RECONCILIATION OF COST AND FINANCIAL … or over-absorption of ... reconciliation statement, ......

1

LESSON 1

RECONCILIATION OF COST AND FINANCIAL ACCOUNTS - I

1.0 Introduction

1.1 Objectives

1.2 Requirement for Reconciliation

1.3 Reasons for difference in Profit/Loss

1.4 System of Reconciliation

1.5 Memorandum Reconciliation Account

1.6 Summary of the chapter

1.7 Exercise

1.1 Objectives

After studying this chapter, you would be able to:

Understand the meaning and need of reconciliation of cost accounts and

financial accounts Explain the reasons for difference in profit or loss as per cost and financial accounts

Know the method of preparing a reconciliation statement or a memorandum

reconciliation account When cost accounts and financial accounts are maintained separately in two different sets of

books, two profit and loss accounts will be prepared-one for costing books and the other for

financial books. The profit or loss shown by financial books may not agree with that shown by

costing books. So, both sets of books are tallied to know the reasons for disagreement of the

two profits.

It is essential to know that the question of reconciliation of cost and financial accounts

arises only under non-integral system. However, under the integral accounts, the problem

of reconciliation does not arise since cost and financial accounts are integrated into one set

of books and only one Profit and Loss Account is prepared.

1.2 Requirement for Reconciliation The necessity for reconciliation arises owing to the following reasons-

1. It discloses the causes for variance in profit or loss between cost and

financial accounts.

2. Reconciliation aids in checking the arithmetic accuracy of both sets of

books. In other words, it enables to test the reliability of cost accounts.

3. It promotes coordination between cost accounting and financial accounting

departments.

2

1.3 Reasons for difference in Profit/Loss

Difference in profit or loss between cost and financial accounts may arise due to the

following reasons:

1. Items shown in cost accounts only- There are a few items which are included

in cost accounts and not in financial accounts. Examples:

• The notional cost of employing capital (Interest on capital employed but

not actually paid.)

• Notional rent (charge in lieu of rent when premises are owned and no

rent is payable), Notional salaries

• Notional depreciation (Depreciation on fully depreciated assets still in use)

2. Items shown only in financial accounts -there are a number of items which does

not appear in cost accounts but shown in financial accounts. At the time of reconciling,

any items under this category must be taken under consideration. Following are the

examples of such items.

(a) financial incomes

▪ Income tax refund

▪ Transfer fees received

▪ Dividend and interest received on investments

▪ Interest received on bank deposits

▪ Rent receivable

(b) financial expenses

• Loss on the sale of capital assets

• Amounts written off, goodwill, discount on debentures, preliminary expenses

• Provision for bad and doubtful debts

• Loss due to theft, pilferage, etc.

• Interest on bank loans and mortgages etc.

3. Under-absorption or over-absorption of overheads - overheads are recovered

at a predetermined rate in cost accounts while in financial accounts overheads are

recorded at actual cost. It causes difference in profit shown by cost accounts and

financial accounts.

4. Bases of stock valuation - stock valuation in financial accounts is based on the

principle of cost or market price whichever is less. Whereas stocks are valued

according to the method adopted in stores accounts, e.g. FIFO, LIFO, etc in cost

accounts. Different stock values result in some difference in profit or loss as shown

by the two sets of account books.

5. Different charges for depreciation- in financial accounts, depreciation may be

charged at straight line or diminishing balance method, etc., whereas machine hour

rate, production unit method, etc., may be adopted in cost accounts. This will also

cause a difference in the profit/ loss figures.

3

1.4 SYSTEM OF RECONCILIATION

The financial and cost accounts are reconciled by preparing a Reconciliation Statement or a

Memorandum Reconciliation Account. The following procedure is suggested for preparing

a Reconciliation Statement:

1. Start with the profit as per cost accounts.

2. Additions/ deductions regarding items

(a) expenses and losses:

Deduct: Items under-charged in cost accounts

Add: Items over-charged in cost accounts

For example, depreciation in cost accounts is Rs. 2,700 and that

in financial accounts is Rs. 2,900. There will be increase in costing

profit by Rs. 200 as compared to financial profit. Then in order to

reconcile, there will be deduction of Rs 200 from costing profit.

(b) Incomes and gains:

Deduct: Items over-recorded in cost accounts

Add: Items under-recorded or not recorded in cost accounts

For example, interest on investments received amounting to Rs.

2500 is not recorded in cost accounts. It will have negative effect in

profit as per cost books. So to reconcile, this amount of Rs. 2500 for

interest should be added in the costing profit.

(c) valuation of stock:

• Opening Stock-

Deduct: Amount of under-valuation in cost accounts

Add: Amount of over-valuation in cost accounts

• Closing Stock-

Deduct: Amount of over-valuation in cost accounts

Add: Amount of under-valuation in cost accounts

6. Closing stock of finished goods in cost accounts in calculated on the basis of cost

of production. Thus

Value of closing stock = Cost of production X Units Produced

Units of Closing Stock

Here

Units Produced =Units sold+ Units in closing stock - Units in opening stock

4. After making all the above additions and deductions in costing profit, the result will

be the profit as per financial books.

4

5. The above treatment of items will be reversed when the starting point in the

Reconciliation Statement is the profit as per financial accounts or loss as per cost

accounts.

Proforma of Reconciliation Statement Rs. Rs.

Profit as per cost accounts

Add:

• Financial incomes not recorded in cost books

• Items charged only in cost accounts

(Notional rent and interest on capital, etc.)

Over-absorption of overheads

• Over-valuation of opening stocks in cost books

• Under-valuation of closing stock in cost books

Less: . Under-absorption of overheads

• financial charges

• Under-valuation of opening stock in cost books

• Over-valuation of closing stock in cost books Profit as per financial accounts

Memorandum Reconciliation Account

It is a method of Reconciliation. The only difference is that the information is

shown in the form of an account. The procedure of its preparation is like that of

reconciliation statement, the only difference is that items shown under "+" column are

shown on the credit side and items shown under "-" column are shown on the debit side of

the memorandum reconciliation account. Proforma of Memorandum Reconciliation Account

Rs.

To (Item to be deducted) -





-(Balancing figure)

Rs.

To Profit as per financial

accounts

By (Item to be added) -





5

PROBLEMS AND SOLUTIONS

Illustration.1 From the following figures, prepare a reconciliation statement:

Rs.

Net profit as per financial books 31890

Net profit as per costing books 33380

Factory overheads under-recovered in costing 2850

Administration overheads recovered in excess 2125

Depreciation charged in financial books 1830

Depreciation recovered in costing 1975

Interest received but not included in costing 225

Income-tax provided in financial books 300

Bank interest credited in financial books 115

Stores adjustment (credited in financial books) 210

Depreciation of stock charged in financial accounts 430

Dividends appropriate in financial accounts 600

Loss due to theft and pilferage provided only in financial books 130

Solution

Reconciliation Statement

Rs. Rs.

Profit as per costing books 33380

Add: 1. Adm. overheads recovered in excess 2125

2. Depreciation overcharged in cost books (1975 - 1830) 145

3. Interest received but not included in costing 225

4. Bank interest credited in financial books only 115

5. Stores adjustment credited in financial books 210 2820

36200

Less: 1. Factory overheads under-recovered 2850

2. Income tax provided in financial books 300

3. Dividends appropriated 600

4. Depreciation of stock in financial books 430

5. Loss due to theft and pilferage not shown in cost books 130

4310

Profit as per financial books 31890

6

Illustration 2.

The profits as per cost accounts were Rs. 14,330, whereas the net profit as per

financial accounts of a company amounted to Rs. 9275. On reconciling the figure,

the following were noted:

Rs.

Director's fees not charged in cost accounts 525

A provision for bad and doubtful debts 485

Bank interest credited 15

Provision for income-tax 4150

Over-recovery of overhead in cost accounts 90

Prepare reconciliation statement. Also prepare memorandum

reconciliation account.

Solution


Particulars Rs. (+) Rs. (-)

Profit as per Cost Accounts 14,330

Less: Directors Fees not charged in Cost Account 525

Less: Provision for bad debts. not shown in Cost Accounts 485

Add: Bank interest credited in Profit & Loss Account 15

Less: Provision for income tax not shown in Cost Accounts 4150

Add: Over-recovery of overhead in Cost Accounts 90

14435 5160

Profit as per Financial Accounts 9275

14,435 14,435


Particulars Rs. Particulars Rs.

To Director's fees not By Profit as per Cost A/cs 14,435

charged in Cost A/c 525 By Bank Interest credited

15

To Provision for Bad Debts 485 in Profit and Loss A/c

To Provision for Income Tax 4150 By Over Recovery of

90

To Profit as per Financial A/cs 9275 Overhead in Cost A/c

14,330 14,330

7

Illustration 3.

From the following figures prepare a reconciliation statement:

Rs.

Profit as per costing records 10,000

Factory overheads under-recovered in costing 6,000

Selling and administration overheads over-recovered in costing 4,000

Bank interest credited in financial books 1000

Preliminary expenses written off in financial books 13000

Opening stock value:

in cost books 10000

in financial books 8000

Closing stock value:

in cost books 24000

in financial books 20,000

Solution (Do it yourself)



Profit as per Cost A/cs 10,000

Add: Selling and administration overheads over-recovered _____

in Cost A/cs ____

Add: Bank Interest credited in Financial Books ______

Add: Opening Stock over valued in Costing Books

Less: Factory overheads under recovered in Cost A/cs _____

Less: Preliminary expenses written off in Financial Books ______

Less: Closing Stock overvalued in Costing Books _____

Loss as per Financial A/cs ______ _____

______

_______ _____

8

Illustration 4.

From the following figures,

prepare a reconciliation statement:

Cost Books Financial Books

Profit 25000 ?

Marketing overheads 4000 4,000

Provision for bad debts - 2500

Factory overheads 4250 3500

Director's fees - 1,000

Income Tax paid - 7500

Rent of owned Premises 3,000 -

Depreciation 5625 6,000

Share transfer fee (Cr.) - 500

Administrative overheads 2500 4,000

Solution


Particulars Rs - (+) Rs. (-)

Profit as per cost books 25000

Less: Provision for bad debts charged in financial books 2500

Add: Factory overheads over-absorbed in cost accounts 750

Less: Director's fees charged in financial books 1,000

Less: Income tax charged in financial books 7500

Add: Rent of owned premises charged in cost books 3,000

Less: Depreciation overcharged in financial books 375

Add: Share transfer fees credited in financial books 500

Less: Administrative overheads under absorbed in cost books 1500

29250

12875

Profit as per Financial Books 16375

29250 29250

9

Illustration 5 From the following information, reconcile the profit as per cost accounts with financial

accounts:

Cost A/c Financial A/c

Rs. Rs.

Profit 86,250

Opening Stock:

Material 10,000 10,300

Work-in-progress 8,500 8,000

Closing Stock:

Material 14,200 15,000

Work-In-Progress 6,000 5,600

Dividend and interest received Rs. 600. Loss on sale of investment Rs. 1,000. Interest

charged by the bank not considered in Financial Accounts and Cost Accounts Rs. 1,500.

Goodwill written off during the year Rs. 2,500. Preliminary expenses written off Rs. 3,000.

Overhead incurred Rs. 40,000. Overhead absorbed in Cost Accounts Rs. 38,500. Find out

profit as per financial accounts.





Add: Overvaluation of opening stock of material in

cost Accounts _____

Add: Overvaluation of opening stock of work-in-

progress in cost accounts _____

Add: Undervaluation of closing stock of material

in cost accounts _____

Less: Overvaluation of closing stock of work-in-progress

in cost accounts ______

Add: Dividend and interest credited in financial accounts ______

Less: Goodwill written off not recorded in cost accounts ______

Less: Preliminary expenses written off not recorded

in cost Accounts _______

Less: Loss on sale of investment not recorded in cost accounts ______

Less: Under-absorption of overheads in cost accounts _______

88,350 8,400

Profit as per Financial Accounts 79,950

88,350 88,350

Working Note: Interest charged by the bank not considered in Financial Accounts as

well as Cost Accounts will not be shown in Reconciliation Statement.

10

Illustration 6 (Do it yourself) A manufacturing company disclosed a net loss of Rs. 3,47,000 as per their cost accounts for the

year ended March 31, 2004. The financial accounts however disclosed a net loss of Rs.

5,10,000 for the same period. The following information was discovered as a result of

inspection of the figures of both the sets of accounts:

Rs.

Factory overheads under-absorbed 40,000

Administration overheads over-absorbed 60,000

Depreciation charged in Financial Accounts 3,25,000

Depreciation recovered in Cost Accounts 2,75,000

Interest on investments not included in Cost Accounts 96,000

Income-tax provided 54,000

Interest on loan funds in Financial Accounts 2,45,000

Transfer fee (credit in financial books) 24,000

Stores adjustment (credit in financial books) 14,000

Dividend received 32,000

Prepare a statement showing reconciliation between the figure of net loss as per

cost accounts and the figure of net loss shown in the financial books.




To Net Loss as per Cost By Administration

Accounts 3,47,000 Overheads Over-absorbed ________

To Factory Overheads By Interest on Investments

Under-absorbed ______ not included in costs _______

To Income Tax not recorded By Transfer fees in

in Cost A/c _______ Financial Books ________

To Depreciation under By Stores Adjustment 14,000

absorbed in Cost A/c ________ By Dividend Received 32,000

To Interest on Loan funds in By Net Loss as per

Financial A/c 2,45,000 Financial Books

7,36,000 7,36,000

11

Illustration 7

M/s shreeram Traders maintains separate cost books which disclosed a profit of

Rs. 15057 for the year ending March 31, 2010. The net profits disclosed by

financial accounts amounted to Rs. 9880. Upon enquiry, it is found that:

(i) Overheads charged to production in cost books were Rs. 3750, whereas

actual overhead expenses amounted to Rs= 3466.

(ii) The company made a provision of Rs. 300 for bad debts.

(iii) The company received interest on bank deposits amounting to Rs. 14.

(iv) It paid income tax Rs. 4500.

(v) Installation of a new plant involved an expenditure of Rs. 6000 but it had

not gone into production as yet. Depreciation @ 5% was provided on the

cost of the plant.

(vi) Directors were paid fee amounting to Rs. 375.

Prepare a reconciliation statement.

Solution


Particulars + Rs. -Rs.

Profit as per cost Books 15057

Less: Provision for bad debts 300

Add: Overheads over absorbed in Cost Accounts

(3750- 3466) 284

Less: Directors fees 375

Less: Depreciation (6000 x5/100) provided in financial

books but not in cost books 300

Add: Interest on bank deposits recorded in financial books 14

Less: Payment of income tax 4500

15355 5475

Profit as per financial books 9880

15355 15355

12

Illustration 8

The following is the Trading and Profit & Loss Account of Sumit Industries Ltd.

for the year ended 31st December, 2016

Rs. Rs.

To Materials 45,000 By Sales (4,800 units) 96,000

To Wages 33,000 By Closing Stock

To Administrative Expenses 240,000 (1,200 units) 20,400

To Net Profit 8,400

1,16,400 1,16,400

The company's cost records show that:

(i) Works Overheads have been absorbed at Rs. 3 per unit produced; and

(ii) Administrative Overheads have been absorbed at Rs. 1.50 per unit produced.

Assuming there is nothing by way of work-in-progress either at the

beginning or at the end and there is no opening stock of finished goods.

Prepare:

(i) A statement of cost indicating the net profit; and

(ii) A statement reconciling the profit as disclosed by cost accounts and that

shown in financial accounts.

Solution:

Statement of Cost

Particulars Rs.

Materials 45,000

Wages 33,000

Prime Cost 78.000

Add: Works overhead (6,000 x 3) 18,000

Works Cost 96,000

Add: Administrative Overhead (6,000 x 1.50) 9,000

Cost of Production 1,05,000

Less: Closing Stock (1,05,000 x 1,200/6,000) 21,000

Cost of Goods sold 84,000

Profit 12,000

Sales 96,000

13

Working Note:

No. of units Produced = No. of units sold

+ No. of units in closing stock = 4.800 + 1.200 = 6,000



Profits as per Cost Accounts 12,000

Less: Works overhead under absorbed in Cost

Accounts 6,000

Add: Administrative Overheads over absorbed in

Cost Accounts 3,000

Less: Closing Stock overvalued in Cost Accounts 600

15,000 6,600

Profits as per Profit and Loss A\c - 8,400

15,000 15,000

Illustration 9

The following Profit and Loss Account for the year ending 31st March, 2010 has

been extracted from the books of Awadesh Ltd.

Profit and Loss Accounts for the year ending 31.3.2010

Rs.

To Direct Materials 10,000

To Direct Labour 20,000

To Factory Expenses 9,500

To Administration Expenses 5,200

To Selling and Distribution Expenses 3,800

To Interest on Capital 1,000

To Goodwill written off 1,500

14

To Net Profit 3,000

54,000

By Sales 50,000

By Work-in-Progress in hand:

Direct labour 600

Direct Material 400

Factory Expenses 300 1,300 2,700

By Finished Stock in hand 54,000

Cost Accounts manual states that the factory overheads are to be recovered

at50% of direct wages, administration overheads at 10% of works-cost and selling

and distribution overheads @ Re. 1. per unit sold.

The units of product sold and in-hand were 4,000 and 257 respectively.

Prepare: Statement of cost and profit as per Cost Accounts and Reconciliation

Statement.

Solution

Statement of Cost and Profit as per Cost Accounts

Particulars

Rs.

Direct Materials 10,000

Direct Labour 20,000

Prime Cost 30,000

Factory Overhead (50% of 20,000) 10,000

Gross Factory Cost 40,000

Less: Work-in-progress in hand 1,300

Factory Cost 38,700

Administration Overhead (10% of 38,700) 3,870

Cost of Production 42,570

Less: Finished stock in hand ( 42,570/4,257X257) 2,570

Cost of Goods Sold 40,000

Selling and Distribution Overheads (4000 x 1) 4,000

Cost of Sales 44,000

Profit (Balancing figure) 6,000

Sales 50,000

15



Profit as per Cost Accounts 6,000 -

Add: Factory Expenses over-absorbed in Cost Accounts 500 -

Selling and Distribution Expenses over-absorbed in

Cost Accounts 200 -

Closing stock of finished goods under-valued in

Cost Accounts 130 -

Less: Interest on Capital not shown in Cost Accounts - 1,000

Goodwill written off not shown in Cost Accounts - 1,500

Administration Overhead under-absorbed in

Cost Accounts - 1,330

6,830 3,830

Profit as per Profit and Loss Account (6,830 - 3,830) 3,000

6,830 6,830

Illustration 10 From the following information, prepare:

(a) Profit and Loss Account

(b) Cost Sheet

(c) Reconciliation Statement.

Rs. Units

Sales 2,50,000 20,000

Materials 1,00,000

Wages 50,000

Factory Overheads 45,000

Office and Administration Overheads 26,000

Selling and Distribution Overheads 18,000

Closing Stock: Finished Goods

Work-in-Progress :

Material 3,000

Wages 2,000

Factory Overheads 2,000

7,000

Goodwill written off 20,000

Interest on Capital 2,000

In Costing Books, factory overhead is charged at 100% on wages,

administration overhead at 10% of factory cost and selling and distribution

overheads at the rate of Re. 1 per unit sold.

16


Profit and Loss Account


To Materials 1,00,000 By Sales 2,50,000

To Wages 50,000 By Closing stock of finished

To Factory Overheads 45,000 Goods ?

To Office and Administration By Work-in-progress

Overheads 26,000 Materials

To Selling and Distribution Wages

Overheads 18,000 Factory overheads ?

To Goodwill written off 2,000

To Interest on Capital 2,000

To Net Profit 11,000

2,72,000 2,72,000

Cost Sheet

Particulars Rs.

Materials 1,00,000

Wages 50,000

Prime Cost 1,50,000

Factory Overhead ?

Gross Factory Cost 2,00,000

Less: Closing Work-in-Progress 7,000

Factory Cost 1,93,000

Office and Administrative Overheads

(10% of Factory Cost 19,300

Cost of Production 2,12,300

Less: Closing Stock of Finished Goods ?

Cost of Goods Sold 2,00,000

?

Cost of Sales 2,20,000

Profit (Balancing figure) 30,000

Sales 2,50,000

17

Working Notes:

(i) Work-in-progress has been adjusted to calculate factory cost.

(ii) Value of work-in-progress has been taken the same as is given for Profit and

Loss Account.

(iii) Value of closing stock of finished goods has been calculated on the basis of

cost of production.

(iv) Number of Units Produced = Number of Units Sold

+ Number of Units in Closing Stock =

20,000 + 1,230 = 21,230 Units

(v) Selling and distribution overhead is calculated for number of units sold.



Profit as per Cost Accounts 30,000 -

Add: Over-absorption of factory overheads in

Cost Accounts ? -

Less: Under-absorption of office and administration

overheads in Cost Accounts - 6700

Add: Over-absorption of selling and distribution

overheads in Cost A/cs ? -

Less: Goodwill written off and interest on capital

not included in Cost Accounts - 2,200

Add: Under-valuation of closing stock in Cost A/cs ?

39,700 28,700

Profit as per Profit and Loss A/c (39,700 - 28,700) - 11,000

39,700 39,700

18

Illustration 11(Do it yourself) From the following information you are required to prepare:

(i) Cost Sheet for Articles A and B.

(ii) Profit and Loss Account as per financial hooks.

(iii) Reconciliation between profit as per cost books and as per financial books.

Works overhead (Actual) 1,42,000

Office expenses (Actual) 95,700

Number of Price per Price per

Articles sold Article Rs.

A 180 1,450

B 220 1,600

There was neither opening stock nor any closing stock. Works overhead are charged

100% on labour and office overhead are charged at 25% on works cost.

Solution:

Profit & Loss Account as per Financials’ Books


To Material communed By Sales

? ?

To Labour ?

To Works Overheads 1,42,000

To Office Overheads 95,700

To Net Profit 1,44,300

6,13,000 6,13,000

Cost Sheet

Particulars A B Total

Rs. Rs. Rs.

Material communed 36,000 48,400 84,400

Labour Cost 63,000 83,600 1,46,600

Prime Cost 99,000 1,32,000 2,31,000

Add: Works overheads @ 100% on Labour Cost ? ? ?

Works Cost 1,62,000 2,15,600 3,77,600

Add: Office overhead @ 25% on works cost ? ? ?

Cost of Goods produced/Sold ? ? ?

Profit 58,500 82 500 1,41,000

Total Sales 2,61,000 3,52,000 6,13,000

19


Particulars Rs.

Profit as per Cost Accounts 1,41,000

Add: Over-absorption of Works Overheads ?

Less: Under-absorption of Office Overheads ?

Profit as per Financial Accounts -1,300

1,44,300

Illustration 12 M/s Mysore petro Ltd. Showed a net loss of Rs 2,08,000 as per their financial accounts for

the year ended 31st march, 1989. The cost accounts, however, disclosed a net loss of Rs

1,64,00 for the same period. The following information was revealed as a result of the

scrutiny of the figures of both the sets of books:

Factory overhead under-recovered 3000

Administration overhead over-recovered 2000

Depreciation charged in financial accounts 60,000

Interest on investment not included in costs 10000

Depreciation recovered in costs 65000

Income-tax provided 60000

Transfer fees (in financial books) 1000

Stores adjustment (credit in financial books) 1000

Prepare a memorandum reconciliation account Solution

Memorandum Reconciliation Account ================================================================ To Net Loss as per Costing Books 1,64,000 By administration overhead Over-recovered in costs 2,000 To Factory overhead Under-recovered in costs 3000 By Depreciation over-charged In costs 5,000 To Income-tax not provided in

Costs 60,000 By interest on investment not included in costs 10,000 By Transfer fees in financial Books 1,000 By Stores adjustments 1,000 By Net loss as per financial Books 2,08,000

2,27,000 2,27,000 =============================================================================== Illustration 13

In reconciliation between cost and financial accounts, one of the areas of differences is for

different methods of stock valuation. State, with reasons, in each of the following

circumstances whether costing profit will be higher or lower than the financial profit.

20

Items of Stock Cost Valuation Financial Valuation

Raw material (opening) 50,000 60,000

Work-in-progress(closing) 60,000 50,000

Finished stock (closing) 50,000 60,000

Finished stock (opening) 60,000 50,000

Solution

In the reconciliation, it does not matter in which form the stock is kept, i.e., raw material,

work-in- progress or finished stocks. The basic principle is that if the opening stock is larger,

profit is lower whereas if the closing stock is larger, profit is higher and vice-versa. On the

basis of this principle, the following conclusions on the four propositions can be drawn:

1. Raw material (opening) is lower in cost accounts, the costing profit will be higher by

Rs 10,000

2. Work-in-progress (closing) is higher in cost Accounts, costing profit will be higher by

Rs 10,000

3. Finished stock (closing) is lower in cost Accounts, costing profit will be lower by Rs

10,000.

4. Finished stock (opening) is higher by Rs 10,000 in cost Accounts, Costing profit will,

therefore, be lower by Rs 10,000.

Illustration 14

A company maintains separate cost and financial Accounts and the costing profit for 1991

differed to that revealed in the financial account which was shown as Rs 50,000.

The following information is available

Cost Accounts Financial Accounts

Opening stock of raw material 5,000 5,500

Closing stock of Raw Material 4,000 5,300

Opening stock of finished Goods 12,000 15,000

Closing stock of finished goods 14,000 16,000

Dividend of Rs 1,000 were received by the company

A machine with net book value of Rs 10,000 was sold during the year for Rs 8,000.

The company charged 10% interest on its opening capital employed of Rs 80,000 to its

process costs.

You are required to determine the profit figure which was shown in the cost accounts.

