CMA Theory

Unit 1

Meaning, nature and scope of Cost Accounting and Management

Accounting
Comparison between Cost Accounting & Management Accounting;
Cost Control, Cost Reduction & Cost Management, Components of
Total Cost
Preparation of Cost Sheet.
Cost Ascertainment: Cost Unit and Cost Center.
Overheads: Meaning, Cost Drivers, Accumulation, Allocation,
Apportionment and Absorption.
Classification of Costs

– Fixed, Variable, Mixed Cost;

– Product, and Period Costs;
– Direct and Indirect Costs;
– Relevant and Irrelevant Costs;
– Shut-down and Sunk Costs;
– Controllable, and Uncontrollable Costs;
– Avoidable, and Unavoidable Costs;
– Imputed / Hypothetical/Implicit Costs and Out-of-pocket Costs;
– Opportunity Costs;
– Expired, and Unexpired Costs.

Unit 2

Absorption Costing and Marginal costing

Contribution
Profit Volume Ratio
Break-even Analysis: Break-even Point, Composite Break-even Point,
Cash Break-even Point
Margin of safety
Angle of Incidence

Relevant Costs and Decision Making such as:

Key Factor
 Pricing
Product Profitability
Dropping a product line
Make or Buy
Export Order
Shut down vs. Continue operations.

Unit 3

Meaning, Steps in Budgetary Control

Sales budget
Production Budget
Raw material consumption Budget
Raw Material Purchase Budget
Overhead Budgets
Cash Budget
Master Budget
Fixed and Flexible Budgets
Zero based budgeting.

Unit 4

Meaning of Standard Cost

Standard Costing Advantages
Standard Costing Limitations
Standard Costing Applications
Material Cost Variance, Price and Usage Variance and Mix and yield
Variance
Labor Cost Variance, Rate and Usage Variance, Idle time, Mix and Yield
variance.

Unit 5

Target Costing
Life Cycle Costing
Quality Costing
 Activity based Costing.

UNIT 1

Cost Accounting

● Cost accounting is the process of accounting for costs.

● It is a branch of accounting that is designed to measure the economic
resources consumed in producing goods or services.
● It is a process of classifying, recording and appropriate allocation of
expenditure for determination of costs of products or services and
furnishing information to enable the managers in controlling these
costs.

– Technique and process of ascertaining cost is called costing

– Application of cost accounting principles and techniques for cost

control and ascertainment of profitability and its presentation is called
cost accountancy.

– It includes costing, accounting, control and audit

Benefits of Cost Accounting

● Inventory Valuation
● Income Determination
● Measuring and increasing efficiency
● Financial Planning
● Costs Control
● Costs Reduction
● Providing basis for managerial decision making

Management Accounting

● Management Accounting deals with providing information to managers

 ●

for use in planning, decision making and control.

● Management Accounting contains reports prepared to fulfill the needs
of management.
● Management Accounting is concerned with data collection from
internal and external sources, analysing, processing, interpreting and
communicating the information for use within the organisation so that
management can effectively plan, make decisions and control
operations.

– Resource allocation, overall strategies and long range plans, cost

planning, performance evaluation and rewards

Features

● Useful in decision making

● Financial and Cost Accounting information
● Internal Use
● Purely Optional
● Concerned with future
● Flexibility in presentation of information

Basis Cost Accounting Management

Accounting
Objective Its main purpose is to Its major objective is
ascertain the cost to make desicions
through presentation
of accounting info
Scope It only deals with cost It also deals with
related aspects revenue along with
costs
Data Utilisation Only quantitative info Both qualitative and
related to transactions quantitative
information for
decision making
Utility Ends at presentation Starts from where cost
of info accounting ends,
meaningful cost info
are inputs
Nature Deals with past and Deals with future
present data policies and course of
actions

What is cost ?
 – Cost is a measurement, in monetary terms, of the amount of
resources used for the purpose of production of goods or
rendering services.
– It is a value sacrificed for current or future benefit
– Cash or non cash, objective is to get benefit, measurable, explicit
or implicit

What is cost object ?

When we think of a cost we ask what is the cost for ? The thing the cost is for is
cost object.

A cost object refers to anything for which costs are measured and
accumulated, typically for the purpose of determining the total cost incurred in
producing goods or delivering services.

It can be a Product, Customer, Department, Project, Activity, Job, Contract,

Process, Item

What is cost unit ?

– In preparing cost accounts, it becomes necessary to select a unit with

which expenditure may be identified.
– The quantity upon which expenditure can be conveniently
allocated is known as cost unit
– Eg Textile Mills : per yard of cloth manufactured, Transport
Companies : per passenger km

What is cost centre ?

A cost center is a department or function within an organization that does not

directly add to profit but still costs the organization money to operate. Cost
centers only contribute to a company's profitability indirectly.

What is cost control ?

– It is exercised by comparing actual costs with predetermined standard

costs so that difference between the two can be measured and
analysed and corrective action taken.

– It is a function of keeping costs within the prescribed limits.

– Techniques of Cost Control : Inventory Control, Budgetary Control and

Variance analysis
Cost reduction

– Effective savings in cost by continuous research for improvement in

products, methods, procedures and organisational practices.

– It can be through increasing productivity, elimination of waste,

improvement in product design, better technology, better bargain on
purchases etc.

Cost control v/s cost reduction

– Cost reduction challenges the standards, cost control doesn’t

– Reduction focuses on present and future and it’s a corrective function
– Control is a preventive function

Cost Management

Cost management is the process of planning and controlling the budget of a

business.

