Types of costs

Costs are expenses the company has to pay during the production of its product. There are 4
main types of costs, these are: direct costs, indirect costs, fixed costs and variable costs.

Direct costs

A cost that can be directly related to producing specific goods or performing a specific service.
For example, the wages of an employee engaged in producing a product can be attributed
directly to the cost of manufacturing that product.

Examples-

 Commission payments, which Rs.10 per piece for Molding department workers and Rs.
15 per piece for finishing department workers.

 Rs. 10 per unit Commission payments for marketing department workers according to
their sales.

 Direct raw materials costs, which Rs. 5.00 for iron and Rs. 7.00 for aluminum.

Indirect costs

Cannot be attached to any specific product, unit or activity. Each business has its own method of
allocating indirect costs to different products, sources of sales revenue and business
units. Business managers and accounts should always keep an eye on the allocation methods
used for indirect costs.
Examples-

 Rs. 216,000 of total electricity bill for whole year.

Electricity Expenses = Rs.18,000 × 12

= Rs.216,000

 Other overhead expenses which are Rs.30000, Rs.5000, Rs.6000 and Rs.45,000 for
Administration, Molding, Finishing and Marketing departments respectively.

Total overhead expenses = Administration + Molding + Finishing + Marketing

= 30,000 + 5,000 + 6,000 + 45,000
= Rs. 86,000

 Indirect labor cost Salaries, which Administration Rs. 20,000 per month , Molding Rs.
8000 per month and Marketing Rs. 25,000 per month for an each employer.

Administration department salary = 20000 per month

2 workers annual salaries = 20000 x 12 x 2
= Rs. 480,000

Molding department salary = 8000 per month

5 workers annual salaries = 8000 x 12 x 5
= Rs. 480,000
 Marketing department salary = 25000 per month
4 workers annual salaries =25000 x 12 x 4
= Rs. 1,200,000

Total indirect labor cost = 480000+ 480000+ 1200000

= Rs. 2,160,000

Total indirect cost = Electricity Expenses + Overhead Expenses + Indirect Labor cost

= 216,000 + 86,000 + 2,160,000

= Rs. 2,462,000

Fixed costs

Costs that don't change over a period of time and don't vary with output. E.g. salaries, rent, tax,
insurance, heating and lighting. Fixed costs can also be called indirect costs as they are not
directly associated with the final product. Fixed costs have to be paid even if the company is not
producing any goods.

Examples-

 The fixed Salaries which they, Administration Rs. 20,000 per month , Molding Rs. 8000
per month and Marketing Rs. 25,000 per month.

 Commission payments which made to workers in Molding department - Rs.10 per piece,
Finishing department -Rs. 15 per piece and Marketing department- Rs. 10 per unit
 according to their sales. (only the per piece prices are belongs to fixed costs, not the
demand or the sales quantity)

 Variable costs:

Costs that vary directly with output so when output increases, variable costs also increase. E.g.
raw materials, electricity. Variable costs can also be called direct costs as they are directly
associated with production.

Examples-

 The raw material cost can vary according to the number of products produced.

 The commission amounts which relate to employees in Molding, Finishing and

Marketing departments can vary due to the changes of its number of products produced
and number of products sold.

Costing methods

Different industries follow different methods for ascertaining cost of their products.
The method to be adopted by business organization will depend on the nature of the production
and the type of out put.

The following are the important methods of costing.

  Activity-based costing (ABC)

Activity-based costing  is a costing model that identifies activities in an organization and assigns
the cost of each activity resource to all products and services according to the actual
consumption by each: it assigns more indirect costs (overhead) into direct costs.

In this way an organization can precisely estimate the cost of its individual products and services
for the purposes of identifying and eliminating those which are unprofitable and lowering the
prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's

resource costs through activities to the products and services provided to its customers. It is
generally used as a tool for understanding product and customer cost and profitability. As such,
ABC has predominantly been used to support strategic decisions such as pricing, outsourcing,
identification and measurement of process improvement initiatives.

