The margin of safety can be defined as the difference between the expected level of sale
and the breakeven sales. The larger the margin of safety , the higher are the chances of
making profits. In the above example if the forecast sale is 1,700 units per month, the
margin of safety can be calculated as follows,
Margin of safety = Projected sales – Breakeven sales
= 1,700 units – 1,000 units
= 700 units or 41 % of sales.
The Margin of Safety can also be calculated by identifying the difference between the
projected sales and breakeven sales in units multiplied by the contribution per unit. This is
possible because, at the breakeven point all the fixed costs are recovered and any further
contribution goes into the making of profits.
Tuesday, March 17, 2009
THE BREAKEVEN POINT
The word contribution has been given its name because of the fact that it literally
contributes towards the recovery of fixed costs and the making of profits. The contribution
grows along with the sales revenue till the time it just covers the fixed cost. This point
where neither profits nor losses have been made is known as a break-even point. This
implies that in order to break even the amount of contribution generated should be exactly
equal to the fixed costs incurred.
contributes towards the recovery of fixed costs and the making of profits. The contribution
grows along with the sales revenue till the time it just covers the fixed cost. This point
where neither profits nor losses have been made is known as a break-even point. This
implies that in order to break even the amount of contribution generated should be exactly
equal to the fixed costs incurred.
COST-VOLUME-PROFIT ANALYSIS
cost, volume and profit. Such an analysis explores the relationship between costs,
revenue, activity levels and the resulting profit. It aims at measuring variations in cost and
volume.
CVP analysis is based on the following assumptions:
1. Changes in the levels of revenues and costs arise only because of changes in the
number of product (or service) units produced and old – for example, the number of
television sets produced and sold by Sony Corporation or the number of packages
delivered by Overnight Express. The number of output units is the only revenue driverand the only cost driver. Just as a cost driver is any factor that affects costs, a revenue
driver is a variable, such as volume, that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that does not vary
with output level and a variable component that changes with respect to output level.
Furthermore, variable costs include both direct variable costs and indirect variable costs
of a product. Similarly, fixed costs include both direct fixed costs and indirect fixed costs
of a product.
revenue, activity levels and the resulting profit. It aims at measuring variations in cost and
volume.
CVP analysis is based on the following assumptions:
1. Changes in the levels of revenues and costs arise only because of changes in the
number of product (or service) units produced and old – for example, the number of
television sets produced and sold by Sony Corporation or the number of packages
delivered by Overnight Express. The number of output units is the only revenue driverand the only cost driver. Just as a cost driver is any factor that affects costs, a revenue
driver is a variable, such as volume, that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that does not vary
with output level and a variable component that changes with respect to output level.
Furthermore, variable costs include both direct variable costs and indirect variable costs
of a product. Similarly, fixed costs include both direct fixed costs and indirect fixed costs
of a product.
MARGINAL COST EQUATION
The contribution theory explains the relationship between the variable cost and selling price. It
tells us that selling price minus variable cost of the units sold is the contribution towards fixed
expenses and profit. If the contribution is equal to fixed expenses, there will be no profit or
loss and if it is less than fixed expenses, loss is incurred. Since the variable cost varies in
direct proportion to output, therefore if the firm does not produce any unit, the loss will be
there to the extent of fixed expenses. These points can be described with the help of following
marginal cost equation: S × U – V × U = F + P
Where,
S = Selling price per unit
V = Variable cost per unit
U = Units
F = Fixed expenses
P = Profit
tells us that selling price minus variable cost of the units sold is the contribution towards fixed
expenses and profit. If the contribution is equal to fixed expenses, there will be no profit or
loss and if it is less than fixed expenses, loss is incurred. Since the variable cost varies in
direct proportion to output, therefore if the firm does not produce any unit, the loss will be
there to the extent of fixed expenses. These points can be described with the help of following
marginal cost equation: S × U – V × U = F + P
Where,
S = Selling price per unit
V = Variable cost per unit
U = Units
F = Fixed expenses
P = Profit
Limitations of Marginal Costing
1. It is difficult to classify exactly the expenses into fixed and variable category. Most of the
expenses are neither totally variable nor wholly fixed. For example, various amenities
provided to workers may have no relation either to volume of production or time factor.
2. Contribution of a product itself is not a guide for optimum profitability unless it is linked
with the key factor.
3. Sales staff may mistake marginal cost for total cost and sell at a price; which will result in
loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.
4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts,
while valuing the work-in- progress. In order to show the correct position fixed overheads
have to be included in work-in-progress.
expenses are neither totally variable nor wholly fixed. For example, various amenities
provided to workers may have no relation either to volume of production or time factor.
2. Contribution of a product itself is not a guide for optimum profitability unless it is linked
with the key factor.
3. Sales staff may mistake marginal cost for total cost and sell at a price; which will result in
loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.
4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts,
while valuing the work-in- progress. In order to show the correct position fixed overheads
have to be included in work-in-progress.
Monday, March 16, 2009
Advantages of Marginal Costing
1. The marginal cost remains constant per unit of output whereas the fixed cost remains
constant in total. Since marginal cost per unit is constant from period to period within a
short span of time, firm decisions on pricing policy can be taken. If fixed cost is included,
the unit cost will change from day to day depending upon the volume of output. This will
make decision making task difficult.2. Overheads are recovered in costing on the basis of pre-determined rates. If fixed
overheads are included on the basis of pre-determined rates, there will be underrecovery
of overheads if production is less or if overheads are more. There will be overrecovery
of overheads if production is more than the budget or actual expenses are less
than the estimate. This creates the problem of treatment of such under or over-recovery
of overheads. Marginal costing avoids such under or over recovery of overheads.
3. Advocates of marginal costing argues that under the marginal costing technique, the
stock of finished goods and work-in-progress are carried on marginal cost basis and the
fixed expenses are written off to profit and loss account as period cost. This shows the
true profit of the period.
constant in total. Since marginal cost per unit is constant from period to period within a
short span of time, firm decisions on pricing policy can be taken. If fixed cost is included,
the unit cost will change from day to day depending upon the volume of output. This will
make decision making task difficult.2. Overheads are recovered in costing on the basis of pre-determined rates. If fixed
overheads are included on the basis of pre-determined rates, there will be underrecovery
of overheads if production is less or if overheads are more. There will be overrecovery
of overheads if production is more than the budget or actual expenses are less
than the estimate. This creates the problem of treatment of such under or over-recovery
of overheads. Marginal costing avoids such under or over recovery of overheads.
3. Advocates of marginal costing argues that under the marginal costing technique, the
stock of finished goods and work-in-progress are carried on marginal cost basis and the
fixed expenses are written off to profit and loss account as period cost. This shows the
true profit of the period.
Presentation of Information:
In absorption costing the classification of expenses is
based on functional basis whereas in marginal costing it is based on the nature of
expenses. In absorption costing, the fixed expenses are distributed over products on
absorption costing basis, that is, based on a pre-determined level of output. Since fixed
expenses are constant, such a method of recovery will lead to over or under-recovery of
expenses depending on the actual output being greater or lesser than the estimate used
for recovery. This difficulty will not arise in marginal costing because the contribution is
used as a fund for meeting fixed expenses.
based on functional basis whereas in marginal costing it is based on the nature of
expenses. In absorption costing, the fixed expenses are distributed over products on
absorption costing basis, that is, based on a pre-determined level of output. Since fixed
expenses are constant, such a method of recovery will lead to over or under-recovery of
expenses depending on the actual output being greater or lesser than the estimate used
for recovery. This difficulty will not arise in marginal costing because the contribution is
used as a fund for meeting fixed expenses.
Control of expenses
The classification of expenses helps in controlling expenses.
Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of
production activity and they are regarded as uncontrollable expenses. Since variable
expenses vary with the production they are said to be controllable. By this classification,therefore, responsibility for incurring variable expenses is determined in relation to activity
and hence the management is able to control these expenses. The departmental heads
always try to keep these expenses within limits set by the management.
Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of
production activity and they are regarded as uncontrollable expenses. Since variable
expenses vary with the production they are said to be controllable. By this classification,therefore, responsibility for incurring variable expenses is determined in relation to activity
and hence the management is able to control these expenses. The departmental heads
always try to keep these expenses within limits set by the management.