It involves setup, resource planning, budget and cost estimation.

Elements of Cost

A manufacturing firm engages in manufacturing, marketing, selling and

administration.

Manufacturing involves conversion of raw material into finished goods and

manufacturing costs will include all costs incurred in converting raw materials
into saleable finished goods.

Total cost includes

– Prime cost

Direct material plus

Direct labour plus
Direct expenses

– Works overheads

– Cost of sales

Office cost plus selling

and distribution overheads
Costs of finished goods comprises of :
○ Direct Materials
○ Direct Labour
○ Direct Expenses
○ Overheads

Material cost all of those resources on which processing is done to add value to
the final product

Direct Material - Those materials which will become a part of the finished
product and can be conveniently traced to it

Indirect Material - Needed in the product it is too inconvenient to charge to

each unit of output

– E.g glue used in chairs

Direct Labour - Labour costs of those workers who are directly involved in the
production process. Labour costs for specific work performed on the product
that can be directly traced to end products.

– E.g labour of machine operators, assemblers

Indirect Labour - Wages of all employees who do not work on the product
itself but assist in the manufacturing process.

– E.g Production supervisors, Factory clerks, maintenance employees

Their efforts are essential to manufacturing but they cannot be related with
specific products

Direct Expenses - Direct expenses refer to those expenses other than material
and labour which can be directly traced to a particular product.

– Inward Carriage, License fees, Specific moulds, royalties, architects

Indirect Expenses - All indirect expenditure incurred from the time

production has started till the time finished goods are transferred to the
store

– They are incurred for the benefit of more than one product and have to
be assigned to different products on appropriate basis.

– E.g : Rent of factory , fire insurance, depreciation, power, light, heat ,

salaries of storekeepers, Factory telephone expenses
Factory Overheads - Indirect Materials, Indirect Labour and Indirect Expenses

Office & Administrative Overheads - Expenses relating to management and

administration of business

– Eg Office salaries, office rent, depreciation of office equipment,

telephone, travel, property taxes, stationary, printing, postage, other
office expenses

Selling and distribution overheads

– Costs incurred for marketing, securing order, dispatching the product

– Eg Advertising expenses, salesmen’s salaries, storage, transportation

Cost Direct or Indirect

Overtime paid for specific jobs Indirect
Wages paid to piece workers Direct
Wages paid to maintenance Indirect
workers
Director’s fees Indirect
Salesmen’s commission Direct
Salaries paid to sweepers Indirect

Group costs into the following classification

● Direct materials
● Direct Labour
● Direct Expenses
● Indirect Production Overhead
● Selling and Distribution Costs
● Research and Development Costs
● Administration costs

Costs Category
Telephone expenses Admin
Wages of security guard in factory Indirect Production Overhead
Parcels sent to customers Selling and disribution
Wages of machine operators Indirect Production Overhead
Developing a new product in the R&D
laboratory
Carriage paid to truck drivers who Direct Expenses
handle raw materials for a product
Wages of security guard in factory Indirect Production Overhead
Parcels sent to customers Selling and disribution
Wages of machine operators Indirect Production Overhead
Developing a new product in the R&D
laboratory
Carriage paid to truck drivers who Direct Expenses
handle raw materials for a product
Wages of storekeepers in materials Indirect Production
store
Chief Accountants’ salary Administration
Cost of painting advertising Selling
slogans on delivery vans
Lubricants for sewing machines Indirect Production
Pen drives for office computers Admin
Maintenance contract for office Admin
photocopy machines
Market research undertaken prior R&D
to new product launch
Royalty paid for using patented Direct Expenses
production technology for a
product
Road licenses for delivery vans Selling
Amount payable for broadcasting Indirect Production
music throughout the factory

Cost Sheet

Format
Adjustment for inventories

. Direct Material consumed = Opening stock of direct material +

Purchases of Direct material – Closing stock of Direct Material
. Works Cost = Gross Works Cost + Opening Work in Progress –Closing
work in progress
. Cost of Production = Works Cost + Office & Admn Overheads
. Cost of Production of Goods sold = Cost of Production + Opening
stock of Finished goods – Closing Stock of Finished goods
 . Cost of Production of Goods sold + S&D exp = Cost of sales

Cost sheet question

Overheads Meaning

– Overheads are business costs that are related to the day-to-day

running of the business.
– Overhead expenses vary depending on the nature of the business and
the industry it operates in.
– Overhead costs are important in determining how much a company
must charge for its products or services in order to generate a profit.

Cost Allocation

– When items of cost are identifiable directly with some products or

departments such costs are charged to such cost centres. This
process is known as cost allocation.

– Wages paid to workers of service department can be allocated to the

particular department. Indirect materials used by a particular
department can also be allocated to the department. Cost allocation
calls for two basic factors - (i) Concerned department/product should
have caused the cost to be incurred, and (ii) exact amount of cost
should be computable.

Cost Apportionment

– When items of cost cannot be directly charged to or accurately

identifiable with any cost centres, they are prorated or distributed
amongst the cost centres on some predetermined basis. This method
is known as cost apportionment.

– Thus we see that items of indirect costs residual to the process of

cost allocation are covered by cost apportionment.

– The basis ultimately adopted should ensure an equitable share of

common expenses for the cost centres and the basis once adopted
should be reviewed at periodic intervals to improve upon the accuracy
of apportionment

Cost Absorption

Absorption costing refers to a method of costing to account for all the costs of
manufacturing. The management uses this method to absorb the costs
incurred on a product. The costs include direct costs and indirect costs. Direct
costs include materials, labour used in production. Indirect costs include
factory rent, administration costs, compliance, and insurance.

