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Digitally signed by Muhammad Shahid DN: CN = Muhammad Shahid, C = US, O = 3S Inc Location: Sargodha Date: 2008.05.11 13:28:55 +05'00'
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To understand the meaning of different costing terms To understand different costing methods To have a basic idea of different costing techniques To understand the meaning of cost sheet
In order to determine and take a dispassionate view about what lies beneath the surface of accounting figures, a financial analyst has to make use of different management accounting techniques. Cost techniques have a precedence over the other techniques since accounting treatment of cost is often both complex and financially significant. For example, if a firm proposes to increase its output by 10%, is it reasonable to expect total cost to increase by less than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behavior, i.e. the way costs change with the levels of activity. The answers to these questions are very much pertinent for a management accountant or a financial analyst since they are basic for a firms projections and profits which ultimately become the basis of all financial decisions. It is, therefore, necessary for a financial analyst to have a reasonably good working knowledge about the basic cost concepts and patterns of cost behavior. All these come within the ambit of cost accounting. Meaning of Cost Accounting COST ACCOUNTING is the process of tracking, recording and analyzing costs associated with the products or activities of an organization. Managers use cost accounting to support decision making to reduce a company's costs and improve its profitability. As a form of management accounting, cost accounting need not follow standards such as GAAP, because its primary use is for internal managers, rather than external users, and what to compute is instead decided pragmatically. Costs are measured in units of nominal currency by convention. Cost accounting can be viewed as translating the Supply Chain (the series of events in the production process that, in concert, result in a product) into financial values. There are at least four approaches:
Standardized Cost Accounting Activity-based Costing Throughput Accounting Marginal Costing / Cost-Volume-Profit Analysis
Classical Cost Elements are: 1. Raw Materials 2. Labor 3. Indirect Expenses / Overhead Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due to competitive nature Chapter 1 Page 3
According to the Chartered Institute of Management Accountants, London, cost accounting is the process of accounting for costs from the point at which its expenditure is incurred or committed to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned. Cost accounting, thus, provides various information to management for all sorts of decisions. It serves multiple purposes on account of which it is generally indistinguishable from management accounting or so-called internal accounting. Wilmot has summarized the nature of cost accounting as the analyzing, recording, standardizing, forecasting, comparing, reporting and recommending and the role of a cost accountant as a historian, news agent and prophet. As a historian, he should be meticulously accurate and sedulously impartial. As a news agent, he should be up to date, selective and pithy. As a prophet, he should combine knowledge and experience with foresight and courage. Objectives of Cost Accounting The main objectives of cost accounting can be summarized as follows: 1. Determining Selling Price Business enterprises run on a profit-making basis. It is, thus, necessary that revenue should be greater than expenditure incurred in producing goods and services from which the revenue is to be derived. Cost accounting provides various information regarding the cost to make and sell such products or services. Of course, many other factors such as the condition of market, the area of distribution, the quantity which can be supplied etc. are also given due consideration by management before deciding upon the price but the cost plays a dominating role. 2. Determining and Controlling Efficiency Cost accounting involves a study of various operations used in manufacturing a product or providing a service. The study facilitates measuring the efficiency of an organization as a whole or departmentwise as well as devising means of increasing efficiency.
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Determination of a cost-volume-profit relationship Shutting down or operating at a loss Making for or buying from outside suppliers Continuing with the existing plant and machinery or replacing them by improved and economic ones
Concept of Cost Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective. In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing. However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors:
In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is Chapter 1 Page 5
All material or components specifically purchased, produced or requisitioned from stores Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.) Purchased or partly produced components
Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc. b. Indirect Material The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste, printing and stationery material etc. are some of the examples of indirect material. Indirect material may be used in the factory, office or the selling and distribution divisions. 2. Labor
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Hire of some special machinery required for a particular contract Cost of defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as chargeable expenses. b. Indirect Expenses These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc. 4. Overhead Chapter 1 Page 7
Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads may be of three types: d. Factory Overheads They include the following things: Indirect material used in a factory such as lubricants, oil, consumable stores etc. Indirect labor such as gatekeeper, timekeeper, works managers salary etc. Indirect expenses such as factory rent, factory insurance, factory lighting etc. e. Office and Administration Overheads They include the following things: Indirect materials used in an office such as printing and stationery material, brooms and dusters etc. Indirect labor such as salaries payable to office manager, office accountant, clerks, etc. Indirect expenses such as rent, insurance, lighting of the office f. Selling and Distribution Overheads They include the following things:
Indirect materials used such as packing material, printing and stationery material etc. Indirect labor such as salaries of salesmen and sales manager etc. Indirect expenses such as rent, insurance, advertising expenses etc.
