Author: indiafreenotes

The Cash Budget is a budget prepared to estimate the cash inflows and outflows during a specific period of time. In other words, cash budget shows the cash inflows and cash outflows expected to occur in the immediate future period.

The purpose of preparing the cash budget is to determine that whether the enterprise has sufficient cash balance to meet out its short-term cash requirements or whether too much cash is being left idle and unproductive in the organization. Thus, it helps the management to determine the surplus and shortage of funds so that suitable actions can be undertaken.

One of the major advantages of cash budget is that it provides a clear picture of all the expected cash flows, thereby enabling the firms to plan their expenditures accordingly. Also, the companies can raise adequate funds in case of the shortage of the cash balance and can make an optimum utilization of funds in case of cash surplus, for example investing in marketable securities.

But however, these cash budgets are not free from the limitations. These are less reliable as the future is uncertain and the cash forecast may not be correct. For example, unseen demands of cash, delayed cash collection, unanticipated cash disbursements, etc. Also, the cash budget is inefficient to track a significant movement in the working capital items.

The cash budget consists of three parts:

(1) The forecast of cash inflows,

(2) The forecast of cash outflows, and

(3) The forecast of cash balance.

Principal Objectives of Cash Budget:

Cash budget in a firm is prepared to accomplish the following objectives:

(1) To project firm’s cash position in future period.

(2) To predict cash surplus or deficit for the ensuing months.

(3) To permit planning for financing in advance of need. By indicating when cash will be required, the budget helps the management to arrange in advance bank loans or other short-term credits, to prepare for a sale of securities or to make other preparations for new financing.

(4) To help in selection of proper source of financing cash requirements of the firm.

(5) To permit proper utilisation of idle cash.

(6) To maintain adequate balance between cash and working capital, sales, investments and loans.

(7) To exercise control over cash expenditure by limiting the spending of various departments.

Utility of Cash Budget:

Cash budget is an extremely important tool available in the hands of a finance manager for planning fund requirements and for controlling cash position in the firm. As a planning device, cash budget helps the finance manager to know in advance the cash position of the firm in different time periods.

The cash budget indicates in which months there will be cash surfeit and in which months the firm will experience cash drain and by how much.

With the help of this information finance manager can draw up a programme for financing cash requirements. It indicates the most opportune time to undertake the financing process. There will be two advantages if the finance manager knows in advance as to when additional funds will be required. First, funds will be available in hand when needed and there will be no idle funds.

In the absence of the cash budget it may be difficult to determine cash requirements in different months. If cash required is not available in time it will entail the firm in a precarious position. The firm’s output is reduced because of imbalance in financial structure and the rate of return consequently declines.

If the firm is marginal, the decline in profits could lead to disaster. Further, it would be difficult for the firm to meet its commitments and would consequently lose its credit standing. A firm with a poor credit standing stands little chance of success.

With the help of cash budget finance manager can determine precisely the months in which there will be cash surplus. Nevertheless, a reasonable amount of cash adds to a firm’s debt paying power of the firm, holding excess cash for any period of time is largely a waste of resource yielding no return. This will result in the decline in profits.

The cash budget offsets the possibility of decline in profits because the finance manager in that case will invest idle cash in marketable securities. Thus, with the help of the cash budget, finance manager can maintain high liquidity without jeopardizing the firm’s profitability.

The cash budget, besides indicating cash requirements, reflects the length of time for which funds will be needed. This will help the finance manager to decide the most likely source from which the funds can be obtained. A firm which stands in need of funds for a short-term duration will use a source different from the one requiring funds for a long time.

Features of Cash Budget

1. The cash-budget period is broken down into periods, mainly in months.
2. The cash-budget is always in columnar form i.e. column showing each month.
3. Payments and receipts of cash are identified in different heading and showing total for each month.
4. The surplus of total cash payment over receipts or of receipts over payment for each month is shown.
5. The running balances of cash, which would be determined by taken the balance at the end of the previous month and adjusting it for either deficit or surplus of receipts over payments for current month, is identified.

Importance of Cash Budget

Cash budget is an important tool in the hands of financial management for the planning and control of the working capital to ensure the solvency of the firm.  The importance of cash budget may be summarised as follow:

2. Helpful in Planning: Cash budget helps planning for the most efficient use of cash. It points out cash surplus or deficiency at selected point of time and enables the management to arrange for the deficiency before time or to plan for investing the surplus money as profitable as possible without any threat to the liquidity. 
3. Forecasting the Future needs: Cash budget forecasts the future needs of funds, its time and the amount well in advance. It, thus, helps planning for raising the funds through the most profitable sources at reasonable terms and costs. 
4. Maintenance of Ample cash Balance: Cash is the basis of liquidity of the enterprise. Cash budget helps in maintaining the liquidity. It suggests adequate cash balance for expected requirements and a fair margin for the contingencies. 
5. Controlling Cash Expenditure: Cash budget acts as a controlling device. The expenses of various departments in the firm can best be controlled so as not to exceed the budgeted limit. 
6. Evaluation of Performance: Cash budget acts as a standard for evaluating the financial performance. 
7. Testing the Influence of proposed Expansion Programme: Cash budget forecasts the inflows from a proposed expansion or investment programme and testify its impact on cash position.
8. Sound Dividend Policy: Cash budget plans for cash dividend to shareholders, consistent with the liquid position of the firm. It helps in following a sound consistent dividend policy. 
9. Basis of Long-term Planning and Co-ordination: Cash budget helps in co-coordinating the various finance functions, such as sales, credit, investment, working capital etc. it is an important basis of long term financial planning and helpful in the study of long term financing with respect to probable amount, timing, forms of security and methods of repayment.

