Tag: University of Mumbai BMS Notes

Budgeting is the process of preparing detailed projections of future amounts. Companies often engage in two types of budgeting:

• Operational budgeting, and
• Capital budgeting

Examples of Operational Budgeting

In a business, the budgeting for operations will include preparing the following projections for the next accounting year:

• Amounts for sales
• Amounts for producing goods
• Amounts for each department’s expenses
• Summarizing the above budgets into a master budget or profit plan
• Cash receipts and disbursements for a cash budget
• Projected financial statements also referred to as pro-forma financial statements

Once prepared and approved, the budgeted amounts are used as a guide or road map in controlling the next year’s business activities.

Example of Capital Budgeting

Capital budgeting involves future projects which overlap several or many future accounting periods. Capital budgeting usually means listing each project along with its cash outlays and expected cash inflows for each year. The amounts should be discounted to their present values and also ranked by priority and profitability.

Once prepared, the capital budget provides a guide for investing in future fixed assets as well as arranging for the financing of the projects.

Approaches to budgeting process

Budgeting can be done in a variety of ways, and it is always a smart choice to be aware of more than just a single way of budgeting. However, two of the most important approaches to budgeting process are:

Top-Down Budget

In the top-down budgeting process, the primary input is made by the top-level executives of the business. The echelon of a certain organizational hierarchy lays down all the guidelines according to which budget will be made. They outline the financial goals that a budget should maintain. Moreover, guidelines related to sales budget, compensation, etc. are all given by the top management. The lower level management is given the least amount of participation in the budgeting process. They are only involved in executing these guidelines.

Bottom-Up Budget

The bottom-up approach to budgeting adopts a more inclusive approach towards the budgeting process. Although the upper-level management gives out the general guidelines related for a budget, however, employees and the lower management formulate these budgets. Each division of the organization forms its budget in accordance to the general guidelines. In the end, the budget of the entire organization is formed by combining the individual budgets of each division. The bottom-up approach for a budgeting process is highly inclusive in nature. The employees overall tend to be much more committed to working under the budget in this approach. This is due to the fact that employees have participated in drawing up a budget and therefore they know that the budget is very acceptable.

Components of budget

There are many divisions of an organization and therefore budgeting for each of the division is specific to its needs. When all the budgets of each division are combined, it results into the final budget, which is often referred to as the “Master Budget”. Various components of the budget are discussed as follows:

Sales Budget

Sales budget outlines the forecasted income stream of the business. It is usually the first budget to be prepared as the revenue generated will ultimately determine the level of expenditure. Under the sales budget, sales of the business are forecasted. Sales are forecasted in terms of sales volume and the sales revenue. The forecasting is done on the following basis:

• Previous pattern of sales
• Economic conditions e.g. rate of inflation, interest rate, exchange rate, economic growth rate
• Political conditions
• State of competition in the market
• Other factors that can affect the sales e.g. technology, etc.

Production Budget

The production budget is of high importance in the overall budgeting process. It determines the number of units of a product that will be produced by the business. It also determines the cost at which the products have to be produced. Production budget is made according to the sales budget. Required sales units, opening inventory and required closing inventory are used to reach the number of units that have to be produced in a budgeted period.

Direct Material Purchases Budget

Direct materials, like the name suggests, are the ones that are being used directly in the production of goods. The budget related to direct material determines the amount and cost of these resources that will be required in the production activity.

Labor, Overhead, and SG&A Budget

Budgets related to labor, overhead and SG&A (selling, general and administrative) are prepared separately. They are then combined under a single head.

The direct labor budget is prepared. Labor that participates in the production process forms the direct labor cost. This budget is prepared according to the number of labor hours and the cost per hour.

Overheads are those costs that are not incurred directly in the production of goods, but are indispensable with regard to the production activity e.g. rent of the factory. The budget of the overhead cost is prepared in relation to the direct labor hours.

SG&A costs are incurred in order to conduct the day to day operations of a business. They consist of fixed and variable costs.

Cash Budget

Cash is known to have a similar importance to a business as blood has to body. No matter how successful a business is, if it runs out of cash, its survival is seriously jeopardized. In order to ensure smooth operations of the business, strong emphasis must be laid upon the development of cash budget. Cash budget helps to formulate in advance the payment and receipt cycles of the business and thus it ensures that cash is readily available to a business. By formulating cash budget, the business can keep track of its accounts receivables and accounts payable. In order to avoid shortage of cash, the business can arrange its credit plans related to accounts receivables and accounts payable accordingly.

