Managerial Accounting and Control Made Easy (MACME) Prof. K.S.

Ranjani

Session Plan for MAC II

Module 1 C S! ACC "#!I#$ %ASICS Session 1 Introduction Reading(s) 1. Basics of Cost Accounting (MACME) 2. Breezy Boat Company(MAC) Session 2 Cost terms purpose! approac" Reading(s) C#assification of Cost(MACME) Case Cost c#assification e$ercise (IIMA%&!A '(() Session ' Brea) E*en Ana#ysis

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Reading(s) Brea) E*en Ana#ysis(MACME) +,o you )no- -"ere your ./rea) e*en. point is01 By 2o"n 3. 4ardozzi C5A +6sing Brea)7E*en Ana#ysis to ,etermine 8our Company9s &inancia# 3ea#t"1Art"ur &. Rot"/erg Managing ,irector C&: Edge ;;C Case< ="e Craddoc) Cup(MAC) Module & C S!I#$ S'S!EMS (ME!) *S Session > A/sorption Costing Reading(s) A/sorption Costing(MACME) Case C#ass E$ercise(MACME) Session ? 2o/ Costing and 5rocess Costing Reading(s) 2o/ Costing and 5rocess Costing(MACME) @endy9s C"i#i< A costing Conundrum(MAC) Session A Acti*ity Based Costing Readings< Acti*ity Based Costing(MACME) Case< C#assic 5en Company< ,e*e#oping an ABC Mode# (3BS%B71BC711() Session ( Acti*ity Based Management and use of ABC in ser*ice industries Reading(s) ABM (MACME) Acti*ity Based Costing at 65S 2. Acti*ity Based Costing ! Capacity (3BS%B71D?7D?B) Case @i#)erson Co (3BS%B71D17DB2) Session C Cost a##ocation and Customer 5rofita/i#ity Reading(s) Acti*ity Based Costing(MACME) Case ,a)ota :ffice 5roducts(3BS%B71D27D21) Module + C S! A#A,'SIS - R *ECISI # MAKI#$ SessionB In7sourcing and :utsourcing decision ana#ysis Reading(s) Margina# Costing and ,ecision Ana#ysis(MACME) Case &ine print Company(A) (B) and (C) Session 1D 5roduct mi$ decisions -it" capacity constraints Readings(s) Margina# Costing and ,ecision Ana#ysis(MACME) Case Moti 3eera (5) ;td (A) ! (B) (IIMA%EMDDD'(A ! B)) Session 11 5ricing and cost management Reading(s) 5ricing and Cost Management(MACME) This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e !

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Case Mridu#a Ice Cream 5ar#our (A) (IIMA%&!A D'1?(A)) Session 12 =arget costing ! #ife cyc#e cost management Reading(s) =arget costing ! #ife cyc#e cost management(MACME) 2. Ac"ie*ing &u## Cyc#e Cost management (SMR 1?' &a## 2DD>) Case =oyota Motor Company< =arget Costing (3BS%B71B(7D'1) Module . %"*$E!I#$ ( /ARIA#CE A#A,'SIS Session 1' Standard Costs and Budgets Reading(s) Standard Costs and Budgets(MACME) Case @i#mont C"emica# Corporation(MAC) Session 1> Fariance Ana#ysis Reading(s) Fariance Ana#ysis and &#e$i/#e Budget(MACME) 2. Fariance Ana#ysis and &#e$i/#e Budget (3BS%B71D17D'B) Case Entertainment no-.com(MAC) Session 1? @rap7up 000

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e "

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1. %ASICS

- C S! ACC "#!I#$

Cost< +A unit of product or ser*ice in re#ation to -"ic" costs are ascertained1 Meaning of cost<
Cost is t"e resource foregone in order to recei*e anyt"ing of *a#ue.

*efinition of Cost CIMA (C"artered Institute of Management Accountants) defines cost as fo##o-s< +t"e amount of e$penditure(actua# or notiona#) incurred on or attri/uta/#e to a specified t"ing or acti*ity1. Cost "nit Costs need not a#-ays /e incurred on output units. It can /e incurred on "our#y /asis it can /e incurred on an acti*ity a department etc. ="erefore a cost unit is any unit -it" respect to -"ic" cost can /e ascertained. &or e$amp#e in an aircraft cost can /e incurred per passenger and in a /ott#e manufacturing unit it cou#d /e ascertained per /ott#e. Co12osite cost units Sometimes costs need not /e incurred on a sing#e output function /ut cou#d /e a com/ination of t-o or more functions. &or a tour operator t"e cost cou#d /e ca#cu#ated for a passenger mi#e for a "ote# it cou#d /e per guest per nig"t. Cost Centre Cost centre refers to t"e point of accumu#ation of cost. A cost centre is a part of t"e company t"at does not generate any profit for t"e company /ut t"ey add cost to t"e company. ="e manager of a cost centre incurs costs and t"e centre is e*a#uated on "o- -e## t"ey contro# t"eir costs (3orngren Sundem Stratton and Burgsta"#er Sc"atz/erg 2DDC). 6n#i)e -"at t"e term sounds #i)e it "as no reference to a p"ysica# p#ace it is an acti*ity or set of acti*ities t"at create costs. &or e$amp#e an administrati*e office is a cost centre. An Engineering or product de*e#opment function is a cost centre. ="is is /ecause performing t"at acti*ity resu#ts in costs /eing incurred. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e #

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:t"er e$amp#es of cost centre are emp#oyees support functions in an organisation and any ot"er acti*ity -"ere costs can /e meaningfu##y accumu#ated. Cost 2ool Costs are assem/#ed into meaningfu# groups ca##ed cost pools (e.g. /y type of cost or source). Simi#ar acti*ities t"at can /e grouped toget"er usua##y ma)es a cost poo#. &or e$amp#e repairs and maintenance of eGuipment is a cost poo#. Eua#ity contro# costs and inspection costs can /e com/ined into a sing#e cost poo#. Cost *ri3er Any factor t"at "as t"e effect of c"anging t"e #e*e# of tota# cost is ca##ed a cost driver. &or e$amp#e num/er of mac"ine "ours -or)ed -i## affect t"e eGuipment maintenance cost. ="erefore mac"ine "ours is a cost dri*er for eGuipment maintenance.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e $

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&.

Classification of Cost /e"a*ior tracea/i#ity in*entoria/i#ity

Cost can /e c#assified on t"e /asis of nature contro##a/i#ity and margina#ity.

:n t"e /asis of nature of cost -e can c#assify cost as fo##o-s< Material Cost < Cost incurred to o/tain materia# and recei*e t"em -it"in t"e organization. ="e cost of "a*ing t"em /roug"t into t"e organization is ca##ed carriage in-ards. ,a4our costs are t"ose t"at are incurred in respect to sa#aries and -ages toget"er -it" re#ated emp#oyment costs 3er5eads or indirect costs< Broad#y c#assified into< &actory or manufacturing o*er"eads :ffice or administrati*e o*er"eads Se##ing and distri/ution o*er"eads

Manufacturing o3er5eads can /e furt"er su/ di*ided into indirect materia# costs indirect #a/our and indirect e$penses. Indirect Materia# Indirect ,a4our

5roduction o*er"eads Administration and se##ing o*er"eads :n t"e /asis of 4e5a3iour of cost -it" respect to *o#ume -e can c#assify cost as fo##o-s< -i6ed costs are t"ose t"at remain constant -it"in a #e*e# of acti*ity This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e %

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/aria4le costs are t"ose t"at *ary as a function of output Mi6ed costs are t"ose costs -"ic" *ary part#y on account of output and part#y remain constant Ste2 costs *ary -it" t"e cost dri*er /ut do so in steps

A 7ord of caution 8 &i$ed costs need not /e &IHE,..It does not *ary as a function of output7 eg rent is a fi$ed cost. Rent cou#d a#ter /ecause of increase in f#oor space rising cost of rea# estate /ut not /ecause -e produce more num/er of units. 3ence p#ease note t"at fi$ed do not *ary as a function of output /ut cou#d *ary due to ot"er factors. :n t"e /asis of tracea4ility cost can /e c#assified as fo##o-s< *irect and indirect cost8 *irect costs are t"ose costs t"at can /e re#ated to a unit of output or to a cost o/Iect (e$amp#e7 product di*ision department etc) A## costs t"at are not direct costs are ca##ed indirect costs :n t"e /asis of in3entoria4ility cost can /e c#assified as fo##o-s< In3entoria4le and Period costs8 Costs t"at are assets -"en t"ey are incurred and /ecome e$penses as t"ey are consumed are ca##ed as in*entoria/#e costs 5eriod costs are t"ose t"at are incurred as a function of a period of time :n t"e /asis of Controlla4ility cost can 4e classified as8 Controlla4le and "ncontrolla4le costs< Controlla4le costs are t"ose t"at can /e contro##ed at a responsi/i#ity centre "ncontrolla4le costs are t"ose t"at are incurred at a responsi/i#ity centre /ut cannot /e contro##ed at t"e #e*e# of t"at responsi/i#ity centre

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e &

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Marginality Margina# and A/sorption cost< ="e additiona# cost to produce an additiona# unit is ca##ed as margina# cost Marginal costing is forma##y defined as< Jt"e accounting system in -"ic" *aria/#e costs are c"arged to cost units and t"e fi$ed costs of t"e period are -ritten7off in fu## against t"e aggregate contri/ution. Its specia# *a#ue is in decision ma)ing9 A4sor2tion Cost8 ="e cost t"at inc#udes a## direct costs as -e## as t"e a/sor/ed o*er"eads in t"e cost is ca##ed as a/sorption cost or fu## cost ="e /asic difference /et-een t"e t-o costs is t"at under margina# costing t"e stoc) is *a#ued at *aria/#e cost -"ereas under a/sorption costing stoc) is *a#ued at margina# cost and a proportion of manufacturing fi$ed o*er"eads ="e fo##o-ing is an i##ustration of "o- entire costs of a product are factored into a cost s"eet<

5articu#ars ,irect materia# ,irect #a/our ,irect e$penses 5RIME C:S= 5roduction o*er"ead Indirect materia# Indirect #a/our Indirect e$penses &AC=:R8 C:S=%5R:,6C=I:4 C:S= Se##ing ,istri/ution and Administration o*er"ead C:S= :& K::,S S:;, SE;;I4K 5RICE 5R:&I=

Amount Amount 1DD ?D 1D 1AD 1D 1? '?

AD 22D 'D 2?D 'DD ?D

Case Cost c#assification e$ercise (IIMA%&!A '(() -i## /e part of t"is session

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e '

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+. %rea9 e3en Analysis Meaning Brea) e*en ana#ysis occupies an important p#ace in economic t"eory. It ana#yses t"e re#ations"ip /et-een cost of production re*enue and profit. Brea)e*en point is t"at point at a particu#ar #e*e# of output at -"ic" tota# re*enue is eGua# to tota# cost. It imp#ies a no profit no #oss zone. At t"is point t"e firm neit"er ma)es a profit nor #oss. 3ere tota# re*enue is e$act#y eGua# to tota# cost. *efinition According to Matz Curry and &ran)1 A /rea) e*en ana#ysis indicates at -"at #e*e# of output cost and re*enue are in eGui#i/rium1 Ele1ents of %rea9 e3en analysis Fixed costs: It is a cost incurred e*en at zero production. &i$ed costs do not c"ange -it" t"e c"ange in t"e Guantity of output. &or e$amp#e rent insurance researc" and de*e#opment etc. Variable cost: ="ese e$penses *ary direct#y -it" t"e #e*e# of output. &or e$amp#e #a/or cost ra- materia#s etc. Contribution Margin ="e re*enue net of *aria/#e e$penses is ca##ed as contri/ution margin. ="e contri/ution margin is a*ai#a/#e to co*er fi$ed e$penses of a /usiness. Break even Point @"en t"e contri/ution margin co*ers t"e fi$ed cost it is ca##ed as /rea) e*en point7t"at is t"e sa#es t"at generates Iust enoug" contri/ution to co*er t"e fi$ed cost. At t"is point t"e firm ma)es neit"er profit nor #oss. Margin of Safety ="e sa#es ac"ie*ed o*er and a/o*e t"e Brea) e*en Sa#es is ca##ed Margin of Safety. It is e$pressed as Actua# Sa#es7Brea) e*en sa#es. A Brea) E*en C"art is s"o-n /e#o- for /etter understanding<

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Pa e (

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Illustration 1 A Kerman Biscuit Company p#ans to se## ?DDDD units at Rs. 2D per unit. ="ey incur a fi$ed cost of Rs.CDDDD and *aria/#e cost Rs.1D per unit. Ca#cu#ate /rea)e*en point in sa#es and margin of safety and profit. So#ution< BE5 in sa#es L &C% CM ratio CM ratio or t"e Contri/ution Margin ratio is ca#cu#ated as Contri/ution%Sa#es and is usua##y e$pressed as percentage. CM ratio L 1DDDDDD M ?DDDDD%1DDDDDD L ?DN BE5 in sa#es L CDDDD% ?DN L 1ADDDD

Margin of safety L Sa#es M BE5 in sa#es L 1DDDDDD M 1ADDDD L C>DDDD Contri/ution L Sa#es M Faria/#e cost L 1DDDDDD M ?DDDDD This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )* Pa e