Solution:


Profit as per Financial Statement 50,000 Add Opening stock undervalued in cost accounts 500

Opening stock of finished goods undervalued

in cost accounts 3,000

21

Loss on sale of machinery excluded from cost accounts 2,000

Interest on capital excluded from cost accounts 8,000

less Closing stock undervalued in cost accounts 1,300

Closing stock of finished goods undervalued

in cost accounts 2,000

Dividend received excluded from cost accounts 1,000 Profit as per cost Accounts 59,200

Note. It has been presumed that interest on capital has been charged only in financial accounts.

1.6 Summary The profit or loss shown by financial books may not agree with that shown by costing books.

So both sets of books are tallied to know the reasons for disagreement of the two profits. It is

essential to know that the question of reconciliation of cost and financial accounts arises only

under non-integral system. Reasons for difference in Profit/Loss may arise due to the

following reasons:

1. Items shown in cost accounts only.

2. Items shown only in financial accounts.

3. Under-absorption or over-absorption of overheads.

4. Bases of stock valuation.

5. Different charges for depreciation.

1.7 Exercise

Objective Type Questions

Fill in the Blanks

1. Dividends paid are excluded from............................... but included in...............

2. Items of pure financial character are…............from cost ascertainment.

3. In................... there is always a need of reconciling the profits shown by financial

accounts and cost accounts.

4. Income tax is recorded in....................................books.

5. Instead of a reconciliation statement, a .............................. may be prepared

6. In, ............................the recovery of overheads is based on estimates.

7. ..................... gains and losses are completely excluded from cost accounts.

Answer

(1) cost accounts, financial accounts (2) excluded.

(3) non-integral system (4) financial

(5) memorandum reconciliation account (6) cost accounts (7) Abnormal

22

True or False Statements

1. The requirement for reconciliation of costing profits and financial profits arises if cost accounts are maintained independent of financial accounts.

2. Income tax is provided only in financial accounts and not in cost accounts. 3. Different methods of charging depreciation are adopted in cost and financial books. 4. Rent on owned building is included in cost: accounts. 5. Purely financial incomes are included in Profit and Loss Account but are excluded

from the cost sheet. 6. Under-absorption of overheads decreases profit in costing books.

Answer

a) True

b) True. c) True d) True

e) True. f) False. Under-absorption of overheads results in more profits.

Descriptive Questions

1. What is meant by Reconciliation Statement? What is the need for Reconciliation

Statement?

2. Enumerate the items which are generally excluded from cost accounts.

3. Name any five items which are included in financial accounts but are excluded in cost

accounts.

4. Describe, in brief, the conditions which necessitate reconciliation of financial and cost

records.

5. State the steps involved in the preparation of reconciliation statement.

6. Write a note on "Memorandum Reconciliation Statement".

7. Explain the causes of difference between profit shown by Financial accounts and

profit shown by Cost Accounts.

8. Enumerate the causes of difference between profits shown by financial and cost

accounts.

9. Indicate the reasons why it is necessary for the cost and financial accounts of an

organisation to be reconciled.

10. Indicate the reasons why it is necessary for the cost and financial accounts of an

organisation to be reconciled and explain the main reasons of difference which would

enter in such accounts.

11. Write short note on items excluded from Cost Accounts.

12. Distinguish between Reconciliation Statement and Reconciliation Account.

13. Name any five items which are included in financial accounts but are not included in

cost accounts and also state the effect on the profits of cost accounts.

14. write short notes on

(a) Why we need reconciliation statement

(b) Items excluded from financial Account

(c) Items added in reconciliation statement

(d) Items less in reconciliation Statement

23

LESSON 2

RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

2.0 Introduction

2.1 Objectives

2.2 Reconciliation

2.3 Profit and Loss Account as per financial books


2.5 Exercise

2.1 Objectives

After Studying this chapter, you would be able to : Explain the reasons for difference in profit or loss as per cost and financial accounts

Know the method of preparing a reconciliation statement or a memorandum

reconciliation account.

Illustration 1.The net profit of a Manufacturing Co. Ltd. appeared at Rs. 64,377

as per financial records for the year ended 31st December, 1990. The cost books,

however, showed a net profit of Rs. 86,200 for the same period. A scrutiny of the

figures from both the sets of accounts revealed the following facts:

Rs.

Works overhead under-recovered in costs 1,560

Administration overhead over-recovered in costs 850

Depreciation charged in financial accounts 5,600

Depreciation recovered in costs 6,250

Interest on investments not included in costs 4,000

Loss due to obsolescence charged in financial accounts 2,850

Income tax provided in financial accounts 20,150

Bank interest and transfer fees in financial books 375

Stores adjustments (credit in financial books) 237

Loss due to depreciation in stock values (charged in financial 3,375

Prepare a statement showing the reconciliation between the figures of net profit

as per cost accounts and the figure of net profit shown in the financial books.

2.1 RECONCILIATION STATEMENT

RECONCILIATION STATEMENT

=============================================================

Net profit as per cost accounts 86,200

Add

Administration overhead over-recovered in costs 850

Excess depreciation charged in costs(6250-5600) 650

Interest on investment not included in costs 4,000

24

Bank interest and transfer fees 375

Stores adjustments 237

Less

Work overhead under-recovered in costs loss

Due to obsolescence not charged income-

Tax not provided 1,560

Depreciation in stock 20,150

Net profit as per Financial Records 64,377

=============================================================

RECONCILIATION WHEN COST AND/OR FINANCIAL PROFIT IS NOT GIVEN

Illustration 2

A transistor manufacturer, who commenced his business on 1st January, 1999

supplies you with the following information and asks you to prepare a statement

showing the profit per transistor sold. Wages and materials are to be charged at

actual cost, works overhead at 75% of wages and office overhead at 30% of works

cost. Number of transistors manufactured and sold during the year was 540.Other

particulars are:

Materials per set Rs. 240 Wages per set Rs. 80

Selling price per set Rs. 600

If the actual works expenses were Rs. 32,160 and office expenses were Rs. 61,800 .

Prepare a Reconciliation Statement.

Solution :

STATEMENT OF PROFIT AS PER COST ACCOUNTS

=============================================================

Materials (Rs 240x540) Rs 1,29,600

Wages (Rs 80*540) 43,200

Prime cost 1,72,800

Works overhead (75% of wages) 32,400

Works cost 2,05,200

Office overhead (30% of works cost) 61,560

Total cost 2,66,760

Profit 57,240

Sales 3,24,000

=============================================================

2.3 PROFIT AND LOSS ACCOUNT (AS PER FINANCIAL BOOKS)

Profit and Loss Account ( As per Financial Books)

=============================================================

To materials 129600 By Sales 3,24,000

To wages 43,200

To works expenses 32,160

To office expenses 61,800


3,24000 3,24000

25

=============================================================


=============================================================

Profit as per cost Account 57,240

Add: works overhead over-recovered in cost accounts 240

Less: office overhead under-recovered in cost accounts 240

Profit as per Financial Accounts 57,240

=============================================================

Illustration 3

In a factory two types of radios are manufactured namely 'Model A' and `Model B'. From the following particulars prepare a statement showing cost and profit per radio sold.

Model A Model B Labour Rs. 15,600 Rs. 69,920 Materials 27,300 1,08,680 Works expenses are charged at 80% on labour and office expenses at 15% on

works cost. The selling price of both radios is Rs. 1,000 each. 75 'Model A' radios and 300 'Model B' radios were sold.

Find out profit as per financial books assuming the actual works expenses as Rs. 64,020 and office expenses as Rs. 46,800. Reconcile the profits shown by cost and financial books.

Solution :

Statement of cost and profit as per cost Accounts

Model A Model B

Radios manufactured

and sold

75 300

Total Per unit Total Per unit

Cost of materials 27,300 364 1,08,680 362.27

Cost of labour 15,600 208 69,920 233.07

Prime cost

Add: works expenses(80%

on labour)

42,900

12,480

572

166.40

1,78,600

55,936

595.34

186.45

Works cost

Add:office expenses(15% on

works cost)

55,380

8,307

738.40

110.76

2,34,546

35,180

781.79

117.27

Total cost 63,687 849.16 2,69,716 899.06

Profit 11,313 150.84 30,284 100.94

Selling price 75000 1,000 3,00,000 1,00.00

Total profit as per costing books

Model A 11,313

Model B 30,284

41,597

26

Profit and Loss Account (As per financial Books)

=============================================================

To materials By sales

Model A 27,300 Model A 75,000

Model B 1,08,680 Model B 3,00,000

To Labour

Model A 15,600

Model 69,920

To work expenses 64,020

To office expenses 46,800


3,75,000 3,75,000

=============================================================


(+)

Profit as per Financial Accounts Rs. 42,680

Less :Works Expenses over-recovered in Costs Rs. 4,396

Add: Office Expenses under-recovered in Costs 3,313

43,993 4,396


Working Notes :

1. Work Expenses charged in Cost

Accounts

Model A 12,480

Model B 55,936 68,416

Works Expenses charged in Financial Accounts 64,020

Works Expenses Over-recovered in Costs

4,396

2. Office Expenses charged in Financial

Accounts

46,800

Office Expenses charged in Cost Accounts

Model A 8,307

Model B 35,180 43,487

Works Expenses under-recovered in Costs.

3,313

27

Illustration 4

Mrs Piano co. which commenced business on 1 st January,1990, puts before you the

following information, and asks you to prepare a statement showing the profit per

piano sold (charge labour and material at actual cost, works overhead at 100% on

labour, and office overheads at 25% on works cost), and a statement showing a

reconciliation between the profits, as shown by the cost accounts and the profit as

shown by the profit and loss account for the year ended 31 st December, 1990.

Two grades of pianos are manufactured and are known as ‘Finis’ and ‘omega’.

There were no pianos in stock or in course of manufacture on 31 stDecember, 1990.

Average cost of materials per piano ‘Finis’ 8.000

Average cost of materials per piano ‘Omega’ 6.625

Average cost of Labour per Piano ‘Finis’ 14.625

Average cost of Labour per Piano ‘Omega’ 12.000

Finished Piano sold ‘finis’ 95

Finished Piano sold ‘Omega’ 160

Sale price per piano ‘Finis’ 60.000

Sale price per piano ‘Omega’ 45.000

Work expenses 4,200.00

Office expenses 1,555.00

You are required to prepare the necessary reconciliation statement

Solution: statement showing profit per piano sold

Particulars Finis Omega

Materials per piano 8.000 6.625

Labour per piano 14.625 12.000

Prime cost 22.625 18.625

Add: works overhead 100% on labour 14.625 12.00

Works cost 37.250 30.625

Add: office overhead 25% on

works cost 9.3125 7.65625

Total Cost 46.5625 38.28125

Profit 13.4375 6.71875

Selling price 60.0000 45.00000

=============================================================

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED DEC. 31, 1990

=============================================================

To Material: Rs Rs By Sales Rs Rs.

‘Finis’ 760 ‘Finis’ 5,700

‘Omega’ 1,060 1,820.000 ‘Omega’ 7,200 12,900.00

To Labour:

‘Finis’ 1,389.375

‘Omega’ 1,920.000 3,309.375

To work expenses 4,200.000

To office expenses 1,555.000

To Net profit 2,015.625

------------- -------------

12,900.000 12,900.000

28

=============================================================

STATEMENT OF RECONCILIATION

=============================================================

(+) (-)

Profit as per profit and loss Account 2,015.625

Add: works overhead undercharged in cost accounts:

Works expenses 4200

Works overhead 3,309.375 890.625

Less: office overhead overcharged in cost accounts

Office overheads 2,109.688

Office expenses 1,565.000 554.688

2,906.250 554.688

Profit as per cost Accounts 2,351.562

‘finis’ Rs 13.4375 per piano on 95 pianos 1,276.562

‘Omega’ Rs 6.71875 per piano on 160 pianos 1,075.000

2,351.562

Illustration 5

The financial records by Modern Manufactures Ltd.

Reveal the following data for the year ended March 31, 1993 :

Sales (20,000 units) 4,000

Materials 1,600

Wages 800

Factory Overheads 720

Office and Administrative Overheads 416

Selling and Distribution Overheads 288

Closing Stock of Finished Goods (1,230 units) 240

Work-in-progress (Closing) Rs.

Materials 48

Labour 32

Overheads (Factory) 32 112

Goodwill written off 320

Interest on Capital 32

In the costing records, factory overhead is charged at 100% of wages,

administration overhead at 10% of works cost and selling and distribution

overhead at Rs. 16 per unit sold.

Prepare a statement reconciling the profit as per cost records with the profit as

per financial records of the company.

All workings should form part of your answer.

29

Solution :

=============================================================

STATEMENT OF PROFIT AS PER COST ACCOUNTS

=============================================================

Materials Rs. 16,00,000 Wages 8,00,000

Prime Cost 24,00,000

Factory Overheads (100% of Wages) 8,00,000

32,00,000

Less :Closing Stock of Work-in-progress 1,12,000

Works Cost 30,88,000

Add: Administration overheads(10% on works cost) 3,08,800

Cost of production(21,230 units) 33,96,800

Less: closing stock (1,230 units) 1,96,800

Cost of production of goods sold 32,00,000

Add: selling and distribution over heads @Rs 16per unit sold 3,20,000

Cost of sales 35,20,000

Profit 4,80,000

Sales 40,00,000

=============================================================

Profit and loss Account (financial Books) =============================================================

To Materials 16,00,000 By Sales 40,00,000

To Wages 8,00,000 By Closing Stock:

To Factory Overheads 7,20,000 work-in-progress 1,12,000

To Office & admin.overheads 4,16,000 finished Goods 2,40,000

To selling &dist. Overheads 2,88,000

To Goodwill written off 3,20,000

To interest on capital 32,000

To Net profit 1,76,000

43,52,000 43,52,000

=============================================================


=============================================================

(+) (-)

Profit as per cost Accounts 4,80,000

Add: over-absorption of factory overheads in cost account 80,000

Over-absorption of selling & dist. Ov.hds. in cost Accounts 32,000

Over-valuation of finished goods in financial Accounts 43,200

Less: un-absorption of admin. Overheads in cost Accounts 1,07,200

Goodwill written off in Financial Accounts 3,20,000

Interest on capital charged in Financial Accounts 32,000

6,35,200 4,59,200

Profit as per Financial Accounts 1,76,000

=============================================================

30

Problems (unsolved)

Problem 1. The following figures are available from financial accounts for the year ended 31st March, 1996 :

Rs. Rs.

Direct material consumption 2,50,000 Legal charges 5,000 Direct wages 1,00,000 Dividend received 50,000 Factory overheads 3,80,000 Interest on deposit received 10,000 Administration overheads 2,50,000 Sales1,20,000 units 7,00,000 Selling and distribution

overheads 4,80,000 Closing stock : Bad debts 20,000 Finished stock 40,000 units 1,20,000 Preliminary expenses (written off) 10,000 Work-in-progress 80,000 The cost accounts reveal: Direct material consumption: Rs. 2,80,000. Factory overheads recovered at 20% on prime cost. Administration overhead at Rs. 3 per unit of production. Selling and distribution overheads at Rs. 4 per unit sold. Prepare

1 . Costing profit and loss account.

2 . Financial profit and loss account.

3 . Statement reconciling the profits disclosed by the costing profit and

loss account and financial profit and loss account. Problem 2 The following figures have been extracted from the financial accounts of a Manufacturing Firm for the first year of its operation :

Rs. Rs.

Direct Material Consumption.

50,00,000 Legal Charges 10,000

Direct Wages 30,00,000 Dividends Received

1,00,000

Factory Overheads 16,00,000 Interest received on Deposits

20,000

Administrative Overheads

7,00,000 Sales (1,20,000 units)

1,20,00,000

Selling and Distribution Overheads

9,60,000 Closing Stocks :

Bad Debts 80,000 Finished Goods (4,000 units)

3,20,000

Preliminary Expenses written off

40,000 Work-in-progress 2,40,000

The cost accounts for the same period reveal that the direct material consumption was Rs. 36,00,000. Factory overhead is recovered at 20% on prime cost. Administration overhead is recovered at Rs. 6 per unit of production. Selling and distribution overheads are recovered at Rs. 8 per unit sold.

31

Prepare the Profit and Loss Accounts both as per Financial Records and as per

Cost Records. Reconcile the profits as per the two records.

Problem 3 The net profit of a company amounted to Rs. 60,412 for the year ending 31st

December, 1996, as per its financial records. The cost records, however, revealed a different figure. A scrutiny of the two sets of accounts disclosed the following facts:

(a) Works overhead recovered in Cost Accounts during the period amounted to Rs. 28,450 while the actual amount of these expenses was Rs. 21,390 only.

(b) Actual office expenses for the period were Rs. 19,850, whereas the office overhead recovered in Cost Accounts amounted to Rs. 14,500.

(c) The annual rental value of premises owned by the company, amounting to Rs: 10,800 was charged in Cost Accounts but not in Financial Accounts.

(d) Selling and Distribution expenses for the period amounting to Rs. 16,490 were excluded from costing records.

(e) Excess depreciation charged in Cost Accounts-Rs. 2,400. (f) Expenses not included in Cost Accounts and shown in Financial Accounts :

Interest of Bank Loan Rs. 1,600 Bank charges 160 Director's fees 750 Penalty due to late completion on contract 2,500

(g) Gains during the year not included in Cost Accounts Transfer fees Rs. 45 Profit on sale of investment 4,250

Interest on investments 9,450 (h) The following appropriation had been made before arriving at the profit

figure of Rs. 60,412, shown above : Transfer to Dividend Equalization Fund Rs. 10,500

Transfer to Income Tax Reserve 6,400 Transfer to Debenture Redemption Fund 9,000

(i) A sum of Rs. 10,000 given as donation to the Prime Minister's Relief Fund had been charged to-Profit and Loss Account as business expense.

Problem 4

The following information is available from the financial books of a company

having a normal production capacity of 60,000 units for the year ended 31st

March 1995 :

(i) Sales Rs. 10,00,000 (50,000 units).

(ii) There was no opening and closing stocks of finished units.

(iii) Direct material and direct wages cost were Rs.5,00,000 and Rs.2,50,000

respectively.

(iv) Actual factory expenses were Rs. 1,50,000 of which 60% are fixed.

(v) Actual administrative expenses were Rs. 45,000 which are completely

fixed.

(vi) Actual selling and distribution expenses were Rs. 30,000 of which 40% are

fixed.

(vii) Interest and dividends received Rs. 15,000.

32

You are required to :

(a) Find out profit as per financial books for the year ended 31st March, 1995;

(b) Prepare the cost sheet and ascertain the profit as per cost account for the year

ended 31st March, 1995 assuming that the indirect expenses are absorbed on the

basis of normal production capacity; and Prepare a statement reconciling

profits shown by financial and cost books.

Problem 5

The following transactions have been extracted from the financial books of

M/s Maheshwari Bros:

Rs. Units

Sales 2,50,000 20,000

Materials ' 1,00,000

Wages 50,000

Factory overheads 45,000

Office and administration overheads 26,000

Selling and distribution overheads 18,000

Closing Stock :

Finished goods 15,000 1,230

Work-in-progress:

Materials Rs. 3,000

Wages 2,000

Factory overheads 2,000 7,000

Goodwill written off 20,000

Interest on capital 2,000

In costing books factory overhead is charged at 100% on wages,

administration overhead at 10% of factory cost and selling and distribution at

the rate of Re 1 per unit sold. Prepare a statement reconciling the profit as per

cost and financial accounts.

Problem 6

From the following information

(i) determine the profit as it would be shown by cost accounts, and

(ii) prepare a statement reconciling it with profit shown by financial accounts

======================================================================

TRADING AND PROFIT AND LOSS ACCOUNT

(for the year ended 31st December, 1990)

======================================================================

Materials consumed Rs. 2,00,000 Sales (1,00,000 units) Rs. 4,00,000

Direct wages 1,00,000

Indirect expenses (works) 60,000

Office expenses 18,000

Selling and distribution

expenses 12,000

Net profit 10,000

Total 4,00,000

4,00,000

33

The normal output of the factory is 1,50,000 units. Works expenses of a fixed nature are Rs. 36,000. Office expenses are for all practical purposes constant. Selling and distribution expenses are constant to the extent of Rs. 6,000, and the balance varies directly with sales.

Problem 7: A firm of Sports Equipments commenced business on 1.4.93 for

manufacturing 2 varieties of bat, 'Senior' and `Sub-Junior'. The following information

has been extracted from the account records for the half-year period ended 30.9.1993:

Rs.

(i) Average material cost per piece of 'Senior' bat 80

(ii)Average material cost per piece of 'Sub-Junior' bat 60

(iii) Average cost of labour per piece of 'Senior' bat 140

(iv) Average cost of labour per piece of `Sub-Junior' bat 110

(v) Finished goods sold :

Senior 300 pieces

Sub-Junior 700 pieces

(vi) Sale price :

—per piece of 'Senior' bat 500

---per piece of `Sub-Junior' bat 390

(vi) Work expenses incurred during the period 1,20,000

(viii) Office expenses 68,000

You are required to prepare a statement showing

(1) The profit per each brand-piece of bat charge labour and material at

actual average cost, works on-cost at 100% on labour cost and office

cost at 25% of works cost. .

(2) Financial profit for the half-year ending 30.9.1993.

Reconciliation between profit as shown by cost accounts and financial accounts

Problem 8

A transistor manufacturer who commenced his business on 1st January, 1999

supplies you with the following information and asks you to prepare a statement

showing the profit per transistor sold. Wages and materials are to be charged at

actual cost, works overhead at 75% of wages and office overhead at 30% of works

cost. Number of transistors manufactured and sold during the year was 540.

Other particulars are:

Materials per set Rs.240

Wages per set Rs. 80

Selling price per set Rs. 600

If the actual works expenses were Rs. 32,160 and office expenses were Rs. 61,800,

prepare a Reconciliation Statement.

Problem 9

The following information is available from the financial books of a company

having a normal production capacity of 60,000 units for the year ended 31st

March 1995 :

(i) Sales Rs. 10,00,000 (50,000 units).

(it) There was no opening and closing stocks of finished units.

34

(iii) Direct material and direct wages cost were Rs. 5,00,000 and Rs.

2,50,000 respectively.

(iv) Actual factory expenses were Rs. 1,50,000 of which 60% are fixed.

(v) Actual administrative expenses were Rs. 45,000 which are completely

fixed. (vt) Actual selling and distribution expenses were Rs. 30,000 of which

40% are fixed. (vii) Interest and dividends received Rs. 15,000.

You are required to :

(a) Find out profit as per financial books for the year ended 31st March,

1995;

(b) Prepare the cost sheet and ascertain the profit as per cost account for the

year ended 31st March, 1995 assuming that the indirect expenses are

absorbed on the basis of normal production capacity; and

Prepare a statement reconciling profits shown by financial and cost books .

Problem 10

M/s Alpha Ltd. made a profit of Rs. 23,000 during the year 1990 as

per costing records, whereas their financial accounts disclosed a profit of Rs.

15,000. From the following profit and 16"ss account for the year ended 31.12.1990,

as per the financial books you are required to prepare a reconciliation statement :

RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

PROFIT & LOSS ACCOUNT

Rs. Rs.

To Opening Stock 1,00,000 By Sales 1,75,000

To Purchases 80,000 By Closing Stock 80,000

To Direct Wages 20,000

To Factory Expenses 15,000

To Administration Expenses 10,000

To Selling Expenses 15,000


2,55,000 2,55,000

The Costing records show the following :

(a) Stock Ledger Closing balance Rs. 89,000.

(b) Factory Overheads Rs. 13,000.

(c) Administrative overheads calculated @ 8% of the selling price.

(d) Selling expenses calculated @ 8% of the selling price.

Problem 11 During the year a company's profits have been estimated from the costing system to be Rs. 46,126, whereas the financial accounts audited by the auditors disclose a profit of Rs. 33,248. Given the following information, you are requi red to prepare a reconciliation statement showing clearly the reasons for the difference:

35

To Opening StockRs. 4,94,358 By Sales Rs. 6,93,000

To Purchases 1,64,308

6,58,666

Less :Closing Stock1,50,242 5,08,424

To Direct Wages 46,266 To Factory Overhea,d 41,652 To Gross Profit c/d 96,658

6,93,000 6,93,000

To Administration Expenses 19,690 By Gross Profit b/d 96,658

To Selling Expenses 44,352 By Sundry Income 632 To Net Profit 33,248

97,290 97,290

(a) Stock ledger closing balance is Rs. 1,56,394;

(b) Credit balance in wages control account is Rs. 49,734;

(c) Credit balance in factory overhead control account is Rs. 39,428;

(d) Administration expenses are charged to sales at 3% of selling price in cost

accounts, Selling price includes 5% (on sales) provision for selling

expenses. Sundry income is not considered in cost accounts.

Problem 12

From the following information (i) determine the profit as it would be shown by cost

accounts, and (a) prepare a statement reconciling it with profit shown by financial accounts

TRADING AND PROFIT AND LOSS ACCOUNT

(for the year ended 31st December, 1990)

Materials consumed Rs.

2,00,000

Sales (1,00,000

units) Rs. 4,00,000

Direct wages 1,00,000

Indirect expenses (works) 60,000

Office expenses 18,000

Selling and distribution

expenses 12,000

Net profit 10,000

Total 4,00,000

4,00,000

The normal output of the factory is 1,50,000 units. Works expenses of a fixed nature are Rs. 36,000. Office expenses are for all practical purposes constant. Selling and distribution expenses are constant to the extent of Rs. 6,000, and the balance varies directly with sales.

Problem 13

M/s B.K Piano Co., which commenced business on 1st January, 1990, puts

before you the following information, and asks you to prepare a statement showing

the profit per piano sold (charge labour and material at actual cost, works

overhead at 100% on labour, and office overheads at 25% on works cost), and a

statement showing a reconciliation between the profits, as shown by the cost

36

accounts and the profit as shown by the profit and loss account for the year

ended 31st December, 1990.

Two grades of pianos are manufactured and are known as 'Finis' and 'Omega'.

There were no pianos in stock or in course of manufacture on 31st December,

1990.