Budgeted Financial Statements

Budgeted financial statements are prepared on the basis of each budget component. These budgeted financial statements are called pro forma financial statements. Through the budgeted financial statements, a business will be able to forecast its profits. Profit forecasting is important because it will determine the viability of carrying out the business.

Steps in the budgeting process

Budgeting is a detailed process with several intricate steps leading up to understanding it at large. A step-by-step guide to the budgeting process is given as below.

1. Update budget assumptions

Budgets are always prepared on certain assumptions. Those assumptions could be related to the sales trends, cost trends or environmental conditions. Before embarking on preparing the budget, these assumptions must be thoroughly reviewed according to the recent environmental conditions.

2. Note Available funding

Limited funding can greatly hinder the growth projects of the business. Therefore, in the preparation of budgets adequate attention has to be given to the available funding as the availability of investable funds will determine the initiation of viable projects.

3. Step costing points

The business environment is subject to dynamism. Every day it is posed with challenges that can completely change its cost structure. Therefore, in the budgeting process certain factors that can affect the costing for the business should be closely considered. These factors should be identified beforehand in order to make the budget realistic.

4. Create budget package

In budget package, previous standards related to the budgeting process are taken in order to formulate a budget for the current period. Previous standards are updated according to the recent environmental conditions. Budget package is a kind of outline according to which budget has to be prepared.

5. Obtain revenue forecast

There is no denying the fact that sales budget is the most crucial budget of all. All the budgets are based on the sales budget. Furthermore, sales budget determines whether the business is generating enough revenue necessary for its survival. Therefore, adequate attention must be given to the preparation of sales budget by forecasting demand accurately.

6. Obtain department budgets

The department budgets will help to reach a budgeted expenditure for the budgeted period. Each department will prepare its own budget and then all of them will be combined to become a part of the master budget.

7. Validate compensation

Compensation plans are a significant component of the budgeting process. As compensation is subject to an annual increase, therefore, it should be prepared with great care. The approval for compensation increase should first be taken from the top management, and then it should be augmented in the budgeted compensation plans.

8. Validate bonus plans

In order to maintain the morale of the employees, bonuses are frequently given to out motivated workers. Bonuses act as an appraisal method. Bonus announcements that are not considered in the budgeting process can create havoc in the profits of the business. Therefore, any bonus plans should be taken into consideration beforehand. The top management should be consulted for any bonus plans.

9. Obtain capital budget requests

Capital expenditure ensures expansion of the business. It helps the business to avail the opportunities necessary for business growth. Any capital expenditure plans should be taken in advance, and they should be included in the budgeting process accordingly.

10. Update the budget model

Any changes in the assumptions of the budget model should be updated, and final budget should be prepared accordingly. A delay in this may lead to glitches later on that could cause confusion.

11. Review the budget

The budget should be reviewed thoroughly once it is prepared in order to correct any flaws. A little decimal placed wrongly can create quite an unbalance in the budget sheet.

12. Obtain approval

The budget should be presented to the top management. They will evaluate whether it has been prepared according to their requirements and finally l approve it if it does not need any changes.

13. Issue the budget

The budget should be formally issued after its approval. All the operations there and then will take place according to it.

Methods of Budgeting

1. Incremental Budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget.  It is the most common method of budgeting because it is simple and easy to understand.  Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year.  However, there are some problems with using the method:

• It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.
• It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.
• It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs. Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.

2. Activity-Based Budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company.  For example, a company sets an output target of $100 million in revenues.  The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

3. Value Proposition Budgeting

In value proposition budgeting, the budgeter considers the following questions:

• Why is this amount included in the budget?
• Does the item create value for customers, staff, or other stakeholders?
• Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

4. Zero-Based Budgeting

As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch.  Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs.  However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.

When the actual cost differs from the standard cost, it is called variance. If the actual cost is less than the standard cost or the actual profit is higher than the standard profit, it is called favorable variance. On the contrary, if the actual cost is higher than the standard cost or profit is low, then it is called adverse variance.

Each element of cost and sales requires variance analysis. Variance is classified as follows:

• Direct Material Variance
• Direct Labor Variance
• Overhead Variance
• Sales Variance

Direct Material Variance

Material variances can be of the following categories:

• Material Cost Variance
• Material Price Variance
• Material Usage Variance
• Material Mix Variance
• Material Yield Variance

