Advance Cost Accounting
description
Transcript of Advance Cost Accounting
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CHAPTER- I
QUESTION NO.1.
BRING ABOUT THE POINTS OF DISTINCTION BETWEEN
INTEGRATED AND NON-INTEGRATED SYSTEM OF ACCOUNTING
WITH THE HELP OF SUITABLE EXAMPLES ? (INCLUDING
MAXIMUM POSSIBLE TRANSACTION)
A )INTEGRATED SYSTEM OF ACCOUNTING
An Integrated Accounting System would be one where only a single set of books would
contain all the information of Financial Accounting as well as Inventory/ Cost
Accounting. Such a system would be very difficult to maintain if accounts are maintained
manually. But most available Computerized Accounting Systems are Integrated
Systems.Here we take the example of an Integrated Accounting System (our own product by
the name: Soft Accounting System) and explain how its functionality differs with Non-
Integrated manual Accounting system.Whereas in manual Financial Accounting, you enter
Cash/Bank transactions in Cash Book and enter all other transactions in General Journal; in
Soft Accounting System, you record Sale/Purchase transactions in Sale Invoice or Purchase
Invoice. In the case of cash purchase/sale, that entry shall automatically be recorded in Cash
Book. And in the case of credit purchase/sale, there will be no need to record it in General
Journal. With a simple entry in sale or purchase invoice, you will not only get all the
Financial Accounting Ledgers and Trial Balance, you will also automatically get your
inventory and cost registers. If yours is a trading Business, then with a simple entry in sales
invoice form, you will also automatically get Cost of that particular Sale calculated on the
basis of both Weighted Average Costing and LIFO Costing methods.If yours is a
manufacturing business, then there is another simple Production Entry Form. You will enter
in it only the basic ongoing production data but as a result, not only you will get detailed
Production Reports, you will also get updated inventory registers of raw-materials and semi-
finished items with a proper breakup of location/process where those semi-finished items
have reached so far. When final production process on semi-finished items have been
performed, then automatically those semi-finished items are removed from semi-finished
inventory registers and go to Finished Goods Inventory Register. And when you will enter
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new sale invoice, then finished goods stock shall be automatically reduced from the Finished
Goods Inventory Register. Not only this, you will also get detailed automated Direct Labor
Payroll Reports. In addition, you will also get automated costing reports like Batch Cost
Report and like etc. And since Soft Accounting System is an Integrated System, so you will
also get automatically updated information in your Financial Accounting Ledgers and Trial
Balance as well.To record daily expenditure and transactions other than Sale/Purchase (or
Sale/Purchase Returns which are to be recorded in Debit/Credit Notes), there are also Cash
Book and General Journal entry forms. So this is the way an Integrated Accounting System
works.
BENEFITS FROM INTEGRATED ACCOUNTING SYSTEM
The benefits of integrated accounting system are as follows:
A. As only one set of accounting records is kept, the need for reconciliation between the
profits shown by the two records is eliminated.
B. The duplication of work is eliminated, thus the cost of operating this system is reduced.
C. This method is simple to understand and easy to operate. Unnecessary complications are
eliminated.
D. Cost data can be available promptly and regularly.
E. There is a cross checking of various figures in cost as well as financial accounts. This
ensures accuracy of figures of cost and financial data.
F. Use of mechanized accounting methods can be made.
EXAMPLE
PROBLEMS AND SOLUTIONS
1. Journalize the following transactions in the integrated books of account in the books of
XYZ Ltd.
Credit purchases Rs.12, 00, 000
Production wages paid Rs. 7, 00, 000
Stocks issued to production orders Rs. 8, 00, 000
Work expenses charged to production Rs. 4, 50, 000
Finished goods transferred from production orders Rs. 18, 00, 000
Administration expenses charged to production Rs. 1,50, 000
Work expenses outstanding Rs. 1, 20, 000
Work expenses paid Rs. 4, 60, 00
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JOURNAL ENTRIE
DATE PARTICULARS L/F DEBIT Rs. CREDIT Rs.
1 Store Ledger Control A/c Dr.
To Sundry Creditors A/c
[Being goods purchased on credit]
1200000
1200000
2 Wages Control A/c Dr
To Cash/Bank A/c
[Being wages paid]
700000
700000
3 Work-in-progress Control A/c Dr
To Stores Ledger Control A/c
[Being stores issued against production orders]
800000
800000
4 Work-in-progress Control A/c Dr.
To Production Overhead Control A/c
[Being the work expenses allocated to
production/ job
450000
450000
5 Finished Goods Ledger Control A/c Dr
To Work-in-progress Ledger Control A/c
[Being goods finished during the year
transferred to finished goods account]
1800000
1800000
6 Work-in-progress Control A/c Dr.
To Administration Overhead Control A/c
[Being administrative overheads charged to
production]
150000
150000
7 Production Overhead Control A/c Dr
To Outstanding Works Overheads
[Being outstanding production overheads
recorded in the books]
120000
120000
8 Overhead Control A/c Dr.
To Cash/Bank A/c
[Being the works expenses paid]
460000
460000
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2. Journalize the following transactions assuming that the cost and financial accounts
are integrated.
Raw materials purchased: Rs.40, 000
Direct materials issued to production: Rs.30, 000
Wages paid [30% direct]: Rs.24, 000
Direct wages charged to production: Rs.16, 800
Manufacturing expenses incurred: Rs.19, 000
Manufacturing overheads charged to production: Rs.18, 400
Selling and distribution costs: Rs.4, 000
Finished products [At cost] : Rs.40, 000
Sales: Rs.58, 000
Closing stock: Nil
Receipts from debtors: Rs.13, 800
Payment to creditors: Rs.22, 000
JOURNAL ENTRIES
DATE PARTICULARS L/F DEBIT Rs.
Credit Rs.