Average cost of materials per piano 'Finis' Rs. 8.000

Average cost of materials per piano 'Omega' 6.625

Average cost of labour per piano 'Finis' 14.625

Average cost of labour per piano `Omega' 12.000

Finished piano sold `Finis' 95

Finished piano sold 'Omega' 160

Sale price per piano 'Finis' 60.000

Sale price per piano 'Omega' 45.000

Works expenses 4,200.000

Office expenses 1,555.000

You are required to prepare the necessary reconciliation statement.

Problem 14 The net profit of a company amounted to Rs. 60,412 for the year ending 31st

December, 1996, as per its financial records. The cost records, however, revealed a different figure. A scrutiny of the two sets of accounts disclosed the following facts:

(a) Works overhead recovered in Cost Accounts during the period amounted to

Rs. 28,450 while the actual amount of these expenses was Rs. 21,390 only. (b) Actual office expenses for the period were Rs. 19,850, whereas the office

overhead recovered in Cost Accounts amounted to Rs. 14,500. (c) The annual rental value of premises owned by the company, amounting to

Rs: 10,800 was charged in Cost Accounts but not in Financial Accounts. (d) Selling and Distribution expenses for the period amounting to Rs. 16,490 were

excluded from costing records. (e) Excess depreciation charged in Cost Accounts-Rs. 2,400. (f) Expenses not included in Cost Accounts and shown in Financial Accounts :

Interest of Bank Loan Rs. 1,600 Bank charges 160 Director's fees 750 Penalty due to late completion on contract 2,500

(g)Gains during the year not included in Cost Accounts Transfer fees Rs. 45 Profit on sale of investment 4,250

Interest on investments 9,450 (h)The following appropriation had been made before arriving at the profit

figure of Rs. 60,412, shown above : Transfer to Dividend Equalization Fund Rs. 10,500

Transfer to Income Tax Reserve 6,400 Transfer to Debenture Redemption Fund 9,000

(i) A sum of Rs. 10,000 given as donation to the Prime Minister's Relief Fund had been charged to-Profit and Loss Account as business expense.

37

2.4 Summary

There is another way of reconciliation which is called Memorandum Reconciliation Account.

The procedure of its preparation is similar to that of reconciliation statement; the only

difference is that items shown under "+" column are shown on the credit side and items

shown under "-" column are shown on the debit side of the memorandum reconciliation

account.

2.5 Exercise

Theory Questions with answers

Question No. 1: Why is it necessary to reconcile the Profits between the Cost Accounts &

Financial Accounts?

Solution: There is need for reconciliation because of maintenance of two sets of accounts. It

finds out reasons for the difference between the Net Profit & Loss in Cost accounts & those

in Financial accounts. It ensures the mathematical accuracy & reliability of Cost accounts in

order to have cost ascertainment, cost control & cost reduction.

Because of maintenance of two sets of accounts & different approach in cost accounts, profit

or loss revealed in Financial accounts may not agree with the profit or loss as per Cost

accounts. Every month or at least every_ six months, the two sets of records-cost and

financial accounts must be reconciled.

Question No. 2 : Explain the procedure for reconciliation.

Solution: There are 3 steps involved in the procedure for reconciliation:

1. Ascertainment of profit as per Financial accounts.

2. Ascertainment of profit as per Cost accounts.

3. Reconciliation of both the profits. It is similar to Bank Reconciliation Statement. _

One may start with profit as per Cost accounts and arrive at the financial profit and vice-versa

by adding and subtracting the items of variation between both sets of accounts as shown in

the following Performa. I. Profit or loss as per cost accounts:

Add:

1. Income and profits taken in Financial accounts and not in Cost accounts

2.. Notional expenses taken in Cost accounts and not in Financial accounts

3. Over-absorption of overheads in Cost accounts

4. Excess valuation of opening inventory in Cost accounts as compared to valuation in

Financial accounts

5. Lower valuation of closing inventory in Cost accounts as compared to valuation in

Financial accounts

6. Excess depreciation accounted for in Cost accounts

38

Less:

7. Expenses and Losses accounted for in Financial accounts sand not in Cost accounts

8. Appropriations in Financial accounts only

9. Notional income taken in Cost accounts and not in Financial accounts

10. Under-absorption of overheads in Cost accounts

11. Lower valuation of opening inventory in Cost accounts as compared to valuation in

Financial accounts

12. Higher valuation of closing inventory in Cost accounts as compared to valuation in

Financial accounts

13. Lower depreciation accounted for in Cost accounts

Profit or loss as per Financial accounts

Note-Inventory includes raw materials, stores, spares, work-in-progress, stock of finished

goods etc. U. Profit as per Financial Accounts Add-Items 7 to 13 as mentioned above Less-

Items 1 to 6 as mentioned above Prof it or loss as per Cost accounts

Memorandum Reconciliation account: Alternatively, reconciliation may be affected by

Memorandum Reconciliation account also. The profit as per Cost accounts is credited to this

account. Items 1 to 6 which are to be added are entered on the credit side A items 7 to 13

which are to be deducted are debited to this account.

Question No. 3: What are the reasons for disagreement of Profits as per financial accounts &

cost Accounts? Discuss.

or

List the Financial expenses which are not included in cost

Solution: Reasons for difference between Profits shown in Cost accounts & those shown in

Financial accounts.

1. Items included in Financial Accounts-only

(a) Purely financial expenses:

(i) Interest on loans, bank mortgages.

(ii) Expenses & discounts on issue of shares, debentures etc.

(iii) Losses on sale of fixed assets & investments.

(iv) Other capital losses i.e., loss by fire not covered by insurance etc.

(v) Fines & penalties.

(vi) Stamp duty & expenses on transfer of shares.

(vii) Goodwill written off.

(viii) Preliminary expenses written off.

(ix) Donations & Subscriptions etc.

(x) Income Tax.

(xi) Underwriting commission written ff.

(xii) Cash Discount allowed to customers.

(b) Purely financial Income:

(i) Interest received on bank deposits, loans & investments.

(ii) Dividends received.

39

(iii) Profit on sale of fixed assets & investments.

(iv) Rents receivable.

(v) Fees received on issue & transfer of shares.

(vi) Profit on sale of shares.

(c) Appropriations of Profits:

(i) Dividends.

(ii) Transfer to reserves.

2. Items included in cost accounts only: These are notional charges called as imputed

costs/opportunity costs.

(a) Interest on capital at notional figure though not incurred. -

(b) Salary of owner manager at notional figure though not incurred.

(c) Notional rent of own building.

(d) Notional Depreciation on the asset fully depreciated for which book value is

nil.

3. Under or over-absorption of overheads, if transferred to next year's accounts: If the

under or over-absorption of overheads is transferred to next year's accounts. Profit or

losses in both sets of accounts may vary as

There will be difference between the overhead actually incurred in financial

accounts & overhead absorbed in cost accounts of a particular period. In other case

i.e., if it is transferred to same year's costing P&L A/c & if it is adjusted by

application of supplementary overhead rate, profit or losses of both sets of accounts

may not differ to this extent.

4. Different basis of stock valuation: In Financial accounts, stock may be valued at the

FIFO, Weighted Average or specific identification method whereas in Cost accounts,

the value of stock in hand may differ depending on the method followed for pricing of

material issues i.e., Simple Average, Specific identification, LIFO, HIFO, FIFO,

Weighted Average etc, resulting in different values of inventories in both these sets of

accounts:-

Valuation of work-in-progress (WTP) may be at prime cost or at prime cost + Factory

overhead & different basis may be used in valuing inventory of WIP in Cost &

Financial accounts. Similarly finished goods may be valued at prime cost ? Factory

overhead + Administration overhead i.e.. Cost of Production in Cost accounts and at

prime cost + Factory overhead in Financial accounts.

5. Different methods of charging depreciation: In Financial accounts, depreciation may

be calculated on the basis of straight line method (SLM) or written down value

(WDV) method etc whereas in Cost accounts, depreciation may be calculated on the

basis of machine hours or production units.

Question No. 4: "Is reconciliation of cost accounts and financial accounts necessary in case

of integrated accounting system?'

Solution: Integrated Accounting is the-name given to a system of accounting whereby cost

and financial accounts are kept in the same set of books. Such a system will have to afford

40

full information required for Costing as well as for Financial Accounts. In other words",

information and data Should be recorded in such a way so as to enable the firm to ascertain

the cost together with the necessary analysis of each product, job, process, operation or any

other identifiable activity.

The integrated accounts give full information in such a manner so that the profit and loss

account and the balance sheet can be prepared according to the requirements of law and the

management maintains full control over the liabilities, and assets of its business.

While non-integrated system of accounting necessitates reconciliation between financial and

cost accounts, no reconciliation between two sets of accounts is required under integrated

accounting.

Question No. 5 : "Reconciliation of cost & financial accounts in the modern computer age is

redundant."

Solution: In the modern computer age the use of computer knowledge and accounting

software has helped the field of Financial and Cost Accounting in a big way. In fact,

computers work at a very high speed and can process voluminous data for generating desired

output in no time. Output produced is precise and accurate. Computers can work for hours

without any fatigue. They can bring out different Financial Accounting Statements A reports

accurately in a presentable form. Financial accounts and Cost accounts show their results

accurately and precisely, when maintained on a computer system, but the profit shown by one

set of books may not agree with that of the other set.

Hence, the above statement is not correct & still reconciliation of financial & cost records is

impatient as both of records may differ.

41

LESSON 3

BUDGETARY CONTROL

3.0 Introduction

3.1 Objectives

3.2 Budget

2.2.1 Meaning

2.2.2 Definition of Budget

2.2.3 Characteristics

3.3 Budgeting

3.3.1 Meaning

3.3.2 Definition of Budgeting


3.3.4 Necessities of Budgeting

3.4 Budgetary Control

3.4.1 Definitions

3.4.2 Steps in the process of Budgetary Control System

3.4.3 Features

3.4.4 Objectives of Budgetary control

3.4.5 Advantages of Budgetary Control

3.4.6 Limitations of Budgetary Control

3.5 Fixed Budget and Flexible budget

3.6 Limitations of Fixed Budget and Flexible budget

3.7 Flexible Budget

3.7.1 Steps in preparing a flexible budget

3.7.2 Features

3.7.3 Benefits

3.8 Distinction between Distinction between Fixed & flexible budget


3.10 Exercise

3.1 Objectives

After studying this chapter, students would be able to:

• Understand Budgeting- Meaning, Definition of Budgeting, characteristics &

Necessities of Budgeting

• Understand Budgetary Control-Definitions

• Understand Steps in the process of Budgetary Control System

• Understand Features and Objectives of Budgetary control

• Understand Advantages of Budgetary Control and Limitations of Budgetary Control

• Understand fixed Budget and Flexible budget and Limitations

• Understand Flexible Budget

--Steps in preparing a flexible budget

--Features

--Benefits • Distinction between Fixed & flexible budget

42


Planning is the basic step for good management because it involves observing systematically at

the future. Monetary planning plays an important role in all the spheres of activities. Whether

it is household or business or government, planning is the first basic exercise to carry out

before venturing out for any activity. Financial budgets help managers in developing

financial plan to guide them in allocating their resources over a specific future period.

Budgeting is the most commonly management used tool of planning and controlling cost.

Control is the process of measuring and correcting actual performance to ensure that plans for

implementing the chosen course of action are carried out.

3.2.1 Meaning

The word ‘budget’ is derived from a French term “bougette” denoting a leather pouch in

which money is put in order to meet expected expenses.

Budget is a plan relating which is expressed in monetary and/ or quantitative terms for a

definite future period of time in relative to commercial aspect; a budget is a formal

expression of the expected incomes and expenditures for a definite future period.

3.2.2 Definition of Budget

"A budget is a pre-determined statement of management policy during a given period which

provides a standard for comparison with the results actually achieved." Brown and Howard

“Budget is an estimate of future needs arranged according to an orderly basis covering

some or all the activities of an enterprise for definite period of time.” George R. Terry

The Chartered Institute of Management Accountants (C.I.M.A.) London, has defined a

budget as "a financial and/or quantitative statement, prepared prior to a defined period of time, of

the policy to be pursued during that period for the purpose of attaining a given objective. ' It may

include income, expenditure and employment of capital.


1. A budget is prepared in advance. Planning precedes an action.

2. A budget is prepared either in monetary or quantitative terms or both.

3. A budget i s prepared for a def in i te future per iod .

4. A budget is a coordinated plan. Budgets are prepared for different divisions/activities

of an enterprise so as to take care of the situations and problems facing each division.

3.3 Budgeting

3.3.1 Meaning & Definition of Budgeting

Budgeting is a process undertaken by organizations to manage money in the most effective

way that facilitates the organizations to meet their financial goals and dreams. It is a means of

finding out how much the organisation would earn and how much should it spend. Thus, it is

an art of building budgets and using them for future planning, coordinating and control

43

purposes. In short, it is the process of preparing a detailed statement of financial applications

and results that are likely to happen in a future period of time.

3.3.2 Definitions

“Budgeting may be said to be the act of building budget.” Rowland & Hary

“The entire process of preparing the budget is known as budgeting.” Batty

Thus budgeting involves studying the business situations, understanding the management

objectives and also the capacity of the enterprise. Budgeting is a planning function while its

implementation is a control function. 3.3.3 Characteristics

• It is the process of allocation of resources within different activities, processes,

departments and levels etc.

• It is a method of planning keeping future aspects in mind.

• Its main objective is fixation and achievement of goals for different parts of the

organization.

• It tries to solve various problems that may arise in future.

It is a method of planning keeping future aspects in mind. b. It tries to solve various

problems that may arise in future. c. It is the process of allocation of resources within

different activities, processes, departments and levels etc. d. Its main objective is fixation and

achievement of goals for different parts of the organization and the organization as a whole.

3.3.4 Necessities of Budgeting

1. Realistic goals. The budget goals should be realistic and almost attainable. The

responsible executives should do a lot of effort before preparing budget.

2. Maximum profits. Budget should be made to get maximum profits.

3. Involvement of executives. Those entrusted with the performance of the budgets should contribute in the process of setting the budget. This will make sure proper implementation of budget programmes.

4. Clearly defined responsibility centres-well defined responsibility centres should be

built up within the organisation to derive maximum benefits from the budget system,.

The controllable costs for each responsibility centres should be separately shown.

5. Integration with standard costing system. Where standard costing system is also

used, it should be completely integrated with the budget programme, in respect of

both budget preparation and variance analysis.

6. Cost of the system. The cost of budget system should not be more than the benefit

of it. Since, it is not practicable to calculate exactly what a budget system is worth, it

only implies a caution against adding expensive refinements unless their value

clearly justifies them.

44

7. Support of top Management. Support of the top management required to implement

the budget system is successfully. No control system can be effective unless the

organisation is convinced that the top management considers the system to be

important. Since the top management must be committed to the budget idea as well as

to the principles, policies and philosophy underlying the system.


3.4.1 Definitions

According to C.I.M.A., London, '"Budgetary control is the establishment of budgets relating to the responsibilities of executives of a policy and the continuous comparison of the actual with the budgeted results, either to secure by individual action the objective of the policy or provide a basis for its revision." "Budgetary control system is a system of controlling costs which includes the preparation of budgets, co-ordinating the departments and establishing achieve maximum profitability"

- Brown and Howard

3.4.2 Steps in the process of Budgetary Control System

A budgetary control system has the following characteristics

1. Establishment of budgets - Budgets are prepared for each department and then

they are presented to the management for approval.

2. Coordination among departments– The plans of various departments are

coordinated and finally integrated into the master budget.

3. Comparison– Under budgetary control, the actual performance is compared with

The budgetary estimates on a continuous basis to discover the variations and fix

responsibilities.

4. Revision – The budgets are revised in the light of changes in the conditions and

Circumstances.

3.4.3 Features

1. The efficiency of budgetary control depends on how correctly estimates have been made

about future.

2. Budgetary control involves comparison of actual results with budgetary standards.

3. Budgetary control is a persistent activity. Managers at all levels need to participate in the

budgetary control.

4. Budgetary control focuses on specific and time-bound goals.

5. Budgetary control is a continuous exercise. A budgeted plan is framed, it is implemented, it

is compared with actual results, it is revised and followed by another plan.

3.4.4 Objectives of Budgetary Control

The following are the main objectives of a budgetary control system.

45

1. Planning. A budget offers a detailed plan of action for a business over a definite period

of time. Plans are drawn up relating to production, sales, raw material requirements,

labour needs, advertising and sales promotion performance, research and development

activities, capital additions, etc.

2. Co-ordination.-It helps managers in co-ordinating their efforts so that objectives of the

organisation as a whole harmonise with the objectives of its divisions. There should be co-

ordination in the budgets of various departments. For example, the budget of sales should

be in co-ordination with the budget of production. Similarly, the production budget

should be prepared in co-ordination with the purchase budget, and so on.

3. Communication- It is a communication device. The agreed budget copies are circulated to

all management personnel who provide not only adequate understanding and knowledge

of the programmes and policies to be followed but also alerts about the restrictions to be

adhered to.

4. Motivation. A budget is a useful device for motivating managers to perform. If personnel have actively participated in the preparation of budgets, it acts as a strong motivating force to achieve the targets.

5. Control. Control is necessary to ensure that plans and objectives as laid down in the budgets are being achieved

3.4.5 Advantages of Budgetary Control

1. A budget motivates executives to attain the given goals.

2. Budgeting co-ordinates the activities of various departments and functions of the business.

3. It shows management where action is needed to remedy a situation.

4. It increases production efficiency, eliminates waste and controls the costs.

5. Budgetary control aims at maximisation of profits through careful planning and control

6. Budgeting compels managers to think ahead-to anticipate and prepare for changing

conditions.

7. It provides a yardstick against which actual results can be compared.

3.4.6 Limitations of Budgetary Control

1. Since budgets are based on the estimates of future and future is uncertain, so the budgets

may or may not be true.

2. Budgets cannot be executed automatically. Thus it may provide a false sense of security.

3. When the staff co-operation is not available, the whole budgetary control exercise will be

waste.

4. Introducing and implementing the budgetary control system is an expensive exercise.

Sometimes it may happen that the cost of introducing and operating a budgetary control

system exceeds the benefits derived there from.

5. Budgets are considered to be rigid documents. Therefore budgets should be thoroughly

revised with the change in the circumstances.

3.5 Fixed budget and Flexible budget

On the basis of level of activity or capacity, budgets are classified into fixed budget and

flexible budget.

46

A fixed budget means a budget which is prepared for fixed level of activity. It is defined as a

fixed budget is a budget designed to remain unchanged irrespective of the level of activity

attained. A fixed budget has following characteristics:

• A fixed budget is a rigid budget.

• It is suitable for the conditions when output and sales can be estimated with a fair

degree of accuracy. It means where sales and output cannot be accurately estimated,

fixed budget does not suit.

• A fixed budget is geared towards a single level of activity,

Fixed budget is also known as "Static" or "Rigid' budget. A fixed budget does not take into

consideration any change in the level of activity,

3.6 Limitations

1. Preparation of fixed budget does not involve detailed analysis of costs into fixed,

variable and semi-variable costs.

2. It cannot be used for price fixation and cost ascertainment.

3. As a tool of cost control, it is ineffective if the level of activity attained is different

from the level of budgeted activity. Generally actual level of activity is different from

budgeted level of activity.

4. Fixed budget does not suit in the situations where sales and output cannot be

accurately estimated.

3.7 Flexible Budget

A flexible budget is designed to change in relation to the change in the level of activity. In

this budget, a series of budgets are prepared at different levels of activity. It can be prepared

for different levels of activity, like 60%, 70%, 80% etc. It is useful for cost control, cost

ascertainment and performance appraisal for the tenders and quotations.

CIMA London defines a flexible budget as a budget which is designed to change in

relation to the level of activity attained:"

3.7.1 Steps

Following are the basic steps in preparing a flexible budget:

(i) The first step is to determine the relevant range over which activity is expected to

fluctuate during the budget period.

(ii.) Next step is to analyse the costs that will be incurred over the relevant range in terms

of determining cost behaviour.

(iii) Now all the costs are classified into fixed, variable and semi-variable costs.

(iv) Semi-variable costs are segregated into fixed component and variable component.

Variable component of semi-variable cost is calculated by using following

formula:

47

Variable Component of Semi-Variable Cost per unit

Change in Semi-variable Cost

Change in Output

On the basis of variable component per unit, variable component of semi-variable

cost is calculated as under:

Variable Component = Variable Component per unit

x No. of units at a production level

Now fixed component of semi-variable cost is calculated as under: Fixed

Component ---- Semi-variable Cost

— Variable Component

(v) Finally various elements of cost are ascertained for various levels of activity.

3.7.2 Features

Flexible budget has following features:

(i) A flexible budget does not confine itself to a single level of activity but is geared

towards a range of activity. A flexible budget can complied for any level of

activity say 50%, 60%„ 70% or 100% capacity utilisation.

(ii) A flexible budget is dynamic in nature rather than static.

(iii) A flexible budget is prepared after making an intelligent classification of all expenses

between fixed, semi-variable and variable expenses.

3.7.3 Benefits

Flexible budget is prepared in such a way so as to present the budgeted cost for different levels of

activity. Flexible budget is more realistic and practical because changes expected at

different levels of activity are given due consideration. Following are the main, advantages

of a flexible budget:

(i) A flexible budget makes it possible to establish budgeted cost for any level of activity

within the relevant range even after the period. 's activity is over.

(ii) A flexible budget is helpful in assessing the performance of departmental

heads because their performance can be judged in relation to the level of

activity attained. Flexible budget is a readymade comparison for cost control,

(iii) Flexible budget makes it possible to ascertain the cost at various levels of activity.

Flexible budget is helpful in price fixation and sending quotations.

(iv) Flexible budget assists in evaluating the effects of varying volumes of activities on profits

and on cash position. Flexible budget facilitates production planning as well as profit

planning.

(v) Flexible budget helps in controlling overheads.

Following are the situations where flexible budget proves its worth in decision-making:

48

(i) Where the industry is subject to sudden changes in fashion, designs, tastes and

consumer preferences.

(ii) Where overall business is highly dynamic and fast changing.

(iii) Where consumer profile, product profile and technology are fast changing.

(iv) Where the company frequently introduces new products.

(v) Where large part of output is meant for export.

3.8 Distinction between fixed budget and flexible budget

Following table shows the distinction between fixed budget and flexible budget:

Basis of distinction Fixed Budget Flexible Budget

Assumption It assumes that business

conditions are static.

It assumes that business Conditions are dynamic. '

Level of activity It is prepared for only one

level of activity.

It is prepared for different

Levels of activity.

Flexibility It does not change with the

actual volume of output

achieved.

It is re-casted quickly

according to actual level of

activity.

cost. Classification

of Costs

It does not require Classification of costs.

It requires classification of costs

into fixed cost, semi-variable cost

and variable cost.

C o m p a r i s o n Comparison between actual

costs and budgeted costs can

not be made if the volume of

output differs. It is of limited

use for control.

Comparison between actual

costs and budgeted costs can

be made. It is useful forecast

control and performance

evaluation.

Illustration 1 ABC Ltd. prepares a flexible budget which revealed that the cost of production is of ' 79000

at an anticipated 10000 unit's activity level. Variable production costs were

Direct Material (per unit) 1.50

Direct labour (per unit) 3.50

Variable Factory Overheads (per unit) 0.75

How much is the total production cost for an activity level of 10800 units

49

Solution: Activity

10000

Levels

10800 Cost per Unit (')

Direct Material 1.50 15000 16200 Direct Labour 3.50 35000 37800 Variable Factory Overheads 0.75 7500 8100

Fixed Cost 21500 21500

Total Cost 79000 83600 Illustration 2

The following data are available in a manufacturing company for a yearly period:

Fixed expenses: Rs. lakhs

Wages and salaries 9.5

Rent, rates and taxes 6.6

Depreciation 7.4

Sundry administration expenses 6.5

Semi--variable expenses (At ,50% of capacity):

Maintenance and repairs 3.5

Indirect labour 7.9

Sales department salaries 3.8

Sundry administration expenses 2.8

Variable expenses (at 50% of capacity)

Materials 21.7

Labour 204

Other expenses 7,9

98

Assume that the fixed expenses remain constant for all levels of production, semi-variable

expenses remain constant between 45% and 65% of capacity, increasing by 10% between 65%

and 80% capacity and by 20% between 80% and 100% capacity.

Sales at various levels are: Rs. (lakhs )

50% capacity 100

60% capacity 120

75% capacity 150

90% capacity 180

100% capacity 200

Prepare flexible budget for the year and forecast the profits at 60%, 75%. 90% and 100%

of capacity.

50

Solution

Flexible Budget for the year

Particulars

50%

Capacity

60%

Capacity

75%

Capacity 90%

Capacity

100%

Capacity

Rs. (lacs) Rs. (lacs) Rs. (lacs) Rs. (lacs) Rs. (lacs)

(A) Sales 100.00 120.00 150.00 180.00 200.00

Variable Costs

Materials 21.70 26.04 32.55 39.06 43.40 Labour 20.40 24.48 30.60 36.72 40.80 Other Expenses 7.90 9.48 11.85 14.22 15.80

(B) Total Variable Expen. 50.00 60.00 75.00 90.00 100.00

Semi-Variable Exp.