Semi-variable expenses
These expenses (also known as semi-fixed expenses) do not
change within the limits of a small range of activity but may change when the output
reaches a new level in the same direction in which the output changes. Such increases or
decreases in expenses are not in proportion to output. An example of such an expense is
delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level
of activity and may increase in total from 60% to 70% level of activity. These expenses
can be segregated into fixed and variable by using any one of the method, as given under
next heading. Depreciation of plant and machinery depends partly on efflux of time and
partly on wear and tear.
change within the limits of a small range of activity but may change when the output
reaches a new level in the same direction in which the output changes. Such increases or
decreases in expenses are not in proportion to output. An example of such an expense is
delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level
of activity and may increase in total from 60% to 70% level of activity. These expenses
can be segregated into fixed and variable by using any one of the method, as given under
next heading. Depreciation of plant and machinery depends partly on efflux of time and
partly on wear and tear.
Fixed expenses
Fixed expenses or constant expenses are those which do not vary in
total with the change in volume of output for a given period of time. Fixed cost per unit of
output will, however, fluctuate with changes in the level of production. Examples of such
expenses are managerial remuneration, rent, taxes, etc. There may, however, be different
levels of fixed costs at different levels of output, as for example, where after certain level
of output extra expenditure may be needed. In the case of introduction of additional shift
working, fixed expenses will be incurred, say, for the appointment of additional
supervisors.
total with the change in volume of output for a given period of time. Fixed cost per unit of
output will, however, fluctuate with changes in the level of production. Examples of such
expenses are managerial remuneration, rent, taxes, etc. There may, however, be different
levels of fixed costs at different levels of output, as for example, where after certain level
of output extra expenditure may be needed. In the case of introduction of additional shift
working, fixed expenses will be incurred, say, for the appointment of additional
supervisors.
Sunday, March 15, 2009
Variable expenses
Apart from prime costs which are variable, the overhead expensesthat change in proportion to the change in the level of activity are also variable expenses.
Thus when expenses go up or come down in proportion to a change in the volume of
output, such that, with every increase of 20% in output, expenses also go up by 20% or
vice versa, these expenses are known as variable expenses. Variable expenses fluctuate
in total with fluctuations in the level of output but tend to remain constant per unit of
output. Examples of such expenses are raw material, power, commission paid to
salesmen as a percentage of sales, etc.
Thus when expenses go up or come down in proportion to a change in the volume of
output, such that, with every increase of 20% in output, expenses also go up by 20% or
vice versa, these expenses are known as variable expenses. Variable expenses fluctuate
in total with fluctuations in the level of output but tend to remain constant per unit of
output. Examples of such expenses are raw material, power, commission paid to
salesmen as a percentage of sales, etc.
Key factor
Key factor or Limiting factor is a factor which at a particular time or over a
period limits the activities of an undertaking. It may be the level of demand for the
products or services or it may be the shortage of one or more of the productive resources,
e.g., labour hours, available plant capacity, raw material’s availability etc. Examples of
Key Factors or Limiting Factors are:
(a) Shortage of raw material.
(b) Shortage of labour.
(c) Plant capacity available.
(d) Sales capacity available.
(e) Cash availability.
period limits the activities of an undertaking. It may be the level of demand for the
products or services or it may be the shortage of one or more of the productive resources,
e.g., labour hours, available plant capacity, raw material’s availability etc. Examples of
Key Factors or Limiting Factors are:
(a) Shortage of raw material.
(b) Shortage of labour.
(c) Plant capacity available.
(d) Sales capacity available.
(e) Cash availability.
Contribution
Contribution or the contributory margin is the difference between sales
value and the marginal cost. It is obtained by subtracting marginal cost from sales
revenue of a given activity. It can also be defined as excess of sales revenue over the
variable cost. The difference between sales revenue and marginal/variable cost is
considered to be the contribution towards fixed expenses and profit of the entire business.
The contribution concept is based on the theory that the profit and fixed expenses of a
business is a ‘joint cost’ which cannot be equitably apportioned to different segments of
the business. In view of this difficulty the contribution serves as a measure of efficiency of
operations of various segments of the business.
value and the marginal cost. It is obtained by subtracting marginal cost from sales
revenue of a given activity. It can also be defined as excess of sales revenue over the
variable cost. The difference between sales revenue and marginal/variable cost is
considered to be the contribution towards fixed expenses and profit of the entire business.
The contribution concept is based on the theory that the profit and fixed expenses of a
business is a ‘joint cost’ which cannot be equitably apportioned to different segments of
the business. In view of this difficulty the contribution serves as a measure of efficiency of
operations of various segments of the business.
Incremental cost
It is defined as, “the additional costs of a change in the level or
nature of activity”. As such for all practical purposes there is no difference between
incremental cost and differential cost. However, from a conceptual point of view,
differential cost refers to both incremental as well as decremental cost. Incremental cost
and differential cost calculated from the same data will be the same. In practice,
therefore, generally no distinction is made between differential cost and incremental cost.
One aspect which is worthy to note is that incremental cost is not the same at all levels.
Incremental cost between 50% and 60% level of output may be different from that which is
arrived at between 80% and 90% level of output. Differential cost or incremental costanalysis deals with both short-term and long-term problems.
nature of activity”. As such for all practical purposes there is no difference between
incremental cost and differential cost. However, from a conceptual point of view,
differential cost refers to both incremental as well as decremental cost. Incremental cost
and differential cost calculated from the same data will be the same. In practice,
therefore, generally no distinction is made between differential cost and incremental cost.
One aspect which is worthy to note is that incremental cost is not the same at all levels.
Incremental cost between 50% and 60% level of output may be different from that which is
arrived at between 80% and 90% level of output. Differential cost or incremental costanalysis deals with both short-term and long-term problems.
Differential cost :
It may be defined as “the increase or decrease in total cost or the
change in specific elements of cost that result from any variation in operations”. It
represents an increase or decrease in total cost resulting out of :
(a) producing or distributing a few more or few less of the products;
(b) a change in the method of production or of distribution;
(c) an addition or deletion of a product or a territory; and
(d) selection of an additional sales channel.
Differential cost, thus includes fixed and semi-variable expenses. It is the difference
between the total costs of two alternatives. It is an adhoc cost determined for the purpose
of choosing between competing alternatives, each with its own combination of income and
costs.
change in specific elements of cost that result from any variation in operations”. It
represents an increase or decrease in total cost resulting out of :
(a) producing or distributing a few more or few less of the products;
(b) a change in the method of production or of distribution;
(c) an addition or deletion of a product or a territory; and
(d) selection of an additional sales channel.
Differential cost, thus includes fixed and semi-variable expenses. It is the difference
between the total costs of two alternatives. It is an adhoc cost determined for the purpose
of choosing between competing alternatives, each with its own combination of income and
costs.
Saturday, March 14, 2009
Direct costing:
Direct costing is the practice of charging all direct cost to operations,
processes or products, leaving all indirect costs to be written off against profits in the
period in which they arise. Under direct costing the stocks are valued at direct costs, i.e.,
costs whether fixed or variable which can be directly attributable to the cost units.
In general, the terms marginal costing and direct costing are used as synonymous.
However, direct costing differs from marginal costing in that some fixed costs considered
direct are charged to operations, processes or products, whereas in marginal costing only
variable costs are considered. Marginal costing is mainly concerned with providing of
information to management to assist in decision making and for exercising control.
processes or products, leaving all indirect costs to be written off against profits in the
period in which they arise. Under direct costing the stocks are valued at direct costs, i.e.,
costs whether fixed or variable which can be directly attributable to the cost units.
In general, the terms marginal costing and direct costing are used as synonymous.
However, direct costing differs from marginal costing in that some fixed costs considered
direct are charged to operations, processes or products, whereas in marginal costing only
variable costs are considered. Marginal costing is mainly concerned with providing of
information to management to assist in decision making and for exercising control.
Definitions:
In order to appreciate the concept of marginal costing, it is necessary to
study the definition of marginal costing and certain other terms associated with this
technique. The important terms have been defined as follows:
1. Marginal costing : 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.
2. Marginal cost: The amount at any given volume of output by which aggregate variable
costs are changed if the volume of output is increased by one unit. In practice this ismeasured by the total variable cost attributable to one unit. Marginal cost can precisely be
the sum of prime cost and variable overhead.
study the definition of marginal costing and certain other terms associated with this
technique. The important terms have been defined as follows:
1. Marginal costing : 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.
2. Marginal cost: The amount at any given volume of output by which aggregate variable
costs are changed if the volume of output is increased by one unit. In practice this ismeasured by the total variable cost attributable to one unit. Marginal cost can precisely be
the sum of prime cost and variable overhead.