A production budget is a financial plan that lists the number of units to be manufactured during a period. In other words, this is a report that estimates the number of units that a plant will produce from period to period.

The production budget calculates the number of units of products that must be manufactured, and is derived from a combination of the sales forecast and the planned amount of finished goods inventory to have on hand (usually as safety stock to cover for unexpected increases in demand). The production budget is typically prepared for a “push” manufacturing system, as is used in a material requirements planning environment.

Managers use the production budget to estimate how many units they will need to produce in future periods based on the future estimated sales numbers. They also use this report as a planning tool for future production processes, machine times, and scheduling. Production managers have to estimate the future demands and plan out the workflow to make sure everything is produced timely and there aren’t long periods of wait time or down time.

This is the main reason why the production budget does not show the costs of production nor the sales revenue from the estimated sales during the period. Instead, it always shows the total estimated sales in units and the budgeted number of units produced. Remember, this is a report used to determine the number of units that need to be produced during the period. The sales budget and manufacturing budget are used to estimate the total revenues and expenses for the period.

The preparation of production budget involves the following stages:

(i) Production planning

(ii) Consideration of plant capacity

(iii) Stock quantity to be held

(iv) Sales budget figures.

A production budget depends on 3 factors:

(1) Sales Forecast in unit as indicated in the sales budget.

(2) Finished Goods Inventory level that management wants at the end of the period.

(3) Anticipated inventory at the start of the budget period.

The production budget also depends on a company’s inventory policy. Inventories may be build-up or liquidated depending upon the outlook adopted by management. Also, the cost of carrying larger inventories should be compared with the cost of being out-of-stock when the firm cannot deliver.

The production budget will project the number of units to be produced in a period using the formula:

Production Budget = Budgeted Sales Units – Opening Stock of Finished Goods + Closing Stock of Finished Goods

This can be justified because:

• The opening stock of finished goods has already been produced, and can
• Therefore be deducted from our calculation of what needs to be made, and
• The closing stock has yet to be made so needs to be added into our total of goods to be produced.

Summary:

• if stocks of finished goods are to increase, then production must be greater than sales
• if finished goods stocks are to remain constant, production will be the same as sales
• if finished goods stocks are to fall, production will be less than sales

Cost of Production Budget:

The production budget determines the number of units to be produced. When these units are converted into monetary terms, it becomes a cost of production budget. The cost of production budget is the total amount to be spent on producing the units stipulated in the production budget. The physical units are broken into elements, i.e., material, quantity, labour, time and manufacturing overheads. The material cost, labour cost and overheads required for manufacturing are totalled together to make it a cost of production budget.

A sales budget estimates the sales in units as well as the estimated earnings from these sales. Budgeting is important for any business. Without a budget companies can’t track process or improve performance. The first step in creating a master company while budget is to create a sales budget.

Like every department, even the Sales department has a budget and adhering to that budget is very important since the Sales Budget is a basic component of the master budget. Sales Budget shows the expenses that have to be made to achieve sales in a defined period of time.

Sales Budget is also associated with determining average estimated earnings after the pre-determined period. A company, at the start of the year, carefully analyzes economic conditions, competition, production capacity, and expenses when determining the sales budget. All of these factors play a crucial role in the company’s future performance. Sales Budget is what the company expects to sell and generate business from.

Cambridge dictionary defines Sales Budget as: “a plan of the money that a company must spend in order to produce and sell goods or provide services in a particular period.”

While determining Sales Budget, one must be aware of the term Sales Forecasting, which means predicting the amount of sales that may happen in a defined period. This is much more than “gut-feeling” and it is determined on the basis of Previous Sales Achieved, Market conditions, industry growth rate, customer analysis, and such factors. Giving a proper forecast for Sales is important since Sales Budget depends on proper forecasting

A sales budget is an estimate of expected total sales revenue and selling expenses of the firm. It is known as a nerve centre or backbone of the enterprise. It is the starting point on which other budgets are also based. It is a forecasting of sales for the period both in quantity and value. It shows what product will be sold, in what quantities, and at what prices.

The forecast not only relates to the total volume of sales but also its break-up product wise and area wise. The responsibility for preparing sales budget lies with the sales manager who takes into account several factors for making the sales budget.

Some of these factors are:

(i) Past sales figures and trend

(ii) Estimates and reports by salesmen

(iii) General economic conditions

(iv) Orders in hand

(v) Seasonal fluctuations

(vi) Competition

(vii) Government’s control

Importance of Sales Budget:

1) Business Budgeting:

The budgeting of different departments might be dependent on the Sales Budget. This is especially true in a production company where the production expenses are proportional to the amount of sales you hope to achieve. Without expected Sales Budget, the company doesn’t know how much to spend on Marketing, how much to spend on production and in any other department. While these are variable expenses, the fixed expenses like rent and utilities also have to be covered from sales budget.

2) Growth Goals:

Another aspect of Sales Budget is that it sets targets for the Sales team and achieving those targets will help the company to grow economically and expand. The Sales team is motivated by giving incentives on hitting numbers and crossing them. The company can expect an overall growth in every department once Sales numbers are achieved.