Elements of Cost
o o o o
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Factory overheads Selling and distribution overheads Office and administration overheads Indirect material Indirect labor Indirect expenses Indirect material Indirect labor Indirect expenses Indirect material Indirect labor Indirect expenses
Components of Total Cost 1. Prime Cost Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost. 2. Factory Cost Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost. 3. Office Cost Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production. 4. Total Cost Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales. Various components of total cost can be depicted with the help of the table below: Components of total cost Direct material Direct labor Direct expenses Prime cost plus works overheads Works cost plus office and administration overheads Office cost plus selling and distribution Chapter 1 Prime cost or direct cost or first cost Works or factory cost or production cost or manufacturing cost Office cost or total cost of production Cost of sales or total cost Page 9
Cost of stock of finished goods on June 30, 1998 55,000 Selling and distribution overheads Sales Administration overheads Prepare a statement of cost. Solution Statement of cost of production of goods manufactured for the period ending on June 30, 1998. 30,000 4,50,000 -----------4,80,000 15,000 Page 10 20,000 9,00,000 30,000
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The total output for the period has been 10000 tons. Solution Cost sheet for the period ended on December 31, 1998 Raw materials Production wages Direct expenses Chapter 1 $. 33,000 71,000 35,000 Page 11
Motive power Haulage Directors fees (works) Factory cleaning Estimating expenses Factory stationery Loses tools written off Water supply Factory insurance Depreciation of plant and machinery Works cost Add-- office overhead Directors fees (office) Sundry office expenses Office stationery Rent and taxes (office) Office insurance Legal expenses Depreciation of office building Bank charges Office cost Add-- selling and distribution overheads Rent of warehouse Depreciation on delivery vans Bad debts Advertising Sales department salaries Commission on sales Upkeep of delivery vans Total cost Cost per ton $. 1,18,200/10,000 = $. 11.82 Classification of Cost
3,000 1,000 500 800 750 600 1,200 1,100 37,050 2,000 1,08,050 2,000 200 5,550 900 500 500 1,13,600 400 1,000 4,600 50 300 1,18,200 200 100 300 1,500 1,500 700
Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows: 1. Fixed, Variable and Semi-Variable Costs The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows: Chapter 1 Page 12
The cost which does not vary but remains constant within a given period of time and a range of activity inspite of the fluctuations in production is known as fixed cost. Some of its examples are as follows:
The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows:
Depreciation Repairs
Fixed costs are sometimes referred to as period costs and variable costs as direct costs in system of direct costing. Fixed costs can be further classified into:
Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc. without impairing an organizations competence to meet the long-term goals. Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are also termed as managed or programmed costs. In some circumstances, variable costs are classified into the following:
The term discretionary costs is generally linked with the class of fixed cost. However, in the circumstances where management has predetermined that the organization would spend a certain percentage of its sales for the items like research, donations, sales promotion etc., discretionary costs will be of a variable character. Engineered variable costs are those variable costs which are directly related to the production or sales level. These costs exist in those circumstances where specific relationship exists between input and output. For example, in an automobile
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The management is considering the following two alternatives: i. To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $. 500.
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Which alternative the management should accept? Solution Statement showing profitability under different alternatives is as follows: Particulars Present situation $. $. 10,000 9,000 1,000 Proposed situations 11,600 10,000 6,000 5,400 10,500 8,400 4,500 3,000 1,100 1,600
Sales. Less: 5,000 Variable purchase costs 4,000 Fixed costs Profit Observations i. ii.
iii.
In the present situation, the company is making a profit of $. 1,000. In the proposed situation (i), the company will make a profit of $. 1,100. The incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation. In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation.
Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii). The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative. In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs. 11. Out-of-Pocket Costs Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as out-of-pocket costs. 12. Opportunity Cost Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned. For example, if a building is proposed to be Chapter 1 Page 17
Collection and classification of expenditure according to cost elements Allocation and apportionment of the expenditure to the cost centers or cost units or both
Cost Unit While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed. Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of cost: (i) Brick works (ii) Collieries (iii) Textile mills (iv) Electrical companies Chapter 1 per 1000 bricks made per ton of coal raised per yard or per lb. of cloth manufac- tured or yarn spun per unit of electricity generated Page 19
Productive, unproductive and mixed cost centers Personal and impersonal cost centers Operation and process cost centers
Productive cost centers are those which are actually engaged in making products. Service or unproductive cost centers do not make the products but act as the essential aids for the productive centers. The examples of such service centers are as follows:
Administration department Repairs and maintenance department Stores and drawing office department
Mixed costs centers are those which are engaged sometimes on productive and other times on service works. For example, a tool shop serves as a productive cost center when it manufactures dies and jigs to be charged to specific jobs or orders but serves as servicing cost center when it does repairs for the factory. Impersonal cost center is one which consists of a department, a plant or an item of equipment whereas a personal cost center consists of a person or a group of persons. In case a cost center consists of those machines or persons which carry out the same operation, it is termed as operation cost center. If a cost center consists of a continuous sequence of operations, it is called process cost center. In case of an operation cost center, cost is analyzed and related to a series of operations in sequence such as in chemical industries, oil refineries and other process industries. The objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside the factory. Cost Estimation and Cost Ascertainment Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-determination may be required for several purposes. Some of the purposes are as follows:
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Preparation of financial statements (valuation of stocks etc.) Make or buy decisions Fixation of the sale prices of products
Cost ascertainment is the process of determining costs on the basis of actual data. Hence, the computation of historical cost is cost ascertainment while the computation of future costs is cost estimation. Both cost estimation and cost ascertainment are interrelated and are of immense use to the management. In case a concern has a sound costing system, the ascertained costs will greatly help the management in the process of estimation of rational accurate costs which are necessary for a variety of purposes stated above. Moreover, the ascertained cost may be compared with the predetermined costs on a continuing basis and proper and timely steps be taken for controlling costs and maximizing profits. Cost Allocation and Cost Apportionment Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost units Thus, the former involves the process of charging direct expenditure to cost centers or cost units whereas the latter involves the process of charging indirect expenditure to cost centers or cost units. For example, the cost of labor engaged in a service department can be charged wholly and directly but the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate share will have to be found out. Charging of costs in the former case will be termed as allocation of costs whereas in the latter, it will be termed as apportionment of costs. Cost Reduction and Cost Control Cost reduction and cost control are two different concepts. Cost control is achieving the cost target as its objective whereas cost reduction is directed to explore the possibilities of improving the targets. Thus, cost control ends when targets are achieved whereas cost reduction has no visible end. It is a continuous process. The difference between the two can be summarized as follows: i. Cost control aims at maintaining the costs in accordance with established standards whereas cost reduction is concerned with reducing costs. It changes all standards and endeavors to improve them continuously. Cost control seeks to attain the lowest possible cost under existing conditions whereas cost reduction does not recognize any condition as permanent since a change will result in lowering the cost. In case of cost control, emphasis is on past and present. In case of cost reduction, emphasis is on the present and future. Cost control is a preventive function whereas cost reduction is a correlative function. It operates even when an efficient cost control system exists.
ii.
iii. iv.
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Overcoming the practical difficulties while introducing a system Main considerations that should govern the installation of such a system
Practical Difficulties The important difficulties in the installation of a costing system and the suggestions to overcome them are as follows: a. Lack of Support from Top Management Often, the costing system is introduced at the behest of the managing director or some other director without taking into confidence other members of the top management team. This results in opposition from various managers as they consider it interference as well as an uncalled check of their activities. They, therefore, resist the additional work involved in the cost accounting system. This difficulty can be overcome by taking the top management into confidence before installing the system. A sense of cost consciousness has to be instilled in their minds. b. Resistance from the Staff The existing financial accounting staff may offer resistance to the system because of a feeling of their being declared redundant under the new system. This fear can be overcome by explaining the staff that the costing system would not replace but strengthen the existing system. It will open new areas for development which will prove beneficial to them. c. Non-Cooperation at Other Levels The foreman and other supervisory staff may resent the additional paper work and may not cooperate in providing the basic data which is essential for the success of the system. This needs re-orientation and education of employees. They have to be told of the advantages that will accrue to them and to the organization as a whole on account of efficient working of the system. d. Shortage of Trained Staff Costing is a specialized job in itself. In the beginning, a qualified staff may not be available. However, this difficulty can be overcome by giving the existing staff requisite training and recruiting additional staff if required. e. Heavy Costs The costing system will involve heavy costs unless it has been suitably designed to meet specific requirements. Unnecessary sophistication and formalities should be avoided. The costing office should serve as a useful service department. Main Considerations Chapter 1 Page 22
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It is possible to ascertain the costs under each of the above methods by two different ways:
Historical Costing Historical costing can be of the following two types in nature:
Post Costing Post costing means ascertainment of cost after the production is completed. This is done by analyzing the financial accounts at the end of a period in such a way so as to disclose the cost of the units which have been produced. For instance, if the cost of product A is to be calculated on this basis, one will have to wait till the materials are actually purchased and used, labor actually paid and overhead expenditure actually incurred. This system is used only for ascertaining the costs but not useful for exercising any control over costs, as one comes to know of things after they had taken place. It can serve as guidance for future production only when conditions in future continue to be the same. Continuous Costing In case of this method, cost is ascertained as soon as a job is completed or even when a job is in progress. This is done usually before a job is over or product is made. In the process, actual expenditure on materials and wages and share of overheads are also estimated. Hence, the figure of cost ascertained in this case is not exact. But it has an advantage of providing cost information to the management promptly, thereby enabling it to take necessary corrective action on time. However, it neither provides any standard for judging current efficiency nor does it disclose what the cost of a job ought to have been. Standard Costing
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Digitally signed by Muhammad Shahid DN: CN = Muhammad Shahid, C = US, O = 3S Inc Location: Sargodha Date: 2008.05.11 13:29:41 +05'00'
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To understand the meanings of marginal cost and marginal costing To distinguish between marginal costing and absorption costing To ascertain income under both marginal costing and absorption costing
Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.