THEORY OF MARGINAL COSTING
The theory of marginal costing is that in relation to a given volume of output, additional
output can normally be obtained at less than proportionate cost because within limits the
aggregate of certain items of cost will tend to remain fixed and only the aggregate of the
remainder will tend to rise proportionately with increase in output. Conversely, a
decrease in the volume of output will normally be accompanied by a less than
proportionate fall in the aggregate cost.
The theory of marginal costing may therefore be explained in three steps:
(i) If the volume of output increases, the average cost per unit will, in the normal
circumstances, be reduced. Conversely, if the output is reduced, the average cost per
unit will go up. If the factory produces 1,000 units at a total cost of Rs. 3,000 and if by
increasing the output by one unit, the cost goes up to Rs. 3,002, the marginal cost of the
additional output is Rs. 2.
output can normally be obtained at less than proportionate cost because within limits the
aggregate of certain items of cost will tend to remain fixed and only the aggregate of the
remainder will tend to rise proportionately with increase in output. Conversely, a
decrease in the volume of output will normally be accompanied by a less than
proportionate fall in the aggregate cost.
The theory of marginal costing may therefore be explained in three steps:
(i) If the volume of output increases, the average cost per unit will, in the normal
circumstances, be reduced. Conversely, if the output is reduced, the average cost per
unit will go up. If the factory produces 1,000 units at a total cost of Rs. 3,000 and if by
increasing the output by one unit, the cost goes up to Rs. 3,002, the marginal cost of the
additional output is Rs. 2.
Criticism of Standard Costing:
The following is some of the criticism which may be levelled
against the standard costing system. The arguments have been suitably answered as stated
against each by advocates of the standard costing and hence they do not invalidate the
usefulness of the system to business enterprises.
(i) Variation in price: One of the chief problem faced in the operation of the standard costing
system is the precise estimation of likely prices or rate to be paid. The variability of prices is
so great that even actual prices are not necessarily adequately representative of cost. But the
use of sophisticated forecasting techniques should be able to cover the price fluctuation to
some extent. Besides this, the system provides for isolating uncontrollable variances arising
from variations to be dealt with separately.
against the standard costing system. The arguments have been suitably answered as stated
against each by advocates of the standard costing and hence they do not invalidate the
usefulness of the system to business enterprises.
(i) Variation in price: One of the chief problem faced in the operation of the standard costing
system is the precise estimation of likely prices or rate to be paid. The variability of prices is
so great that even actual prices are not necessarily adequately representative of cost. But the
use of sophisticated forecasting techniques should be able to cover the price fluctuation to
some extent. Besides this, the system provides for isolating uncontrollable variances arising
from variations to be dealt with separately.
Advantages of Standard Costing:
It serves as a basis for measuring operating performance and cost control. By setting
standards, proper classification and determination of variances, is possible. This serves as a
signal for prompt corrective action. This system provides for reporting on the principle of
exception. The basis of this principle is that only matters which are not proceeding according
to plan are reported upon. This enables the managers to concentrate upon essential matters
and leave the non-essentials to take care of themselves. By using special forms, any
excessive time taken, extra material used or additional services consumed can be brought to
light as part of the ordinary routine. In other words, if the variances are negligible, it means
that the performance is more or less in accordance with the standards. Significant variances
which warrant the attention of the manager are brought to his knowledge.
standards, proper classification and determination of variances, is possible. This serves as a
signal for prompt corrective action. This system provides for reporting on the principle of
exception. The basis of this principle is that only matters which are not proceeding according
to plan are reported upon. This enables the managers to concentrate upon essential matters
and leave the non-essentials to take care of themselves. By using special forms, any
excessive time taken, extra material used or additional services consumed can be brought to
light as part of the ordinary routine. In other words, if the variances are negligible, it means
that the performance is more or less in accordance with the standards. Significant variances
which warrant the attention of the manager are brought to his knowledge.
Friday, March 13, 2009
ABOUT GLOBAL COMMUNICATIONS
Global Communication Ltd. (GCL), manufacturers of Telephone Exchanges, had been
incorporated in the early 90s and has since grown rapidly. Today it is considered as one
of the largest Telecom Company in the country. Till only a few months back, being the
only manufacturer of such products, GCL was enjoying monopoly and huge Gross Profit
Margins to its credit. Costing was hence not thought to be important, except to facilitate
statutory Financial Audits. However, the Telecom revolution changed the scenario in no
time, with more business houses venturing into Exchange production. Sensing
competition, the management had been quick to hire the services of Mr. Ravi Shankar in
order to help implement a relevant Costing System for its plant located at Kanpur. The
system was to be such, so as to fulfil the requirements of Material and Expenses Control,
facilitate Statutory Audit, help in Pricing Decisions and provide for the day-to-day
requirements of Excise, etc. Since the variable cost component within the production
process was quite high a Standard Costing System was thought off to be most
appropriate.
incorporated in the early 90s and has since grown rapidly. Today it is considered as one
of the largest Telecom Company in the country. Till only a few months back, being the
only manufacturer of such products, GCL was enjoying monopoly and huge Gross Profit
Margins to its credit. Costing was hence not thought to be important, except to facilitate
statutory Financial Audits. However, the Telecom revolution changed the scenario in no
time, with more business houses venturing into Exchange production. Sensing
competition, the management had been quick to hire the services of Mr. Ravi Shankar in
order to help implement a relevant Costing System for its plant located at Kanpur. The
system was to be such, so as to fulfil the requirements of Material and Expenses Control,
facilitate Statutory Audit, help in Pricing Decisions and provide for the day-to-day
requirements of Excise, etc. Since the variable cost component within the production
process was quite high a Standard Costing System was thought off to be most
appropriate.
Overhead expenses variance
As discussed above, the Production Volume Variance
analyses the unrecovered fixed overheads. Apart from this, there can be variations in the
actual spending of both fixed and variable overheads when compared to what was established
as a standard. Such variations can be accounted for by analyzing a Overhead expenses
variance.
The following illustration shows how overhead expense rates are computed and variance
analysed.
analyses the unrecovered fixed overheads. Apart from this, there can be variations in the
actual spending of both fixed and variable overheads when compared to what was established
as a standard. Such variations can be accounted for by analyzing a Overhead expenses
variance.
The following illustration shows how overhead expense rates are computed and variance
analysed.
Production Volume Variance:
The term fixed overheads implies that the element of
cost does not vary directly in proportion to the output. In other words fixed overheads do not
change within a given range of activity. However the unit cost changes even though the fixed
overheads are constant in total within the given range of output. So, higher the level of
activity, the lower will be the unit cost or vice versa. The management is, therefore, faced with
a costing difficulty because it requires a representative rate for charging fixed overheads
irrespective of changes in volume of output.
cost does not vary directly in proportion to the output. In other words fixed overheads do not
change within a given range of activity. However the unit cost changes even though the fixed
overheads are constant in total within the given range of output. So, higher the level of
activity, the lower will be the unit cost or vice versa. The management is, therefore, faced with
a costing difficulty because it requires a representative rate for charging fixed overheads
irrespective of changes in volume of output.
Overheads
Normally, for several type of overhead expenses either a single recovery
rate or two recovery rates, one representing fixed overheads and the other representing
variable overheads, will be prepared. Refer to the ‘Estimated Standard Cost’ table on page
8,2. Overheads have been classified as both fixed and variable thereby giving a standard fixed
cost (overhead) per unit and standard variable cost (overhead) per unit. The recovery of the
fixed components of the estimated overheads depends upon capacity utilization.
rate or two recovery rates, one representing fixed overheads and the other representing
variable overheads, will be prepared. Refer to the ‘Estimated Standard Cost’ table on page
8,2. Overheads have been classified as both fixed and variable thereby giving a standard fixed
cost (overhead) per unit and standard variable cost (overhead) per unit. The recovery of the
fixed components of the estimated overheads depends upon capacity utilization.
Labour
Similar to material usage variance, labour efficiency variance measures the
efficiency of labour by identifying the difference between the actual hours worked and the
hours which should have been worked as per the established standards. Deviations in the
actual rate of pay and the ones estimated are measured by the labour rate variance.
Mathematically
Labour efficiency variance = Std. rate (Std. time – Actual time)
Labour rate variance = Actual time (Std. rate – Actual rate)
efficiency of labour by identifying the difference between the actual hours worked and the
hours which should have been worked as per the established standards. Deviations in the
actual rate of pay and the ones estimated are measured by the labour rate variance.