1 Stores Ledger Control A/c Dr.
To Sundry Creditors A/c
[Being materials purchased]
40000
40000
2 Work-in-progress ledger control A/c Dr
To Stores Ledger Control A/c
[Being material issued to production]
30000
30000
3 Wages Control A/c Dr.
To Bank A/c
[Being wages paid including 30% indirect
wages]
24000
24000
4 Factory Overheads A/c Dr.
To Wages Control A/c
[Being the indirect wages charged to
production]
7200
7200
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5 Work-in-progress Ledger Control A/c Dr
To Wages Control A/c
[Being the direct wages charged to the
production]
16800
16800
6 Factory Overheads A/c Dr.
To Bank A/c
[Being the manufacturing overheads
incurred]
19000
19000
7 Factory Overheads A/c Dr.
To Bank A/c
[Being the manufacturing overheads
incurred]
18400
18400
8 Selling and Distribution Overheads A/c Dr
To Bank A/c
[Being selling and distribution costs
incurred]]
4000
4000
9 Finished Stock Ledger Control A/c Dr
To Work-in-progress Ledger Control A/c
[Being cost of production transferred to
Finished Stock Ledger Control A/c
40000
40000
10 Cost Of Sales A/c Dr
To Finished Stock Ledger Control A/c
To Selling And Distribution Overheads A/c
[Being the cost of finished units] *
44000
44000
11 Sales Ledger Control A/c Dr
To Cost of Sales A/c
[Being the amount of Sales]
58000
58000
12 Bank A/c Dr
To Sales Ledger Control A/c
[Being amount received from debtors]
13800
13800
13 Bought Ledger Control A/c Dr
To Bank A/c
[Being the amount paid to sundry
2200
2200
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creditors]
NON-INTEGRATED SYSTEM OF ACCOUNTING
When we use both financial accounting and cost accounting for recording transactions
separately, at that time , it is called non integral system of accounting. Non integral system of
accounting is just opposite the integral system of accounting. In non-integral system of
accounting, we need to make reconciliation statement for knowing the reasons of difference
in the profit which have been calculated in cost accounting system and financial accounting
system.
Non-Integrated and Integrated Accounting for only the monetary aspects of every business
transaction. You purchase hundreds of inventory items but to record purchase, you only debit
one Purchase Account with purchase value without any mention of quantities involved.
Similarly you sell different trade items and record them by giving credit to only Sales
Account. Consequently your Financial Accounts fail to tell you the complete story of your
business affairs. You get a Trial Balance and Final Accounts. You know your Gross Profit
and Net Profit. You also know financial worth of your business on the Balance Sheet
date. The things you dont know in this way are the details of your inventory items
purchased/ sold, inventory stocks, inventory costs taken up in every sales transactions
(Trading Businesses) or ongoing production activities (Manufacturing Businesses).To
overcome these limitations of Financial Accounting, large businesses usually adopt and
implement another difficult and expensive Accounting System which is known as Cost and
Management Accounting. This is also non-integrated accounting method because it functions
parallel to the Financial Accounting. Small businesses end up in the maintenance of only
some Stock Registers, in addition to the usual Financial Accounting. It means that under
non-integrated accounting systems, Financial Accounting and Inventory/Cost Accounting
books/ ledgers are separately maintained. To explain an Integrated Accounting System, we
here assume that reader already knows the usual procedure of recording transactions where
entries are basically recorded in Cash Book and General Journal, then posted to Ledger, then
summarized in the form of Trial Balance and then results are taken in the form of Final
Accounts.
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MAINTENANCE OF ACCOUNTS
As maintained above, the fi nance department is responsible for maintaining the fi nancial
ledgers. Thisdepartment maintains the following ledgers.
_ General ledger: It includes all real, nominal and personal accounts except debtors and
creditorsaccounts.
_ Debtors Ledger: It contains the personal accounts of trade debtors.
_ Creditors Ledger: It contains the personal accounts of trade creditors.On the other hand,
the cost accounting department maintains the following cost ledgers.
_ Stores ledger for recording all stores transactions
_ Work-in-progress ledger: Cost of materials, labour and overheads of all jobs, which are in
progress, are posted to this account.
_ Finished goods/stock ledger: This ledger has the record of fi nished goods/stock.
_ Cost ledger: This ledger maintains the accounts relating to income and expenditure. The
following accounts are maintained in this ledger.
A. Cost control accounts: These accounts are maintained to exercise control over the three
subsidiary ledgers maintained above and also to complete the double entry in cost accounts.
The importantcost control accounts are as follows.
I. Stores ledger control a/c
II. Work-in-progress ledger control a/c
III. Finished goods ledger control a/c
IV. General ledger adjustment a/c
B. Other accounts: They include all other impersonal accounts [real as well as nominal]
whicheffect costs, e.g. wages control account, factory overhead accounts, administration
overheadaccount, selling and distribution overhead account, cost of sales account etc.
Depending uponthe requirement, the following additional accounts may also be maintained.
_ Overhead suspense account
_ Capital orders account
_ Service orders account.
Treatment of Elements of Cost
The following treatment is given to the various elements of cost.
_ Materials: Certain transactions relating to material are recorded in the fi nancial accounts
also.
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Examples of such transactions are purchase of material, return of materials. These
transactions arerecorded in financial as well as cost accounts. On the other hand, certain
transactions like issue ofmaterials from stores, transfer of material from one job to the other
one, return of excess materials tostores are recorded in cost accounts only.
_ Labour: Wages paid are recorded in the cost accounts through wages control account and
the generalledger adjustment account.
_ Overheads: Various types of overheads like production, administration and selling and
distributionare absorbed to the products on some suitable basis. The production overhead
accounts is creditedwith the amount of overheads absorbed and the work in progress account
is credited. In case ofadministrative overhead account, the amount absorbed is credited to the
administrative overheadaccount and finished stock account is debited. Selling and distribution
overheads are credited tothe selling and distribution overhead account and corresponding
debit is given to the cost of sales
account. Finally, the amount of under/over absorbed overheads is transferred to the Costing
Profitand Loss A/c.
