Tag: University of Mumbai BMS Notes

Horngreen, Datar and Foster define management control system “as a means of gathering and using information to aid and coordinate the process of making planning and control decisions through- out the organisation and to guide the behaviour of its managers and employees. The goal of management control system is to improve the collective decisions within an organisation in an economically feasible way.”

Different managers perform different responsibilities in an organisation and therefore different kinds of information are needed by them to manage the activities in their respective areas. Management control system should be able to develop, gather and communicate information to management at different levels in the organisation. Also, management control system should aim to provide financial as well as non-financial information as needed by different managers.

Some examples of financial information are material costs, labour costs, net profit, investments made etc. Non-financial data are those which are not in monetary terms such as production units per worker, labour hours, machine hours, time taken to comply with the customer’s orders, absenteeism. Some information gathered under management control system may emerge from internal data maintained within the firm.

Some other information required by managers may be gathered from external sources such as information about competitors’ product. As stated earlier, different types of information are needed by persons working at different levels in the organisation. For example, top managers may require internal as well as external financial and non-financial data as their responsibilities relate to total organisation. However, a production manager would be more interested in internally generated financial and non-financial data.

Management Control Systems:

Broadly, management control system (MCS) refers to the design, installation and operation of management planning and control systems.

The term ‘management control systems’ emphasises on two distinct, but highly interrelated and sometimes indistinguishable, subdivisions of controls systems:

(i) Structure or organisation structure or relationships among the units in the organisation, more specifically the responsibility centres, the relationship among responsibility centres, performance measures and the information that flows among these responsibility centres.

(ii) Process or set of activities, or steps or decisions that are taken by an organisation or managers to establish purposes, allocate resources and achieve organisational purposes.

The process consists of interrelated phases of programming (programme selection), budgeting, execution, measurement and evaluation of actual performance.

The structure of a management control system indicates what the system “is” and process of a management control system indicates what the system “does.” The management control systems knits the organisation together so that each part, by exercising the autonomy given to it, fulfills a purpose that is consistent with and contributes to the fulfillment of the overall purpose of the organisation.

The control system should be designed to achieve unity of purpose through the use of the diverse talents of individuals in the organisation. The constant requirement of management control is the achievement of unity in diversity through coordination, in pursuit of short-term objectives and long-term goals.

Management Control System” Formal and Informal:

Management control system includes both formal control system and informal control system. A formal control system requires that an organisation should have clear-cut rules, procedures, guidelines, plans relating to different managerial aspects. Such things are needed to guide, direct, motivate the managers and other employees and coordinate their behaviour to achieve organisational goals.

In an organisation, many formal control systems may exist such as cost accounting system, management accounting system, production engineering systems, human resource system, quality maintenance system etc. Informal management control systems are always unwritten and implicit.

However, they contribute greatly in the implementation of business goals and strategies and help the organisation to attain high degree of motivation and goal congruence. Examples of informal management control systems are unwritten norms about good behaviour of managers and employees, loyalties, shared values, organisational culture and ethics, mutual commitments among managers and employees.

A major objective of management control is to encourage goal congruence, which means that as people work to achieve their own goals, they also work to achieve the goals of the company. People must have incentives to work toward the company’s goals. To accomplish that objective, managers must assign responsibilities and develop performance evaluation criteria that motivate employees to work toward the company’s goals.

A management control system is most effective when it establishes evaluation criteria that encourage goal-congruent behaviour and is implemented through a responsibility accounting system that employees trust to report their performance.

Characteristics of Management Control Systems:

Management control systems designed in an organisation should fulfill the following characteristics:

(i) Management control systems should be closely aligned to an organisation’s strategies and goals.

(ii) Management control systems should be designed to fit the organisation’s structure and the decision-making responsibility of individual managers.

(iii) Effective management control systems should motivate managers and employees to exert efforts toward attaining organisation goals through a variety of rewards tied to the achievement of those goals.

Factors Influencing Management Control Systems:

Factors influencing the design of Management Control Systems are as follows:

(i) Size and Spread of the Enterprise:

The size and spread of a large firm is bound to be different compared with that of a small firm. This would certainly determine the content and nature of the control system for each organisation.

(ii) Organisational Structure, Delegation and Decentralisation:

Statutes and conventions govern organisational structure, and the extent of decentralisation and delegation in all enterprises. For example, the management philosophy of the State Bank of India is bound to be different from that of the State Trading Corporation. Also, within an enterprise, the degree of decentralisation and delegation changes from one point of time to another to meet changed environmental challenges and the opportunities that these may present. All these influence management control systems practiced in organisations.

(iii) Nature of Operations and Divisibility:

Nature of operations and their divisibility affect management control systems. For example, in the oil industry, for instance, sub-units can not be formed on the basis of products. In many large trading companies, however, divisions can be created on the basis of products. Again, in the paper industry, the different stages in pulp making can not be subdivided for the purposes of management control, though pulp making as a whole can be regarded as a division.

(iv) Types of Responsibility Centres:

Different control systems are needed for the various responsibility centres or sub-systems within an organisation. Whether the performance of a responsibility centre should be measured in terms of expenses or profitability or return on investment depends on the type of responsibility centre. For example, a bank may apply different performance measures to measure performance of its different branches.

There are transactional differences between branches; some are deposit heavy or advance heavy, some are with or without safe deposit facilities or foreign exchange transaction. It is, therefore, not possible to have profit as the sole criteria for performance evaluation of all branches. Hence, control systems with different criteria of performance should be used for different sub-units.

