Tag: University of Mumbai BMS Notes

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

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

Establishment of Cost Centres:

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

Types of Standard:

There are three types of standards:

(a) Current Standard:

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

Ideal Standard:

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

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

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

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

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

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

(b) Basic Standard:

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

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

Comparison of Current Standard and Basic Standard:

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

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

(c) Normal Standard:

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

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

Setting the Standards or Establishment of Standard Cost:

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

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

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

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

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

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

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

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

(a) Direct Material Cost:

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

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

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

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

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

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

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

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

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

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

(b) Direct Labour Cost:

Determination of standard direct labour cost will include determination of:

(i) Standard time.

(ii) Standard rate.

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

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

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

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

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

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

Overheads:

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

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

The formula for the calculation of standard rate is:

Standard variable overhead rate:

Standard Hours:

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

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

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

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

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

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

Importance of historical cost concept

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

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

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

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

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

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

Benefits of Historical Cost Accounting:

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

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

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

Limitations of Historical Cost Accounting:

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

The drawbacks of HCA are listed as follows:

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

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

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

(i) There is no inflation, or

(ii) The rate of inflation can be ignored.

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

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

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

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

‘Overstated’ profits become harmful in the following respects:

(a) Over-distribution of dividends.

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

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

(d) Under-pricing of sales.

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

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

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

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

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

(1) Total Overhead Cost Variance:

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

This can be computed by applying the following formula:

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

Or

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

(2) Variable Overhead Variance:

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

The formula for computing this variance is as follows:

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

Or

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

(3) Fixed Overhead Variance:

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

This variance is found by using the following formula:

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

Or

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

Or

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

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

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

This variance is found by using the following:

(Actual variable overhead – Budgeted variable overhead)

(5) Variable Overhead Efficiency Variance:

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

This variance is found by us­ing the following formula:

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

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

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

The formula for comput­ing this variance is as follows:

(Actual fixed overhead – Budgeted fixed overhead)

(7) Fixed Overhead Volume Variance:

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

The formula for computing this variance is as follows:

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

Or

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

Volume variance is further sub-divided into three variances:

(8) Fixed Overhead Calendar Variance:

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

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

The formula is as follows:

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

Then the formulae are:

Hours Basis:

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

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

Output Basis:

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

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

(9) Fixed Overhead Efficiency Variance:

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

The formula is:

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

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

(10) Fixed Overhead Capacity Variance:

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

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

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

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

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

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

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

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

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

The different variances under these categories are listed below:

(A) Two-way Variance Analysis:

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

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

(ii) Volume variance = Fixed volume variance

(B) Three -Way Variance Analysis:

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

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

(ii) Efficiency variance = Variable efficiency variance

(iii) Volume variance = Fixed volume variance

(C) Four-way Variance Analysis:

The four-way analysis includes:

(i) Variable spending variance

(ii) Fixed spending (budget) variance

(iii) Variable efficiency variance

(iv) Fixed volume variance.

Need for Marginal Costing

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

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

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

Against and in favour of marginal costing

Favour

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

Against

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

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

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

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

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

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

where,

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

Calculation of Marginal Cost

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

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

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

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

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

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

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

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

Managerial Uses of Marginal Costing:

(a) Cost Ascertainment:

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

(b) Cost Control:

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

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

(c) Decision-Making:

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

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

(a) Profit planning

(b) Pricing of products

(c) Make or buy decisions

(d) Product mix etc.

Limitations of Marginal Costing:

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

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

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

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

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

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

Some of the areas where a cost control is essential in a Business are:

(I) Labour

(ii) Materials

(iii) Sales

(iv) Overheads

(v) Energy

Costs have been rising faster than ever before. The business executives have neglected the more important task of providing effective information to management for the control and reduction of costs. The management and control of the resources used in most business firms leaves a great deal to be desired.

(i) Labour:

Labour costs have risen in three ways:

(a) Higher basic pay,

(b) Shorter working hours, and

(c) Reduced output.

Reducing labour cost is a little tricky question. It is not possible to reduce wage rates due to the existence of trade unions and minimum wage legislations. The policy of wage reduction is also counter­productive for a management. So to motivate the workers, wage rates would need to be revised up­wards. The reduction in labour costs would be possible only if over time, the rate of output per worker increases faster than the wage rate increase. This is possible by raising labour productivity.