IN NON-INTEGRAL SYSTEM OF ACCOUNTING, WE KEEP THE COST
LEDGERS :
1. General Ledger Adjustment Account
This account is opening just for self-balancing. This account represents the personal accounts
in cost accounting's non integral system.
Credit side
balance b/d - opening balance
Store ledger control account - purchase
work in process control account - special purchase
Wages control account - total wages ( Direct + indirect + administrative + selling department
salaries)
Production overhead control account - Production expenses
administrative overhead control account - administrative expenses
Selling and distribution overhead control account - selling and distribution expenses
Costing profit and loss account - transfer from costing and profit and loss account
Credit
Store ledger control account - Return to suppliers
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Sales account - total sales
Balance c/d - balancing figure
2. Stores Ledger Control Account
Opening stock in store balance will be debited in this account. New buying of material will
be debited with the name of general ledger adjustment account in stores ledger control
account. Material issued for production will be credited with the name of work in process
control account. Return to supplier will be credited with the name of general ledger
adjustment account in this account. Difference of debit side and credit side will be the closing
stock in store.
3. Wages Control Account
This account is debited with total wage payment ( Direct + indirect + administrative + selling
department salaries). We total all these account and general ledger adjustment account will be
debited in this account. After this, we will credit the direct wage with work in process
account. We will credit indirect wage with production overhead control account. We will
credit salaries of administration department with administrative overhead control account. In
end, we will credit salaries of selling department with selling and distribution overhead
control account
4. Production Overhead Control Account
Production overhead will show all production overheads in its debit side.
Debit Side
Indirect material used - Store ledger control account
Indirect wage - Wages control account
Indirect Expenses - General Ledger Adjustment Account
Credit Side
Production overhead absorbed by production - Work in process control account
Difference of credit side and debit side will go to costing profit and loss account
5. Work in process Ledger Control Account
Debit
Balance b/d Opening balance of work in process
Production overhead control account - production overheads absorbed by production
Wages Control Account - Direct Wages
Store Ledger Control Account - Indirect material used for production
Credit
Finished goods ledger control account - Producing of finished goods during the year.
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Balance C/d - Closing stock which in production process
6. Administrative Overhead Ledger Control Account
Debit
General Ledger Adjustment Account - Administrative Expenses
Salaries for Administrative department
Credit
Finished Goods Ledger Control Account - Absorption of administrative overhead by finished
goods
balance - Costing profit and loss account
7. Finished Goods Ledger Control Account
Debit
Balance b/d - opening balance of finished goods
work in process control account - production during the year
administrative overhead control account - Absorption of administrative overhead by finished
goods
Credit
Cost of Sale Account - Finished Goods sold at cost
Balance C/d -Closing stock of finished goods
8. Selling and Distribution Overhead Control Account
This account is debited with general ledger adjustment account and wages control account
(payment for sales to employees) and credited with cost of sales. Difference between debit
and credit side will transfer to costing profit and loss account.
9. Cost of Sale Account
This account is debited with finished goods ledger control account and selling and
distribution overhead control account and this account is transferred to sales account.
10. Sales Account
In the debit side, we will show cost of sale account and costing profit and loss account and it
will be transfer to general ledger adjustment account.
11. Costing Profit and Loss Account
This account shows the net profit as per the cost accounting rules. In the credit side, we show,
sales account and production overhead control account In the debit side, we show
administrative overhead control account, selling and distribution overhead control account
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and difference of credit and debit side will be net profit which will be transfer to general
ledger adjustment account's credit side.
TRANSACTION
DIFFERENCE BETWEEN INTEGRATED AND NON-INTEGRATED ACCOUNTIN
SYSTEM
The journal entries under integral and non-integral accounting systems are given in the
following table.
ITEMS NON-
INTEGRATED
SYSTEM OF
FINANCIAL
BOOK
NON-
INTEGRATED
SYSTEM OF
COST BOOKS
INTEGRATED
SYSTEM
Purchase ofMaterials Purchase A/c Dr To Purchase Ledger To Purchase Ledger Control A/c [or creditors]
Stores Ledger Control A/c Dr. To General Ledger Adjustment A/c
Stores Ledger Control A/c To Creditors A/c
Issue ofmaterials for
Production
No entry Work-in-progress Ledger Control A/c Dr To Stores Ledger Control A/c
Work-in-progress A/c Dr To Stores Ledger Control A/c
Payment ofwages Wages A/c Dr To Cash/bank A/c
Wages A/c/ Wages Control A/c Dr. To General Ledger Adjustment A/c
Wages A/c / Wages Control A/c Dr To Cash A/c
Paymentfor indirect
Expenseslike power,
repairs etc.
Expenses A/c Dr To Cash A/c To Creditors A/c
Factory/Adm/S & D Overhead A/c Dr To General Ledger Adjustment A/c
Factory/Adm/S & D Overhead A/c Dr To Cash A/c To Creditors A/c
Recordingof Factory
Overheadsat pre deter-
mined rates
No entry
Work-in-progress Control A/c Dr To Factory Overheads Control A/c
Work-in-progress Control A/c Dr To Factory Overheads Control A/c
FactoryOverheadsover
absorbed
No entry Factory Overhead Control A/c Dr
Factory Overhead Control A/c Dr
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To Costing Profi t & Loss A/c
To Costing Profi t & Loss A/c
Jobscompleted No entry Stock Ledger Control A/c Dr To work-in-progress Ledger Control A/c
Stock Ledger Control A/c Dr To work-in-progress Ledger Control A/c
Interest paid
Interest A/c Dr To Cash A/c
No entry Interest A/c Dr To Cash A/c
Rent of ownpremises
Rent of own premises
Works Overhead A/c To General Ledger Adjustment A/c
Works Overhead A/c Dr To Rent [notional]
A/c
Sales [Credit]
Sales Ledger Control A/c Dr To Sales A/c
General Ledger Adjustment A/c Dr To Cost of Sales A/c
Sales Ledger Control A/c Dr To Sales A/c
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EXAMPLE
NON-INTEGRATED ACCOUNTING SYSTEM
Pass the journal entries in the cost books non-integrated system for the following transaction.
i) Material worth Rs.25000/- returned to the stores from job.
ii) Gross total wages paid Rs. 48000. Employer contribute to P.F. and State insurance
Amounts to Rs. 2000/-. Wages analysis book detailed Rs.20000/-. Towards directs
labour ,Rs. 12000/- towards indirect factory labour Rs.10000/- towards salaries
etc.To office staff and Rs. 8000/- for salaries, etc.To selling and distribution staff.
