INTRODUCTION (03)

WHAT IS COST & MANAGEMENT ACCOUNTING?

CIMA London has defined, Management Accounting as an integral part of management
concerned with identifying, presenting and interpreting information used for,
i) Formulating strategy
ii) Planning and controlling activities (ex. of Fiat, Planning & Control)
iii) Decision making
iv) Optimizing the use of resources
v) Disclosure to shareholders and other external to the entity
vi) Disclosure to employees
vii) Safeguarding assets
The Institute of Cost Accountants of India has defined Management Accounting as a system
of collection and presentation of relevant economic information relating to an enterprise for
planning, controlling and decision making.

Management Accountant is often considered as Controller rather than a compiler.

One of the leading Cost & Management accountant in Mumbai once defined
COST as Commercially Oriented Strategies and Tactics; the strategies and tactics
company should follow to reach on the top along with commercially oriented approach.
Management Accounting has emerged as a key element to attain and sustain a strategic
competitive advantage through long-term anticipation and formation of costs level, costs
structure, and costs behavior pattern for products, processes, and recourses. For this purpose,
management accounting must provide managers with different information. Strategic cost
management sees products, processes, and resources themselves as creative objects for
attaining a strategic competitive advantage. This goal may not be achieved based on
traditional cost management. It is also argued that strategic cost management must determine
and analyze long term cost benefits by way of economics of scale, experience, etc. and their
impact on costs level, costs structure, and costs behavior pattern.
The ultimate aim of any business is to strengthen its bottom line and improve its top line so as
be competitive in the market. Hence, the strategy and the cost management should be such
that it helps the company in achieving its goal.

Nature Management Accounting:

1) Useful in decision making
2) Financial and Cost information
3) Internal use
4) Purely optional
5) Concerned with future
6) Flexibility in presentation of information: (eg.: L&T internal task, FIAT Budget)

Scope of Management Accounting:

1) Financial accounting
2) Cost accounting
3) Budgeting and forecasting
4) Tax planning (eg. MNCs Vs. Family owned)
5) Reporting to management
6) Cost control procedures
7) Statistical tools
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 8) Internal control and internal audit
9) Financial analysis and interpretation
10) Office services

Functions / objectives of Management accounting:

1) Planning
2) Coordinating
3) Controlling
4) Communication
5) Financial analysis and interpretation
6) Qualitative information
7) Tax policies
8) Decision making

Differentiation between Cost Accounting and Management Accounting:

Basis Cost Accounting Management Accounting

1. Scope Limited to providing cost Broader than cost accounting as it
information for managerial provides all types of information ,
uses. i.e., cost accounting as well as
financial accounting information
for managerial uses.
2. Emphasis On cost ascertainment and cost On planning, controlling and
control to ensure maximum decision making to maximize
profit. profit.
3. Techniques Include standard costing and Also uses all these techniques but
employed variance analysis, marginal in addition it also uses techniques
costing & cost volume profit like ratio analysis, fund flow
analysis, budgetary control, analysis, statistical analysis,
uniform costing & inter-firm operations research and certain
comparison. techniques like mathematics,
economics etc., whosoever can
help management in its tasks.
4. Evolution Mainly due to the limitations of Due to limitations of cost
financial accounting. accounting. It’s an extension of
the managerial aspects of cost
accounting.
5. Statutory Maintenance of cost records has Voluntary and its use depends
requirements been made compulsory in upon its utility to management.
selected industries as notified
by the Govt. from time to time.
6. Database Based on the data derived from Based on the data derived from
financial accounts. cost accounting, financial
accounting and other sources.
7. Installation Can be installed without Can’t be installed without a
management accounting. proper system of cost accounting.

COST CENTER, COST UNIT, COST CONTROL & COST REDUCTION

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Cost center means a department or a center against which the costs are collected. In an ERP
environment, any accounting entry passed in the systems needs to be supported by the cost
center. Unless the cost center is mentioned, the accountant can’t pass the entry in ERP. With
the help of cost center wise expenses report, the CMAs analyze, monitor and control the
department wise expenses. Any department spending more money than the budget or
spending more money over previous year is asked to explain the reasons for such extra
spending. Such extra spending needs special approval from the top management.
The cost centers are bifurcated into 1) Manufacturing cost centers (responsible for
manufacturing activity) 2) Service/utility cost centers (provides support service to the
manufacturing activity).
For example: Manufacturing cost centers are, Sugar solution, Beverage mixing, Beverage
preparation (flavor), Bulk beverage, packing etc.
Service cost centers are, Maintenance, Power, Steam, Finance, Human resources, Information
technology, Security, Purchases etc.
The above mentioned service cost centers provides services to the manufacturing cost centers
hence, their cost is charged to the manufacturing cost centers on the pre-determined logic.
With this, we have reached a stage where we need to understand the most important concepts
in cost accounting i.e. allocation, apportionment & absorption of overheads. In practical
life, allocation and apportionment are the terms used as alternative to each other conveying
the same meaning of distributing the cost. But technically, these two terms are different.

A Cost Center
- A responsibility center incurring only expense (cost) items and producing no direct revenue
from the sale of goods or services. A department where costs are accumulated.
- Managers are held responsible only for specified expense items.
- The appropriate goal of an expense center is the long-run minimization of expenses.
- Short-run minimization of expenses may not be appropriate.
Outside of relatively large corporations, the cost center is the most common building block
for responsibility accounting. In fact, the terms cost center and responsibility center are often
used interchangeably.
Cost Unit: Cost unit is a form of measurement of volume of production or service. This unit
is generally adopted on the basis of convenience and practice in the industry concerned. For
e.g.: Per Pack, Per Carton, Per Tablet, Per Capsule, Per Car, Per Student, Per Bottle, Per
Tetra-pack, Per KWH, Per Liter., Per Hour, Per Man-hour etc.
The Cost Units and Cost Centers should be those which are natural to the business and which
are readily understood and accepted by all concerned.

Cost Control:
CIMA London has defined cost control as, “the regulation by executive action of the cost of
operating an undertaking particularly where action is guided by cost accounting’. Cost
control is simply the utilization of the available resources economically and prevention of the
wastage within the existing environment. It is the function of keeping costs within the
prescribed limits based on the established norms, compare the actual cost incurred with the
norms and take corrective actions in case of cost overruns.

Cost Reduction:
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CIMA London has defined Cost reduction as ‘the achievement of real and permanent
reduction in the unit cost of goods manufactured or services rendered without impairing their
stability for use intended. Cost reduction should be real, measurable, and sustainable and
must impact the profitability in significant way. With the application of cost reduction
measures, the company must ensure that the quality of the product or service is not
compromised as it may affect the goodwill in the market and effectively have a negative
impact on the profitability.
Areas of Cost Reduction:
1) Material cost: Rate contracts, Alternate suppliers etc.
2) Labor cost: Redeployment of labor.
3) Wastage reduction: Tracking of rejections as compared to standards. Set challenging
standards.
4) Overhead control: By setting limits and stringent budgetary control.
5) Product design: Change in product design without compromising the quality.