Productivity schemes aimed at paying for more output are self-defeating unless the net result is a reduction in unit cost.

Productivity must be seen as one or other of the following:

(i) Producing more for the same cost, or

(ii) producing the same for a lower cost.

Productivity should mean lower unit costs it is, in other words, cost reduction. This means finding better ways of doing things so that production increases for each hour’s efforts expanded. This is the only way to defeat rising labour costs.

(ii) Material:

The inefficient use of materials is one of the prime causes of increased costs. Wastage through poor control and design has risen to such an extent that waste recovery is now a major industry. Waste must be controlled if costs are to be contained.

The price paid for materials is affected by commodity markets. There are different ways of reducing material cost. If purchasing of materials is done properly, the firm can get various types of discounts. A number of decisions are involved in the case of materials used by a firm.

• Firstly, the sources where materials are available will have to be identified.
• Secondly, a cheaper substitute available to the material being presently used by the firm has to be found out.
• Thirdly, the cost of freight has to be examined.
• Fourthly, a suitable product design to reduce the material usage is needed.
• Fifthly, alternative process of production has to be examined.

Since material cost form a major part of the total cost of production, control and reduction of material cost in these cases is of vital importance. R&D efforts, inventory management, improved production planning, elimination of slow moving stocks, and improved flow of parts and materials, etc. can be effective in controlling and reducing these costs.

(iii) Sales:

Sales are another area which needs monitoring of costs. Sales control requires making sure that the company is not over-spending to achieve its sales goals. In order to sell, a firm maintains a sales force and spends on advertisement, etc. The key ratio to watch is marketing expense to sales.

It consists of five component expenses to sales ratios:

(i) Sales force to sales

(ii) Advertising to sales

(iii) Sales promotion to sales

(iv) Marketing research to sales

(v) Sales administration to sales.

Management needs to monitor these marketing expense ratios. Sales cost can be controlled by rearranging market segments as the basis of demand. It should reschedule the sales force based on suitability of each member of the team. Peculiarities of consumer choices must be ascertained and communicated to the management, so that products are altered according to consumer needs.

(iv) Overheads:

Overhead costs are fixed costs. Fixed costs are defined as those which remain the same at a given capacity and do not vary with output. These costs will exist even if no output is produced. A proper selection of capacity, a right choice of equipment and its proper maintenance are likely to keep over­heads down.

The costs of plant, equipment and building, etc. are examples of fixed cost. Included in them are costs that require a fixed amount of funds in each period without reference to output such as rent, depreciation charges, property taxes and salaries of employees who cannot be retrenched during peri­ods of reduced demand. Careful planning is required regarding the complete layout of the plants. The overhead costs can be reduced by means of effective planning and implementation.

(v) Energy:

Faulty designs result in excessive use of power and materials. Lighting costs can be reduced by high quality electronic energy saving light bulbs. The increase in oil prices has shown the very high levels of waste. The problem of energy conservation is attracting considerable interest because high prices warrant some action.

The costs of reducing the consumption of energy can now be offset by the savings. Yet there has always been value in reducing energy consumption. Changing attitudes towards the use of what has always been cheap and plentiful is difficult, yet the task must be tackled if the pressure on profits is to be reduced.

It is stated that, in India, there is no economy in the use of fuel, energy or power. Fuel wastage in Indian industry is as high as 25 per cent. All these areas of rising costs must be tackled if industry and commerce hope to survive intact. They can only be tackled if a continuous examination of resource consumption is instituted. Only a well thought out and continuous cost reduction programme will produce the necessary long term benefits.

Cost Reduction Program

Followings are the essentials of a cost reduction program:

• Cost reduction program should be according to requirement of the company.
• Cost reduction program is a continuous activity that cannot be treated as one time or short-term activity. Success of any cost reduction program may lie in only continuous improvement of efforts.
• Cost reduction program should be real and permanent.
• Example setter of cost reduction program should be top management employee. Success of this program depends on co-operation of all employees and department of an organization.
• Employees should be rewarded for their participation in cost reduction program and for giving innovative ideas related to this program.