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CONTRIBUTION SALES - MARGINAL COST The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context. Note Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.
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For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300280). The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output. There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing. Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
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Profit will increase by the amount of contribution earned from the extra item. b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
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5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. 6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. 7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. 3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. 4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. 5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. 6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. 7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer. Presentation of Cost Data under Marginal Costing and Absorption Costing Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.
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The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm. Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:
$ Marginal Costing Profit xx ADD xx (Closing stock opening Stock) x OAR = Absorption Costing Profit xx Budgeted fixed production overhead Where OAR( overhead absorption rate) = Budgeted levels of activities
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The features which distinguish marginal costing from absorption costing are as follows.
a. In absorption costing, items of stock are costed to include a fair share of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing. b. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will: i. include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period; ii. exclude some fixed production overhead costs incurred in the current period by including them in closing stock values. In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.) c. In absorption costing, actual fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing. d. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume). In absorption costing, however, the effect on profit in a period of changes in both: i. ii. production volume; and sales volume; is not easily seen, because behaviour is not analysed
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and incremental costs are not used in the calculation of actual profit.
Summary
Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all mangers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting. Absorption costing and marginal costing are two different techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used for managerial decision-making and control.
Questions
1. Is marginal costing and absorption costing same? 2. What is presentation of cost data? Answer with suitable example.
Digitally signed by Muhammad Shahid DN: CN = Muhammad Shahid, C = US, O = 3S Inc Location: Sargodha Date: 2008.05.11 13:30:02 +05'00'
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$ 50 20 8 24 102 1,000 units 900 units 4,850 kgs, $46,075 4,200 hrs, $21,210 $9,450 $25,000 $140 per unit
ACTUAL Results Production: Sales: Materials: Labour: Variable o/hds: Fixed o/hds: Selling price:
1,000 units should have cost (x $50) But did cost Direct material total variance It can be divided into two sub-variances
1,000 units should have cost (x $20) But did cost Direct material price variance
1,000 units should have taken (x 4 hrs) But did take Variance in hrs Chapter 12
When idle time occurs the efficiency variance is based on hours actually worked (not hours paid for) and an idle time variance (hours of idle time x standard rate per hour) is calculated.
1,000 units should have cost (x $8) But did cost Variable production o/hd expenditure variance
4,200 hrs should have cost (x $2) But did cost Variable production o/hd expenditure variance
If either the numerator or the denominator or both are incorrect then we will have under- or overabsorbed production overhead.
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If actual production / hours of activity budgeted production / hours of activity (denominator incorrect) volume variance. The workforce may have been working at a more or less efficient rate than standard to produce a given output volume efficiency variance (similar to the variable production overhead efficiency variance). Regardless of the level of efficiency, the total number of hours worked could have been more or less than was originally budgeted (employees may have worked a lot of overtime or there may have been a strike and so actual hours worked were less than budgeted) volume capacity variance.
4. The fixed production overhead variances are calculated as follows: Fixed production overhead variance
This is the difference between fixed production overhead incurred and fixed production overhead absorbed (= the under- or over-absorbed fixed production overhead) $ 25,000 24,000 1,000 (A)
Actual production at std rate (1,000 x $24) Budgeted production at std rate (1,200 x $24)
KEY.
The fixed overhead volume capacity variance is unlike the other variances in that an excess of actual hours over budgeted hours results in a favourable variance and not an adverse variance as it does when considering labour efficiency, variable overhead efficiency and fixed overhead volume efficiency. Working more hours than budgeted produces an over absorption of fixed overheads, which is a favourable variance.
Revenue from 900 units should have been (x $150) But was (x $140) Selling price variance
No fixed overhead volume variance Sales volume variances are valued at standard contribution margin (not standard profit margin)
(F) unforseen discounts received, greater care taken in purchasing, change in material standard (A) price increase, careless purchasing, change in material standard.
Material usage
(F) material used of higher quality than standard, more effective use made of material (A) defective material, excessive waste, theft, stricter quality control
Labour rate
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(F) use of workers at rate of pay lower than standard (A) wage rate increase
Idle time
Labour efficiency
(F) output produced more quickly than expected because of work motivation, better quality of equipment or materials (A) lost time in excess of standard allowed, output lower than standard set because of deliberate restriction, lack of training, sub-standard material used.