Material Cost Variance
Standard cost of materials for actual output – Actual cost of material used Or Material price variance + Material usage or quantity variance Or Material price variance + Material mix variance + Material yield variance
Material Price Variance
Actual usage ( Standard Quantity Price – Actual Unit Price) Actual Usage = Actual Quantity of material (in units) used Standard Unit Price = Standard Price of material per unit Actual Unit Price = Actual price of material per unit
Material Usage or Quantity Variance
Material usage or Quantity variance: Standard price per unit (Standard Quantity – Actual Quantity )
Material Mix Variance
Material mix variance arises due to the difference between the standard mixture of material and the actual mixture of Material mix. Material Mix variance is calculated as a difference between the standard prices of standard mix and the standard price of actual mix. If there is no difference between the standard and the actual weight of mix, then: Standard unit cost (Standard Quantity – Actual Quantity ) Or Standard Cost of Standard Mix – Standard cost of Actual Mix Sometimes due to shortage of a particular type of material, standard is revised; then: Standard unit cost (Revised Standard Quantity – Actual Quantity) Or Standard cost of revised Standard Mix – Standard Cost of Actual mix If the actual weight of mix differs from the standard weight of mix, then: Standard cost of revised standard mix × (Total weight of actual mix /mixTotal weight of revised standard mix)
Material Yield Variance
When the standard and the actual mix do not differ, then Yield Variance = Standard Rate × (Actual Yield – Standard Yield) Standard Rate = Standard cost of standard mix /Net standard output (i.e.Gross output−Standard loss)

Direct Labor Variance

Direct labor variances are categorized as follows:

• Labor Cost Variance
• Labor Rate of Pay Variance
• Total Labor Efficiency Variance
• Labor Efficiency Variance
• Labor Idle Time Variance
• Labor Mix Variance or Gang Composition Variance
• Labor Yield Variance or Labor Efficiency Sub Variance
• Substitution Variance

Labor Cost Variance

Standard Cost of Labor – Actual Cost of Labor

Labor Rate of pay Variance

Actual Time taken × (Standard Rate – Actual Rate)

Total Labor Efficiency Variance

Standard rate × (Standard time – Actual time)

Labor Efficiency Variance

Standard Rate (Standard time for actual output – Actual time worked)

Labor Idle Time Variance

Idle Time Variance = Abnormal Idle Time × Standard Rate Total Labor Cost Variance = Labor rate of Pay variance + Total labor Efficiency Variance Total Labor Efficiency Variance = Labor Efficiency Variance + Labor Idle Time Variance

Labor Mix Variance or Gang Composition Variance

If actual composition of labor is equal to standard: LMV = Standard Cost of Standard Composition (for Actual time taken) – Standard Cost of Actual Composition (for Actual time worked) If standard composition of labor revised due to shortage of any specific type of labor but the total actual time is equal to the total standard time: LMV = Standard Cost of Revised Standard Composition (for Actual Time Taken) – Standard Cost of Actual Composition (for Actual Time Worked) If actual and standard time of labor differs: = (Total time of actual labor composition/ Total time of standard labor composition) × Std.cost of std.composition − Std.cost of actual composition In case the Standard is revised and there is a difference in the total Actual and the Standard time: = (Total time of actual labor composition/Total time of revised std./labor composition) × Std.cost of (revised std.composition − actual composition)

Labor Yield Variance

Std. Labor Cost per unit × (Actual Yield In units – Std. Yield in units expected from Actual time worked on production)

Substitution Variance

(Actual hrs × Std. Rate of Std. Worker) – (Actual hrs × Std.Rate actual worker)

 

Fixed Budget:

This budget is drawn for one level of activity and one set of conditions. It has been defined as a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained. It is rigid budget and is drawn on the assumption that there will be no change in the budgeted level of activity. It does not take into consideration any change in expenditure arising out of changes in the level of activity.

Thus, it does not provide for changes in expenditure arising out of change in the anticipated conditions and activity. A fixed budget will, therefore, be useful only when the actual level of activity corresponds to the budgeted level of activity.

A master budget tailored to a single output level of (say) 20,000 units of sales is a typical example of a fixed budget. But, in practice, the level of activity and set conditions will change as a result of internal limitations and external factors like changes in demand and prices, shortages of materials and power, acute competition etc.

It is hardly of any use as a mechanism of budgetary control because it does not make any distinction between fixed, variable and semi-variable costs and provides for no adjustment in the budgeted figures as a result of change in cost due to change in level of activity. It does not provide a meaningful basis for comparison and control. It is also not helpful at all in the fixation of price and submission offenders.

Flexible Budget:

The Chartered Institute of Management Accountants, England, defines a flexible budget (also called sliding scale budget) as a budget which, by recognising the difference in behaviour between fixed and variable costs in relation to fluctuations in output, turnover, or other variable factors such as number of employees, is designed to change appropriately with such fluctuations. Thus, a flexible budget gives different budgeted costs for different levels of activity.