Fields Covered under the Cost Reduction Program

A number of fields come under the scope of cost reduction. They are discussed below.

Design

Manufacturing of any product starts with the design of product. At the time of improvement in design of old product as well as at the time of designing new product, some investment is recommended to find a useful design that may reduce the cost of the product in following terms:

Material Cost

Design of product should encourage to find out possibility of cheaper raw material as a substitute, maximum production, less quantity etc.

Labor Cost

Design of product may reduce time of operation, cost of after-sale service, minimum tolerance, etc.

Organization

Employees should be encouraged for cost reduction scheme. There should be no scope for doubts and frictions; there should be no communication gap between any department or any level of management; and there must be proper delegation of responsibilities with defined area of functions of an organization.

Factory Layout and Equipment

There should be a proper study about unused utilization of material, manpower and machines, maximum utilization of all above may reduce cost of any product effectively.

Administration

An organization should make efforts to reduce the cost of administrative expenses, as there is ample scope to do so. A company may evaluate and reduce the cost of following expenses, but not the cost of efficiency:

• Telephone expenses
• Travelling expenses
• Salary by reducing staff
• Reduction in cost of stationery
• Postage and Telegrams

Marketing

Following areas can be covered under the cost reduction program:

• Advertisement
• Warehouse
• Sales Promotion
• Distribution Expenses
• Research & Development Program

Any cost accountant should keep the following points in mind while focusing on cost reduction for the Marketing segment:

• Check the distribution system of an organization about the overall efficiency of the system and how economically that system is working.
• Find out the efficiency of the sales promotion system
• Find out if the costs can reduced from the sales and distribution system of an organization and whether the research and development system of market is sufficient.
• A cost accountant should also do an ABC analysis of customers in which customers may be divided into three categories. For example:

ABC Analysis of Customers
Category	Number of Dispatches	Volume of Sale Covered
Customer…A	About 10%	60% to 80%
Customer…B	About 20%	20% to 30%
Customer…C	About 70%	5% to 10%

After performing this analysis, the organization can focus on the customers who are covering most of the sales volume. According to it, the cost reduction program may be run successfully in the area of category B and C.

Financial Management

Attention should be given to the following areas:

• If there is any over-investment.
• How much economical is the cost of capital received?
• If the organization is getting maximum returns for the capital employed.
• If there is any over-investment, that should be sold and similarly, unutilized fixed assets should be eliminated. Slow-moving or non-moving inventories should be removed and should transfer this surplus to the working capital to re-invest it in a cycle of more profitable area of business.

Personal Management

Cost reduction programs can be run using staff welfare measures and improving labor relation. Introduction of incentive schemes for labor and giving them better working conditions is very important to run an efficient cost reduction program.

Material Control

Cost reduction program should be run by purchasing economical and more useful material. Economic Order Quantity (EOQ) technique should be used. Inventory should be kept low. Proper check on inward material, control over warehouse and proper issuance of material, and effective material yield should be done.

Production

Using effective control over material, labor, and machine a better cost reduction program may be run.

Performance Management Information Systems identifies the accounting information requirements and the types of information systems used; describes and identifies the main characteristics of transaction processing, management information and executive information systems; and defines the good and bad of open and closed systems with regard to performance management.

Different types of information systems used for strategic planning, management control and operational control and decision-making.

Accounting information can be drawn from both internal and external sources and is used to create plans and for decision making.

• For strategic planning, information about competitors, profitability of products, customer profitability, pricing decisions and the value of the market share are useful in order to set goals and create a strategy.
• For management control, information about resources, efficiency and effectiveness is required to set targets and objectives. Much of this information can be generated internally.
• For operational control, information about the operations, transaction data (e.g. customer purchases), detailed operating information that is expressed in the right units is used to organize day to day tasks and activities.

Management information systems include transaction pro cessing systems, management information systems, executive information systems and enterprise resource planning systems.