3) Performance:

Sales Budget is prescribed to the Sales team at the beginning of the year and the targets are distributed accordingly. At the end of the year, this budget can be used to know the performance of the sales team and, in turn, the performance of the organization. This depends on the forecasting done and also on the market conditions and competitor activities. But Sales Budget helps analyze the performance of every sales team member quantitatively.

Process of Sales Budget

Most organizations use a bottom-up planning method to determine Sales Budget. All the budgets from every Salesperson are collated and sent to the manager, every manager’s budget is sent to Regional in charge and so on and so forth till a single collective statement is generated. The top management then makes necessary changes and adjustments and syncs it with organizations vision and percolates the budget top-bottom.

The total Sales Forecast with unit price will give gross sales. Sales discounts and allowances, if any, are deducted and the final figure will the Net Sales realized.

To chalk out a few common steps carried out in Sales Budget would be:

1. Research and Analysis: Check the status of the market for scenarios
2. Sales Forecast: The Sales team then prepares a forecast based on past achievement and market conditions put together. Generally, a growth is expected.
3. Collecting Forecasts: All the forecasts are collected together and sent to higher management as a single file.
4. Modification and review: The top management then decides on the Sales Budget obtained, takes reviews and suggestions and decides a final figure.

Although these are the common steps in every sales budget, every company may modify according to their needs.

Methods of Sales Budgeting

There are a variety of methods which can be used to prepare a sales budget.

The following are some of the popular methods to prepare a sales budget:

Affordable Budgeting

This is a method generally used by organizations dealing in industrial goods. Also, firms, which do not give importance to budgeting or firms which are having small size of operation, make use of this judgmental method.

Rule of Thumb

Such as a given percentage of sales. Companies involved in mass selling of goods and companies dominated by the finance function are the major users of this method.

Competitive Method

A few companies, the products of which face tough competition and many challenges in selling and which need effective marketing strategy to maintain profits, make use of this method. Using this method needs knowledge of how our competitor is working with regards to resource allocation.

Companies make use of a combination of the above methods. Depending upon the past experiences, budgeting approaches are refined time to time. The status of the sales & marketing helps the organization to figure out the extent of sophistication needed in approaching sales budgeting.

Advantages

Planning: Sales Budget helps in the proper planning of the organizational budget.

Resource allocation: Sales Budget helps in the allocation of resources for all other departments based on Sales forecast, sales plan and other factors.

Expense Check: Sales Budget is also helpful to keep a check on the expenses of the company.

Yardstick: Sales Budget serves as a yardstick for evaluation of Forecast vs achievement or Target vs Achievement and overall economy of the company.

Weak areas: Sales Budget also helps identify weak links and areas in the organization which are a hindrance in achieving the sales budget. Necessary actions can be taken to correct those weak links and strengthen the front line.

Guide: Sales Budget acts as a guide and constant reminder throughout the year for the organization about the agreed budgets and helps everyone to be on track.

Disadvantages

Sales budget cannot always be 100% accurate since no one can predict future events or sudden market trends for the company.

A sales budget decided by authority or management may not go well for various reasons. The unrealistic sales budget is a common complaint by the front line executives.

Preparing, editing, modifying, re-working, and getting the approval of sales budget can take up too much of managerial time, in which time actual sales can be realized.

Unforeseen expenses are not considered in Sales Budget which may arise out of any calamity or unpredicted market conditions.

Following preliminaries should be gone through before a standard costing system is established:

1. Establishment of cost centres
2. Types of standard
3. Setting the standards

Establishment of Cost Centres:

As defined earlier in this book, a cost centre is a location, person or item of equipment for which costs may be ascertained and used for the purpose of cost control. Establishment of cost centres is necessary for fixing responsibilities for unfavourable variances.

Types of Standard:

There are three types of standards:

(a) Current Standard:

A standard which is related to current conditions and is established for use over a short period of time. This standard may be fixed on the basis of ideal standard or expected standard.

Ideal Standard:

This is the standard which can be attained under the most favourable conditions possibly. In other words, this standard is based upon a very high degree of efficiency which is rather impossible to achieve.

In this standard, it is assumed that there will be the most desirable conditions of performance and that there will be no wastage of materials or time and no inefficiencies in the manufacturing processes. This standard is not likely to be achieved because ideal conditions of performance will not prevail. It is, therefore, a theoretical standard.

The utility of this standard is that it sets a target which, though not attainable in practice, is always aimed at. The criticism of the standard is that when actual costs are compared with such standard costs, large unfavourable variances are shown and these variances become a permanent feature of the concern.

The ideal standard will breed frustration among employees because such standard is never to be attained. Nobody will pay serious attention to such standard and setting up of this standard will become a farce.

Expected or Attainable Standard, This is the standard which is anticipated during a future specified budget period. In fixing this type of standard present conditions and circumstances prevailing within a particular industry are taken into consideration. Besides, due weight-age is given to the expected changes in the present circumstances and conditions.

In setting up this standard, a reasonable allowance is also made for unavoidable (normal) wastages. This standard is, therefore, considered to be more realistic than the ideal standard because this standard is based on realities rather than on the most ideal conditions. Hence, this type of standard is best suited from control point of view because this standard reveals real variances from the attainable performance.

(b) Basic Standard:

It is a standard which is established for use unaltered over a long period of time. This standard is fixed for long periods so as to help forward planning. Basic standard is established for some base year and is not changed for a long period of time as material prices, labour rates and other expenses change.