Date Particulars Debit Rs. Credit Rs.
1
Store Ledger Control A/C Dr.
To Work In Progress Ledger A/C
[ ToWork In Progress Returned To Store From
The Job.]
25000
25000
2a Wages Control A/C Dr.
To General Ledger Adjustment A/C
[ Being Entry In Cost Books For Gross Wages
And Employer Contribution To P.F]
50000
50000
B WIP Ledger Control A/C Dr.
Factory Overheads A/C Dr.
Administration Overheads A/C Dr.
Selling And Distribution Overheads A/C Dr.
To Wages Control A/C
[ Being The Amount Of Direct Labour To WIP
Control Account And Indirect Expenses
Transferred To Respective Overheads Accounts)
20000
12000
10000
8000
50000
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Problem . 2
a) Issue of material
Direct 550000
Indirect 150000
b) Allocation of wages and salaries
Direct 200000
Indirect 40000
c) Overheads absorbed in jobes
Factory 150000
Administration 50000
Selling 30000
d) Under/absorbed overheads
Factory (over) 20000
Administration (under) 10000
JOURNAL ENTRIES
NO PARTICULARS DEBIT Rs. CREDIT Rs.
1 Work In Progress Ledger Control A/C Dr.
Factory Overheads Control A/C Dr.
To Stores Ledger Control A/C
550000
150000
700000
2
Work In Progress Ledger Control A/C Dr.
Overheads Control A/C Dr.
To Wages Control A/C
200000
40000
240000
3 Work-In- Progress Ledger Control A/C Dr.
To Factory Overheads Control A/C
150000
150000
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4 Finished Goods Ledger Control A/C
Dr.
To Administration Overheads Control A/C
50000
50000
5 Cost Of Sale A/C
Dr.
To Selling Overheads Control A/C
30000
30000
6 Factory Overheads Control A/C Dr.
To Costing P&L A/C
20000
20000
7 Costing P&L A/C Dr.
To Administration Overheads Control
A/C
10000
10000
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CHAPTER- II
Question No.2.
Explain the following concept with the help of graphical
presentation ?
1. Angle of incident
2. Break-Even chart
3. Margin of Safety
4. Profit volume Graph
ANGLE OF INCIDENT
This is the angle between sales line and total cost line. This angle is formed by the
intersection of the total cost line and the sales line (at the BEP). This angle is an indicator of
profit-earning capacity over BEP. Large angle indicates the earning of high margin of profit.
Small angle indicates a low margin of profit which, in turn, suggests that variable costs
constitute a major chunk of cost of sales.
In general, a small angle of incidence indicates that firms are highly stablewith narrow
profit margin, low BEP, high margin of safety, low fixed cost and high variable cost, whereas
a large angle of incidence indicates that firms are highly riskywith high BEP, high fixed
cost, low variable cost and low margin of safety.
It is an angle that is created when the entire sales line intercepts the entire cost line from
below in the breakeven chart. It is inferred that higher the angle, higher is the profit, and
lower the angle lower the profit.
Angle of incidence (0) is the angle between the total cost line and the total sales line. If the
angle is large, the firm is said to make profits at a high rate and vice-versa.
A high angle of incidence and a high margin of safety indicate sound business conditions.
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BREAK-EVEN CHART
Break Even Point
The concept of Break Even Point is extremely important for decision making in various
areas. This concept is based on the behaviour of costs, i.e. fi xed cost and variable costs. As
discussed earlier, fixedcosts are those costs that remain constant irrespective of the changes in
the volume of production. On theother hand, variable costs are the costs that vary with the
level of production. While fixed cost per unit isalways variable, variable cost per units is
always fi xed. In addition to these two types of costs, there aresemi variable costs that are
partially fi xed and partially variable. Semi variable costs thus have the featuresof both types
of costs. They remain fi xed up to a certain level of production and after crossing that level,
they become variable.The Break Even Point is a level of production where the total costs are
equal to the total revenue, i.e. sales. Thus at the break even level, there is neither profit nor
loss. Production level below the break-even-pointwill result into loss while production above
break-even point will result in profits. This concept can be better understood with the help of
the following table.Break-even analysis is a technique widely used by production
management and management accountants. It is based on categorising production costs
between 1those which are "variable" (costs that change when the production output changes)
and those that are "fixed" (costs not directly related to the volume of production).Total
variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a loss
(the "break-even point").
Break even level can also be worked out with the help of the following formulae.
Break even point [in units] = Fixed Cost / Contribution per Unit
Break even point [in Rs.] = Fixed Cost / Profit Volume [P/V] Ratio Break even point can also be shown on the graph paper as follows:
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Y Total Revenu
Revenue Cost
Total Cost
BEP
Total Fixed Cost
Margin of Safety
Production / sales Volume X
Explanation: On horizontal axis, production and sales volume is shown while on the vertical
axis, salesand costs in amount are shown.
Assumptions of Break Even Point: The concept of break even point is based on the
followingassumptions.
1. Production and sales are the same, which means that as much as is produced is sold out in
the market.
Thus there is no inventory remaining at the end.
2. Fixed cost remains same irrespective of the production volume.
3. Variable cost varies with the production. It changes in the same proportion that of the
production.
Hence it has a linear relationship with the production. In other words, variable cost per unit
remainsthe same.
4. Selling price per unit remains same irrespective of the quantity sold.
Margin of Safety: Margin of Safety is the difference between the actual sales and the break
even sales. As we have discussed, at the break even point there is neither any profi t nor loss.