1. Transaction processing systems (TPS)

Transaction processing systems (TPS) “collect, store, modify and retrieve the transactions of an organization” and are characterized by:

• Controlled processing
• Inflexibility
• Rapid response
• Reliability

2. Management information systems (MIS)

Management information systems (MIS) “convert data into information” and are characterized by the following:

• Provide support for structured decision
• Are designed to report on existing operations
• Have little analytical capability
• Inflexible
• Focus on the internal

3. Executive information systems (EIS)

 Executive information systems (EIS) use data from the MIS and allow to create a “generalized computing and communication environment.” Characteristics include:

• User friendly interfaces
• Interactive tutorials that visualize situations
• Links to external databases
• Tracking of critical information

4. Enterprise resource planning systems (ERP systems)

 Enterprise resource planning systems (ERP systems) are software packages that pull together the organization’s processes into one system. Some characteristics are:

• Can be accessed by anyone who’s computer is linked to the central server
• Has decision support features
• Can be linked to external systems
• Works well for global operations
• Allow for standardization of information and work practices

When it comes to a management report, the key areas that you focus on are the profits and losses amongst your clients, products, geographic regions, and even the company’s departments. The first step would be to have a computerized system develop the necessary data, which is collected by a mid-level manager and written up using the following reports:

1. Cash Flow: This report provides the monthly transactions for your bank, which includes your company’s expenses and liabilities, along with the income you have received. For example, by analyzing your cash flow, you may realize that you had a $30,000 increase in accounts receivable. The increase could be that your client was invoiced for $50,000, but you only received $20,000. The amount in accounts receivable is the difference. This is only one of many examples of how there could be a difference between the cash in your bank and the profit in your reports, which is easily explained with this amazing cash flow tool.
2. Balance Sheet is a summary of the company’s assets, retained earnings, and liabilities are shown on this report. This report delivers an accurate evaluation of your company’s worth (e.g. vehicles, equipment, and cash on hand) minus what has to be paid (e.g. suppliers, future bills). Using a balance sheet, you can easily discover which clients are behind on their payments and how much money is owed to you. And you also have the option of comparing the sales from a previous month to the current month. This tool goes as far as averaging the revenue per customer and the amount of sales that each salesperson generated.
3. Profit and Loss is income from sales, minus expenses that are generated on a daily basis. The report will divide your expenses into their necessary spending categories. Maybe you want to average out your numbers for the year. You can do this by viewing your sales and expenses on a quarter-to-quarter or month-to-month basis. Now, you will know which months or quarters are the strongest for your company and which ones you have to work on. You can even view the numbers by a specific team, department, or assignment.
4. Sales: one of the most important reports is the sales report, because it generates information about the invoices that were raised for the past month.
5. Trade Creditor is a list of all the businesses that you have to pay.
6. Trade Debtor is a record of all the clients that have invoices with your business and still owe you money.

Importance of Management Reports

1. You can discover trends and make the best decisions

Whenever you perform a financial report, you know exactly if the company is gaining or losing. The only downside is that you don’t know exactly how and why this may be happening. There is no benefit in simply knowing that you are winning or losing. With a management report, you are able to go within the workings of your company to see what is actually causing your company to win or lose. Even better, you can find out what areas need work and which parts of the company are the strongest. This is necessary, because you could have a profit for the year and still have a weak link within the company. This issue could be preventing you from making even more money for the company. Are you in business to leave money on the table?

2. Prevent any unnecessary losses and expenses

And with the world of business constantly changing, it is critical to know when and where you may need to make some adjustments within the company. You definitely don’t want to be the company that reacts, after it is too late. By then, your business is in the hole and you have a lot more to lose.

3. A powerful tool that delivers up-to-date information about your company

With a management report, you always have the upper hand and can easily adjust to the new changes in business. This is a strategic tool that can be used for long-term plans of growth and profits. Investing in an informative management report is a no-brainer for any organization. Invest in your future today and make sure you have the best Corporate Service Provider to cover your back from registration of your business in the UAE to monthly management reports and annual reporting.

Every business is a little different, but as a starting point for many of our clients we like to look at the following items. You’ll notice this might seem a little sparse, and that’s by design. Too much information is almost worse than no information, so we like to focus on what really matters in your business and nothing else.

1. Budget

A well-crafted budget is a beautiful thing indeed. It will enable you to set a path for the business to follow over the coming year(s) and give you a framework within which to operate the business and achieve your goals. What do we need to do in sales next month? Check the budget. How much can we spend at the office party? Check the budget. Typically you’ll set a new budget each year and periodically update the budget during the year as new information comes to hand.