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L ?DDDDD 5rofit L contri/ution M &i$ed cost 5rofit L ?DDDDD M CDDDD L >2DDDD E$p#anation< ="e /rea)e*en point in sa#es margin of safety and profit ca#cu#ation depends upon t"e num/er of units fi$ed cost and *aria/#e cost. ="e /rea)e*en point in sa#es margin of safety and profit -i## c"ange if t"ere is a c"ange in any of t"ese *aria/#es. Readings * /y =o5n ). #ardo>>i? CPA 4ardozzi Consu#ting ;;C Is your /usiness profita/#e0 Most oi#"eat dea#ers can ans-er t"at Guestion -it" a fair degree of accuracy7for #ast year. 8ou )no- "o- t"e num/ers added up and -"et"er or not t"e in) on t"e /oo)s -as /#ac) or red. But -"at a/out t"is year0 Are you ma)ing money no-0 3o- many ga##ons -i## you "a*e to se## t"is year /efore you turn a profit0 At -"at price0 Ono-ing your ./rea) e*en. point is a re#ati*e#y uncomp#icated yet important /usiness p#anning too#. 3a*ing an idea of -"en your costs -i## /e co*ered and profits /egin can "e#p you ma)e /etter purc"asing decisions and is a *ita# part of t"e price setting process. ="ere is a -ay to determine your /rea) e*en point -it"out consu#ting a crysta# /a## or pa#m reader.="roug" a simp#e ana#ysis of t"ree )ey factors you can )no- -"at it -i## ta)e t"is year for your company to ma)e money. ="e first factor is t"e num/er of ga##ons you e$pect to se## t"is season. Ana#yzing your companyPs past "istory and factoring in predicted -eat"er patterns -i## pro*ide a fair#y accurate gauge of -"at youP## /e de#i*ering t"is year. 8our state oi#"eat dea#ers association can "e#p you -it" degree day estimates and -eat"er "istory. By determining "o- many customers you e$pect to "a*e t"is year and t"e a*erage use per customer you can come up -it" a tota# ga##ons figure. ="e ne$t factor is your margin per ga##on. ;i)e a## retai#ers oi#"eat dea#ers continua##y strugg#e -it" pricing. ="e o/Iect is to price your product 7 in t"is case a ga##on of "eating oi# 7 #o- enoug" to /e competiti*e yet as "ig" as possi/#e to ma)e t"e ma$imum profit. =oo often t"is /ecomes an e$ercise in "and -ringing guess-or) and gut reaction. @orse many oi#"eat dea#ers simp#y copy t"e ne$t guy up t"e 8e##o- 5ages #ist -it"out regard to t"e differences in t"e t-o /usinesses. It need not /e t"at -ay. :ur /rea) e*en ana#ysis can "e#p ma)e t"is decision more c#ear cut. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )) Pa e ' " K# : :)ERE ' "R ;%REAK E/E#; P I#! IS<

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="e t"ird factor in our /rea) e*en eGuation is o*er"ead (administration) costs. Again an e$amination of your o*er"ead costs (inc#uding payro## rent eGuipment interest payments insurance ta$es etc.) from pre*ious years -i## pro*ide an indication of -"at your e$pected o*er"ead -i## /e for t"e upcoming season. @e do not inc#ude t"e cost of product (oi#) or o-nerPs sa#ary in t"is ana#ysis. At t"is point you "a*e t"e information a*ai#a/#e to esta/#is" your /rea) e*en point for t-o critica# areas< gross margin and minimum ga##ons. 8our /rea) e*en point comes -"en tota# o*er"ead cost is met /y tota# gross margin. 3o- -ou#d t"is -or) in practice0 @"at are you trying to esta/#is"0 &irst you -ant to )no- "o- many ga##ons you need to se## at your e$pected margin in order to /rea) e*en. Second you -ant to determine t"e minimum margin you need to ac"ie*e -"en you se## t"e e$pected ga##ons so t"at you -i## co*er costs. ;etPs ta)e a simp#e set of facts. 8our company e$pects to se## fi*e mi##ion ga##ons and your gross margin (sa#e price #ess t"e cost of product and de#i*ery) is targeted at 'DQ per ga##on. &ina##y your o*er"ead%administrati*e e$penses run a/out R1 mi##ion. BREAO EFE4 KA;;:4S 7 If you di*ide your o*er"ead e$penses (R1 mi##ion) /y your targeted margin (RD.'D) you esta/#is" t"e minimum num/er of ga##ons you need to se## /efore you s"oany profit. In our e$amp#e t"is -ou#d /e ' ''' DDD ga##ons (R1 mi##ion S RD.'D). ="is te##s you t"at t"e margin on e*ery ga##on after ' ''' DDD goes direct#y to t"e /ottom #ine of t"e company. BREAO EFE4 MARKI4 7 3ere -e are trying to esta/#is" t"e sma##est margin you can get a-ay -it" for a## fi*e mi##ion ga##ons you e$pect to se##. :nce t"is #e*e# is set youP## )no- t"at e*ery penny added to t"e margin goes direct#y to t"e /ottom #ine. If you di*ide your o*er"ead%administrati*e e$penses (R1 mi##ion) /y your tota# e$pected ga##ons (? mi##ion) you s"o- t"at your minimum margin per ga##on is RD.2D. In our ana#ysis -e do not inc#ude t"e o-nerPs sa#ary in t"e o*er"ead e$penses as -e consider company profit and any sa#ary dra-n /y t"e o-ner to /e part of t"e o*era## /enefit of o-ners"ip. In your ana#ysis you mig"t decide to inc#ude some part of your sa#ary in t"e ca#cu#ation. ="is /rea) e*en ana#ysis is not comp#e$. =o /e more accurate -e factor in degree days and mar)et trends. But e*en in its simp#est form a /rea) e*en ana#ysis can /e a po-erfu# too# to "e#p you p#an your seasonPs /uying and in determining a se##ing price for your product. 8ou "a*e t"e information on "and to ma)e t"is ana#ysis and s"ou#d ta)e t"e time to sit do-n -it" your financia# officer or accountant to #ocate your o-n ./rea) e*en. point.

"SI#$ %REAK@E/E# A#A,'SIS ! )EA,!)

*E!ERMI#E ' "R C MPA#'AS -I#A#CIA,

Art5ur -. Rot54erg? Managing *irector? C-

Edge? ,,C Pa e

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )!

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,etermining t"e /rea)7e*en point is crucia# to determining margins -"ic" in turn aid in financia# p#anning for t"e ne$t year. Brea)7e*en ana#ysis determines /ot" t"e minimum amount of sa#es reGuired to a*oid a #oss or to +/rea)7e*en1 at t"e end of t"e fisca# year and permits you to adIust sa#es estimates according#y. @"i#e t"ere are a num/er of different *ariations on /rea)7e*en ana#ysis t"ey are a## usefu# in determining t"e #o-er #imits of profits for ca#cu#ating margins. ="ese *ariations are a## dependent on a num/er of cost factors -"ic" s"ou#d /e determined /efore attempting any )ind of /rea)7e*en ana#ysis. Cost Co12onents of %rea9@E3en Analysis Brea)7e*en ana#ysis is primari#y dependent on a fe- )ey factors. &irst and foremost it is necessary to "a*e t"e capacity to accurate#y forecast your company9s costs and sa#es. ="e resu#t -i## t"en /e dependent on fi$ed costs a*erage per7unit *aria/#e costs and per7unit re*enue as a##ocated across t"e -"o#e /usiness. @it" t"ese num/ers /rea)7e*en ana#ysis /ecomes a matter of simp#e mat"< Brea)7E*en 5oint L &i$ed Costs % (6nit Se##ing 5rice 7 Faria/#e Costs). As mentioned t"ere are se*era# types of costs t"at must /e considered -"en conducting /rea)7 e*en ana#ysis. Among t"ese t"e most re#e*ant are fi$ed costs -"ic" are t"ose e$penses t"at are t"e same regard#ess of t"e num/er of items so#d. &i$ed costs a#so genera##y -ou#d remain t"e same e*en if t"e company discontinued a## sa#es. ="e most common fi$ed costs are rent and insurance. ="e cost of maintaining corporate property -ou#d /e t"e same no matter t"e amount of product so#d. 3o-e*er #a/or s"ou#d a#so /e considered as a fi$ed cost since rep#acing a s)i##ed #a/or force is e$treme#y difficu#t to do. In7p#ace #a/or -i## usua##y not *ary -it" moderate c"anges in *o#ume. ="e ot"er main category of cost to /e considered -"i#e conducting /rea)7e*en ana#ysis is *aria/#e costs. ="ese are e$penses t"at are /ased on t"e num/er of units processed. As suc" t"ey -i## f#uctuate depending on t"e *o#ume of t"e /usiness. As t"e /usiness and sa#es gro- *aria/#e costs -i## a#so increase. ="e most common *aria/#e costs are t"ose pertaining to ra- materia#s necessary for manufacturing products. !5e Margin of Safety ="e margin of safety is a nota/#e outcome of /rea)7e*en ana#ysis as it is indicati*e of t"e strengt" of t"e /usiness. &or any #e*e# of sa#es t"e margin of safety indicates specifica##y t"e amount of sa#es do##ars a/o*e or /e#o- t"e /rea)7e*en point. In essence t"is num/er ma)es it possi/#e for t"e company to determine t"e e$act amount of money it may "a*e gained or #ost during t"e period in Guestion. @"en sa#es are a/o*e t"e /rea)7e*en point t"en t"e margin of safety is positi*e typica##y indicating o*era## gains. 3o-e*er -"en sa#es are /e#o- t"e /rea)7e*en point t"en t"e margin of safety is considered negati*e -"ic" indicates an o*era## #oss for t"e period.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )"

Pa e

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Contri4ution Margin Analysis @"en conducting a /rea)7e*en ana#ysis it is "e#pfu# to )eep in mind t"e concept of Contri/ution Margin -"ic" is defined as re*enue #ess *aria/#e costs. Contri/ution margin differs from gross profit as on#y *aria/#e costs are ta)en into account -"ereas in gross profit ana#ysis a## costs of sa#es are considered. =ypica##y a company9s optima# output #ies -"ere t"e contri/ution margin e$ceeds *aria/#e margina# cost meaning t"at t"e re*enue from se##ing a product e$ceeds t"e *aria/#e cost of production. 3o-e*er if a #o-er price t"an norma# is offered a## ot"er factors /eing eGua# t"at offer oug"t to /e considered so #ong as t"e price sti## e$ceeds *aria/#e costs. Suc" a price -"ic" sti## co*ers a## *aria/#e costs may yet /e considered profita/#e since it -i## "e#p to a/sor/ any fi$ed costs. :n#y -"en t"e contri/ution margin is positi*e -i## any #osses im/ued t"roug" t"e acceptance of a #o-er offer /e compensated t"roug" increases in t"e *o#ume of sa#es. In Su11ary Brea)7e*en ana#ysis is an e$ceptiona##y usefu# too# for assessing t"e state of t"e company9s finances. 3o-e*er in order to successfu##y conduct /rea)7e*en ana#ysis t"ere are a fe- figures t"at must first /e ascertained< T &i$ed costs are t"ose e$penses t"at remain t"e same regard#ess of company success. ="ey must /e factored in -"en determining o*era## gains or #osses. T Faria/#e costs are a#so important to consider during /rea)7e*en ana#ysis. ="ese are e$penses t"at -i## f#uctuate in accordance -it" company sa#es figures suc" as primari#y ra- materia#s. T ="e margin of safety is a usefu# too# in t"e ana#ysis process as it supports assessment of #ong7 term in*estments. T Contri/ution margin ana#ysis is an indispensa/#e part of price setting as it a##o-s setting #o-er t"an norma# price especia##y -"en *o#ume considerations are ta)en into account. ="e /rea)7e*en process is in*a#ua/#e in assessing t"e financia# "ea#t" of your company. ;os Ange#es CE:s and C&:s -"o fee# t"at t"ey do not "a*e t"e interna# e$pertise or /and-idt" to conduct a /rea)e*en ana#ysis can /enefit significant#y from consu#ting -it" an outsourced C&: ser*ices firm. A professiona# ser*ices firm of t"is nature can #end t"eir e$pertise to your financia# ana#ysis and pro*ide an o/Iecti*e report for your use. References and -urt5er Reading C"apter 11< Con*entiona# ;inear Cost Fo#ume 5rofit Ana#ysisU 2ames R. MartinU Management Accounting< Concepts =ec"niGues ! Contro*ersia# Issues "ttp<%%maa-.info%C"apter11."tmV="eN2DMarginN2DofN2DSafety Brea)7E*en Ana#ysisU =im BerryU Business Ono-73o-U 2DD' "ttp<%%---./usiness)no-"o-.com%startup%/rea)7e*en."tm @"at is 5rocess Ana#ysisU 6ni*ersity of Centra# &#orida "ttp<%%oeas.ucf.edu%processTana#ysis%-"atTisTpa."tm Case< ="e Craddoc) Cup(MAC)

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )#

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Section &@ Costing Syste1s and Met5ods .. A%S RP!I # C S!I#$ Meaning A/sorption costing means t"at a## of t"e manufacturing costs are a/sor/ed /y t"e units produced. In ot"er -ords t"e cost of a finis"ed unit in in*entory -i## inc#ude direct materia#s direct #a/or and /ot" *aria/#e and fi$ed manufacturing o*er"ead. As a resu#t a/sorption costing is a#so referred to as fu## costing or t"e fu## a/sorption met"od.