Classification of costs: Costs are divided into 3 broad elements; 1) Material 2) Labor 3)
Overheads

Material cost is further divided into Direct Material & Indirect Material. Direct Material is a
material that directly goes into the product and is major ingredient of the final product, eg. :
Mango Pulp, Sugar, Preservatives in the manufacturing of mango based beverage drink.
Packing material is also treated as direct material as the final product directly goes into the
packing material, eg.: Tetrapak, PET bottles, cartons, labels in the manufacturing of mango
based beverage drink.
Indirect materials are some kind of chemicals or other fringe materials those are used as
support materials. These materials are not part of recipe of the product.

Labor cost is further divided into Direct Labor & Indirect Labor. Direct labor is a person
who works directly in the manufacturing plant on the manufacturing machine. His wages are
based on output. The more he produces the more wages he earns and vice versa. Indirect
labor is a person who works in support function to direct labor like loading unloading of
material etc. His wages are generally fixed and not related to variation in the output.

eg.: Person working on beverage manufacturing can be called as direct labor whereas the
person working as helper or maintenance man can be treated as indirect labor.

Direct Expenses are expenses directly related to the product for eg. Royalty paid for
manufacturing the mango based beverage on behalf of the principal owner, cost of tools, dies,
moulds in Preform (PET Bottles) manufacturing etc.

Other than Direct material, direct labor and direct expenses all other costs are treated as
Overheads. Even Indirect material and indirect labor is treated as Overheads. Overheads are
basically expenses from P&L debit side (other than direct material, direct labor, direct
expenses) which are bifurcated into factory, administration and selling & distribution. This
category is called as overheads as these expenses are “Over the Head” means they are over &
above the direct costs.

Factory overheads are the overheads incurred within the factory gate other than the direct
costs. These overheads are incurred for keeping the plant and manufacturing process
operational. E.g.: Power & fuel, Repairs & maintenance, Stores & spares, Consumables,

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salaries & wages, local conveyance, telephone expenses and notional costs like depreciation
etc.

Administration overheads are the overheads of corporate office from where the controllers
of business actually manage the show like the Chairman, Managing Director, CEO, CFO,
CMO etc. eg.: Electricity cost, Repairs & maintenance, salaries & wages, local conveyance,
telephone expenses and notional costs like depreciation.

Distribution overheads are the overheads incurred on the route from the factory to the
market place. These overheads are incurred for distributing the product and making it
available in the market for sale. Eg.: Godown rent, repairs to delivery van, depreciation on
delivery van, salary of the driver, electricity consumed at own godown, telephone expenses
etc. Selling overheads are the overheads incurred for making the manufactured & distributed
product saleable in the market. For eg.: Schemes, marketing spends, salary of salesman,
commission to salesman, sales office expenses, advertising & media expenses, commission to
distributor etc. Selling and distribution overheads are collectively called as S&D overheads.
These are post manufacturing expenses incurred for distributing and selling the product in the
market.

The chart mentioned below will clear the flow of costing process:

From the academics point of view the above concepts are discussed in brief. The same are
discussed in details in next modules along with its practical application in the corporate
world. The role of Management Accountant is very crucial from the growth point of view.
The tag line of the Institute of cost accountants of India says “Behind every successful
decision, there is a CMA”. So your role will be of a Controller than of a Compiler.

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BUDGETING (12)

BUDGETARY CONTROL
Budgetary control and MIS are closely related though the processes for both are entirely
different. While both the topics deals with the profitability and financial position of the
company, budgetary control speaks about the estimated or forecasted financial statements
whereas the MIS deals with the actual financial reporting and its comparison with budgets.
Now let’s see this in details.
BUDGETARY CONTROL:
To budget means to plan the future. Almost all the companies they have the system of
planning the next years financial performance and comparing the actual performance against
the budget. There are some MNCs who prepare their budgets for next year and plan for next 2
to 3 years based on the available information. This helps company in two ways, 1) The road
map is clear for next year (and possibly for next 3 years) 2) Control over actual expenses
against budgets, this helps in cost control, cost reduction and maximizing the sales and
ultimately the bottom line (i.e. profit).
Now let us see the process of budgeting, the budgeting process starts generally in the month
of October in case the accounting year is April-March. Most of the MNCs they strictly adhere
to the deadlines based on their parent company calendar whereas for few Indian companies,
the budget process is on even after the budget year has begun. For some Indian companies,
budgeting is just a formality where in actuals will have no connection to budgets. This may
be due to bad corporate governance or may be due to the fast changing nature of the market
& business. Eg.: In one of the leading automotive graphics company, the budgets are not
adhered to as the market situation may change drastically due to change in customer’s
requirements & plans.

The above diagram explains the flow of budgetary control process. In some MNCs, rolling
forecasts are prepared i.e. if 5 months of actual period are over than the rolling forecast is
prepared based on 5 months actuals and 7 months estimates. The advantage of rolling
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forecast is you can realign your estimates for 7 months based on actual scenario during 5
months actuals. First 5 months actual data can be a roadmap as to how next 7 months are
going to be. This gives more realistic view of how the company is going to end the financial
year. These forecasts generally are F5+7, F6+6, F8+4, F10+2 etc. The budgeted P&L account
is as under. Some companies prepare the budgeted balance sheet also specially for planning
the cash flow for the future but generally, the companies monitor their profitability based on
budgeted P&L account.

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At times especially in MNCs, two sets of budgets are prepared, the formal budget and the
internal task budget. Internal task budget for expenses will be slightly lower than the formal
budget so as to put pressure on the user departments. User department will get the sanction
for say Rs.80 against the actual sanction of Rs.100. Finance department will apply pressure
on user department saying that the expenses should be within Rs.80. If actual expenditure is
say Rs.85 then the user department will be asked to explain the reasons for overspending
whereas while reporting to the parent company management, Indian arm will report saving of
Rs.15 against the formal & original budget.

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Objective of budgetary control:

1) Planning: Planning is an important managerial function. It helps to decide in advance,

what to do, how to do, when to do and who is to do it. Planning thus, helps the
managers to anticipate eventualities, prepare for contingencies for achieving the
ultimate goals. Budget preparation drives the managers to plan ahead. Manager
express their operational plans for anticipated business conditions. Without a formal
procedure of budgetary control, many operating managers will not find the time to
plan ahead. Thus, budgeting is an important planning device.

2) Communication: The employees of an organization should know organizational aims,

objectives of sub-units (budget centers) and the part that they have to play for their
attainment. Budgets effectively communicate this information to employees. Besides,
budgets keep different sections of the organization informed about the contribution of
different sub-units in the attainment of overall organizational objectives.
3) Coordination: To coordinate is to harmonize all the activities of a company so as to
facilitate its working and its success. Coordination will lead to following results:
a) Each department will work in harmony with others
b) Each department will know the specific role that it has to play in the
accomplishment of overall organizational objectives
c) The sequential arrangement of activities of different departments is so governed
that overlapping activities and wastage of time and labor is avoided.

A comprehensive system of budgeting helps to coordinate different functional

budgets, in other words, a budget will preclude the production department from
producing more than the sales department can sell.