(v) People and their Perceptions:

Perceptions of people in the organisation about the likely effects of the control system on their work life, job satisfaction, job security, promotion and general well-being could differ across organisations. These considerations will significantly influence the nature and content of the management control system needed in the organisation and must be duly considered while designing management control systems.

Managerial decision making is a process of making choices. If a choice is to be made among alternatives, there must be differences among the alternatives. Relevant information should be used by the decision maker in evaluating the alternatives and in making decisions.

Characteristics of Relevant Information:

Relevant information has two characteristics:

1. Impact on the Future:

Relevant information has bearing on the future. Relevant information focuses on the future because every decision deals with selecting courses of action for the future. Noth­ing can be done to alter the past. The consequences of decisions are born in the future, not the past. Information to be relevant (i.e. relevant costs and benefits) to a decision should imply a future event.

Since relevant information involves future events, the managerial accountant must predict the amounts of the relevant costs and benefits. In making these predictions, the accountant often will use estimates of cost behavior based on historical data. There is an important and subtle issue here. Relevant information must involve costs and benefits to be realized in the future. However, the ac­countant’s predictions of those costs and benefits often are based on data from the past.

2. Different under Different Alternatives:

Relevant information includes costs and benefits that differ among the alternatives. Expected future revenues and costs that do not differ or remain the same across alternatives have no impact on the decision and therefore irrelevant and should be eliminated from the relevant information analysis.

Further, in relevant information, due weight-age must be given to qualitative factors and quan­titative non financial factors.

According to Hilton, information to be useful for decision making should possess three char­acteristics:

1. Relevance
2. Accuracy
3. Timeliness

Relevant Information and Differential Analysis:

Relevant information implies relevant costs and relevant revenues (benefits) which are useful to evaluate alternatives, to ascertain the effect of various alternatives on profit and to finally select the alternative with the greatest benefit.

Relevant revenues and relevant costs are defined as the current and future values that differ among the alternatives under consideration. They are the differences between the alternatives under consideration. The amounts of such differences are called differentials and the (accounting) analysis concerned with the effect of alternatives on revenues and costs is called differential analysis.

Thus, differential analysis, known as relevant information analysis also, is defined as the use of relevant revenues and relevant costs in decision making. Relevant revenues and costs are also known as differential revenues and differential costs. This analysis provides a decision rule to managers in decision-making which is ‘the alternative that gives the greatest incremental profit should be selected’. Incremental profit is the difference between the relevant revenues and relevant costs of each alternative.

A differential analysis of relevant costs is always preferable to complete analysis of all costs and revenues for a number of reasons:

(i) A differential analysis focuses on only those items that differ, providing a clearer picture of the impact of the decision at hand. Management is less apt to be confused by this analysis than by one that combines relevant and irrelevant items.

(ii) A differential analysis contains fewer items, making it easier and quicker to prepare.

(iii) A differential analysis can help to simplify complex situations (such as those encountered by multiple-product or multiple-plant firms), when it is difficult to develop complete firm-wide statements to analyze all decision alternatives.

Relevant Revenues:

Relevant (differential) revenue as stated earlier, is the amount of increase or decrease in revenue expected from a particular course of action as compared with an alternative. For instance, assume that a plant is being used to manufacture product A, which gives revenue of Rs 3, 00,000. If the plant could be used to make product B, which will provide revenue of Rs 3,50,000 the differential revenue from making and selling product B will be Rs 50,000.

Accrual Profit and Cash Flow:

Relevant revenues are like cash inflows. If the amount of accrual profit and cash flow differs, the manager should give importance to cash flow. I or short-run managerial decisions, timing of cash flow, i.e., when the cash flows are received, are not so important. However, for long-run decisions where the time span is usually for more than one year, the timing of cash flows is important in the evaluation of alternatives and in making decisions.

Relevant Costs:

Relevant Costs are also known as differential costs, decision making costs. Relevant or differential cost is the difference in the total costs between alternative choices. It is difference in total costs between two volumes. It is the cost that should be considered when a decision is made involving an increase or decrease of n units of output above a specified output.

When a decision results in an increased cost, the differential cost may be referred to as an incremental cost. If the cost decreases, the differential cost may be referred to as a decremental cost. The incremental cost includes the change in fixed component as well as the variable component. Assume that a company has physical facilities to manufacture 20,000 units of a product; production beyond that point would require the installation of additional equipment, that is, fixed costs as well as variable costs will have to be incurred if management desires to produce more than 20,000 units.

Differential and Incremental:

The term differential is more inclusive than incremental. The latter term suggests increases, and some decisions produce decreases in both revenues and costs. But the terms are not as important as what they denote. Differential costs are avoidable costs. If a company can change a cost by taking one action as opposed to another, the cost is avoidable and therefore differential.

Suppose a company could save Rs 5, 00,000 in salaries and other fixed costs if it stopped selling a product in a particular geographical region. The Rs 5, 00,000 is avoidable (differential) because it will be incurred if the company continues to sell in the region and will not be incurred if the firm stops selling in that region. Of course, the company will lose revenue if it discontinues sales in the region. Hence, the lost revenue is also differential in a decision to stop selling in the region.

Relevant costs vary with the type of decision. However, the following are the common char­acteristics of relevant costs:

(1) Relevant costs are expected future costs.

(2) They differ between different decision alternatives.