*efinition A manageria# accounting cost met"od of e$pensing a## costs associated -it" manufacturing a particu#ar product. A/sorption costing uses t"e tota# direct costs and o*er"ead costs associated -it" manufacturing a product as t"e cost /ase. Kenera##y accepted accounting princip#es (KAA5) reGuire a/sorption costing for e$terna# reporting.W *ifference 4et7een A4sor2tion and Marginal Costing @"en a/sorption costing is used a## stoc) items are *a#ued at t"eir fu## production cost. ="is inc#udes fi$ed production o*er"eads -"ic" "a*e /een a/sor/ed into cost. In contrast margina# cost *a#ues a## stoc) items at t"eir *aria/#e or margina# costs on#y. &i$ed costs are treated as period costs and are -ritten off in fu## against t"e contri/ution earned in t"at period. Illustration .ABC Company se##s its products for Rs AA eac". ="e current production #e*e# is 2?DDD unit a#t"oug" on#y 2DDDD units are so#d. Ca#cu#ate *a#ue of c#osing stoc) using a. Margina# Cost /. A/sorption Cost :t"er information are as fo##o-s< 6nit manufacturing cost

,irect materia#

Rs.12 Pa e

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )$

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,irect #a/our Faria/#e manufacturing o*er"ead Faria/#e mar)eting o*er"ead

Rs.1C Rs.B Rs.A

&i$ed manufacturing o*er"eads are Rs.1(? DDD%7 and fi$ed mar)eting o*er"eads are Rs.AD DDD%7 for t"e period. So#ution Fa#ue of c#osing stoc) using a/sorption cost< A/sorption cost uses a## *aria/#e costs and t"e proportion of fi$ed e$penses re#ating to production. So cost per unit -i## /e ca#cu#ated as fo##o-s<

,irect materia# ,irect #a/our Faria/#e manufacturing o*er"ead

Rs.12 Rs.1C Rs.B

5roportion of fi$ed o*er"ead Rs.( a/sor/ed -i## /e L1(? DDD%2?DDD Cost per unit Rs.>A

Fa#ue of c#osing stoc)L >AX?DDDLRs.2'D DDD%7 Fa#ue of c#osing stoc) using margina# cost< Ca#cu#ation of cost per unit ,irect materia# ,irect #a/our Faria/#e manufacturing o*er"ead Rs.12 Rs.1C Rs.B

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )%

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Cost per unit

Rs.'B%7

Fa#ue of c#osing stoc)L'BX?DDDL1B? DDD%7 4ote< Mar)eting o*er"eads are treated a speriod costs and are conseGuent#y -ritten off in t"e same year under /ot" t"e met"ods. Role of A4sor2tion Costing in Pricing *ecisions A/sorption costing a##o-s companies to c#ear#y and comp#ete#y s"o- information a/out t"eir financia# condition. It a#so a##o-s companies to price more accurate#y ensuring t"at t"e fina# price of a product or ser*ice ta)es into account t"e actua# costs t"at -ent into t"em. ="is is particu#ar#y usefu# for sma## /usinesses -"ic" need to gi*e more consideration to o*er"ead e$penses. A/sorption costing is ta)en in opposition to *aria/#e costing. 6nder *aria/#e costing -"ic" may a#so /e referred to as direct costing on#y *aria/#e e$penses are inc#uded in t"e computation. ="erefore fi$ed manufacturing costs are not inc#uded in t"e computation. Since *aria/#e costing focuses more on e$penses -"ic" can /e modified or adIusted it "e#ps management p#an and ma)e decisions on "o- e$penses can /e minimized. ,ata ta)en from a/sorption costing s"o-s t"e entire picture toget"er -it" fi$ed costs so does not con*enient#y pro*ide t"is information. :n t"e ot"er "and since *aria/#e costing on#y s"o-s part of t"e picture it may not /e ta)en /y in*estors as re#ia/#e information. A#so since fi$ed costs are inc#uded in t"e computation of a/sorption costing it mig"t /e more /eneficia# to use t"is information -"en sa#es c"ange since t"e figures -on9t f#uctuate too muc". ,ue to t"e "uge differences /et-een t"e t-o costing met"ods it is important to specify -"ic" met"od is /eing used. :ne -ay in -"ic" a/sorption costing can /e "e#pfu# is -"en a company -ants to ma)e sure t"at a retai# price accurate#y ref#ects t"e costs in*o#*ed in t"e production of a good. ="is can /e especia##y critica# -it" sma## companies -"ic" #ac) financia# reser*es and t"erefore cannot afford to ta)e a #oss or to se## products -it"out accounting for o*er"ead. &or e$amp#e a garment manufacturer mig"t t"in) not Iust a/out t"e cost of -oo# and #a/or for ma)ing a s-eater /ut a#so t"e costs of )nitting mac"ines t"e factory -"ere t"e mac"ines are insta##ed t"e cost of running t"e mac"ines insurance and ot"er types of o*er"ead costs.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )&

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B. = % A#* PR CESS C S!I#$

S2ecific order costing< ="e c"oice of met"od of costing to /e used /y an organization depends upon t"e nature of acti*ity underta)en /y t"e organization Specific order costing met"ods are appropriate for organizations -"ic" produce cost units -"ic" are separate#y identifia/#e from one anot"er 2o/ costing /atc" costing and contract costing are a## types of specific order costing @e -ou#d in t"e fo##o-ing section co*er Io/ costing in detai#.

=o4

rder Costing

2o/ Costing is met"od of costing in -"ic" -e ca#cu#ate t"e cost of eac" Io/. 2o/ "ere means a sma## -or) or group of sma## acti*ities -"ic" -e can identify in any product9s production.

A Io/ order costing system is used -"en a Io/ or /atc" is significant#y different from ot"er Io/s or /atc"es .Cost accounting is usua##y fair#y simp#e in t"ese systems. ;a/our and materia#s are entered on a Io/ tic)et :*er"ead is usua##y added to t"e amount t"e customer -i## /e c"arged for #a/our and materia#s

2o/ costing in*o#*es )eeping an account of direct and indirect costs. :*er"ead is added to t"e price customers -i## /e c"arged for #a/or and materia#. Suc" met"od is used in construction motion picture and s"ipping industries in fa/rication repair and maintenance -or)s and in ser*ices suc" as auditing etc.

If you go to an auto repair s"op t"ey -i## start a Io/ tic)et Iust for t"e -or) to /e done on your car 8our Io/ tic)et -i## s"o- c"arges for #a/our and materia#s Iust for your Io/. ;etPs This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )' Pa e

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say t"ey c"arge you Rs.'?D per "our for #a/our. ="is c"arge inc#udes t"e mec"anicPs payro## cost. But it a#so inc#udes an o3er5ead c5arge 7 -"ic" is genera##y not stated separate#y .="e o*er"ead c"arge co*ers t"e costs of operating t"e garage 7 too#s and eGuipment rent insurance maintenance uti#ities etc. It is a -ay to allocate o3er5ead (discussed /e#o-) and /ui#d it in to t"e amount c"arged to customers ="e garage -i## a#so ma)e a gross profit on t"e parts t"ey use to repair your car. ="is gross profit co*ers t"e cost of /uying and maintaining a parts in*entory inc#uding department emp#oyee -ages insurance and -are"ousing costs Allocating o3er5eads ;etPs #oo) at a typica# product 7Before production starts no costs "a*e /een incurred. @or)ers stand ready to ma)e t"e product in*entory -aits patient#y in t"e -are"ouse and t"e manufacturing p#ant contains a## t"e resources necessary to perform t"e manufacturing operation. @e first add materia#s into production from t"e in*entory. At t"e same time t"e accounting department transfers t"e cost of in*entory items to t"e J@or) in 5rocess9 account and t"e product or Io/ no- "as a *a#ue. 4e$t t"e -or)ers start to con*ert t"e ra- in*entory into a product. As #a/our is added t"e accounting department transfers payro## costs to t"e @or) in 5rocess account increasing t"e *a#ue of t"e product or Io/. :*er"ead costs are a##ocated to t"e product or Io/ /ased on t"e costing met"od used. As -or) progresses on t"e product or Io/ it accumu#ates #a/our materia#s and o*er"ead costs. &ina##y t"e tota# finis"ed product or Io/ cost is transferred to &inis"ed Koods and -"en it is so#d t"e cost is transferred to Cost of Koods So#d

Accounting for

3er5ead Costs

:*er"ead is a##ocated to products or Io/s using a reasona/#e a##ocation met"od. @e try to find some part of t"e manufacturing process t"at is regu#ar and predicta/#e -"ic" is ca##ed as cost dri*er ;a/our "ours used is t"e most popu#ar a##ocation met"od. ="e num/er of #a/our "ours in a year is fair#y predicta/#e. ,ifferences in emp#oyees pay rates are not re#e*ant -"en This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore )( Pa e

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using "ours. ="e information is readi#y a*ai#a/#e from e$isting payro## records. ="ere is usua##y a direct corre#ation /et-een #a/our and t"e production process ;a/our cost is t"e second most popu#ar a##ocation met"od. It is used /y *ery #arge companies -it" #arge -or) forces operating under #a/our contracts ="e #a/our costs are fair#y predicta/#e and are c#ose#y #in)ed to production. Because of t"e #arge num/er of emp#oyees #a/our costs tends to /e a *ery sta/#e and predicta/#e measure of t"e progress of production

:t"er o*er"ead (simp#er) met"ods inc#ude< num/er of units produced mac"ine "ours use (Iet engines diese# #ocomoti*es) sGuare footage of f#oor space ("eating coo#ing ! Ianitoria# costs) mi#es (ta$is truc)ing)

Some companies use a sop"isticated met"od in*o#*ing ser*ice departments suc" as maintenance and computer processing. ="ese departments pro*ide ser*ices to ot"er departments. Ser*ice departments are -ide#y used in "ospita# accounting.

Si12le

3er5ead Allocation

="e simp#est form of o*er"ead a##ocation is to treat a## annua# o*er"ead as a sing#e cost poo# and a##ocate it to one annua# cost dri*er Some termino#ogy t"at -ou#d /e usefu# in t"e discussion of distri/ution of o*er"eads are discussed as fo##o-s< Cost allocation< A##ocation is t"e process of identifying and attri/uting a cost to a specific cost centre7eg. product de*e#opment cost for a ne- product can /e a##ocated to t"at product. Cost A22ortion1ent< @"en it is not possi/#e to a##ocate a cost to a particu#ar cost centre since t"e cost "as /een incurred for t"e Ioint /enefit of se*era# cost centres a reasona/#e estimation of t"e /enefits recei*ed /y eac" of t"e cost centre is made and cost is apportioned according#y. Pa e

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !*

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Cost A4sor2tion< ="e #ast stage of distri/ution of costs -"ere o*er"eads are a/sor/ed into t"e production units of a cost centre @e determine t"e predetermined o*er"ead a/sorption rate as t"e /udgeted o*er"eads di*ided /y t"e /udgeted cost dri*er.

Illustration 1 Assume 2o"nsonPs Ba)ery produces 2 DDD DDD #oa*es of /read per year and incurs RsAD DDD in annua# o*er"ead cost. 3o- muc" o*er"ead cost must 2o"nson a##ocate to eac" #oaf of /read0 =ota# Annua# :*er"ead 777777777777777777777777 6nits of Cost ,ri*er L cost per unit of cost dri*er

RsAD DDD 777777777777777777777777 2 DDD DDD #oa*es

L 'D paise per #oaf

In addition to direct costs (#a/our ! materia#s) 2o"nson -i## a##ocate 'D paise per #oaf to o*er"ead costs

*ecision 1a9ing using o3er5ead costs Illustration & Assume 2o"nsonPs Ba)ery must #ease a ne- o*en for Rs2D DDD per year to rep#ace an o#d o*en. ,irect costs per #oaf -i## not c"ange. 2o"nson c"arges a## #ease costs to t"e :*er"ead account A## ot"er o*er"ead costs -i## stay t"e same 3o- -i## t"e ne- o*en #ease c"ange 2o"nsonPs o*er"ead costs0

AD DDD Y 2D DDD 777777777777777777777777

L >D paise per #oaf Pa e

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !)

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2 DDD DDD #oa*es 2o"nsonPs o*er"ead cost per #oaf -i## increase 1D paise from 'D to >D paise Illustration + Sonia Auto parts "as C mec"anics -or)ing fu## time 1 ?DD "ours per year eac" for a tota# of 12 DDD "ours t"at -i## /e /i##ed to Io/s ="ey incur Rs12D DDD per year in o*er"ead costs Sonia a##ocates o*er"ead costs to car repair Io/s /ased on t"e num/er of "ours -or)ed on eac" Io/ 3o- muc" -i## Sonia a##ocate per #a/our "our0 12D DDD 777777777777777777777777 12 DDD "ours

L Rs1D%7 o*er"ead per #a/our "our

Sonia Auto parts -i## a##ocate Rs1D%7 per #a/our "our for o*er"ead

Illustration . E$amp#e of :*er"ead A##ocation to a 2o/ Sonia Auto parts -or)s on t"e de#i*ery truc) /e#onging to 2o"nsonPs Ba)ery. ="e Io/ ta)es 2DD "ours 3o- muc" o*er"ead cost -i## Sonia a##ocate to t"is Io/0 :*er"ead per #a/our "our H #a/our "ours on Io/ L o*er"ead a##ocated to Io/ 1C 6 &CC D Rs.&CCC Sonia Auto parts -i## a##ocate Rs2DDD in o*er"ead costs to t"e repair Io/ @"y donPt you see :*er"ead costs #isted separate#y on repair tic)ets0 Customers usua##y donPt understand -"at o*er"ead costs are or -"y t"ey are important for a /usiness :*er"ead costs are genera##y ./ui#t in. to ot"er costs. Sonia Auto parts -i## add t"e o*er"ead cost to itPs regu#ar #a/our rate .Since o*er"ead is a##ocated /y #a/our "our t"is is an easy met"od for a garage or simi#ar types of /usinesses :*er"ead costs are genera##y ."idden. from customers in t"is -ay /ut t"e company must c"arge t"e customer for t"ese costs in some -ay "nderE 3er A4sor2tion of o3er5eads @e discussed in t"e preceding sections t"at direct e$penses are fair#y easy to trace. 3o-e*er a #ot of appro$imation is used in predicting and su/seGuent#y distri/uting o*er "eads to a Io/. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !! Pa e

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@"i#e o*er"eads are predicted(t"is predicted o*er"eads is ca##ed t"e /udgeted o*er"eads) and a##ocated to Io/s t"e actua# o*er"eads incurred at t"e end of an accounting period may /e more or #ess t"an t"e /udgeted o*er"eads. @"en t"e /udgeted o*er"eads is #ess t"an t"e actua# o*er"eads t"en t"ere is an under a/sorption of o*er"eads and -"en /udgeted o*er"eads is more t"an t"e actua# o*er"eads t"ere is o*er a/sorption of o*er"eads. Illustration B In t"e e$amp#e discussed a/o*e suppose Sonia Auto parts -or)s a /udgeted 'DDD #a/our "ours across se*era# Io/s inc#uding t"at of 2o"nson9s Ba)ery. At t"e end of t"e accounting period t"e tota# o*er"eads incurred /y Sonia tota#s Rs.'2 DDD%7 Ca#cu#ate under%o*er a/sor/ed o*er"eads. Solution Budgeted o*er"eadsL Budgeted #a/our "oursXo*er "ead a##ocation rate L'DDDX1DLRs.'D DDD%7 Actua# o*er"eadsLRs.'2 DDD%7(gi*en) Since t"e /udgeted o*er"eads (t"is is a#so referred to as a/sor/ed o*er"eads in some te$ts) is #ess t"an t"e actua# o*er"eads t"ere is an under a/sorption of o*er"eads /y Rs.2DDD%7 Illustration F H #td fo##o-s Io/ order costing. ="e fo##o-ing are t"e detai#s of Io/s during t"e period :cto/er 2D1D to Marc" 2D11. 5articu#ars 2o/ 1D1 2o/ 1D2 2o/ 1D' 2o/ 1D> 2o/ 1D? :pening @I5 2>DDDD BDDDD 77777777777 77777777777 77777777777 Materia# >DDDDD 'DDDDD ?DDDDD 22DDDD 2>DDDD ;a/or 1ADDDD >DDDDD 'DDDDD 2>DDDD 2ADDDD

5roduction :*er"eads c"arged to Io/ is ?DN of #a/or cost and administration o*er"ead c"arged to Io/s is ?DN of materia#.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !"