Overhead expenditure
(F) savings in cost incurred, more economical use of services. (A) increase in cost of services used, excessive use of services, change in type of services used
Overhead volume
(F) production greater than budgeted (A) production less than budgeted
Material price or material usage and labour efficiency Labour rate and material usage Sales price and sales volume
The type of standard being used Interdependence between variances Controllability Materiality
In period 3, 13 units of product X were produced from 250 kgs of material A and 350 kgs of material B. Solution 1: individual prices per kg as variance valuation cases
Mix Variance Standard mix of actual use: A: 2/5 x (250+350) B: 3/5 x (250+350) Kgs 240 360 600 === B 360 kgs 350 kgs 10 kgs (F) x $5 $50 (F) ===
Mix should have But was Mix variance in x standard cost Mix variance in
A 240 kgs 250 kgs 10 kgs (A) x $10 $100 (A) ===== 50 (A)
Solution 2: budgeted weighted average price per unit of input as variance valuation base. Therefore, Budgeted weighted average price =$350/50 = $7 per kg
Mix variance A B 13 units of product X should have used but did use kgs
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x $3 ____ $30 (F) === $50 (A) === x ($2) $80 (A) ===
Yield variance A B Usage variance in kgs (F) x budgeted weighted average Price per kg
10 kg (F)
40 kg
$ 280 (F)
The difference between the actual total quantity sold in the standard mix and the actual quantities sold, valued at the standard margin per unit. The difference between actual sales and budgeted sales, valued at (standard profit per unit budgeted weighted average profit per unit)
The difference between actual sales volume in the standard mix and budgeted sales valued at the standard margin per unit. The difference between actual sales volume and budgeted sales valued at the budgeted weighted average profit per unit.
KEY.
With all variance calculations, from the most basic (such as variable cost variances) to the more complex (such as mix and yield / mix and quantity variances), it is vital that you do not simply learn formulae. You must Chapter 12 Page 10
Materials (10kg x 8 per kg) Labour (5hrs x 6 per hr) Variable O/Hds (5hrs x 8 per hr) Fixed O/Hds (5hrs x 9 per hr)
Budgeted Results
Production Sales Selling Price 10000 units 7500 units 300 per unit 8000 units 6000 units 85000 kg Cost 700000 36000 hrs Cost 330900 400000 500000 260 per unit
Actual Results
Production Sales Materials Labour Variable O/Hds Fixed O/Hds Selling Price Calculate a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 2
Standard Cost for Product TUH Materials (10kg x 8 per kg) 80 Labour (5hrs x 6 per hr) 30 Variable O/Hds (5hrs x 8 per hr) 40 Chapter 12 Page 11
11000 units 7500 units 300 per unit 9000 units 7000 units 85000 kg Cost 700000 36000 hrs Cost 330900 410000 520000 260 per unit
Calculate
a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 3
Standard Cost for Product TD Materials (10kg x 5 per kg) Labour (5hrs x 6 per hr) Variable O/Hds (5hrs x 8 per hr) Fixed O/Hds (5hrs x 9 per hr) Budgeted Results Production Sales Selling Price Actual Results Production Sales Materials Labour Chapter 12 50 30 40 45 165
8000 units 7500 units 300 per unit 11000 units 10000 units 85000 kg Cost 700000 36000 hrs Cost 330900 Page 12
Calculate
a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 4
Standard Cost for Product WXYZ Materials (4kg x 8 per kg) Labour (5hrs x 10 per hr) Variable O/Hds (5hrs x 8 per hr) Fixed O/Hds (5hrs x 6 per hr) Budgeted Results Production Sales Selling Price Actual Results Production Sales Materials Labour Variable O/Hds Fixed O/Hds Selling Price Calculate a. b. c. d. e. f. g. Chapter 12 Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Page 13 32 50 40 30 152
10000 units 7500 units 300 per unit 8000 units 6000 units 85000 kg Cost 700000 36000 hrs Cost 330900 400000 500000 260 per unit
Question 5
Standard Cost for Product RTY Materials (10kg x 8 per kg) Labour (5hrs x 6 per hr) Variable O/Hds (5hrs x 8 per hr) Fixed O/Hds (5hrs x 9 per hr) Budgeted Results Production Sales Selling Price Actual Results Production Sales Materials Labour Variable O/Hds Fixed O/Hds Selling Price 80 30 40 45 195
13000 units 10000 units 300 per unit 12000 units 9000 units 90000 kg Cost 750000 40000 hrs Cost 350000 500000 600000 350 per unit
Calculate
a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 6
Standard Cost for Product RED Materials (10kg x 7 per kg) Labour (5hrs x 6 per hr) Variable O/Hds (5hrs x 8 per hr) Fixed O/Hds (5hrs x 9 per hr) 70 30 40 45 185 Page 14
Chapter 12
Calculate
a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 7
Standard Cost for Product BUZZ Materials (3kg x 8 per kg) Labour (5hrs x 10 per hr) Variable O/Hds (5hrs x 9 per hr) Fixed O/Hds (5hrs x 10 per hr) Budgeted Results Production Sales Selling Price Actual Results Production Sales Materials Labour Variable O/Hds Fixed O/Hds Chapter 12 24 50 45 50 169
10000 units 7500 units 300 per unit 8000 units 6000 units 85000 kg Cost 700000 36000 hrs Cost 330900 400000 500000 Page 15
Calculate
a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 8
Standard Cost for Product RST Materials (10kg x 20per kg) Labour (5hrs x 16 per hr) Variable O/Hds (5hrs x 8 per hr) Fixed O/Hds (5hrs x 9 per hr) Budgeted Results Production Sales Selling Price Actual Results Production Sales Materials Labour Variable O/Hds Fixed O/Hds Selling Price 200 80 40 45 365