Maintenance & Repairs 3.50 3.50 3.85 4.20 4.20 Indirect Labour 7.90 7.90 8.69 9.48 9.48 Sales Deptt. Salaries 3.80 3.80 4.18 4.56 4.56 Sundry Adm. Exp. 2.80 2.80 3.08 3.36 3.36

(C) Total Semi-Variable

Exp. 18.00 18.00 19.80 21.60 21.60

Fixed Expenses

Wages & Salaries 9.50 9.50 9.50 9.50 9.50 Rent, rates & taxes 6.60 6.60 6.60 6.60 6.60 Depreciation 7.40 7.40 7.40 7.40 7.40 Sundry Adm. Exp. 6.50 6.50 6.50 6.50 6.50

Total Fixed Expenses 30.00 30.00 30.00 30.00 30.00

(0) Total Cost (B + C + 0) 98.00 108.00 124.80 141.60 151.60

PROFIT (A -- E) 2.00 12.00 25.20 38.40 48.40 , Illustration 3 XYZ Ltd. has its annual budget for the year ending 31-3-2013 on the basis of 40% capacity utilization. Given below is the summarized budget for the period:

Amount (in lacs)

I. Sales 600 II. Direct Material 125

Direct Labour 125

Direct Expenses 50

III. Semi-Variable Expenses

Repairs & Maintenance 50 Indirect Labour 25 Supervision 25 Heating & Lighting 10

IV. Fixed Expenses

Salaries–Managers 15

Rents, Rates &Taxes 15

51

Depreciation 20

Audit Fees 10

V. Total Cost of Sales 470

VI. Budget Profit 130

Construct a Flexible Budget for 30%, 50% and 70% capacity utilization, showing

Variable and Semi-Variable Cost, Cost of Sales and Profit with the help of following

assumptions: Fixed Expenses will remain constant at all the levels of the activity. Semi Variable Expenses remains constant between 25% and 45% capacity, increases by

10% between 45% and 60% capacity and by 20% above 60% capacity.

Solution3:

Flexible Budget for the year ended 31-3-2013 (inLacs) Activity Level 40% 30% 50% 70%

I Sales 600 450 750 1050

II Direct Cost

125

93.75

156.25

218.75 Material

Labour 125 93.75 156.25 218.75

Expenses 50 37.5 62.50 87.5

Total 300 225 375 525

III Semi-Variable Cost

50

50

55

60 Repairs&

Maintenance Indirect Labour 25 25 27.5 30

Supervision 25 25 27.5 30

Heating & Lighting 10 10 11 12

110 110 121 132 IV Total of II and III 410 335 496 657

V Fixed Expenses

15

15

15

15 Salaries–Managers Rents, Rates & 15 15 15 15 Taxes Depreciation 20 20 20 20 Audit Fees 10 10 10 10

60 60 60 60 VI Total Cost of

Sales IV&V

470 395 556 717

VII Profit(I–VI) 130 55 194 333

Illustration 4 Prepare Flexible Budget. for production at 80 per cent and 100 per cent activity on the basis of

the following information:

Production at 50% capacity 5,000 units

Raw materials Rs. 80 per unit.

Direct labour Rs. 50 per unit.

Direct Expenses Rs. 15 per unit.

Factory Expenses Rs. 80,000 (50% fixed)

Administration Expenses Rs. 1,60,000 (60% variable)

52

Solution

Statement of Budgeted Cost (Flexible Budget)

Particulars 80%Capacity 8000 units

100% Capacity 10,000units

Total

Rs.

Per Unit

Rs. Total

Rs.

Per Unit

Rs.

Raw Materials 6,40,000 80 8,00,000 80

Direct Labour 4,00,000 50 5,00,000 50

Direct Expenses 1,20,000 15 1,50,000 15

Factory Expenses

— Fixed 40,000 5 40,000

— Variable 64,000 8 80,000 8

Administration Expenses

— Fixed 64,000 8 64,000 6.4

— Variable 1,28,000 16 1,60,000 16

14,56,000 182 17,94,000 179.4

Illustration 5

Production costs of Oriental Enterprises Limited are as follows:

Level of Activity

60% 70% 80% Output (units) 1200 1400 1600

Costs (Rs.):

Direct materials 24000 28000 32000

Direct labour 7200 8400 9600

Factory overheads 12,800 13,600 14,400

Works cost 44,000 50,000 56,000

A proposal to increase production to 90% level of activity is under the consideration of

management. The proposal is not expected to involve any increase in fixed factory

overheads.

Prepare a statement showing the prime cost, total marginal cost and total factory cost at

60%, 70%, 80% and 90% activity levels.

53

Solution (try to find yourself)

Statement -Showing Costs at Various Levels of Activities Level of Activity

Output (in units)

Direct material

Direct labour

Prime Cost

Variable factory overhead

Marginal Cost

Fixed factory overhead

Factory Cost

Working note:

Factory overhead is a semi-variable cost.

Variable component of factory overhead will be calculated as under:

Variable Component per unit = Change in Cost

Change in Output

13,600-12,800

1,400-1,200

Rs. 4

Fixed Component of Factory Overhead = 12,800 - (1,200 x 4)

= Rs. 8,000

Illustration 6

You are required to draw a flexible budget for overhead expenses on the following data at

70%, 80% and 90% plant capacity.

Variable overheads:

At 70%

Capacity

At 80% At 90%. Capacity LCapacity

Rs. Rs. Re.

Indirect labour - 12,000 -

Stores including spares - 4,000 -

Semi-variable overhead

Power (30% fixed, 70% variable) - 20,000 -

Repairs and maintenance (60% fixed

40% variable) - 2,000 -

Fixed overheads

Depreciation - 11,000 --

Insurance - 3,000 -

Salaries - 10,000 -

Total overheads 62,000 _

54

Solution

Flexible budget for the period…………

Particulars ,

At 70% At 80%

Capacity Capacity

Ri At 90% Capacity i .

Variable overheads: Rs. Rs. R s .

Indirect labour 10,500 12,000 13,500

Stores including spares 3,500 4,000 4,500

Semi-variable overheads:

Power—Fixed 6,000 6,000 6,000

Variable 12,250 14,000 15,750

Repairs and maintenance—Fixed

Variable

1200 700

1200 800

1200 900

Fixed overheads:

Depreciation 11000 11,000 11,000

Insurance 3,000 3,000 3,000

Salaries 10,000 10,000 10,000

Total overheads 58,150 62,000 62,850

Illustration 7

The budget manager of Jupiter Electricals Limited is preparing a flexible budget for the

accounting year starting from 1 July, 2008.

The company produces one product-DETX II. Direct material costs Rs. 7 per unit. Direct

labour averages Rs. 2.50 per hour and requires 1.6 hours to produce one unit of DETX II.

Salesmen are paid a commission of Re. I per unit sold. Fixed selling and administrative expenses

amount to Rs. 85,000 per year..

Manufacturing overhead is estimated in the following amounts under specified

conditions of volume:

Volume of production (m units):1,20,0001,50,000

Rs.. Rs.

Expenses:

Indirect material 2,64,000 3,30,000

Indirect labour 1,50,000 1,87,500

Inspection 90,000 1,12,500

Maintenance 84,000 1,02,000

Supervision 1,98,000 2,34,000

Depreciation-plant and equipment 90,000 90,000

Engineering Services 94,000 94,000

Total manufacturing overhead 9,70,000 11,50,000

Prepare a Total Cost Budget for 1,40,000 units of production.

55

Solution

Particular Total

Rs,

Per Unit

Rs,

Direct Materials 9,80,000 7:00

Direct Labour 5,60,000 4 . 00 Salesmen's Commission 1,40,000 1.00 Indirect Materials 3,08,000 2.20 Indirect Labour 1,75,000 1.25 Inspection 1,05,000 0.75 Supervision — Fixed 54,000 0.39

Variable 1,68,000 1.20 Maintenance — Fixed 12,000 0.09

Variable 84,000 0.60 Depreciation 90,000 0 64 Engineering Services 94,000 0.67

Selling and Distribution Expense 85,000 0.60

28,55,000 20.39

Working Notes.

(i) Depreciation and engineering services are same at two levels of production and,

therefore, are of fixed nature.

(ii) Supervision and maintenance are semi-variable costs. Variable components of these

two items will be calculated as under:

(iii) Variable cost per unit = Change in Cost

Change in Output

Variable component of supervision per unit= 2,34,000-1,98,000

1,50,000 – 1,20,000

36,000

30,000

= Rs. 1.20 per unit

Fixed component of supervision = Total cost – Variable cost

= 1,98,000 – (1,20,000 x 1.20)

= 1,98,000 – 1,44,000

= Rs. 54,000

(iv) Fixed and variable components of maintenance will be calculated as above.

3.9 Summary

Financial budgets help managers in developing financial plan to guide them in allocating

their resources over a specific future period.

56

Budgeting is the most commonly management used tool of planning and controlling cost.

Control is the process of measuring and correcting actual performance to ensure that plans for

implementing the chosen course of action are carried out.

Budgeting is a process undertaken by organizations to manage money in the most effective

way that facilitates the organizations to meet their financial goals and dreams. On the basis of

level of activity or capacity, budgets are classified into fixed budget and flexible budget. A

fixed budget means a budget which is prepared for fixed level of activity. A flexible budget is

designed to change in relation to the change in the level of activity. Flexible budget is more

realistic and practical because changes expected at different levels of activity are given

due consideration.

3.10 Exercise

Exercise 1: True or False

1. A master budget is a summary of all functional budgets.

2. Fixed budgets are most suited for fixed expenses.

3. A budget is a forecast of future expectation.

4. In a fixed budget, figures are adjusted according to actual level of activity.

5. The budget that is prepared first and all other budgets are subordinate to it is cash

budget.

Answer

1. True, 2. True, 3. False, 4. False, 5. False

Exercise 2: Short Answer Type Questions:

1. What do you mean by budget?

2. Define budgetary control.

3. Define Master budget.

4. Explain the concept of zero-based budgeting.

5. Explain briefly the concept of fixed budget and flexible budget.

Exercise 3: Long Answer Type Questions:

1. What do you mean by Budgetary Control? Explain its advantages and disadvantages.

2. Explain all the functional budgets prepared by the business.

3. What is a cash budget? Explain the objectives of preparing the cash budget.

4. Explain the concept of flexible budget and its advantages.

5. Differentiate between fixed and flexible budget.

Exercise 4: Solved Long Answer Type Questions:

Q1. What is meant by a "Fixed Budget" and a "Flexible Budget"?

Ans. Fixed Budget A fixed budget translates a plan in monetary terms for a definite level of

activity while a flexible budget , on the other hand, covers certain ranges of production round

57

about the initial target on similar monetary terms. This is necessary due to the behaviour of

costs towards volume changes. When we say a budget or forecast of expenditure and income,

the expenditure represented the total of all items of expenses and the income or all items of

output-all for total activity for a period.

Flexible Budget

We know that certain items of expenditure vary either proportionately or otherwise

with changing levels of production and some do not. A budget refers to a certain volume of

activity which in actual practice might or might not be adhered to due to several causes. With

the characteristic behaviour of cost the total expenditure might vary with changing levels of

production. Non-varying or fixed costs will be almost static for different volumes of activity

within certain ranges. Hence the comparison of total actual expenditure comprising both

variable and fixed elements, for varying levels of production with the budget for a definite

volume of production might more often lead to erroneous conclusions and invariably be

irrational in assigning responsibility. Thus, any expenditure, except for fixed elements,

cannot be compared unless adjustments are made for the level of activity actually attained.

The adjustment will be done by an analysis of the various elements of expenses and their

individual behaviour with reference to the volume of activity. This will lead to a preparation

of flexible budgets for varying ranges of production or output volume. This assumes much

greater significance especially when it is realised that an influence of volume on costs is

extremely pertinent in assessing the profitability of individual products and any change in the

pricing policy of a management in trade cycles.

Thus any scheme of budgeting which fully recognises the behaviour of costs towards volume

changes and translates in financial terms the expenditure for varying levels of output, within

of course a certain range, will be called "Flexible Budgeting". In flexible budget, therefore, a

certain amount of flexibility is introduced for varying levels of activity within a range.

Q2. What do you understand by the term "Budgetary Control"?

Ans. Budgetary Control forms an integral part of Management Accounting. Budget and

Budgetary Control comprises the preparation of various aspects of the plan in detail,

conversion of the plan in financial terms and subsequent comparison and checking of actual

performances with the plan. The profitability aspect for otherwise of an enterprise is to a

certain extent forecast much earlier to the commencement of the period by means of a budget.

Budget is nothing but a pre-estimated financial and quantitative interpretation of a set plan of

a policy to be pursued for that period and budgetary control is an establishment of

departmental budgets relating to each responsibility centre in consonance with the policy to

be pursued so that each individual is given an opportunity to secure the objectives of the

policy and control his action wherever possible.

A budget is always aimed for a specific period and that period should be determined

to have a sufficient tenure which will permit fairly accurate predictions. If it is a long period,

the validity of such a forecast will be watered down. Usually in all manufacturing enterprises,

the period corresponds to a financial year.

No budget will be considered worth the while unless control is exercised in

comparing the cost in its actual performance with that budgeted, analysing the variances as to

quantum and causes, and taking remedial steps to secure as close an adherence to budget

plans as is possible under the existing conditions.

Thus, Budget and Budgetary Control is one of the most fruitful and effective tool for

any management. This is achieved by "Planning, Recording, Comparing and Controlling".

58

There is no better method of co-ordinating the financial, production, sale and

operational results than through budget and budgetary control.

A properly constructed budget and planned system of control.

(i) "provides for a well-defined objective for future operations:

(ii) formulates and elucidates the executive policies for ensuring periods:

(iii) forms a yard stick for measuring actual performance of planned objectives;

(iv) fixes responsibility on individuals for the attainment of planned objectives;

(v) creates an incentive and incites the psychology of responsible individuals in

comparing and matching actual performances with planned target; and

(vi) Encourages the staff in the attainment of planned objectives."

59

LESSON 4

CASH BUDGET

4.0 Introduction

4.1 Cash Budget

4.2 Advantages of Cash Budget

4.3 Zero–Based Budgeting

4.3.1 –Advantages

4.3.2 -Limitations

4.4 Master Budget


4.6 Exercise

Objectives


• Understand the definition of Cash Budget

• Explain the Advantages of Cash Budget

• Understand the Zero–Based Budgeting-Advantages-Limitations

• Understand the Master Budget

4.1 Cash Budget

The cash budget is one of the most important and one of the last to be prepared. It is a

detailed estimate of cash receipts from all sources and cash payments for all purposes and the

resultant cash balances during the budget period. It makes certain that the business has sufficient

cash available -to- meet its needs as and when these arise. It is a device for coordinating and

controlling the financial side of the business to ensure solvency and provide a basis for planning

and financing required to cover up any deficiency in cash. Cash budget thus plays an important

role in the financial management of a business undertaking.

Purposes: The main purposes of cash budget are outlined below:

a) It ensures that sufficient cash is available when required.

b) It indicates cash excesses and shortages so that action may be taken in time to invest any excess

cash or to borrow funds to meet any shortages.

c) It establishes a sound basis for credit.

d)It shows whether capital expenditure may be financed internally.

e) It establishes a sound basis for control of cash position.

Cash budget is prepared on the basis of anticipated cash receipts and anticipated cash

payments during the budget period. One part of the budget shows anticipated cash receipts

while other part shows estimated cash payments. The excess of opening cash balance and

estimated cash receipts over estimated cash payments results in budgeted closing balance of

60

cash. Budgeted closing balance of cash may be positive or negative. The equation of cash

budget may be expressed as under:

Budgeted Closing Cash Balance = Opening Cash Balance + Anticipated Cash Receipts

- Anticipated Cash Payments

4.2 Advantages of Cash Budget Cash budget is an important financial tool for the management. Following are the main advantages of cash budget: Efficient Cash Management: Cash is the basis for all operations. Cash budget helps in evaluating financial policies and cash position. Cash budget enables the management to plan and coordinate the financial operations properly. The management can know how much cash is needed and from which source it will be generated. Internal Financial Management: Cash budget provides information about cash which will be available. This will help the management in determining policies regarding internal financial management e.g. possibility of payment of long-term debt, dividend policy, replacement of machinery etc. Movement of Cash: Cash budget discloses the complete story of cash movement. Cash budget enables a company to meet all its commitments in time and at the same time prevent accumulations of unnecessary large balance with it. Cash Planning: Cash budget determines the future cash needs of the firm. The extent of success or failure of cash planning can be known by the cash budget. Cash budget ensures that sufficient cash is available when required. If shortage of cash is expected, action may be taken to raise the funds internally or externally. If surplus of cash is expected management may invest or lend this surplus.

4.3 Zero–Based Budgeting

This is a method of budgeting which is based on the objective of resetting the clock

each year. In this method of budgeting, during the process of review, no reference is made

to the previous level of expenditure and budgets are re-evaluated thoroughly, starting from

the zero-base level. In this method of budgeting, each cost element is justified specifically

as if the activities which are related to the budget are undertaken for the first time, as this is

based on the promise that even the expenditure of a rupee requires justification. No

reference is made to the previous level of expenditure during the process of review of this

method. This method of budgeting is based on the premises that even the expenditure of a

rupee requires justification. Therefore, the activities related to the budget which are

undertaken for the first time are required to be justified for each cost element. Thus, in this

method of budgeting the concentration is put on, “why this unit requires a particular amount

and not simply on how much” this unit requires. With the use of this method of budgeting

there is an effective utilization of limited resources, so that organization objectives can be

achieved. 4.3.1 Advantages

1. Different activities are evaluated on the basis of systematic approach. 2. On the basis of priorities, different activities are ranked and resources are allocated

accordingly by the management. 3. It improves coordination and communication in the organization. 4. It improves the decision-making ability of managers as it requires them to review

61

their activities each time a budget is developed.

5. It increases the motivation in the organization because of increased participation. 6. It enables the management to make optimum utilization of scarce resources as funds

are allocated on the basis of priority. 7. This method enables the critical appraisal of different activities of an organization. 8. It makes the managers cost conscious and helps them in identifying priorities in the

interest of the organization. 4.3.2 Limitations

1. This method is very expensive and time consuming. 2. Assigning ranking on the basis of priority is very subjective and may cause conflicts

in the organization. 3. This method is not adopted by those managers who resist changes and new ideas. 4. Lot of paper work is involved in this method of budgeting.

Illustration 1 From the following data, prepare a cash budget for the three months commencing from 1st June, 2008 when the bank balance was Rs. 1,00,000:

There is a two months credit period allowed to customers and received from suppliers. Wages, production expenses and administration expenses are payable in the following month. Solution

Preparation of Cash Budget from June to August, 2008

Month Sales Purchases Wages Production Administration

Expenses Expenses

Rs. Rs. Rs. Rs. Rs.

April 80,000 41,000 5,600 3,900 10,000

May 76,500 40,500 5,400 4,200 14,000

June 78,500 38,500 5,400 5,100 15,000

July 90,000 37,000 4,800 5,100 17,000

August 95,000 35,000 4,700 6,000 13,000

Particulars June July August Opening Balance Add: Receipts:

Collection from Debtors

1,00,000 80,000 1,15,400 76,500 1,25,900 78,500

1,80,000

1,91,900

2,04,400

Less: Payments:

Paid to Creditors

Wages

Production Expenses

Administration Expenses

41,000

5,400

4,200

14,000

40,500

5,400

5,100

15,000

38,500

4,800

5,100

17,000

64,600

66,000

65,400

Closing Balance

1,15,400

1,25,900

1,39,000

62

\

Illustration 2:

A company is expected to have an Opening Cash Balance of ' 40000 on 1st April

2014. You are required to prepare the Cash Budget of this company during the three

months of April to June 2014. The following information is provided:

Sales

Purchases

Wages

Factory

Expenses

Office

Expenses

Selling

Expenses

February 12000 50000 12000 8500 6000 4500 March 80000 45000 9000 7250 7000 3500 April 95000 65000 8500 7500 6000 3000 May 130000 60000 11000 6270 5000 5500 June 100000 65000 10000 5890 4000 5000 Other information provided is as follows: -

Period of credit allowed by suppliers - 1 month

25% of sales are for cash and period of credit allowed to customers for credit sales is one

month.

Delay in payment of all expenses - 1 month.

Income tax of ' 60000 is required to be paid on 30-June-2014.

The company is required to pay dividends to shareholders of ' 20000 in the month of

April and bonus to workers of ' 25000 in the month of May.

A plant costing ' 200000 has been ordered by the company and is expected to be

received and paid in the month of June.

Solution :

Cash Budget

April May June

Receipts:

Opening Balance of Cash Receipts 40000 32000 20750

Cash Sales (25% of current month's sales) 23750 32500 25000

Collection from Debtors (75% of previous month's

sale)

60000 71250 97500

Total Receipts 123750 135750 143250

Payments:

Creditors 45000 65000 60000

Wages 9000 8500 11000

Factory Expenses 7250 7500 6270

Office Expenses 7000 6000 5000

Selling Expenses 3500 3000 5500

Dividend to Shareholder 20000

Bonus to Workers 25000

Purchase of Plant 200000

Payment of Income Tax 60000

Total Payments 91750 115000 347770

Closing Balance (Receipts - Payments) 32000 20750 204520 Notes: The company is required to make overdraft facility to the extent of 204520 in the month of June.

63

Fifty per cent to credit sales are realized in the month following the sales and the remaining fifty per cent in the second month following.

Creditors are paid in the month following the month of purchase. Wages paid in the month itself. Cash at bank on 1.4.2008 (estimated) Rs. 25,000. Solution

Cash Budget for 3 Months Ending

Bank Overdraft to be arranged for May is Rs. 47,000; for June is Rs. 1,20,000 (1,67,000-47,000).

Illustration 4

A company making for stocks in the first quarter of the year is assisted by its bankers with overdraft accommodation. The following are the relevant figures (budgeted): Sales Purchases Wages (Rs.) (Rs.) (Rs.) November 2007 60,000 41,500 4,900 December 2007 64,000 48,000 5,000 January 2008 36,000 81,000 4,000 February 2008 58,000 82,000 3,800 March 2008 42,000 89,500 5,200

Budgeted cash at the bank 1 st January is Rs. 8,600. Credit terms of sales are payment by the

end of the month following the month of supply. On average, one half of the sales are paid on

Illustration 3 Prepare a cash budget from the following data for three months from 1.4.2008

(Rs.) Month Credit sales Purchases Wages

February 2008 1,80,000 1,24,800 12,000

March 2008 1,92,000 1,44,000 14,000

April 2008 1,08,000 2,43,000 11,000

May 2008 1,74,000 2,46,000 10,000

June 2008 1,26,000 2,68,000 15,000

Particulars April May June

Opening Balance

Receipts:

Collection from

Debtors

Payments: Purchases

Wages

Closing Balance

25,000 1,86,000 56,000 1,50,000 (47,000) 1,41,000

2,11,000 2,06,000 94,000

1,44,000 11,000

2,43,000

10,000

2,46,000

15,000

1,55,000 2,53,000 2,61,000

56,000 (47,000) (1,67,000)

64

the due date while the other half are paid during the next month. Creditors are paid during the

month following the month of supply.

You are required to prepare a Cash Budget for the quarter 1st January to 31st March, 2008

showing the budgeted amount of bank facilities required at each month end. Solution

Cash Budget for the quarter ending 31st March, 2008

Note: Bank overdraft required for February is Rs. 16,200 and for March is

Rs. 40,200 (56,400- 16,200). Illustration 4 A company is expecting to have Rs. 35,000 cash in hand on 1st April, 2008 and it requires you to prepare a budget for three months April to June 2008. The following information is supplied to you:

Other information: 1. Period of credit allowed by suppliers: two months.

2. 25% of the sales are for cash and period of credit allowed to customers for credit

sales one month.

3. Delay in payment of wages and expenses: one month.

4. Income Tax of Rs. 20,000 is to be paid in June 2008.

Particulars January February March

Opening Cash balance as on

Receipts:

Sales proceeds

Total Receipts

Payments:

Purchases

Wages

Total Payments Closing Balance

Rs.

8,600

62,000

Rs.

18,600

50,000

Rs.

(-)16,200

47,000

70,600 68,600 30,800

48,000

4,000

81,000

3,800

82,000

5,200

52,000 84,800 87,200

18,600 (-)

16,200

(-)

56,400

Sales Purchases Wages Expenses

Rs. Rs. Rs. Rs.

February 70,000 40,000 8,000 6,000

March 80,000 50,000 8,000 7,000

April 92,000 52,000 9,000 7,000

May 1,00,000 60,000 10,000 8,000

June 1,20,000 55,000 12,000 9,000

65

Solution

Cash Budget for the three months April-June 2008

Particul

ars

April Rs. May

Rs.

June

Rs.

Opening Balance (A)

Receipts:

Cash sales

Debtors

Total (B)

Payments:

Creditors

Wages

Expenses

Income Tax

Total (C)

Closing Balance (A + B -

C)

35,000 63,000 91,000

23,000

60,000

25,000

69,000

30,000

75,000

83,000 94,000 1,05,000

40,000

8,000

7,000

_-------

50,000

9,000

7,000

-------

52,000

10,000

8,000

20,000

55,000 66,000 90,000

63,000

91,000

1,06,000

Illustration 5 Prepare cash budget of a company for April, May and June 2008 in a columnar

form using the following information:

Months Sales Purchases Wages Expenses

2008 Rs. Rs. Rs. Rs.

January (Actual) 80,000 45,000 20,000 5,000

February (Actual) 80,000 40,000 18,000 6,000

March (Actual) 75,000 42,000 22,000 6,000

April (Budgeted) 90,000 50,000 24,000 7,000

May (Budgeted) 85,000 45,000 20,000 6,000

June (Budgeted) 80,000 35,000 18,000 5,000

You are further informed that:

(a) 10% of the purchases and 20% of the sales are for cash.

(b) The average collection period of the company is — month and the credit purchases

arc paid off regularly after one month.

(c) Wages & Expenses are paid half-monthly and the Rent of Rs. 500 included in

expenses is paid monthly.

(d) Cash and Bank balance as on April 1, was Rs. 15,000 and the company wants to keep

it on the end of every month below this figure, the excess cash being put in Fixed

Deposits.

66

Solution

CASH BUDGET for April-June 2008

Note: It is assumed that wages and expenses are paid on 16th and 1st of the following

month i.e. fortnightly.