Cost Classification

Fixed Fixed Costs are those costs that

do not change with the levels of
activity. Remain constant
regardless of changes in level of
activity / output within a relevant
range
Variable Variable costs vary directly and
proportionately with the output.
There is a constant ratio between
change in the cost and change in
level of output.
Mixed (Semi-Variable) Mixed costs are made up of fixed
and variable components.
Because of variable component,
they change with the level of
output but because of fixed
component, they do not vary in
direct proportion to output

Direct Costs which are easily identifiable

or traceable with a cost object .
Eg : Direct material, labour
Indirect Costs which cannot be identified
with or traced to a single product
because they are common to
several products.

Product Costs Product Costs are inventoriable

costs which are identified as a
part of inventory on hand and
included in stock valuation. These
are those costs which are
necessary for production and
which will not be incurred if there
is no production
Period Costs These costs are those costs which
are not included in stock valuation
and are written off as expenses
 because they are common to
several products.

Product Costs Product Costs are inventoriable

costs which are identified as a
part of inventory on hand and
included in stock valuation. These
are those costs which are
necessary for production and
which will not be incurred if there
is no production
Period Costs These costs are those costs which
are not included in stock valuation
and are written off as expenses
during the period in which they are
incurred.
They are assigned to the period of
time in which they are incurred

Opportuinity Costs Cost of Oppurtunity lost or next

best alternative
Oppurtunity costs is the net cash
inflow that could have been
obtained if the resources
committed to one action were used
in the other desirable alternative
Not incorporated into formal
accounts
Important in decision making and
evaluating alternatives
Sunk Costs Already incurred and cannot be
changed by any decision made in
the future. Not relevant for
decision making.
Relevant Cost Those expected future costs that
differ amongst alternative courses
of action
For eg: When we compare two
alternative methods of production,
if the cost of direct material to be
used is same in both, this costs
becomes irrelevant.
Imputed Costs Hypothetical costs that do not
involve cash outlay
Out of Pocket Costs Cash cost
Shut Down Cost Incurred in situations of closure of
department or product
Controllable Costs Controllable cost is a cost which
can be influenced by a specified
 Imputed Costs Hypothetical costs that do not
involve cash outlay
Out of Pocket Costs Cash cost
Shut Down Cost Incurred in situations of closure of
department or product
Controllable Costs Controllable cost is a cost which
can be influenced by a specified
member of an undertaking
Uncontrollable Costs Cannot be controlled

UNIT 2

Absorption Costing

Total cost technique under which variable as well as fixed manufacturing cost is
charged as production cost. All manufacturing costs are absorbed in the cost
of the products.

Also known as total costing or full costing.

Characteristics

– Variable and fixed manufacturing costs are charged to the cost of

products

– Stocks are valued at total cost

– Fixed costs may be charged on actual basis or at pre determined

overhead rates based on normal capacity

– There may be under or over absorption of factory overhead, which can

be adjusted.

– Non manufacturing costs are treated as period costs and charged to

P&L

Marginal Cost

Marginal cost is the cost of producing an additional unit of product. it is the

total of all variable costs per unit.

The amount at any given volume of output by which aggregate costs are
changed if volume of output is increased or decreased by one unit.

Marginal cost remains unchanged irrespective of activity level.

Marginal Costing
The accounting system in which variable costs are charged to cost units and
fixed costs of the period are written off in full against the aggregate
contribution.

Characteristics

– Costs are segregated into fixed and variable elements.

– Only marginal costs are charged as product costs
– Fixed costs are period costs
– Valuation of inventory is at marginal cost only
– Contribution - The difference between sales value and marginal cost
of sales. Relative profitability of departments or products is made by
study of contribution
– Pricing is based on marginal cost + contribution

Difference between absorption and marginal costing

. Treatment of fixed and variable costs

 . Valuation of Stock

Marginal - At marginal cost

Absorption - At total cost

Profitability

Relative profitability between departments or products is seen through

contribution in marginal costing.

In absorption costing relative profitability is judged by profit figures.

Income Statements
Advantages of Marginal Costing

– Helps in managerial decisions (make or buy etc.)

– Cost control
 – Simple technique
– No under or over absorption
– Constant per unit cost
– Realistic valuation of inventory

Disadvantages

– Analysis is difficult
– Ignores time factor by ignoring fixed costs
– Application is difficult
– Cannot be used in capital intensive industries
– Improper basis of pricing

Cost Volume Profit Analysis

– Studies relationship between cost, volume and profit.

CVP analysis includes the analysis of sales price, fixed costs, variable costs,
the number of goods sold, and how it affects the profit of the business.

Break Even Analysis

A technique to study CVP relationship.

Narrow meaning - determining break even point

Broad sense - Determine probable profit at any given level of production/sales.

Also can be used to determine amount of sales to earn desired level of profit.

Assumptions under BEA

– All costs can be seperated into fixed or variable

– Variable cost per unit remains constant and TVC moves in direct
proportion to volume
– Fixed cost is constant
– SP per unit does not change
– Sales mix ratio does not change
– Production = sales
– Productivity is constant
– General price level is the same

P/V Ratio

Profit Volume ratio is an indicator of the rate at which profit is being earned.
Higher the better.
It helps in calculating

– BEP
– Profit at given sales
– Volume of sales for given profit

Can be increased by increasing SP, reducing VC or changing sales mix i.e

selling more profitable products

Formulae
Contribution Sales - Variable Cost
PV Ratio Contribution/ Sales
Break Even Point Total Fixed cost/ Contribution per
unit
(Total fixed cost/contribution) *
Sales
Total Fixed Cost/ PV ratio
Cash Break Even Point [Excludes Cash fixed costs/ Contribution per
FC which are not payable in cash unit
ieg. depreciation]
Margin of Safety Actual Sales - Break Even Point
Composite Break Even Point (Total Contribution/ Total
[BEP of all different products Sales)*100
together]

Break Even Chart

Angle of Incidence - This angle is formed by the intersection of sales line and
total cost line at the break even point This angle shows the rate at which profits
are being earned after break-even point has been reached.