4) Motivation: To motivate means to cause to act. If employees have actively

participated in budget preparation and if they are convinced that their personal
interests are closely associated with the success of the organizational plan, budget
provides motivation in the form of goals to be achieved. Whether the budgets will
motivate the workers, depends on purely on how the workers have been mentally and
physically involved with the process of budgeting.
5) Control: Under the system of budgetary control, budget forecast is thoroughly
discussed and reviewed to be finally approved as functional budgets. Thereafter, a lot
of ‘cuts’ and ‘ adjustments’ are made to make functional budgets fit in the
organizational objectives. Then budget formation is followed by a feedback system to
pinpoint the extent of variation between the actual level of performance against the
budgeted level of performance. Thus, inbuilt mechanism of the routine of budgetary
control is bound to precipitate to an operational control.
6) Approved plan: A master budget provides an approved summary of result to be
expected from proposed plan of operations. If concerns all functions of organization
and serves as a guide to executives and departmental heads responsible for various
departmental objectives.

Requirements of good budgeting system:

1) Budgeting process should be backed and supported by the CEO of the organization.

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 2) The organizational goals should be quantified and clearly stated. These goals should
be within the framework of organization’s strategic and long range plans.
3) The organizational goals must be divided into functional goals.
4) The functional goals should not conflict with organizational goals.
5) The persons responsible for execution of budget should participate in budget
preparation.
6) The entire organization should mentally accept the budget exercise.
7) The budget should be realistic. It should represent goals that are reasonable attainable.
8) The budget should cover all the phases of the organization.
9) The budgeting and controlling should be a continuous exercise.
10) The most important part is to capture the actual against the budget and report the
variances and analyze the reasons for abnormal variations.
11) Clear cut organizational lines should be established with appropriate delegation of
responsibilities for effective budget implementation.
12) The budgetary system should be based on information, communication and
participation.

Advantages of Budgetary control

1) A budget program forces the managers to plan ahead

2) It forces early consideration of basic policies
3) All members of top management participate in budget committee. For this reason
even planning at departmental level gets benefits of experience of seasoned
executives.
4) All functional heads are compelled to make plans in harmony with the plans of other
departments
5) Management is forced to put down in cold figures, what it means by satisfactory
results.
6) It demands most economical use of labor, materials and facilities and capital
7) It inculcates a habit of timely, careful, adequate consideration of all factors before
reaching important decisions.
8) The use of budgets removes clouds of uncertainties over lower levels of management
regarding basic policies and objectives.
9) The use of budgets promotes understanding of the problems of co-workers.
10) It facilitates periodic self-analysis of the organization.
11) It aids in obtaining bank credit.
12) Management is forced to give timely and adequate attention to the effect of changing
business conditions.
Limitations of budgetary control
1) Estimates are used as basis for budget plan and estimates are based mostly on
available facts and best managerial judgement. Since a lot of human element is involved
in exercising managerial judgement, it is but natural to give some allowance in
interpretation and utilization of estimated results. Budgeting based on inaccurate
forecasts is useless as a yardstick for measuring the actual performance.
2) The circumstances are constantly changing and therefore, budgets and budgetary
techniques will not be useful till they are continually adapted.
3) In order that a system may be successful, adequate budget education should be
imparted at least through the formative period. Sufficient training programs should be
arranged to make employees give positive response to budgeting activities.
4) Execution of budgetary control will not automatically occur. A continuous budget
consciousness throughout the organization is needed for achievement of this objective.
5) Budgetary control cannot reduce the managerial function to a formula. It is only a
managerial tool which increases the effectiveness of managerial control.
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 6) The use of budgets may lead to restricted use of resources. Budgets are often taken as
limits. Efforts may, therefore, not be made to exceed the performance beyond the
budgeted targets, even though it may be physically possible due to change in business
environment.
7) Frequent changes may be called for in budgets due to fast changing industrial climate.
It may be difficult for a company to keep pace with these fast changes, because revision
of budget is an expensive exercise.
8) Non availability of system to track the actual performance against the budget and
analysis of variances makes the budgetary control system a big failure, restricted only to
mere formality.

Cash Budget

▪ Tracks all the cash payments and receipts

▪ Helps in maintaining adequate liquidity as required for smooth operations

▪ All the investments and divestments can be planned based on the cash-flow positions

▪ Cash transactions are pooled under the following heads:

• Receipts include all cash inflows (sales, interest income, dividend received)

• Disbursements include all cash outflows (salaries & wages, power & fuel,
general exp etc.)

• Cash Surplus/Deficit :

– Opening balance + Cash receipts – Cash disbursements –

desired closing balance.

Operating
Budget

Sales Budget

Production Budget
Financial Budget
Direct Material Budget
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Direct Labor Budget

Cash Budget
 – Surplus can be invested and deficit needs to be funded.
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 • Financing: arranges funding in case of shortfall and looks for investment
vehicles to park surplus funds.

▪ Cash flows forecast need to be accurate for the smooth business operations. To
forecast collection of sales proceeds, companies analyze account receivable’s pattern
and prepare Pro-forma cash receipt and pro-forma cash disbursement.

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Approac Project Activity Incrementa Z-Based Continuous Flexible
h Based l

Method A project’s Breaks the Uses Evaluates A new Apart from a

revenue process previous every activity month/quarte base budget,
and costs into year as thoroughly r is added as flexible
can be multiple reference a budgets are
identified activities and modify month/quarte prepared at diff
separately and it slightly r ends output levels
estimate
their cost
Positives Easy to Higher Simple & Only feasible Long term More useful
check the accuracy easy activities are decision than static
feasibility continued making budget
Negatives Subjectivit Time- Ignores Overspending Time- More of a
y in consumin thorough consuming complementar
Shared g and review y tool
cost expensive
allocation

Approval from
Unit heads and
Create Master Budget Company
and sub-budgets for Management
each Dept/sub-unit before finalization

Evaluate actual
Collect feedback performance against
and revisit the Budgeted on
Budget Cycle monthly/qtrly basis
budget if required

Take corrective
steps where Examine
possible reasons for
variations for
each sub-unit

STANDARD COSTING & VARIANCE ANALYSIS (13)

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Standard Costing (Material, Labor, Overhead, Sales & Profit)
Standard costing, according to CIMA (London): “Standard costing is a control technique
which compares standard costs and revenues with actual results to obtain variances which are
used to stimulate improved performance.” Use of standard costing is not confined to
industries having repetitive processes and homogenous products only. This technique has
established the advantages of its use in industries having non-repetitive processes like
manufacture of automobile, turbines, boilers etc.
Variance analysis, in budgeting (or management accounting in general), is a tool of budgetary
control by evaluation of performance by means of variances between budgeted amount,
planned amount or standard amount and the actual amount incurred/sold. Variance analysis
can be carried out for both costs and revenues. The concept of variance is intrinsically
connected with planned and actual results and effects of the difference between those two on
the performance of the entity or company. Variances can be divided according to their effect
or nature of the underlying amounts.
When effect of variance is concerned, there are two types of variances:
• When actual results are better than expected results given variance is described as favorable
variance. In common use favorable variance is denoted by the letter F - usually in parentheses
(F). A favorable variance might mean that: Costs were lower than expected in the budget, or
Revenue/profits were higher than expected.
• When actual results are worse than expected results given variance is described as adverse
variance, or unfavorable variance. In common use adverse variance is denoted by the letter u
or the letter A - usually in parentheses (A). an adverse variance might arise because Costs
were higher than expected or Revenue/profits were lower than expected.
All adverse variances are not bad and all favorable variances are not indicators of
efficiency in operation - An adverse variance might result from something that is good that
has happened in the business. For example, a budget statement might show higher production
costs than budget (adverse variance). However, these may have occurred because sales are
significantly higher than budget (favorable budget). In a standard costing system, some
favorable variances are not indicators of efficiency in operations. For example, the materials
price variance, the labor rate variance, the manufacturing overhead spending and budget
variances, and the production volume variance are generally not related to the efficiency of
the operations. On the other hand, the materials usage variance, the labor efficiency variance,
and the variable manufacturing efficiency variance are indicators of operating efficiency.
However, it is possible that some of these variances could result from standards that were not
realistic. For example, if it realistically takes 2.4 hours to produce a unit of output, but the
standard is set for 2.5 hours, there should be a favorable variance of 0.1 hour. This 0.1 hour
variance results from the unrealistic standard, rather than operational efficiency.
Remember, it is the cause and significance of a variance that matters –not whether it is
favorable or adverse.