A flexible budget is prepared after making an intelligent classification of all expenses between fixed, semi-variable and variable because the usefulness of such a budget depends upon the accuracy with which the expenses can be classified.

Such a budget is prescribed in the following cases:

(i) Where the level of activity during the year varies from period to period, either due to the seasonal nature of the industry or to variation in demand.

(ii) Where the business is a new one and it is difficult to foresee the demand.

(iii) Where the undertaking is suffering from shortage of a factor of production such as materials, labour, plant capacity etc. The level of activity depends upon the availability of such a factor of production.

(iv) Where an industry is influenced by changes in fashion.

(v) Where there are general changes in sales.

(vi) Where the business units keep on introducing new products or make changes in the design of its products frequently.

(vii) Where the industries are engaged in make to order business like ship-building.

Utility (or Importance) of Flexible Budget

1. Flexible budget provides a logical comparison of budgeted allowances with the actual cost i.e., a comparison with like basis.
2. Flexible budget reckons operational realities and streamlines control function and profit planning. It gives balanced perspective on comparison. When flexible budget is prepared, actual cost at actual activity is compared with budgeted cost at actual activity i.e., two things to a like basis.
3. Flexible budget recognises concept of variability and provides logical comparison of expenditure with actual expenditure as a means of control.
4. With flexible budget, it is possible to establish budgeted cost for any range of activity.
5. A flexible budget is very useful for purposes of budgetary control because it corresponds with changes in the level of activity.
6. It is helpful in assessing the performance of departmental heads because their performance can be judged in relation to the level of activity attained by the organisation.
7. Cost ascertainment at different levels of activity is possible because a flexible budget is prepared for various levels of activity.
8. It is helpful in price fixation and sending quotations.

Difference

	Fixed Budget	Flexible Budget
Meaning	The budget designed to remain constant, regardless of the activity level reached is Fixed Budget.	The budget designed to change with the change in the activity levels is Flexible Budget.
Nature	Static	Dynamic
Activity Level	Only one	Multiple
Performance Evaluation	Comparison between actual and budgeted levels cannot be done accurately, if there is a distinction in their activity levels.	It provides a good base for making a comparison between the actual and budgeted levels.
Rigidity	Fixed Budget cannot be modified as per the actual volume.	Flexible budget can be easily modified in accordance with the activity level attained.
Estimates	Based on assumption	Realistic and Practical

Direct labour variances arise when actual labour costs are different from standard labour costs. In analysis of labour costs, the emphasis is on labour rates and labour hours.

Labour variances constitute the following:

Labour Cost Variance:

Labour cost variance denotes the difference between the actual direct wages paid and the standard direct wages specified for the output achieved.

This variance is calculated by using the following formula:

Labour cost variance = (AH x AR) – (SH x SR)

Where:

AH = Actual hours

AR = Actual rate 

SH = Standard hours

SR = Standard rate

Labour Efficiency Variance:

The calculation of labour efficiency or usage variance follows the same pattern as the computa­tion of materials usage variance. Labour efficiency variance occurs when labour operations are more efficient or less efficient than standard performance. If actual direct labour hours required to complete a job differ from the number of standard hours specified, a labour efficiency variance results; it is the difference between actual hours expended and standard labour hours specified multiplied by the stand­ard labour rate per hour.

Labour efficiency variance is computed by applying the following formula:

Labour efficiency variance = (Actual hours – Standard hours for the actual output) x Std. rate per hour.

Assume the following data:

Standard labour hour per unit = 5 hr

Standard labour rate per hour = Rs 30

Units completed = 1,000

Labour cost recorded = 5,050 hrs @ Rs 35

Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable) It may be noted that the standard labour hour rate and not the actual rate is used in computing labour efficiency variance. If quantity variances are calculated, changes in prices/rates are excluded, and when price variances are calculated, standard quantities are ignored.

(i) Labour Mix Variance:

Labour mix variance is computed in the same manner as materials mix variance. Manufacturing or completing a job requires different types or grades of workers and production will be complete if labour is mixed according to standard proportion. Standard labour mix may not be adhered to under some circumstances and substitution will have to be made. There may be changes in the wage rates of some workers; there may be a need to use more skilled or expensive types of labour, e.g., employ­ment of men instead of women; sometimes workers and operators may be absent.

These lead to the emergence of a labour mix variance which is calculated by using the following formula:

Labour mix variance = (Actual labour mix – Revised standard labour mix in terms of actual total hours) x Standard rate per hour

(ii) Labour Yield Variance:

The final product cost contains not only material cost but also labour cost. Therefore, gain or loss (higher or lower output than the standard output) should take into account labour yield variance also. A lower output simply means that final output does not correspond with the production units that should have been produced from the hours expended on the inputs.