Hence any firm will alwaysbe interested in being as much above the break even level as
possible. Margin of safety explains precisely
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this thing and the higher the safety margin the better it is. Margin of safety is computed as
follows.
The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at various
levels of activity shown on the same chart as the variation of income (or sales, revenue) with
the same variation in activity. The point at which neither profit nor loss is made is known as
the "break-even point" and is represented on the chart below by the intersection of the two
lines:
In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.
At low levels of output, Costs are greater than Income. At the point of intersection, P, costs
are exactly equal to income, and hence neither profit nor loss is made.
Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
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costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result
of investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related
costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a
particular product or service and allocated to a particular cost centre. Raw materials and the
wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with
output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase
when output reaches certain levels. These are largely related to the overall "scale" and/or
complexity of the business. For example, when a business has relatively low levels of output
or sales, it may not require costs associated with functions such as human resource
management or a fully-resourced finance department. However, as the scale of the business
grows (e.g. output, number people employed, number and complexity of transactions) then
more resources are required. If production rises suddenly then some short-term increase in
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warehousing and/or transport may be required. In these circumstances, we say that part of the
cost is variable and part fixed.
Limitations of Break even Point: Break Even point is extremely useful in decision- making
regarding the production level. It indicates the level of production where there is neither any
profi t nor loss. Howeverthis is based on the assumption that the variable cost per unit, sales
price per unit and the fixed remains the same. If there is any change in these variables, the
break even point will give misleadingresults.
Problems and Solutions:
1. From the following fi gures, fi nd the Break Even Volume
Selling price per ton Rs.69.50
Variable cost per ton Rs.35.50
Fixed Cost Rs.18.02 lakhs
If this volume represents 40% capacity, what is the additional profi t for an added production
of 40%
capacity, the selling price of which is 10% lower for 20% production and 15% lower than the
existing
price, for the other 20% capacity?
Solution: Existing Break Even Sales = Fixed Cost/Contribution per unit
Rs.18.02 lakhs/Rs.69.50 Rs.35.50
Rs.18.02 lakhs/Rs.34 = 53 000 units
Sales Value = 53, 000
_ Rs.69.50 = Rs.36, 83, 500
It is given in the problem that 40% capacity represents 53, 000 units
Hence 80% capacity will represent 1 06 000 units
_ For additional 20% capacity, selling price falls by 10%
_ Revised Selling Price = Rs.69.50 Rs.6.95 = Rs.62.55
Less: Variable Cost = Rs.35.50
Contribution = Rs.27.05
20% capacity = 53, 000 units/2 = 26, 500 units
Profi t if sale price is Rs.62.55 = Contribution per unit
_ Sales units
Rs.27.05
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22
_ 26, 500 units = Rs.7, 16, 825
_ Contribution by 20% capacity for which selling price falls by 15%
_ Revised Selling Price = Rs.69.50 Rs.10.425 = Rs.59.075
_ Less: Variable Cost = Rs.35.50
Contribution = Rs.23.575
Profi t is sale price is Rs.59.075 = Contribution per unit
_ Sales units
Rs.23.575
_ 26, 500 units = Rs.6, 24, 737
Additional profi t by 40% sales = Rs.7, 16, 825 + Rs.6, 24, 737 = Rs.13, 41, 562
2. A retail dealer in garments is currently selling 24, 000 shirts annually. He supplies the
following
details for the year ended 31st March 2007.
Selling price per shirt: Rs.800
Variable cost per shirt: Rs.600
Fixed Cost:
Staff salaries: Rs.24, 00, 000
General Office Cost: Rs.8, 00, 000
Advertising Cost: Rs.8, 00, 000
As a Cost Accountant, you are required to answer the following each part independently:
1. Calculate Break Even Point and margin of safety in sales revenue and number of shirts sold. 2. Assume that 30, 000 shirts were sold during the year, fi nd out the net profi t of the fi rm.
3. Assuming that in the coming year, an additional staff salary of Rs.10, 00, 000 is
anticipated, and price of shirt is likely to be increased by 15%, what should be the break even
point in number ofshirts and sales?
Solution:
Break Even Point: [units] = Fixed Cost / Contribution Per Unit =
Rs.40, 00, 000/Rs.200 = 20 000 number of shirts
_ Note: Contribution per units is selling price variable cost per unit Rs.800 Rs.600 =
Rs.200
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23
_ Break Even Point [sales value] = 20000 units
_ Rs.800 = Rs.1, 60, 00, 000
_ Margin of safety = Actual Sales Break Even Sales
_ 24, 000 shirts
_ Rs.800 = Rs.1, 92, 00, 000 Rs.1, 60, 00, 000 = Rs.32, 00, 000
_ Margin of safety [units] = 24, 000 shirts 20, 000 shirts = 4000 shirts
2. Amount of profi t if 30, 000 shirts are sold:
_ Sales [units] = Fixed Cost + Profi t / Contribution Per Unit
_ 30, 000 = Rs.40, 00, 000 + Profi t /Rs.200 = Profi t = Rs.20, 00, 000
3. Revised Break Even Point if fi xed cost rise by Rs.10, 00, 000 and selling price
increase by 15%
_ New selling price = Rs.800 + 15% = Rs.920, new fi xed cost = Rs.40, 00, 000 + Rs.10, 00,
000 = Rs.50, 00, 000
_ Revised Break Even Point [number of shirts] = Rs.50, 00, 000 / Rs.920 Rs.600
_ Break Even Point = 15, 625 shirts and 15, 625
_ Rs.920 = Rs.1, 43, 75, 000
4. The following figures are available from the records of Venus Traders as on 31stMarch
MARGIN OF SAFETY
Margin of safety (MOS) is the excess of budgeted or actual sales over the break evenvolume
of sales. It stats the amount by which sales can drop before losses begin to be incurred. The
higher the margin of safety, the lower the risk of not breaking even.