Expected future costs imply that the costs are expected to occur during the time period covered by the decision. For example, new product will need the incurrence of direct material, direct labour and other costs. Relevant costs also differ between decision alternatives. For example, a graduate may choose between higher education and immediate employment.

The costs that are relevant in this decision and which differ between the two decision are the costs of books, fees, etc., because these costs will not be incurred if the graduate takes up employment. However, irrelevant costs are costs of accommodation, clothing’s, etc. which will have to be incurred under both the decisions.

The differential cost concept is one of the most useful in planning and decision making. It provides a tool for testing the profitability of increased output for an acceptable alternative. In many short-run decisions, only costs, not revenues, will change. In this case, the most beneficial (profitable) decision will be one with the lowest cost because the lowest cost alternative will give the highest profit for the business enterprise, provided all other factors remain constant.

There are some industries where two or more products come out of a single raw material which is equally important. These are referred to as joint products.

C.l.M.A. defines joint product as ‘Two or more products separated in the course of processing, each having a sufficiently high saleable value to merit recognition as a main product’.

According to T. Lang, Joint products means “Two-or more products separated in the course of the same processing operation, usually requiring further processing, each product being in such proportion that no single product can be designated as major product”.

In short, we can say, when two or more products of equal importance are simultaneously produced, then they are known as joint products.

Example:

In oil industry kerosene, gasoline, fuel oil, lubricants etc. are all produced from the same product, crude petroleum. They are of equal important; hence they are called joint products.

Meaning of By-Products:

Terminologically, a by-product is defined as “a product which is recovered incidentally from the material used in the manufacture of recognised main products, such a by­product having either a net realisable value or a usable value which is relatively low in comparison with the saleable value of the main products. By-product may be further processed to increase their realisable value.”

Example:

(a) In soap-making industry—in the process of mixing and boiling ingredients many rejections take place. These rejections are collected for recovery as by-product.

(b) In coke ovens gas and tar are treated as by-products.

Distinctions between Joint Products and By-Products:

The following are points of distinctions:

(i) Joint products are of equal importance while by-products are of not equal importance as compared to that of the main products.

(ii) Joint products are produced simultaneously while by-products are produced incidentally.

(iii) Joint products are of more or less equal sales value while by products is of insignificant sales value.

Meaning of Co-Products:

Co-products are such products which are produced simultaneously with the main product but not necessarily from the same raw material.

Example:

In lumbering operations, it is possible to obtain oak, pine and walnut boards at the same time but from different trees.

The concept of joint product, by-product and co-product can be clarified by the following diagram:

M: Material

P₁ & P₂ = Process I and Process II

S = Split-off point

M₁ = Material required for co-product A

M₂ = Material required for co-product B

P_A & P_B = Process operation for Products A and B, respectively.

Job Costing

Job costing is accounting which tracks the costs and revenues by “job” and enables standardized reporting of profitability by job. For an accounting system to support job costing, it must allow job numbers to be assigned to individual items of expenses and revenues. A job can be defined to be a specific project done for one customer, or a single unit of product manufactured, or a batch of units of the same type that are produced together.

To apply job costing in a manufacturing setting involves tracking which “job” uses various types of direct expenses such as direct labour and direct materials, and then allocating overhead costs (indirect labor, warranty costs, quality control and other overhead costs) to the jobs. A job profitability report is like an overall profit & loss statement for the firm, but is specific to each job number.

Job costing may assess all costs involved in a construction “job” or in the manufacturing of goods done in discrete batches. These costs are recorded in ledger accounts throughout the life of the job or batch and are then summarized in the final trial balance before the preparing of the job cost or batch manufacturing statement.

Job Costing Allocation of Materials

In a job costing environment, materials to be used on a product or project first enter the facility and are stored in the warehouse, after which they are picked from stock and issued to a specific job. If spoilage or scrap is created, then normal amounts are charged to an overhead cost pool for later allocation, while abnormal amounts are charged directly to the cost of goods sold. Once work is completed on a job, the cost of the entire job is shifted from work-in-process inventory to finished goods inventory. Then, once the goods are sold, the cost of the asset is removed from the inventory account and shifted into the cost of goods sold, while the company also records a sale transaction.

Job Costing Allocation of Labor

In a job costing environment, labor may be charged directly to individual jobs if the labor is directly traceable to those jobs. All other manufacturing-related labor is recorded in an overhead cost pool and is then allocated to the various open jobs. The first type of labor is called direct labor, and the second type is known as indirect labor. When a job is completed, it is then shifted into a finished goods inventory account. Then, once the goods are sold, the cost of the asset is removed from the inventory account and shifted into the cost of goods sold, while the company also records a sale transaction.

Job Costing Allocation of Overhead

In a job costing environment, non-direct costs are accumulated into one or more overhead cost pools, from which you allocate costs to open jobs based upon some measure of cost usage. The key issues when applying overhead are to consistently charge the same types of costs to overhead in all reporting periods and to consistently apply these costs to jobs. Otherwise, it can be extremely difficult for the cost accountant to explain why overhead cost allocations vary from one month to the next.

The accumulation of actual costs into overhead pools and their allocation to jobs can be a time-consuming process that interferes with closing the books on a reporting period. To speed up the process, an alternative is to allocate standard costs that are based on historical costs. These standard costs will never be exactly the same as actual costs, but can be easily calculated and allocated.

Features of job costing:

(a) It is a Specific Order Costing.