1000 units 7500 units 800 per unit 8000 units 6000 units 85000 kg Cost 700000 36000 hrs Cost 330900 400000 500000 260 per unit
Calculate
a. b. c. d. e. f. g. h. i. j. Chapter 12 Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance Page 16
10000 units 7500 units 300 per unit 13000 units 6000 units 85000 kg Cost 700000 36000 hrs Cost 330900 400000 500000 260 per unit
Calculate
a. b. c. d. e. f. g. h. i. j. Material total variance Material price variance Material usage variance Labour total variance Labour rate variance Labour efficiency variance Variable overhead total variance and all sub- variances Fixed Production overhead total Variance and all sub-variances Selling price variance Sales volume variance
Question 10
Standard Cost for Product White Diamond Materials (7kg x 9 per kg) Labour (6hrs x 9 per hr) Variable O/Hds (6hrs x 6 per hr) Fixed O/Hds (6hrs x 7 per hr) Budgeted Results Production Sales Chapter 12 63 54 36 42 195
Digitally signed by Muhammad Shahid DN: CN = Muhammad Shahid, C = US, O = 3S Inc Location: Sargodha Date: 2008.05.11 13:30:37 +05'00'
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Chapter 17
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To understand the meaning of standard costing, its meaning and definition To learn its advantages and limitations To learn how to set of standards and determinations To learn how to revise standards
Introduction
You know that management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control. It can also be applied to your own daily/monthly expenses, if necessary. These measures should be applied correctly so that performance takes place according to plans. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs. Standard costing is a technique which helps you to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.
Meaning of Standard
When you want to measure some thing, you must take some parameter or yardstick for measuring. We can call this as standard. What are your daily expenses? An average of $50! If you have been spending this much for so many days, then this is your daily standard expense. The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances. In the words of Backer and Jacobsen, Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.
Definition
The CIMA, London has defined standard cost as a predetermined cost which is calculated from managements standards of efficient operations and the relevant necessary expenditure. They are the predetermined costs on technical estimate of material labor and overhead for a selected period of time and for a prescribed set of working conditions. In other words, a standard cost is a planned cost for a unit of product or service rendered. The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures.
Advantages
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Setting Standards
Normally, setting up standards is based on the past experience. The total standard cost includes direct materials, direct labor and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control. Various Elements which Influence the Setting of Standards
When you want to purchase material, the quality and size should be determined. The standard quality to be maintained should be decided. The quantity is determined by the production department. This department makes use of historical records, and an allowance for changing conditions will also be given for setting standards. A number of test runs may be undertaken on different days and under different situations, and an average of these results should be used for setting material quantity standards. The second step in determining direct material cost will be a decision about the standard price. Materials cost will be decided in consultation with the purchase department. The cost of purchasing and store keeping of materials should also be taken into consideration. The procedure for purchase of materials, minimum and maximum levels for various materials, discount policy and means of transport are the other factors which have bearing on the materials cost price. It includes the following:
The purpose should be to increase efficiency in procuring and store keeping of materials. The type of standard used-- ideal standard or expected standard-- also affects the choice of standard price. Chapter 17 Page 4
Standard labor time indicates the time taken by different categories of labor force which are as under:
For setting a standard time for labor force, we normally take in to account previous experience, past performance records, test run result, work-study etc. The labor rate standard refers to the expected wage rates to be paid for different categories of workers. Past wage rates and demand and supply principle may not be a safe guide for determining standard labor rates. The anticipation of expected changes in labor rates will be an essential factor. In case there is an agreement with workers for payment of wages in the coming period, these rates should be used. If a premium or bonus scheme is in operation, then anticipated extra payments should also be included. Where a piece rate system is used, standard cost will be fixed per piece. The object of fixed standard labor time and labor rate is to device maximum efficiency in the use of labor.