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Administration o*er"eads are c"arged after comp#etion of Io/. ,uring Marc" 2o/ 1D1 1D2 and 1D? -ere comp#ete. 2o/ no 1D' and 1D> -ere sti## in process. Se##ing price is determined after mar)ing up ''.''N profit on Cost. Ca#cu#ate t"e fo##o-ing< (1) Cost of comp#eted Io/s. (2) Fa#ue of c#osing -or) in process. (') 6nder a/sorption%:*er a/sorption of production o*er"eads assuming t"at actua# o*er"eads incurred during t"e period is Rs.?DDDDD%7 (>) Se##ing price of 2o/ 1D1 1D2 and 1D?. Solution (1) Cost of comp#eted Io/s. 5articu#ars :pening @I5 Materia# ;a/or 5roduction :*er"eads @or)s Cost Administration :*er"eads =ota# Cost 1D1 2>DDDD >DDDDD 1ADDDD CDDDD CCDDDD 1D2 BDDDD 'DDDDD >DDDDD 2DDDDD BBDDDD 1D? D 2>DDDD 2ADDDD 1'DDDD A'DDDD

2DDDDD 1?DDDD 12DDDD 1DCDDDD 11>DDDD (?DDDD

(2) Fa#ue of c#osing -or) in process. 5articu#ars :pening @I5 Materia# ;a/or 5roduction :*er"eads C#osing @I5 1D' D ?DDDDD 'DDDDD 1?DDDD B?DDDD 1D> D 22DDDD 2>DDDD 12DDDD ?CDDDD

(') 6nder a/sorption%:*er a/sorption of production o*er"eads assuming t"at actua# o*er"eads incurred during t"e period is Rs.?DDDDD%7

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !#

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Budgeted :*er"ead<7 CDDDDY2DDDDDY1'DDDDY1?DDDDY12DDDDLACDDDD Actua# :*er"ead<7?DDDDD. :*er A/sorption<7 ACDDDD7?DDDDDL1CDDDD. (>) Se##ing price of 2o/ 1D1 1D2 and 1D?. =ota# Cost 5rofit S5 1DCDDDD 11>DDDD (?DDDD '?BBA> '(BBA2 2>BB(? 1>'BBA> 1?1BBA2 BBBB(?

PR CESS C S!I#$ @ ME!) * A#* !EC)#IG"ES 5rocess costing is a costing met"odo#ogy t"at arri*es at an indi*idua# product cost t"roug" t"e ca#cu#ation of a*erage costs for #arge Guantities of identica# products. A process costing system is used -"en a /usiness is producing a #arge num/er of identica# products. In t"is situation it is most efficient to accumu#ate costs at an aggregate #e*e# for a #arge /atc" of products and t"en a##ocate t"em to t"e indi*idua# units produced. 5rocess Costing may /e adopted using any of t"e tec"niGues of costing. ="e tec"niGue adopted -ou#d decide t"e procedure adopted in re#ation to *arious accounting aspects. &or e$amp#e for t"e purpose of *a#uation of stoc)s< &i$ed costs -i## /e considered a#ong -it" Faria/#e costs if .A/sorption Costing. is adopted as t"e tec"niGue :n#y *aria/#e costs -i## /e considered if .margina# costing. is adopted as t"e tec"niGue

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !$

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E6a12le of an area 75ere Process Costing is a22lied A common e$amp#e of an industry -"ere process costing may /e app#ied is .Sugar Manufacturing Industry1

="e processes in t"is industry are< Cane S5redding ="e cane is /ro)en% cut into sma## pieces to ena/#e easier mo*ement t"roug" t"e mi##ing mac"ine Milling ="e s"redded cane is passed t"roug" ro##ers -"ic" crus" t"em to e$tract cane Iuice ZSimi#ar to t"e cane Iuice e$tracted /y t"e *endors -"o se## you sugar cane Iuice[ )eating and Adding li1e ="e e$tracted Iuice is t"en "eated to ma)e it a concentrate and #ime is added to t"e "eated Iuice Clarification Muddy su/stance is remo*ed from t"e concentrate t"roug" t"is process E3a2oration @ater is remo*ed from t"e Iuice /y e*aporation

Crystallisation and Se2aration This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !% Pa e

[MACME]
Sugar crysta#s are gro-n from t"e dry Iuice concentrate in t"is process S2inning Mo#asses are separated from sugar using Centrifuga#s in t"is process *rying Sugar is o/tained /y drying t"e -et ra- sugar o/tained in t"e spinning process ="e fo##o-ing features may /e identified -it" process costing< ="e output consists of products -"ic" are "omogenous 5roduction is carried on in different stages (eac" of -"ic" is ca##ed a process) "a*ing a continuous f#o5roduction ta)es p#ace continuous#y e$cept in cases -"ere t"e p#ant and mac"inery are s"ut do-n for maintenance etc :utput is uniform and a## units are identica# during eac" process It -ou#d not /e possi/#e to trace t"e identity of any particu#ar #ot of output to any #ot of input ="e input -i## pass t"roug" t-o or more processes /efore it ta)es t"e s"ape of t"e output ="e output of eac" process /ecomes t"e input for t"e ne$t process unti# t"e fina# product is o/tained -it" t"e #ast process gi*ing t"e fina# product ="e output of a process (e$cept t"e #ast) may a#so /e sa#ea/#e in -"ic" case t"e process may generate some profit ="e input of a process (e$cept t"e first) may /e capa/#e of /eing acGuired from t"e outside sources ="e output of a process is transferred to t"e ne$t process genera##y at cost to t"e process It may a#so /e transferred at mar)et price to ena/#e c"ec)ing efficiency of operations in comparison to t"e mar)et conditions 4orma# and a/norma# #osses may arise in t"e processes

I##ustration ( In a factory process cost accounts are in use for a certain period t"e production of t"e commodity -as 1DDD tones. ="ree processes *iz. A B C and t"e ra- materia# -ere added in a## t"e processes. ="e costs -ere as fo##o-s< 5articu#ars Materia# ;a/or Mfg E$penses 5rocess A 'DDD 1?DD 1?DD 5rocess B 1?DD 'DDD >?DD 5rocess C 1?DD ?2?D ?2?D Pa e

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !&

[MACME]

Assume t"at t"ere -as no -or) in process eit"er at t"e /eginning or at t"e end. S"o- t"e process costs for eac" cost of t"e finis"ed product. ="e production is 1DDD tones at t"e end of process. 5rocess A A%c 5articu#ars =o materia# =o ;a/or =o Mfg E$penses =ota# 5rocess B A%C 5articu#ars =o materia# =o ;a/or =o Mfg E$penses =ota# 5rocess C A%C 5articu#ars =o materia# =o ;a/or =o Mfg E$penses =ota#

Amt 'DDD 1?DD 1?DD ADDD

5articu#ars By transferred out

Amt ADDD

=ota#

ADDD

Amt 1?DD 'DDD >?DD BDDD

5articu#ars By transferred out

Amt BDDD

=ota#

BDDD

Amt 1?DD ?2?D ?2?D 12DDD

5articu#ars By C:KS

Amt 12DDD

=ota#

12DDD

)o7 Process Cost is A22lied in %usiness If you "a*e e*er spi##ed mi#) t"ere is a good c"ance t"at you used Bounty paper to-e#s to c#ean up t"e mess. 5rocter ! Kam/#e (5!K) manufactures Bounty in t-o main processing departments\5aper ma)ing and 5aper Con*erting. In t"e 5aper Ma)ing ,epartment -ood pu#p is con*erted into paper and t"en spoo#ed into 2 DDD pound ro##s. In t"e 5aper Con*erting ,epartment t-o of t"e 2 DDD pound ro##s of paper are simu#taneous#y un-ound into a mac"ine This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !' Pa e

[MACME]
t"at creates a t-o7p#y paper to-e# t"at is decorated perforated and em/ossed to create te$ture. ="e #arge s"eets of paper to-e#s t"at emerge from t"is process are -rapped around a cy#indrica# card/oard core measuring eig"t feet in #engt". :nce enoug" s"eets -rap around t"e core t"e eig"t foot ro## is cut into indi*idua# ro##s of Bounty t"at are sent do-n a con*eyor to /e -rapped pac)ed and s"ipped. In t"is type of manufacturing en*ironment costs cannot /e readi#y traced to indi*idua# ro##s of BountyU "o-e*er gi*en t"e "omogeneous nature of t"e product t"e tota# costs incurred in t"e 5aper Ma)ing ,epartment can /e spread uniform#y across its output of 2 DDD pound ro##s of paper. Simi#ar#y t"e tota# costs incurred in t"e 5aper Con*erting ,epartment (inc#uding t"e cost of t"e 2 DDD pound ro##s t"at are transferred in from t"e 5aper Ma)ing ,epartment) can /e spread uniform#y across t"e num/er of cases of Bounty produced. 5!K uses a simi#ar costing approac" for many of its products suc" as =ide Crest toot"paste and 5ring#es 2oint 2roducts and %y@2roducts @"en a production process yie#ds t-o or more products simu#taneous#y out of common ramateria# t"e output products are termed as Ioint products. ="e Ioint products -"ic" arise out of common ra- materia# may "a*e -anted or un-anted *a#ue. ="ose -"ic" "a*e insignificant *a#ue are termed as /y7product. By7 products are secondary products. &or e$amp#e from crude oi# -e get petro# and diese# -"ic" "as "ig" significant *a#ue and t"erefore )no-n as Ioint products. At t"e same time -e a#so get some #u/ricant -"ic" is un-anted so it is termed as /y7product. CIMA(C"artered Institute of Management Accountants) defines Ioint product as Jt-o or more product separated in processing eac" "a*ing a sufficient#y "ig" sa#e *a#ue to merit recognition as a main product1 and /y product as +output of some *a#ue produce incidenta##y in manufacturing somet"ing e#se (main product)1. Some e$amp#es of 2oints products are as fo##o-s< 1. :i# refining< 5etro# ,iese# ;iGuid 5etro#eum Kas Oerosene 5araffin ;u/ricants 2. Meat 5rocessing< Meat 3ides Bones Krease. '. Mining< Iron copper Si#*er. >. S"eep Rearing< Meat @oo# 3ides. Some e$amp#es of By7 products are as fo##o-s< 1. Sugar manufacture< Mo#asses used for industria# a#co"o# 2. Iron and Stee# manufacture< &urnace s#ag used in construction acti*ities '. Meat trade< Bones Krease This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore !( Pa e

[MACME]
>. Co)e industry < ;ino#eum =oint 2roduct costing7 2oint product is defined as a costing of a production process t"at yie#ds mu#tip#e products simu#taneous#y. %y@2roducts costing7 By product costing is defined as costing of products in t"e Ioint production process -it" #o- sa#es *a#ue. ="e costing is done at t"e time of production or at t"e time of sa#es.