(b) The job is carried out or a product is produced to meet the specific requirements of the order. It may be related to single unit or a batch of similar units.

(c) It is concerned with the cost of an individual job or batch regardless of the time taken to produce it, but normally short duration jobs.

(d) Costs are collected to each job at the end of its completion.

(e) The costs of each job is ascertained by adding materials, labour and overheads.

(f) Only prime cost elements are traceable and the overheads are apportioned to each job on some appropriate basis and sometimes it is difficult to select a suitable method of absorption of overheads to individual jobs.

(g) Standardization of controls is comparatively difficult as each job differs and more detailed supervision and control is necessary.

(h) Work-in-progress may or may not exist at the end of the accounting period.

Advantages of Job Costing:

(a) The profit or loss made on each job can be measured if cost is set against the price tendered for the job.

(b) It generates the cost data useful for the analysis and control by the management.

(c) It highlights whether or not a job is likely to be profitable or not.

(d) It readily fits into the double entry system, and lends itself to performance evaluation and review of costs.

(e) Job costing enables a comparison to be made with performance on other jobs so that inefficiencies are identified and rectified.

(f) Some jobs are negotiated on a ‘cost plus’ basis, if there is difficulty in estimating a price for a certain job and the customer agrees to pay the cost of the job plus an agreed percentage as a profit margin. In cost plus jobs it is essential to maintain reliable costing records.

(g) The cost incurred to date on the job are known before the job is completed, and any mistakes or excessive costs show up at an early stage.

The major disadvantage of Job costing is that it is too expensive, time consuming in maintenance of cost records for each job undertaken.

Batch Costing

Batch Costing is used where articles are produced in batches and held in stock for assembly of components to produce finished products or for sale to customers. Costs are collected against each batch. When the batch is completed cost per unit is computed by dividing total cost by the number of units in each batch.

Batch Costing is used for producing articles like radio, television, watches, pen etc. where a large number of components are assembled to complete the finished products. If the components are produced in batches of large quantity it becomes economical and reduces overall cost of the product. In Batch Costing the important problem is to determine the optimum size of the batch or how much to produce.

Like Economic Order Quantity for materials the Economic Batch Quantity can be derived with the help of table, graph or mathematical formula since production under Batch Costing Method involves two elements of cost namely.

1) Setup or preparation costs which remains fixed per batch irrespective of the size of the batch and

2) Carrying Cost or Storage Cost which vary directly with the size of the batch.

Nature and Uses

Batch costing is a modified form of job costing. While job costing is concerned with costing of jobs that are executed against specific orders of the customers, batch costing is used where articles are manufactured in definite batches. The articles are usually kept in stock for selling to customers on demand.

The term batch refers to the ‘lot’ in which the articles are to be manufactured. Whenever a particular product is required, one unit of such product is not produced but a lot of ‘say’ 500 or 1,000 units of such product is produced. It is therefore also known as “Lot Costing”.

This method of costing is used in case of pharmaceutical or drug industries, ready-made garment factories, industries manufacturing component parts of radios, television sets, watches etc. The costing procedure for batch costing is similar to that under job costing except with the difference that a batch becomes the cost unit instead of a job.

Separate job cost sheets are maintained for each batch of products. Each batch is allotted a number. Material requisitions are prepared batch wise, the direct labour is engaged batch wise and the overheads are also recovered batch wise. Cost per unit is ascertained by dividing the total cost of a batch by number of items produced in that batch. Ordinary principles of inventory control are used.

Production orders are issued only when the stock of finished goods reaches the ordering level. In case the batches are repetitive, the costing work is much simplified.

Features

1. The batch is the cost unit.
2. The batch cost sheet is prepared in the similar manner as it is done in case of job costing. It shows essentially the same information in respect of the batch that job cost sheet shows in respect of a job.
3. Economic batch quantity is calculated after considering set up cost, carrying cost and annual demand.
4. Batch Account is opened for each batch. All direct materials, direct labour and production overheads are debited to the Batch Account. After completion, batch cost is transferred to cost of sales.

Formula

Cost per Unit = Total Batch Cost/ Total units in a Batch

For each and every batch, the cost sheet is prepared and maintained, by allotting the batch number. There is batch wise preparation of material requisition note, engagement of labor and recovery of overheads.

This costing method is employed by firms to manufacture a large number of similar items or components, as they pass through the same process and so it is beneficial to ascertain their cost of production collectively.

Job costing vs. Process costing

Job costing (known by some as job order costing) is fundamental to managerial accounting. It differs from Process costing in that the flow of costs is tracked by job or batch instead of by process.

The distinction between job costing and process costing hinges on the nature of the product and, therefore, on the type of production process:

Process costing is used when the products are more homogeneous in nature. Conversely, job costing systems assign costs to distinct production jobs that are significantly different. An average cost per unit of product is then calculated for each job.

• Process costing systems assign costs to one or more production processes. Because all units are identical or very similar, average costs for each unit of product are calculated by dividing the process costs by the number of units produced.
• Many businesses produce products with some unique features and some common processes. These businesses use costing systems that have both job and process costing features.

Process Costing is defined as a branch of operation costing, that determines the cost of a product at each stage, i.e. process of production. It is an accounting method which is adopted by the factories or industries where the standardized identical product is produced, as well as it passes through multiple processes for being transformed into the final product.

Process costing is a cost accounting technique, in which the costs incurred during production are charged to processes and averaged over the total units manufactured. For this purpose, process accounts are opened in the books of accounts, for each process and all the expenses relating to the process for the period is charged to the respective process account.