Illustration 6 Prepare a Cash Budget for the three months ending 30th June, 2008 from the information given below:

(b) Credit terms are:

Sales and debtors - 10% sales are on cash, 50% of the credit sales are collected next

month and the balance in the following month:

Creditors— Materials 2 months

Wages 1/4 month

Overheads 1/2 month

(ii) Cash and bank balance of 1st April, 2008 is expected to be Rs. 6,000.

Other relevant information is:

(i) Plant and machinery will be installed in February 2008 at a cost of Rs. 96,000. The

monthly installments of Rs. 2,000 is payable from April onwards.

(ii)Dividend @ 5% on Preference Share Capital of Rs. 2,00,000 will be paid on 1st June.

(iii)Advance to be received for sale of vehicles Rs. 9,000 in June.

(iv) Dividends from investments amounting to Rs. 1,000 are expected to be received in

June.

(v) Income tax (advance) to be paid in June is Rs. 2,000.


Cash Balance b/d 15,000 11,700 12,700

Add: Cash inflows:

Cash sales-20% 18,000 17,000 16,000

Cash Collection from debtors 66,000 70,000 66,000

99,000 98,700 94,700

Less: Cash out flows:

Cash purchases 10% 5,000 4,500 3,500

Payment to Creditors 37,800 45,000 40,500

Wages 23,000 22,000 19,000

Rent 500 500 500

Expenses 6,000 6,000 5,000

Fixed Deposits 15,000 8,000 13,000

Balance c/d 11,700 12,700 13,200

99,000 98,700 94,700

(a ) Months Sales Purchases Wages Expense

s

Rs. Rs. Rs. Rs.

February 14,000 9,600 3,000 1,700

March 15,000 9,000 3,000 1,900

April 16,000 9,200 3,200 2,000

May ' 17,000 10,000 3,600 2,200

June 18,000 10,400 4,000 2,300

67

Solution

Cash Budget For three months ending 30th June, 2008

Working Notes:

(i) Cash sales —April (10% of 16,000) = Rs. 1,600

—May (10% of 17,000) = Rs. 1,700 —June (10% of 18,000) = Rs. 1,800

(ii) Credit Sales = Sales - Cash Sales

Credit Sales of Feb. = 14,000-1,400 = Rs. 12,600

Credit sales realised in April = 12,600x50/100 =Rs. 6,300

(iii) Credit Sales of March = 1,5000-1,500 = Rs. 13,500

Credit Sales realised in April = 13,500x50/100 = Rs. 6,750

Credit Sales realised in May = Rs. 6,750

(iv) Credit Sales of April = 16,000 - 1,600 = Rs. 14,400

Credit Sales realised in May = 14,400x50/100 =RS. 7,200

Credit Sales realised in June = Rs. 7,200

(v) Credit Sales of May = 17,000 - 1,700 = Rs. 15,300

50

Credit Sales realised in June = 15,300 x 50/100

= Rs. 7,650

Collection from Debtors

April = 6,300 + 6,750 = Rs. 13,050

May = 6,750 + 7,200 = Rs. 13,950

June = 7,200 + 7,650 = Rs. 14,850


Rs. Rs. Rs.

Opening Balance 6,000 3,950 3,000

Receipts:

Cash Sales 1,600 1,700 1,800

Collection from Debtors 13,050 13,950 14,850

Dividend — — 1,000

Advance against vehicle — — 9,000

Total 20,650 19,600 29,650

Payments:

Creditors (materials) 9,600 9,000 9,200

Wages 3,150 3,500 3,900

Overheads 1,950 2,100 2,250

Instalment for plant 2,000 2,000 2,000

Preference dividend — — 10,000

Income-tax advance — — . 2,000

Total 16,700 16,600 29,350

Closing balance 3,950 3,000 300

68

Payment to creditors for materials will be as under:

Purchases of February will be paid in April

Purchases of March will be paid in May

Purchases of April will be paid in June

Payment of Wages in April = (3,000x1/4)+(3,200x3/4)= RS. 3,150

Payment of Wages in May = (3,200x ¼)+(3,600x3/4) = RS. 3,500

Payment of Wages in June = (3,600x1/4)+(4,000x3/4) = Rs 3,900

Payment of Overhead in April = (900x1/2)+(2,000x1/2) = Rs 1,950

Payment of Overhead in May = (2,000x1/2)+(2,200x1/2) =Rs 2,100

Payment of Overhead in June = (2,200x1/2)+( 2,300x1/2) =Rs 2,250.

4.4 Master Budget

Each manager who is responsible for meeting the budgeted performance has to prepare a

budget. When all the budgets are prepared by respective managers, these are coordinated

with each, other and summarized into a budget which is known as Master Budget. Thus, a

master budget is a consolidated summary of all the functional budgets. According to CIMA

London "Master budget is a summary budget incorporating its component functional

budgets. Accordingly, master budget comprises the functional budget summaries. Master

budget projects the activities of a business during the budget period and is, thus, a profit

plan. Master budget gives a projected overall profit position of the organisation. Master

budget serves as a set of goals to be achieved by the organisation during the budget period.

This budget consists of three parts. budgeted income statement, budgeted balance sheet, and

budget ratios.

4.5 Summary

The cash budget is one of the most important and one of the last to be prepared. It is a

detailed estimate of cash receipts from all sources and cash payments for all purposes and the

resultant cash balances during the budget period. Zero–Based Budgeting this is a method of

budgeting which is based on the objective of resetting the c lock each year. In this method of

budgeting, during the process of review, no reference is made to the previous level of

expenditure and budgets are re–evaluated thoroughly, starting from the zero base level. Each

manager who is responsible for meeting the budgeted performance has to prepare a budget.

When all the budgets are prepared by respective managers, these are coordinated with each,

other and summarized into a budget which is known as Master Budget. Thus, a master budget

is a consolidated summary of all the functional budgets.

4.6 Exercise


(i) Budget is prepared in advance for a specified period.

(ii) Fixed budgets are more useful than fluctuating budgets.

(iii) Master budget is a summary of ail functional budgets.

(iv) Cash budget is a master budget.

69

(v) A fixed budget is useful only when the actual level of activity corresponds to the

budgeted level of activity.

(vi) A flexible budget is one which changes from year to year.

(vii) A budget discloses area of potential improvement in the company's operations.

(viii) A budget is nothing but an estimate.

(ix) Budgetary control is exercised through the establishment of budgets.

(x) Forecasting is concerned with planned events.

(xi) A budget usually covers a long period while forecasting is planned for short period.

(xii) Budgetary control is based on the principle of management by exception.

(xiii) A budget is a means and the budgetary control is the end.

(xiv) Flexible budget is one which is designed to change with the level of activity.

Ans.

True (ii) (iii) (v) (vii) (ix) (xii) (xiii) (xiv)

False (ii) (iv) (vi) (viii) (x) (xi)

Exercise 2:Fill in the banks

(i) ------------is a summary of all functional budgets.

(ii) Cash budget is a budget_

(iii) ------------------Budget is useful where the business is new one and it is difficult to

foresee the demand.

(iv) …………….is a budget for a single level of some measure of activity.

(v) A budget is a quantitative statement prepared prior to a ______ period.

(vi) Budget helps in _____ the policies.

(vii) Forecasting is concerned with______ events.

(viii) -------------is pre-requisite to budgetary control.

(ix) --------relate to economic activities while----may relate to economic and non-

economic activities.

(x) Budget is a ------------ and budgetary control is the

Ans.

(i) Master budget

(ii) Functional

(iii) Flexible

(iv) Fixed

(v) Defined

(vi) Making

(vii) Anticipated

(viii) Forecasting

(ix) Budgets, forecasts

(x) Means, end.

Exercise 3: Long Answer Type Questions:

1. Define budgetary control and state its advantages.

2. Discuss briefly the objectives and limitations of budgetary control.

70

3. "A budget is a means and budgetary control is the end result." Explain.

4. What is a budget? How does it serve as an instrument of control.

5. Distinguish between a forecast and a budget!

6. What are functional budgets? Describe any one functional budget.

7. What is a cash budget? What are its objectives.

8. What is a flexible budget? What advantages has a flexible budget over a fixed budget?

9. Define flexible budget and explain its importance.

10. Distinguish between fixed budget and flexible budget. Exercise 4: Problems

Sales and purchases all are on credit. You are given the following further information:

Plant costing Rs. 16,000 is due for delivery in July, payable 10% on delivery and the balance after three months.

Advance Tax installments of Rs. 8,000 each are payable in March and June.

The period of credit allowed by suppliers is 2 months and that allowed to customers is one

months.

Time-lag in payment of manufacturing expenses is 1/2 month, while the lag in payment of all

other expenses is one month.

You are required to prepare a Cash Budget for three months starting on 1st May, 2008 when

cash balance was Rs. 8,000.

Ans. Cash balance May Rs. 13,750, June Rs. 12,250 and July Rs. 16,900.

2. From the following forecasts of income and expenditure, you are required to prepare a

cash budget for three months ending 30th November. The bank balance on 1st September

was Rs. 10,000.

1: Summarised below are the income and expenditure forecasts for the months March to August 2008.

Month Sales Purchases Wages Mfg.

Exp,

Office Exp. Selling Exp.

Rs. Rs. Rs. Rs. Rs. Rs.

March 60,000 36,000 9,000 4,000 2,000 4,000

April 62,000 38,000 8,000 3,000 1,500 5,000

May 64,000 33,000 10,000 4,500 2,500 4,500

June 58,000 35,000 8,500 3,500 2,000 3,500

July 56,000 39,000 9,500 4,000 1,000 4,500

August 60,000- 34,000 8,000 3,000 1,500 4,000

71

A sales commission of 4% on sales, due in the month following the month in which the

sales dues are collected, is payable in addition to office expenses. Fixed assets worth Rs.

65,000 will be purchased in September to be paid for in the following month. Rs. 20,000

in respect of debenture interest will be paid in October. The period of credit allowed to

customers is two months and one month credit is obtained from suppliers of goods.

Wages are paid on an average fortnightly on 1 and 16 of each month in respect of dues for

period ending on the date preceding such days. Expenses are paid in the month in which

they are due. Ans. Cash balance - 30 Sept. Rs. 24,000, 31 Oct. Rs. (-) 53,150, 30 Nov. (-) Rs. 40,610.

3.Vani Ltd. a newly started company wishes to prepare cash budget from January. Prepare

a cash budget for the first six months from the following estimated revenue and expenses:

Cash balances on 1st January was Rs. 10,000. A new machinery is to be installed at Rs.

20,000 on credit, to be repaid by two equal installments in March and April.

Sales Commission @ 5% on total sales is to be paid within a month following actual

sales.

Rs. 10,000 being the amount of 2nd call may be received in March. Share premium

amounting to Rs. 2,000 is also obtainable with the 2nd call.

Period of credit allowed by suppliers - 2 months

Period of credit allowed to customers - 1 month

Delay in payment of overheads -1month

Delay in payment of wages - ½ month

Assume cash sales to be 50% of total sales.

Ans. Closing Balances: Jan. Rs. 18,000; Feb. Rs. 29,800; March Rs. 27,000; April Rs.

24,700, May Rs. 33,100; June Rs. 36,000.

Months Sales Purchases Wages Factory Office

expenses expenses

Rs. Rs. Rs. Rs. Rs.

July 80,000 40,000 5,600 3,900 10,000

August 76,500 42,000 5,800 4,100 12,000

September 78,000 38,500 5,800 4,200 14,000

October 90,000 37,500 5,900 5,100 16,000

November, 95,000 43,000 5,900 6,000 13,000

Overheads

Months Total Sales Materials Wages Production Selling and

distribution

Rs. Rs. Rs. Rs. Rs.

Jan. 20,000 20,000 4,000 3,200 800

Feb. 22,000 14,000 4,400 3,300 900

Mar. 28,000 14,000 4,600 3,400 900

April 36,000 22,000 4,600 3,500 1,000

May 30,000 20,000 4,000 3,200 900

June 40,000 25,000 5,000 3,600 1,200

72

4: Make out a Cash Budget for April, May and June 2008 from the following information: Actual and Budgeted Sales:

Actual Rs. Budgeted Rs.

January 80,000 April 90,000

February 80,000 May 85,000

March 75,000 June 80,000

Actual and Budgeted Purchases:

Actual and Budgeted Wages and Expenses:

Actual

Wages Expenses

Rs. Rs.

January 20,000 5,000

February 18,000 6,000

March 22,000 6,000

Budgeted

wages Expenses

Rs. Rs.

April 24,000 7,000

May 20,000 6,000

June 18,000 5,000

1. Special: The advance income tax for May, Rs. 4,000 plant in April, Rs. 10,000.

2. Rent of Rs. 300 payable each month, not included in expenses.

3. 10% of purchases and sales are on cash terms.

4. Credit purchases are paid after one month and credit sales are collected

5. after two months. The time lag in wages and expenses 1/2 month.

6. Cash and bank balances in April, Rs. 13,000.

Ans. Cash balance Rs. 11,400, Rs. 5,100, Rs. 25,300.

5: The cost of an article at capacity level of 5,000 units is given under A below. For a

variation of 20% in capacity above or below this level, the individual expenses vary as indicated under B below:

Actual Rs. Budgeted Rs.

January 45,000 April 50,000

February 40,000 May 45,000

March 42,000 June 35,000

73

A(Rs) B

Material cost 25,000 (100%varying)

Labour cost 15,000 (100% varying)

Power 1,250 (80% varying)

Repairs and maintenance 2,000 (75% varying)

Stores 1,000 (100% varying)

Inspection 500 (20% varying)

Depreciation 10,000 (100% fixed)

Administration overheads 5,000 (25% varying)

Selling overheads 3,000 (50% varying)

62,750

Cost per unit 12.55

Find the unit cost of the product under each individual expense at production levels of

4,000 units and 6,000 units.

Ans. 4,000 units Total cost 53,480 Per unit 13.37

6,000 units Total cost 72,020 Per unit 12.00.

6: The monthly budgets for manufacturing overhead of a concern for two levels of activity

were as follows:

Capacity 60% 100%

Budgets production (units) 600 1,000

Rs. Rs.

Wages 1,200 2,000

Consumable stores 900 1,500

Maintenance 1,100 1,500

Power & fuel 1,600 2,000

Depreciation 4,000 4,000

Insurance 1,000 1,000

9,800 12,000

You are required to: (i) Indicate which of the items are fixed, variable and semi-

variable, (ii) Prepare a budget for 80% capacity; and (iii) Find the total cost, both fixed and

variable, per unit of output at 60%, 80% and 100% capacity.

Ans. 80% Total Cost Rs. 10,900.

7: Gemini Steel Ltd. manufactures a single product for which market demand exists for

additional quantity. Present sales of Rs. 60,000 per month utilises only 60% capacity

of the plant. Marketing Manager assures that with the reduction of 10% in the price he

would be in a position to increase the sale by about 25% to 30%.

The following data are available:

Selling price Rs. 10 per unit

Variable cost Rs. 3 per unit

Semi-variable cost Rs 6,000 fixed + 50 paise per unit

Fixed cost Rs. 20,000, at present level estimated to be

Rs. 24,000 at 80% output.

74

You are required to prepare the following statements:

(i) The operating profits at 60%, 70% and 80% levels at current

Selling price, and

(ii) The operating profits at proposed selling price at the above levels

Ans. Profit at 60% Rs. 13,000; at 70% Rs. 19,500 at 80% Rs. 22,000.

Profit at proposed selling prices in above levels Rs. 7,000, Rs. 12,500, Rs, 14,000.

8: For production of 10,000 articles, the following are budgeted expenses per unit:

Prepare a flexible budget for production of 6,000, 7,000 and 8,000 units of articles,

showing clearly Variable cost, Fixed cost and Total cost.

Ans. Rs. 10,30,000; Rs. 11,67,000; Rs. 12,98,000.

9: The following data is for a 60% activity. Prepare a flexible budget at 80% and 100%

activity.

Production at 60% capacity-600 units.

Materials Rs. 100 per unit.

Labour Rs. 40 per unit.

Expenses Rs. 10 per unit.

Factory expenses Rs. 40,000 (40% fixed).

Administrative expenses Rs. 30,000 (60% fixed).

Ans. Total Rs. 1,60,000; 2,02,000; 2,44,000.

10: The expenses budgeted for production of 10,000 units in a factory are furnished below:

Prepare a budget for production of

Expenses Per unit

Rs.

Direct materials 60

Direct labour 30

Variable overheads 20

Fixed overheads (Rs. 1,60,000) 16

Variable expenses (direct) 5

Selling expenses (20% fixed) 15

Administration expenses (Rs. 50,000 fixed for

all levels of production) 5

Distribution expenses (20% fixed) 5

156

Per unit

Rs.

Materials 70

Labour 25


Fixed overheads (Rs. 1,00,000) 10

Variable expenses (Direct) 5

Selling expenses (10% Fixed) 13

Distribution expenses (20% Fixed) 7

Administrative expenses (Rs. 50,000) 5

Total cost of sales per unit (to make and sell) 155

75

I 8,000 units, and

6,000 units.

Assume that administrative expenses are rigid for all levels of production.

Ans. Rs. 12,75,400; 10,00,800.

11: A manufacturing company has the production capacity of 20,000 units per annum. The

expenses budgeted for 12,000 units for a period are as follows:

Per unit

Rs.

Materials 100

Wages (40% Fixed) 20

Manufacturing Expenses (40% Fixed) 20

Administration Expenses (Fixed) 10

Selling & Distribution Expenses (60% Fixed) 10

160

Profit 40

Selling Price 200

Prepare a Flexible Budget showing 70% and 100% level of capacity. It is expected that

the per unit selling price will remain constant upto 60% capacity, there after a 5%

reduction is expected upto 90% capacity level. Above 90% a2 * 1 /2 .

2 % reduction-in original price is expected for every 5% increase in volume.

Ans. Profit.70% 4,84,000; 100% 8,56,000

76

LESSON 5

MARGINAL COSTING-I

5.0Introduction

5.1 Marginal cost- Definition and Concept

5.2 Methods of segregation of semi-variable costs

5.3 Two popular methods are described-Level of Activity Method

and Range of High and Low Method

5.4 Definition of marginal costing

5.5 Features of marginal costing

5.6 Ascertainment of Net Profit under Marginal Costing

5.7 Distinction between Absorption/full/ convention Costing and Marginal Costing

5.8 Assumptions underlying Marginal Costing

5.9 Advantages of Marginal Costing

5.10 Limitations of Marginal Costing

5.11 Applications of Marginal Costing

5.12 Cost-Volume-Profit (c-v-p) Analysis- Definition, meaning,

Impact of the factors on the profit.

5.13 Break-even Analysis-Assumptions Underlying Break-Even Analysis

5.14 Methods of Break-Even Analysis-

1) Algebraic Method (following terms explained with numerical problems)

(i) Contribution

(ii) PV Ratio

(iii) Break-even point (BEP)

(iv) Margin of Safety. (explained in next chapter)

2 Graphic method (explained in next chapter)


5.16 Exercise

Objectives


• Understand the definition of marginal cost

• Explain the methods of segregation of semi-variable costs

• Understand the definition of marginal costing and features of marginal costing

• Understand the Ascertainment of Net Profit under Marginal Costing

5.1 Marginal Costing

Marginal costing provides the cost information to management for decision making. The cost

of the product, service, department etc, can be determined by different methods like single

Output costing, job costing, process costing etc. In addition to these methods, there are

several techniques of costing used for managerial decision making. These techniques can be

combined with any of the methods of costing. Marginal costing is one of the techniques of

77

costing used for the purpose of assessing the profitability or otherwise of the products,

processes, departments or cost centres.

The technique of marginal costing includes the term marginal cost.

Marginal Cost

According to C.I.M.A. London, "Marginal cost means the amount at any given volume of

output by which aggregate costs are changed if the volume of output is increased or

decreased by one unit."

Therefore, marginal cost is the cost through which total cost changes when there is a change

in output by one unit. An important point is that marginal cost per unit remains unchanged

irrespective of the level of activity or output.

For example,

If the total cost of producing 10 units of a product is Rs. 100 and the cost for 11 units is Rs.

105, the marginal cost of producing one additional unit will be Rs. 5.

Marginal cost is also called as variable cost because an increase of one unit in production will

cause an increase invariable costs only. Hence,

Marginal Cost = Direct Materials cost + Direct Labour cost + Direct Expenses +

Variable Factory Overheads + Variable Office and Administration

Overhead + Variable Selling and Distribution Overheads.

Example

A plant produces =10 units of product per annum.

Variable cost = Rs. 10(per unit)

The fixed costs = Rs. 2,00 per annum.

Calculate the total cost of 10units of product.

Rs.

Variable Cost (10 x Rs. 10) 100

Fixed Cost 200

Total Cost 300

Suppose production is increased by one unit then it will become 11 units of product per

annum;

Rs.

Variable Cost (11 x RS. 10) 110

Fixed Cost 200

Total Cost 310

marginal cost of producing one additional unit is Rs. 10 and it is same as variable cost.

Question 1

Following is the cost sheet of producing 500units of product against a capacity of 750units:

Cost per unit {in Rs.)

Direct materials 72

Direct wages 60

Works overheads (50% of this is variable) 20

Selling overheads (25% of this is variable) 8

The manufacturer decides to increase his output to 600 units. You are required to calculate

marginal cost of 100 units and total cost of 600 units.

78

Solution

Statement Showing Marginal Cost and Total Cost

Particulars 500 units

(Rs.)

100

units (Rs.)

600 units

(Rs.)

Direct Materials

Direct Wages

Variable Works Overhead

Variable Selling Overhead

Marginal or Variable Costs

Fixed Works Overhead

Fixed Selling Overhead

Total Cost

36000

30000

5000

1000

7200

6000

1000

200

43,200

36000

6000

1200

72000

500

30000

14,400

------

------

86,400

6000

3600

75,500 14,400 96000

5.2 Methods of Segregation of Semi-variable Costs

Semi-variable cost can be separated into fixed and variable costs by the following methods.

1. Level of activity method

2. Range or high and low method

3. Scatter graph method

4. Analytical method

5. Simultaneous equation method.

6. Least squares method

5.3 Two Popular Methods

The first two methods are commonly used, which have been discussed below:

Level of Activity Method

Under this method, output and overheads are compared at two levels of output.

The variable overhead per unit can be obtained by dividing the change in overheads by the

change in output or activity and fixed overheads remain fixed.

Variable overhead per unit = Change in Overheads /change in Output

Question 2

March April

Output (in units) 2000 2,400

Factory Overheads ( in Rs.) 25,600 27,200

Calculate the fixed factory overhead of the company.

Solution:

Variable overhead per unit = Change in Factory Overheads /change in Output

=1600/400

= Rs. 4 per unit

To calculate fixed OH apply Rs 4 per unit rate for the month of March,

79

Fixed Factory Overheads = Total Factory Overheads- Variable Factory Overheads

= 25,600 - (2000 x 4)

= Rs. 17,600.

For the month of April

Fixed Factory Overheads = Total Factory Overheads- Variable Factory Overheads

= 27,200 - (2400 x 4)

= Rs. 17,600.

Fixed overhead is same for the month of March and April.

Range of High and Low Method

Highest and lowest points of output are taken into consideration, under this method. Change

in overhead is divided by the change in output to obtain the variable cost per unit.

Question 3

January February March April

Units of Output 500 600 700 1000

Factory Overheads (Rs )6,000 6600 7200 8000

You are required to calculate fixed overheads.

Solution

Output {units) Factory Overhead (Rs.)

Highest 1000 8000

Lowest 500 6000

Change 1500 14000

Variable overhead per unit= 2000/1500

= Rs. 4 per unit

Fixed overhead = 8000 - (1000 x 4)

= 8000- 4000

= Rs. 4,000

5.4 Marginal Costing

According to Chartered Institute of Management Accountants, London "The accounting

system in which variable costs are charged to cost units and fixed costs of the period are

written off in full against the aggregate contribution. Its special value is in decision making"

only variable costs are charged to cost units. It is also called as 'variable costing'. Profit is

measured by contribution minus total fixed costs. Fixed costs are charged to Profit and Loss

Account during which costs are incurred because it is considered as period costs.

5.5 Features of Marginal Costing

1. It is a technique for managerial decision making.

80

2. Only variable costs are taken into consideration for computing cost of production and

value of stocks.

3 Semi-variable costs are segregated into fixed and variable costs.

4. Marginal contribution is calculated by sales value less variable costs, to ascertain the

profitability of a product or department.

5. Fixed costs are charged to Profit and Loss Account of the period for which costs are

incurred.

6. Marginal costing is not a method of costing just as job costing, process costing etc.

5.6 Ascertainment of Net Profit under Marginal Costing

Net Profit is ascertained by deducting fixed costs from marginal contribution. For this

purpose marginal cost sheet is prepared. Proforma of marginal cost sheet is shown as under:

Marginal Cost Sheet

(A) Sales

Direct Materials

Direct Labour

Direct Expenses

Variable Overheads

Rs.

(B) Variable Costs

(C) (D)

Contribution (A - B)

Fixed Overheads

(E) Profit (C - D)

5.7 Distinction between Absorption/full/ convention Costing and Marginal Costing

Under absorption costing, all manufacturing costs whether fixed or variable are ‘absorbed’ in

the cost of the products produced.

According to C.I.M.A, London, "Absorption costing as the practice of charging all costs, both

variable and fixed, to operations, process or products ".

Product cost= prime cost + variable manufacturing overheads + fixed manufacturing

overheads.

Absorption costing is also known as full costing or total costing. It is the basis of all financial

accounting statements. In this technique, the cost per unit varies to a large extent with the

volume of production because fixed costs are also included therein. In this method, profit

means the difference between sales and cost of sales.

81

Following table shows the distinction between absorption costing and marginal costing:

Basis of Distinction Absorption Costing Marginal Costing

(i) product costing

All costs are allocated

to products. All costs are treated as

product costs.

Only variable costs are treated

as product costs.