Deviations of actual costs from basic standards will not serve any practical purpose because basic standards remain unaltered over a long period of time and are not adjusted to current market conditions. Thus, this type of standard is not suitable from cost control point of view. However, variances calculated on the basis of basic standards will help in studying the trends in manufacturing costs over a long period of time.

Comparison of Current Standard and Basic Standard:

Current standards relate to current conditions and operate only for a short period before they are revised when conditions change. On the other hand, basic standards are set for a long period and there is no need for constant revision for such standards. Deviation of actual costs from basic standard costs will not serve any practical purpose because standards are not adjusted to current market conditions.

However, such standards will be helpful in studying the trends of variances over a long period of time which is not possible in case of current standards which go on changing. Current standards will take care of inflationary tendencies because they are adjusted to current market conditions. On the other hand, basic standards are static and do not take care of inflationary tendencies.

(c) Normal Standard:

This standard is defined as “the average standard which it is anticipated can be attained over a future period of time, preferably long enough to cover one trade cycle”. Such standards are established on the basis of average estimated performance over a future period of time (say 5 years) covering one trade cycle.

It is difficult to follow normal standards in practice as it is not possible to forecast performances with a reasonable degree of accuracy for a long period of time. Such standards are attainable under anticipated normal conditions and are not attainable if anticipated conditions do not prevail over a future period of time. That is why normal standards may not be a useful device for the purpose of cost control.

Setting the Standards or Establishment of Standard Cost:

Just like a Budget Committee, there should be a Standard Committee which should be entrusted with the work of setting standard costs. This Committee will include General Manager, Purchase Officer, Production Engineer, Production Manager, Sales Manager, Cost Accountant, and other functional heads, if any.

Of all the persons, the cost accountant plays a very important role in setting the standards because he is to supply the necessary costs figures and coordinate the activities of the committee so that standards set are as accurate as possible.

It may be noted that standards set should neither be too high nor too low. Nobody will take interest in the standards if these are too high because such standards are not capable of being achieved and employees will always have an opportunity to excuse the failure to reach such standards.

Such standards are not realistic and, therefore, cannot be used in inventory valuation, product costing and pricing, planning and control, and capital investment decisions.

Low standards, on the other hand, will not induce employees and management to put more efforts because they can be achieved very easily. They defeat the objectives of standard costing and fail to disclose inefficiencies because they can be attained by poor performance.

As a general rule, currently attainable standards should be set which can be attained if employees and management become more efficient or put some more efforts. Such standards motivate employees and are most appropriate for performance appraisal, cost control and decision making.

According to the National Association of Accountants (U.S.A.), “Such standards provide definite goals which employees can usually be expected to reach and also appear to be fair bases from which to measure deviations for which the employees are held responsible. A standard set at a level which is high yet still attainable with reasonable diligent effort and attentive to the correct methods of doing the job may also be effective for stimulating efficiency.”

The success of standard costing depends upon the establishment of correct standards. Thus, every possible care should be taken in the establishment of standards and standards should be established for each element of cost as follows:

(a) Direct Material Cost:

Standard material cost for each product should be predetermined. This will include:

(i) Determination of standard quantity of materials needed for the production.

(ii) Determination of standard price per unit of material.

In ascertaining standard quantity of materials, the standard specification of materials should be planned by the engineering department after consulting the past records. While setting standards an allowance should be made for the normal wastage of materials.

The purpose of determining standard quantities of materials should be to achieve maximum economies in material usage.

A detailed listing of all materials required for a product is made on a Standard Material specification, the specimen of which may be as follows:

Standard Material Specification
No……			Date……
Description of the Product……….
Code No.	Description of The Product	Quantity of the Product per Material	Remarks
Prepared By…
Checked By…

The standard prices of materials should be determined for the various types of material needed for the production. This is done by the cost accountant in collaboration with the purchase officer. Standard price for each item of material is established after carefully studying the market conditions and forecasting the trend of prices for a future period.

While setting standard material price, the cost of purchasing and storekeeping should also be included in the price of materials. The object of fixing standard prices of materials is to increase efficiency in the purchasing so that prices of materials may be kept down.

Any difference between standard price and actual price is to be referred to the Purchasing Department for explanation, so before setting standards for material prices, it is advisable to see that purchasing functions are efficiently managed. Setting up of standard prices of materials required is a difficult task because it depends on so many factors beyond anybody’s control. Generally standard prices are based on current prices adjusted to expected changes in future.

(b) Direct Labour Cost:

Determination of standard direct labour cost will include determination of:

(i) Standard time.

(ii) Standard rate.

It becomes necessary to standardise the time to be taken for each category of labour and for each operation involved. Time and motion study will determine how much time is to be allowed for each operation involved. While fixing the standard time, due allowance should be made for fatigue, tool setting, receiving instructions and normal idle time. Standard time can also be determined on the basis of the average of the past performance. Though this method is simple, it is not scientific.

Thus, standard time is established on the basis of time and motion study and this is done in conjunction with the work study engineers. Standard times established according to time and motion study are independent of previous performances. It is good for the development of objective standards. Standard time can also be set by taking trial runs for new products. This method is not satisfactory as real conditions are not available in such runs.

The fixation of standard labour rates is not as difficult as the fixation of standard prices of materials is because labour rates are usually pre-established.