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Need for standard costing:
The following limitations of traditional or historical costing have necessitated the emergence
of standard costing:
1) Since historical costs are reported to the management after they are incurred, it
becomes a post mortem job for the management to resolve an issue. The data received
is not useful for any correction as the event is over before it could be repaired.
2) The actual cost may be excessive due to inefficient use of materials, wastage,
rejections, idle time, unwanted expenditure etc. Historical costing does not provide a
yard-stick or parameter to judge the performance of the concern department. There
are no standards available for management to compare, analyze the variance about
existence of such historical cost. Standard costs are not actual but pre-determined
costs. Hence, management can use standard costs to control the actual costs, calculate
variances, analyze the variances, and quote prices or to plan the production schedule.
Management can find out whether the actual costs are reasonable or excessive as
compared to the pre-determined standards.
Advantages of standard costing:
1) Standard costing enables the management to compare actual costs with standard costs
in order to control actual cost as and when they occur.
2) Standard cost act as the yardstick for evaluation of performance of a company.
Standard cost denote what the costs ought to be. Variances are analyzed to control
wastages and inefficiencies.
3) Prompt evaluation of the performance with respect to standard is done so as to take
corrective action.
4) Standard costing is excellent tool for management planning, it helps during the
formulation of budgets.
5) It acts as stable base for fixation of selling price.
6) Establishment of standard costing system involves a deep study of process of
production, setting up different standards for input and output, labor efficiency,
budgeted overheads etc. In other words, it takes the company towards standardisation
and perfection.
7) It fixes responsibility and accountability for variances.
8) Modern day management is more keen on receiving exception reports where in
abnormalities in the process are surfaced and rectified. Standard costing act as a tool
for this.
9) Standards are set as powerful incentive to work harder and achieve the goals.
10) It simplifies the accounting transactions and audit. Auditors develop confidence in
system if the proper standard costing system is in place.
Limitations of standard costing:
1) Establishment of standards may demand lot of skill, imagination and experience. If all
these factors are not in harmony, desired results will not be forthcoming.
2) Variance analysis is useful, whereas deviations are linked with responsibilities.
Sometimes, it is difficult to fix responsibility because the result happens to the
outcome of a number of contributory factors.
3) Standards should correspond to current conditions for best results. Current conditions
change very rapidly. Revision of standard is a costly exercise and leads to a lot of
associated problems. For this reason, revision of standards may get ignored. This
delay may be disastrous for effectiveness of the system.
4) It is difficult to use standard costing, when working conditions do not permit
standardization of material contents, labor contents or the use of indirect services
relating to different jobs, processes and services.
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 5) Lack of interest by appropriate level of management renders the use of standard
costing ineffective.
6) Isolating the controllable and uncontrollable elements of variances is a very difficult
exercise and this difficulty restricts the application of standard costing.
7) Sometimes, use of standard costing creates adverse psychological effects, if standards
are set very high.
Total Standard cost for a product includes,
a) Standard material cost
b) Standard labor cost
c) Standard variable overhead cost
d) Standard fixed overhead cost
The standard is always set with respect to actual quantity of output.
(A) Material Cost Variance
Standard cost of material is determined with two components of cost
1) Determination of standard quantity of materials
Fixing standard quantity of each raw material is a highly technical matter. Quantity
standards are fixed by technical people involved in production activity. Standards are
fixed for the quantity of input for obtaining the desired output after considering the
normal loss, rejection, wastage etc.
2) Determination of standard price of materials
Standard price of raw materials is determined by the finance manager in consultation with
the purchase manager. The standard price is fixed on the basis of historical prices or
expected prices in near future. The expected price needs to be fixed after considering the
existing stock levels of the same material and the open purchase orders.

Material Cost Variance (MCV):

It represents the difference between actual cost of material used and standard cost of material
specified for output achieved. Material cost variance arises due to variation in prices and
usage of materials
Material Price Variance (MPV):
Material price variance is that part of material cost variance which is due to difference
between actual price paid and standard price specified for the material. It represents the
difference between standard cost of actual quantity purchased and actual cost of these
materials. Although material price variance may not be controllable, it provides management
with important information for purposes of planning and decision making. The knowledge of
this variance may prompt the management to increase product price, use alternate material or
find offsetting sources of cost reduction.
Material Usage Variance (MUV):

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It is also referred to as quantity variance. It is that part of material cost variance which is due
to difference between actual quantity used and standard quantity specified for output. This
indicates whether or not material was properly utilized. A debit balance of material usage
variance indicates that material used was in excess of standard requirements. A credit balance
will indicate saving in the use of material. Material usage variance is further bifurcated into
Material Mix variance and Material Yield variance.
Material Mix Variance (MMV):
This variance is that part of material usage variance which is due to difference between actual
composition of mix and standard composition of mixing the different types of materials.
Short supply of a particular material is often the most common reason for material mix
variance.
Material Yield Variance (MYV):
In certain industries, it is possible to lay down that output will be a particular percentage of
total input of material. In a particular situation, it may be given that normal loss in production
will be 20% of input of material. In a case like this, 80% of the total input of material will be
the yield specified. If actual yield obtained happens to be different from the standard yield
specified, there will be a yield variance which is due to difference between actual yield
obtained and standard yield specified.
Calculation Trick for Material Cost Variance

MCV= Material Cost Variance

MPV= Material Price Variance
MUV= Material Usage Variance
MMV= Material Mix Variance
MYV= Material Yield Variance
SQ= Standard Quantity
AQ= Actual Quantity
RSQ= Revised Standard Quantity
SR= Standard Rate
AR= Actual Rate
(B) Labor Cost Variance
The establishment of standard labor cost means fixing the standard time and the standard rate
of wages. Standard time is fixed as the expected time required for the worker to complete a
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job or to produce one unit of output. Standard rate is calculated by the accounts manager in
consultation with the personnel manager. It is mainly based on past data after giving effect to
inflationary trends.