(ii) Cost element

Fixed overheads are added to the

cost of production.

Fixed overheads are not included

in the cost of production.

(iii) inventory

valuation

Value of inventory is

comparatively higher because

inventory is valued at total cost

(including variable and fixed costs)

Value of inventory is

comparatively lower because

inventory is valued at variable

costs only:

(iv) Profit concept

Profit is computed and decisions

are taken on profit basis. Under

absorption costing, profit is the

difference between sales and cost

of sales.

Contribution is the key to take

decisions under marginal costing.

Sales and variable cost of sales is

contribution. Profit is calculated

by difference between

contribution and fixed cost.

(v) Effect of

inventory

Increase in inventory results in

higher profit and vice- versa.

Increase in inventory results in

lower profit and vice-versa.

5.8 Assumptions underlying Marginal Costing

Following are the assumptions underlying marginal costing: Selling price per unit does not change as volume changes.

Total fixed cost will remain constant at all levels of output. Variable cost per unit remains constant. It implies that the law of variable proportions

does not apply. Total variable cost varies in direct proportion to the volume of production.

Sales mix will remain constant.

Total variable cost will change only due to change in volume.

Costs can be categorized into fixed and variable costs.

5.9 Advantages of Marginal Costing

Following are the advantages of marginal costing:

1. Benefit to Management: Marginal costing is helpful to management in taking many valuable decisions like fixing selling prices below cost, introduction of new product line, make or buy, selecting the most profitable product or product mix, accepting orders, at low price, reduction of price in times of competition or depression, etc.

82

2. Easy to apply: Marginal costing is simple to use as it avoids the complications

involved in allocation, apportionment and absorption of fixed overheads on estimated basis.

3. Cost Control: control over cost can be possible by classifying costs into fixed and variable costs. Management can concentrate more on the control of variable costs which are usually controllable and pay less attention to fixed costs which may be controlled only by the top management.

4. No under and over- absorption of overheads: In Marginal costing, there is no problem of under or over-absorption of overheads.

5. Tool of Profit Planning: cost- volume-profit analysis is one of the important tools used by the management for profit planning. The use of break even analysis and chart allows the management to understand the implications of change in different variables on the profitability of the enterprise.

5.10 Limitations of Marginal Costing The main limitations of Marginal costing are as follows:

1. Difficulties in cost division: marginal cost assumes that all costs can be divided into fixed and variable cost precisely. However, in practice, there are certain items of semi-variable cost which cannot be precisely divided into fixed and variable. These items of costs are segregated on the basis of some estimation and may differ from person to person. 2. Inventories Valuation: Finished goods and work-in-progress are evaluated at marginal cost, under marginal costing. It would not show the true and fair view of the financial position, from the point of view of Balance Sheet. 3. Suitable for labour intensive industries: In capital intensive industries, the proportion of fixed costs is more. The marginal costing technique, which ignores fixed cost, thus proves less effective in such industries. 4. Difficulty in application: Marginal costing may not be applied by the concerns which have to carry large stocks by way of work-in- progress. Further, marginal costing is not suitable to industries working on contract basis. 5. Time Factor: By ignoring fixed costs, time factor is also ignored. For example, marginal cost of two jobs may be identical but if one job takes twice as long to complete as the other, the true cost of the job taking longer time is higher than that of the other. It is not disclosed by marginal costing. It creates an illusion that fixed costs have nothing to do with production.

5.11 Applications of Marginal Costing

1. Pricing of products: Pricing of products can be done by applying the technique of

marginal costing. The price of the product should be fixed so that it covers marginal

cost and also makes a reasonable contribution to fixed overheads.

2. Volume of sales: The Company may need to change volume of sales to get a desired

level of profit. It can be ascertained by the marginal costing technique.

3. Different Level of production: This technique is helpful to the management to decide

optimum level of activity (where contribution per unit is the maximum). When the

management is considering different levels of production or selling activities.

4. Valuation of Profitability of various Departments: it helps the management of the

company to decide whether a department should continue or be closed.

83

5. Optimum Sales Mix: A firm needs to decide the best product mix which yields the

maximum contribution. It can be ascertained with the help of marginal costing.

6. Different Techniques to Manufacture: Marginal costing is helpful in deciding best

method of production which can give the greater contribution. For example hand

work or machine work.

7. Make or Buy Decision: When management has to decide whether to make product or

buy it from outside then management compares the marginal cost of manufacturing

the product with its purchase price. Marginal costing techniques are used to make

such decisions.

8. Plant Shut-down Decision: this decision totally depends on revenue generated from

the sales activity. If the sales of the product are inadequate to cover fixed costs, the

management may decide whether to shut down the production of the product

temporarily or continue. Marginal costing assists the management in taking such

decision.

9. Launching of a New Product: Marginal costing technique is used, when a firm

intends to introduce a new product in the market to make use of the available facilities

or to capture a new market.

10. Acceptance of special Price: In the course of normal circumstances, price is fixed on

the basis of the total cost. But under abnormal conditions, the prices may be fixed

below the total cost. If selling price is equal to or more than marginal cost, the firm

may accept a price less than the total cost.

Following circumstances necessitate the fixation of price below total cost:

(i) To eliminate weak competitors.

(ii)To make a new product popular in the market.

(iii) To explore a foreign market.

(iv) To keep plant and machinery in running condition.

(v)When a product can be sold with profit in combination with other products.

5.12 Cost-Volume-Profit (c-v-p) Analysis

Cost-Volume-profit analysis is a profit planning technique to study the impact of change in

any of the variables affecting the profit.

according to C.I.M.A. London, it is “the study of the effects on future profits of changes in

fixed cost, variable cost, sales price, quantity and mix". Sales volume, Selling price, fixed

cost, variable cost per unit and sales mix are the factors which affect the profit of a concern.

Cost- volume-profit analysis explains the inter-relationships of these variables for decision-

making. It is used to determine the impact of fluctuations in cost and volume on the financial

results. It studies the inter-relationship of cost, levels of activity and the profit of different

alternatives available to a firm.

The cost-volume-profit analysis explains the impact of the following on the profit:

(i) Change in the volume of sales

(ii) Change in the selling price

(iii) Change in the fixed cost

(iv) Change in the variable cost

84

5.13 Break-even Analysis

Break-even analysis is a widely used technique to study the cost-volume-profit relationship.

In the narrow sense, break-even analysis is concerned with determining break-even point, i.e.,

that level of production and sales where there is no profit and no loss. At this point total cost

is equal to total sales revenue. In broader sense, break-even analysis is used to determine

probable profit/loss at any given level of production/sales. It also helps to determine the

amount or volume of sales to earn a desired amount of profit.

Assumptions Underlying Break-Even Analysis

Break-even analysis is based on the following assumptions:

1. All costs can be categorized into fixed and variable.

2. Total fixed cost remains constant.

3. There will be no change in general price level.

4. The state of technology, methods of production and efficiency remain unchanged.

5. Productivity per worker does not change.

6. Selling price per unit does not change as volume changes.

7. Variable costs vary in proportion to output and fixed costs remain constant.

8. Stocks are valued at marginal cost.

9. There is synchronization between production and sales. It means volume of production

equals volume of sales.

10. Sales-mix will remain constant.

5.14 Methods of Break-Even Analysis

There are two methods of break-even analysis:

(i) Algebraic (mathematical) method

(ii) Graphic method.

Algebraic Method

(i) Contribution

(ii) PV Ratio

(iii) Break-even point (BEP)

(iv) Margin of Safety.

Contribution

Contribution is the difference between sales and marginal cost of sales. Contribution is also

known as "Gross Margin" or contribution margin.

Contribution is calculated by the following formula:

Contribution = Sales - Variable cost

Contribution = Fixed Cost + Profit

Thus, Profit = Contribution - Fixed costs

Contribution per unit = Selling price per unit - Variable cost per unit

Total Contribution = Contribution per unit x Number of units sold.

85

It is one of the important concepts in marginal costing. It helps to find out the profitability of

a product or the department. It also helps the management to decide a better product mix and

maximize the profits.

It is affected by the change in any or both of the following factors:

(i) Variable cost per unit.

(ii) Selling price per unit

Illustration 1

Selling price per unit Rs. 20

Variable cost per unit Rs. 15

Fixed cost Rs. 1,00,000

Output 1,00,000 units. Find out the contribution and profit earned during the year:

Solution

Contribution per unit = Selling price per unit - Variable cost per unit

= 20-15

= Rs. 5

Total Contribution = Contribution x Number of units sold

= Rs. 5 x 1, 00,000

= Rs. 5, 00,000.

Contribution (total) may also be calculated as under:

Contribution = Sales - Variable cost

= 1, 00,000 x 20-1, 00,000 x 15

= 20, 00,000- 15, 00,000

= Rs. 5, 00,000.

Profit= Contribution - Fixed cost

= 5, 00,000-1, 00,000

= Rs. 4, 00,000

Profit-Volume Ratio (P/V Ratio)

Profit-volume ratio (P/V Ratio) is also called as contribution-sales ratio (C/S Ratio). P/V ratio

expresses the relation of contribution to sales. A higher P/V ratio shows higher proportion of

contribution in the given sales. As the fixed cost remains same, higher is the profit. Hence,

P/V Ratio is affected by the change in any or both of the following two factors:

(i) Selling price per unit

(ii) Variable cost per unit.

Improvement in P/V Ratio

(a) Reducing the variable cost per unit.

(b) Increasing the selling price per unit.

(c) Changing the sales mix

It can be computed in three different ways:

• When the information is given in amount

86

P/V Ratio = Contributionxl00

Sales

• When the information is given per unit

P/V Ratio = Contribution per unit xl00

Selling Price per unit

• When the information is given for two time periods

P/V Ratio =Change in Profit/Contributionxl00

Change in Sales

Illustration 2

Marginal cost Rs. 48,000

Sales Rs. 1, 20,000

Find P/V Ratio Solution

Contribution = Sales - Marginal Cost

= 1,20,000-48,000

= Rs. 72,000

P/v Ratio = (contribution/ sales) X 100

= (72,000/1,20,000) x 100

= 60%

Illustration 3

Period I(lacs) Period II(lacs)

Sales Rs. 30 Rs. 20

Profit Rs. 4 Rs. 2

Calculate P/V Ratio.

Solution

P/V Ratio= Change in Profit x lOO

Change in Sales

= 4 Lakhs - 2 Lakhs x lOO =20%.

30 Lakhs - 20 Lakhs

Illustration 4

Following information is given below:

Selling price per unit = Rs. 10

Variable cost per unit = Rs. 8

Contribution per unit = Rs. 2

Fixed overheads are Rs. 8,000 per month

Calculate the present and future P/V Ratio (if there is a reduction of 10% in selling price)

87

Solution

Present P/V Ratio= Contribution per unit x 100

Selling price per unit

= 2/10x 100= 20%

Future Selling price = 10-1= Rs. 9

Future Variable Cost = Rs. 8

Future Contribution = 9 – 8 = Rs. 1

Future P/V Ratio= Contribution per unit x 100


= 1/9x100

=11.11%

Illustration 5

Selling price per unit Rs. 200

Variable cost per unit Rs. 120

(i) Find out P/V Ratio.

(ii) Calculate the revised P/V Ratio if

(a) Decrease in selling price by 10%.

(b) Increase in variable cost by 10%.

Solution

i) P/v Ratio = Contribution per unit x 100


= 200-120x100

200

= 40%

(ii) (a) Future P/V Ratio = 180-120 Xl00 = 30%

200

(b) Future P/V Ratio = 200-132 x 100 = 34%

200

Break-even Point

It is the level of sales where the total revenue is equal to the total costs. Break-even point is

the point of "no profit, no loss." Any level of sales above the break-even point gives profit

and if the sale decreases from this level gives loss. Lower the break-even point, higher will be

the chances of higher profitability.

Break-even point may be expressed in terms of units of production (or sales) or in terms of

sales volume. It may be calculated as under:

88

Break-even point (in units) = Fixed Cost /contribution per unit

Break-even point (in sales volume or in Rs.) =Fixed Cost x Sales

Contribution

or

= Fixed Cost

P/V Ratio

A firm which attains break-even point earlier (at less number of units) is definitely better than

one which attains it later (at more number of units).

Illustration 6

Rs.

Selling Price per unit 10

Variable Cost per unit 2

Fixed Cost 40,000

Estimated Sales 1, 00,000

Calculate the break-even point.

Solution

Contribution= Selling price per unit - Variable cost per unit

= Rs. 10-Rs. 2 = Rs. 8

P/V Ratio= (Contribution per unit /Selling Price per unit) x l00

= 8/10 xl00 = 80%

B.E.P. (in units)=Fixed Cost / Contribution per unit

= 40,000/8=5000

B.E.P. (in sales volume) =Fixed Cost / P/V Ratio

= 40000/80 x100

= 50,000 units.

Calculation of Sales for Desired Profit

The level of sales required to earn the desired amount of profit is called desired sales.

Sales for Desired Profit (in units) =Fixed Cost + Desired Profit

Contribution per unit

Sales for Desired Profit (in Rs.) = Fixed Cost + Desired Profit

P/V Ratio

89

Illustration 7

(i) Compute break-even point in terms of units and sales

(ii) Compute how many units must be produced and sold to earn a profit of Rs. 30,000.

You are required to use the information given below

Production = 5,000 units.

The variable cost = Rs. 10 per unit.

The fixed cost = Rs. 20,000.

The selling price is fixed to earn a profit of 25% on cost.

Solution:

Variable Cost per unit = Rs 10

Budgeted Production = 5000 units

Variable Cost (5000 x 10) = Rs 50,000

Fixed Cost =Rs 20,000

Total Cost = variable cost+ fixed cost

= 50,000 +20,000

= Rs. 70,000

Profit = 25% of Total Cost

= 25% of Rs. 70,000

= Rs. 17500

Sales = Total Cost + Profit

70,000 + 17500

Rs. 87500

Selling Price per unit =Sales /No. of Units Sold

=87500/ 5,000

=Rs. 17.5

Contribution per unit = Selling price unit- Variable cost per unit

= 17.5-10 = 7.5

Sales =Total Cost + Profit

=70,000 + 17500

=Rs. 8,75,00

P/V Ratio = (Contribution per unit /Selling Price per unit) xl00

= 7.5/17.5x100

=42.86%

(i) Break-even Point (in units) = fixed cost/Contribution per unit

= 20000/7.5

= 2667 units

Break-even Point (in sales) =Fixed Cost /P/V Ratio

=20,000/42.86xl00

90

=Rs. 46663.56

(ii) Sales (in units) to earn a desired profit of Rs. 30,000

=Fixed Cost + Desired Profit


=20,000 + 30,000 = 6666.66 units.

7.5

Illustration 8

Profit volume ratio of a company = 25%

Margin of safety is 20%

Sales volume of the company =Rs. 25 lakhs

Find out its break-even point and net profit.

Solution

Method-I

Sales = Rs. 25, 00,000

Less: Margin of safety (20% of 25, 00,000) = Rs. 5,00,000

(i) Break-even point = Rs. 20, 00,000

P/V Ratio = 25%

Total Contribution = P/V Ratio x Sales

= 25% of 25, 00,000

= Rs. 625000

Less: Fixed Cost = Rs. 5, 00,000

(ii) Net Profit = Rs. 125000

Working notes

Break Even Point =Fixed Cost

P/V Ratio

Hence Fixed Cost = Break Even Point x P/V Ratio

= 20, 00,000 x 25 =RS. 5, 00,000

100

Method-II, for calculating net profit:

Margin of Safety Profit=Profit/P/V Ratio

Profit= Margin of Safety x p/V Ratio

= 5, 00,000 x 25 =RS. 125000

100

Illustration 9

The following figures are available at 31 March of 2007 and 2008:

2007 2008

Rs. (Lacs) Rs. (Lacs)

Sales 200 150

Profit 50 30

91

Calculate:

1. P/V ratio and total fixed expenses.

2. Break-even level of sales.

3. Sales required to earn a profit of Rs. 90 lakhs.

4. Profit or loss that would arise if the sales were Rs. 280 lakhs.

Solution

1. P/V Ratio = Difference in Profit / Difference in Sales

= 20/50 x100

= 40%

Applying P/V Ratio to the sales for the year ending 31st March, 2007

Contribution = 40% of 200 Lakhs

= Rs. 80 Lakhs

Fixed Cost = Contribution - Profit

= 80 Lakhs - 50 Lakhs

= Rs. 30 Lakhs.

Fixed cost of Rs. 30 lakhs would be obtained even if P/V Ratio is applied to the sales for the

year ending 31st March, 2008:

(b) Break-even level of Sales = Fixed Expenses/ P/V Ratio

=Rs. 30 lakhs/40%

= Rs. 75 Lakhs

(c) Sales to earn a profit of Rs. 90 lakhs =Fixed Cost + Required Profit

P/V Ratio

= Rs. 30 lakhs + Rs. 90 lakhs

40%

= Rs. 300 Lakhs

(d) Profit or loss that would arise if the sales were Rs. 280 Lakhs

Profit = Contribution - Fixed Expenses

= (P/V Ratio x Sales) - Fixed Expenses

= (40% x Rs. 280 lakhs) - Rs. 30 lakhs

= Rs. 82 lakhs.


In this chapter few topics of marginal costing are covered and rest topics are covered in next

two chapters. Marginal or variable costing is a managerial technique of income determination

under which only variable cost is taken in consideration. Cost-volume-profit analysis is a

powerful tool of profit planning and break-even analysis is a widely used technique to study

CVP analysis. Break-even analysis is a widely used technique to study the cost-volume-profit

relationship. In the narrow sense, break-even analysis is concerned with determining break-

even point, i.e., that level of production and sales where there is no profit and no loss. At this

point total cost is equal to total sales revenue.

92

5.16 Exercise


True or False

1. Absorption costing is a total cost technique.

2. Under absorption costing, inventory valuation is at total cost.

3. Variable costing is used mainly for internal reporting.

4. At break-even point, fixed cost is equal to contribution.

5. Cost volume profit analysis assumes that sales volume does not change.

1. True, 2. True, 3. True, 4. True, 5. False

Exercise 2: fill in the blanks

1. When fixed cost is Rs 5 lakhs, P/V ratio is 40%, then the break-even point is

Rs………..

2. When sales increase from Rs 20,000 to 40,000 while profit increase from Rs 1,000 to

Rs 2,000, P/V ratio is …………..

3. Break-even sales are 1000 units, fixed cost Rs 2000, contribution per unit is

Rs…………

4. Fixed cost is Rs 2000 and variable cost is 60% of sales, the break-even point is

Rs…………

5. When contribution is Rs 15000, P/V ratio 40%, the sales is Rs………..

Answer

(1) 12,50,000 (2) 5%, (3) Rs 2, (4) 5000, (5) Rs 37,500

Exercise 3: Multiple choice Questions

1) To obtain the break-even point in rupee sales value, total fixed costs are divided

by:

a) Variable cost

b) Profit/ volume ratio

c) Fixed cost per unit

2) The break-even point is the point at which:

a) total revenue is equal to total cost

b) Contribution margin is equal to total fixed cost

c) All of the above

3) CVP analysis is based on several assumptions. Which one of the following is not

one of these assumptions:

a) inventory quantities change during the year

93

b) The sales mix of the products is constant

c) Material prices and labour rates do not change

4) When sales volume increases

a) Total profit increases

b) Total loss increases

c) All of these

5) An increase in fixed cost results in

a) increase in break-even point

b) Increase in contribution

c) Increase in P/V ratio

Answer

1) b, 2) c, 3) a, 4) a, 5) a

Exercise 4: Consider the each of the following as independent situations, indicate whether P/V ratio

will increase, decrease or not change

1. an increase in sales quantity

2. an increase in fixed cost

3. a 10% increase in both selling price and variable cost per unit

4. A 50% increase in variable cost per unit and 50% decrease in fixed cost.

5. A decrease in contribution.

Answer

1. No change, 2. No change, 3. No change, 4. Decrease, 5. Decrease

94

LESSON 6

MARGINAL COSTING-II

6.0 Introduction

6.1 Objectives

6.2 Meaning of Margin of Safety

6.3 Introduction of Break-even Chart

6.4 Uses of break-even chart

6.5 Assumptions Regarding Break-even Chart

6.6 Steps in Preparing Break-even Chart

6.7 Angle of incidence

6.8 Types of Break-Even Charts

6.9 Advantages of Break-Even Analysis and Chart

6.10 Specific Applications Break-Even Chart and Analysis

6.11 Limitations of Break-Even Chart

6.12 Cost Break-Even Point

6.13 Composite Break-Even Point

6.14 Cash Break-Even Point


6.16 Exercise

6.1 Objectives


• Understand the Margin of Safety and Break-even Chart

• Explain the Uses of break-even chart and Assumptions Regarding Break-even Chart

• Understand the Steps in Preparing Break-even Chart and Angle of incidence

• Understand the Types of Break-Even Charts and Advantages of Break-Even Analysis

• Understand Specific Applications Break-Even Chart and Analysis

• Limitations of Break-Even Chart

• Understand Cost Break-Even Point, Composite Break-Even Point and Cash Break-

Even Point

6.2 Margin of Safety

Margin of safety is the difference between total sales and the sales at breakeven, point.

Margin of safety may be calculated as under:

Margin of Safety = Total Sales - Sales at B.E.P.

or

Margin of Safety = Profit/ PV Ratio

95

Margin of Safety (as a percentage) = Margin of Safety xl00

Total Sales

Margin of safety indicates the soundness of the business. A high margin of safety indicates an

extremely favorable position of the firm in the market since even with a substantial decline in

sales, the firm will continue to earn profit. If the margin of safety is small, any decline in

sales may touch BEP and finally results into a loss. Since higher margin of safety implies

higher strength of the business, the management of the concern would like to improve its

margin of safety by :

(a) Increasing the selling price if the market permits.

(b) Increasing the volume of sales if capacity is available for increasing the production.

(c) Reducing the variable costs.

(d) Reducing the fixed costs.

(e) Switching the production to more profitable products.

Illustration 1

Rs.

Sales 5, 00,000

Fixed Costs 150000

Profit 1, 00,000

Compute break-even sales and margin of safety:

Solution

Contribution = Fixed Costs + Profit

= 150000 + 1, 00,000

= 250000

P/V Ratio =Contribution x 100

Sales

=(250000 /5,00,000)x100

=50 %

(i) Break-even Sales =Fixed Costs / P/V Ratio

=150000xl00 = Rs. 3,00,000

50

(ii) Margin of Safety = Actual Sales - Break-even Sales

= 5,00,000-3,00,000

= Rs. 2,00,000

Alternatively,

Margin of Safety =Profit/ P/V Ratio

=1,00,000x100

50

= Rs. 2,00,000.

96

Illustration 2

Profit =Rs. 30,000

Marginal cost = Rs. 4 per unit

Selling price = Rs. 5 per unit

Find out the amount of 'Margin of Safety'.

Solution

Selling Price per unit = Rs. 5

Marginal Cost per unit = Rs. 4

Contribution per unit (5-4) = Rs. 1

P/V Ratio = Contribution per unit xl00


= (1/5)x100

=20%

Margin of safety = Profit

P/V Ratio

=(30,000/20)x100

= Rs. 150000

Illustration 3

The profit volume ratio = 25%

and the margin of safety = 20%.

calculate the net profit if the sales volume is Rs. 50000.

Solution

P/V Ratio = 25%

Margin of Safety = 20%

% Break - even Sales = 100 %- Margin of Safety

= 80% of Present Sales

= 80 % Rs. 50000 = 40,000

Break-even sales =Fixed Cost/P/V Ratio

40,000 =Fixed Cost/25%

Fixed Cost = 25% of 40,000

=Rs. 10,000

Profit =Contribution - Fixed Cost

=25% of 50000 - 10,000 = Rs. 2500

Margin of Safety =Profit / P/V Ratio

20% =Profit /25%

Profit =20 x 25 x100= 5% of Sales

100 x 100

Profit = 5% of 50000 = Rs. 2500.

97

Illustration 4

Rs.

Sales 10,000

Total Cost 8000

Variable Cost 6000

calculate:

(i) Break-even Sales.

(ii) Margin of Safety, and

(iii) Sales to earn a profit of Rs. 2,000.

Solution

Sales =10,000

Variable Cost =6,000

Contribution =4,000

Fixed Cost = Total Cost - Variable Cost

=8,000- 6,000 = Rs. 2,000

Profit =Contribution - Fixed Cost

=4,000 - 2,000 = Rs. 2,000

P/V Ratio =(Contribution/sales )x100

= (4000/10000)x100=40%

(i) Break-even Sales =Fixed Costs/ P/V Ratio

=(2000/40)x100

= Rs. 800

(ii) Margin of Safety =Actual Sales - BEP Sales

=10,000- 800 =Rs. 9200

Alternatively,

Margin of Safety = profit/ P/V Ratio

= (2000/40)x100

=Rs. 800

(iii) Sales to earn a profit of Rs. 2,000

=Fixed Cost + Desired Profit

P/V Ratio

=2,000 + 2,000x100

40

=(4,000/40)x100

=RS. 10,000.

98

Illustration 5

ABC LTD manufactures cycles. The cost structure of a cycle is as under:

Material = Rs. 25

Labour = Rs. 40

Variable Overheads = 50% of labour

Fixed overheads = Rs. 120 lakhs per annum

Sale Price = Rs. 115

(a) Calculate the number of cycles that have to be manufactured and sold in a year to

break-even.

(b) How many cycles have to be sold to make a profit of Rs. 50,000 per year?

(c) Suppose sale price is decreased by Rs. 8 each, how many cycles have to be sold to

break-even?