The wider the angle, the greater is the rate of profits.

The angle of incidence is of particular importance when expanding. In boom

periods large incidence with a high margin of safety indicates favourable
position. However in recession low angle of incidence is favourable as it would
help minimise losses.

Relevant cost and decision making

Limiting factor

The objective of a business is to earn maximum profit. However, it is not always

easy to achieve this objective because profit earning is affected by a variety of
factors. For example a manufacturing unit may have sufficient orders but not
enough material, then raw material becomes the limiting factor. If it’s vice-versa
sales becomes the limiting factor.

Examples of limiting factors are:

– Sales
– Labour of particular skill
– Financial resources
– Materials
– Production capacity or machine hours

The purpose of the limiting factor technique is to indicate the most profitable
course.

Contribution per unit of key factor

When a key factor is operating, the most profitable position is reached when
contribution per unit of key factor is maximum. For instance, if choice lies
between producing product A which yields a contribution of 15 per unit ad
product B which yields a contribution of 20 per unit, product B would be more
profitable.

However, product A takes 3 kg of material (which is a limiting factor) and

product 3 takes 5 kg the respective contributions per kg of material would be:
Product A = 15+3 kgs = 25

Product B 20+5 kgs = 4 Product A, which gives the greater contribution in

terms of per unit of limiting factor will be more profitable.

Make or Buy decision

When a firm has no spare capacity and manufacturing a component involves

setting aside other work, the loss of contribution of displaced work should also
be given due consideration.
In other work, it will be profitable to buy only when the purchase price is below
variable cost plus loss of contribution of displaced work.

In make or buy decisions, opportunity cost may have to be considered.

Insourcing is producing the goods by the firm itself whereas outsourcing is the
process of purchasing the goods or services from outside suppliers.
For example, a car manufacture may rely on outside vendors to supply some
component parts but chooses to manufacture other parts internally.

Company may be tempted to buy a component from the market when own cost
of production is more than the market price.

This is particularly so when a component part is available in the market at a

price below firm's own total cost. This type of decision based on total cost
analysis may be misleading.

Such a decision can be arrived at by comparing the outside supplier's price

with firm's own marginal cost. On the face of it, since the only cost to
manufacture the component is its marginal cost, then the amount by which
marginal cost falls below supplier's price is the saving that arises in making.
Therefore, it will be profitable to buy from outside only when supplier's price is
below firm's own marginal cost.

– For example, total cost of making a component is 100 per unit,

consisting of ₹ 80 as variable cost and 20 as fixed cost. Suppose, an
outside firm is prepared to supply this component at 90, it may appear
that it is cheaper to buy the component. But a study of cost analysis
will show that each unit if manufactured makes a contribution of 20
towards recovery of fixed cost. This fixed cost has to be incurred
whether we make or buy. The real cost of making the component part
is only 80 which is its variable cost. This offer of 90 per unit should
not be accepted because if accepted, the component will really cost
110, i.e., 90 of purchase price plus 20 of fixed cost which cannot be
saved if component is not produced.

– However, before arriving at final decision, due consideration should be

given to other factors. For example, it should also be considered as to
whether plant capacity released by the non-manufacture of the
component part is put to some alternative use or not.

Non-cost or Qualitative Factors

While making a decision on make or buy a component, the following non-cost

factors should also be considered.

– Assurance of continued supply, if bought from outside.

– Assurance of quality of the product by the supplier.

– Assurance of no price increase during the period of agreement.

Pricing

The most useful contribution of marginal (variable) costing is the assistance

that it renders to the management in vital decision-making.

Fixation of Selling Price

Although prices are regulated more by market conditions of demand and supply
and other economic factors than by the decisions of management, the
management while fixing prices has to keep in view the level of profit desired.
In the long-run, the selling prices of products or services must be higher than
the total cost as otherwise the profit cannot be earned.

But frequently circumstances arise for management to consider special

conditions and sell its regular product at a special price which may be lower
than the total cost.

Fixation of selling prices is discussed below:

– Under normal circumstances

– Must cover total cost and give reasonable profit

– In times of competition and/or trade depression

– In special market conditions, management should price products to

reduce losses.

– When variable cost technique is used for pricing, the price should be
higher than the variable cost so that it makes a contribution towards
fixed cost and help reduce the loss.
– When price is just equal to variable cost the amount of loss will also be
equal to the amount of fixed cost because in such situations the
selling prices make no contribution towards fixed cost.

– Thus, under special circumstances like the trade depression or

competition, if selling price is higher than variable cost, even though it
is below total cost, the production should not be stopped.
– This is because fixed costs will have to be incurred irrespective of
whether production is continued or not, and continuing the production
will help in reducing the amount of loss.

– Ffixation of selling price below total cost should be made only on a

short- term basis. Pricing based on variable cost plus contribution
helps companies to take advantage of short-term opportunities. But at
 –

the same time, no firm can afford to incur loss on a long-term basis
and thus in the long-run, the selling price must cover total cost and
give a reasonable amount of profit.