Determination of overheads Determination of labor hours or units manufactured Calculating overheads rate by dividing A by B
The overheads are classified into fixed overheads, variable overheads and semi-variable overheads. The fixed overheads remain the same irrespective of level of production, while variable overheads change in the proportion of production. The expenses increase or decrease with the increase or decrease in output. Semi-variable overheads are neither fixed nor variable. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. The division of overheads into fixed, variable and semi-variable categories will help in determining overheads. Chapter 17 Page 5
2. Current Standards
A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year. It is presumed that conditions of production will remain unchanged. In case there is any change in price or manufacturing condition, the standards are also revised. Current standard may be ideal standard and expected standard.
3. Ideal Standard
This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption that favorable conditions will prevail and management will be at its best. The price paid for materials will be lowest and wastes etc. will be minimum possible. The labor time for making the production will be minimum and rates of wages will also be low. The overheads expenses are also set with maximum efficiency in mind. All the conditions, both internal and external, should be favorable and only then ideal standard will be achieved. Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not practicable and may not be achieved. Though this standard may not be achieved, even then an effort is made. The deviation between targets and actual performance is ignorable. In practice, ideal standard has an adverse effect on the employees. They do not try to reach the standard because the standards are not considered realistic.
4. Basic Standards
A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period. Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions. It is indeed just like a number against which subsequent process changes can be measured. Basic standard enables the measurement of changes in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an increase of 25% in the cost of materials. The changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose because the standard is not revised for a long time. The deviation between standard cost and actual cost cannot be used as a yardstick for measuring efficiency. Chapter 17 Page 6
7. Accounting System
Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue item. Codes can be used to have a speedy collection of accounts. A standard is a pre-determined measure of material, labor and overheads. It may be expressed in quality and its monetary measurements in standard costs.
Revision of Standards
For effective use of this technique, sometimes we need to revise the standards which follow for better control. Even standards are also subjected to change like the production method, environment, raw material, and technology. Standards may need to be changed to accommodate changes in the organization or its environment. When there is a sudden change in economic circumstances, technology or production methods, the standard cost will no longer be accurate. Standards that are out of date will not act as effective feed forward or feedback control tools. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department. If standards are continually not being achieved and large deviations or variances from the standard are reported, they should be carefully reviewed. Also, changes in the physical productive capacity of the organization or in material prices and wage rates may indicate that standards need to be revised. In practice, changing standards frequently is an expensive operation and can cause confusion. For this reason, standard cost revisions are usually made only once a year. At times of rapid price inflation, many managers have felt that the high level of inflation forced them to change price and wage rate standards continually. This, however, leads to reduction in value of the standard as a yardstick. At the other extreme is the adoption of basic standard which will remain unchanged for many years. They provide a constant base for comparison, but this is hardly satisfactory when there is technological change in working procedures and conditions.
Summary
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Digitally signed by Muhammad Shahid DN: CN = Muhammad Shahid, C = US, O = 3S Inc Location: Sargodha Date: 2008.05.11 13:30:58 +05'00'
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Chapter 20
Page 1
To describe as to how the concepts of fixed and variable costs are used in C-V-P analysis To segregate semi-variable expenses in C-V-P analysis To identify the limiting assumptions of C-V-P analysis To work out the breakeven analysis, contribution analysis and margin of safety To understand how to draw a breakeven chart To compute breakeven point
Introduction
In this lesson, we will discuss in detail the highlights associated with cost function and cost relations with the production and distribution system of an economic entity. To assist planning and decision making, management should know not only the budgeted profit, but also:
the output and sales level at which there would neither profit nor loss (break-even point) the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety)
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Volume of production Product mix Internal efficiency and the productivity of the factors of production Methods of production and technology Size of batches Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services. In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volumeprofit analysis can answer a number of analytical questions. Some of the questions are as follows: 1. What is the breakeven revenue of an organization? 2. How much revenue does an organization need to achieve a budgeted profit? 3. What level of price change affects the achievement of budgeted profit? 4. What is the effect of cost changes on the profitability of an operation? Cost-volume-profit analysis can also answer many other what if type of questions. Cost-volumeprofit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to what if theme by telling the volume required to produce. Chapter 20 Page 3
3. 4.
5. 6.
7.
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Strategic and long-range planning decisions Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same. For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:
Number of output units Number of customer visits made for sales Number of advertisements placed
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
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Example
Following is the spreadsheet of ABC Ltd.,
2,500
3,000
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The booth rental at the ABC convention raises to $. 3,000 (thus increasing fixed cost to $. 3,000) The software suppliers raise their price to $. 140 per unit (thus increasing variable costs to $. 140)
An aspect of sensitivity analysis is the margin of safety which is the amount of budgeted revenue over and above breakeven revenue. The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the what if questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitors better product, poorly executed marketing programs and so on. Assume you have fixed cost of $. 2,000, selling price of $. 200 and variable cost per unit of $. 120. For 40 units sold, the budgeted point from this set of assumptions is 25 units ($. 2,000 $. 80) or $. 5,000 ($. 200 x 25). Hence, the margin of safety is $. 3,000 ($. 8,000 5,000) or 15 (40 25) units. Sensitivity analysis is an approach to recognizing uncertainty, i.e. the possibility that an actual amount will deviate from an expected amount.
