Accounting for Managers by Srinivas R. Rao - HTML preview

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5.1.3.8 Summary

Traditional accounting or financial accounting can no longer serve

the purposes of all concerned. Especially the internal organs of the business

concerns, namely managements, want a lot of analytical information

which could not be provided by the financial accounting. Hence to serve

the needs of management two more kinds of accounts – management

accounting and cost accounting have evolved. Simply stated, management

accounting serves the needs of management and cost accounting tries to

determine the costs through a formal system of accounting. Costs can be

classified on various bases and cost sheet is a statement presenting the

items entering into cost of products or services.

5.1.3.9 Key Words

Direct Expenses: expenses that can easily be identified with a particular

product.

Indirect Expenses: expenses which cannot be easily identified with a

particular product.

Overheads: total of all indirect expenses.

Works Cost: prime cost + factory overheads.

Cost Of Production: works cost + administration overheads.

Cost Of Sales: cost of production + selling and distribution overheads.

Cost Sheet: a statement which is prepared to ascertain the cost of sales.

Tenders: a statement which quotes the price for a particular job or level of

production activity.

5.3.10 Self Assessment Questions

1.What are the limitations of financial accounting?

2.Justify the need for cost accounting.

3.Explain the various bases for classification of costs.

4.What are the differences between àcost sheet’ and `tender’.

5.Prepare a cost sheet for the production of 100 units of an article

using imaginary figures.

6.Prepare a statement of cost showing:

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(a) value of materials consumed

(b) total cost of production

(c) cost of goods sold and

(d) the amount of profit

From the following details relating to a toy manufacturing concern:

Rupees

Opening stock: raw materials

25,000

finished

goods

20,000

Raw materials purchased

2,50,000

Wages paid to labourers

1,00,000

Closing stock: raw materials

20,000

finished goods

25,000

Chargeable expenses

10,000

Rent, rates and taxes (factory)

25,000

Motive power

10,000

Factory heating and lighting

10,000

Factory insurance

5,000

Experimental expenses

2,500

Waste materials in factory

1,000

Office

salaries

20,000

Printing and stationery

1,000

Salesmen’s

salary

10,000

Commission to travelling agents

5,000

Sales

5,00,000

7.Kolam products ltd., produces a stabilizer that sells for rs.300. An

increase of 15% in the cost of materials and 10% in the cost of labour is

anticipated. If the only figures available are those given below, what must

be the selling price to give the same percentage of gross profit as before?

Ֆ Material costs have been 45% of cost of sales

Ֆ Labour costs have been 40% of cost of sales

Ֆ Overhead costs have been 15% of the sales

Ֆ The anticipated increased costs in relation to the present sale

Ֆ Price would cause a 35% decrease in the amount of present gross

Profit.

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5.1.3.11 Key To Self Assessment Questions (For Problems

Only)

6. Materials used rs.2,55,000; prime cost rs.3,65,000; works cost

Rs.4,18,500; cost of production rs.4,39,500; cost of sales rs.4,49,500 and

profit rs,50,500.

7. Selling price: rs.332.25.

5.1.3.12 Case Analysis

A small scale manufacturer produces an article at the operated

capacity of 10,000 units while the normal capacity of his plant is 14,000

units. Working at a profit margin of 20% on sales realisation, he has

formulated his budget as under:

10,000

units

14,000

units

Rs.

Rs.

Sales realisation

2,00,000

2,80,000

Variable overheads

50,000

70,000

Semi-variable overheads

20,000

22,000

Fixed overheads

40,000 40,000

He gets an order for a quantity equivalent to 20% of the operated

Capacity and even on this additional production profit margin is desired

At the same percentage on sales realisation as for production to operated

Capacity. As you are a cost manager, he approached you to advise him as

To what should be the minimum price to realise this objective.

Solution:

Computation of prime cost

Profit margin is 20% on sale

Therefore cost of sale, 80% of rs.2,00,000 i.e. 1,60,000

Variable overheads 50,000

Semi-variable overheads 20,000

Fixed overhead 40,000 1,10,000

Prime cost 50,000

Since an additional production of 4000 units requires an increase

of rs.2000 in semi-variable expenses, an additional production of 2000

units will require an increase of rs.1000 in semi-variable expenses:

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Differential cost of production of 2000 extra units

10000

12000 Differential Cost

Units

Units

For 2000 Units

Rs.

Rs.

Rs.

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Prime cost

50,000

60,000

10,000

Variable overheads

50,000

60,000

10,000

Semi-variable overheads

20,000

21,000

1,000

Fixed overheads

40,000

40,000

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1,60,000

1,81,000

21,000

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The different cost for 1 unit is rs.21000 ÷ 2000 units i.e. Rs.10-50. Profit

margin required is 20% on sale or 25% on cost. Hence the minimum selling

price = rs.10.50 + rs.2.625 = rs.13.125.