Export Sales

Additional orders may be accepted from a foreign market at below normal price
or below total cost but above marginal cost.

Export sales yield additional contribution when such sales are at a price which
is above variable cost.

While determining profitability of accepting export orders, the following

additional factors should be considered.

– Export sales may result in additional costs like special packing cost,
additional quality checks. freight and insurance charges, etc., if not
borne by importer. These costs should be deducted from contribution
to determine profit from export order.

– Export sales may result in certain cost benefits like export subsidy
from government, exemption or concessions in excise duty or duty
drawbacks, etc. In determining profit from export order, these items
should be deducted from cost or added in contribution

– In order to utilise spare plant capacity, bulk orders from home market
or from foreign market may be accepted at less than total cost but
above marginal cost. This adds to the total profit of the company. This
is possible only when price discrimination is such sales in different
markets is possible

Product Mix Decisions

– Sales mix or product mix denotes the proportion in which various

products are sold or produced.

– The problem of selecting a profitable mix of sales thus, arises only

when a business enterprise has a variety of product lines and each
making a contribution of its own.

– Any change in sales mix also results in the change in profit position.

The discussion on selection of the most profitable product mix may be

discussed in two parts:

When there is no key factor

– When there is no key factor, the product mix that provides the highest
amount of contribution is considered as the most profitable sales mix.

– This holds good when fixed cost does not change due to changes in
sales mix.

– If sales mix changes fixed cost then profit has to be seen and not
contribution

When there is a key factor

– When a key factor is operating, selection of the most profitable sales

mix a hased on contribution per unit of key factor.

– The product which makes the highest amount of contribution per unit
of key factor, is the most profitable one and its production is pushed
up.

– The second preference is to be given to product which yields the

second highest contribution per unit of key factor and so on.

– In case a number of key factors are operating simultaneously, the

basic principle remains the same but problem becomes more
mathematical in nature and one has to resort to Linear Programming to
determine the optimal product mix.

Plant Shut Down Decisions

The management under certain circumstances might feel that plant shut down,
i.e., closing down the business, is better than operating at a loss. However,
variable costing analysis may prove that this is not always so. This type of
situation usually arises when sufficient sales cannot be achieved.

This type of decision may be either

– Temporary suspension of production activities

– Permanent closing down of production.

In the long run, if selling prices do not prevail above total cost to give a profit,
plant may have to be shut down.

Temporary Closing Down.

Temporary suspension of activities is a short-term measure. The object is
usually to stop operations until trade depression has passed.

– The question before management is: when should operations be

suspended? or in other words, how long should operations be
continued? The answer to this question is that if products are making
a contribution towards fixed cost, then generally speaking, production
should not be suspended.
– This is so because continuing production will help minimising loss
which would be incurred if plant is shut down. Thus, the information
needed to solve this type of problem involves a comparison between
probable loss at a given level of output and the loss that would be
suffered if production is suspended temporarily. If plant is shut down,
the loss due to fixed cost would be 1,00,000 However, if plant is
operated, the loss would only be 75,000.
– This is because selling price is above the marginal cast and is making
a contribution towards fixed cost.

Role of Committed and Discretionary Fixed Costs

Sometimes, certain fixed costs can be avoided by management when plant is

not operative. These are termed as discretionary fixed costs.

Committed fixed costs, on the other hand, are those that cannot be avoided
even if production is discontinued.

In decisions to close down temporarily, contribution should be compared with

fixed cost which is to be incurred when plant is shut down, te, committed fixed
cost.

– Examples of fixed costs which may be avoided by closing down are:

advertisement cost, research and development, part of salaries, etc.
Longer the period of shut down, the larger the amount of avoidable
fixed cost is likely to be.
Now if the plant is shut down, the loss due to fixed cost would be ₹ 80,000
whereas, if plant operated, the loss would be & 75,000. The effect of plant
operating is only a small amount of lon ef 5,000 (... 80,000 - 75,000). Thus
keeping in view this small amount, operating a plant offers certain non-cost
advantages like keeping the plant in gear, retaining the customers, retaining
allsed Labour and amount of lessonnel. Thus, it would be advisable to continue
the production even these is a small amount of loss because the non-cost
factors outweigh the other factors.

In case the selling price is below the marginal cost and makes no contribution
towards fixed cost. then an cast be taken after the plant should be temporarily
shut down. But regard should be taken after considering non-cost factors like
effect of shut down on plant fear of the market, effect on relationship with
workers and suppliers. tett

Permanent Shut Down.

Such a decision is a drastic step and should be taken only when in the long run,
the business does not expect a suficient return to cover the risk involved. In
other words, in the long-run, selling price must not only cover the total cost but
should also give a reasonable return on the capital employed.

UNIT 3

Budget

Budget is an estimate prepared for definite future period either in financial or

non-financial terms to achieve the enlisted objectives.

– Budget is prepared for any course of action or business or state or

Nation, as a whole. The budget is usually expressed in terms of total
 –

volume.

– According to ICMA, England, a budget is as follows “a financial and or

quantitative statement prepared and approved prior to a defined
period of time, of the policy to be pursed during the period for the
purpose of attaining a given objective.

Budgeting

– Budgeting means the process of preparing budgets.