Solution

Sale Price per cycle 115

Less: Marginal Cost per motor

Material 25

Labour 40

Variable overhead (50% of Rs. 40) 20 = Rs. 85

Contribution per unit =115- 85

= Rs. 30

Fixed overheads per year = Rs. 1, 20,000

(a) B.E.P. (units) =Fixed Cost


= 120000/30

= 40000 cycles

(b) Sales to earn a profit of Rs. 1 lakh = Fixed Cost+1,00,000


= 1,20,000 + 50,000

30

= 1,70,000

30

= 5667 cycles

(c) Revised Selling Price = 115- 8 = Rs. 107

Marginal Cost = Rs. 85

Revised Contribution = New Selling Price - Marginal Cost

= 107-85

= 22

Revised B.E.P. (units) = Fixed Cost /Contribution per unit

= 1,20,000

22

= 5455cycles

99

Illustration 6

Two Companies ABC Ltd. and XYZ Ltd. sell the same type of product in the same market.

The forecasted Profit and Loss Accounts for the year 2011-12 are as follows:

ABC Ltd. XYZ Ltd.

Rs. Rs. Rs. Rs.

Sales 10,00,000 10,00,000

Less: Variable Cost of Sales 8,00,000 6,00,000

Fixed Costs 100,000 9,00,000 3,00,000 9,00,000

Forecasted Net

Profit before tax 100,000 100,000

You need to determine which company is likely to earn greater profits in conditions of:

(a) Low demand, and

(b) High demand.

Solution

(a) In the conditions of low demand, a company having low BEP and fixed cost i.e.

higher margin of safety is more profitable. So ABC LTD Limited is more profitable in case

of low demand because its margin of safety is higher. Even if the sale is reduced to 50% due

to low demand, it will not incur any loss.

Particulars ABC Ltd. XYZ Ltd.

Sales Rs. 10,00,000 Rs. 10,00,000

Variable Cost Rs. 8,00,000 Rs. 6,00,000

Contribution (Sales - Variable

Cost)

Rs. 2,00,000 Rs. 4,00,000

Fixed Costs Rs. 100,000 Rs. 3,00,000

Profit (Contribution - Fixed

Cost)

Rs. 100,000 Rs. 100,000

P/V Ratio = Contributionx100

Sales

2,00,000 x100

10,00,000

4,00,000x100

10,00,000

= 20% = 40%

BEP Sales = Fixed Cost

P/V Ratio

100,000 x100

20

3,00,000x100

40

= Rs. 5,00,000 = Rs. 7,50,000

Margin of Safety

= Actual Sales - BEP Sales 10,00,000-

5,00,000

10,00,000-7,50,000

= Rs. 5,00,000 Rs. 2,50,000

100

(b) In the conditions of high demand, a company having high P/V Ratio is more

profitable. SoXYZ Ltd. is more profitable as its P/V Ratio is higher (40%) as compared to

ABC Ltd. (20%). XYZ Ltd. will earn 40% of the additional sales as profit while ABC Ltd

will earn only 20% of the increased sales.

Illustration 7

A company budgets for a production of 1,50,000 units. The variable cost per unit is Rs. 14

and fixed cost is Rs. 2 per unit. The company fixes its selling price to fetch a profit of 15% on

cost.

(i) What is the break-even point?

(ii) What is the profit-volume ratio?

(iii) If it reduces its selling price by 5%, how does the revised selling price affect the

break-even point and the profit-volume ratio?

(iv) If a profit increase of 10% is desired more than the budget, what should be the sales at

the reduced price?

Solution

Variable Cost per unit = Rs. 14.00

Fixed Cost per unit = Rs. 2.00

Total Cost per unit = Rs. 16.00

Profit (15% of Rs. 16) = Rs. 2.40

Selling price per unit = Rs. 18.40

Contribution per unit (18.40-14) = Rs. 4.40

(i) B.E.P. (in units) = Fixed Cost


= 1,50,000x2

4.40

= 68,182 units (approx)

B.E.P. (in volume) = Fixed Cost / P/V Ratio

= (1,50,000/23.91)x100

= Rs. 12,54,549 (approx)

(ii) P/V Ratio = Selling Price per unit x 100


= (4.40/18.40)x100=23.91%

(iii) New Selling Price = 18.40-5%

= Rs. 17.48

New Contribution = 17.48-14= Rs. 3.48

New BEP (units) = 3,00,000/ 3.48

= 86,207 units

New P/V Ratio = (3.48/17.48)x 100=19.90%

(iv) Budgeted Profit (1,500,000 x 2.40) = Rs. 3,60,000

Add: 10% increase = Rs. 36,000

101

New Profit =Rs. 3,96,000

Sales (in units) for a profit of Rs. 3,96,000

= Fixed Cost + Profit


= 3,00,000 + 3,96,000

3.48

= 2,00,000

Sales (in Rs.) for a profit of Rs. 3,96,000

= Break-even units x Selling Price Per unit

= 2,00,000 x 17.48 = Rs. 34,96,000.

Illustration 8

A retail dealer in garments is currently selling 24,000 shirts annually. He supplies the

following details for the year ended 31st March, 2008:

Rs.

Selling price per shirt 40

Variable cost per shirt 25

Staff salaries for the year 1,20,000

General office costs for the year 80,000

Advertising costs for the year 40,000

As a cost accountant of the firm, you are required to answer the following each part

independently:

(i) Calculate the break-even point and margin of safety in sales revenue and number of shirts

sold.

(ii) Assume that 20,000 shirts were sold in year, find out the net profit of the firm.

(iii) If it is decided to introduce selling commission of Rs. 3 per shirt, how many shirts would

require to be sold in a year to earn a net income of Rs. 15,000?

(iv) Assuming that for the year 2008-09 an additional staff salary of Rs. 33,000 is anticipated,

and price of a shirt is likely to be increased by 15%, what should be the break-even point in

number of shirts and sales revenue?

Solution

Selling Price per shirt = Rs. 40

Variable Cost per shirt = Rs. 25

Contribution per unit = Rs. 15

P/V Ratio = Contribution per unit x100


= (15/40) x100=75%

2

Fixed Cost (1,20,000 + 80,000 + 40,000) = Rs. 2,40,000

(i) Break-even Point (in units) = Fixed cost


= 2,40,000

15

102

= 16,000 shirts

B.E.P (in sales revenue) = Fixed Cost

P/V Ratio

= 2,40,000x2xl00

75

= Rs. 6,40,000

Margin of Safety (in units) =Actual Sales - B.E.P. Sales

=24,000 - 16,000

=8,000 units

Margin of safety (in sales revenue) =Actual Sales - B.E.P. Sales

=9,60,000 - 6,40,000

= Rs. 3,20,000

(ii) Profit on the sale of 20,000 shirts =Contribution on 20,000 shirts

-Fixed Cost

= 15 x 20,000-2,40,000

= Rs. 60,000

(iii) Revised Variable Cost per shirt = Previous variable cost per shirt + Commission

= 25 + 3 = Rs. 28

New contribution per shirt =40-28 = Rs. 12

Sales (in units) for a profit of Rs. 15,000 = New Fixed cost

New Contribution Per unit

= 1,40,000+ 15,000

12

= 21,250 shirts

(iv) New Selling Price (Rs. 40 + 15%) = Rs. 46

New Contribution (46 - 25) = Rs. 21

New Fixed Cost (2,40,000 + 33,000) = Rs. 2,73,000

New Break Even Point (in units) = New Fixed Cost

New Contribution per unit

= 2,73,000

21

= 13,000 shirts

New B.E.P. (in sales revenue) = 13,000 x 46 = Rs. 5,98,000.

6.3 Break-even Chart

Break-even chart is the graphic of break-even analysis. This chart takes its name from the fact

that the point at which the total cost line and the sales line intersect is the break-even point. It

is the presentation of the relationship between cost, volume and profit. It depicts the point of

production at which there is no profit and no loss i.e. break-even point. It not only shows the

break-even point but also shows profit and loss at various levels of activity. According to

CIMA (chartered institute of management accountant), “a chart which shows profit or loss at

various levels of activity, the level at which neither profit nor loss is shown being termed as

break-even point”.

103

6.4 Uses of break-even chart

A break-even chart is used to get the following information

• Break-even point- the point where there is no profit or loss.

• To know the profit or loss at different levels of output.

• The relationship between variable cost, fixed cost and total cost.

• To know the margin of safety.

• The angle of incidence, indicating the rate at which profit is being made.

• The amount of contribution at various levels of sales.

6.5 Assumptions Regarding Break-even Chart

Following are the assumptions on which break-even graph (chart) are drawn:

1. Costs can be categorized into fixed and variable costs.

2. Fixed costs will be fixed i.e. static during the relevant range of graph.

3. During the relevant range of graph variable cost per unit will remain constant.

4. Change in the volume of sales will not affect selling price per unit. In other words,

selling price per unit will be constant

5. Sales mix will be constant.

6. Production and sales volume are equal.

7 The relationship between costs and revenue will be linear i.e. all are indicated by

way of straight lines.

6.6 Steps in Preparing Break-even Chart

Following are the steps in preparing break-even chart:

1. There are two sides on a graph which are known as "axis". The horizontal side at the

bottom of the graph is X-axis which shows the volume of output (units, in rupees

value, in percentage etc.). The vertical side is the Y-axis which shows the cost and

sales in rupee value.

2. Preferably the graph should be in the square form. Both the areas are drawn on the

basis of appropriate scale.

3. Production quantity and cost and sales are inserted on X-axis and Y-axis respectively.

4. Fixed cost line is drawn parallel to the X-axis because fixed costs remain the same.

5. The total cost line is drawn above the fixed cost line. For this purpose, the variable

cost is added to the fixed cost.

6. Sales line is drawn beginning at zero and finishing at the last point.

7. The point at which the sales line cuts the total cost line is known as Break-even Point.

When a line is drawn from Break-even Point to X-axis, it indicates Break-even Point

(units) and when a line is drawn from Break-even Point to Y-axis, it indicates Break-

even Point (sales volume).

8. The difference between the sales line and the total cost line to the left of Break-even

Point indicates the loss while to the right of Break-even Point indicates the profit.

6.7 Angle of incidence

Angle of incidence is formed by the intersection of sales line and the total cost line at break-

even point. It shows the rate at which profits are being earned once break-even point has been

104

reached. The wider the angle, the greater is the rate of earning profits and a smaller angle of

incidence indicates that the profits are being made at a lower rate. It is formed to the right of

break-even point and graphical representation of profitability.

Illustration 9

Prepare the break-even chart from the following information:

Fixed Cost Rs. 2,000

Variable Cost per unit Rs. 0.50

Selling Price per unit Rs. 1

Solution

Break-even Chart Table

Output Fixed cost Variable cost Total Cost Sales Profit

(Units) (.Rs.) (Rs.) (Rs.) (Rs.) (Rs.)

Zero 2,000 Zero 2,000 Zero -2,000

2,000 2,000 1,000 3,000 2,000 -1,000

4,000 2,000 2,000 4,000 4,000 Zero

6,000 2,000 3,000 5,000 6,000 1 000

8,000 2,000 4,000 6,000 8,000 2,000

10,000 2,000 5,000 7,000 10,000 3,000

6.8 Types of Break-Even Charts

Following are the important of types of break-even charts:

1. Simple Break-Even Chart: it is a traditional break-even chart which shows direct

cost line, variable cost line and the sales line. This chart is used to determine profit or

loss from a certain level of sales. There are two ways of drawing a break-even chart:

➢ Fixed cost line, total cost line and sales line are drawn.

105

➢ Variable cost line, total cost line and sales line are drawn.

2. Contribution Break-Even Chart: It is an alternate type of break-even chart and

shows the amount of contribution at different levels of output. Under this chart, sales

line and variable cost line are drawn. The difference between sales line and variable

cost line shows the contribution at the different levels of activity. Total cost line is

drawn parallel to the variable cost line. Difference between the variable cost line and

total cost line shows the fixed cost.

3. Analysis Break-Even Chart: It shows the greater details by breaking down fixed

and variable into sub-divisions. Variable costs may be classified into direct material,

direct wages, variable factory overheads, selling and distribution overhead, etc. fixed

costs may be divided into fixed factor overhead and fixed administration, selling and

distribution overhead.

4. Control Break-Even Chart: Such a graph is prepared when budgeting control

system is followed by the enterprise. Budgeted direct costs, budgeted variable costs

and budgeted sales are also plotted on the graph in addition to actual sales. This graph

facilitates the comparison of budgeted and actual profits, break-even point and sales.

5. Profit Volume Chart: It is an improved form of simple break-even chart. The sales

line is drawn horizontally and profit loss line or drawn vertically. The profit line is

plotted on the basis of difference between sales revenue and total cost at each volume.

At break-even point, profit line intersects sales line.

6.9 Advantages of Break-Even Analysis and Chart

The main advantages of break-even analysis and break-even chart are given below

1. It shows the relationship between the cost, volume and profit.

2. Break-even chart is act as a management guide for decision-making as it shows

relationship between cost, volume and profit.

3. It shows the profit for different sales volumes and the sales volume to produce

desired profit.

4. It stresses the importance of optimum capacity utilization for achieving cost

reduction.

5. It is used for forecasting plans and profit.

6. It provides detailed and clear information about the elements of cost, sales and

profit.

7. It may be used for controlling costs and achieving better efficiency.

6.10 Specific Applications Break-Even Chart and Analysis

Following are the more specific applications

1. Operating profit at a given level of sales volume.

2. Sales volume required to produce desired profit.

3. Effect of changes in variable cost or fixed cost or both.

4. Effect of multiple changes i.e. changes in cost, price and volume simultaneously.

5. Effect on operating profits of a given percentage change in sales.

6. Additional sales volume required to compensate reduction in selling price.

106

6.11 Limitations of Break-Even Chart

Following are the Limitations

1. There is an assumption that variable costs will always vary proportionately but it is

not correct always.

2. There is an assumption that fixed costs will always remain constant but it does not

hold good in every business concern and at all levels of production.

3. The assumption that all cost can be clearly separated into fixed and variable

components is not possible to achieve accurately in practice, thereby resulting in

inaccurate break-even analysis.

4. It is assumed that production and sales are synchronized. This is not always so.

Sales may fall short of production or may be capable of increase to match production

only by effecting a reduction in selling prices.

5. Break-even chart does not consider the capital employed, market aspects, effects of

government policy etc. which are very important factors for measuring profitability.

6. Break-even chart represents a static picture of the operations. In real life, business

operations are not static.

6.12 Cost Break-Even Point

Cost break-even point is a point where the costs of operating two alternatives is equal. Cost

break-even point helps the management in identifying which alternative is better to operate at

or a given level of output. Cost break-even point may be calculated as under:

Cost Break-Even Point = Difference in Fixed Costs

Difference in Variable Cost per unit

6.13 Composite Break-Even Point

The composite break-even point shows the break even sales of the company for all its

products taken together. This concept is applicable only in case of a multi-product. The firm

would like to compute the break-even point of the company as a whole.

Formula

Composite Break-Even Point (sales) = Total Fixed Costs / Composite P/v Ratio

Composite P/V Ratio = Total Contribution / Total Sales xl00

6.14 Cash Break-Even Point

It is the level of sales required to recover the entire cash costs. At this level of sales, the total

sales revenue is equal to total cash costs so that there is neither any cash profit nor cash loss.

In other words, it is the level of output where a cash break even i.e. there is "no cash profit

and no cash loss". The fixed costs are divided into cash fixed cost and non-cash fixed cost.

Cash break-even point is used to know the liquidity position of the firm i.e. firm's ability to

meet cash obligations. The management ascertains the level of activity below which there are

chances of insolvency.

Algebraically

Cash Break-Even Point (in units) = Cash Fixed Cost / Contribution per unit

107

Cash Break-Even Point (sales volume) = Cash Fixed Cost / P/V Ratio

Graphically, the cash break-even point is determined at the point of meeting of total

cash cost line and total sales line. The area to the left of point signifies cash losses and

area on the right side indicates cash profits.

Illustration 10

Fixed expenses = 2,25,000

Sales = 7,50,000 and

Earned a profit = 1,50,000 (during the first half year)

loss = 1,25,000(during second half, it suffered a loss)

you are required to find out:

(i) The profit-volume ratio, break-even point and margin of safety for the first half year.

(ii) Expected sales-volume for the second half year assuming that selling price and fixed

expenses remained unchanged during the second half year.

(iii)The break-even point and margin of safety for the whole year.

Solution

(i) In the first half year

Contribution = Fixed Cost + Profit

= 2,25,000 + 1,50,000

=Rs. 3,75,000

P/V Ratio =Contribution / Sales

= 375000 / 750000x 100

= 50%

Break-even Point = Fixed Cost / P/V Ratio

= 2,25,000 / 50% = Rs. 4,50,000

Margin of Safety =Actual Sales - BEP Sales

=750000-450000

= Rs. 3,00,000

(ii) In the Second half year

Contribution = Fixed Cost - Loss

= 2,25,000- 1,25,000

= Rs. 1,00,000

Expected Sales volume =Fixed Cost – Loss

P/V Ratio

= 2,25,000-125000

50%

= Rs. 2,00,000

108

(iii) For the whole year

BEP =Fixed Cost /P/V Ratio

=2,50,000 x 2

50%

= Rs. 9,00,000

Margin of safety = Profit / P/V Ratio

=1,50,000-1,25,000

50%

=Rs. 50,000.

Illustration 11

A company has annual fixed costs of Rs. 14,00,000. In 2007-08 sales amounted to Rs.

60,00,000 as compared with Rs. 45,00,000 in 2006-07 and profit in 2007-08 was Rs.

4,20,000 higher than in 2006-07:

(i) At what level of sales does the company breakeven?

(ii) Determine profit or loss on a precast sales volume of Rs. 80,00,000.

(iii) If there is a reduction in selling price in 2007-08 by 10% and the company desires to

earn the same profit as in 2006-07 what would be the required sales volume?

Solution

Sales in 2007-08 Rs. 60,00,000

Sales in 2006-07 Rs. 45,00,000

Increase in Sales (60,00,000 - 45,00,000) Rs. 15,00,000

Increase in Profit Rs. 4,20,000

PA/ Ratio = Increase in Profit x100

Increase in Sales = 4,20,000 x100 =28%

15,00,000

Fixed Cost = Rs. 14,00,000

(i) Break-even Sales = Fixed Cost / P/V Ratio

= 14,00,000x100

28

= Rs. 50,00,000

Present Sales Volume = Rs. 80,00,000

(ii) Profit on Present Sales Volume = Contribution - Fixed Cost

= Sales x P/V Ratio - Fixed Cost

=80,00,000 x28 -14,00,000

100

= 22,40,000-14,00,000

= Rs. 8,40,000

109

Profit earned in 2007-08 = Sales x PV/ Ratio-Fixed Cost

=60,00,000 x 28-14,00,000

100

= 16,80,000- 14,00,000

= Rs. 2,80,000

In 2007-08 reduction in sales price = 10%

Therefore sales at reduced prices = 60,00,000-6,00,000

= Rs. 54,00,000

Contribution at reduced prices = Contribution at original prices -

Decline in sales)

= 16,80,000-6,00,000

= Rs. 10,80,000

New P/V Ratio = Contributionx100

Sales

= 10,80,000 x100

54,00,000

=20%

Sales to earn profit of 2,80,000 = Fixed Cost+ 2,80,000

P/V Ratio

=14,00,000 + 2,80,000x100 20

=16,80,000x100

20

= Rs. 84,00,000.


Margin of safety is the difference between total sales and the sales at breakeven,

point. Margin of safety indicates the soundness of the business. Break-even chart is the

graphic of break-even analysis. This chart takes its name from the fact that the point at which

the total cost line and the sales line intersect is the break-even point. It is the presentation of

the relationship between cost, volume and profit. Angle of incidence is formed by the

intersection of sales line and the total cost line at break-even point. It shows the rate at which

profits are being earned once break-even point has been reached. It is formed to the right of

break-even point and graphical representation of profitability. Break-even chart is act as a

management guide for decision-making as it shows relationship between cost, volume and

profit. Break-even chart does not consider the capital employed, market aspects, effects of

government policy etc. which are very important factors for measuring profitability. Cost

break-even point is a point where the costs of operating two alternatives are equal. Cost

break-even point helps the management in identifying which alternative is better to operate at

or a given level of output. The composite break-even point shows the break even sales of the

company for all its products taken together. This concept is applicable only in case of a multi-

product. It is the level of sales required to recover the entire cash costs. At this level of sales,

the total sales revenue is equal to total cash costs so that there is neither any cash profit nor

cash loss.

110

6.17 Exercise


True or False

1. Margin of safety can be improved by lowering fixed cost.

2. Break-even chart does not show profit or loss at various levels of sales.

3. In a break-even chart, angle of incidence is formed at the intersection of sales line and

variable cost line.

4. In a break-even chart, on X-axis production or sales may be represented.

5. Angle of incidence is an angle that is formed at the intersection of sales line and total

cost line in a break-even chart.

Answer

1. True 2. False 3. False 4. True 5. True

Exercise 2: Fill in the blanks

1. Break-even point is Rs 10,000, the fixed cost is Rs 3000, P/V ratio

is……………

2. Fixed cost Rs 4000, profit Rs1000, break-even sales Rs 20,000, the P/V ratio

is………..

3. Profit is 10% of sales, margin of safety is 40%, P/V ratio is………

4. When BE point is Rs 20,000 and margin of safety is 20%, actual sales are

Rs…………

5. When Contribution is Rs 15000, P/V ratio 40%,the sales is Rs………..

Answer

1. 30%, 2. 20%, 3. 25%, 4. 25000, 5. Rs 37,500


1. On break-even chart, X-axis represents,

a) sales in units/Rs

b) Output in units

c) any of these

2. Margin of safety refers to as:

a) Excess of actual sales over break-even sales

b) Excess of actual sales over fixed expenses

c) excess of actual sales over variable expenses

3. When sales increase from Rs 40,000 to 50,000 and profit increases by Rs. 5000,

the P/V ratio is

a) 50%

b) 10%

c) 20%

4. An increase in fixed cost results in

a) increase in break-even point

b) increase in contribution

111

c) increase in margin of safety.

5. when sales volume increases

a) Total cost increases

b) break-even point increases

c) Total loss increases

Answer

1. c, 2. a, 3. a, 4. a, 5. a

Exercise 4: Short Questions

Q1. What is meant by "Direct Costing" or "Marginal Costing"? Describe the salient

features in practice.

Q2. What are the similar and distinguishing features in Direct and Absorption Cost

Accounting?

Q3. What are the advantages and disadvantages of Direct/Marginal Costing? How does it

help a management in its policy decisions? Q4. What is a "Break-Even-Volume? Q5. What are the assumptions to be made in the calculation of a break-even point?

Q6. Illustrate what is meant by a "Break-Even Chart"? What does it indicate? Is there any

difference between "Break-Even Chart" and "Volume-Cost-Profit " Chart?

Q7. (a) What do you understand by the term "Margin of Safety" with reference to a

volume of production?

(b) How do the following reflect on a break-even volume and on a

profit-volume ratio ?Increase in total fixed costs,

(i) Increase in physical sales,

(ii) Decrease in variable cost per unit,

(iii) Discount on the selling price,

(iv) Unfavourable variation in material prices, and

(v) Adverse fluctuation in wages rates of Direct Labour.

Q8.Explain with illustrative examples the concept of Fixed Cost and Variable Cost.

Q9. Selling Price is Rs. 10 & VC is Rs. 6 Per unit while the FC is Rs. 20,000 find.

1) CPU

2) P V r a t i o

3) BEP

4) BES

5) BEP to earn Rs. 80,000 Profit

6) BES to earn a Profit of Rs. 80,000

Q 10. Sales (100000 units) = Rs. 1L

VC = Rs. 40K

FC = RS. 50K

Find (1) PV Ratio, BEP & MOS

(2)Find the impact of the following on Pv ratio, BEP & MOS

a) 20% increase in sales volume

b) 10% increase in FC

c) 5% Decrease in VC

d) 10% increase in selling Price.

112

LESSON 7

MARGINAL COSTING-II

7.0 Introduction

7.1 Objectives

7.2 Meaning of decision-making

7.2.1 pricing decision

7.2.2 Make or buy decision

7.2.3 Product mix decision

7.3 Key Factor


7.5 Exercise

7.1 Objectives


• Understand the concept of decision-making

• Explain the Uses of

-pricing decision

-Make or buy decision

-Product mix decision

• Understand the concept of Key Factor

7.2 Decision-Making

Decision making is one of the important aspects which decides the success or failure of any

enterprise. A business has to take the decisions in the different complex situations. Decision

making is the process of selecting the best alternative among the different choices available in

order to attain the desired objectives. According to CIMA, "its special value is in recognizing

cost behavior and, hence, in assisting in decision-making." Marginal costing is a decision-

making technique especially for short-run or tactical decisions.

Following are some of the specific areas where marginal costing is extensively used as a

decision-making technique:

(i) Pricing decision

(ii) Make or buy decision

(iii) Product mix decision.

7.2.1 Pricing Decision

Pricing of a product is the most crucial decision. Price affects sales volume which, in turn,

determines the revenue and profit of the company. There are a quite number of prices which a

113

company can fix. Pricing decision is influenced by a number of factors, some of them are

given as under:

(i) Cost

(ii) Competition

(iii) Objective of the company

(iv) Nature of the product

(v) Nature of the demand for the product

(vi) Government regulations.

Every company will like to maximize its profit. Hence, price of a product has to be more than

its total cost i.e. variable costs plus fixed costs. This is known as "cost plus pricing." Thus

Price = Variable costs + Fixed costs + Profit.

The underlying theory of marginal costing is that the revenue of a product should be more

than its variable cost so that it may contribute towards recovering fixed costs and providing

profits. Once the fixed costs are recovered at a particular level of production, the additional

units of production would contribute towards profit. The marginal cost sets the lower limit to

price fixation. The minimum selling price should not be below marginal cost. Under this

situation, the figure of loss will be equal to the amount of fixed cost. Fixed cost will have to

be incurred irrespective of production or no production.