Hence, it ascertains the total cost and unit cost of a process, for all the processes carried out in industry. Further, the average cost represents the cost per unit, wherein the total cost is divided by the total number of outputs produced during the period to arrive at the cost per unit. The cost per unit can be calculated using First in First Out Method (FIFO), Average Method and Weighted average Method.

Features of Process Costing

• The plant has various divisions, and each division is a stage of production.
• The production is carried out continuously, by way of the simultaneous, standardized and sequential process.
• The output of a process is the input of another.
• The production from the last process is transferred to finished stock.
• The final product is homogeneous.
• Both direct and indirect costs are charged to the processes.
• The production may result in joint and by-products.
• Losses like normal and abnormal loss occur at different stages of production which are also taken into consideration while calculating the unit cost.
• The output of one process is transferred to another one at a price that includes the profit of the previous process and not at the cost.
• At the end of the period, if there remains the stock of finished goods, then it is also expressed in equivalent completed units. It can be calculated as:
  Equivalent units of semi-finished goods or WIP = Actual number of units in process × Percentage of work completed

Process costing is employed by the industries whose production process is continuous and repetitive, as well as the output of one process is the input of another process. So, chemical industry, oil refineries, cement industries, textile industries, soap manufacturing industries, paper manufacturing industries use this method.

Process costing is used when there is mass production of similar products, where the costs associated with individual units of output cannot be differentiated from each other. In other words, the cost of each product produced is assumed to be the same as the cost of every other product. Under this concept, costs are accumulated over a fixed period of time, summarized, and then allocated to all of the units produced during that period of time on a consistent basis. When products are instead being manufactured on an individual basis, job costing is used to accumulate costs and assign the costs to products. When a production process contains some mass manufacturing and some customized elements, then a hybrid costing system is used.

Examples of the industries where this type of production occurs include oil refining, food production, and chemical processing. For example, how would you determine the precise cost required to create one gallon of aviation fuel, when thousands of gallons of the same fuel are gushing out of a refinery every hour? The cost accounting methodology used for this scenario is process costing.

Process costing is the only reasonable approach to determining product costs in many industries.   It uses most of the same journal entries found in a job costing environment, so there is no need to restructure the chart of accounts to any significant degree.  This makes it easy to switch over to a job costing system from a process costing one if the need arises, or to adopt a hybrid approach that uses portions of both systems.

Example of Process Cost Accounting

As a process costing example, ABC International produces purple widgets, which require processing through multiple production departments. The first department in the process is the casting department, where the widgets are initially created. During the month of March, the casting department incurs Rs. 50,000 of direct material costs and Rs. 120,000 of conversion costs (comprised of direct labor and factory overhead). The department processes 10,000 widgets during March, so this means that the per unit cost of the widgets passing through the casting department during that time period is Rs. 5.00 for direct materials and Rs. 12.00 for conversion costs. The widgets then move to the trimming department for further work, and these per-unit costs will be carried along with the widgets into that department, where additional costs will be added.

Manufacturing costs are the costs incurred during the production of a product. These costs include the costs of direct material, direct labor, and manufacturing overhead. The costs are typically presented in the income statement as separate line items. An entity incurs these costs during the production process.

Direct material is the materials used in the construction of a product. Direct labor is that portion of the labor cost of the production process that is assigned to a unit of production. Manufacturing overhead costs are applied to units of production based on a variety of possible allocation systems, such as by direct labor hours or machine hours incurred.

Example of Manufacturing Costs

Manufacturing costs are typically divided into three categories:

1. Direct materials cost

The cost of raw materials used in the manufacturing process is one of the most common manufacturing expenses companies measure. You should always strive to deal with vendors to get the lowest possible prices on raw materials, and you should initiate quality control methods to avoid wasting raw materials. Another way raw materials costs can get out of hand is by keeping too much materials inventory. This costs you not only for the cost of the materials themselves, but also for warehousing and tracking them. Review your ordering methods to make sure you keep only the minimum amount of raw materials on hand.

2. Direct labor cost

Paying wages to employees will be one of your major manufacturing expenses. You will need to constantly monitor this cost to make sure you are getting enough production for the money you are putting into labor. Average all the wages of your production crew and calculate how much labor costs you per hour and per day. Here is how to do the calculaton. Add all wages paid in a month and divide by the number of employees. Divide this figure by the number of work days in the month. This is your daily average wage paid. Divide this figure by the number of hours in a shift to get wages paid per hour.

3. Manufacturing overhead

Manufacturing overhead is any manufacturing cost that is neither direct materials cost or direct labor cost. Manufacturing overhead includes all charges that provide support to manufacturing.

Manufacturing overhead includes

• Indirect labor cost: The indirect labor cost is the cost associated with workers, such as supervisors and material handling team, who are not directly involved in the production.
• Indirect materials cost: Indirect materials cost is the cost associated with consumables, such as lubricants, grease, and water, that are not used as raw materials.
• Other indirect manufacturing cost: includes machine depreciation, land rent, property insurance, electricity, freight and transportation, or any expenses that keep the factory operating.

4. Incidental Expenses

In addition to the three most common manufacturing costs, you have expenses for supplies such as tools, tape, lubricants and safety gear. Once you get a handle on your three largest manufacturing expenses, examine your facility to see where else you spend money that goes into your manufacturing costs. One issue you should pay particular attention to is defective products. The costs of manufacturing products that get rejected in quality control can add up quickly.