Labor Cost Variance (LCV):

It represents the difference between actual wages paid and standard wages specified for the
production. Standard wages specified for the production represents the wages which should
have been paid according to standard specification for production achieved. Standard wages
specified for production can be determined by multiplying standard labor cost per unit and
units produced.
Labor Rate Variance (LRV):
It is that portion of labor variance which is due to difference between actual wage rate paid
and standard wage rate specified. It represents difference between actual payment to worker
for actual hours worked and payment involved if the worker had been paid at standard rate.
Labor Efficiency Variance (LEV):
It is that part of labor cost variance which is due to difference between actual hours paid and
standard hours allowed for output achieved.
Labor Mix Variance (LMV) (Gang Composition):
It is that portion of labor efficiency variance which is due to difference between actual
composition of gang used and standard composition specified for a gang. A need to change
the composition of a gang may arise due to shortage of a particular grade of labor.
Labor Yield Variance (LYV):
It is that part of labor efficiency variance which is due to difference between actual output of
worker and standard output of worker specified. There will be no difference between labor
efficiency variance and labor yield variance if efficiency variance had been exclusively due
to difference between actual level of performance of workers and standard level of
performance of workers.

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Calculation Trick for Labor Cost Variance:

LCV= Labour Cost Variance

LRV= Labour Rate Variance
LEV= Labour Efficiency Variance
LMV= Labour Mix Variance
LYV Labour Yield Variance
SH= Standard Hours
AH= Actual Hours
RSH= Revised Standard Hours
SR= Standard Rate
AR= Actual Rate

(C) Overhead Cost Variance

(C1) Variable Overhead Variance:

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Calculation Trick for Variable Overhead Variance:
V01= Actual overheads incurred (it is normally given)
V02= Actual hours worked at standard variable overhead rate (Standard variable overhead
rate per hour x Actual hours worked)
V03= Standard variable overhead for the production. (Standard or budgeted variable
overhead per unit x actual production)
Variable Overhead Variance: It represents the difference between actual overhead incurred
during the period and standard variable overhead for production. Difference between V01 &
V03 is variable overhead variance.
Variable Overhead Expenditure Variance: It is that portion of variable overhead variance
which arises due to difference between actual variable overhead and standard variable
overhead appropriate to the level of activity attempted. Difference between V01 & V02
represents variable overhead expenditure variance.
Variable Overhead Efficiency Variance: Some accountants try to determine variable
overhead efficiency variance like labor efficiency variance. The variance will be difference
between actual hours worked at standard variable overhead rate and standard variable
overhead for production. Difference between V02 & V02 represents variable overhead
efficiency variance.
(C2) Fixed Overhead Variance:
Fixed overhead variance arises when a company uses absorption standard costing system.
Under this system, a standard rate is developed for fixed overhead by dividing the total fixed
overhead by a suitable base like labor/machine hours/ number of units etc. Fixed overheads
incurred differs from standard allowance for fixed overhead or standard fixed overhead for
production for various reasons which gives rise to different kinds of fixed overhead
variances.

Calculation Trick for Fixed Overhead Variance:

F01= Actual Fixed overhead incurred
F02= Budgeted fixed overhead for the period or standard fixed overhead allowance
It represents the amount of fixed overhead which should be spent according to budget or
standard during the period. The amount is predetermined for finding out the fixed overhead

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rate for the related period. The amount of standard allowance for fixed overhead does not
change due to change in volume.
F03= Fixed overhead for the days/ hours available at standard during the period.
The related period may be given in terms of days/ hours. The value of this step is found out
by multiplying days/hours available and standard overhead rate.
F04= Fixed overhead for actual hours worked at standard rate
In actual working conditions, hours worked and hours available during the period may be
different due to strike, lockout etc. Therefore, value of F04 can be determined by multiplying
actual hours worked and standard rate.
F05= Standard fixed overhead for production
It is different from budgeted fixed overhead for the period or standard fixed overhead
allowance. It is arrived at by multiplying the actual production and standard rate. Standard
and fixed for production denotes the amount which should have been incurred for the
production if standard relating to fixed overhead had been adhered to. The standard fixed
overhead for production can be found out by i) Unit method: Actual production in units x
standard fixed overhead rate per unit ii) Hour method: Actual production in standard hours x
standard fixed overhead rate per hour.
Fixed Overhead Variance:
It represents the difference between actual fixed overhead incurred and standard cost of fixed
overhead absorbed. It can also be referred to as the difference between actual fixed overhead
incurred and standard fixed overhead for production. Difference between F01 & F05 will be
fixed overhead variance.
Fixed Overhead Expenditure Variance:
It is that part of fixed overhead variance, which is due to difference between actual fixed
overhead incurred and budgeted fixed overhead or the standard allowance for fixed overhead.
This variance indicates difference between actual fixed overhead incurred and budgetary
estimates of what should have been spent. It highlights how far the budgeted overhead for the
period has been taken care of. It is also referred to as budget variance. Difference between
F01 and F02 will be fixed overhead expenditure variance.
Fixed Overhead Volume Variance:
It is that part of fixed overhead variance which is due to difference between budgeted fixed
overhead for the period and standard fixed overhead for actual production. This variance
indicates how far the plant and facilities have been under/ over utilized compared to budgeted
level of operation. Difference between F02 & F05 will be fixed overhead volume variance.
Fixed Overhead Calendar Variance (days) or Idle Time Variance (hours):
Calendar variance is that part of fixed overhead volume variance which is due to difference
between budgeted fixed overhead and fixed overhead for days available during the period at
standard rate. This variance arises due to difference between days in budgets and days
actually available during the related period. Calendar variance represents difference between
Budgeted fixed overhead and fixed overhead for days available during the period at standard
rate. It is calculated as difference between F02 & F03
Fixed Overhead Capacity Variance:
It is that part of fixed overhead variance which arises due to difference between capacity
utilized and planned capacity or available capacity. It represents difference between budgeted
fixed overhead or standard fixed overhead for days/hours available at standard rate and fixed

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overheads for actual hours worked at standard rate. It should be remembered that difference
between budgeted capacity and capacity available gives rise to capacity variance. Adverse
capacity variance indicates that available capacity has not been fully utilized. It will lead to
unabsorbed fixed overheads. Favorable variance indicates that the actual production has
exceeded standard capacity which means fixed overheads are over-absorbed. It is calculated
as difference between F03 & F04.
Fixed Overhead Efficiency variance:
It is that portion of volume variance which reflects increased or reduced output arising from
efficiency being above or below standard. This is the difference between budgeted or
standard efficiency and actual efficiency in utilization of fixed common facilities. A
supervisor is responsible for the efficient utilization of space, equipment and fixed overhead
facilities. If he is able to utilize the facility more than expected in standard, the result will be
favorable and vice versa. It is a barometer by which management comes to know how
efficiently or inefficiently fixed indirect facilities are being used. It represents difference
between F04 & F05.
(D) Sales Variance
Variance analysis would be incomplete if along with cost variances, sales variances are not
analyzed. Since Standard Sales Less Standard Cost = Standard Profit, the difference between
standard and actual profit requires analysis of cost as well as sales variances.
Calculation Trick for Sales Variance:
Adverse and favorable rules shall be exactly opposite that of material cost variances.

Sales Value Variance (SVV):

Sales value variance is said to be favorable when the actual sales are more than the budgeted
sales and adverse when the actual sales are less than the budgeted sales. This variance is
caused by the variations in the quantity sold and the price.
Sales Volume Variance (SVOLV):

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Sales volume variance is said to be favorable when the actual quantity sold is more than the
budgeted quantity and adverse when the actual quantity sold is less than the budgeted
quantity.