– Refers to the management action of formulating budgets.
– Preparation of budgets involves study of business situations and
understanding of management goals as also the capacity of the
organisation

Objectives of Budgeting

– Portraying overall aim

– Laying responsibilities
– Basis for comparison
– Optimum utilisation of resources
– Providing basis of revision and yardstick

Advantages

– Efficiencey
– Control on Expenditure
– Finding deviations
– Effective utilisation of resources
– Revision of plans
– Implementation of standard costing
– Credit rating and cost consciousness

Limitations

– Based on estimates
– Requires time from management, during which they cannot expect
much
– Co-operation is required
– Expensive
– Not a substitute for management
– Rigid document

How to prepare a budget - Rules

 – It is prepared for a definite period well in advance.
– It may be stated in terms of money or quantity or both
– It is a statement defining the objectives to be attained and the policy
to be followed to achieve them in a future period
– It is a statement expressed in monetary and/or physical units prepared
for the implementation of policy formulated by the management.
– It is laid down prior to the budget period during which it is followed.
– The policy to be followed to attain the given objective must be laid
before the budget is prepared

Forecast V/S Budgeting

Forecasts, being statements of Tool of control. Actions may be
future events, no control. suited to will and conditions that
may or may not happen
It is a statement of probable events Shows policy and programme to be
under anticipated conditions followed
during a specified period of time.
Wider scope Limited scope
Preliminary step for budgeting Forecasts are converted into
budgets

Sales Budget

1. Last sales figures

2. Estimates of the salesmen who is frequently operating in the market, known
much greater than any body in the market 3. Capacity of the plant and
machinery to produce
4. Funds availability
5. Availability of raw materials to the tune of demand in the respective time
period
6. Changes in the taste and preferences of the customer or consumer
7. Changers in the competition structure - Monopoly to Perfect competition

Master Budget

Includes production budget, sales budget, manufacturing budget, purchases

budget, Cogs budget, operating expenses budget, pro-forma income statement

Fixed Budget

– It is a budget known as constant budget, never registers the changes

in the preparation of a budget, being prepared for irrespective level of
output or production.
– This budget is mainly meant for the fixed overheads of the firm which
are constant in volume irrespective level of production.
– The ultimate utility of the budget is to control the cost as a cost
controlling measure, but the fixed budget is meaningless in having
comparison with the actual performance.

Flexible Budget

– Flexible budget is prepared for any level of production as an estimate

of statement of all expenses i.e. the expenses are classified into three
categories viz. variable, semi-variable and fixed expenses.
– The structure of the budget for any output is only to the tune of the
actual performance achieved.
– This is the budget facilitates not only to have comparison in between
various levels of production but also to identify the level of lowest
production cost.

– This budget is most useful tool of analysis in studying the sales at

–
when the circumstances are not warranting to predict.
– It is mostly suited to the seasonal business, where the sales volume
is getting differed from one period to another due to changes taken
place in the taste and preferences of the buyers.
– The production is being done on the basis of demand of the products
in the market. The demand of the products is studied only through
demand forecasting.
– The flexible budget is more applicable in the case of products, which
are greatly finding difficult to forecast the demand.
– The budget is prepared only during the time of acute shortage of
resources of production viz. Men, Material and so on.
Budgetary Control

Features

– The business objectives, plans and policies should be clearly

defined.
– The organisational chart should be clear with responsibility and
authority.
– The budgeted output should be stated in clear terms.
– Budget committee should be setup for the establishment and
efficient execution of the plan.
– Budget centres should be established for cost control and all budgets
should be related to cost centres.
– The budgetary control system should have full support of top
management of the organisation.
– The accounting system should provide accurate and timely
information.
 – Staff of the organisation should be strongly and properly motivated
towards the system.
– The budget should lay down the targets which are realistic and
attainable,
– The budgets should be flexible in nature for permit the adjustments in
the light of changed operational circumstances.

Objectives

– To use different levels of management in a co-operative endeavour for

achievement of the objectives of the firm.
– To facilitate centralised control with delegated authority and
responsibility.
– To achieve maximum profitability by planning income and expenditure
through optimum use of the available resources.
– To ensure adequate working capital in other resources for efficient
operation of business.
– To reduce losses and wastes to the minimum.
– To bring out clearly where effort is needed to remedy the situation.
– To see that the firm is not deflected from marching towards its long-
term objectives without being overwhelmed by emergencies.
– Various activities like production, sales, purchase of materials, etc.,
are coordinated with the help of budgetary control.
– To define the goal of the enterprise.

Zero Based Budgeting

– Zero-base budgeting is one of the renowned managerial tools,

developed in the year 1962 in America by the Former President Jimmy
Carter. The name suggests, it is commencing from the scratch, which
never incorporates the methodology of the other types of budgeting in
determining the estimates.

– The Zero base budgeting considers the current year as a new year for
the preparation of the budget but the yester period is not considered
for consideration. The future activities are forecasted through the zero
base budgeting in accordance with the future activities.

– Shifts the burden of proof to each manger to justify why he should

spend money at all. Emphasise reason of spending.
Phases

– List objectives
– Extent of application
– Prioritise the activities
– Select and approve decision packages and finalise budget

Benefits

– It acts as guide for the management to allocate the resources more

accurately depends upon the priority for an effective implementation.
– It enhances capability of the managers who prepares the budget for
future action.
– It paves way for optimum utilization of resources available.
– t is a technique of utilitarian of the resources with reference to the
activity involved.
– It is dome shaped only towards the achievement of organizational
goals
–

Criticism

– Non-financial matters cannot be considered for the cost and benefit

analysis.
– Difficulties involved in the process of ranking of the decision
packages.
– It needs more time span for preparation and cost of operations is more
and more.
UNIT 4

Standard costing

Standard cost is a predetermined cost, which is estimated from

management’s standard of efficient operation and the relevant necessary
expenditure

– Standard costing is a tool, which replaces the bottleneck of the

historical costing.
– Historical costing is one of the tools, which fulfils the one of the
objectives of costing i.e. ascertainment of costs.
– The cost of a product can be ascertained only after the production of
a product which is historical costing .
– The ultimate aim of studying standard costing is to control the cost of
a product as one among the objectives of cost effectiveness strategy
of the business enterprise.