Production Costs vs. Manufacturing Costs Example

For example, a small business that manufactures widgets may have fixed monthly costs of $800 for its building and $100 for equipment maintenance. These expenses stay the same regardless of the level of production, so per-item costs are reduced if the business makes more widgets.

In this example, the total production costs are $900 per month in fixed expenses plus $10 in variable expenses for each widget produced. To produce each widget, the business must purchase supplies at $10 each. Each widget sells for $100. After subtracting the manufacturing cost of $10, each widget makes $90 for the business.

To break even, the business must produce 10 widgets every month. It must make more than 10 widgets to become profitable.

Cost can be classified into (i) fixed, (ii) variable and (iii) mixed costs, in terms of their vari­ability or changes in cost behaviour in relation to changes in output, or activity or volume. Activity may be indicated in any forms such as units of output, hours worked, sales, etc.

The classification of cost behaviour has been explained below:

1. Fixed Cost

Fixed cost is a cost which does not change in total for a given time period despite wide fluc­tuations in output or volume of activity. The ICMA (U.K.) defines fixed cost as “a cost which tends to be unaffected by variations in volume of output. Fixed costs depend mainly on the affluxion of time and do not vary directly with volume or rate of output.” These costs, also known as standby costs, capacity costs or period costs, arise primarily because of the provision of facilities, physical and human, to carry on business operations.

Fixed costs enable a business firm to do a business, but they are not purely incurred for manu­facturing. Examples of fixed costs are rent, property taxes, supervising salaries, depreciation on office facilities, advertising, insurance, etc. They accrue or are incurred with the passage of time and not with the production of the product or the job. This is the reason why fixed costs are expressed in terms of time, such as per day, per month or per year and not in terms of unit. It is totally illogical to say that a supervisor’s salary is so much per unit.

By nature, the total fixed costs are constant which means that the fixed costs per unit will vary. Shows the behaviour of fixed costs in total and on a per unit basis. When a greater num­ber of units are produced, the fixed cost per unit decreases. On the contrary, when a lesser number of units are produced, the fixed cost per unit increases. This variability of fixed cost per unit creates problems in product costing. The cost per unit depends on the number of units produced or the level of activity achieved.

However, it should be improper to say that total fixed costs never change in amount. Rents, insurance, rates, taxes, salaries and other similar items may go up or down depending on the circum­stances. The basic concept is that the term “fixed” refers to fixity (non-variability) related to specific volume (or relevant range); the term does not imply that there will be no changes in fixed cost. This characteristics of fixed cost has been shown in below.

According to Exhibit. 2.4, the following are the fixed costs at different levels of production:

(a) Rs 50,000 fixed cost between 20,000 and 80, 000 units of production.

(b) Rs 60,000 fixed cost in excess of 80,000 units. This assumes that increases in production after a certain level (80,000 units) requires increase in fixed expenses which have been fixed earlier, e.g., additional supervision, increase in quality control costs.

(c) Rs 25,000 fixed cost from zero units (shut down) to 20,000 units. This explains that if the level of activity comes to less than 20,000 units, some fixed costs may not be incurred. For example, if the plant is shut down or production is reduced, many of the fixed costs, such as costs on accounting functions, supplies, staff, will not be incurred. However, if laying off of staff and personnel, etc. is not possible, then the fixed cost will remain at Rs 50,000.

2. Variable Cost

Variable costs are those costs that vary in total amount directly and proportionately with the output. There is a constant ratio between the change in the cost and change in the level of output. Direct material cost and direct labour cost are the costs which are generally variable costs. For example, if direct material cost is Rs 50 per unit, then for producing each additional unit, a direct material cost of Rs 50 per unit will be incurred.

That is, the total direct material cost increases in direct proportion to increase in units manufactured. However, it should be noted that it is only the total variable costs that change as more units are produced; the per unit variable cost remains constant. Variable cost is always expressed in terms of units or percentage of volume; it cannot be stated in terms of time. Fig. shows behaviour of variable costs in total and on a per unit basis.

Fig. shows graphically the behaviour pattern of direct material cost. For the every increase in the units produced there is a proportionate increase in the cost when production increases in direct proportion at the constant rate of Rs 50 per unit. The variable cost line is shown as linear rather than curvilinear. That is, on a graph paper, a variable cost line appears as unbroken straight line in place of a curve. Variable cost per unit is shown by constant.

3. Mixed Costs

Mixed costs are costs made up of fixed and variable elements. They are a combination of semi- variable costs and semi-fixed costs. Because of the variable component, they fluctuate with volume; because of the fixed component, they do not change in direct proportion to output. Semi-fixed costs are those costs which remain constant upto a certain level of output after which they become variable as shown in fig.

Semi-variable cost is the cost which is basically variable but whose slope may change abruptly when a certain output level is reached as shown in fig. An example of a mixed cost is the earnings of a worker who is paid a salary of Rs 1,500 per week (fixed) plus Re. 1 for each unit completed (variable). If he increases his weekly output from 1,000 units to 1,500 units, his earnings increase from Rs 2500 to Rs 3,000.

An increase of 50% in output brings only a 20% increases in his earnings.

Mathematically, mixed costs can be expressed as follows:

Total Mixed Cost = Total Fixed Cost + (Units x Variable Cost per Unit)

Cost Volume-Profit (CVP) relationship is an analysis which studies the relationships between the following factors and its impact on the amount of profits.