Sales Price Variance (SPV):

This variance is reported when there is a variation in the budgeted selling price and actual
selling price. When actual selling price is more than the budgeted selling price the variance is
said to be favorable and if the actual selling price is less than the budgeted selling price, the
variance is reported as adverse.
Sales Mix Variance (SMV):
Sales mix variance is that portion of sales volume variance which is due to the difference
between the budgeted sales mix and the actual sales mix. Sales mix variance is said to be
favorable when the actual mix is more than the budgeted mix. It is said to be adverse when
the actual sale quantity is less than the revised quantity.

(E) Sales Margin Variance (Profit Variance)

For the purpose of computation of variances, all costs are to be taken at standard cost. This is
done because extraction of all the differences between planned costs & actual costs is done
by the cost variance analysis.

Total Sales Margin Variance (TSMV):

This is the basic variance by which the difference between the budgeted profit & actual
profit is represented. The formula is:

Budgeted profit – Actual profit at standard purchase price

This basic variance has two components (a) sales margin price variance, & (b) sales
margin volume variance.
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Sales Margin Price Variance (SPMV):

The effect of a change in selling price on profits, other things being at standard is
represented by Sales Margin Price variance. The formula is:

Standard Profit – Actual Profit

Or, (Actual quantity sold * Standard profit per unit) – Actual profit
Or, (Standard profit per unit – Actual profit per unit) * Actual quantity sold

Sales Margin Volume Variance (SMVV):

The difference in price resulting from a change in sales volume is shown by Sales
margin volume variance. The formula is:

Budgeted Profit – Standard Profit

Or, Standard Profit per unit * (Budgeted quantity – Actual quantity)

The sales margin volume variance can be sub-divided into two components (a) sales
margin mix variance & (b) sales margin quantity variance, when sale of more than one
product is made.

Sales-Margin-Mix-Variance (SMMV):
The difference between the revised standard profit & the standard profit is shown by the
sales margin mix variance. The formula is:

Revised Standard Profit – Standard Profit

Or, Standard profit per unit * (Actual quantity at standard mix – Actual quantity at actual
mix)

Sales Margin Quantity Variance (SMQV):

The difference between budgeted profit & revised standard profit is reflected by the
sales margin quantity variance. The formula is:

Budgeted Profit – Revised Standard Profit

Or, Standard profit per unit * (Actual quantity at standard mix – Budgeted quantity at
standard mix)

Relationship between the variances:

Total Sales Margin Variance = Price Variance + Volume Variance

Sales Margin Volume Variance = Mix Variance + Quantity Variance

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ACTIVITY BASED COSTING (04)

ACTIVITY BASED COSTING (ABC)

Activity based costing known as ABC is the modern technique of cost accounting. This
gives the edge over the traditional absorption costing and marginal costing approaches. Often,
ABC is termed as Old wine in the New bottle but with the focus on cost reduction by way of
eliminating the non-productive activities. Traditional costing too had the thrust on cost
reduction but eliminating non-productive activities was not very easy as the costs were
recorded under cost centers and not activity centers.

Now let us see the comparison of traditional costing and ABC. Under ABC cost centers are
further broken down into various activities and they are termed as Activity centers. The cost
is then collected under these Activity centers.
Basis of allocation/apportionment are called as Cost Drivers; the one who drives or
apportions the cost within activity centers and finally to the end product.
The idea behind breaking down cost centers into various activities is to identify the non-
productive or non-value added activities and eliminate them so as to reduce the cost and
ultimately improve the profit.
For eg.: Traditionally purchase & stores is a cost center under which the cost of purchase
department is collected and then apportioned to manufacturing cost centers on some pre-
determined basis.
Under ABC, the purchase & stores department is broken down into various activities and cost
is collected under various activities before they are apportioned to manufacturing activity
centers based on cost drivers. This concept can be well understood with the help of following
diagram.

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Looking at the ABC diagram above, cost is collected under various activities so that the
identification on non-productive activities is possible and such non-productive activities can
be eliminated. Refer diagram of traditional costing above, identification of non-productive
activities is not possible as costs are collected under one cost center called Purchase & stores.
Similarly, such ABC modules can be developed for all the manufacturing and service
activities in the company.

ABC system is good but the only disadvantage is identification of activities and collecting
costs under such activities. For eg. It is very difficult to classify the process into activity and
all the more difficult to collect the cost under such activity. At times, it may not be worth to
capture costs under minor activities. At times, the accountant accounting the voucher or bill
may not feel it important to account the cost under relevant activity hence, cost may get
booked under wrong activity.

In an ERP environment, especially SAP, Activity based costing module is available which
can be used for working out the cost and reduce the cost provided the efforts are put in to
identify the activity and more importantly collect cost under those activities.

Now let us see the activity based costing process with specific reference to Screen printing
industry.

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The above mentioned chart shows the processes involved in screen printing process. The
machine hour rate is activity rate worked out for each of the process/activity and output is the
optimum output each process can deliver. The processing cost per sheet is worked out by
multiplying the activity rate and the output, finally working out per square inch processing
cost for the screen printing activity. The activities where the cost is Zero are the activities not
required for particular product, hence eliminated.
In nutshell, ABC is a useful technique to reduce the cost provided the company is geared up
to identify the activities and collect the cost under activities. Otherwise, it remains the old
wine in new bottle.
Steps in ABC:
1) Identifying major activities that takes place in an organization.
2) Creating cost pool for each activity where costs are collected.
3) Determining cost driver for each major activity.
4) Assigning cost of activities to products based on product’s consumption or demand for
activities.
Activity Cost Driver
Pricing Number of orders
Number of customers
Complexity of orders
Setting agreements Location of customers Number of orders
Number of customers
Size of orders
Customer vetting Number of customers Size of orders
Location of customers
Customer liaison Order book position Number of orders
Number of customers
Problem resolution Delivery performance Product quality
Number of orders
Number of customers
Location of customers
Expediting Delivery Production hold ups Number of orders
Admin / secretarial Number of orders
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 Number of problems
Number of staff
Material planning Number of material transactions Volume of material receipts
Volume of material orders
Inspection Inspection plans
Number of problem suppliers
Lack of good quality
Production control Engineering changes Supplies performance
Number of operational parts
Number of machine changes
Production Numbers to be supervised Shift patterns
Industrial relations issues
Flow of product from assembly
Volume of service parts
Accounting costs Number of billings
Number of cash receipts
Number of cheque payments
Number of general entries
Number of reports issued
Admin cost Hours charged to law suits Number of stock holders contacts
Engineering costs Hours charged to design work Hours charged to process planning
Hours charged to tool designing
Number of change orders
Facility costs Area occupied by each activity
HR costs Employee head count
Number of benefits
Number of insurance claims
Number of training hours
Manufacturing costs Number of direct labour hours
Number of field support visits
Number of jobs scheduled
Number of machine hours
Number of machine set ups
Number of work orders
Number of production orders
Number of purchase orders
Number of shipments
Quality control Number of inspections
Number of suppliers reviews
Purchase department Number of purchase orders
Depreciation, storage
cost Inventory turnover
Number of shifts handled
Area occupied by each activity
WDV of each machine

Benefits of ABC:

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 1) Points a way to increase shareholder value with accurate return on investment due to
accurate cost allocation.
2) Effectively appraises a distribution channel cost due to accurate identification.
3) Eliminates non value added activities there by achieve cost reduction which adds to the
bottom line of the company.
4) Effectively compares inter plant performance due to accurate and rational cost allocation
and apportionment.
5) Provides reliable and accurate data for decision making.
6) Helps to collect benchmark cost which can be used for potential acquisition
targets.
7) Determines cost of each activity which eliminates the scope of wrong costing.
8) Helps to charge optimum and justified price.
9) Helps to identify most profitable customers.
10) Translates company goals into activity goals by promoting standards of excellence and
business process reengineering.

