value Variance = Sales Price Variance + Sales Volume Variance

` 15,000 (F) = ` 3,000 (F) + ` 12.000 (F)

`15,000 (F) = `15,000 (F)

Sales Volume Variance = Sales Mix Variance + Sales Quantity Variance

` 12,000 (F) = ` 1200 (F) + ` 10,800 (F)

` 12,000(F) = ` 12,000(F)

• (B) The Profit or Margin Method

The sales variances based on profit are also known as Sales Margin Variances which indicates the
deviation or difference between actual profit and standard or budgeted profit.

(1) Total Sales Margin Variance: This sales variance reveals the difference between
actual profit and standard or budgeted profit.
Total Sales Margin Variance = Actual Profit - Budgeted Profit
or = (Actual Qty. of Sales  Actual Profit per unit)
- (Budgeted Qty. of Sales Budgeted Profit per unit)
(2) Sales Price Variance: It is that part of Total Sales Margin Variance per unit which
shows the difference between the standard price of the quantity of sales effected and the
actual price of those sales.
Sales Price Variance = Actual Qty. of Sales (Actual Profit per unit - Budgeted Profit per unit)
or = (Actual Qty. of Sales  St. Price) - (Actual Qty. of Sales  Actual Price)
(3) Sales Volume Variance: It shows the difference between the actual units sold and the
budgeted quantity multiplied by either the standard profit per unit or the standard
contribution per unit.
Note: In Absorption Costing, standard profit per unit is used, but in Marginal Costing, standard
contribution per unit must be used,
Sales Volume Variance = St. Profit per unit (Actual Qty. of Sales - St. Qty. of Sales)
or = (St. Profit on Actual Qty. of Sales) - (St. Profit on St. Qty. of Sales)
Sales Volume Variance can be further divided into:
3 (a) Sales Mix Variance: This variance arises only when the firm manufactures and sells more
than one type of product. This variance will be due to variation of actual mix and budgeted
mix of sales.
Sales Mix Variance - St. Profit per unit (Actual Qty. of Sales - Revised St. Qty. of Sales)
or = Standard Profit - Revised Standard Profit
3 (b) Sales Quantity Variance: It is that part of Sales Volume Variance which arises due to the
difference between the standard profit and revised standard profit. Sales Quantity
Variance = St. Profit per unit (St. Proportion for Actual Sales - Budgeted Qty. of
Sales)
or = Revised St. Profit - Budgeted Profit
or = Budgeted Margin per unit on budgeted Mix  (Total Actual Qty. - Total
Budgeted Qty.)
Illustration 4.12
Rama Ltd. is manufacturing and selling three products X, Y and Z. The company has a
standard costing system and analysis the variances between the budget and the actuals periodically.
The summarised working results for 2013-14 were as follows:
Product Budget Actual
Selling Price Cost per unit No. of Units Selling Price Cost per unit No. of Units
p. u.(`) (`) Sold p. u.(`) (`) Sold

X 50.00 16.00 20,000 48.00 15.00 24,000

Y 40.00 12.00 28,000 42.00 12.50 24,000
Z 30.00 9.00 32,000 31.00 10.00 30,000

(a) Calculate variances in profit during the period.

(b). Analyse the variance in profit into: (1) Sales Price Variance; (2) Sales Volume Variance; (3)
Total Sales Margin Variance; (4) Sales in Quantity Variance; and (5) Sales Margin Mix Variance.
Solution:
Working Notes:
1 (a). Actual Margin per unit = Actual Sales Price per unit - St. Cost per unit
X = ` (4816) = `32
Y = ` (4212) = `30
Z = ` {31  9} = ` 22
1 (b). Budgeted Margin per unit - Budgeted Selling Price per unit - St. Cost per unit
X = `(5016) = `34
Y = ` (40  12) =` 28
Z = ` (30  9) = ` 21
2 (a). Actual Profit = Actual Quantity of Units Sold x Actual Margin per unit
X = 24,000 units  ` 32 = ` 7,68,000
Y = 24,000 units  ` 30 = ` 7,20,000
Z = 30.000 units  `22 = ` 6.60,000
Total = ` 21.48.000
2 (b). Budgeted Profit = Budgeted Quantity of Units Sold x Budgeted Profit per unit
X = 20,000 units  `34 =` 6,80,000
Y = 28.000 units  ` 28 = ` 7,84,000
Z = 32,000 units  `21 =` 6,72,000
Total = ` 21,36,000
3 (a). Budgeted Margin per unit on Actual Mix


 34  24, 000    28  24, 000    21 30, 000 
 24, 000  24, 000  30, 000  units

8,16, 000    6, 72, 000    6,30, 000 
78, 000 units
21,18, 000
 = `27.154
78, 000 units
3 (b). Budgeted Margin per unit on Budgeted Mix