 Job Costing

Job costing is concerned with the finding of the cost of each job or work order. Thismethod is
followed by these concerns when work is carried on by the customers request, such as printer
general engineering work shop etc. under this system a job cost sheet is required to be prepared
find out profit or losses for each job or work order.

 Contract Costing:
Contract  costing is applied for contract work like construction of dam building civil engineering
contract etc. each contract or job is treated as separate cost unit for the cost ascertainment and
control.

 Batch Costing 
A batch is a group of identical products. Under batch costing a batch of similar products is
treated as a separate unit for the purpose of ascertaining cost. The total costs of abatch is divided
by the total number of units in a batch to arrive at the costs per unit. This type ofcosting is
generally used in industries like bakery, toy manufacturing etc.

 Process Costing
This method is used in industries where production is carried on through different stages or
processes before becoming a finished product. Costs are determined separately for
each process. The main feature of process costing is that output of one processbecomes the
raw materials of another process until final product is obtained. This type of costingis
generally used in industries like textile, chemical  paper, oil refining etc.

 Service (Operating) Costing
This method is used in those industries which rendered services instead of producing goods.
Under this method cost of providing a service is also determined. It is also called
service costing. The organisation like water supply department, electricity department etc. are
the examples of using operating costing.

 Operation Costing
This is suitable for industries where production is continuous and units are exactly identical
to each other. This method is applied in industries like mines or drilling, cement works etc.
Under this system cost sheet is prepared to find out cost per unit and profits or loss on
production.

 Multiple Costing
It means combination of two or more of the above methods of costing. Where a product
comprises many assembled parts or components (as in case of motor car) costs have to be
ascertained for each component as well as for the finished product for different components,
different methods of costing may be used. It is also known as composite costing.
Overhead cost allocation method
Give an Introduction abt this topic… .. difficult to find it from internet…. Try to find from books

According to the different types of costing methods, Overhead cost allocation method is the best
and most suitable costing method to use in this SBU.

Table 1

Indirect Salary Other Overhead Electricity

Dept Total Overheads
(Refer appendix 1) Expenses (Refer appendix 2)

Admin 480,000 30,000 10,286 520,286

Molding 480,000 5,000 74,805 559,805

Finishing 0 6,000 110,338 116,338

Marketing 1,200,000 45,000 20,571 1,265,571

Table 2
 Apportion
Dept Allocation Absorption

(Refer Appendix 3) (Refer Appendix 4)

No of Total Admin Mold Finis Mark Admin Mold Finish Mark

Worker Overheads
s
2 21.1
Admin 520,286 - 26.3% 52.6% - 136,835 273,670 109,781
%

Molding 5 559,805 - - - - - - - -

Finishing 10 116,338 - - - - - - - -
4 109,781 +
- 457,992 917,360 -
1,265,571
Marketing - 33.3% 66.7% -
=
1,375,352

594,827 1,191,03
0

Budgeting

Budgeting in a business sense is the planned allocation of available funds to each department
within a company. Budgeting allows executives to control overspending in less productive areas
and put more company assets into areas which generate significant income or good public
relations. Budgeting is usually handled during meetings with accountants, financial experts and
representatives from each department affected by the budgeting.

Purpose and the nature of Budgeting Process

Department managers in a business make decisions every day that affect the profitability of the
business. In order to make effective decisions and coordinate the decisions and actions of the
various departments, a business needs to have a plan for its operations. Planning the financial
operations of a business is called budgeting. A budget is a written financial plan of a business for
a specific period of time, expressed in rupees. Each area of a business’s operations typically has
a separate budget. For example, a business might have an advertising budget, a purchasing
budget, a sales budget, a manufacturing budget, a research and development budget, and a cash
budget. New and ongoing projects would each have a detailed budget. Each budget would then
be compiled into a master budget for the operations of the entire company.