Criticism of ABC:
1) ABC implementation requires significant amount of time and cost to implement.
2) An environmental change must be created for implementation within organization, the
barriers could be fear of unknown and shift in status quo, potential loss of status, necessity to
learn new skill, too many whys what’s how’s shall be asked.
3) Top management must involve in implementation which may be difficult due to
clash of priorities.
4) Conceptual up grading is required for employees, suppliers, customers which is very
difficult in Indian scenario.
5) Additional time needs to be devoted for analysis of activities, costs, decisions etc.
6) ABC does not conform to Generally Accepted Accounting Principles (GAAP), hence, legal
and governmental bodies will not accept data worked out based on ABC. This calls for
double work.
7) It does not promote TQM or continuous improvement, also identified costs against
activities might be too insignificant where in cost of implementation will be costlier than the
cost saving.

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MARGINAL COSTING & CVP ANALYSIS (10) AND TACTICAL DECISION
MAKING (14)
Marginal Costing and Managerial Decision Mix
Before understanding the concept of Marginal costing, let us understand what is traditional
costing or historical costing. Traditionally, costing was done on the basis of absorption
costing where all the costs related to the product were absorbed (charged to) in the product.
The classification of cost was not done on the basis its variability i.e. fixed cost, variable cost,
semi-variable or semi-fixed cost (the concepts are discussed later in the topic). The reporting
format of absorption costing is Cost sheet, the format is as under:

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The major point of difference between Marginal costing and Absorption costing is as under:

Now let us understand the concept of Marginal costing:

CIMA defines marginal costing as the accounting system in which variable costs are charged
to the cost units and fixed costs of the period are written off in full against the aggregate
contribution. Its special value is in decision making.
This technique is the most commonly used technique for decision marking. The sales team is
allowed to operate on the contribution margin (i.e. selling price less variable cost) provided
they give the assurance of significant increase in the market share by selling higher volumes
of the product. Before, understanding the practical use of marginal costing for decision
making, let us understand the marginal costing as studied in the academics.

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Marginal cost is the cost that is incurred for one extra unit of production which the variable
cost of the product.
Variable cost is the cost that changes in direct proportion to the output produced. This can be
understood with the help of following example.

It can be seen from the above example that the variable cost per unit remains unchanged
whereas the variable cost value is increasing in direct proportion to the production quantity.
Higher the production higher the cost, lower the production lower the cost, no production no
cost without changing the per unit cost.
So, cost of manufacturing one additional unit of production is Rs.2 which is a marginal cost
which in turn is a variable cost. For example, material cost, Direct Labor cost.

Fixed cost is treated as period cost which does not change with the change in output
produced. This can be understood with the help of following example.

It can be seen from the above example that the fixed cost per unit is going down with higher
production and is going up with lower production, but, remains constant in value form. So
fixed cost has got no influence on the decision related to the product. For example, Rent,
Depreciation, Salaries, etc.

In Hindustan Unilever, decision on launching a new product is taken based on based on

Variable cost and Contribution Margin i.e. Selling Price Less Variable cost. Fixed cost being
period cost or sunk cost is not considered for decision making on product as the fixed cost
will have to be incurred despite on existence or non-existence of the product. (author’s
personal experience with the company). According to HUL, if the product has healthy
contribution to selling price ratio (P/V ratio, the concept is explained below in the chapter),
then even if the product incurs net loss, such product should be launched as the higher sales
volume will help the product to recover its fixed cost which will eventually bring the product
into profit zone.

Semi variable/ Semi-fixed costs: Cost that will partly move as per variable cost and partly as
per fixed cost. For example, Electricity cost, the minimum demand charges are fixed and
usage charges are variable
Repairs & maintenance, preventive maintenance is fixed and routine maintenance is variable.
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Contribution: Contribution is that part of Profit which is available to the company for
covering up its fixed cost. If the contribution is positive & we have loss at the end, we can
continue with that product with the hope of higher sales volume converting that loss making
product into profit making one. Product with negative contribution should be discontinue as
for such product, the more we sell, the more loss we will incur.

Now let us see the practical example of product cost sheet and the decision related to the
product.

It can be seen from the above mentioned Marginal cost sheet that the mango drink has
positive contribution and profit at the end; apple drink has positive contribution and loss at
the end; lemon drink has negative contribution and loss at the end. Looking at the above, the
management will take a call to discontinue the lemon drink as the more we sell the more loss
we will incur in lemon drink because of the negative contribution. In case of apple drink,
there is a ray of hope that with higher volumes, loss at the end can be turned into profit. This
is explained in the example below,

At 200 output, Apple drink is at no profit no loss i.e. Break even situation, with 201 st unit,
apple drink can start earning profit for itself. Lemon drink on the other hand, despite of
selling 1000 units it still shows huge loss at the end.
Someone can argue that the negative contribution can be turned into positive by increasing
the selling price or reducing the variable cost.
In reality, the selling price is generally controlled by the market & the competitors; hence it is
difficult to increase the selling price to improvise the contribution. Variable cost (mainly
material cost) on the other hand can be reduced but the efforts required and the time frame for
achieving the cost reduction are too high. For example, If we decide to reduce the purchase
price/content of mango pulp and sugar in mango drink, then it can’t be done overnight as
these prices are fixed for the year. Company may use alternate & cheaper mango pulp but it
may change the basic taste of the final product. Hence, reducing variable cost is not
impossible but very difficult.

The Break Even Point (BEP) (the concept is explained below in the chapter) shown above is
dynamic in nature unlike our examination problem wherein we calculate the BEP and leave it
at that stage. In practical life, breakeven point needs to be monitored regularly for change in
variable cost, change in selling price, change in fixed cost due to capacity change etc. The
dynamism of BEP is analyzed on regular basis so as to present true and fair view of the
product profitability to the management.
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P/V Ratio:
When the contribution from sales is expressed as a percentage of sales value, it is known as
profit volume ratio or P/V Ratio. Better P/V ratio is an index of sound financial health of the
company. It shows how large the contribution is with respect to covering up the fixed cost
and give some profit for the product.
Advantages of P/V ratio:
1) It helps in determining the break even point
2) It helps in determining the profit at various sales levels.
3) It helps to find out the desired volume required to earn the desired profit.
4) It helps to calculate the relative profitability of the products for comparison purpose.
Disadvantages of P/V ratio:
1) It heavily leans of excess of revenues over variable cost.
2) It fails to take into consideration the capital outlays required by the additional
production capacity and additional fixed cost.
3) It is an indicative ratio related to financial health of the company or the product, real
life dynamism of cost (inflation factor) & sales (market dynamics) is not considered.
Improvement in P/V ratio can be done by way of increasing selling price & reducing variable
cost. Increasing the selling price is difficult due to market competition and reducing variable
cost may affect the quality of the product or composition of the product.