Mathematically
Labour efficiency variance = Std. rate (Std. time – Actual time)
Labour rate variance = Actual time (Std. rate – Actual rate)
Wednesday, March 11, 2009
Material
The two basic variances arising during material consumption are material
usage and material price variances. The former arises because of variations in the quantity of
material actually consumed when compared with what should have been consumed as per the
established standards and the latter because of the differences between the planned and the
actual material prices paid to the suppliers. Mathematically
Material usage variance = Std. price (Std. Qty. – Acutal qty.)
Material price variance = Actual qty. (Std. price – Actual price)
usage and material price variances. The former arises because of variations in the quantity of
material actually consumed when compared with what should have been consumed as per the
established standards and the latter because of the differences between the planned and the
actual material prices paid to the suppliers. Mathematically
Material usage variance = Std. price (Std. Qty. – Acutal qty.)
Material price variance = Actual qty. (Std. price – Actual price)
Controllable and un-controllable variances:
The purpose of the standard costing
reports is to investigate the reasons for significant variances so as to identify the problems
and take corrective action. Variances are broadly of two types, namely, controllable and
uncontrollable. Controllable variances are those which can be controlled by the departmental
heads whereas uncontrollable variances are those which are beyond their control. For
example, price variance is normally regarded as uncontrollable if the price increase is due to
fluctuations of prices in the market. It becomes controllable if the production controller has
failed to place orders in time and urgent purchase was made at extra cost.
reports is to investigate the reasons for significant variances so as to identify the problems
and take corrective action. Variances are broadly of two types, namely, controllable and
uncontrollable. Controllable variances are those which can be controlled by the departmental
heads whereas uncontrollable variances are those which are beyond their control. For
example, price variance is normally regarded as uncontrollable if the price increase is due to
fluctuations of prices in the market. It becomes controllable if the production controller has
failed to place orders in time and urgent purchase was made at extra cost.
THE PROCESS OF STANDARD COSTING
Standard costs are pre-determined by using a careful analysis of production methods, physical
conditions and price factors. They represent achievable targets and help to build up budgets,
gauge performance and obtain product costs. The actual costs will vary from month to month
or even from day to day. The basic objective, therefore, of standard costing system is to
assist the departmental head by identifying and describing the variances over which he has
control. Thus, a set of standards developed under the standard costing system outlines how a
task must be accomplished and how much it should cost. As work is done actual costs are
recorded and compared with standard cost to determine the variances.
conditions and price factors. They represent achievable targets and help to build up budgets,
gauge performance and obtain product costs. The actual costs will vary from month to month
or even from day to day. The basic objective, therefore, of standard costing system is to
assist the departmental head by identifying and describing the variances over which he has
control. Thus, a set of standards developed under the standard costing system outlines how a
task must be accomplished and how much it should cost. As work is done actual costs are
recorded and compared with standard cost to determine the variances.
Uses of Standard Costs
1. Use of standard costs is an effective way for planning and controlling costs.
2. Pricing decisions and decisions involving submission of quotations, answering tenders
etc., are also facilitated by the use of standard costs.
3. Identification and measurement of variances from standards has been made possible
with the use of standard cost, with a view to improve performance or to correct loose
standards, if any.
4. Facilitates management by exception.
2. Pricing decisions and decisions involving submission of quotations, answering tenders
etc., are also facilitated by the use of standard costs.
3. Identification and measurement of variances from standards has been made possible
with the use of standard cost, with a view to improve performance or to correct loose
standards, if any.
4. Facilitates management by exception.
NEED FOR STANDARD COSTS
Since standard costs are pre-determined costs computed before the production takes place,
they are preferable to actual costs. Moreover, certain conditions resulting from mass
production make standard costs necessary and strongly advisable. Some of such conditions
are:
(a) Historical costs may be too expensive to compute. For example, in a manufacturing
concern producing about 1,00,000 parts, divided into various lots, imagine the time and
clerical labour involved in arriving at the actual cost lot by lot and then averaging it to
determine the cost per unit.
(b) The unit costs computed on historical data may vary from day to day and they are of no
use to the sales department in setting selling prices. For example, if the historical costs per
unit of product in a week are Rs. 1.05, 0.99, 1.27, 1.18, 1.42, 1.56, the selling price cannot be
varied from day to day to match the costs.
they are preferable to actual costs. Moreover, certain conditions resulting from mass
production make standard costs necessary and strongly advisable. Some of such conditions
are:
(a) Historical costs may be too expensive to compute. For example, in a manufacturing
concern producing about 1,00,000 parts, divided into various lots, imagine the time and
clerical labour involved in arriving at the actual cost lot by lot and then averaging it to
determine the cost per unit.
(b) The unit costs computed on historical data may vary from day to day and they are of no
use to the sales department in setting selling prices. For example, if the historical costs per
unit of product in a week are Rs. 1.05, 0.99, 1.27, 1.18, 1.42, 1.56, the selling price cannot be
varied from day to day to match the costs.
Tuesday, March 10, 2009
Current standards:
These standards reflect the management’s anticipation of what
actual costs will be for the current period. These are the costs which the business will incur if
the anticipated prices are paid for the goods and services and the usage corresponds to that
believed to be necessary to produce the planned output. The variances arising from expected
standards represent the degree of efficiency in usage of the factors of production, variation in
prices paid for materials and services and difference in the volume of production.
actual costs will be for the current period. These are the costs which the business will incur if
the anticipated prices are paid for the goods and services and the usage corresponds to that
believed to be necessary to produce the planned output. The variances arising from expected
standards represent the degree of efficiency in usage of the factors of production, variation in
prices paid for materials and services and difference in the volume of production.
Basic or Bogey standards:
These standards are used only when they are likely to
remain constant or unaltered over a long period. According to this standard, a base year is
chosen for comparison purposes in the same way as statisticians use price indices. Since
basic standards do not represent what should be attained in the present period, current
standards should also be prepared if basic standards are used. Basic standards are,
however, well suited to businesses having a small range of products and long production runs.
Basic standards are set, on a long-term basis and are seldom revised. When basic standards
are in use, variances are not calculated as the difference between standard and actual cost.
Instead, the actual cost is expressed as a percentage of basic cost.
remain constant or unaltered over a long period. According to this standard, a base year is
chosen for comparison purposes in the same way as statisticians use price indices. Since
basic standards do not represent what should be attained in the present period, current
standards should also be prepared if basic standards are used. Basic standards are,
however, well suited to businesses having a small range of products and long production runs.
Basic standards are set, on a long-term basis and are seldom revised. When basic standards
are in use, variances are not calculated as the difference between standard and actual cost.
Instead, the actual cost is expressed as a percentage of basic cost.
Normal standards:
These are standards that may be achieved under normal operating
conditions. The normal activity has been defined as “the number of standard hours which willproduce at normal efficiency sufficient goods to meet the average sales demand over a term
of years”. These standards are, however, difficult to set because they require a degree of
forecasting. The variances thrown out under this system are deviations from normal efficiency,
normal sales volume, or normal productive volume. If the actual performance is found to be
abnormal, large variances may result and necessitate revision of standards.
conditions. The normal activity has been defined as “the number of standard hours which willproduce at normal efficiency sufficient goods to meet the average sales demand over a term
of years”. These standards are, however, difficult to set because they require a degree of
forecasting. The variances thrown out under this system are deviations from normal efficiency,
normal sales volume, or normal productive volume. If the actual performance is found to be
abnormal, large variances may result and necessitate revision of standards.
Ideal standards:
These represent the level of performance attainable when prices for
material and labour are most favourable, when the highest output is achieved with the best
equipment and layout and when the maximum efficiency in utilisation of resources results in
maximum output with minimum cost. These type of standards are criticised on three grounds:
(i) Since such standards would be unattainable, no one would take them seriously.
(ii) The variances disclosed would be variances from the ideal standards. These would not,
therefore, indicate the extent to which they could have been reasonably and practically
avoided.
(iii) There would be no logical method of disposing of these variances.
material and labour are most favourable, when the highest output is achieved with the best
equipment and layout and when the maximum efficiency in utilisation of resources results in
maximum output with minimum cost. These type of standards are criticised on three grounds:
(i) Since such standards would be unattainable, no one would take them seriously.
(ii) The variances disclosed would be variances from the ideal standards. These would not,
therefore, indicate the extent to which they could have been reasonably and practically
avoided.
(iii) There would be no logical method of disposing of these variances.