A business that does not have a budget or a plan will make decisions that do not contribute to the
profitability of the business because managers lack a clear idea of goals of the business. A
budget serves five main purposes—communication, coordination, planning, control, and
evaluation.

IN BUDGETARY PLANNING, IT NEEDS THE FOLLOWING:

COMMUNICATION

In the budgeting process, managers in every department justify the resources they need to
achieve their goals. They explain to their superiors the scope and volume of their activities as
well as how their tasks will be performed. The communication between superiors and
subordinates helps affirm their mutual commitment to company goals. In addition, different
departments and units must communicate with each other during the budget process to
coordinate their plans and efforts. For example, the MIS department and the marketing
department have to agree on how to coordinate their efforts about the need for services and the
resources required.

COORDINATION

Different units in the company must also coordinate the many different tasks they perform. For
example, the number and types of products to be marketed must be coordinated with the
purchasing and manufacturing departments to ensure goods are available. Equipment may have
to be purchased and installed. Advertising promotions may need to be planned and implemented.
And all tasks have to be performed at the appropriate times.
PLANNING

A budget is ultimately the plan for the operations of an organization for a period of time. Many
decisions are involved, and many questions must be answered. Old plans and processes are
questioned as well as new plans and processes. Managers decide the most effective ways to
perform each task. They ask whether a particular activity should still be performed and, if so,
how. Managers ask what resources are available and what additional resources will be needed.

CONTROL

Once a budget is finalized, it is the plan for the operations of the organization. Managers have
authority to spend within the budget and responsibility to achieve revenues specified within the
budget. Budgets and actual revenues and expenditures are monitored constantly for variations
and to determine whether the organization is on target. If performance does not meet the budget,
action can be taken immediately to adjust activities. Without constant monitoring, a company
does not realize it is not on target until it is too late to make adjustments.

EVALUATION

One way to evaluate a manager is to compare the budget with actual performance. Did the
manager reach the target revenue within the constraints of the targeted expenditures? Of course,
other factors, such as market and general economic conditions, affect a manager’s performance.
Whether a manager achieves targeted goals is an important part of managerial responsibility.

Methods of Budgeting

INCREMENTAL BUDGETING
Incremental budgeting is a traditional method, widely used in commercial organizations and in
the public sector. Incremental budgeting means basing the budget for a department or function
on that of the previous period, usually adjusting for inflation by a percentage increase. Specific
changes, such as a planned expansion or reduction in activities, would also be allowed for. In
some cases the previous year’s actual costs may be used as a starting point, rather than the
budget, particularly if the actual costs were lower

Zero base budgeting

Zero base budgeting is a method which was developed in the 1970s with a view to eliminating
some of the problems of incremental budgeting. It takes the opposite view: instead of assuming
everything will continue as before, the focus is on achieving the organization’s objectives in the
most efficient way. Zero Base Budgeting means that the budget for each budget centre starts
from a base of zero for each period. Budgets for proposed activities are then put forward,
assessed and prioritized (in relation to the organization’s objectives) and allocated funds in order
of priority.

PROGRAMME BASED BUDGETING

Programme based budgeting is a method which is applicable to non-profitmaking organisations.
Programme based budgeting means breaking down the work of the organisation into
‘programmes’ designed towards achieving its various objectives. Several departments within the
organisation may contribute towards a single programme. The total funds available are shared
between the programmes, rather than being split into budgets for departments. It is usually the
case that insufficient funds are available to achieve all the desired objectives, and decisions have
to be made as to which programmes are to be carried out and what level of work can be
supported. The choice of programmes should ensure that cost-effective methods are used, to
achieve as much as possible (in terms of the organization’s objectives) with the total funds
available.
Forecasted Demand

Table 3

Year Demand

2006 71,975

2007 78,453

2008 66,640

2009 70,887

Forecasted demand (for year 2010) = 71,975 + 78,453 + 66,640 + 70,887

= 287,955 / 4

= Rs. 71,989

Sales Budget
Sales budget = Forecasted demand X forecasted selling price

Sales budget =71,989 x 140

=Rs. 10,078,460

Production Budget

Production Budget = Forecasted Demand - Forecasted Ope/ Stock+ Forecasted Closing Stock

To calculate production budget, we are taking the opening stock as zero, as this is a newly started
SBU. And closing stock taken as 10% from the demand.