P/V ratio = (Contribution / Sales) x 100

Or P/V ratio = Change in contribution / Change in sales
Or P/V ratio = Change in profit / Change in sales

BREAK EVEN POINT:

Break even point is the point of sales at which company makes neither profit nor loss. The
marginal costing technique is based on the idea that difference of sales and variable cost of
sales provides a fund which referred to as contribution. Contribution provides for fixed cost
and profit. At break even point, the contribution is just enough to provide for fixed cost. If
actual sales is above break even point, the company will make profit. If actual sales is below
break even sales company will incur losses. When Cost-Volume-Profit relationship is plotted
on the graph, the point at which total cost line and total sales line intersect each other will be
the break even point.

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(Figures in the graph are for representation only)
The formula for Break-even point is as under:
Break Even Point in Units = Fixed Cost / Contribution per Unit
Break Even Point in Value = Fixed Cost / P/V. Ratio
Margin of Safety:
Margin of safety represents the difference between sales at a given activity and sales at break
even point. Consequently, it indicates the extent to which a fall in demand could be absorbed,
before the company begins to sustain losses. The margin of safety always depends on the
accuracy of cost estimates. It is the cushion available to the company when the fall in sale
happens. The wide margin of safety is advantageous for the company. Margin of safety
depends on level of fixed cost, rate of contribution and levels of sales. The relationship of
margin of safety with sales can be expressed as follows:
Sales – Sales at Break even point = Margin of safety.
Margin of Safety x P/V ratio = Profit
Angle of Incidence:
The angle that the sales line makes with the total cost lines is known as the angle of
incidence. The angle gives the pictorial relationship between profit and sales (refer graph
above). The angle indicates the profit earning capacity of a company over the break-even
point. A large angle of incidence will indicate earning of high margin of profit and vice versa.
Low angle of incidence indicates that variable costs form a major part of cost of sales.
Normally, Margin of safety and Angle of incidence are considered together.
Features/advantages of marginal costing:

1) Costs are divided into 2 categories fixed and variable.

2) Fixed cost is treated as period cost and remains out of consideration for product cost
and decision making. This makes the company more competitive in the market with
reference to pricing of the product.
3) Fixed cost under this, gets recovered through increase in volume achieved due to
competitive or lower prices as compared to competition.
4) Prices are determined with reference to variable cost and contribution margin.
5) Contribution plays dominant role in decision making which keeps the pressure on
sales team to achieve desired volumes so as to recover the fixed cost.

Criticisms or disadvantages of marginal costing:

1) It is not proper to disregards fixed cost for product cost determination and inventory
valuation
2) It is especially useful in short run profit planning and decision making. For decision
of far reaching importance, one is interested in special purpose cost rather than
variability of the cost.
3) Marginal costing technique disregards the use of recovering fixed cost through
product pricing. For long run continuity of business, it is not good. Assets have to be
recovered in the long run.
4) Establishing variability of costs is not an easy task. In real life situations, variable
costs are rarely completely variable and fixed costs are rarely completely fixed.
5) Exclusion of fixed cost from Inventory valuation does not conform to accepted
accounting practice.

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 6) The income tax authorities do not recognize the marginal cost for inventory valuation.
This necessitates keeping of separate books for separate purposes.

Application of Marginal Costing Techniques:

1) Profit Planning: Normally, a company carries on its activities for the year and at the
end of the year an exercise of accounts closing is carried out to compute profit for the
year. Under profit planning, this order is reversed. Profit planning involves
forecasting activity level in order to gain or maintain specified amount of profit. Profit
figure is planned and the revenue associated with that profit plan is considered as
target. Marginal costing helps in profit planning as it is based on behavioral study of
cost.
2) Presentation of data for control purpose: Marginal costing data can be used for
control purposes as the management clearly gets the classification of fixed cost and
variable cost which can be looked upon as controllable and non-controllable cost.
Management may looked at costs which are non-value added costs depending on its
nature.
3) Make or buy decision: Sometimes, a company has to decide, whether it should make
the component of its product or it should buy it from the market. On the face of it,
decision to make or buy should involve comparison of seller’s price with marginal
cost of that component. But this approach will lead to wrong conclusion. When the
component is produced, a part of plant capacity is utilized, which will bring down the
incidence of fixed cost as the fixed cost will be spread over the larger output base.
Thus, company will have ‘lost contribution’ if they go ahead with buying the
component. If the company is not working on its full capacity, then the question of
‘lost contribution’ does not arise, thus lost contribution becomes another point of
consideration. The decision on make or buy will be considered based on seller’s price,
marginal cost of producing the component (fixed cost being sunk cost), “lost
contribution”, reliability of the supplies (if purchased) and Government policy and
taxation which will give advantage of making it rather than buying.
4) Optimizing product mix: When a concern manufactures a number of products, a
problem arises as to which product or sales mix will yield maximum profit. Such a
problem can be solved by marginal contribution analysis. Product mix, which gives
the maximum contribution, will be the optimum mix.
5) Alternative use of production facilities: When an alternative method of
manufacturing a product or alternative is available, marginal contribution analysis
should be made to arrive at the decision the alternative yielding the highest
contribution will be selected.
6) Evaluation of performance: A company may have difference departments of
product lines, all these departments and product lines may have different revenue
earning potential. A company always concentrates on the departments or product lines
which more contribution. Thus, marginal cost becomes a parameter to evaluate the
performance. (Refer the mango, apple, lemon drink example above).
Relevant Costs:
As the name suggests, Relevant costs are the costs relevant to the business decision the
company is likely to take. A cost is said to be relevant if the company ceases to incur that cost
once a business decision is executed to close down a particular division. If the company
continues to incur the cost despite of closing down a particular division, then such cost is
called as Irrelevant cost.
To simplify this, let’s look at one corporate example.

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A company called PAPL had 2 Business divisions, a) Beverage division b) Snack Food
division. The relevant details about both the divisions are as under:

Company has taken a strategic decision of closing down the Snack food division as its
incurring huge losses and focus on their core business of Beverage manufacturing and selling.

So the decision is to discontinue Snack food operations.

Relevant cost for the decision:
1) Manpower cost of Snack food division: INR 68 crores
2) Canteen Expenses: INR 0.50 crores
Total: INR 68.50 crores
Let’s discuss about Rent and Security expenses.
If the company is going to surrender the rented space used for Snack food division then the
Rent cost is to be considered as relevant for the decision as the company is going to achieve
the cost reduction of INR 1 crore. But if the company has plans of expanding its Beverage
business using the vacant space of Snack food division, then the company will continue to
pay the same rent, hence rent cost will be irrelevant for the decision.
If the company is planning to re-deploy the security guards for Beverage division, Security
expenses of INR 0.50 crores are considered to be irrelevant for the decision under
consideration, else the security expenses are considered to be relevant.

Now, let’s look at the Manpower cost of Chartered Accountants. Since the company is
planning to close down the snack food division, 10 Chartered Accountants are going to lose
their job giving a saving of INR 3 crores to the company. But in case the growing Beverage
division is in need of 5 Chartered Accountants, then 5 out of 10 CAs may be transferred to
beverage wherein they will continue to draw existing salary. In such case the total saving for
the company is INR 1.50 crores instead of INR 3 crores. Here, INR 1.50 cores (cost of CAs
going home) will be relevant and INR 1.50 crores (cost CAs getting re-deployed at Beverage)
will be irrelevant for the company.

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 Thank you

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