TYPES OF STANDARDS
The accuracy and relevance of an established standard cost depends upon the reliability of
the standards set up. In order to compute the standards we must know what degree of
accuracy is necessary. There are four different bases or standards which should be
considered.
the standards set up. In order to compute the standards we must know what degree of
accuracy is necessary. There are four different bases or standards which should be
considered.
Monday, March 9, 2009
Standard hour:
In industries like coal mining, where the products are homogeneous, the
calculation of output is relatively simple. But in concerns manufacturing several products it is
difficult to establish a satisfactory basis on which to measure output of the various
departments because of differences in volume of individual products, quality, etc.
The most satisfactory method of common measure is the use of standard hour. ICMA, London,
defines a standard hour as a hypothetical hour, which measures the amount of work which
should be performed in one hour. The standard hour is thus a unit of work and not of time.
calculation of output is relatively simple. But in concerns manufacturing several products it is
difficult to establish a satisfactory basis on which to measure output of the various
departments because of differences in volume of individual products, quality, etc.
The most satisfactory method of common measure is the use of standard hour. ICMA, London,
defines a standard hour as a hypothetical hour, which measures the amount of work which
should be performed in one hour. The standard hour is thus a unit of work and not of time.
Overhead expense standards:
In computing the overhead expense standards, consideration
should be given to the level of output and the expenses budgeted. A budget showing the level
of output to be considered for arriving at overhead expense standards may be based on the
practical manufacturing capacity or the average sales capacity or the budgeted capacity to be
utilised in the coming year. After having chosen one of the methods of output level, the
expenses can be budgeted under different heads under what the management calls good
performance for the level of output chosen. These expenses are classified under fixed and
variable categories.
should be given to the level of output and the expenses budgeted. A budget showing the level
of output to be considered for arriving at overhead expense standards may be based on the
practical manufacturing capacity or the average sales capacity or the budgeted capacity to be
utilised in the coming year. After having chosen one of the methods of output level, the
expenses can be budgeted under different heads under what the management calls good
performance for the level of output chosen. These expenses are classified under fixed and
variable categories.
Wage rate standard:
Standard wage rates may be set to cover various grades of labour. In
factories ‘where contracts with workers’ unions exist, the rates approved by contract usually
become the standard for the period for which the contract applies.
factories ‘where contracts with workers’ unions exist, the rates approved by contract usually
become the standard for the period for which the contract applies.
Material price standards:
Material prices are not altogether within the control of the
manufacturer; but the purchasing department, on being apprised of production quantities
required, should be able, from its knowledge of current market conditions and trends, to state
with reasonable accuracy price for the constituent items. The standards for prices of materials
should be based on the following factors, if price fluctuations are small and are not serious.
(a) Stock of materials on hand and the prices at which they are held;(b) The prices at which orders for future deliveries of materials have already been placed
and
(c) Anticipated fluctuation in price levels.
manufacturer; but the purchasing department, on being apprised of production quantities
required, should be able, from its knowledge of current market conditions and trends, to state
with reasonable accuracy price for the constituent items. The standards for prices of materials
should be based on the following factors, if price fluctuations are small and are not serious.
(a) Stock of materials on hand and the prices at which they are held;(b) The prices at which orders for future deliveries of materials have already been placed
and
(c) Anticipated fluctuation in price levels.
Price or Rate standards:
Broadly, the price or rate standards can be set on either of the
following bases:
(a) Actual average or mean price expected to prevail during the coming period, say one
year; or
(b) Normal prices expected to prevail during a cycle of seasons which may be of a number of
years.
following bases:
(a) Actual average or mean price expected to prevail during the coming period, say one
year; or
(b) Normal prices expected to prevail during a cycle of seasons which may be of a number of
years.
Problems faced while setting physical standards:
The problems involved while setting
physical standards will vary from industry to industry and may be illustrated as under:
(a) A situation may arise where the company is introducing the manufacture of a new line of
product. In such cases, it may be necessary to employ workers who have no experience in
the job. This creates a problem of setting standard time because it is necessary to make
adjustment for the inexperience of workers.
(b) Changes in technology may necessitate installation of sophisticated machines. When
such machines are installed, the precise estimation of output and standard of efficiency
achievable will pose a problem until after a long time when the working conditions are settled.
Thus, setting standards for these machines and estimating the standard costs will need
considerable amount of work.
physical standards will vary from industry to industry and may be illustrated as under:
(a) A situation may arise where the company is introducing the manufacture of a new line of
product. In such cases, it may be necessary to employ workers who have no experience in
the job. This creates a problem of setting standard time because it is necessary to make
adjustment for the inexperience of workers.
(b) Changes in technology may necessitate installation of sophisticated machines. When
such machines are installed, the precise estimation of output and standard of efficiency
achievable will pose a problem until after a long time when the working conditions are settled.
Thus, setting standards for these machines and estimating the standard costs will need
considerable amount of work.
Labour quantity standards:
The following are the steps involved in setting labour quantity
standards:
(a) Standardisation of product, as explained above.
(b) Product classification, as defined earlier.
(c) Standardisation of methods: Selection of proper machines to use proper sequence and
method of operations.
(d) Manufacturing layout: A plan of operation for each product listing the operations to be
performed is prepared.
(e) Time and motion study is conducted for selecting the best way of completing the job or
motions to be performed by workers and the standard time which an average worker will take
for each job.
(f) The operator is given training to perform the job or operations in the best possible
manner.
standards:
(a) Standardisation of product, as explained above.
(b) Product classification, as defined earlier.
(c) Standardisation of methods: Selection of proper machines to use proper sequence and
method of operations.
(d) Manufacturing layout: A plan of operation for each product listing the operations to be
performed is prepared.
(e) Time and motion study is conducted for selecting the best way of completing the job or
motions to be performed by workers and the standard time which an average worker will take
for each job.
(f) The operator is given training to perform the job or operations in the best possible
manner.
Material quantity standards:
The following procedure is usually followed for setting material
quantity standards.
(a) Standardisation of products: Detailed specifications, blueprints, norms for normal
wastage etc., of products along with their designs are settled.
(b) Product classification: Detailed classified list of products to be manufactured are
prepared.
(c) Standardisation of material: Specifications, quality, etc., of materials to be used in the
standard products are settled.
(d) Preparation of bill of materials: A bill of material for each product or part showing the
symbol or code, description and quantity of each material to be used is prepared.
(e) Test runs: Sample or test runs under regulated conditions may be useful in setting
quantity standards in a precise manner.
quantity standards.
(a) Standardisation of products: Detailed specifications, blueprints, norms for normal
wastage etc., of products along with their designs are settled.
(b) Product classification: Detailed classified list of products to be manufactured are
prepared.
(c) Standardisation of material: Specifications, quality, etc., of materials to be used in the
standard products are settled.
(d) Preparation of bill of materials: A bill of material for each product or part showing the
symbol or code, description and quantity of each material to be used is prepared.
(e) Test runs: Sample or test runs under regulated conditions may be useful in setting
quantity standards in a precise manner.
Physical standards:
The first step in manufacturing a product is to determine standard
quantity of different materials to be used under the manufacturing process; various subassemblies,
components, other small parts, etc. Besides this the length of time an average
worker should take to complete a job. These standards so determined are known as physicalstandards. The purposes of setting physical standards are:
(a) To secure economies in manufacture, and
(b) Set selling prices in advance to make it possible to estimate the cost. In printing
industry, for example, the standards relating to the printed output are necessary in submitting
quotations, for proposed jobs.
In manufacturing organisations, the task of setting physical standards is assigned to the
industrial engineering department.
quantity of different materials to be used under the manufacturing process; various subassemblies,
components, other small parts, etc. Besides this the length of time an average
worker should take to complete a job. These standards so determined are known as physicalstandards. The purposes of setting physical standards are:
(a) To secure economies in manufacture, and
(b) Set selling prices in advance to make it possible to estimate the cost. In printing
industry, for example, the standards relating to the printed output are necessary in submitting
quotations, for proposed jobs.
In manufacturing organisations, the task of setting physical standards is assigned to the
industrial engineering department.
SETTING UP OF STANDARD COST
A standard cost by definition is an estimate correlating a technical specification of materials
and labour to the prices and wage rates with the addition of overhead for a prescribed level of
output. It is thus a measure in quantities, hours and value of the factors of production. There
are three main parts of standard costs, viz., (a) direct material, (b) direct labour, and (c)
overhead expenses.
and labour to the prices and wage rates with the addition of overhead for a prescribed level of
output. It is thus a measure in quantities, hours and value of the factors of production. There
are three main parts of standard costs, viz., (a) direct material, (b) direct labour, and (c)
overhead expenses.