In simple words, CVP is a management accounting tool that expresses relationship among total sales, total cost and profit. Cost Volume-Profit relationship is one of the important techniques of cost and management accounting. It is a powerful tool which furnishes the complete picture of the profit structure and helps in planning of profits. It can also answer what if type of questions by telling the volume required to produce. This concept is relevant in all decision making areas, particularly in the short run.

Managerial accounting provides useful tools, such as cost-volume-profit relationships, to aid decision-making. Cost volume profit relationship helps you understand different ways to meet your company’s net income goals.

1. The Basics of Cost-Volume-Profit (CVP) Analysis

Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters.

(a) Contribution Margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit.

(b) Unit Contribution Margin

The unit contribution margin can be used to predict changes in total contribution margin as a result of changes in the unit sales of a product. To do this, the unit contribution margin is simply multiplied by the change in unit sales. Assuming no change in fixed costs, the change in total contribution margin falls directly to the bottom line as a change in profits.

(c) Contribution Margin Ratio

The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given dollar change in total sales. The contribution margin ratio is often easier to work with than the unit contribution margin, particularly when a company has many products. This is because the contribution margin ratio is denominated in sales dollars, which is a convenient way to express activity in multi-product firms.

2. Some Applications of CVP Concepts

CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on profit of a change in any one (or any combination) of these parameters. A variety of examples of applications of CVP are provided in the text.

3. CVP Relationships in Graphic Form

CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs at the point where the total revenue and total expenses lines cross.

4. Break-Even Analysis and Target Profit Analysis

Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero.

(a) Basic CVP equations

Both the equation and contribution (formula) methods of break-even and target profit analysis are based on the contribution approach to the income statement. The format of this statement can be expressed in equation form as:

Profits = Sales – Variable expenses – Fixed expenses

(b) Break-even point using the equation method

The break-even point is the level of sales at which profit is zero. It can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses. Break-even analysis can be approached either by the equation method or by the contribution margin method. The two methods are logically equivalent.

Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of dollars:

Margin of safety in dollars = Total sales – Break-even sales

Cost Structure

Cost structure refers to the relative proportion of fixed and variable costs in an organization. Understanding a company’s cost structure is important for decision-making as well as for analysis of performance.

Operating Leverage

Operating leverage is a measure of how sensitive net operating income is to a given percentage change in sales.

Assumptions in CVP Analysis

Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic.

• Selling price is constant: The assumption is that the selling price of a product will not change as the unit volume changes. This is not wholly realistic since unit sales and the selling price are usually inversely related. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic assumptions. A number of examples and problems in the text show how to use CVP analysis to investigate situations in which prices are changed.
• Costs are linear and can be accurately divided into variable and fixed elements: It is assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable. It also implies that the fixed costs are really fixed. When volume changes dramatically, this assumption becomes tenuous. Nevertheless, if the effects of a decision on fixed costs can be estimated, this can be explicitly taken into account in CVP analysis. A number of examples and problems in the text show how to use CVP analysis when fixed costs are affected.
• The sales mix is constant in multi-product companies: This assumption is invoked so as to use the simple break-even and target profit formulas in multi-product companies. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence on the results of CVP analysis. If a manager can predict how the sales mix will change, then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed.
• In manufacturing companies, inventories do not change: It is assumed that everything the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting net operating income and the profits calculated using the contribution approach. This topic is covered in detail in the chapter on variable costing.

Although management actions differ from organization to organization, they generally follow a four-stage management process. As illustrated at the beginning of this chapter and in the chapters that follow, the four stages of this process are:

• Planning
• Performing
• Evaluating
• Communicating

Management accounting is essential in each stage of the process as managers make business decisions.

1. Planning

Diagram below shows the overall framework in which planning takes place. The overriding goal of a business is to increase the value of the stakeholders’ interest in the business. The goal specifies the business’s end point, or ideal state. For example, Wal-Mart’s end point is “to become the worldwide leader in retailing.”

A company’s mission statement describes the fundamental way in which the company will achieve its goal of increasing stakeholders’ value. It also expresses the company’s identity and unique character.

The mission statement is essential to the planning process, which must consider how to add value through strategic objectives, tactical objectives, and operating objectives.

Strategic objectives are broad, long-term goals that determine the fundamental nature and direction of a business and that serve as a guide for decision making. Strategic objectives involve such basic issues as what a company’s main products or services will be, who its primary customers will be, and where it will operate.

Tactical objectives are mid-term goals that position an organization to achieve its long-term strategies. These objectives, which usually cover a three to five-year period, lay the groundwork for attaining the company’s strategic objectives.

Operating objectives are short-term goals that outline expectations for the performance of day-to-day operations. Operating objectives link to performance targets and specify how success will be measured.

To develop strategic, tactical, and operating objectives, managers must formulate a business plan. A business plan is a comprehensive statement of how a company will achieve its objectives. It is usually expressed in financial terms in the form of budgets, and it often includes performance goals for individuals, teams, products, or services

2. Performing

Planning alone does not guarantee satisfactory operating results. Management must implement the business plan in ways that make optimal use of available resources in an ethical manner. Smooth operations require one or more of the following:-

• Hiring and training personnel
• Matching human and technical resources to the work that must be done
• Purchasing or leasing facilities
• Maintaining an inventory of products for sale
• Identifying operating activities, or tasks, that minimize waste and improve the quality of products or services

Critical to managing any retail business is a thorough understanding of its supply chain. The supply chain is the path that leads from the suppliers of the material to its final consumers. The supply chain expresses the links between businesses growers to vendors to the business to their customers.