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Lesson 5.2

Standard Costing And Variance Analysis

5.2.1 Introduction

During the evolutionary stage of costing, the focus was only on the

determination of actual cost i.e. The main activity of the cost accountants

was determining the actual cost of production. This resulted in the non-

availability of cost control measures to the management. Standard costing

was developed by cost accountants to meet these contingencies.

5.2.2

Know the meaning of standard costing

Understand the advantages of standard costing system

Understand the different kinds of variances with special reference

to material variance and labour variance

Understand the reasons for these variances

Realize the importance of variance analysis

5.2.3 Contents of concepts:

5.2.3.1 Meaning Of Standard Costing

5.2.3.2 Objectives Of Standard Costing

5.2.3.3 Advantages Of Standard Costing

5.2.3.4 Limitations Of Standard Costing

5.2.3.5 Standard Costing And Budgetary Control

5.2.3.6 Variance Analysis

5.2.3.7 Cost Variances

5.2.3.8 Direct Material Cost Variance

5.2.3.9 Direct Labour Cost Variance

5.2.3.10 Summary

5.2.3.11 Keywords

5.2.3.12 Self Assessment Questions

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5.2.3.13 Key To Self Assessment Questions

5.2.3.1 Meaning Of Standard Costing

Standard costing is a technique which uses standards for costs and

revenues for the purpose of control through variance analysis. Standard

costing involves the setting of predetermined cost estimates in order

to provide a basis for comparison with actual costs. Standard costing

is universally accepted as an effective instrument for cost control in

industries.

A standard cost is a planned cost for a unit of product or service

rendered. According to h.j. wheldon, “standard costs are pre-determined

or forecast estimates of cost to manufacture a single unit or a number of

units of product during a specific immediate future period”. Standard cost

is defined in the cima official terminology as: “a predetermined calculation

of how much costs should be under specified working conditions. It is

built up from an assessment of the value of cost elements and correlates

technical specifications and the qualification of materials, labour and other

costs to the prices and/or usage rates expected to apply during the period

in which the standard cost is intended to be used. Its main purpose is to

provide basis for control through variance accounting for the valuation of

stock and work-in-progress and in some cases, for fixing selling prices”.

5.2.3.2 Objectives Of Standard Costing

Ֆ The objectives of standard costing technique are as follows:

Ֆ To provide a formal basis for assessing performance and efficiency.

Ֆ To control costs by establishing standards and analyzing of

variances.

Ֆ To enable the principle of ‘management by exception’ to be

practiced at the detailed operational level.

Ֆ To assist in setting budgets

To achieve the above objectives the following steps are adopted in standard

costing:

Ֆ Determining the standard for direct material, direct labour and

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different overheads

Ֆ Ascertaining the actual cost of production

Ֆ Ascertaining the variances by comparing actual costs with

standard costs

Ֆ Analyse the variances to know the reason for variances.

Ֆ Adopting corrective measures to control the variances in futures.

5.2.3.3 Advantages Of Standard Costing

A good standard costing system results in the following advantages:

Ֆ The setting of standards should result in the best resources and

methods being used and thereby increase efficiency.

Ֆ Budgets are compiled from standards.

Ֆ Actual costs can be compared with standard costs in order to

evaluate performance

Ֆ Areas of strengths and weakness are highlighted

Ֆ It acts as a form of feed forward control that allows an organization

to plan the manufacturing inputs required for different levels of

output.

Ֆ It acts as a form of feedback control by highlighting performance

that did not achieve the standard set.

Ֆ It operates via the management by exception principle where only

those variances (i.e. Differences between actual and expected

results) which are outside certain tolerance limits are investigated,

thereby saving managerial time and maximizing managerial

efficiency.

Ֆ The process of setting, revising and monitoring standards

encourages reappraised of methods, materials and techniques

thus leading to cost control as an immediate effect and to cost

reduction as a long term effect.

5.2.3.4 Limitations Of Standard Costing

Standard costing suffers from the following limitations:

Ֆ A lot of input data is required which can be expensive

Ֆ Unless standards are accurately set any performance evaluation

will be meaningless.

Ֆ Uncertainty in standard costing can be caused by inflation,

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technological change, economic and political factors, etc.

Standards therefore need to be continually updated and revised.

Ֆ The maintenance of the cost data base is expensive.

Ֆ Setting of standards involves forecasting and subjective judgments

with inherent possibilities of error and ambiguity.

Ֆ Standard costing cannot be adopted in the firms which do not

have uniform and standard production programme.

Ֆ It is very difficult to predict controllable and uncontrollable

variances.

5.2.3.5 Standard Costing Vs. Budgetary Control

Standard costing and budgetary control are control techniques

adopted in a firm with specific objectives. Following points of differences

between the two can be observed:

1. Standard costing is a long range control activity developed and

adopted with focus on production. Budgetary control is an activity

concerned with every functional area of the firms and functional

budgets are prepared to control that function in a shorter term.