Friday, March 6, 2009
DEFINITION OF STANDARD COST
Standard cost is defined “as 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 fixing and for cost control through variance analysis.”
The standard cost of a product has been defined by Blocker and Weltmer “as a predetermined
cost based upon engineering specification and representing highly efficient
production for quantity standards and forecasts of future market trends for price standards
with a fixed amount expressed in dollars for material, labour and overhead for an estimated
quantity of production.” It may be seen from this definition that engineering specifications are
the basis for quantity standards for materials and time standards for labour while budgets are
of importance in determining material price standards, labour rate standards and overhead
standards.
standards of efficient operation and the relevant necessary expenditure. It may be used as a
basis for price fixing and for cost control through variance analysis.”
The standard cost of a product has been defined by Blocker and Weltmer “as a predetermined
cost based upon engineering specification and representing highly efficient
production for quantity standards and forecasts of future market trends for price standards
with a fixed amount expressed in dollars for material, labour and overhead for an estimated
quantity of production.” It may be seen from this definition that engineering specifications are
the basis for quantity standards for materials and time standards for labour while budgets are
of importance in determining material price standards, labour rate standards and overhead
standards.
Where they require further processing
In this case, the net realisable value of the
by-product at the split-off point may be arrived at by subtracting the further processing
cost from the realisable value of by-products.
If total sales value of by-products at split-off point is small, it may be treated as per the
provisions discussed above under (i).
In the contrary case, the amount realised from the sale of by-products will be considerable and
thus it may be treated as discussed under (ii).
(Students must solve a large number of questions from process costing so as to acquire the
required proficiency in the area).
by-product at the split-off point may be arrived at by subtracting the further processing
cost from the realisable value of by-products.
If total sales value of by-products at split-off point is small, it may be treated as per the
provisions discussed above under (i).
In the contrary case, the amount realised from the sale of by-products will be considerable and
thus it may be treated as discussed under (ii).
(Students must solve a large number of questions from process costing so as to acquire the
required proficiency in the area).
When the by-products are of considerable total value
Where by-products are of
considerable total value, they may be regarded as joint products rather than as byproducts.
To determine exact cost of by-products the costs incurred upto the point of
separation, should be apportioned over by-products and joint products by using a logical
basis. In this case, the joint costs may be divided over joint products and by-products by
using relative market values ; physical output method (at the point of split off) or ultimate
selling prices (if sold).
considerable total value, they may be regarded as joint products rather than as byproducts.
To determine exact cost of by-products the costs incurred upto the point of
separation, should be apportioned over by-products and joint products by using a logical
basis. In this case, the joint costs may be divided over joint products and by-products by
using relative market values ; physical output method (at the point of split off) or ultimate
selling prices (if sold).
Treatment of By-Product Cost in Cost-Accounting
By-product cost can be dealt
in cost accounting in the following ways :—
(i) When they are of small total value : When the by-products are of small total value,
the amount realised from their sale may be dealt in any one the following two ways :
1. The sales value of the by-products may be credited to the Profit and Loss Account and
no credit be given in the Cost Accounts. The credit to the Profit and Loss Account here is
treated either as miscellaneous income or as additional sales revenue.
2. The sale proceeds of the by-product may be treated as deductions from the total costs.
The sale proceeds in fact should be deducted either from the production cost or from the
cost of sales.
in cost accounting in the following ways :—
(i) When they are of small total value : When the by-products are of small total value,
the amount realised from their sale may be dealt in any one the following two ways :
1. The sales value of the by-products may be credited to the Profit and Loss Account and
no credit be given in the Cost Accounts. The credit to the Profit and Loss Account here is
treated either as miscellaneous income or as additional sales revenue.
2. The sale proceeds of the by-product may be treated as deductions from the total costs.
The sale proceeds in fact should be deducted either from the production cost or from the
cost of sales.
Re-use basis
In some cases the by-product may be of such a nature that it can be
reprocessed in the same process as part of the input of the process. In that case the
value put on the by-product should be same as that of the materials introduced into the
process. If, however, the by-product can be put into an earlier process only, the value
should be the same as for the materials introduced into the process.
reprocessed in the same process as part of the input of the process. In that case the
value put on the by-product should be same as that of the materials introduced into the
process. If, however, the by-product can be put into an earlier process only, the value
should be the same as for the materials introduced into the process.
Thursday, March 5, 2009
Comparative price
Under this method, the value of the by-product is ascertained
with reference to the price of a similar or an alternative material. Suppose in a large
automobile plant a blast furnace not only produces the steel required for the car bodies
but also produces gas which is utilised in the factory. This gas can be valued at the price
which would have been paid to a gas company if the factory were to buy it from outside
sources.
with reference to the price of a similar or an alternative material. Suppose in a large
automobile plant a blast furnace not only produces the steel required for the car bodies
but also produces gas which is utilised in the factory. This gas can be valued at the price
which would have been paid to a gas company if the factory were to buy it from outside
sources.
Standard cost in technical estimates
By-products may be valued at standard
costs. The standard may be determined by averaging costs recorded in the past and
making technical estimates of the number of units of original raw material going into the
main product and the number forming the by-product or by adopting some other consistent
basis. This method may be adopted where the by-product is not saleable in the condition
in which it emerges or comparative prices of similar products are not available.
costs. The standard may be determined by averaging costs recorded in the past and
making technical estimates of the number of units of original raw material going into the
main product and the number forming the by-product or by adopting some other consistent
basis. This method may be adopted where the by-product is not saleable in the condition
in which it emerges or comparative prices of similar products are not available.
Market value or value on realisation
The realisation on the disposal of the byproduct
may be deducted from the total cost of production so as to arrive at the cost of the
main product. For example, the amount realised by the sale of molasses in a sugar factory
goes to reduce the cost of sugar produced in the factory.
When the by-product requires some additional processing and expenses are incurred in
making it saleable to the best advantage of the concern, the expenses so incurred should be
deducted from the total value realised from the sale of the by-product and only the netrealisations should be deducted from the total cost of production to arrive at the cost of
production of the main product. Separate accounts should be maintained for collecting
additional expenses incurred on :
(i) further processing of the by-product, and
(ii) selling, distribution and administration expenses attributable to the by-product.
may be deducted from the total cost of production so as to arrive at the cost of the
main product. For example, the amount realised by the sale of molasses in a sugar factory
goes to reduce the cost of sugar produced in the factory.
When the by-product requires some additional processing and expenses are incurred in
making it saleable to the best advantage of the concern, the expenses so incurred should be
deducted from the total value realised from the sale of the by-product and only the netrealisations should be deducted from the total cost of production to arrive at the cost of
production of the main product. Separate accounts should be maintained for collecting
additional expenses incurred on :
(i) further processing of the by-product, and
(ii) selling, distribution and administration expenses attributable to the by-product.
Market value method
This is the most popular and convenient method because it
makes use of a realistic basis for apportioning joint costs. Under this method joint costs
are apportioned after ascertaining “what the traffic can bear”. In other words, the products
are made to bear a proportion of the joint cost on the basis of their ability to absorb the
same. Market value means weighted market value i.e. units produced × price of a unit of
joint product.
makes use of a realistic basis for apportioning joint costs. Under this method joint costs
are apportioned after ascertaining “what the traffic can bear”. In other words, the products
are made to bear a proportion of the joint cost on the basis of their ability to absorb the
same. Market value means weighted market value i.e. units produced × price of a unit of
joint product.
Contribution margin method
According to this method, joint costs are segregated
into two parts - variable and fixed. The variable costs are apportioned over the joint
products on the basis of units produced (average method) or physical quantities. In casethe products are further processed after the point of separation, then all variable cost
incurred be added to the variable costs determined earlier. In this way total variable cost
is arrived which is deducted from their respective sales values to ascertain their
contribution. The fixed costs are then apportioned over the joint products on the basis of
the contribution ratios.
into two parts - variable and fixed. The variable costs are apportioned over the joint
products on the basis of units produced (average method) or physical quantities. In casethe products are further processed after the point of separation, then all variable cost
incurred be added to the variable costs determined earlier. In this way total variable cost
is arrived which is deducted from their respective sales values to ascertain their
contribution. The fixed costs are then apportioned over the joint products on the basis of
the contribution ratios.
Wednesday, March 4, 2009
Survey method
This method is also known as point value method. It is based on
technical survey of all the factors involved in the production and distribution of products.