Only 2 possible ways to increase profit

– Increasing the selling price and keeping the cost remains the same.
– Reducing the cost and retaining the selling price as it is.

They are classified into revenue standards and cost standards.

It involves

. Material consumption
. Hours taken/consumed
. Incurring of miscellaneous expenditures - Overheads.

Steps of standard costing

– Develop pre determined standards

– Record actual costs

– Compare standards and actual cost

Standard costing starts with the preparation of standards and ends with the
comparison in between them. The preparation of standard costs is meaningful
only through the completion of variance analysis.

– Reasons for variances need to be probed and analysed to reduce cost

 –
and increase profit

Application

– Prediction of future cost for decision making

– Standard costs are set after taking all present conditions and future
possibilities into consideration. Hence, standard cost is future cost for
the purpose of cost estimation and profitability from a proposed
project/ order/ activity.

– Provides target to be achieved

– Standard costs are the target cost which should not be crossed by the
responsibility centres. Performance of a responsibility centre is
continuously monitored and measured against the set standards. Any
variance from the standard is noted and reported for appropriate
action.

– Used in budgeting and performance evaluation

– Standard costs are used to set budgets and based on these budgets
managerial performance is evaluated. This is of two benefits, one
managers of a responsibility centre will not compromise with the
quality to fulfill the budgeted quantity and second, variances can be
traced with the responsible department or person.

– Interim profit measurement and inventory valuation

– Actual profit can only be known after the closure of the accounts. But
an organisation may need to prepare profitability statement for interim
periods for managerial reporting and decision making. To arrive at
profit figure, standard costs are deducted from the revenue.

Advantages

– It serves as a basis for measuring operations’ performance and helps

control costs

– Standard costing can be used to predict costs as they usually remain

stable over a period of time. This helps in fixing a price and finding
costs of new products.

– Helps evaluate jobs and can introduce incentives

– Serves as a basis of inventory valuation

 – Helps in planning, budgeting, decision making

– Used in standardisation of products and processes

Limitations

– Variation of price - Estimation of prices is difficult. Actual prices are

not necessarily representative of cost. Price fluctuation is difficult to
adapt to

– Varying levels of output

– Changing standards of technology - if frequent changes then standard

costing is not suitable

– Have to be revised constantly

– Mix of raw materials and products may vary

– Standards may be too strict or too liberal

– Fixing standards can be costly

Labour Cost Variance Difference between standard cost
of labour and actual cost of labour.
Formula Standard cost (std hours * Std
rate) - Actual Cost (act hours* act
rate)
Reasons Comes from either difference in
labour rate or difference in number
of hours .
It can be divided into three parts Labour rate variance, efficiency
variance and idle time variance

Labour Rate Variance Difference in actual rate paid from

standard rate.
Formula Actual hours * Standard rate -
Actual hours * Actual rate
Reasons External factors, Responsibility of
personnel Manager

Labour Efficiency Variance Deviation in actual working hours

from standard working hours
Formula Standard hours*Std rate - Actual
hours*Std rate
Reasons External factors, Responsibility of
personnel Manager

Labour Efficiency Variance Deviation in actual working hours

from standard working hours
Formula Standard hours*Std rate - Actual
hours*Std rate
Reasons Ability of workers, inappropriate
team, inefficiency of foreman or
manager
Further Sub Parts
- Labour Mix Variance Change in combination of skill set
Formula New Std hours in std proportion *
Standard rate - Actual hours in
actual proportion * Standard Price

- Labour Yield Variance Variation due to productivity of

workers.
Reason Poor productivity
Formula Std hours for actual production*
actual hours - actual hours in std
proportion * Std rate

Idle Time Variance Difference between paid and

worked hours
Formula Actual hours paid *Standard rate -
Actual hours worked*Standard rate

UNIT 5

Target Costing

– Target costing is a system under which a company plans in advance

for the price points, product costs, and margins that it wants to
achieve for a new product.

– Target costing is not just a method of costing, but rather a

management technique wherein prices are determined by market
conditions, taking into account several factors, such as homogeneous
products, level of competition, no/low switching costs for the end
customer, etc.
 – When these factors come into the picture, management wants to
control the costs, as they have little or no control over the selling
price.

A market-based cost that is calculated using sales price necessary to capture a

predetermined market share is known as Target Cost.

A market-based cost that is calculated using sales price necessary to capture a

predetermined market share is known as Target Cost.

Features

– Market conditions determine product price. Company is a price taker

and not the price maker.