3. Evaluating

When managers evaluate operating results, they compare the organization’s actual performance with the performance levels they established in the planning stage. They earmark any significant variations for further analysis so that they can correct the problems. If the problems are the result of a change in the organization’s operating environment, the managers may revise the original objectives. Ideally, the adjustments made in the evaluation stage will improve the company’s performance.

4. Communicating

Whether accounting reports are prepared for internal or external use, they must provide accurate information and clearly communicate this information to the reader. Inaccurate or confusing internal reports can have a negative effect on a company’s operations. Full disclosure and transparency in financial statements issued to external parties is a basic concept of generally accepted accounting principles, and violation of this principle can result in stiff penalties.

a. Define the Investment Goals

What is the purpose of my investment? Answer to this should be the foundation of your mutual fund choices. For instance, if you want a regular income with capital protection, you can choose to invest in a debt fund. However, if you have a higher risk appetite and an aim to build your wealth, equities will suit your purpose. So it is crucial to define your financial goal first and then decide your investment. This also has a pivotal role in fund evaluation.

b. Shortlist a few peer Funds to compare

It is difficult to assess a mutual fund in isolation. So, you should always make a small list of comparable funds and continuously compare them. There are many FinTech firms and third party websites that offer free mutual fund screener tools.

c. Check the historical Performance Data

Now every mutual fund handbook comes with a disclaimer stating that past performance is no indicator of future performance. However, this data can help you check how the fund has fared across different market cycles. Consistency can also shed light on the skill of the fund manager. In short, it will be easier for you to find a fund with lower risks but higher returns.

d. Fee Structure of the Fund

A mutual fund company charges you for its services and expertise. Some funds require deft management and quick decisions on whether to buy, sell or hold on to an asset. Please remember that a fund with a higher fee is automatically better. Do check out other parameters too before choosing.

e. Risk-Adjusted Returns

Every fund expects certain risks related to the market and the industry. When fund strategies in such a way that they make more returns against anticipated risks, we call them risk-adjusted returns.

f. Performance against Index

Indexes like Nifty, BSE Sensex and BSE 200 set benchmarks, and all fund performances are evaluated on this basis. Comparing different timelines against the benchmark as well as peers, can be insightful. A well-managed fund won’t fall too hard during a market low.

Why track the Investment Performance

You might have seen the disclaimer that past performance does not indicate the future performance of a fund’. It means that you cannot expect guaranteed returns on investment. Therefore, you need to look beyond the previous years’ returns to assess a mutual fund. Primarily, you should monitor your investments so that you can make informed decisions that can lead to higher returns.

You know that the capital market keeps fluctuating with changes in the overall economic conditions. Such a change disturbs the asset allocation of the portfolio. For instance, an original allocation of 50:50 in equity and debt may change to 60:40 owing to a market rally. It may increase the risk profile of the fund beyond your requirements. Fund evaluation also helps you to compare the performance of your investment against other similar funds. Additionally, a change in fund manager or fundamental attributes of your fund may also trigger an evaluation. Hence, a review and rebalancing might be required to keep the risk profile of the portfolio intact.

How often to Evaluate Fund Performance

The market is subject to fluctuations. However, that doesn’t mean you need to assess the fund performance daily. Ideally, you should evaluate your fund every six months to a year, depending on the tenure of the investment. Evaluating the funds in a shorter period does not give an accurate insight into the performance of your investments. If all this sounds too much, you may invest in regular funds. As qualified intermediaries, they advise you to invest in funds based on your financial goals and risk profile.

Financial Ratios & Fund Performance 

While you may have taken due diligence and advice before investing, you still need to track the performance of your funds. The easiest way to do it is by using the fund fact sheet. In simple terms, the fund fact sheet shows the performance of all the schemes managed by your fund house, including your investment. You must compare these financial ratios with the mutual fund schemes in the same category to understand where your fund stands.

a. Alpha

The fund’s Alpha gives an overview of the fund manager’s skills and strategies and how they fared in the past. It should always be higher than the expense ratio of the fund. Additionally, your fund’s Alpha needs to be higher than the peers, which are at a similar level of beta.

b. Expense Ratio

This is essentially the fee for the fund house for managing your mutual fund. Expense ratios reflects the value-for-money aspect of a fund. It consists of fund management charges and all the other costs related to that of fund management. It impacts your ultimate take-home returns.

c. Benchmark

It is always advisable to compare the fund performance against the benchmark. The benchmark acts as a standard for funds’ performance. If your fund is outperforming the benchmark consistently, it is a sign that the fund is doing well. You can also compare the average return during a specific time frame with its peer funds in the same category.

d. Portfolio Holdings

Look for considerable changes and probable overlapping in the portfolio holdings. The fund needs to hold good quality stocks which have a lower Price to Earnings-per-share (P/E) Ratio vis-a-vis Price to Book Value (P/B) ratio. Additionally, ensure that the fund is investing as per its investment objective. For instance, fund having a high portfolio turnover ratio vis-a-vis lower returns is a bad indicator.

e. Sharpe Ratio

This ratio shows how much extra return you receive for the additional risks you undertake. It is a rule of thumb that higher risks must be compensated more. Moreover, you deserve a reward (excess returns) for the added volatility. Sharpe Ratio tells you how much exactly that reward should be.