Standard rates of pay should be established for every category of labour. Labour rates in the past may not be reliable basis for determination of rates if the labour rates are subject to fluctuating demand and supply of the labour force. Any expected increase in rates should be considered in the determination of standard rates.

Establishment of standard rates of pay do not present ay problem in those industries where wage rates have been fixed by contracts, Law, Wages Tribunals and Wages Boards. Fixation of standard rates will depend upon the method of wage payment.

Standard rates per hour or per day will be fixed if wages are paid according to time wages system and when the method of wage payment is piece rate, standard wages per piece will be fixed. Personnel department will help the cost accountant in determining standard rates of pay.

Overheads:

Broadly speaking overheads are segregated into fixed and variable and standard overhead rate should be determined for fixed as well as variable overhead. Standard fixed overhead rate and standard variable overhead rate should also be determined according to the function-wise classification of overheads manufacturing, administrative and selling and distribution so that exact place of overhead variance may be located and corrective action may be taken.

Standard overhead rate is determined keeping in view past experience, present conditions and future trends. Fixation of standard overhead rate involves determination of standard overhead costs, estimation of standard level of production reduced to a common base such as units of production, direct labour hours, machine hours, etc. and finally determination of standard overhead rate by dividing standard overhead costs by standard level of production.

The formula for the calculation of standard rate is:

Standard variable overhead rate:

Standard Hours:

Production is generally expressed in physical units such as kilos, tons, gallons, units, dozens etc. But it is difficult to express all the products in one common unit when different types of products which are measured in different units are manufactured in a factory. In such a case, it is essential to have a common unit in which all the products can be measured.

Time factor is common to all the products, and, therefore, production can be expressed in standard hours. A standard hour can be defined as an hour which measures the amount of work that should be performed in one hour under standard conditions. 

Historical cost is the preferred method of valuing assets because it can be proven. It is easy for a company to look at the title of a piece of property and see what was paid for it. Other valuation or costing methods like replacement cost or current cost fluctuate with the market and economy. If these methods were used, the company would report the same piece of property at different values every year based on the market. This fluctuation violates the accounting concept or consistency.

The assets and liabilities recorded in the balance sheet with its original acquisition cost, the i.e. amount spent at the time of its acquisition are called as the Historical Cost. In other words, the historical cost is an accounting method in which the assets of the firm are recorded in the books of accounts at the same value at which it was first purchased.

The purpose behind the use of historical cost is to ascertain the total amount spent on purchasing the asset and determining the opportunity cost lost in the past. Also, the amount spent on the purchase of the asset is compared with the changes in profits and expenses incurred as a result of the purchase of such asset.

Historical cost values don’t change from year to year, so the consistency concept is not violated. There are some problems with the historical costing method. For instance, it doesn’t take into consideration time value of money or inflation. The historical cost concept assumes that inflation is not relevant and only values assets based on the purchase price.

Importance of historical cost concept

An important advantage of historical cost concept is that the records kept on the basis of it are considered consistent, comparable, verifiable and reliable.

Any valuation basis other than historical cost may create serious issues for companies. For example, if a company uses current market value or sales value rather than historical cost, each member of accounting department is likely to suggest a different value for each asset of the company.

Further, current market or sales value is not appropriate for entities that prepare their financial statements more than once a year. For example, companies computing net income or preparing balance sheet on monthly basis would have to establish a new sales value for inventory and other assets at the end of each month which is usually inconvenient.

For example, if a company purchases the building worth Rs 15,00,000 in the year 2000, then the value of the building will be recorded in the balance sheet of the year 2000 at Rs 15,00,000. If the company still owns the building in the year 2016, then it will be recorded in the balance sheet of 2016 at the same value, i.e. 15,00,000 irrespective of the current market value of the building (even if the building value has increased to Rs 50,00,000, as per the current standards).

The historical cost method is the most widely used methods of accounting as it is easy for a firm to ascertain what price was paid for the asset. Also, the value of the asset remains same from year to year, thereby complying with the concept of consistency.

But, however, the historical cost method does not take into consideration the current market value of the asset and also ignores the time value of money or inflation. The historical cost is based on the assumption that the inflation is not relevant, and the asset is valued on the basis of its purchase price.

Benefits of Historical Cost Accounting:

3. Accounting data under HCA are generally considered free from bias, independently verifiable, and hence more reliable by the investing public, and other external users. Financial statements can easily be verified with the help of relevant documentary and other evidence. Because of the verifiability feature, accounting profession has more preference for traditional accounting
4. Historical accounting reduces to a minimum the extent to which the accounts may be affected by the personal judgements of those who prepare them. Being based on actual transactions, it provides data that are less disputable than are found in alternative accounting systems.
5. It has been generally found that users, internal and external, have preferences for HCA and financial statements prepared under it. According to Mautz,“if those who make management and investment decisions had not found financial reports based on historical cost useful over the years, changes in accounting would long since have been made”.

Ijiri, a strong supporter of HCA, argues that HCA has played a significant role in the past and will continue to be important in financial reporting in the future. Berkin favours historical cost because of its ability to present actual events without arbitrary adjustments by management. According to him, if corporate income was arbitrarily adjusted to show the impact of inflation, labour would be in an untenable bargaining position.