It can be computed by ap­plying the following formula:

Labour yield variance = (Actual output – Standard output based on actual hours) x Av. Std. Labour Rate per unit of output.

Or

Labour yield variance = (Actual loss – Standard loss on actual hours) x Average standard labour rate per unit of output

Labour yield variance is also known as labour efficiency sub-variance which is computed in terms of inputs, i.e., standard labour hours and revised labour hours mix (in terms of actual hours).

Labour efficiency sub-variance is computed by using the following formula:

Labour efficiency sub-variance = (Revised standard mix – standard mix) x Standard rate

Labour Rate Variance:

Labour rate variance is computed in the same manner as materials price variance. When actual direct labour hour rates differ from standard rates, the result is a labour rate variance. It is that portion of the direct wages variance which is due to the difference between actual rate paid and standard rate of pay specified.

The formula for its calculation is:

Labour rate variance = (Actual rate – Standard rate) x Actual hours

Using data from the example given above, the labour rate variance is Rs 25,250, i.e.,

Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250 (unfavourable)

The number of actual hours worked is used in place of the number of the standard hours speci­fied because the objective is to know the cost difference due to change in labour hour rates, and not hours worked. Favourable rate variances arise whenever actual rates are less than standard rates; unfavourable variances occur when actual rates exceed standard rates.

Idle Time Variance:

Idle time variance occurs when workers are not able to do the work due to some reason during the hours for which they are paid. Idle time can be divided according to causes responsible for creat­ing idle time, e.g., idle time due to breakdown, lack of materials or power failures. Idle time variance will be equivalent to the standard labour cost of the hours during which no work has been done but for which workers have been paid for unproductive time.

Activity-based costing (ABC) is a methodology for more precisely allocating overhead costs by assigning them to activities. Once costs are assigned to activities, the costs can be assigned to the cost objects that use those activities. The system can be employed for the targeted reduction of overhead costs. ABC works best in complex environments, where there are many machines and products, and tangled processes that are not easy to sort out. Conversely, it is of less use in a streamlined environment where production processes are abbreviated.

The Activity Based Costing Process Flow

Activity-based costing is best explained by walking through its various steps. They are:

1. Identify costs. The first step in ABC is to identify those costs that we want to allocate. This is the most critical step in the entire process, since we do not want to waste time with an excessively broad project scope. For example, if we want to determine the full cost of a distribution channel, we will identify advertising and warehousing costs related to that channel, but will ignore research costs, since they are related to products, not channels.
2. Load secondary cost pools. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services. The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs. These costs are later allocated to other cost pools that more directly relate to products and services. There may be several of these secondary cost pools, depending upon the nature of the costs and how they will be allocated.
3. Load primary cost pools. Create a set of cost pools for those costs more closely aligned with the production of goods or services. It is very common to have separate cost pools for each product line, since costs tend to occur at this level. Such costs can include research and development, advertising, procurement, and distribution. Similarly, you might consider creating cost pools for each distribution channel, or for each facility. If production batches are of greatly varying lengths, then consider creating cost pools at the batch level, so that you can adequately assign costs based on batch size.
4. Measure activity drivers. Use a data collection system to collect information about the activity drivers that are used to allocate the costs in secondary cost pools to primary cost pools, as well as to allocate the costs in primary cost pools to cost objects. It can be expensive to accumulate activity driver information, so use activity drivers for which information is already being collected, where possible.
5. Allocate costs in secondary pools to primary pools. Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools.
6. Charge costs to cost objects. Use an activity driver to allocate the contents of each primary cost pool to cost objects. There will be a separate activity driver for each cost pool. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based on their use of the activity driver.
7. Formulate reports. Convert the results of the ABC system into reports for management consumption. For example, if the system was originally designed to accumulate overhead information by geographical sales region, then report on revenues earned in each region, all direct costs, and the overhead derived from the ABC system. This gives management a full cost view of the results generated by each region.
8. Act on the information. The most common management reaction to an ABC report is to reduce the quantity of activity drivers used by each cost object. Doing so should reduce the amount of overhead cost being used.

We have now arrived at a complete ABC allocation of overhead costs to those cost objects that deserve to be charged with overhead costs. By doing so, managers can see which activity drivers need to be reduced in order to shrink a corresponding amount of overhead cost. For example, if the cost of a single purchase order is $100, managers can focus on letting the production system automatically place purchase orders, or on using procurement cards as a way to avoid purchase orders. Either solution results in fewer purchase orders and therefore lower purchasing department costs.