The margin of safety is the reduction in sales that can occur before the breakeven point of a
business is reached. The amount of this buffer is expressed as a percentage.
The margin of safety concept is especially useful when a significant proportion of sales are at
risk of decline or elimination, as may be the case when a sales contract is coming to an end.
By knowing the amount of the margin of safety, management can gain a better understanding
of the risk of loss to which a business is subjected by changes in sales. The opposite situation
may also arise, where the margin of safety is so large that a business is well-protected from
sales variations.
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24
The margin of safety concept does not work well when sales are strongly seasonal, since
some months will yield catastrophically low results. In such cases, annualize the information
in order to integrate all seasonal fluctuations into the outcome.
To calculate the margin of safety, subtract the current breakeven point from sales, and divide
by sales. The formula is:
Current Sales Level Breakeven Point
Current Sales Level
Margin of Safety: Margin of Safety is the difference between the actual sales and the break
even sales. As we have discussed, at the break even point there is neither any profi t nor loss.
Hence any firm will alwaysbe interested in being as much above the break even level as
possible. Margin of safety explains preciselythis thing and the higher the safety margin the
better it is. Margin of safety is computed as follows.
Here are two alternative versions of the margin of safety:
1. Budget based. A company may want to project its margin of safety under a budget for
a future period. If so, replace the current sales level in the formula with the budgeted
sales level.
2. Unit based. If you want to translate the margin of safety into the number of units sold,
then use the following formula instead (though note that this version works best if a
company only sells one product.
3. For example, Lowry Locomotion is considering the purchase of new equipment to
expand the production capacity of its toy tractor product line. The addition will
increase Lowry's operating costs by Rs.100,000 per year, though sales will also be
increased. Relevant information is noted in the following table:
Before Machinery Purchase After Machinery Purchase
Sales Rs.4,000,000 Rs.4,200,000
Gross margin percentage 48% 48%
Fixed expenses Rs.1,800,000 Rs.1,900,000
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25
Breakeven point Rs.3,750,000 Rs.3,958,000
Profits Rs.120,000 Rs.116,000
Margin of safety 6.3% 5.8%
The table reveals that both the margin of safety and profits worsen slightly as a result of the
equipment purchase, so expanding production capacity is probably not a good idea.
The margin of safety concept is also applied to investing, where it refers to the difference
between the intrinsic value of a company's share price and its current market value. An
investor wants to see a large variance between the two figures (which is the margin of safety)
before buying stock. This implies that there is substantial upside potential for the stock price -
or at least, it means any error in deriving the intrinsic value must be a big one in order to
erase the margin of safety.
PROFIT VOLUME RATIO
A graphic that shows the relationship between a company's earnings (or losses) and its sales.
The chart tells how different levels of sales affect a company's profits. Companies can use
profit-volume charts to establish sales goals, to analyze whether a potential project is likely to
be profitable and to see the maximum potential profit or loss of a given project, as well as
where the breakeven point lies.
Companies use PV charts in cost-volume-profit analysis along with breakeven charts and
contribution
charts.
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CHAPTER- III
Question No. 3.
With the help of suitable example explain how the management
takes the following decision?
1. Accept or Rejects special order decision.
2. Make or Buy decision.
3. Keep or Replace decision.
4. Reduces or Maintain the price the decision.
5. Add or Drop the products decision.
6. Operate or Shut-down decision.
7. Expand or Reduce the capacity decision.
8. Sales or Process decision.
9. Key factor and products mix decision
ACCEPT OR REJECTS SPECIAL ORDER DECISION.
When Should Special Orders Be Accepted?
Special orders should be accepted only if:
Incremental revenue exceeds incremental costs
Present sales are unaffected
The company has idle capacity to handle the order
Special orders which do not meet these criteria should generally not be accepted. Of course,
soft-benefits should be considered as well.
Accept or Reject?
If incremental revenues are less than incremental costs, reject the order, unless qualitative
characteristics overwhelmingly impact the decision.
If incremental revenues are greater than incremental costs, accept the order unless qualitative
characteristics overwhelmingly impact the decision.
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27
If incremental revenues are equal to incremental costs, focus primarily on qualitative
characteristics to assess the decision.
An Example
Flowers Inc. manufactures silk roses. Bud Company has approached Flowers with a proposal
to buy 2,000 silk roses for 8,000. Flowers has the necessary capacity. The following costs are
associated annually with silk roses when 10,000 units are produced:
Direct material 21,000
Direct labor 13,000
Manufacturing overhead 9,000
Total 43,000
Forty percent of the overhead is variable. All fixed overhead is allocated equally to all
products produced. In good form, prepare an incremental analysis to analyze whether Flowers
should accept the order from Bud Company.
Forty percent of the overhead is variable. All fixed overhead is allocated equally to all
products produced. In good form, prepare an incremental analysis to analyze whether Flowers
should accept the order from Bud Company.
Step 1: Decide what is not relevant. Allocated fixed overhead is not relevant. The total fixed
overhead of 5,400 (60%*9,000) is the same no matter what decision is made, so it is not part
of the analysis.
Step 2: Determine incremental revenue. The amount of 8,000 is given for this problem.
Step 3: Determine incremental costs. The variable material cost must be determined:
21,000/10,000 = 2.10 per unit
You must then multiply unit cost by the total units in the special order:
2.10 * 2,000 = 4,200
Because variable costs are increased by $4,200, profit will decrease by $4,200, so the amount
is shown as a negative in the incremental analysis.
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Step 4: Direct labor is another incremental variable cost. The variable cost per unit is:
13,000/10,000 units = 1.30 per unit
The labor cost of all 2,000 units = 2,000*1.30 = $2.600
Because variable costs are increased by 2,600, profit will decrease by 2,600, so this amount is
Step 5: Only the variable portion of the fixed shown as a negative in the incremental
analysis. overhead is relevant. First you must determine the variable overhead per unit which
is 9,000/10,000, or 0.90 per unit. Of this amount, 40% is variable amounting to 0.36 per unit.