4. Historical accounting is also defended on the ground that it is only the legally recognised accounting system accepted as a basis for taxation, dividend declaration, defining legal capital, etc.
5. Historical cost valuation is, among all valuation methods currently proposed, the method that is least costly to society considering the social costs of recording, reporting, auditing and settling disputes.

Limitations of Historical Cost Accounting:

In an economic environment, where prices are constantly rising, as has been the case in most countries of the world, HCA suffers from some limitations.

The drawbacks of HCA are listed as follows:

1. In times of inflation, the value of money declines and, therefore, the monetary unit (e.g., rupee in India) which is used as a standard of measurement does not have a constant value and shrinks in value as the prices rise.

The HCA ignores this decline in the value of rupee and keeps adding transactions acquired at different dates with rupees of varying purchasing power. Thus, in historical accounts, the monetary unit (e.g., rupee in India) used to measure incomes and expenditures, assets and liabilities, has a mixture of values depending on the date at which each item was originally brought into the accounts.

The HCA is based on the assumption of stable monetary unit which assumes that:

(i) There is no inflation, or

(ii) The rate of inflation can be ignored.

This assumption does not prove true during inflation because of the change in general purchasing power of the monetary unit. This creates serious problems in measuring and communicating results of a business enterprise.

2. Secondly, HCA does not match current revenues with the current costs of operations. Revenues are measured in inflated (current) rupees whereas production costs are a mix of current and historical costs.

Some costs are measured in very old rupees (e.g., depreciation), other tend to be in more recent rupees (e.g., inventories), while still others reflect current rupees (e.g., wages, salary, selling expenses and similar current operating expenses).

In general, whenever there is a time lag between acquisition and utilisation, historical cost may well differ significantly from current cost. Accordingly, HCA tends to report ‘inflated’ or “inventory’ profits and lower costs of consuming stocks and fixed assets during a period of increasing prices.

‘Overstated’ profits become harmful in the following respects:

(a) Over-distribution of dividends.

(b) Settlement of wage claims on terms which companies could not afford.

(c) Excessive taxation on the corporate sector in general and inequitable distribution of tax burden between companies.

(d) Under-pricing of sales.

(e) Investors being misled as to the performance of companies.

3. The ‘inflated’ profits resulting under HCA are not the real profits but exaggerated and illusory. This causes the depreciation allowance to become inadequate to replace fixed assets and finance growth and expansion.

In periods of inflation, therefore, inflated profits result in substantial fall in the operating capital and in turn, in the operating capability of a business enterprise. This is a major problem and is best illustrated by two examples.

The analysis of factory overhead variances is more complex than variance analysis for direct materials and direct labour. There is no standardisation of the terms or methods used for calculat­ing overhead variances. For this reason, it is necessary to be familiar with the different approaches which can be applied in overhead variances.

Generally, the computation of the following overhead variances are suggested:

(1) Total Overhead Cost Variance:

This overall overhead variance is the difference between the actual overhead cost incurred and the standard cost of overhead for the output achieved.

This can be computed by applying the following formula:

(Actual overhead incurred) – (Standard hours for the actual output x Standard overhead rate per hour)

Or

(Actual overhead incurred) – (Actual output x Standard overhead rate per unit)

(2) Variable Overhead Variance:

It is the difference between actual variable overhead cost and standard variable overhead allowed for the actual output achieved.

The formula for computing this variance is as follows:

(Actual Variable Overhead Cost) – (Actual Output x Variable Overhead rate per unit)

Or

(Actual Variable Overhead Cost) – (Std. hours for actual output x Std. Variable overhead rate per hour)

(3) Fixed Overhead Variance:

This variance indicates the difference between the actual fixed overhead cost and standard fixed overhead cost allowed for the actual output.

This variance is found by using the following formula:

Fixed Overhead Variance = (Actual Fixed Overhead Cost – Fixed Overhead absorbed)

Or

(Actual Fixed Overhead Cost) – (Actual Output x Fixed Overhead rate per unit)

Or

(Actual fixed overhead cost) – (Std. hours for actual output x Std. fixed overhead rate per hour)

(4) Variable Overhead Expenditure (Spending or Budget) Variance:

This variance indicates the difference between actual variable overhead and budgeted variable overhead based on actual hours worked.

This variance is found by using the following:

(Actual variable overhead – Budgeted variable overhead)

(5) Variable Overhead Efficiency Variance:

This variance is like labour efficiency variance and arises when actual hours worked differ from standard hours required for good units produced. The actual quantity produced and standard quantity fixed might be different because of higher or lower efficiency of workers employed in the manufacturing of goods.

This variance is found by us­ing the following formula:

(Actual hours – Standard hours for actual output) x Standard variable overhead rate per hour

(6) Fixed Overhead Expenditure (Spending or Budget) Variance:

This variance indicates the difference between actual fixed overhead and budgeted fixed overhead.

The formula for comput­ing this variance is as follows:

(Actual fixed overhead – Budgeted fixed overhead)

(7) Fixed Overhead Volume Variance:

Volume variance relates to only fixed overhead. This variance arises due to the difference between the standard fixed overhead cost allowed (absorbed) for the actual output and the budgeted fixed overhead based on standard hours allowed for actual output achieved during the period. The variance shows the over-or-under-absorption of fixed overheads dur­ing a particular period. If the actual output is more than the standard output, there is over-absorption and variance is favourable. If actual output is less than the standard output, the volume variance is unfavourable.