Uses of Activity Based Costing

The fundamental advantage of using an ABC system is to more precisely determine how overhead is used. Once you have an ABC system, you can obtain better information about the following issues:

• Activity costs. ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.
• Customer profitability. Though most of the costs incurred for individual customers are simply product costs, there is also an overhead component, such as unusually high customer service levels, product return handling, and cooperative marketing agreements. An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit. This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits.
• Distribution cost. The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogs. Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even to drop unprofitable channels.
• Make or buy. ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item is outsourced, versus which costs will remain.
• Margins. With proper overhead allocation from an ABC system, you can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resources to earn the largest margins.
• Minimum price. Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold.
• Production facility cost. It is usually quite easy to segregate overhead costs at the plant-wide level, so you can compare the costs of production between different facilities.

Clearly, there are many valuable uses for the information provided by an ABC system. However, this information will only be available if you design the system to provide the specific set of data needed for each decision. If you install a generic ABC system and then use it for the above decisions, you may find that it does not provide the information that you need. Ultimately, the design of the system is determined by a cost-benefit analysis of which decisions you want it to assist with, and whether the cost of the system is worth the benefit of the resulting information.

Problems with Activity Based Costing

Many companies initiate ABC projects with the best of intentions, only to see a very high proportion of the projects either fail or eventually lapse into disuse. There are several reasons for these issues, which are:

• Cost pool volume. The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools – and the more cost pools there are, the greater the cost of managing the system. To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information. Doing so should keep the number of cost pools down to manageable proportions.
• Installation time. ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations.
• Multi-department data sources. An ABC system may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers.
• Project basis. Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a company’s current operational situation, and it gradually declines in usefulness as the operational structure changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be “done” once and then discarded. To mitigate this issue, build as much of the ABC data collection structure into the existing accounting system, so that the cost of these projects is reduced; at a lower cost, it is more likely that additional ABC projects will be authorized in the future.
• Reporting of unused time. When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyone’s work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth. Employees usually mask these activities by apportioning more time to other activities. These inflated numbers represent misallocations of costs in the ABC system, sometimes by quite substantial amounts.
• Separate data set. An ABC system rarely can be constructed to pull all of the information it needs directly from the general ledger. Instead, it requires a separate database that pulls in information from several sources, only one of which is existing general ledger accounts. It can be quite difficult to maintain this extra database, since it calls for significant extra staff time for which there may not be an adequate budget. The best work-around is to design the system to require the minimum amount of additional information other than that which is already available in the general ledger.
• Targeted usage. The benefits of ABC are most apparent when cost accounting information is difficult to discern, due to the presence of multiple product lines, machines being used for the production of many products, numerous machine setups, and so forth – in other words, in complex production environments. If a company does not operate in such an environment, then it may spend a great deal of money on an ABC installation, only to find that the resulting information is not overly valuable.

The broad range of issues noted here should make it clear that ABC tends to follow a bumpy path in many organizations, with a tendency for its usefulness to decline over time. Of the problem mitigation suggestions noted here, the key point is to construct a highly targeted ABC system that produces the most critical information at a reasonable cost. If that system takes root in your company, then consider a gradual expansion, during which you only expand further if there is a clear and demonstrable benefit in doing so. The worst thing you can do is to install a large and comprehensive ABC system, since it is expensive, meets with the most resistance, and is the most likely to fail over the long term.

Fixation of selling price of a product is, no doubt, one of the most significant factors in modern management.

It becomes necessary for various purposes, like, under normal circumstances of the interest; at trade depression, accepting additional order etc.

Under normal conditions, according to Financial Accounting technique, the selling price of the product must cover the total cost plus a certain margin of profit. But, under Marginal Costing technique, the price must equal the marginal cost plus a certain amount which depends on the nature, variety, demand and supply, policy pricing and other related factors.

Needless to mention that, if the selling price of the product is fixed at Marginal Cost, the amount of loss will be the amount of fixed overheads and the amount of loss will be same or lower if the production is suspended or closed down.

That is why selling in all the periods/loss must be higher than Marginal Cost. In this regard we should remember that it would be easier for us if profitability of a product is known while fixation of selling price.

Illustration:

X Ltd. has an average P/V ratio of 50%. The Marginal Cost of a product is estimated at Rs. 30. What will be the amount of selling price?

Solution:

If selling price is Rs. 100, Variable Cost will be Rs. 50 i.e., contribution will be Rs. 50.

Thus, P/V Ratio = C/S = Rs. 50/Rs.100 = ½ or 50%

So, the selling price which have a marginal cost of Rs. 60 should be:

100 /50 x Rs. 30 = Rs. 60

Alternatively

P/V Ratio = S – V/S

or,.