Co11on costs8 ="ese costs cannot /e identified -it" a particu#ar Ioint product. By definition Ioint products incur common costs unti# t"ey reac" t"e sp#it7off point. S2lit@off 2oint8 At t"is stage t"e Ioint products acGuire separate identities. Costs incurred prior to t"is point are common costs and any costs incurred after t"is point are separa/#e costs. Se2ara4le costs8 ="ese costs can /e identified -it" a particu#ar Ioint product. ="ese costs are incurred for a specific product after t"e sp#it7off point. At or /eyond t"e sp#it off point decisions re#ating to t"e sa#e or furt"er processing of eac" identifia/#e product can /e made independent#y of decisions a/out t"e ot"er products. ="e c"aracteristic feature of Ioint products is t"at a## costs incurred prior to t"e sp#it7off point are common costs and cannot /e identified -it" indi*idua# products t"at are deri*ed at sp#it7 off.,istinction among main products Ioint products and /yproducts are not so definite in practice. &or e$amp#e some companies may c#assify )erosene o/tained -"en refining crude oi# as a /yproduct /ecause t"ey /e#ie*e )erosene "as a #o- tota# sa#es *a#ue re#ati*e to t"e tota# sa#es *a#ues of gaso#ine and ot"er products. :t"er companies may consider t"e *ice *ersa. Moreo*er t"e c#assification of products can c"ange o*er time depending on t"e price of t"e product in t"at year. Illustration H @or) out t"e estimated pre separation cost per ton of /y 7 products 8 ! ] from t"e fo##o-ing data< Costs of manufacturer /efore separation< 2? AD DDD. Main product is H. ="ere are t-o /y7products 8 ! ] -"ose norma# se##ing price is as fo##o-s< Sa#es price of 8< ?DD per ton Sa#es price of ]< CDD per ton

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "*

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[MACME]
Se##ing and distri/ution e$penses "a*e /een estimated to /e 2?N of S5 and t"e net profit is e$pected to /e 1DN of S5. Costs to manufacture eac" ton after separation from t"e main product are < B? (8) and 1>? (]). Assume eGua# -eig"t for 8 and ] So#ution< 5articu#ars Se##ing 5rice ;ess< Se##ing and ,istri/ution E$ps (2?N of S5) 5roduct 8 ?DD 12? '(? ;ess< 4et profit(1DN of S5) ?D '2? ;ess< 5ost separation cost 5re Separation Cost B? 2'D CDD 2DD ADD CD ?2D 1>? '(? 5roduct ]

I##ustration B =-o products 5 ! E are o/tained in a crude form and reGuire furt"er processing at a cost of Rs.? for 5 and Rs. > for E unit /efore sa#e. Assuming a net margin of 2?N on cost t"eir sa#es are fi$ed ^ Rs.1'.(? and Rs.C.(? per unit respecti*e#y. ,uring t"e process Ioint cost incurred -as Rs. CC DDD and t"e outputs -ere< 57 C DDD units E7A DDD units. Ascertain t"e Ioint cost per unit

5roduct E :utput(units) ADDD

5roduct 5 CDDD Pa e

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore ")

[MACME]
Se##ing 5rice ;ess< 5rofit(2?N on cost ie.2DN on S5) Cost of Sa#es ;ess<&urt"er processing cost after separation 5re Separation Cost S"are of 2oint Cost(C<')X 2oint Cost per unit 1'.(? 2.(? 11.DD ?.DD A.DD A> DDD C.DD C.(? 1.(? (.DD >.DD '.DD C> DDD >.DD

XRatio in Apportioning 2oint Costs< 5 L C DDD units X A L >C DDD E L A DDD units X ' L 1C DDD ="erefore >C DDD<1C DDD L C<'

Case< @endy9s C"i#i< A costing Conundrum(MAC)

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "!

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[MACME]

F. Acti3ity %ased Costing Acti*ity Based Costing (ABC) is a system t"at Assigns :*er"ead cost to t"e acti*ities performed in a manufacturing or Ser*ices de#i*ery process. M;es#ie K.E#den/urg (2DD?) ABC is a costing t"at first assigns cost to acti*ities and t"en to goods and ser*ices /ased on "o- muc" eac" goods and ser*ice uses t"e acti*ity. M Rona#d @.3i#ton Mic"ae# @.Ma"er and &ran) 3 Se#to (2DDA)

@e "a*e a#ready seen in t"e foregoing discussions in 2o/ and 5rocess Costing t"at traditiona# costing met"ods use a sing#e /ase(;a/our "ours t"at -e "ad seen in t"e Io/ costing e$amp#e) or at most a com/ination of t-o /ases of cost. 3o-e*er Acti*ity /ased Costing is /ased on t"e princip#e t"at a sing#e a/sorption /ase cannot Iustifia/#y ref#ect t"e /e"a*iour of o*er"ead costs. :*er"ead costs are not a#-ays direct#y re#ata/#e to time or production *o#ume. In a modern manufacturing en*ironment o*er"eads are more dependent on t"e comp#e$ity of t"e production. An ABC approac" attempts to ensure t"at o*er"eads are traced to products in a -ay t"at more accurate#y ref#ects t"e o*er"ead costs t"at "a*e /een incurred on t"eir /e"a#f. According to Ray 3 Karrison and Eric @ 4oreen t"ere are si$ /asic steps reGuired to imp#ement an ABC system< Identify and define acti*ities and acti*ity poo#s ,irect#y trace costs to acti*ities (to t"e e$tent feasi/#e) Assign costs to acti*ity cost poo#s Ca#cu#ate acti*ity rates Assign costs to cost o/Iects using t"e acti*ity rates and acti*ity measures pre*ious#y determined 5repare and distri/ute management reports ="is ana#ysis of o*er"ead costs into acti*ities and t"eir a/sorption using a *ariety of cost dri*ers is /e#ie*ed to produce more accurate resu#ts in a##ocating o*er"eads to product cost.

Acti*ity /ased costing focuses on acti*ities and costs are a##ocated to acti*ities using resource dri*ers. Resource dri*ers s"o- t"e cause of costs and are used to a##ocate costs to acti*ities. Cost is a##ocated depending on "o- muc" of t"e resource dri*er is used in t"e acti*ity. It

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore ""

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[MACME]
increases a-areness of cause and effect re#ations"ips and promotes performance impro*ement. It a#so "e#ps to identify non7*a#ue added acti*ities and moti*ates cost reduction.

.I##ustration 1 H8] Company is considering Acti*ity /ased costing to a##ocate :*er"eads. &o##o-ing information is gi*en for t"e production of t-o products A and B. Acti*ity Set7up Mac"ine maintenance =ota# Manufacturing Cost Cost 2DDDDD BDDDD 2BDDDD

5roduct 4um/er of setups Mac"ine 3ours

A >D 1?DD

B AD '?DD

=ota# 1DD ?DDD

H8] Company p#ans to produce '?D units of product A and 2?D units of product B. Compute t"e manufacturing cost for eac" product. So#ution &irst -e -i## identify t"e acti*ities performed /y t"e company and assigning cost to eac" acti*ity t"en c"oosing t"e cost dri*er for ca#cu#ating t"e a##ocation rate. After ca#cu#ating t"e a##ocation rate -e can a##ocate t"e coat to product. In a/o*e case company performs t-o acti*ities i.e. Setup and maintenance of mac"ine. 4o- -e -i## ca#cu#ate A##ocation rate for eac" acti*ity 1. Setup Cost<

=ota# Cost %=ota# 4o.of Setups L 2 DD DDD 1DD 2. Mac"ine Maintenance<

L Rs 2DDD per setup

=ota# Mac"ine Maintenance cost% =ota# Mac"ine 3our This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "# Pa e

[MACME]
L BDDDD % ?DDD "rs L Rs 1C per "our

Since -e "a*e ca#cu#ated t"e A##ocation RateU ne$t step is to a##ocation of cost to eac" product &o##o-ing ta/#e s"o-s t"e a##ocation of cost. Acti*ity Setup 5roduct A 4o.of Setup Xcost per >DX2DDD L CD DDD Setup 5roduct B ADX2DDD L 1 2D DDD

Mac"ine Maintenance

Mac"ine 3ourXCost per 1?DDX1C L 2(DDD 3our

'?DDX1C LA'DDD

=ota# Cost 4um/er of units 6nit cost

Rs 1D(DDD 'DD Rs.'DA%7

Rs 1C'DDD 2?D Rs.('2%7

Case< C#assic 5en Company< ,e*e#oping an ABC Mode# (3BS%B71BC711()

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "$

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[MACME]

I. Acti3ity %ased Manage1ent Acti*ity7/ased management and acti*ity7/ased costing (ABM%ABC) "a*e /roug"t a/out radica# c"ange in cost management systems. ABM "as gro-n #arge#y out of t"e -or) of t"e =e$as7 /ased Consortium for Ad*anced Manufacturing7Internationa# (CAM7I). 4o #onger is ABM9s app#ica/i#ity #imited to manufacturing organisations. ="e princip#es and p"i#osop"ies of acti*ity7 /ased t"in)ing app#y eGua##y to ser*ice companies go*ernment agencies and process industries. ="e acronym itse#f "as e*o#*ed from ABC to ABCM (acti*ity7/ased cost management) to ABM and t"e app#ication of ABC e*o#*ed from a manufacturing product costing orientation to a management p"i#osop"y of acti*ity management app#ied in industries and organisations ot"er t"an manufacturing. Acti*ity7/ased costing and acti*ity7/ased management "a*e /een around for more t"an fifteen years. Most for-ard7t"in)ing companies "a*e imp#emented t"em or are in t"e process of doing so. ABM dra-s on ABC to pro*ide management reporting and decision ma)ing. ABM supports /usiness e$ce##ence /y pro*iding information to faci#itate #ong7term strategic decisions a/out suc" t"ings as product mi$ and sourcing. It a##o-s product designers to understand t"e impact of different designs on cost and f#e$i/i#ity and t"en to modify t"eir designs according#y. ABM a#so supports t"e Guest for continuous impro*ement /y a##o-ing management to gain neinsig"ts into acti*ity performance /y focusing attention on t"e sources of demand for acti*ities and /y permitting management to create /e"a*ioura# incenti*es to impro*e one or more aspects of t"e /usiness. ABM is a fundamenta# s"ift in emp"asis from traditiona# costing and performance measurement. 5eop#e underta)e acti*ities -"ic" consume resources M so contro##ing acti*ities a##o-s you to contro# costs at t"eir source. ="e rea# *a#ue and po-er of ABM comes from t"e )no-#edge and information t"at #eads to /etter decisions and t"e #e*erage it pro*ides to measure impro*ement.mABM ena/#es management to ma)e informed decisions on t"e fo##o-ing< ;ines of /usiness product mi$ process and product design -"at ser*ices s"ou#d /e offered This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "% Pa e

[MACME]
capita# in*estments and pricing. ABM is more t"an an accounting too#U itPs a system for continuous impro*ements. It is not a sing#e ans-er /ut mere#y one of t"e many too#s t"at can /e used to en"ance organisationa# performance management. ABM -i## not reduce costs it -i## on#y "e#p you understand costs /etter to )no- -"at to correct.="e process of ABM does consume resources and t"e manpo-er costs can /e significant. Companies considering or a#ready imp#ementing ABM s"ou#d rea#ise t"at a#t"oug" certain product or mar)et factors mig"t ma)e it potentia##y /eneficia# t"ose same factors mig"t not #ead to a successfu# imp#ementation. ABM gi*es us a muc" /etter c"ance of esta/#is"ing a usefu# costing for outputs. But t"ere is a price to pay. It can /e difficu#t to find out -"at costs app#y in a particu#ar acti*ity and t"ose in*o#*ed may /e suspicious of ot"ers c"arged -it" finding out. Some areas of acti*ity o*er#ap and are difficu#t to separate. And of course ABM is a cost#y e$ercise in its o-n rig"t. :t"er priorities top management commitment I= capa/i#ities and integration -it" financia# and /udgeting systems s"ou#d /e considered /efore imp#ementation. :rganisations "a*e /egun to #oo) at ABM for a *ariety of reasons. Among t"e most common#y cited are< \ top7do-n pressure to reduce costsU \ competiti*e pressure%mar)et conditionsU \ organisation7-ide programmeU \ t"e introduction of /enc"mar)ingU \ regu#atory issuesU \ see)ing -or#d7c#ass status t"roug" process management. ABC and ABM are a continuum of *a#ue. ABM is t"e app#ication of ABC data to manage product portfo#ios and /usiness processes /etter. Reading< Acti*ity Based Costing and Capacity By Ro/ert.S.Oap#an Case @i#)erson Co (3BS%B71D17DB2)

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "&

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[MACME]

H. MAR$I#A, C S!I#$ A#* *ECISI # A#A,'SIS So1e i12ortant definitions8 Rele3ant cost8 Cost t"at can /e a*oided if a decision is not imp#emented is ca##ed re#e*ant cost Sun9 Cost8 Costs t"at cannot /e re*ersed or do not a#ter irrespecti*e of any future decision 22ortunity cost8 Cost of t"e opportunity foregone in order to se#ect a decision option ="is presupposes t-o important factors7 pre e$istence of an opportunity and a reasona/#e possi/i#ity of accessing it Contri4ution8 Contri/ution margin is t"e amount remaining from sa#es re*enue after *aria/#e e$penses "a*e /een deducted. ="us it is t"e amount a*ai#a/#e to co*er fi$ed e$penses and t"en to pro*ide profits for t"e period. Contri4ution Margin Ratio (CM Ratio)8 ="e contri/ution margin as a percentage of tota# sa#es is referred to as contri/ution margin ratio (CM Ratio). Contri/ution margin ratio can /e used in cost7*o#ume profit ca#cu#ations. 4jecti3es of C/P Analysis8 Cost 3olu1e 2rofit analysis (C/P analysis) is one of t"e most po-erfu# too#s t"at managers "a*e at t"eir command. It "e#ps t"em understand t"e interre#ations"ip /et-een cost *o#ume and profit in an organisation /y focusing on interactions among t"e fo##o-ing fi*e e#ements< 1. 5rices of products 2. Fo#ume or #e*e# of acti*ity '. 5er unit *aria/#e cost >. =ota# fi$ed cost ?. Mi$ of product so#d Because cost7*o#ume7profit (CF5) ana#ysis "e#ps managers understand t"e interre#ations"ips among cost *o#ume and profit it is a *ita# too# in many /usiness decisions. ="ese decisions inc#ude for e$amp#e -"at products to 1anufacture or sell -"at pricing This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "' Pa e

[MACME]
po#icy to fo##o- -"at 1ar9eting strategy to emp#oy and -"at ty2e of 2roducti3e facilities to acJuire.

A22lications of Cost /olu1e Profit (C/P) Conce2ts8 4o- -e can e$p#ain "o- CF5 concepts de*e#oped on a/o*e pages can /e used in p#anning and decision ma)ing. @e s"a## use t"ese concepts to s"o- "o- c"anges in *aria/#e costs fi$ed costs sa#es price and sa#es *o#ume effect contri/ution margin and profita/i#ity of companies in a *ariety of situations.