Selecting product mix or sales mix for profit maximization Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows: Sales Marginal cost of P/V ratio sales = Sales Contribution Sales Changes in = contribution Changes in sales Change in = profit Change in sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity. A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:
Breakeven point Profit at any volume of sales Sales volume required to earn a desired quantum of profit Profitability of products Processes or departments
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
Increasing selling price Reducing marginal costs by effectively utilizing men, machines, materials and other services Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that: Contribution = Fixed cost Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit. a. Using Marginal Costing Equation S (sales) V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S V = F Chapter 20 Page 8
4. Margin of Safety (MOS) Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production. Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business. Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio. Margin of safety = Sales at selected activity Sales at BEP = Margin of safety is also presented in ratio or percentage as follows: Profit at selected activity P/V ratio Margin of safety (sales) x 100 % Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken. a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the
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Problem 1 A company earned a profit of $. 30,000 during the year 2000-01. Marginal cost and selling price of a product are $. 8 and $. 10 per unit respectively. Find out the margin of safety. Solution Margin of safety = P/V ratio = Problem 2 A company producing a single article sells it at $. 10 each. The marginal cost of production is $. 6 each and fixed cost is $. 400 per annum. You are required to calculate the following:
Profits for annual sales of 1 unit, 50 units, 100 units and 400 units P/V ratio Breakeven sales Sales to earn a profit of $. 500 Profit at sales of $. 3,000 New breakeven point if sales price is reduced by 10% Margin of safety at sales of 400 units
Solution Marginal Cost Statement Particulars Amount Units produced 1 Sales (units * 10) 10 Variable cost 6 Contribution (sales- VC) 4 Fixed cost 400 Profit (Contribution FC) -396
Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40% Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000 Sales at BEP = Contribution at BEP/ PVR = 100 units
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Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 % (Actual sales BEP sales/Actual sales * 100) Breakeven Analysis-- Graphical Presentation Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship. Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss). Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales. Construction of a Breakeven Chart The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows: 1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis. 2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis. 3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line. 4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained. Uses of Breakeven Chart A breakeven chart can be used to show the effect of changes in any of the following profit factors:
Chapter 20
Problem A company produces a single article and sells it at $. 10 each. The marginal cost of production is $. 6 each and total fixed cost of the concern is $. 400 per annum. Construct a breakeven chart and show the following:
Breakeven point Margin of safety at sale of $. 1,500 Angle of incidence Increase in selling price if breakeven point is reduced to 80 units
Solution A breakeven chart can be prepared by obtaining the information at these levels: Output units 40 $. Sales 400 Fixed cost 400 Variable cost 240 Total cost 640 80 $. 800 400 480 880 120 $. 1,200 400 400 1,120 200 $. 2,000 400 720 1,600
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein: This chart clearly shows the breakeven point, margin of safety and angle of incidence. a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of $. 1,000 or 100 units. b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of ($. 1,500 - $. 1,000), i.e. $. 500 or 50 units. c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence. d. At 80 units, total cost (from the table) = $. 880. Hence, selling price for breakeven at 80 units = $. 880/80 = $. 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of $. 10 per unit. Limitations and Uses of Breakeven Charts
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The total budgeted sales (100%) are $. 6,00,000 per month. The operating costs are:
Ambience Luxury Comfort Lavish 60% 68% 80% 40% of of of of selling selling selling selling price Luxury price Comfort price Lavish price
The fixed costs are $. 1,59,000 per month. a. Calculate the breakeven point for the products on an overall basis. b. It has been proposed to change the sales mix as follows, with the sales per month remaining at $. 6,00,000:
Brand Name Ambience Luxury Comfort Lavish Percentage 25 40 30 05 --100
Assuming that this proposal is implemented, calculate the new breakeven point. Solution a. Computation of the Breakeven Point on Overall Basis b. Computation of the New Breakeven Point Profit Graph Profit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of profit to volume of sales. The construction of a profit graph is relatively easy and the procedure involves the following: 1. Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or loss on vertical axis. The area above horizontal axis is called profit area and the one below it is called loss area. 2. Plotting the profits of corresponding sales and joining them. This is profit line. Summary 1. Fixed and variable cost classification helps in CVP analysis. Marginal cost is also useful for such analysis. Chapter 20 Page 14
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Digitally signed by Muhammad Shahid DN: CN = Muhammad Shahid, C = US, O = 3S Inc Location: Sargodha Date: 2008.05.11 13:31:15 +05'00'
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