The formula for computing this variance is as follows:

(Budgeted fixed overhead applied to actual output – Budgeted fixed overhead based on standard hours allowed for actual output)

Or

(Actual production – Budgeted production) x Std. fixed overhead rate per unit

Volume variance is further sub-divided into three variances:

(8) Fixed Overhead Calendar Variance:

It is that portion of volume variance which is due to the difference between the number of actual working days in the period to which the budget is applicable and budgeted number of days in the budget period.

If actual working days is more than the budgeted working days, the variance is favourable as work has been done on days more than budgeted or allowed and vice-versa.

The formula is as follows:

(No. of actual working days – No. of budgeted working days) x Std. fixed overhead rate per day. Calendar variance can be computed based on hours or output.

Then the formulae are:

Hours Basis:

Calendar Variance = (Revised Budget Capacity hours – Budget Hours) x Std. Fixed Overhead rate per hour

If revised budgeted capacity hours are more than the budgeted hours, the variance will be favourable. In the reverse situation, the variance will be unfavourable.

Output Basis:

Calendar Variance = (Revised budgeted quantity in terms of actual number of days worked – Budgeted quantity) x Standard fixed overhead rate per unit

If revised budgeted quantity is more than the budgeted quantity; the variance is favourable; if revised budgeted quantity is less, the variance will be unfavourable.

(9) Fixed Overhead Efficiency Variance:

It is that portion of volume variance which arises when actual hours of production used for actual output differ from the standard hours specified for that output. If actual hours worked are less than the standard hours, the variance is favourable and when actual hours are more than the standard hours, the variance is unfavourable.

The formula is:

Fixed Overhead Efficiency Variance = (Actual hours – Standard hours for actual production) x Fixed overhead rate per hour

Fixed Overhead Efficiency Variance = (Actual production – Standard production as per actual time available) x Fixed overhead rate per unit

(10) Fixed Overhead Capacity Variance:

It is that part of fixed overhead volume variance which is due to the difference between the actual capacity (in hours) worked during a given period and the budgeted capacity (expressed in hours). The formula is

Capacity Variance = (Actual Capacity Hours – Budgeted Capacity) x Standard fixed overhead rate per hour

This variance represents idle time also. If actual capacity hours are more than the budgeted capacity hours, the variance is favourable and if actual capacity hours are less than the budgeted capacity hours the variance will be unfavourable.

In case actual number of days and budgeted number of days are also given, then budgeted capacity hours will be calculated in terms of actual number of days and it will be known as revised budgeted capacity hours, i.e., budgeted hours in actual days worked.

In this situation, the formula for calculating capacity variance will be as follows:

Capacity Variance = (Actual Capacity hours – Revised Budgeted Capacity hours) x Standard fixed overhead rate per hr.

In the above formula, the variance will be favourable if actual capacity hours are more than the revised budgeted hours. However, if actual capacity hours are lesser than the revised budgeted hours, the variance will be adverse as lesser hours means that lesser actual hours have been worked taking the actual days utilised into account.

Two-way, Three-way and Four-way Variance Analysis:

The above overhead variances are also classified as Two-way, Three-way and Four-way variance.

The different variances under these categories are listed below:

(A) Two-way Variance Analysis:

The two-way analysis computes two variances budget variance (sometimes called flexible budget or controllable variance) and volume variance, which means:

(i) Budget variance = Variable spending variance + Fixed spending (budget) Variance + Variable efficiency variance

(ii) Volume variance = Fixed volume variance

(B) Three -Way Variance Analysis:

The three-way analysis computes three variances spending, efficiency and volume variances. Therefore,

(i) Spending variance = Variable spending variance + Fixed spending (budget) variance

(ii) Efficiency variance = Variable efficiency variance

(iii) Volume variance = Fixed volume variance

(C) Four-way Variance Analysis:

The four-way analysis includes:

(i) Variable spending variance

(ii) Fixed spending (budget) variance

(iii) Variable efficiency variance

(iv) Fixed volume variance.

Need for Marginal Costing

Variable cost per unit remains constant; any increase or decrease in production changes the total cost of output.

Total fixed cost remains unchanged up to a certain level of production and does not vary with increase or decrease in production. It means the fixed cost remains constant in terms of total cost.

Fixed expenses exclude from the total cost in marginal costing technique and provide us the same cost per unit up to a certain level of production.

Against and in favour of marginal costing

Favour

• Easy to operate and simple to understand.
• Marginal costing is useful in profit planning; it is helpful to determine profitability at different level of production and sale.
• It is useful in decision making about fixation of selling price, export decision and make or buy decision.
• Break even analysis and P/V ratio are useful techniques of marginal costing.
• Evaluation of different departments is possible through marginal costing.
• By avoiding arbitrary allocation of fixed cost, it provides control over variable cost.
• Fixed overhead recovery rate is easy.
• Under marginal costing, valuation of inventory done at marginal cost. Therefore, it is not possible to carry forward illogical fixed overheads from one accounting period to the next period.
• Since fixed cost is not controllable in short period, it helps to concentrate in control over variable cost.