2. Cash flow

The lifeblood of any business, it’s important to know what cash flow is doing in your business. Unless you’re in dire straits there is no need to micro-manage cash, but you should be able to report on what the future cash balance is for the business over the coming year as well as know what kind of state your trade receivables are in.

And finally we like to look at a some Key Performance Indicators. These will vary business by business, but below are a few that we recommend for most service businesses.

3. Wage Revenue ratio

Too often we’re not getting a good return on our wage spend so it’s a wise idea to track this carefully. A good goal is to spend no more than 65% (ideally, less) of revenues on labour costs. And remember that when we talk about revenue we really mean gross profit (i.e. sales less direct costs).

4. Staff productivity

This one helps you dig into the reasons behind revenue shortfalls as it shows which staff are hitting their personal productivity targets and which are not. Some businesses will report on hours, others on revenue generated, but either way there is accountability on a per-head basis. We would also consider write-offs per team member here as well.

5. Client/job profitability

This information will let you know which clients or job types are profitable in your business and those which are not. Regular analysis here may lead to letting certain clients go, re-quoting other clients, redesigning or ditching certain service offerings all in the pursuit of profit.

Five items. That’s it. With the information gathered from these five items you should have most, if not all, of what you need for a really useful set of management reports. From here we can see if we’re hitting our targets, keep an eye out for future cash dramas, and find out which staff/clients/jobs are helping or hindering the bottom line.

Performance Analysis in Private Sector Organizations describes financial performance indicators; describes non-financial performance indicators; analyses past performance; explains the causes and problems created by short-termism and financial manipulation of results; explains the Balanced Scorecard and the Building Block Model and discusses the difficulties of target setting in qualitative areas.

Performance Analysis in not for Profit Organizations and the Public Sector

Not for profit organizations have general objectives which include:

• “Surplus maximization (Similar to profit maximization)
• Revenue maximization
• Usage maximization
• Usage targeting (Matching the capacity available)
• Full/ partial cost recovery (Minimizing subsidy)
• Budget maximization: Maximizing what is offered
• Producer satisfaction maximization: Satisfying the wants of staff and volunteers
• Client satisfaction maximization: Generating the support of the public”

Performance could be measured in Private Sector Organizations through:

Performance can be measured using the value for money criteria of economy, effectiveness and efficiency.

• Economy is spending money frugally
• Efficiency is getting the most for the money spent.
• Effectiveness is getting what has to be done economically and efficiently
• Public sector organizations

Public sector organizations come in many shapes and forms. The most obvious examples are schools and hospitals, police forces and local transport providers, but there are many less visible organizations such as regulatory bodies. The objectives of public sector organizations are very different from those of commercial organizations, and this can make performance management more complicated. The following factors in particular differentiate public sector organizations from commercial:

1. They have a broader group of stakeholders than commercial organizations. This can lead to greater conflicts. Commercial organizations are likely to be mainly concerned with shareholders, employees, customers and their lenders. Public sector organizations are likely to be interested in pleasing the providers of funding (the government), the users of the service and the taxpayer. In the case of schools, for example, parents would be happy to see more money spent on education but, as taxpayers, they may not wish to pay more taxes.
2. Customers do not pay directly for the services they receive, and there may be little relationship between the costs of providing the service and the amount it is used. Consider a subsidised bus service, for example. The daily costs of running the buses are likely to be largely fixed, and do not depend on the number of passengers using them at least in the short term. This makes it harder to decide how much should be spent on the service.
3. Many public sector organizations operate as monopoly providers. Even if customers are not happy with the service they receive, they cannot switch to an alternative supplier. In commercial organizations, this is generally not the case, and bad performance will lead to a loss of customers and, therefore, loss of funding.
4. The output of public sector bodies is often difficult to measure. How do you determine how much work a police force has performed? Statistics such as the number of crimes reported may be used. If the police force is doing a good job however, and crime is falling, the number of crimes reported may fall. So the lower number of crimes reported would wrongly suggest that the police force is not working so hard.

There is a perception that performance in public sector organizations is poorer than in the private sector, both in terms of efficiency and quality of service.