Under this method joint cost are apportioned over the joint products, on the basis of
percentage/point values, assigned to the products according to their relative importance.
The percentage or points used for the purpose are usually computed by management with
the help of technical advisers. This method is considered to be more equitable than other
methods.
technical survey of all the factors involved in the production and distribution of products.
Under this method joint cost are apportioned over the joint products, on the basis of
percentage/point values, assigned to the products according to their relative importance.
The percentage or points used for the purpose are usually computed by management with
the help of technical advisers. This method is considered to be more equitable than other
methods.
Physical unit method
This method is based on the assumption that the joint
products are capable of being measured in the same units. Accordingly joint costs here
are apportioned on the basis of some physical base, such as weight or measure
expressed in gallons, tonnes etc. In other words, the basis used for apportioning joint cost
over the joint products is the physical volume of material present in the joint products at
the point of separation. Any loss arising during the stage of processing is also apportioned
over the products on the same basis. This method cannot be applied if the physical units
of the two joint products are different. The main defect of this method is that it gives equal
importance and value to all the joint products.
products are capable of being measured in the same units. Accordingly joint costs here
are apportioned on the basis of some physical base, such as weight or measure
expressed in gallons, tonnes etc. In other words, the basis used for apportioning joint cost
over the joint products is the physical volume of material present in the joint products at
the point of separation. Any loss arising during the stage of processing is also apportioned
over the products on the same basis. This method cannot be applied if the physical units
of the two joint products are different. The main defect of this method is that it gives equal
importance and value to all the joint products.
Method of apportioning joint cost over joint products
Proper apportionment of
joint cost over the Joint Products is of considerable importance, as this affects (a)
Valuation of closing inventory; (b) Pricing of products; and (c) Profit or loss on the sale of
different products.
The commonly used methods for apportioning total process costs upto the point of separation
over the joint products are as follows :
(i) Physical unit method
(ii) Average unit cost method
(iii) Survey method
(iv) Contribution margin method
joint cost over the Joint Products is of considerable importance, as this affects (a)
Valuation of closing inventory; (b) Pricing of products; and (c) Profit or loss on the sale of
different products.
The commonly used methods for apportioning total process costs upto the point of separation
over the joint products are as follows :
(i) Physical unit method
(ii) Average unit cost method
(iii) Survey method
(iv) Contribution margin method
Apportionment of joint costs
Joint product costs occur in many industries such
as : petroleum, oil refinery, meat-making, textiles, dairy, flour mill, saw mill and many
other process industries and top management of business concerns require the
Accountants to give their opinion for many managerial decisions such as to processfurther or to sell at split-off stage. To answer this question they require apportionment of
joint costs over different products produced.
The main problem faced in the case of joint products/by-products is the apportionment of the
total cost incurred upto the point of separation of joint products/or by products. For costs
incurred after the split off point there is no problem, as these costs can be directly allocated to
individual joint products or by-products. Thus the apportionment of joint costs over different
products produced involve the following two cases.
as : petroleum, oil refinery, meat-making, textiles, dairy, flour mill, saw mill and many
other process industries and top management of business concerns require the
Accountants to give their opinion for many managerial decisions such as to processfurther or to sell at split-off stage. To answer this question they require apportionment of
joint costs over different products produced.
The main problem faced in the case of joint products/by-products is the apportionment of the
total cost incurred upto the point of separation of joint products/or by products. For costs
incurred after the split off point there is no problem, as these costs can be directly allocated to
individual joint products or by-products. Thus the apportionment of joint costs over different
products produced involve the following two cases.
By-Products
These are defined as “products recovered from material discarded in a main
process, or from the production of some major products, where the material value is to be
considered at the time of severance from the main product.” Thus by-products emerges as a
result of processing operation of another product or they are produced from the scrap or waste
of materials of a process. In short a by-product is a secondary or subsidiary product which
emanates as a result of manufacture of the main product. Examples of by-products are
molasses in the manufacture of sugar, tar, ammonia and benzole obtained on carbonisation of
coal and glycerine obtained in the manufacture of soap.
process, or from the production of some major products, where the material value is to be
considered at the time of severance from the main product.” Thus by-products emerges as a
result of processing operation of another product or they are produced from the scrap or waste
of materials of a process. In short a by-product is a secondary or subsidiary product which
emanates as a result of manufacture of the main product. Examples of by-products are
molasses in the manufacture of sugar, tar, ammonia and benzole obtained on carbonisation of
coal and glycerine obtained in the manufacture of soap.
Tuesday, March 3, 2009
Co-Products
Joint products and co-products are used synonymously in common parlance,
but strictly speaking a distinction can be made between two. Co-products may be defined as
two or more products which are contemporary but do not emerge necessarily from the same
material in the same process. For instance, wheat and gram produced in two separate farms
with separate processing of cultivation, are the co-products. Similarly timber boards made
from different trees are co-products.
but strictly speaking a distinction can be made between two. Co-products may be defined as
two or more products which are contemporary but do not emerge necessarily from the same
material in the same process. For instance, wheat and gram produced in two separate farms
with separate processing of cultivation, are the co-products. Similarly timber boards made
from different trees are co-products.
Joint Products
Joint products represent “two or more products separated in the course of the
same processing operation usually requiring further processing, each product being in such
proportion that no single product can be designated as a major product”. In other words, two
or more products of equal importance, produced, simultaneously from the same process, are
known as joint products. For example, in the oil industry, gasoline, fuel oil, lubricants, paraffin,
coal tar, asphalt and kerosene are all produced from crude petroleum. These are known as
joint products.
same processing operation usually requiring further processing, each product being in such
proportion that no single product can be designated as a major product”. In other words, two
or more products of equal importance, produced, simultaneously from the same process, are
known as joint products. For example, in the oil industry, gasoline, fuel oil, lubricants, paraffin,
coal tar, asphalt and kerosene are all produced from crude petroleum. These are known as
joint products.
Meaning of Joint Products and By-Products
Agricultural product industries,
chemical process industries, sugar industries, and extractive industries are some of the
industries where two or more products of equal or unequal importance are produced either
simultaneously or in the course of processing operation of a main product. In all such
industries, the management is faced with the problems such as, valuation of inventory,pricing of product and income determination, problem of taking decision in matters of
further processing of by-products and/or joint products after a certain stage etc. In fact the
various problems relate to (i) apportionment of common costs incurred for various
products and (ii) aspects other than mere apportionment of costs incurred upto the point
of separation. Before taking up the above problems, we first define the various necessary
concepts.
chemical process industries, sugar industries, and extractive industries are some of the
industries where two or more products of equal or unequal importance are produced either
simultaneously or in the course of processing operation of a main product. In all such
industries, the management is faced with the problems such as, valuation of inventory,pricing of product and income determination, problem of taking decision in matters of
further processing of by-products and/or joint products after a certain stage etc. In fact the
various problems relate to (i) apportionment of common costs incurred for various
products and (ii) aspects other than mere apportionment of costs incurred upto the point
of separation. Before taking up the above problems, we first define the various necessary
concepts.
INTER-PROCESS PROFITS
In some process industries the output of one process is transferred to the next process not at
cost but at market value or cost plus a percentage of profit. The difference between cost and
the transfer price is known as inter-process profits. The advantages and disadvantages of
using inter-process profit, in the case of process type industries are as follows :
Advantages :
1. Comparison between the cost of output and its market price at the stage of completion is
facilitated.
2. Each process is made to stand by itself as to the profitability.
Disadvantages :
1. The use of inter-process profits involves complication.
2. The system shows profits which are not realised because of stock not sold out.
cost but at market value or cost plus a percentage of profit. The difference between cost and
the transfer price is known as inter-process profits. The advantages and disadvantages of
using inter-process profit, in the case of process type industries are as follows :
Advantages :
1. Comparison between the cost of output and its market price at the stage of completion is
facilitated.
2. Each process is made to stand by itself as to the profitability.
Disadvantages :
1. The use of inter-process profits involves complication.
2. The system shows profits which are not realised because of stock not sold out.
Valuation of work-in-progress
For the valuation of work-in-progress following
three methods are available :
(1) First-in-First Out (FIFO) method.
(2) Last-in-First Out (LIFO) method.
(3) Average Cost method (or weighted average cost method).
(1) First-in-first-out method - Under this method the units completed and transferred
include completed units of opening work-in-progress and subsequently introduced units.