Against

1. The total costs cannot be easily segregated into fixed costs and variable costs.

2. Moreover, it is also very difficult to per-determine the degree of variability of semi-variable costs.
3. Under marginal costing, the fixed costs remain constant and variable costs are varying according to level of output. The fixed costs do not remain constant and the variable costs are not varying according to level of output.
4. There is no meaning in the exclusion of fixed costs from the valuation of finished goods since the fixed costs are incurred for the purpose of manufacture of products.
5. In the case of loss by fire, the full amount of loss cannot be recovered from the insurance company since the stocks are undervalued.
6. Tax authorities do not accept the valuation of stock since the shock does not show true value.
7. The calculation of variable overheads does not include all the variable overheads.
8. The profit fluctuates as per the fluctuation of sales volume. Hence, the preparation of periodic operating statements becomes unrealistic.
9. The elimination of fixed costs renders cost comparison of jobs difficult.
10. The management cannot take a quality decision with the help of contribution alone. The contribution may vary if new techniques followed in the production process.
11. The fixed costs are constant only for short period. In the long run, all the costs are variable.
12. Firms may find it difficult to cover up costs and earn a fair return on capital employed when they follow marginal cost principle in times of recession when demand is slack and price reduction becomes inevitable to retain business.
13. Marginal cost pricing requires a better understanding of marginal cost technique. Some accountants are not fully conversant with the marginal techniques themselves. Therefore, they are not capable of explaining their use to the management.

In spite of its advantages, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal pricing has not been adopted extensively. It is confined to cases of special orders only.

Marginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit and it is calculated by dividing the change in the costs by the change in quantity.

Marginal cost is the change in the total cost of production upon a change in output that is the change in the quantity of production. In short, it is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, it is expressed as a derivative of the total cost with respect to quantity.

Marginal Cost = (Change in Costs) / (Change in Quantity)

where,

• Change in Total Cost = Total Cost of Production including additional unit – Total Cost of Production of normal unit
• Change in Quantity = Total quantity product including additional unit – Total quantity product of normal unit

Calculation of Marginal Cost

Step 1: Consider the total output, fixed cost, variable cost, and total cost as input.

Step 2: Prepare a production graph considering a different quantity of output.

Step 3: Find the change in cost i.e. difference of the total cost of production including additional unit and total cost of production of the normal unit.

Step 4: Find the change in quantity i.e. total quantity product including additional unit and total quantity product of normal unit.

Step 5: Now, as per the formula of Marginal cost divide change in cost by a change in quantity and we will get marginal cost.

This produces a dollar amount for each additional unit of a product that is produced.

The change in costs will greatly depend on the scale of production that is already in place. For instance:

• A baker working out of their home kitchen may be able to produce anywhere from one to fifty baguettes without a significant change in costs since they can continue using the same oven in the same room. (Their largest cost increase in going from a single loaf to a 50-loaf production run would be the extra flour, salt, water, and yeast all quite low as far as raw materials go.)
• However, if the baker wants to scale up to producing hundreds of baguettes, they will probably need to start working in a much larger space than their home kitchen. In this case, increasing the quantity of output will result in a much greater fixed cost, since they will probably have to lease space in a larger facility, and perhaps purchase new equipment.
• Increased production costs do not necessarily indicate diminished total revenue. To the contrary, most businesses lower their per-unit cost of production by increasing their level of output. This ties to the principle of “economies of scale.” As the level of production increases, the average cost per unit produced tends to go down provided, of course, that there is a sufficient market for consumers willing to purchase your product.

Managerial Uses of Marginal Costing:

(a) Cost Ascertainment:

Marginal costing technique facilitates not only the recording of costs but their reporting also. The classification of costs into fixed and variable components makes the job of cost ascertainment easier. The main problem in this regard is only the segregation of the semi-variable cost into fixed and variable elements. However, this may be overcome by adopting any of the methods in this regard.

(b) Cost Control:

Marginal cost statements can be understood easily by the management than those presented under absorption costing. Bifurcation of costs into fixed and variable enables management to exercise control over production cost and thereby affect efficiency.

In fact, while variable costs are controllable at the lower levels of management, fixed costs can be controlled at the top level. Under this technique, management can study the behaviour of costs at varying conditions of output and sales and thereby exercise better control over costs.

(c) Decision-Making:

Modern management is faced with a number of decision-making problems every day. Profitability is the main criterion for selecting the best course of action. Marginal costing through ‘contribution’ assists management in solving problems.

Some of the decision-making problems that can be solved by marginal costing are:

(a) Profit planning

(b) Pricing of products

(c) Make or buy decisions

(d) Product mix etc.

Limitations of Marginal Costing:

(a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a major technical difficulty arises in drawing a sharp line of demarcation between fixed and variable costs. The distinction between them hold good only in the short run. In the long run, however, all costs are variable.

(b) In marginal costing, greater importance is attached to the sales function thereby relegating the production function largely to a secondary position. But, the real efficiency of a business is to be assessed only by considering the selling and production functions together.

(c) The elimination of fixed costs from the valuation of inventories is illogical since costs are also incurred in the manufacture of goods. Further, it results in the understatement of the value of stock, which is neither the cost nor the market price.

(d) Pricing decision cannot be based on contribution alone. Sometimes, the contribution will be unrealistic when increased production and sales are effected, either through extensive use of existing machinery or by replacing manual labour by machines. Another possibility is that there is danger of too many sales being affected at marginal cost, resulting in denial to the business of inadequate profits.

(e) Although the problem of over or under absorption of fixed overheads can be overcome to a certain extent, the same problems still persists with regard to variable overheads.

(f) The application of the technique is limited in the case of industries in which, according to the nature of business, large stocks have to be carried by way of work-in-progress (e.g. contracting firms).