C"ange in fi$ed cost and sa#es *o#ume C"ange in *aria/#e cost and sa#es *o#ume C"ange in fi$ed cost sa#es price and sa#es *o#ume C"ange in *aria/#e cost fi$ed cost and sa#es *o#ume C"ange in regu#ar sa#es price

I12ortance of Contri4ution Margin8 CF5 ana#ysis can /e used to "e#p find t"e most profita/#e com/ination of *aria/#e costs fi$ed costs se##ing price and sa#es *o#ume. 5rofits can sometimes /e impro*ed /y reducing t"e contri/ution margin if fi$ed costs can /e reduced /y a greater amount. %rea9 E3en Analysis8 Brea) e*en is t"e #e*e# of sa#es at -"ic" t"e profit is zero. Cost *o#ume profit ana#ysis is some time referred to simp#y as /rea) e*en ana#ysis. ="is is unfortunate /ecause /rea) e*en ana#ysis is on#y one e#ement of cost *o#ume profit ana#ysis. Brea) e*en ana#ysis is designed to ans-er Guestions suc" as "How far sales could drop before the company begins to lose money." Cost /olu1e Profit (C/P) Consideration in C5oosing a Cost Structure8 Cost structure refers to t"e re#ati*e proportion of fi$ed and *aria/#e costs in an organization. An organization often "as some #atitude in trading off /et-een t"ese t-o types of costs. &or e$amp#e fi$ed in*estment in automated eGuipment can reduce *aria/#e #a/or costs. ="e purpose of management is to reduce t"e cost /y c"oosing a /#end of fi$ed and *aria/#e cost t"at ma$imizes t"e u#timate o/Iecti*e i.e.U profit. So1e illustrations on C/P analysis8 This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore "( Pa e

[MACME]

Ma9e or %uy8

I##ustration 1 Suppose ,i*ision A in 5riyan)a 5roducts "ad a capacity to produce 1DDD units a mont" and t"e /rea) up of cost is as fo##o-s< 5articu#ars Amount Materia# cost 1DD ;a/our (? Faria/#e o*er"eads 2? Sa#es commission ? &i$ed o*er"ead 2D =ota# 22? ,i*ision B -anted >DD units from ,i*ision A. ,i*ision A "as t"e capa/i#ity to produce t"ese additiona# units -it"out incurring additiona# fi$ed costs. ,i*ision A Guotes Rs.2?D%7 per unit and ,i*ision B "as an offer from t"e mar)et to /uy t"ese units ^ 2>D per unit. S"ou#d 5riyan)a decide to stop producing t"ese products in "ouse0 So#ution Cost of producing one unit(margina# cost)L1DDY(?Y2?L2DD%7 Cost of purc"asing one unitLRs.2>D%7 It is ad*isa/#e to continue producing t"e products in "ouse S5ut *o7n or Continue8 I##ustration 2 Ra"u# Enterprises is operating under difficu#t mar)et conditions and are incurring mont"#y una*oida/#e costs of Rs.>D DDD%7 ="eir contri/ution is s"o-ing t"e fo##o-ing trend< 2anuary AD DDD%7 &e/ruary ?D DDD%7 Marc" ?? DDD%7 Apri# >? DDD%7 Considering t"e *o#ati#e trend Ra"u# decides t"at it is /etter to suspend operations. Ad*ise "im. So#ution ="e una*oida/#e cost -i## continue to /e incurred e*en after suspending operations 3o-e*er t"e contri/ution -i## not /e earned if operations are suspended. 3ence operations s"ou#d /e continued ti## contri/ution /ecomes zero. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #* Pa e

[MACME]

Illustration + Product 1i6 decisions 7it5 ca2acity constraints ="e fo##o-ing costs and ot"er data app#y to t-o component parts used /y BaIaI E#ectrica#s #imited. 5articu#ars ,irect materia# ,irect #a/our :*er"eads 6nit cost 6nits needed per year Mac"ine "ours per unit 6nit cost if purc"ased 5art H D.CD 2.DD C.DD 1D.CD A DDD 2 1D 5art 8 1A.DD B.>D >.DD 2B.>D C DDD 1 'D

="e company "it"erto "as /een manufacturing a## reGuired components. 3o-e*er in t"e current year on#y 1> DDD "ours of ot"er-ise id#e mac"ine time can /e de*oted to t"e production of component. According#y some of t"e parts must /e purc"ased from outside supp#iers. In producing parts o*er"eads are app#ied at Rs.> per mac"ine "our. &i$ed capacity costs -"ic" -i## not /e affected /y any ma)e or /uy decision represent (DN of t"e app#ied o*er"ead. ReGuired< 1. Assuming t"at 1> DDD "ours of a*ai#a/#e mac"ine time is to /e sc"edu#ed so t"at t"e company rea#izes ma$imum potentia# cost sa*ings determine t"e re#e*ant production costs t"at s"ou#d /e considered in t"e decision to sc"edu#e mac"ine time. 2. Compute t"e num/er of units t"at BaIaI E#ectrica#s s"ou#d produce if it a##ocates mac"ine time on t"e /asis of t"e potentia# cost sa*ings per mac"ine "our. So#ution

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #)

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@"ene*er t"ere is a #imiting factor or capacity constraint product mi$ s"ou#d /e decided so as to ma$imise t"e profits. 3ence -e use margina# costing to support t"is decision. ="e contri/ution per unit is arri*ed at. ="en t"e contri/ution is ca#cu#ated -it" respect to t"e constraining factor. &or e$amp#e if #a/our "ours are in s"ort supp#y t"en contri/ution is ca#cu#ated -it" respect to #a/our "our. ="e product t"at yie#ds ma$imum #a/our "our contri/ution is gi*en priority in ran)ing. ="e top ran)ed product is produced as per reGuirement and t"e #east ran)ed product is produced to t"e e$tent t"at t"e constraining resource is a*ai#a/#e. In t"e a/o*e i##ustration #et us first ca#cu#ate t"e contri/ution per unit< 5articu#ars ,irect materia# ,irect #a/our Faria/#e :*er"eads ('DN) 6nit *aria/#e cost Cost to purc"ase from outside Sa*ings if produced in "ouse ;imiting factor7Mac"ine "our%unit Sa*ings%mac"ine "our Ran) 4um/er of units 5art H D.CD 2.DD 2.>D ?.2D 1D.DD >.CD 2 2.>D 2 'DDDXX 5art 8 1A.DD B.>D 1.2 2A.AD 'D.DD '.>D 1 '.>D 1 CDDD

XX After producing CDDD units of 8 num/er of mac"ine "ours a*ai#a/#e is 'DDD. So -e can on#y produce 'DDD units of H. Case Moti 3eera (5) ;td (A) ! (B) (IIMA%EMDDD'(A ! B))

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #!

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K. Pricing and Cost Manage1ent

5ricing a product is a *erita/#e c"a##enge for most organizations since mar)ets are dynamic and se*era# *aria/#es t"at inf#uence prices are eit"er too *o#ati#e or unpredicta/#e. 5ricing and cost are t"e prime factors t"at ma$imize profit. 5rofit :ptimization mode# 5rofit optimization mode# is /ased on t"e economic t"eory t"at profit is ma$imized at t"e output #e*e# -"ere t"e margina# cost is eGua# to t"e margina# re*enue. 3o-e*er many of t"e *aria/#es in t"is mode# are Guite difficu#t to predict. ,emand function is *ery difficu#t to /e predicted accurate#y. :-ing to t"e a/o*e se##ing price /ased profit ma$imization or demand /ased profit ma$imization may /e difficu#t to ac"ie*e for /usinesses. 3ence se*era# of t"e pricing strategies are /ased on cost. Some of t"e cost /ased pricing strategies are as fo##o-s< a. &u## Cost p#us pricing ="is pricing met"od is used -ide#y /y producers. ="is is a traditiona# met"od of pricing popu#ar#y used /y -"o#esa#ers retai#ers construction contractors In t"is met"od prices are set /y adding a N of profit to t"e tota# cost of t"e output. ="is is )no-n as t"e mar) up price or a margin price. In t"is met"od t"e cost of a product is ca#cu#ated and a margin of profit is added on. ="ere is empirica# e*idence to s"o- t"at t"e producers usua##y set t"eir prices on t"e /asis of a cost p#us a fair margin of profits. &air profit is most#y a fi$ed percentage of profit -"ic" is ar/itrari#y determined. &air profit may differ from industry to industry or among firms in t"e same #ine of production. ="e *ariations occur due to factors #i)e differences in turno*er rate differences in ris)s intensity of competition etc. &u## cost pricing is t"e simp#est pricing met"od. In t"is met"od /asica##y t"e firm ca#cu#ates t"e cost of a product and t"e mar)up N is added to arri*e at t"e se##ing price. &u## cost pricing can /e done in t-o -ays ie.fu## cost pricing -"ic" ta)es into consideration /ot" *aria/#e and fi$ed costs and adds a percentage as mar)up /. Margina# Cost p#us pricing ="e margina# cost pricing met"od considers t"e a##ocation of resources as a /ase for pricing. ="e pricing is done in suc" a -ay so as to a##ocate t"e resources efficient#y. &or instance in t"e case of pu/#tc underta)ings t"e returns may not co*er t"e costs. As a resu#t in t"e case of pu/#ic underta)ings t"e returns may not e*en co*er t"e costs and "ence in many cases pricing on t"e /asis of margina# cost may not /e profita/#e to t"e in*estor. Some pu/#ic sector underta)ings may "a*e fa##ing margina# costs. Margina# cost may /e #o-er t"an a*erage cost. In This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #" Pa e

[MACME]
suc" a situation if t"e price is fi$ed /y eGuating margina# cost and a*erage re*enue it -i## #ead to #osses.="is type of pricing may /e resorted to to ena/#e t"e pu/#ic to /uy certain essentia# goods. :t"er pricing strategies are /road#y descri/ed as fo##o-s< Crea1ing or s9i11ing In most s)imming goods are so#d at "ig"er prices so t"at fe-er sa#es are needed to /rea) e*en. Se##ing a product at a "ig" price sacrificing "ig" sa#es to gain a "ig" profit is t"erefore .s)imming. t"e mar)et. S)imming is usua##y emp#oyed to reim/urse t"e cost of in*estment of t"e origina# researc" into t"e product< common#y used in e#ectronic mar)ets -"en a ne- range suc" as ,F, p#ayers are first#y dispatc"ed into t"e mar)et at a "ig" price. ="is strategy is often used to target .ear#y adopters. of a product or ser*ice. Ear#y adopters genera##y "a*e a re#ati*e#y #o-er price7sensiti*ity 7 t"is can /e attri/uted to< t"eir need for t"e product out-eig"ing t"eir need to economiseU a greater understanding of t"e productPs *a#ueU or simp#y "a*ing a "ig"er disposa/#e income. ="is strategy is emp#oyed on#y for a #imited duration to reco*er most of t"e in*estment made to /ui#d t"e product. =o gain furt"er mar)et s"are a se##er must use ot"er pricing tactics suc" as economy or penetration. ="is met"od can "a*e some set/ac)s as it cou#d #ea*e t"e product at a "ig" price against t"e competition. ,i1it 2ricing A #imit price is t"e price set /y a monopo#ist to discourage economic entry into a mar)et and is i##ega# in many countries. ="e #imit price is t"e price t"at t"e entrant -ou#d face upon entering as #ong as t"e incum/ent firm did not decrease output. ="e #imit price is often #o-er t"an t"e a*erage cost of production or Iust #o- enoug" to ma)e entering not profita/#e. ="e Guantity produced /y t"e incum/ent firm to act as a deterrent to entry is usua##y #arger t"an -ou#d /e optima# for a monopo#ist /ut mig"t sti## produce "ig"er economic profits t"an -ou#d /e earned under perfect competition. ="e pro/#em -it" #imit pricing as a strategy is t"at once t"e entrant "as entered t"e mar)et t"e Guantity used as a t"reat to deter entry is no #onger t"e incum/ent firmPs /est response. ="is means t"at for #imit pricing to /e an effecti*e deterrent to entry t"e t"reat must in some -ay /e made credi/#e. A -ay to ac"ie*e t"is is for t"e incum/ent firm to constrain itse#f to produce a certain Guantity -"et"er entry occurs or not. An e$amp#e of t"is -ou#d /e if t"e firm signed a union contract to emp#oy a certain ("ig") #e*e# of #a/or for a #ong period of time. In t"is strategy price of t"e product /ecomes t"e #imit according to /udget. ,oss leader A #oss #eader or #eader is a product so#d at a #o- price (i.e. at cost or /e#o- cost) to stimu#ate ot"er profita/#e sa#es. ="is -ou#d "e#p t"e companies to e$pand its mar)et s"are as a -"o#e.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore ##

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Mar9et@oriented 2ricing Setting a price /ased upon ana#ysis and researc" compi#ed from t"e target mar)et. ="is means t"at mar)eters -i## set prices depending on t"e resu#ts from t"e researc". &or instance if t"e competitors are pricing t"eir products at a #o-er price t"en itPs up to t"em to eit"er price t"eir goods at an a/o*e price or /e#o- depending on -"at t"e company -ants to ac"ie*e . Penetration 2ricing 5enetration pricing inc#udes setting t"e price #o- -it" t"e goa#s of attracting customers and gaining mar)et s"are. ="e price -i## /e raised #ater once t"is mar)et s"are is gained.Z'[ Price discri1ination 5rice discrimination is t"e practice of setting a different price for t"e same product in different segments to t"e mar)et. &or e$amp#e t"is can /e for different c#asses suc" as ages or for different opening times. Pre1iu1 2ricing 5remium pricing is t"e practice of )eeping t"e price of a product or ser*ice artificia##y "ig" in order to encourage fa*ora/#e perceptions among /uyers /ased so#e#y on t"e price. ="e practice is intended to e$p#oit t"e (not necessari#y Iustifia/#e) tendency for /uyers to assume t"at e$pensi*e items enIoy an e$ceptiona# reputation are more re#ia/#e or desira/#e or represent e$ceptiona# Gua#ity and distinction. Predatory 2ricing 5redatory pricing a#so )no-n as aggressi*e pricing (a#so )no-n as .undercutting.) intended to dri*e out competitors from a mar)et. It is i##ega# in some countries. Case Mridu#a Ice Cream 5ar#our (A) (IIMA%&!A D'1?(A))

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #$

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c. 1C. !arget Costing and life cycle costing