– Minimum profit margin is included in SP

– Product design, specs and expectations of the customer are built into
the sp

– Diff btwn current cost and trgt cost is cost reduction

Objectives

– Lower costs so req profit level can be achieved

– New prodducts should meet quality, delivery timing and price required
by the market

– To motivate all company employees to achieve target profit by making

trgt costing a companywide activity

Process

– Identifying customer needs

– Planning of selling price as per the needs
– Identifying the target cost
– Keep the price in consideration after identifying suppliers and fixing
the manufacturing process
– Compare sample product with the target and start production for
product launch

Advantages
 – Shows management commitment to improvement and competitive
advantages

– Product is created with the expectations of the consumer

– Companies operations improve and creates economies of scale

– Companies approach is market driven

– Value for money

Key Principles

– Price led costing

– Focus on the customer
– Focus on product design
– Focus on process design
– Cross functional teams
– Life cycle costs
– Value chain costs reduced

Target Pricing Method Cost-based Pricing

Prices determine costs. Costs determine price
Design is key to cost reduction. Waste and inefficiency is focus of
cost reduction efforts.
Customer input guides cost Cost reduction is not customer
reduction. driven.
Uses cross-functional teams to Cost accountants are responsible
manage costs. for cost reduction.
Supplier involved early. Suppliers involved after product
designed.
Minimizes cost of ownership to Minimizes initial price paid by
customer customer.
Competitive market considerations Market considerations not part of
drive cost planning. cost planning

Activity Based Costing

The activity-based costing (ABC) system is a method of accounting you can

use to find the total cost of activities necessary to make a product. The ABC
system assigns costs to each activity that goes into production such as workers
testing a product, setting up of machines, orders passed for purchase of raw
materials.

Steps

– Identify which activities are necessary

– Seperate each activity into its cost pool
– Assign activity cost drivers
– Divide total overhead in each cost pool by cost drivers to get cost
driver rate
– Compute the hours/units the activity used and multiply it by cost
driver rate
– Calculate cost per unit

Use of ABC

– Identifies necessary activities - shows how overhead is used

– Focus on value adding activities

– Ensures profit margin

– Product pricing - assigns costs to each activity

– Can improve productivity

– Helps in deciding Make or Buy decision

Life cycle costing

– Life cycle costing is a system that tracks and accumulates the

actual costs and revenues attributable to cost object from its
invention to its abandonment. Life Cycle Cost (LCC) of an item
represents the total cost of its ownership, and includes all the costs
that will be incurred during the life of the item to acquire it, operate
it, support it and finally dispose it.

– Total cost during its life including design etc. Enables common
ebaluation basis for specified period

Tracing of costs and revenues of a product over several calendar periods

throughout its life cycle.

Traces research, design and development costs and total magnitude of these
costs for each individual product and compared with product revenue.
Each phase of the product life-cycle poses different threats and opportunities
that may require different strategic actions.

Product life cycle may be extended by finding new uses or users or by

increasing the consumption of the present users

Includes

•Disposal cost
•Initial cost
•Installation cost
•environmental cost
•Operational cost
•Failure cost
•Maintenance cost

Product life cycle costing

Identify consumer need, invent product get it patended, develop, manufacture,

expand, competitors, product degenerated

Stages - Market research, specification, design, prototype, development,

tooling (making production line), manufacture

Purpose - Sense of total costs associated with the product, helps identify
profit. Helps identify env costs. Help identify decomissioning costs so that they
can be controlled.

Benefits - Early action, shows all factors, realistic assesment, long term
reward, overall framework

Project life cycle costing

– Costs associated with acquiring using caring for and disposing

physical assets. Estimating useful life and calculating costs over that
period

– Includes cost of research, design, testing, production or purchase of

capital equipment. Training costs, logistics, energy costs, spare parts
and disposal costs of capital equipment.

Purpose - Choose between two or more assets, determine assets benefits,

create accurate budgets

Use cases - projects are in capital intensive industry, major expansion, prone to
disruption and down time
Quality Costing

Cost of quality is the total expenses incurred by an organization in achieving

and maintaining good quality as well as in managing poor quality throughout its
line of operations with an aim of attaining the highest level of customer
satisfaction.

Cost of Conformance (COC) or Cost of Good Quality (COGQ): Can be

defined as Costs associated with doing quality job, conducting quality
improvements, and achieving quality goals. These are the costs that aim at
assurance of quality and prevention of bad quality.

– Cost of Assurance : These costs are associated with the control

measures and audits to ensure appropriate quality standards are used
and complied such as money spent on establishing methods and
procedures; Process Capability Studies; robust Product Design;
proper employee training, supplier rating / supplier certification
Quality audits, acquiring tools, and planning for quality. Quality
assurance provides confidence in the system that ensures quality of
deliverables.

– Cost of Prevention: The costs that arise from efforts to keep defects
from occurring at all- prevent errors to happen and to do the job right
the first time. Prevention costs may include Costs of Verifications –
checking of incoming material, processes etc. Preventive
Maintenance; Calibration of measuring and test equipment etc. These
are planned and incurred before actual operation and money is all
spent before the product is actually built. The focus on prevention
tends to reduce preventable costs of bad quality.

Cost of Non-Conformance (CONC) or Cost of Poor Quality (COPQ) is the

costs associated with all activities and processes that do not meet agreed
performance and / or expected outcomes. These costs would disappear if every
task were always performed without deficiency. These costs have two sub-
divisions: Cost of Appraisal and Cost of Failure.

– Cost of Appraisal: Money spent to review completed products

against requirements. Appraisal includes the cost of inspections,
testing, and reviews. This money is spent after the product is built but
before it is shipped to the user or moved into customers place. They
could include: inspection of finished goods, field testing, pre- dispatch
inspection, checking the shipping documents before dispatch

– Cost of Failure: All costs associated with defective products

–
produced and or that have been delivered to the user

– Internal faliure costs – These are the Costs generated before a

product is shipped but after a product is made and inspected and
found non-conformance to requirements, such as – Product/service
design failure cost

– External faliure costs - Costs generated after a product is shipped as a

result of non-conformance to requirements, such as Complaint
investigation/customer service; Returned goods;