Variable Cost/Sales = 50/100

Selling Price will be = Variable Cost/sales = Rs. 30/50%= Rs. 60

1. Preparation of Organization Manual

The organization manual contains the duties, powers, scope and responsibilities of each executive in an organization. Moreover, it indicates the means and line of communication between the executives. This prevents the overlapping of functions.

2. Appointment and Training of Employees

Right candidates should be appointed and suitable training should be provided to them. If so, they can perform their work independently very effectively.

3. Preparation of Various Forms and Reports

The top management can design various forms and decide the contents of reports according to the needs of managerial decision making. The main objective of preparing various forms and reports is avoiding “Bureaucratization”.

4. Classification and Codification of Accounts

The financial accounting information is classified and codified for effective analysis and interpretation. The accounts are classified on the basis of nature of accounts. The codification accounts facilitate for easy identification of accounts.

5. Setting up of Cost Centres

There is a need of setting up of cost centre, profit centre, investment centre and budget centre. If so, only relevant information is collected and analysed in relation to each of them.

6. Integration of Cost and Financial Data

Both cost accounting data and financial accounting data are used in the management accounting. Hence, there is a need of suitable system to integrate both cost accounts and financial accounts. It avoids duplication of data. The integration system should be accurate and reliable.

7. Introducing Management Accounting Techniques

The needs of one business organization is differing from another. The top management can introduce various management accounting techniques on the needs of organization and practicability.

8. Setting up of Budgetary Control System

Every organization should prepare the budgets in order to achieve its objectives economically and efficiently. Hence, the management should establish suitable budgetary control system. Moreover, the proposed system should be flexible and accommodate the changes in future.

9. Using of Operations Research Techniques

Every business is running under fast changing economic, political and social environment. Everyday number of new types of problems may be encountered by the management. The Operations Research Techniques are highly useful to cope with the emerging problems.

10. Formulating Standard Costing Techniques

The top management can fix the standard for every business activity relating to cost and revenue. If so, the actual performance can be used to measure the deviations from the standard. Thus, standards are fixed at all levels. The standard should be one which can be adopted by a normal employee.

Management accounting is an important tool of management. Hence, it serves the management in many ways. Even though, the management accounting has some limitations or disadvantages. They are briefly explained below:

Limitations or disadvantages of management accounting

1. Based on Financial and Cost Records

Both financial and cost accounting information are used in the management accounting system. The accuracy and validity of management account is largely based on the accuracy if financial and cost records maintained. These records determine the Strength and weakness of management accounting.

2. Personal Bias

The analysis and interpretation of financial statements are fully depending upon the capability of the analyst and interpreter. Hence, personal prejudices and bias of an individual can affect the objectivity and effectiveness of the conclusions and recommendations.

3. Lack of Knowledge and Understanding of the Related Subjects

Financial accounting, cost accounting, statistics, economics, psychology and sociology are the related subjects of management accounting. The organization can derive more benefits of management accounting if the management accountant has thorough knowledge over related subjects. If not so, the success of management accounting system is questionable.

4. Provides only Data

Under management accounting system, many alternatives are developed to solve a problem and submitted before the management. Out of the many alternatives available, the management can select any one of alternatives or even discard all of them. Hence, management accounting can only provide data and not prescribe any course of action.

5. Preference to Intuitive Decision Making

Scientific decisions can be taken with the help of using management accounting techniques. But, majority of the management accountant and top level executives prefer their past experience and intuition in making business decisions. The reason is that an intuitive decision making is very simple and easy.

6. Management Accounting is only a Tool

The management accountant is using the management accounting system as a tool to give advice and facilitate the management for decision making. The actual decisions, their implementation and follow up action are the prerogative of the management.

7. Continuity and Participation

The decisions are taken by the management. Their implementation is vested in the hands of management accountant. The continuous efforts of management accountant and full participation of all levels of management are necessary for successful operation of management accounting system.

8. Broad Based Scope

The scope of management accounting is very wide since it considers both monetary and non-monetary transactions of the business organization. The limited knowledge and experience of the management accountant can lead to prepare the data unreliable and undependable.

9. Costly Installation

The cost of installation of management accounting system is very high. Hence, a small business organization can not bear the cost of such installation. Moreover, the utility of this system is restricted only to big and complex organizations.

10. Resistance to Change

The installation of management accounting system brings some changes in the organizational set up and accounting practice. The personnel concerned may resist such changes unless they are getting confidence.