The cost of the variable overhead for the 2,000 units in the special order equal 2,000*0.36 =
720. This is an increase cost which causes profit to decrease so the amount is shown as a
negative in the analysis.
The analysis should appear in the following format with respective labels as follows:
Incremental revenue 8,000
Incremental costs:
Direct materials (4,200)
Direct labor (2,600)
Variable overhead (720)
Incremental increase in profit if the order is accepted 480
Because profit increases by 480 if the order is accepted, managers should follow through and
accept the order unless qualitative issues warrant otherwise.
THE MAKE OR BUY DECISION
Marginal costing can be applied in the area of fixation of selling price. The next important
area is whether to make or buy decision. When a company has unused capacity and wants to
manufacture some components, it has two alternatives:
(A) to make within the organization or
(B) to buy from the market.
Often, firms face the question whether to outsource production of a component or continue to
make it in the factory. Comparison of the relevant costs of both the alternatives in such cases
will show whether to continue the existing arrangement or change to buying it, discontinuing
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29
the current production. The answer depends upon whether the firm has the option to use the
freed capacity, profitably, or not.
Illustration No. 1
Suresh Ltd. is producing a part at a cost of Rs. 11 per unit. The composition of the cost is as
follows:
Materials 3.00
Wages 4.00
OverheadsVariable2.50
- Fixed 1.50
11.00
Presently, the firm has been incurring a total fixed cost of Rs. 15,000 for manufacturing the
current production of 10,000 units. An outsider is offering the same component, in all aspects
identical in features, for Rs. 10 per unit. On enquiry, it is found from the firm that the
machinethat is manufacturing the parts would remain idle as the machinery cannot be
utilized elsewhere.
(A) Should the offer be accepted?
(B) Would your answer would be different, if the outside firm reduces the price to Rs. 9,
after negotiation. What is the impact of the fixed costs in the decision-making process?
Solution:
The variable cost of the product is as under:
(Rs.)
Materials 3.00
Wages 4.00
OverheadsVariable 2.50
Total Variable Cost 9.50
(A) Here, the additional costs (variable costs) for making are Rs. 9.50. The outside market
priceis Rs. 10. The outside offer is on a higher side by Rs. 0.50 per unit, so the offer is to be
rejected. For every unit bought outside, it results in a loss of Rs. 0.50 per unit.
(B) Now, the outside firm is willing to reduce the price to Rs. 9, while the variable cost is
Rs. 9.50. The offer is to be accepted.
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30
So far as the fixed costs Rs. 15,000 is concerned, the firm would incur, whether the firm
makes the product itself or buys it outside. In other words, the existing fixed costs are not to
beconsidered, while taking a decision.
KEEP OR REPLACEMENT DECISION
A company is considering replacing an old machine with a new one. Details about the old m
achine and the new machine are as follows:
Old Machine
Original Cost 1,000,000
Depreciated amount 800,000
Remaining useful life3 years Current disposal value 10,000
Disposal value after 3 years Nil
New Machine
Current purchase cost 300,000
Useful life 3 years
Disposal value after 3 years 60,000
The new machine can reduce operating costs by 80,000 per annum.
Solution
CostBenefit Analysis for Replacement
Incremental Benefits of Replacement
Total costs saving (3 x $80,000) 240,000
Disposal value of new machine after 3 years 60,000
Current disposal value of old machine 10,000
310,000
Less: Incremental Costs
Purchase cost of new machine (300,000)
Net Incremental Benefits of Replacement 10,000
Conclusion: Since replacement would make a net incremental benefit, it should be replaced.
ADD OR DROP DECISION
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A decision whether or not to continue an oldproduct line or department, or to start a new one
is called an add-or-drop decision. An add-or-drop decision must be based only on relevant
information.Relevant information includes the revenues and costs which are directly related
to a product line or department. Examples of relevant information aresales revenue, direct
costs, variable overhead and direct fixed overhead. Such decision must not be based on
irrelevant information such as allocated fixed overhead because allocated fixed overhead will
not be eliminated if the product line or department is dropped.
The following example illustrates an add-or-drop decision:
Example
A company has three products: Product A, Product B and Product C. Income statements of
the three product lines for the latest month are given below:
Product Line A B C
Sales 467,000 314,000 598,000
Variable Cost 241,000 169,000 321,000
Contribution Margin 226,000 145,000 277,000
Direct Fixed Cost 91,000 86,000 112,000
Allocated Fixed Costs 93,000 62,000 120,000
Net Income 42,000 3,000 45,000
Use the incremental approach to determine if Product B should be drop
Solution
By dropping Product B, the company will loose the sale revenue from the product line. The
company will also obtain gains in the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product B and not the allocated fixed costs. Hence:
If Product B is Dropped
Gains:
Variable Costs Avoided 169,000
Direct Fixed Costs Avoided 86,000 255,000
Less: Sales Revenue Lost
314,000
Decrease in Net Income of the Company
59,000
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SALE OR PROCESS DECISION Folllowing information has been made available from the cost record of company
manufacturing spares parts:
Particulars Per.Unit Direct Material A Rs.8
B Rs.6
Direct Wages
A 4 Hr @ Rs. 2 Per Hr.
B 6 Hr. @ Rs. 2Per Hr.
Variable overheads 150 % of Wages
Fixed overheads Rs. 750
Selling Price of A Rs.30 Selling Price of B Rs.35
The directors want to be acquainted with the desirability of adapting any one of the following altenative sales mixed in the budget for the next period :
1. 250 Units of A and 250 Units of B. 2. 400 units of only B. 3. 400 Units of A and 100 units of B.
4.150 Units of A and 350 Units of B.
State which of The alternative sales mix you would recommend to the management.
Solution
1) Statement of Contribution (Per Uuit) PARTICULARS A B
Selling Price 30 35
Variable Expenses
Direct Material 8 6
Direct Wages 8 12
Variable Overheades 12 28 18 36
Contribution 2 -1
2) Evaluation Of
Alternative
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PARTICULARS
A 250 Units of A &
250Units of B
B 400Units
of B
C 400 Units of A & 100 units Of B
D 150 Units of A & 350 Units of
B.