A company would not like to follow the alternative of suspending the production of the

product. When a company decides to suspend the production of the product, the company

will suffer a loss equal to fixed cost because fixed cost cannot be avoided. Hence, the primary

interest of the company is fix the price equal to or more than the marginal cost.

Thus

Price > Marginal cost

or

Price = Marginal cost.

Sometimes, selling price falls below the marginal cost. In such a case, the company will

suffer a loss more than the amount of fixed cost. Under this situation, a company has an

alternative to stop production so as to reduce the amount of loss upto fixed cost. However,

under following special circumstances, a company may decide to continue production even if

the price is less than marginal cost:

I. When the product is of perishable nature and company wants to avoid total loss by

disposing the product.

II. When the company introduces a new product in the market (because a new

product can be sold at a very low price)

III. When there is a cut-throat competition in the market and company wants to drive

out its competitors.

IV. When the company wants to export the product.

V. When the employees cannot be retrenched.

VI. When the sale of this product at a price below the marginal cost will push up the

sale of other profitable products. (The loss of this product will be made up by

profits other products)

114

VII. When suspension of production and re-opening of production requires a heavy

expenditure.

Students should note that reduction in price leads to reduction in contribution per unit.

Illustration 1

ABC Ltd. manufactures a document reproducing machine which has a variable cost structure

as follows:

Material Rs. 20

Labour Rs. 5

Overhead Rs. 2

Selling price Rs. 45

Sales Rs. 6,75,000

(during the current year are expected to be)

and fixed cost Rs. 70,000.

Under a wage agreement, an increase of 5% is payable to all direct workers from the

beginning of the forthcoming year, whilst material costs are expected to increase by 4% ,

variable overhead costs by 2.5% and fixed overhead costs by 1.5%.

You are required to calculate the new selling price if the current Profit/ Volume Ratio is to be

maintained.

Solution

Computations of New Selling Price

Cost Element Variable cost Increase Variable Cost for

for current forth-coming

year year

Rs. Rs.

Material 20 4% 20.8

Labour 5 5% 5.25

Overhead 2 2.5% 2.05

Total variable cost 27 28.1

Selling price 45

Contribution (45 - 27) 18

Current year's P/V Ratio = Contribution per unit x 100

selling price per unit

= (Rs 18/ Rs 45)x100

= 40%

Thus, the current year's marginal cost is 60% of the selling price of Rs. 45. In order to

maintain the current Profit/Volume ratio of 40% in the forthcoming year, the new selling

price should be:

Rs. 28.10 x 100

60 = Rs. 46.833

115

Illustration 2

In a purely competitive market, 5,000 small motors can be manufactured and a certain profit

is generated. It is estimated that 1,000 small motors need be manufactured and sold in a

monopoly market to earn the same profit.

Profit under both the conditions is targeted at Rs. 1,00,000. The variable cost per

motors is Rs. 50 and the total fixed cost is Rs. 18500.

You are required to find out the unit selling prices both under monopoly and

competitive conditions

Solution

Under monopolistic conditions

Suppose X is the selling price per unit

Therefore Sales = 1,000 X

Variable cost = 1,000 x Rs. 50 or Rs. 50,000

Fixed Cost = Rs. 18500

Desired Profit = Rs. 1,00,000

Sales - Variable Cost = Fixed cost + Profit

1,000x - 50,000 = 18500 + 1,00,000

1,68,500

X = 1 000 = 168.50 per unit

Thus selling price = Rs. 168.50 per unit

Under competitive conditions

Suppose X is the selling price per unit

Sales =5,000 X

Variable cost (5,000 x Rs 50) =Rs. 250000

Fixed cost = Rs. 18500

Desired profit =Rs. 1,00,000

Sales - Variable Cost =Fixed cost + Profit

Thus 5000x- 250000 =18500 + 1,00,000

368500

X = 5000 = 73.70 per unit

Thus selling price = Rs. 73.70 per unit.

Illustration 3

A manufacturer makes an average profit of Rs. 2.50 per unit on a selling price of Rs. 14.30 by producing and selling 60,000 units at 60 per cent of potential capacity. His cost of sales per unit is as follows: Direct materials Rs. 3.50

Direct wages Rs. 1.25 Factory overhead Rs. 6.25 (50% fixed) Sales overhead Re. 0.80 (25% variable) During the current year, he intends to produce the same number but estimates that his

fixed costs would go up by 10 per cent while the rates of direct wages and direct materials will increase by 8% and 6% respectively. However, the selling price cannot be changed. Under this situation, he obtains an offer for a further 20% of his potential capacity. What

116

minimum price would you recommend for acceptance of the offer to ensure the manufacturer an overall profit of Rs. 1,67,300?

Solution

Statement of Marginal Cost and Profit

Direct materials

Direct wages

Variable overhead -

factory

sales

3.500

1.250

3.125

0.200

2,10,000

75,000

1,87,500

12,000

Per unit Rs.

60,000 units Rs.

Sales (A) 14.300 8,58,000

Marginal cost (B) 8.075 4,84,500

Contribution (C = A - B) 6.225 3,73,500

Fixed overhead -

factory

sales

3.125

0.600

1,87,500

36,000

Total fixed cost (D) 3.725 2,23,500

Profit (C - D) 2.500 1,50,000

Statement of Marginal Cost and Profit

(For current year)

Per unit Rs.

60,000 units Rs.

Sales (A) 14.300 8,58,000

Direct materials

Direct wages

Variable overhead -

Factory

Sales

3.710

1.350

3.125

0.200

2,22,600

81,000

1,87,500

12,000

Marginal cost (B) 8.385 5,03,100

Contribution (C = A - B)

Fixed cost (D) (Rs. 22,3,500 + 10%)

3,54,900

2,45,850

Profit (C - D) 1,09,050

117

Statement of Price (For 20,000 units)

Rs.

Marginal cost (Rs. 8.385 x 20,000 units) 1,67,700

Additional profit required (1,67,300 - 1,09,050) 58,250

Total sales value 2,25,950

Selling price per unit (2,25,950 / 20,000) = Rs. 11.30 (Approx.) 7.2.2 Make or Buy Decision

Marginal costing technique is used to decide whether to manufacture a component used

in the company's assembled product or purchase it from outside. For this, the company will compare the cost of purchase of the component with its own cost of manufacturing. It implies that fixed cost will be entirely ignored on the assumption that fixed cost will not increase with the manufacturing of the component. If the marginal cost of the component is less than the cost of purchase of the component, it is better to make it internally. If the marginal cost of the component is more than the purchase price, it is better to purchase it from the market. However, if the manufacturing of the component increases the fixed cost, the increase in fixed cost will be taken into account.

The above-mentioned treatment is based on the assumption that the company has idle

capacity that can be used to manufacture the component. Thus, there will be no opportunity cost. However, if there is no idle capacity and manufacturing of the component in the factory involves the loss of other work, opportunity cost should be added to marginal cost (variable cost) of production. Here the opportunity cost will be the contribution foregone from the displacement of work. The concept of opportunity cost will be relevant only when company is running at its full capacity.

Following are some non-cost considerations governing make or buy decision:

(i) The company should be assured of uninterrupted supply of the component so as not to suffer the production of main product.

(ii) The supplier should assure the company about the quality of the component. (iii)The component of be bought should be available at the same price at which we are

considering to buy it at present. (iv) If the production of the component is not carried out, labour problems should not

crop up. (v) When component is bought from the outside, secrecy cannot be maintained, and

manufacturing know-how is to be passed on to the supplier of the component. Secrecy can be maintained only when component is manufactured internally.

The company should have the facility of wider choice in case of buy-decision. Illustration 4 Suman Ltd. uses a component "Z651" in its manufacturing process that can be purchased from a supplier for Rs. 90 per unit. The same component is manufactured by Suman Ltd. at the following cost per unit:

118

Rs. Direct Material 30 Direct Labour. 25 Variable Overheads 28 Fixed Overheads (75% of Direct Material) 23 106 Suggest whether to make or buy this component. What would be your suggestion if the offer offers the component at Rs. 80. Solution Statement Showing Comparative Costs of Make or Buy

Particulars Make

cost per unit

Buy

cost per

Rs. Rs.

Direct Materia! 30

Direct Labour 25

Variable Overheads 28

Total Marginal Cost 83

(i) Case I 90

(ii) Case II 80

Case I : The cost of producing the component is Rs. 83. When it is compared with cost of

purchasing the component i.e. Rs. 90, it will be logical to suggest that Suman Ltd. should

continue to manufacture the component.

Case II: When cost of producing the component is compared with cost of purchasing the

component i.e. Rs. 80, it is suggested that Suman Ltd. should buy the component. There is a

saving of Rs. 3 per unit. Further, the capacity released can be profitably employed in some

other activity.

Illustration 5

A company uses three different components (materials) in manufacturing its primary product.

It manufactures two of the components and purchases one (designated as Component I) from

outside suppliers. The company is currently developing the annual profit plan. Sales are

highly seasonal. Component 2 cannot be acquired from outsiders; however Component 3 can

be purchased. The three components have critical specifications. The annual profit plan

provided data for the following computations:

Component 3 unit cost

{At 12,000 units)

Rs.

Material (direct) 1.40

Labour (direct) 2.20

Fixed overhead (apportioned) 0.40

Annual machine rental

(special machine used only for Component 3) 0.50

Variable factory overhead 1.00

Average storage cost per year (fixed) 0.40

Total 5.90

119

Average inventory level 500 units.

The Purchase Manager investigated outside suppliers and found one that would sign a one

year contract to deliver "12,000 top quality units as needed during the year at Rs. 5.20 per

unit". Serious consideration is being given to this alternative. Should the company make or

buy component 3? Explain the relevant factors influencing your decision.,

Solution

Rs.

Material (direct) 1.40

Labour (direct) 2.20

Annual machine rental (special machine used only

for Component 3) 0.50

Variable factory overhead 1.00

Variable cost of manufacturing 5.10

Purchase price 5.20

Since the variable cost of manufacturing the Component 3 is lesser than the purchase price, it

is advisable to make the component. However, there is a very negligible difference of Rs.

0.10 per unit. Suman company may think of purchasing the component from outside if the

manufacturing facilities released by the non-manufacture of the component are put to some

alternative use.

Illustration 6

A machine manufactures 5,000 units of a part at a total cost of Rs. 11 of which Rs. 8 is

variable. This part is readily available in the market at Rs. 9 per unit.

If the part is purchased from the market then the machine can either be utilised to

manufacture a component in same quantity contributing Rs. 1 per component or it can be

hired out at Rs. 11500. Recommend which of the alternatives is profitable?

Solution

Statement Showing Comparative Costs of Make or Buy

Particulars Make cost Buy cost per unit

per unit Rs.

Alternative 1 Rs.

Alternative II Rs.

Variable cost of Manufacturing

(5,000 x 8)

Purchase cost (5,000 x 9)

Less: Contribution from component

made by utilizing the machine (5,000 x 1)

Less: Income from hire of machine

40,000

45,000

-5,000

45,000

-11,5,00

40,000 40,000 33,500

Cost of manufacturing the part and buying cost is same. i.e. Rs 40,000 . if alternative II will

be opted then buying from outside will be considered. Further, existing machine should be

hired out.

120

Illustration 7

Sukanya Ltd. produces a variety of products each having a number of component parts.

Product B takes 5 hours to produce on a particular machine which is working at full capacity.

B has a selling price of Rs. 100 and variable cost of Rs. 60 per unit. A component part X-100

could be made on the same machine in two hours at a variable cost of Rs. 10 per unit. The

supplier's price for the component is Rs. 25 per unit. Advise whether the company should buy

the component X-100. (If necessary make suitable assumptions.) Solution Here, cost of buying the component from outside should be compared with relevant cost of manufacturing which will include opportunity cost i.e. loss of contribution due to non-manufacturing of product B.

Selling price of product B Rs. 100

Less: Variable cost of Product B Rs. 60

Contribution Rs. 40

Contribution per hour (40/5) Rs. 8

Statement Showing Comparative Costs of Make or Buy

Since cost of manufacturing is more than cost of buying, it is advisable to buy the component

part.

Illustration 8

A company wants to manufacture automobile accessories and parts. The following are the

total costs of processing 50,000 units:

Direct material cost Rs.2.5 lakhs

Direct labour cost 4 lakhs

Variable factory overhead 3 lakhs

Fixed factory overhead 2.5 lakhs

The purchase price of the component is Rs. 11. The fixed overhead would continue to be

incurred even when the component is bought from outside, although there would have been

reduction to the extent of Rs. 1,00,000.

Required:

(i) Should the part be made or bought considering that the present facility when

released following a buying decision would remain idle?

(ii) In case the released capacity can be rented out to another manufacturer for

Rs. 75,000 having good demand, what should be the decision?

Particulars Make

cost

Buy cost

per unit per unit

Rs. Rs.

Variable cost of making 10

Opportunity cost (2 Hours, x Rs. 8) 16

Cost of purchase 25

26 25

121

Solution

Statement Showing Costs of Make of Buy

Particulars Make cost Buy cost

per unit per unit

(Rs. in (Rs. in

lakhs) lakhs)

Materials 2.5

Labour 4


Total variable cost 9.5

Case 1

Cost of Purchase 11

Less: Reduction in fixed overhead

(1,00,000/50,000)

-2

Effective Cost of Purchase 9

Case II

Cost of Purchase (Calculated as above) 9

Less: Income from renting the

released(75000/50000)

- 1.5

Capacity 7.5

Case I - Component should be purchased from outside

Case II - Component should be purchased from outside.

7.2.3 Determination of Product Mix

Product mix refers to the proportion in which the different products are produced. This

decision relates to a situation where the firm has the limited resources but the different

products may be produced using the same resources and the facilities. The firm has to select

the most profitable product mix with the use of given limited resources. A profitable product

mix should consist of the products which gives the highest contribution. It means that product

mix should not have the product which is less profitable than others. The products, which

give the maximum contribution, are to be included in the product mix. Thus, the most

profitable product mix is one which yields the largest overall contribution. The profitability

of various product mixes may be evaluated by comparing the P/V ratio and break-even point.

A change in product mix will be favorable if it increases the P/V ratio or reduces the break-

even point. Thus, decision regarding product mix is taken on the basis of P/V Ratio or

contribution.

The selection of profitable product mix is also influenced by key factor or factors.

7.3 Key Factor

In any business, one or the other factor limits the size of activity. It may be the availability of

funds, availability of materials, availability of skilled labour or the sales that can be made in

the market. This factor is known as the key factor or the limiting factor. Following are some

examples of key factors:

(i) Demand in the market

(ii) Restrictions imposed by the government on the use of raw materials

122

(iii) Shortage of power-supply

(iv) Shortage of skilled labour

(v) Shortage of workers

(vi) Shortage of capital and/or space

(vii) Scarcity raw material

Note:- There may be more than one key factor influencing the product-mix of the firm. When

there is a key factor, the profitability of products is measured by the following formula:

Profitability = Contribution per unit / Key factor per unit Key factor is the most important

factor for deciding about the most profitable product-mix. The most profitable product will

be the product which yields the highest contribution per unit in terms of key factor. Illustration 9 Mohan Ltd. submits the following information in respect of its two products:

xyz abc

per unit per unit

Rs. Rs.

Direct Material 100 150

Direct Wages 100 75

Variable Overheads 75 125

Selling Price 375 625

Fixed Overheads Rs. 7,50,00 per annum.

You are required to recommend the management the profitable sales mix from the following

alternatives:

(a) 300 units of xyz only (c) 50 units of xyz and 150 units of abc

(b) 400 units of abc only (d) 150 units of xyz and 100 units of abc

Solution

Statement Showing Profitability of Different Product Mixes

Particulars xyz abc Total

Rs. Rs. Rs.

Direct Material 100 150

Direct Wages 100 75

Variable overheads 75 125

Marginal cost 275 350

Selling Price 375 625

Contribution 100 275

Product Mix (a)

Total contribution 100 x 300

= 30,000 Nil 30,000

Product Mix (b) 400 x 275

Total contribution Nil = 1,10,000 1,10,000

Product Mix (c)

Total contribution 50 x 100 150 x 275

= 5,000 = 41250 46250

Product Mix (d)

Total contribution 150 x 100 100 x 275

= 15,000 = 27500 42500

123

Product mix (b) gives the maximum contribution. So product mix (b) would be suggested. Illustration 10 The budget results of Suresh Ltd. includes the following:

Product Sales Variable cost

(Rs. in lakhs) as % of sales

A 25 30%

B 20 25%

C 40 33%

D 15 40%

E 22 38% Fixed overhead for the period are Rs. 90 lakhs.

Management of Suresh Ltd. wants to change the product mix by dropping only one product and increasing the sale of only one product. Suggest the change in product mix.

Solution:

Particulars A B C D E

Sales (in

lakhs)

25 20 40 15 22

Variable cost

as % of

Sales

30% 25% 33% 40% 38%

PA/ Ratio 100-30 100-25 100-33 100-40 100-38

=70% = 75% = 67% = 60% =62%

P/V ratio of product D is the minimum. Hence, product D should be dropped. P/V ratio of

product B is the maximum. Hence, the sales of product B should be increased. New product

mix will consist products A, B, C and E.

Illustration 11

Anamika Tools Factory has a plant capacity adequate to provide 15,800 hours of machine

use. The plant can produce all "A" type tools or all "B" type tools or a mixture of the two

types. The following information is relevant:

"A" Type "B" Type

Selling Price per unit Rs. 10 Rs. 15

Variable Cost per unit Rs. 8 Rs. 12

Hours required to produce per unit 3 4

Market conditions are such that not more than 4,000 A type tools and 3,000 B Type tools can

be sold in a year. Annual fixed costs are Rs. 9,900.

Compute the product-mix that will maximise the net income to the company and find that

maximum net income.

124

Solution:

Statement Showing Comparative Profitability

Particulars Type A Type B

Selling Price per unit Rs. 10 Rs. 15

Variable Cost per unit Rs. 8 Rs. 12

Contribution per unit Rs. 2 Rs. 3

PA/ Ratio = Contribution per unit x 100 (2/10)x 100 (3/15)x100

Selling Price per unit = 20% = 20%

Contribution per machine hour 2/3=.67 =3/4=.75

Rankings II I

Since "B" type tools give higher contribution per machine hour (key factor), they should be

produced to the maximum extent. Remaining machine hours should be utilised for production

of "A" type tools.

Statement of Production

Total machine hours available 19,800

Less: Machine hours for producing 3,000 B type tools (300 x 4) 12,000

Remaining machine hours available to produce A type tools 7,800

Number of A type tools to be produced 7,800

3

= 2,600

Most profitable product mix = A type tools 2,600 + B type tools 3,000

Statement of Maximum Net Income

A Type B Type Total

Number of tools to be produced 2,600 3,000

Contribution per unit Rs. 2 Rs. 3

Contribution (Total) Rs. 5,200 Rs. 9,000 Rs. 14,200

Less: Fixed cost Rs. 9,900

Net Income Rs. 4,300

Illustration 12

ABC LTD company can produce three different materials using same production facilities.

The requisite labour is available in plenty at Rs. 8 per hour for all products. The supply of

raw material, which is imported at Rs. 8 per kg., is limited to 10,400 kg. for the budget

period. The variable overheads are Rs. 5.60 per hour. The fixed overheads are Rs. 50,000.

The selling commission is 10% on sales. From the following information, you are required to

suggest the most suitable sales mix which will maximise the company's profit.

Also, determine the profit that will be earned at that level.

Product Market Selling Labour Raw material

demand per unit per unit required per

units. Rs. unit

X 8,000 30 1 0.7

Y 6,000 40 2 0.4

Z 5,000 50 1.5 1.5

125

Solution

(a) Statement of Marginal Cost and Contribution : Statement of marginal cost and

contribution is shown on the next page

Statement of Marginal Cost and Contribution

Particulars Per unit of Products

X Y Z

Rs. Rs. Rs.

Direct materials @ Rs. 8 per kg. 5.60 3.20 12.00

Direct wages @ Rs. 8 per hr. 8.00 16.00 12.00

Variable overhead @ Rs. 5.60 per hr. 5.60 11.20 8.40

Sales commission @ 10% on S.P. 3.00 4.00 5.00

(A) Marginal Cost 22.20 34.40 37.40

(B) Selling Price 30.00 40.00 50.00

(C) Contribution (B-A) 7.80 5.60 12.60

(D) Raw material per unit (kg.) 0.70 0.40 1.50

(E) Contribution per kg. of raw

material (C + D) Rs. 11.14 14.00 8.40

Ranking II I III

Statement of Sales Mix

Raw materials available (Kgs) 10,400

Less: Raw materials required for product x Y (0.4 x 6,000) 2,400

8,000

Less: Raw materials required for product (0.7 x 8,000) 5,600

Raw materials available for product Z 2,400

Units of product Z to be produced = 2400/1.5 = 1,600 units.

Profitable Sales Mix = X = 8,000,Y = 6,000, Z = 1,600 units

Statement of Profit

X Y Z Total

Rs.

No. of units 8,000 6,000 1,600

Contribution per unit 7.80 5.60 12.60

Total contribution 62,384 33,600 20,160 1,16,144

Less: Fixed cost 50,000

Profit 66,144


A business has to take the decisions in the different complex situations. Decision

making is the process of selecting the best alternative among the different choices available in

order to attain the desired objectives. Pricing of a product is the most crucial decision. Price

affects sales volume which, in turn, determines the revenue and profit of the company. Every

company will like to maximize its profit. Hence, price of a product has to be more than its

126

total cost i.e. variable costs plus fixed costs. This is known as "cost plus pricing." Thus Price

= Variable costs + Fixed costs + Profit.

Marginal costing technique is used to decide whether to manufacture a component used in the

company's assembled product or purchase it from outside. For this, the company will

compare the cost of purchase of the component with its own cost of manufacturing. It implies

that fixed cost will be entirely ignored on the assumption that fixed cost will not increase

with the manufacturing of the component. Product mix refers to the proportion in which the

different products are produced. This decision relates to a situation where the firm has the

limited resources but the different products may be produced using the same resources and

the facilities. The firm has to select the most profitable product mix with the use of given

limited resources. A profitable product mix should consist of the products which gives the

highest contribution. In any business, one or the other factor limits the size of activity. It may

be the availability of funds, availability of materials, availability of skilled labour or the sales

that can be made in the market. This factor is known as the key factor or the limiting factor.

Key factor is the most important factor for deciding about the most profitable product-mix.

The most profitable product will be the product which yields the highest contribution per unit

in terms of key factor.

7.5 Exercise


True or False

1. Management may sell at a price which is even below marginal cost in certain special

circumstances.

2. Export orders should not normally be accepted at a price below total cost.

3. In make or buy decision, it is profitable to buy outside firm when supplier’s price is

below firm’s own total cost.

4. A mix that provides the highest amount of contribution is considered as the most

profitable mix.

5. Cost per unit of key factor is the basis of ranking products on profitability.

Answers

1. True, 2. False, 3. False, 4. True, 5. False

Exercise 2: Fill in the blanks

1. When a ………is operating, selection of the most profitable sales mix is based on

contribution per unit of key factor.

2. When selling price falls below …………, the loss will be more than the amount of

fixed cost.

3. When a company is not able to fully utilize plant capacity by selling at total cost

plus profit basis, in such a case, it may …………

4. Additional orders may be accepted from a foreign market at below normal or below

total cost but above …………..

5. Any change in sales mix also results in the change in …………..

127

Answer

1. Key factor, 2. Variable cost, 3. Explore new markets, 4. Marginal cost,

5. Profit position


Q1. Factor, which are largely considered in making or buying decisions is

a) quality of suppliers

b) dependability of suppliers

c) both a and b

Q2. One of the following is not a relevant cost in replacement decision regarding a

machine which can increase production capacity if replaced.

a) Direct Material

b) Variable Manufacturing Overheads

c) Rent of Office Building

Q3. A cost which has no role or doesn’t affect manager’s decision is called

a) Opportunity cost

b) Sunk cost

c) Irrelevant cost

Q4 Which of the following is not limiting factor examples which may include limit

production or sales volume?

a) Shortage of material

b) Shortage of labour

c) Sufficient market demand

Q5 Pricing decision is influenced by a number of factors, some of them are given as

under:

(a) Objective of the company

(b) Competition

(c) a and b

Answer

1. C, 2. C, 3. C, 4. C, 5. C

Long Questions

Q1 What do you mean by make or buy decisions? State the quantitative as well as

qualitative considerations influencing a ‘make’ or ‘buy’ decision.

Q 2 “The technique of marginal costing can be valuable aid to management”. Discuss.

Q3. Explain briefly the circumstances under which selling below marginal cost may be

Justified.

Q4. Do you think a producer can sell his output even below variable cost? If so, mention

these circumstances.

Q5. Indicate any five circumstances under which you will allow to fix a price which is less

than the marginal cost.

128

Short Questions

Q1. Write short notes on “Key-factor”.

……………..……………………………………………………………………………………

………………………………………………………………………………………………..…

………………………………………………………………………………………………..…

Q2. State the factors that the managers must consider in selecting the product mix.

……………..……………………………………………………………………………………

………………………………………………………………………………………………..…

………………………………………………………………………………………………..…

Q3. Identify the major factors that should be considered for determining the selling price of a

Product.

……………..……………………………………………………………………………………

………………………………………………………………………………………………..…

………………………………………………………………………………………………..…

Q4. what factors have to be taken into account in a make or buy decision?

……………..……………………………………………………………………………………

………………………………………………………………………………………………..…

………………………………………………………………………………………………..…

Q5.“Marginal costing is extensively used as a decision-making technique”. Explain

……………..……………………………………………………………………………………

………………………………………………………………………………………………..…

………………………………………………………………………………………………..…

RECONCILIATION OF COST AND FINANCIAL … or over-absorption of ... reconciliation statement, ......

Documents

Transcript of RECONCILIATION OF COST AND FINANCIAL … or over-absorption of ... reconciliation statement, ......