11. Evolutionary State

Management accounting is a recent development discipline. The utility of management accounting is depend upon the intelligent interpretation of the data available for managerial use. Hence, it is presumed that the management accounting stands in evolutionary stage.

12. Unquantifiable Variables

Management accounting seeks to interpret and evaluate an objective historical event on record in terms of money. But, in practice, the business organization is facing many problems which cannot be exposed.

1. Difficulty to analyse overhead: Separation of costs into fixed and variable is a difficult problem. In marginal costing, semi-variable or semi-fixed costs are not considered.
2. Time element ignored: Fixed costs and variable costs are different in the short run; but in the long run, all costs are variable. In the long run all costs change at varying levels of operation. When new plants and equipment are introduced, fixed costs and variable costs will vary.
3. Unrealistic assumption: Assumption of sale price will remain the same at different levels of operation. In real life, they may change and give unrealistic results.
4. Difficulty in the fixation of price: Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus contract, it is very difficult to fix price.
5. Complete information not given: It does not explain the reason for increase in production or sales.
6. Significance lost: In capital-intensive industries, fixed costs occupy major portions in the total cost. But marginal costs cover only variable costs. As such, it loses its significance in capital industries.
7. Problem of variable overheads: Marginal costing overcomes the problem of over and under-absorption of fixed overheads. Yet there is the problem in the case of variable overheads.
8. Sales-oriented: Successful business has to go in a balanced way in respect of selling production functions. But marginal costing is criticised on account of its attaching over- importance to selling function. Thus it is said to be sales-oriented. Production function is given less importance.
9. Unreliable stock valuation: Under marginal costing stock of work-in-progress and finished stock is valued at variable cost only. No portion of fixed cost is added to the value of stocks. Profit determined, under this method, is depressed.
10. Claim for loss of stock: Insurance claim for loss or damage of stock on the basis of such a valuation will be unfavourable to business.
11. Automation: Now-a-days increasing automation is leading to increase in fixed costs. If such increasing fixed costs are ignored, the costing system cannot be effective and depend­able.

Marginal costing, if applied alone, will not be much use, unless it is combined with other techniques like standard costing and budgetary control.

Diversification of Products:

In order to capture a new market or to utilise idle facilities etc., it may so happen that a new product may be introduced in the market together with the existing one. Naturally, the question arises before us whether the same will be a profitable product one.

In this regard it may be mentioned that the new product may be introduced only when the same is capable of contributing something against fixed cost and profit. Fixed cost will not be considered here on the assumption that the same will not increase, i.e., the new product will be produced out of existing resources.

Marginal Costing Application # 3. Selection of Most Profitable Product-Mix:

If any firm produces more than one product it may have to decide in what ratio should the products be produced or sold in order to earn maximum profit. However, the marginal costing techniques help us to a great extent while determining the most profitable product or sales mix.

Contribution under various mix will be determined first. Then the product which gives the highest contribution must be given the highest priority, and vice versa. Similarly, any product which gives negative contribution should be discontinued.

The following illustration will, however, make the principle clear:

Illustration:

The directors of a company are considering sales budget for the next budget period. From the following information you are required to show clearly to management:

(i) The marginal product cost and the contribution per unit;

(ii) The total contribution resulting from each of following sale mixtures;

	Product A (Rs.)	Product B (Rs.)
Direct Material	10	9
Direct Wages	3	2
Selling Price	20	15
Fixed Costs (Total)	800
(Variable Expenses are allotted to products as 100% of direct wages

Sales Mixture:

(a) 100 units of product A and 200 of B

(b) 150 units of product A and 150 of B

(c) 200 units of product A and 100 of B

Recommend which of the sale-mixtures should be adopted.

Solution:

Statement showing the Comparative Contribution of the Products:
	Product A		Product B
	Rs.	Rs.	Rs.	Rs.
Selling Price		200		15
Less: Variable Cost
Direct Material	10		9
Direct Wages	3		2
Variable Expn.	3		2
		16		13
Contribution		4		2
P/V Ratio		20%		13(1/2)%

(ii) From the above Comparative Contribution statement, it becomes clear that as P/V Ratio of Product A is higher in comparison with the Product B, Product A is more profitable one. And, as such, the mixtures which consider the maximum number of Product A would be the most profitable one which is proved from the following table:

Sales Mixture (C) i.e., 200 units of Product A and 100 units of Product B will yield highest contribution.

Product	Contribution Per unit	Sales Mixtures
		Units	Total Cost Rs.	Units	Total Cost Rs.	Units	Total Cost Rs.
A	4	100	400	150	600	200	800
B	2	200	400	150	300	100	200
Total		300	800	300	900	300	1,000