Contribution of A 500 - 800 300
Less: Contribution Of B -250 -400 -100 -350
Total Contribution 250 -400 700 -50
Less: Fixed Overheads 750 750 750 750
Profit / (Loss) -500 -1150 -50 -800
Alternatively ( c) with 400 units of A and 100 Units of B is recommended to the management as the loss as the loss is minimum ( or the least)
REDUCES OR MAINTAIN THE PRICE THE DECISION
The Price structure of an Electric Fan made by the Vijay Elcetric Company Ltd. Is as follows
PARTICULRSA PER FAN
Material 600
Labour 200
Variable Overheads 200 1000
Fixed Overheads 500
Profit 500 Selling Price 2000
This cost is based on Manufature of 1,00,000/- fan p.a. The company excwpt due to competition, they will have to reduce the sellin price
However,they want to keep the total profit intact.
Your required to prepare a statement showing the position, if
1. Selling price reduce by 10% and
2.Selling price is reduced y 20%.
Solution- Profit at predest = 100000fans x Rs. 500 per fan = Rs. 5 Crores.
fixed cost at present = Rs.5 Crores.
1. If selling price is reduced by 10% P/V Ratio = contribution/Sales x 100 = 1000-200/2000-200= 44.44%
Therefore, sales requried for Profit of Rs. 5 Crores. Fixed cost + desired profit/ P.V Ratio = RS.5 Crores + RS.5
Crores/44.44%= Rs. 22.50 Crores
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Number of Fans to be sold= 225000000/RS. 1800 Per fan = 125000 Fans
2. If sellin price is reduced by 20% P.V Ratio= contribution/Sales X 100 = 1000-400/2000-400 X 100=37.5%
Sales required for Profit of Rs. 5 Crores Fixed cost + Desired Profit / P.V Ratio = Rs. 5Crores + Rs. 5 Crores /
37.5% =Rs. 262666667/-
Number of Fans to be sold = 266666667/Rs. 1600 Per Fan = 166667 fans.
Statement of sale and Profit for April
Particulras i) Selling Price Reduced by 10% (1,25,000 fans )
ii) Selling Price reduced by 20% ( 166667 fans)
Rs Per Fan
Rs. Rs.
Per Fan Rs.
Sales 22,50,00,000 1800 22,66,67,200 1600
Less : Material 7,50,00,000 600 10,00,00,000 600
Labour 2,50,00,000 200 3,33,33,400 200
Variable Overheads 2,50,00,000 200 3,33,33,400 200
Contribution 10,00,00,000 800 6,00,00,400 600
Less: Fixed Overheads 5,00,00,000 400 5,00,00,000 300
Contribution 5,00,00,000 400 1,00,00,400 300
KEY FACTOR AND PRODUCT MIX DECISIONS
From the following particulars find the most profitable product mix and prepare a statement of profitability of that product mix.
Particulars Product A Product B Product
C
Units Budgeted to be produced and sold 1800 3000 1200
selling price per units Rs 60 55 50
Requirement per units
Direct Material 5kg 3 Kg 4 Kg
Direct Labour 4 Hrs. 3 Hrs. 2 Hrs.
Variable Overheads Rs 7 Rs. 13 Rs.8 Fixed Overheads Rs.10 Rs.10 Rs.10 Cost of direct Material Per (K.G) Rs.4 Rs.4 Rs.4 Direct labour hr. Rate Rs.2 Rs.2 Rs.2
Maximum possibale units of Sales 4000 5000 Rs.1500
All the three products are poroduced from the same direct material using the same type of machine and labour.Direct Materil Which is the Key Factor Iimited to 18600Hrs.
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35
Solution
Statement of Most Profitable Product Mix
Particulars A Rs. B Rs. C Rs.
Selling Price per Units (i) 60 55 50 Variable Cost Direct Material 20 12 16
Direct Labour 8 6 4
Variable overheads 7 13 8
totla veriable cost (ii) 35 31 28
Contribution Per Unit (I - ii) 25 24 22
Contribution Per hrs.( WN 1) 6.25 8 11 Ranking of most profitable Product Mix III II I
Statement of Profitability of the most Profitable Product Mix
Particulrs Products Total
A B C
Ranking III II I
1.Units Produced and sold (WN 2) 150 5000 1500
2.contribution per units per Units Rs. 25 24 22
3.Total contricbution units of sold (Rs) (1 X2) 3750 120000 33000 156750
4.Less: fixed Cost (Rs.) (WN 3) 60000
5.Profit (Rs.) (3-4) 96750
Working Notes. WN 1
Particulrs Products
A B C
1.Contribution Per Units Rs. 25 24 22
2. Direct Labour Hours Per Units 4 3 2 3.Contribution per hrs.(Rs) (1/2) 6.25 8 11
WN 2
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36
Here direct labour hrs. is the key factor and only 18600 hrs. are avaliable to produced the three products. The available 18000 hrs. are utilised hrs are in order of the ranking assigned i.e. first of all products see then [products B and lastly product A will be produced. the number of which products to be Produced will be depend upon the maximum possible od sale each products the details of the products to be produced keeoping in view of avalibale hrs. and their ranking are as below.
Products
Total hrs.Utilised
(Rs)
C 1500 Units x 2 hrs. 3000
B 5000 units x 3000 15000
A 150 units X 4 Hrs 600
Total Hrs. 18600
WN 3
PARTICULARS PRODUCTS TOTAL
A B C 1. Budgeted units to be produced sold : 1800 3000 1200
2. Fixed Overheads (Rs) Per unit 10 10 10 3. Total fixed Overheads (Rs) (1 X 2) 18000 30000 12000 60000
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37
BIBILIOGRAPHY
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WWW.ACCOUNTING TOOLS.COM
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ADVANCE COST ACCOUNTING BOOKS AUTHOER NAME :
DR. VARSHA M. AINAPURE