2. Standard costs are scientifically predetermined. Budgetary

control is concerned with the overall profitability and financial

position of the concern.

3. Standard costing is concerned with ascertainment and control of

costs. Budgetary control is concerned with the overall profitability

and financial position of the concern.

4. The emphasis of standard costing is on what should be the cost

whereas in budgetary control the emphasis is on the level of costs

not to be exceeded.

5. Standards are determined for each element of cost. Budgets are

determined for a specified period.

6. Standard cost is a projection of cost accounts. Budget is a

production of financial accounts.

7. Standard costing is concerned with the control of costs and is

more intensive in scope. Budgetary control is concerned with the

operation of business as a whole and is more extensive.

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5.2.3.6 Variance Analysis

The difference between the standard cost and the actual cost is

known as ‘cost variance’. If actual cost is less than the standard cost, the

variance is favorable. If the actual cost is more than the standard cost, the

variance is unfavorable. A favorable variance indicates efficiency, while an

unfavorable one denotes inefficiency. However, mere knowledge of these

variances would not be useful for ensuring cost control. These have to be

thoroughly analyzed so as to find out the contributory factors. It would

then be possible to find out whether the variances are amenable to control

or not. The term ‘variance analysis’, thus, may be defined as ‘the resolution

into constituent parts and the explanation of variances’.

Variances are of two types: cost variances and sales variances. In

this lesson cost variances relating to material and labour are explained.

5.2.3.7 Cost Variances

As noted previously, the difference between the standard cost and

the actual cost is known as ‘cost variance’. The total cost variance should

be split into its constituent parts, in order to analyze the cost variances in

greater detail. The following figure reveals the picture clearly:

Total cost variance

Direct Material Direct Labour Overhead

Cost Variance Cost Variance

Cost Variance

(DMCV) (DLCV) (OCV)

Price

Usage Rate Efficiency Variable Fixed

Variance Variance Variance Variance Overhead Overhead

(DMPV)

(DMUV) (DLRV) (DLEV)

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Cost Cost

Variance Variance

(VOVC) (FOCV)

Expenditure Volume

Variance

Variance

(FOEXPV)

(FOVV)

5.2.3.8 Direct Material Cost Variance

It is the difference between the standard cost of material specified

for the output achieved and the actual cost of materials used. The standard

cost materials is computed by multiplying the standard price with the

standard quantity for actual output and the actual cost is obtained by

multiplying the actual price with actual quantity. The formula is:

= Standard Cost For Actual Output – Actual Cost

or

DMCV = (Standard Price × Standard Quantity For Actual Output)

– (Actual Price × Actual Quantity)

= (SP × SQ) – (AP × AQ).

Example 1.

The standard cost of material for manufacturing a unit of a

particular product is estimated as under :

16 kg of raw materials @ rs. 1 per kg. On completion of the unit it

was found that 20 kg. Of raw material costing rs. 1.50 per kg. Have been

consumed. Compute material cost variance:

DMCV= (SP × SQ) – (AP × AQ)

= (16 × 1) – (20 × 1.50)

= Rs. 14 (Adverse)

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Direct Material Price Variance (DMPV)

It is that portion of material cost variance which is due to the

difference between the standard prices specified and the actual price

paid. This variance may be due to a number of reasons: change in price,

inefficient buying, standard quality of materials not purchased, favorable

discounts not obtained etc. The formula is:

Dmpv = actual quantity (standard price – actual price)

If the actual price is more than the standard price, the variance

would be adverse and in case the standard price is more than the actual

price, it would result in a favourable variance.

Example 2.

Use the information given in example 1 and compute the material

price variance.

DMPV = AQ (SP – AP)

= 20 (1 – 1.50)

= Rs. (10) Adverse.

Direct Material Usage Or Quantity Variance (DMUV)

It is the difference between the standard quantity specified and the

actual quantity used. This variance may arise because of: careless handling

of materials, wastage, spoilage, theft, pilferage, changes in product design,

use of inferior materials, defective tools and equipment etc. The formula

is:

DMUV = Standard Price (Standard Quantity For Actual Output – Actual

Quantity)

= SP (SQ – AQ).

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Example 3.

Use the information given in example 1 and compute the material

usage variance.

DMUV = SP (SQ – AQ)

= 1 (16 – 20)

= Rs. 4 (Adverse)

Note. The total of material price and usage variances is equal to

material cost variance. Thus,

DMCV = DMPV + DMUV

in the example that has been used so far, let us verify this:

DMCV = DMPV + DMUV

Rs. 14 (A) = Rs. 10 (A) + Rs. 4 (A)

Illustration 1.

A manufacturing concern which had adopted standard costing

furnishes the following information.

Standard :