!arget costing8 =arget costing means a cost of product -"ic" can /e incurred -"en -e need to ac"ie*e t"e reGuired profit. =arget costing "e#ps to impro*e t"e process design and at t"e same time to reduce cost to offer a good competition to t"e ot"er p#ayers in t"e mar)et. ="e estimated cost is a#so )no-n as =arget cost )o7 !arget Cost is Set8 =arget cost is set for a product /ased on t"e company9s strategic po#icy. ,esign7to7cost responsi/i#ity is t"en assigned to cross7functiona# teams -it" e$treme#y /road aut"ority. ="is aut"ority inc#udes of course product features and can a#so e$tend to a## upstream and do-i1stream support acti*ities and t"eir met"od of de#i*ery. Cost7reduction acti*ity continues unti# t"e target cost is ac"ie*ed or a## parties rea#ize it is not possi/#e. =arget costing is an inno*ati*e tec"niGue t"at ena/#es companies to de#i*er a customer7 defined product at t"e #o-est possi/#e cost. @it"out proper p#anning "o-e*er target costing can /e difficu#t to imp#ement effecti*e#y. =arget Costing presents a frame-or) for managers to understand "o- target costing -or)s and "o- to p#an and imp#ement an effecti*e system. =arget costing can /e re#ated -it" t"e /ac)-ard integration mode#. 3ere instead of ca#cu#ating costs first and t"en setting t"e price /ased on t"ese ca#cu#ated costs target costing does it t"e ot"er -ay around. =arget costing is con*enient for firms operating in perfect competition. !5e ste2s in target costing are as follo7s8 ,etermine t"e price t"e consumer is -i##ing to pay for t"e specific productU -e## t"is can /e done /y conducting a mar)et researc". &or e.g. t"e consumers are ready to pay Rs.1DDDD%7 ("ypot"etica# figures) for "ig" end mo/i#e p"ones -"ic" "as a## t"e /est ! t"e #atest features in it. After t"at t"e company s"ou#d decide t"e profit margin t"at it -i## accept say for e.g. "ere company is p#anning to "a*e a profit margin of 1D N( "ypot"etica# figures). i.e. Rs.1DDD%7 This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #% Pa e

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Su/tract t"e price t"e consumer is -i##ing to pay -it" t"e profit margin t"e company is -i##ing to "a*e i.e. 1DDDD71DDDLBDDD. ="is is t"e target cost -"ic" is /een determined. 3ence Rs.BDDD%7 is t"e target cost. I##ustration 1 A company is p#anning a ne- product. Mar)et researc" information suggests t"at t"e product s"ou#d se## 1D DDD units at Rs.21.DD%unit. ="e company see)s to ma)e a mar)7up of >DN product cost. It is estimated t"at t"e #ifetime costs of t"e product -i## /e as fo##o-s< 1 ,esign and de*e#opment costs Rs.?D DDD 2 Manufacturing costs Rs.1D%unit' End of #ife costs Rs.2D DDD ="e company estimates t"at if it -ere to spend an additiona# Rs.1? DDD on design manufacturing costs% unit cou#d /e reduced. Solution ="e target cost of t"e product can /e ca#cu#ated as fo##o-s< (a) Cost Y Mar)7up L Se##ing price 1DDN >DN 1>DN Rs.1? Rs.A Rs.21 (/) ="e origina# #ife cyc#e cost per unit L (Rs.?D DDD Y (1D DDD $ Rs.1D) Y Rs.2D DDD)%1D DDD L Rs.1( ="is cost%unit is a/o*e t"e target cost per unit so t"e product is not -ort" ma)ing. (c) Ma$imum tota# cost per unit L Rs.1?. Some of t"is -i## /e caused /y t"e design and end of #ife costs< (Rs.?D DDD Y Rs.1? DDD Y Rs.2D DDD)%1D DDD L Rs.C.?D ="erefore t"e ma$imum manufacturing cost per unit -ou#d "a*e to fa## from Rs.1D to (Rs.1? M Rs.C.?D) L Rs.A.?D. In conc#usion it can /e said t"at a#t"oug" target cost is used t"roug"out t"e product #ife cyc#e it is primari#y used and most effecti*e in t"e product de*e#opment and design stage. ="e mar)et7 dri*en p"i#osop"y target costing is /ased on t"e price7do-n cost7do-n strategy -"ic" "as a##o-ed companies to -in considera/#e s"are of t"eir respecti*e mar)ets. ="ere -i## pro/a/#y /e a range of products and prices /ut t"e company cannot dictate tot"e mar)et customers or competitors. ="ere are po-erfu# constraints on t"e product and its price This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #& Pa e

[MACME]
and t"e company "as to ma)e t"e reGuired product se## it at an accepta/#e and competiti*e price and at t"e same time ma)e a profit. If t"e profit is going to /e adeGuate t"e costs "a*e to /e sufficient#y #o-. ="erefore instead of starting -it" t"e cost and -or)ing to t"e se##ing price /y adding on t"e e$pected margin target costing -i## start -it" t"e se##ing price of a particu#ar product and -or) /ac) to t"e cost /y remo*ing t"e profit e#ement. ="is means t"at t"e company "as to find -ays of not e$ceeding t"at cost.

,ife cycle cost 1anage1ent ;ife cyc#e costing a#so emp"asizes on cost reduction and not cost contro#. ;ife cyc#e cost management is a re#ated approac" t"at /ui#ds a conceptua# frame-or) t"at faci#itates management9s a/i#ity to e$p#oit interna# ! e$terna# #in)ages. ="e fo##o-ing diagram represents t"e p"ases in t"e product #ife cyc#e<

In life cycle 1anage1ent s2ecific cost is associated 7it5 eac5 stage of t5e 2roduct or ser3ices. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #' Pa e

[MACME]

Stage 1 5re7production%5roduct de*e#opment stage Since t"is is t"e #aunc"ing stage a "ig" #e*e# of cost is incurred (preproduction costs) inc#uding researc" and de*e#opment (R!,) product design and /ui#ding of production faci#ities. Stage & ;aunc"%Mar)et de*e#opment stage E$tensi*e mar)eting and promotion cost is incurred in t"is stage as t"is stage -or)s on creating a-areness a/out t"e e$istence of product%ser*ices Stage + Kro-t" stage Mar)eting and promotion -i## continue t"roug" t"is stage. In t"is stage sa#es *o#ume increases dramatica##y and unit costs fa## as fi$ed costs are reco*ered o*er greater *o#umes. Stage . Maturity stage Initia##y profits -i## continue to increase as initia# setup and fi$ed costs are reco*ered. Mar)eting and distri/ution economies are ac"ie*ed.

3o-e*er price competition and product differentiation -i## start to erode profita/i#ity as firms compete for t"e #imited ne- customers remaining

Stage B ,ec#ine stage Mar)eting costs are usua##y cut as t"e product is p"ased out 5roduction economies may /e #ost as *o#umes fa##

Mean-"i#e a rep#acement product -i## need to "a*e /een de*e#oped incurring ne#e*e#s of R!, and ot"er product setup costs. A#ternati*e#y additiona# de*e#opment costs may /e incurred to refine t"e mode# to e$tend t"e #ife7cyc#e (t"is is typica# -it" cars -"ere Pproduct e*o#utionP is t"e norm rat"er t"an Pproduct re*o#utionP.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore #(

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Illustration & Company H is considering -"et"er to pursue 5roIect A or 5roIect B. 5roIect B "as an initia# cost of Rs.2 DDD -"i#e 5roIect A "as an initia# cost of Rs.' DDD. Company H is more inc#ined to ta)e on 5roIect B /ecause of t"e percei*ed #o-er cost. 3o-e*er app#ying t"e #ife cyc#e cost formu#a -i## "e#p Company H determine if 5roIect B is tru#y more cost7effecti*e t"an 5roIect A. Calculating life cycle cost

PR =EC! A Initial Cost Annual Costs E#ectricity Maintenance Project ,ife (8ears) *iscount -actor (Based on an interest rate of 'N) Calculations ,I-E C'C,E C S! 1? Rs. 1?D Rs. ?D Rs.' DDD

PR =EC! % Rs. 2 DDD

Rs. 2?D Rs.1?D 1?

D.A>

D.A>

Rs. ' DDD Y (Rs.2DD $ Rs.2 DDD Y (Rs.>DD $ 1? $ 1? $ D.A>) D.A>) Rs.> B2D Rs.? C>D

="e formu#a for ca#cu#ating #ife cyc#e cost is< ,I-E C'C,E C S! D I#I!IA, C S! L (A##"A, C S!S 6 PR =EC! ,I-E 6 *ISC "#! -AC! R)

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $*

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As t"e a/o*e comparison demonstrates t"e #o-est initia# cost does not #ead to t"e #o-est cost o*era##. 5roIect A is t"e more cost effecti*e option to pursue. :5en is life cycle costing useful< @"en e*a#uating capita# in*estment options using ;ife Cyc#e Costing (;CC) can "e#p you determine t"e option -"ic" is most cost effecti*e. Rat"er t"an e*a#uating proIects so#e#y on t"e /asis of initia# costs ;CC #oo)s at t"e tota# cost of o-ning operating and maintaining a proIect o*er its usefu# #ife (inc#uding its fue# energy #a/or and rep#acement components). ;ife cyc#e costing ca#cu#ates operating and maintenance costs incurred during t"e #ifetime of t"e proIect p#us t"e initia# capita# costs. Companies sometimes need to consider target prices and target costs for a product o*er a mu#ti7year product #ife cyc#e. 5roduct #ife cyc#e spans t"e time from initia# R!, on a product to -"en customer ser*ice and support I s no #onger offered for t"at product. &or Automo/i#e companies suggest &ord 4issan t"e product #ife cyc#e is from 12 to 1? years. In suc" "ig" operations #ife cyc#e costing is used in de*e#opment period for R!, and design is #ong and cost#y. It is a#so /eing used for pricing t"e product after a## costs incurred for producing t"e product. ="e decision ma)ing process in*o#*es a cross functiona# team in -"ic" emp#oyees from *arious departments (5roduction Engineering R!, Mar)eting and Accounting) are gi*en t"e responsi/i#ity of determining an accepta/#e mar)et price and corresponding Return on Sa#es as -e## as a feasi/#e cost in -"ic" a gi*en item may /e produced. In order to minimize costs team mem/ers focus on e#iminating non7*a#ue7added costs of t"e process impro*ing product design and modifying process met"ods. Ac"ie*ing &u## Cyc#e Cost management (SMR 1?' &a## 2DD>) Case =oyota Motor Company< =arget Costing (3BS%B71B(7D'1)

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11. Standard Cost and %udgets

@"en /udgets are prepared t"e costs are usua##y computed at t-o #e*e#s in tota# do##ars so an income statement can /e prepared and cost per unit. ="e cost per unit is referred to as a standard cost. A standard cost can a#so /e de*e#oped and used for pricing decisions and cost contro# e*en if a /udget is not prepared. A standard cost in a manufacturing company consists of per unit costs for direct materia#s direct #a/or and o*er"ead. ="e per unit costs can /e furt"er di*ided into t"e e$pected amount and cost of materia#s per unit t"e e$pected num/er of "ours and cost per "our for direct #a/or and t"e e$pected tota# o*er"ead costs and a met"od for assigning t"ose costs to eac" unit. @it"in t"e e$pected amount of materia#s -aste or spoi#age must /e considered -"en determining t"e standard amount. &or e$amp#e if a product suc" as a c"air reGuires materia# more materia# t"an is actua##y needed for t"e c"air must /e ordered /ecause t"e s"ape of t"e seat and t"e fa/ric are usua##y not e$act#y t"e same. ="e scraps of materia# are ca##ed -aste -"ic" is not a*oida/#e gi*en t"at t"e c"air is /eing produced -it" t"is specific fa/ric. ="e cost of t"e fu## piece of materia# is used as t"e standard cost /ecause t"e -aste "as no ot"er use.

Simi#ar#y -"en considering #a/or "ours do-ntime from production due to maintenance or start up and /rea) time must /e inc#uded in t"e num/er of "ours it ta)es to ma)e a product. :nce standards are esta/#is"ed t"ey are used to ana#yze and determine t"e reasons for actua# cost *ariances from standards. ="e *ariances may /e in Guantity of materia#s or "ours used to manufacture a product or in t"e cost of t"e materia#s or #a/or. Because o*er"ead is norma##y app#ied on some /asis t"e *ariances in o*er"ead -i## occur /ecause t"e tota# o*er"ead poo# of do##ars or t"e acti*ity #e*e# (for e$amp#e direct #a/or do##ars or "ours) used to a##ocate t"e o*er"ead is different from -"at -as p#anned. :nce standard costs are used in preparing /udgets ana#ysis of *ariances can /e used to pro*ide management -it" information a/out -"et"er a *ariance is caused /y Guantity or price so t"at appropriate action can /e ta)en.

Standard Cost /ariances A *ariance is t"e difference /et-een t"e actua# cost incurred and t"e standard cost against -"ic" it is measured. A *ariance can a#so /e used to measure t"e difference /et-een actua# and e$pected sa#es. ="us *ariance ana#ysis can /e used to re*ie- t"e performance of /ot" re*enue and e$penses. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $! Pa e

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="ere are t-o /asic types of *ariances from a standard t"at can arise -"ic" are t"e rate *ariance and t"e *o#ume *ariance. 3ere is more information a/out /ot" types of *ariances<

Rate variance. A rate *ariance (-"ic" is a#so )no-n as a price *ariance) is t"e difference /et-een t"e actua# price paid for somet"ing and t"e e$pected price mu#tip#ied /y t"e actua# Guantity purc"ased. ="e +rate1 *ariance designation is most common#y app#ied to t"e #a/or rate *ariance -"ic" in*o#*es t"e actua# cost of direct #a/or in comparison to t"e standard cost of direct #a/or. ="e rate *ariance uses a different designation -"en app#ied to t"e purc"ase of materia#s and may /e ca##ed t"e purc"ase price *ariance or t"e materia# price *ariance. Volume variance. A *o#ume *ariance is t"e difference /et-een t"e actua# Guantity so#d or consumed and t"e /udgeted amount mu#tip#ied /y t"e standard price or cost per unit. If t"e *ariance re#ates to t"e sa#e of goods it is ca##ed t"e sa#es *o#ume *ariance. If it re#ates to t"e use of direct materia#s it is ca##ed t"e materia# yie#d *ariance. If t"e *ariance re#ates to t"e use of direct #a/or it is ca##ed t"e #a/or efficiency *ariance. &ina##y if t"e *ariance re#ates to t"e app#ication of o*er"ead it is ca##ed t"e o*er"ead efficiency *ariance.