Proportionate cost to complete the opening work-in-progress and that to process the
completely processed units during the period are derived separately. The cost of opening
work-in-progress is added to the proportionate cost incurred on completing the same to
get the complete cost of such units. Complete cost of such units plus cost of units
completely processed constitute the total cost of units transferred.
three methods are available :
(1) First-in-First Out (FIFO) method.
(2) Last-in-First Out (LIFO) method.
(3) Average Cost method (or weighted average cost method).
(1) First-in-first-out method - Under this method the units completed and transferred
include completed units of opening work-in-progress and subsequently introduced units.
Proportionate cost to complete the opening work-in-progress and that to process the
completely processed units during the period are derived separately. The cost of opening
work-in-progress is added to the proportionate cost incurred on completing the same to
get the complete cost of such units. Complete cost of such units plus cost of units
completely processed constitute the total cost of units transferred.
Monday, March 2, 2009
COSTING OF EQUIVALENT PRODUCTION UNITS
In the case of process type of industries it is possible to determine the average cost per unit
by dividing the total cost incurred during a given period of time by the total number of unitsproduced during the same period. But this is hardly the case in most of the process type
industries where manufacturing is a continuous activity. The reason is that the cost incurred in
such industries represents the cost of work carried on opening work-in-progress, closing workin-
progress and completed units. Thus to ascertain the cost of each completed unit it is
necessary to ascertain the cost of work-in-progress in the beginning and at the end of the
process.
The valuation of work-in-progress presents a good deal of difficulty because it has units under
different stages of completion from those in which work has just begun to those which are only
a step short of completion. Work-in-progress can be valued on actual basis, i.e., materials
used on the unfinished units and the actual amount of labour expenses involved. However, the
degree of accuracy in such a case cannot be satisfactory. An alternative method is based on
converting partly finished units into equivalent finished units.
by dividing the total cost incurred during a given period of time by the total number of unitsproduced during the same period. But this is hardly the case in most of the process type
industries where manufacturing is a continuous activity. The reason is that the cost incurred in
such industries represents the cost of work carried on opening work-in-progress, closing workin-
progress and completed units. Thus to ascertain the cost of each completed unit it is
necessary to ascertain the cost of work-in-progress in the beginning and at the end of the
process.
The valuation of work-in-progress presents a good deal of difficulty because it has units under
different stages of completion from those in which work has just begun to those which are only
a step short of completion. Work-in-progress can be valued on actual basis, i.e., materials
used on the unfinished units and the actual amount of labour expenses involved. However, the
degree of accuracy in such a case cannot be satisfactory. An alternative method is based on
converting partly finished units into equivalent finished units.
Abnormal gain
Sometimes, loss under a process is less than the anticipated normal figure. In
other words, the actual production exceeds the expected figures. Under such a situation the
difference between actual and expected loss or actual and expected production is known asabnormal gain. So abnormal gain may be defined as unexpected gain in production under
normal conditions. The process account under which abnormal gain arises is debited with the
abnormal gain. The cost of abnormal gain is computed on the basis of normal production.
other words, the actual production exceeds the expected figures. Under such a situation the
difference between actual and expected loss or actual and expected production is known asabnormal gain. So abnormal gain may be defined as unexpected gain in production under
normal conditions. The process account under which abnormal gain arises is debited with the
abnormal gain. The cost of abnormal gain is computed on the basis of normal production.
Abnormal process loss
It is defined as the loss in excess of the pre-determined loss.
This type of loss may occur due to the carelessness of workers, a bad plant design or
operation etc. Such a loss cannot obviously be estimated in advance. But it can be kept under
control by taking suitable measures. The cost of an abnormal process loss unit is equal to the
cost of a good unit. The total cost of abnormal process loss is credited to the process account
from which it arise. Cost of abnormal process loss is not treated as a part of the cost of the
product. In fact, the total cost of abnormal process loss is debited to costing profit and loss
account.
This type of loss may occur due to the carelessness of workers, a bad plant design or
operation etc. Such a loss cannot obviously be estimated in advance. But it can be kept under
control by taking suitable measures. The cost of an abnormal process loss unit is equal to the
cost of a good unit. The total cost of abnormal process loss is credited to the process account
from which it arise. Cost of abnormal process loss is not treated as a part of the cost of the
product. In fact, the total cost of abnormal process loss is debited to costing profit and loss
account.
Normal process loss
It is defined as the loss of material which is inherent in the
nature of work. Such a loss can be reasonably anticipated from the nature of the material,
nature of operation, the experience and technical data. The cost of normal process loss in
practice is absorbed by good units produced under the process. The amount realised by
the sale of normal process loss units should be credited to the process account.
nature of work. Such a loss can be reasonably anticipated from the nature of the material,
nature of operation, the experience and technical data. The cost of normal process loss in
practice is absorbed by good units produced under the process. The amount realised by
the sale of normal process loss units should be credited to the process account.
TREATMENT OF NORMAL PROCESS LOSS, ABNORMAL PROCESS LOSS AND
Loss of material is inherent during processing operation. The loss of material under different
processes arises due to reasons like evaporation or a change in the moisture content etc.
Process loss is defined as the loss of material arising during the course of a processing
operation and is equal to the difference between the input quantity of the material and its
output.
processes arises due to reasons like evaporation or a change in the moisture content etc.
Process loss is defined as the loss of material arising during the course of a processing
operation and is equal to the difference between the input quantity of the material and its
output.
Sunday, March 1, 2009
Costing Procedure
The Cost of each process comprises the cost of :
(i) Materials (ii) Labour
(iii) Direct expenses, and (iv) Overheads of production.
Materials - Materials and supplies which are required for each process are drawn against
material requisitions from stores. Each process for which the above drawn materials will be
used should be debited with the cost of materials consumed on the basis of the information
received from the Cost Accounting department. The finished product of first process generally
become the raw materials of second process; under such a situation the account of second
process, be debited with the cost of transfer from the first process and the cost of any
additional material required under this second process.
(i) Materials (ii) Labour
(iii) Direct expenses, and (iv) Overheads of production.
Materials - Materials and supplies which are required for each process are drawn against
material requisitions from stores. Each process for which the above drawn materials will be
used should be debited with the cost of materials consumed on the basis of the information
received from the Cost Accounting department. The finished product of first process generally
become the raw materials of second process; under such a situation the account of second
process, be debited with the cost of transfer from the first process and the cost of any
additional material required under this second process.
Basic features
Industries, where process costing can be applied, have normally
one or more of the following features :
1. Each plant or factory is divided into a number of processes, cost centres or departments,
and each such division is a stage of production or a process.
2. Manufacturing activity is carried on continuously by means of one or more process run
sequentially, selectively or parallely.
3. The output of one process becomes the input of another process.
one or more of the following features :
1. Each plant or factory is divided into a number of processes, cost centres or departments,
and each such division is a stage of production or a process.
2. Manufacturing activity is carried on continuously by means of one or more process run
sequentially, selectively or parallely.
3. The output of one process becomes the input of another process.
MEANING OF PROCESS COSTING
Process Costing is a method of Costing used in industries where the material has to pass
through two or more processes for being converted into a final product. It is defined as “a
method of Cost Accounting whereby costs are charged to processes or operations and
averaged over units produced”. Such type of costing method is useful in the manufacturing of
products like steel, soap, chemicals, rubber, vegetable oil, paints, varnish etc. where the
production process is continuous and the output of one process becomes the input of the
following process till completion.
through two or more processes for being converted into a final product. It is defined as “a
method of Cost Accounting whereby costs are charged to processes or operations and
averaged over units produced”. Such type of costing method is useful in the manufacturing of
products like steel, soap, chemicals, rubber, vegetable oil, paints, varnish etc. where the
production process is continuous and the output of one process becomes the input of the
following process till completion.
MULTIPLE COSTING
It refers to the method of costing followed by a business wherein a large variety of articles
are produced, each differing from the other both in regard to material required and
process of manufacture. In such cases, cost of each article is computed separately by
using, generally, two or more methods of costing. For instance, for ascertaining the cost
of a bicycle, cost of each part will be ascertained by using batch or job costing method
and, then the cost of assembling the parts will be ascertained by following the method of
single or output costing.
are produced, each differing from the other both in regard to material required and
process of manufacture. In such cases, cost of each article is computed separately by
using, generally, two or more methods of costing. For instance, for ascertaining the cost
of a bicycle, cost of each part will be ascertained by using batch or job costing method
and, then the cost of assembling the parts will be ascertained by following the method of
single or output costing.
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