 34  20, 000    28  28, 000    21 32, 000 
 20, 000  28, 000  32, 000  units

 6,80, 000    7,84, 000   6, 72, 000
80, 000 units
21,36, 000
 = `26.70
80, 000 units
Calculation of Sales Margin Variances:
(1) Sales Margin Price Variance = Actual Qty. {Actual Margin per unit
 Budgeted Margin per unit)
X = 24,000 units (` 32  ` 34) = ` 48,000 (A)
Y = 24.000 units (`30  ` 28) = ` 48,000 (F)
Z = 30,000 units (` 22  `21) = ` 30,000 (F)
Total Sales Margin Price Variance =` 30.000 (F)
(2) Sales Margin Volume Variance = Budgeted Margin per unit (Actual Qty. - Budgeted Qty.)
X = ` 34 {24,000 units  20,000 units =` 1.36,000 (F)
Y = ` 28 (24,000 units  28,000 units) = ` 1,12,000 (A)
Z = ` 21 {30,000 units  32,000 units) = ` 42,000 (A)
 Total Sales Margin Volume Variance =` 18,000 (A)
(3) Total Sales Margin Variance = Actual Profit - Budgeted Profit
= ` 21,48,000  ` 21,36,000 = `12,000 (F)
(4) Sales Margin Quantity Variance = Budgeted Margin per unit on Budgeted Mix
(Total Actual Qty.  Total Budgeted Qty.)
= ` 26,70 (78,000 units - 80,000 units)
Total Sales Margin Qty. Variance = ` 53,400 (A)
(5) Sales Margin Mix Variance = Total Actual Qty. (Budgeted Margin per unit on Actual Mix
 Budgeted Margin per unit on Budgeted Mix)
= 78,000 units (` 27.154  ` 26.70)
 . Total Sales Margin Mix Variance = ` 35,412 or ` 35,400
Confirmation:
Total Sales Margin Variance = Sales Margin Price Variance + Sales Margin Volume Variance
` 12,000 (F) = ` 30,000 (F) + ` 18,000 (A)
` 12,000 (F) = ` 12,000 (F)
Sales Margin Volume Variance = Sales Margin Qty. Variance + Sales Margin Mix Variance
`18.000 (A) = ` 53.400 (A) + ` 35,400 (F)
`18,000 (A) = ` 18,000 (A)
• Disposition of Variances
When standard costs are used by a business enterprise only as a statistical data and are not entered
in the books of account, the disposition of variances is not needed since no adjustments are required for
variances in such a case. But when standard costs are incorporated into accounting system through
work-in-progress, finished goods and cost of goods sold accounts, the adjustment and disposition of
variances is required. There is no hard and fast rule regarding the disposition of variances nor there is any
single way of dealing with them. Hence, the method which will be adopted depends on the accountants
attitude and the practice that is followed by the business enterprise. However, the following methods may
be usually applied:
(1) Transfer to Costing Profit and Loss Account: According to this method, the
unfavourable variances are debited to Costing Profit and Loss Account whereas
favourable variances are credited to Costing Profit and Loss Account, at the end of
accounting period. Thus, work-in-progress, finished goods, and cost of goods sold
accounts are maintained at standard cost. This method has the significance of quick and
uniform valuation of stocks and shows the different variances separately to enable the
management to pay dual attention quickly and correctly.
(2) Allocation of Variances to Stocks and Cost of Sales: According to this method, cost
variances are allocated among finished goods, work-in-progress and cost of sales on the basis
of units or value. As a result, the stocks and cost of sales will appear in the books of actual
cost.
(3) Transfer of Variances to Reserve Account: The variances, whether favourable or
unfavourable are transferred to a Reserve Account to be carried forward to the next
accounting period as deferred 'debits' or 'credits'. If variances are favourable, they are
shown on liability side of Balance Sheet. On the other hand, if variances are
unfavourable, they are shown on asset side of Balance Sheet.
4.4 SUMMARY
 Variances may be classified into two categories, “Favourable and unfavourable, Controllable and
uncontrollable variances.
 Variance is the Difference between standard and Actual is known as variance.
 Favourable variance will be designated by (F) and Adverse variance by (A).
 Revision variance represents the difference between the original standard cost nad the revised
standard cost.
 Direct material mix variance is that portion of the material usage variance which is due to the
difference between standard and actual composition of materials.
4.5 KEY TERMS
 Actual production: is mean actual quantity produced during the actual hours worked.
 Standard Production: It means the quantity which have been produced during actual hours
worked.
 Budgeted cost: it means the budgeted quantity to be produced at the standard cost per unit.
 Standard cost: It means the actual quantity produced at the standard cost per unit.
 Material cost variance: Material cost variance is the difference between the standard cost of
materials specified for the actual output and actual cost of materials used.
 Material price variance: Material price variance is the portion of the material cost variance which
arises due to the difference between the standard price specified and actual price paid.
 Material usage variance: Material usage variance is the difference between the standard quantity
specified and the actual quantity used.
 Material mix variance: Material mix variance is that portion of material usage variance which is
due to the difference between the standard and actual composition of as mixture.
 Material yield variance: Material yield variance represents the portion of material usage variance
which is due to the difference between the standard yield specified and the actual yield obtained.
 Labour cost variance: it is the difference between the standard labour cost and actual labour cost
of the product.

4.6 SELF ASSESMENT QUESTIONS

1. What is standard costing? Explain its advantages and disadvantages.

2. What is standard costing? Explain the requisites of standard costing method.
3. Explain the procedure for determining standards.
4. Distinguish between the following:
5. Standard Cost and Estimated Cost, (b) Standard Costing and Budgetary Control.
6. What do you mean by variances? What are its different kinds and explain it?
7. What do you mean by 'Analysis of Variances'? Explain briefly the various types of
variances.
8. "Standard Costing is always accompanied by a system of budgeting, but budgetary
control may be operated in business where standard costing would be impracticable."
Comment.