="us *ariances are /ased on eit"er c"anges in cost from t"e e$pected amount or c"anges in t"e Guantity from t"e e$pected amount. ="e most common *ariances t"at a cost accountant e#ects to report on are su/di*ided -it"in t"e rate and *o#ume *ariance categories for direct materia#s direct #a/or and o*er"ead. It is a#so possi/#e to report t"ese *ariances for re*enue.

A budget usua##y refers to a departmentJs or a companys proIected re*enues costs or e$penses. A standard usua##y refers to a proIected amount per unit of product per unit of input (suc" as direct materia#s factory o*er"ead) or per unit of output. Budgeting may /e defined as t"e process of preparing p#ans for future acti*ities of t"e /usiness enterprise after considering and in*o#*ing t"e o/Iecti*es of t"e said organisation. ="is a#so pro*ides process%steps of co##ection and preparation of data /y -"ic" de*iations from t"e p#an can /e measured. ="is ana#ysis "e#ps to measure performance cost estimation minimizing -astage and /etter uti#isation of resources of t"e organisation. ="us /udgets are prepared on t"e /asis of future estimated production and sa#es in order to find out t"e profit in a specified period. In ot"er -ords Budget is an estimate and a Guantified p#an for future acti*ities to coordinate and contro# t"e uses of resources for a specified period. According to Institute of Cost and @or)s Accountants +A /udget is a financia# and % or Guantitati*e statement prepared prior to a defined period of time of t"e 5o#icy to /e pursued during t"at period for t"e purpose of attaining a gi*en o/Iecti*e.1 Budgeting is a process -"ic" inc#udes /ot" t"e functions of /udget and /udgetory contro#. Budget is a p#anning function and /udgetory contro# is a contro##ing system or a tec"niGue.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $"

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CaseU @i#mont C"emica# Corporation

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $#

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1&. /ariance Analysis and -le6i4le %udgets Meaning of /ariance Analysis Fariance is t"e difference in t"e actua# resu#t and t"e standard resu#t. It is a contro##ing tec"niGue in -"ic" t"e standard resu#t is first set in t"e /eginning of t"e mont" or year according to t"e accounting ru#es or company standards. ="en t"e actua# resu#ts are processed after t"e period. ="en t"e actua# resu#ts are compared -it" t"e e$pected or set standard resu#ts. @"en t"ere is a difference in t"e resu#t t"is difference is )no-n as *ariance. ="is difference is studied /y t"e cost accountant to understand -"y t"is gap -as formed and t"e reasons for it. ="is study or t"e reasons found out /y t"e accountants on t"e /asis of *ariance is )no-n as *ariance ana#ysis. If t"e actua# resu#t is /etter t"an t"e set resu#t t"en it is )no-n as a fa*oura/#e resu#t and if t"e actua# resu#t is -orst t"en t"e standard resu#t t"en it is unfa*oura/#e or ad*erse resu#t. =a)ing re*enue into consideration if actua# is more t"an e$pected t"an fa*oura/#e and standard more t"an actua# t"an unfa*oura/#e resu#t. =a)ing cost into consideration if actua# more t"an e$pected t"an unfa*oura/#e and standard more t"an actua# t"an fa*oura/#e resu#t. *efinition In accounting a *ariance is defined as t"e difference /et-een t"e e$pected amount and t"e actua# amount of costs or re*enues. Fariance ana#ysis uses t"is standard or e$pected amount *ersus t"e actua# amount to Iudge performance. ="e ana#ysis inc#udes an e$p#anation of t"e difference /et-een actua# and e$pected figures as -e## as an e*a#uation as to -"y t"e *ariance may "a*e occurred. ="e purpose of t"is detai#ed information is to assist managers in determining -"at may "a*e gone rig"t or -rong and to "e#p in future decision7ma)ing. -a3oura4le /ariance A *ariance can /e put into t"e fa*ora/#e category -"en t"e resu#ts are /etter t"an e$pected. ="is means t"at re*enues -ere more t"an t"e e$pected amount or costs -ere /e#o- t"e /udgeted amount. In accounting practice a fa*ora/#e *ariance is s"o-n /y noting a #etter & in parent"esis on t"e reports. A fa*ora/#e *ariance mig"t earn a /onus for a manger or per"aps a mo*e up t"e corporate #adder. "nfa3oura4le /ariance In contrast t"e *ariance can /e Iudged as unfa*ora/#e if t"e resu#ts are -orse t"an e$pected. If t"e re*enues -ere /e#o- e$pectations or t"e costs -ere "ig"er t"an standard t"e *ariance -ou#d /e termed unfa*ora/#e or ad*erse. ="is -ou#d /e denoted on t"e reports -it" t"e #etter A or 6. Consistent#y creating an unfa*oura/#e *ariance mig"t resu#t in a manger /eing reprimanded or #osing t"eir Io/. 3o-e*er t"e ana#ysis is typica##y used to "e#p mangers pre*ent a negati*e situation from recurring /y pro*iding information a/out -"at -ent -rong. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $$ Pa e

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Co11on "ses Fariance ana#ysis is common#y used in se*era# aspects of /usiness accounting. :ne of t"e most common is in t"e purc"ase of manufacturing materia#s. ="e *ariance is t"e price paid for t"e materia#s #ess t"e e$pected cost and t"en mu#tip#ied /y t"e actua# num/er of units used in t"e process. Anot"er common#y seen usage is t"e se##ing price *ariance or t"e actua# sa#es price minus e$pected times t"e num/er of units. ="e ana#ysis is a#so used -it" o*er"ead and #a/or spending and efficiency. Pro4le1s 4ot a## companies use *ariance ana#ysis in t"eir manageria# process. ="ere are se*era# reasons for t"is one of -"ic" is t"at it can /e Guite comp#e$ for t"e accountants to process a## of t"e information necessary to disco*er -"y t"ere may "a*e /een a pro/#em or /enefit t"at caused t"e *ariance. &ina##y t"e standard figures used to ca#cu#ate t"e *ariance may not /e as accurate as t"e actua# figures t"us t"e ana#ysis may "a*e #itt#e usefu#ness. Many peop#e t"in) t"at ad*erse resu#t is not good for t"e company /ut it is not true. Many a time -"at "appens t"at t"e sa#es crosses t"e e$pected so in case of re*enue t"ere is a fa*oura/#e resu#t and t"at time o/*ious#y t"e costs -i## /e incurred more t"an e$pected i.e. ad*erse. So at t"is time you cannot say t"at t"e resu#ts -ere /ad t"e resu#ts e*entua##y -ere /etter t"an e$pected. ="erefore ad*erse effects are not a#-ays /ad. Ite1 %udget _PDDD SA,ES RE/E#"E Standard product 5remium product =ota# sa#es re*enue C S!S @ages Rent Mar)eting :t"er o*er"eads =ota# costs '? 1? 2D 2( B( 'C 1( 1> '? 1D> ' 2 7A C ( A A & A A (? 'D 1D? BD 2? 11? 1? 7? 1D & A & Actual _PDDD /ariance _PDDD -a3oura4le or Ad3erse

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $%

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5rofit

11

'

&

In t"e gi*en i##ustration 1) Standard product actua# is /etter t"an t"e e$pected t"us t"e resu#t is fa*oura/#e 2) 5remium products actua# sa#es are #ess t"an e$pected t"erefore unfa*oura/#e resu#t. ') ="erefore o*era## sa#es are /etter t"an e$pected. >) @ages rent and ot"er o*er"eads "as its actua# cost more t"an t"e e$pected t"us ad*erse resu#t. ?) Mar)eting cost "as its actua# #ess t"an t"e e$pected t"us its resu#t is fa*oura/#e. A) ="us o*era## cost "as its actua# more t"an t"e e$pected t"e resu#t is ad*erse. () ="e o*era## re*enue is /etter t"an t"e o*era## cost structure in actua# condition t"us t"e tota# profit is fa*oura/#e. In t"e gi*en i##ustration t"oug" t"e cost is ad*erse t"e tota# profit is more t"an e$pected t"us t"e tota# *ariance "as a positi*e effect on t"e cost account. Fariance ana#ysis "e#ps in finding out -"ere t"e actua# resu#ts "a*e /een increased or decreased and t"us correcti*e action can /e ta)en /y t"e managers to impro*e t"e profita/i#ity of t"e company /y doing *ariance ana#ysis. ="ey can see -"ere t"e costs "a*e increased and t"us t"ey can eit"er increase t"e sa#es *a#ue or reduce ot"er costs to )eep t"e profit per unit of t"e product same.

Reconciliation of Actual and %udgeted 2rofits Budgeted 5rofit is t"e profit -"ic" financia# ana#ysts of a company e$pect to "a*e in a specific period of time (-"ic" norma##y is one year) in t"e future and Actua# 5rofit is t"e profit -"ic" is actua##y earned /y t"e company Budgeting for a /usiness is a process of preparing a detai#ed statement of financia# resu#ts t"at are e$pected for a gi*en time period in t"e future. ="ere are t-o )ey-ords in t"at statement. ="e first )ey-ord is .e$pected.. E$pected means somet"ing t"at is #i)e#y to "appen. ="e second )ey-ord is .future. -"ic" is a period in t"e time to come. So /udgeting is t"e process of preparing a detai#ed statement of financia# resu#ts t"at are #i)e#y to "appen in a period in a time to come. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $& Pa e

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Reconci#iation is t"e process of ana#yzing t-o re#ated records and if differences e$ist /et-een t"em finding t"e cause and /ringing t"e t-o records into agreement. ="e more c#oser t"e Budgeted profits are to t"e actua# profits t"e /etter t"e accuracy of estimated uti#isation of resources. A *ariance is t"e difference /et-een an actua# resu#t and a /udgeted amount. @e c#assify a *ariance as fa*oura/#e or unfa*oura/#e /ased on t"eir effect on current profit. A fa*oura/#e (&) *ariance means t"at performance e$ceeded e$pectations\actua# re*enue e$ceeded /udgeted re*enue or actua# cost -as #ess t"an /udgeted cost. An unfa*oura/#e (A) *ariance or ad*erse *ariance means t"at performance fe## s"ort of e$pectations\actua# re*enue -as #ess t"an /udgeted re*enue or actua# cost e$ceeded /udgeted cost. ="e fle6i4le 4udget is a too# for performance e*a#uation. It is prepared at t"e end of t"e period. A f#e$i/#e /udget adIusts t"e fi$ed /udget as per t"e actua# #e*e# of output. ="e moti*ation for t"e f#e$i/#e /udget is to compare app#es to app#es. If t"e factory actua##y produced 1D DDD units t"en management s"ou#d compare actua# factory costs for 1D DDD units to -"at t"e factory s"ou#d "a*e spent to ma)e 1D DDD units not to -"at t"e factory s"ou#d "a*e spent to ma)e B DDD units or 11 DDD units or any ot"er production #e*e#. Re#ations"ip /et-een t"e /udgeted and actua# profit

Budgeted profit p#us A## fa*oura/#e *ariances minus A## ad*erse (unfa*oura/#e) *ariances eGua#s Actua# profit

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $'

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Illustration 1

Amt in Rs Per -i6ed unit %udget Sa#es *o#ume Sa#es 5urc"ases Insta##ation costs ,e#i*ery fi$ed costs ,e#i*ery :*er"eads Solution8 Per unit Sa#es *o#ume Sales ,ess 3aria4le costs 5urc"ases Insta##ation costs ,e#i*ery Contri4ution ,ess fi6ed costs ,e#i*ery :*er"eads #et 2rofit BDD -i6ed %udget 1 DDD B DD DDD 1 DDD BDD.DD B DD DDD ?DD.DD ? DD DDD CD.DD ?.DD CD DDD ? DDD 1 DDD 1 2D DDD

-le6i4le Actual %udget Result 1 2DD 1D CD DDD A DD DDD BA DDD A DDD 1 DDD 1 2D DDD 1 2DD B AD DDD ? (A DDD B( DDD A DDD 1 DDD 1 2' DDD

-le6i4le Actual %udget Result /ariance 1 2DD 1 2DD 12D DDD 1C?HC?CCC K?FC?CCC A

?DD CD ?

? DD DDD CD DDD ? DDD ? C? DDD +?1B?CCC

F?CC?CCC KF?CCC F?CCC ( D2 DDD +?IH?CCC

B?IF?CCC KI?CCC F?CCC A (B DDD 2 C1 DDD

2> DDD & 1DDD A D A'DDD &

1 DDD 1 2D DDD 1 21 DDD 1 B> DDD

1?CCC 1?&C?CCC 1 21 DDD 2 ?( DDD

1?CCC 1?&+?CCC 1 2> DDD 1 ?( DDD

D 'DDD A '(DDD A

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore $(

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Reconciliation 4et7een Actual and %udgeted Profit

%udgeted Profit Add -a3oura4le 3ariances 2>DDD A'DDD ,ess ad3erse 3ariances 12DDDD 1DDD 'DDD Actual 2rofit 712>DDD 1BICCC C(DDD

1K.CCC

A#t"oug" t"e /udget report s"o-s *ariances it does not e$p#ain t"e reasons for t"e *ariance. ="e /udget report is used /y management to identify t"e sa#es or e$penses -"ose amounts are not -"at -ere e$pected so management can find out -"y t"e *ariances occurred. By understanding t"e *ariances management can decide -"et"er any action is needed. &a*oura/#e *ariances are usua##y positi*e amounts and unfa*oura/#e *ariances are usua##y negati*e amounts

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore %*

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This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore %)

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