Production Budget = 71,989 – 0 + (71,989 X 10%)

 =71,989 – 0 + 7,199

=Rs. 79,188

Material Budget

Diagram 1

AB2010

A (1) B (2)

Iron-2 Aluminum-1 Iron-2 Aluminum-3

Total iron needed =Rs. 475,128

Total Aluminum needed = Rs. 554,316

(Refer Appendix 5)

Material purchase budget

Material purchase budget= Demand for Raw Material – Opening Stock + Closing Stock

Amount to be Purchased of Iron = Rs. 522,641

Amount to be Purchased of Aluminum = Rs. 609,748

(Refer Appendix 6)

Direct Material Cost Budget

Direct Material Cost Budget = Amount to be Purchase × Cost per unit

Direct material cost budget = Rs. 6,255,852

(Refer Appendix 7)

Direct Labor Budget

Direct Labor Budget = Production budget X Direct labor cost per unit

Total direct labor cost = Rs. 2,699,590

(Refer Appendix 8)

Pro forma Trading and profit loss statement for year ending 7th May 2011

   Rs.  Rs.  Rs.

     
Sales   10,078,460
Cost of sales    
Direct Material Refer Appendix 9 5,687,131  
Direct Labor Refer Appendix 10 2,519,615 8,206,746
Gross profit   1,871,714
(-) Expenses    
Administration salary 480,000    
Molding salary 480,000    
Marketing salary 1,200,000 2,160,000  
Administration Overheads 30,000    
Molding Overheads 5,000    
Finishing Overheads 6,000    
Marketing Overheads 45,000 86,000  
Electricity 216,000 2,462,000
Net loss   -590,286
       
Cost of sales = Direct material cost + Direct labor cost

= 5,687,131 + 2,519,615

= Rs. 8,206,746

Cash flow statement

Pro forma cash flow statement for the year ending 7th May 2011

Statement of Cash Flow Rs.

     
Cash Inflow    
Sales   10,078,460
     
Cash Outflow    
Direct Material Cost 6,255,852  
Direct Labor Cost 2,699,590  
Indirect Labor Cost 2,160,000  
Electricity 216,000  
Overheads 86,000 11,331,442
Net Cash Outflow   -1,252,982

In this cash flow statement it shows a negative cash outflow of Rs. 1,252,982. This is a Situation
where the cash outflows during a period are higher than the cash inflows during the same period.
Negative cash flow does not necessarily means loss, and may be due only to a mismatch of
expenditure and income. Chronic mismatch, however, may indicate ineffective credit
management, leakage of funds through fraud, or actual loss. Temporary mismatch is covered
usually by arranging an overdraft facility.

Break Even Analysis

Break-even analysis is a technique widely used by production management and management
accountants. It is based on categorizing production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a loss
(the "break-even point").

Total Fixed costs = Salaries (Administration, Molding and Finishing) + Electricity + Other Overhead

= 2,160,000 + 216000 + 86,000

= 2,462,000

Total Variable Cost = Material cost per unit + labor cost per unit

=79 + 35

= 114

Selling Price Rs.140.00

Break Even Point = Fixed Cost / (Selling Price – Variable Cost [per unit] )
= Rs.2462000 / (Rs.140 – Rs.114)
= Rs.2462000 / Rs.26
= 94,692.30
Break even point at 94,963 Units means Total variable and fixed costs are compared with sales
revenue in order to determine the level of sales volume, sales value or production at which the
business makes neither a profit nor a loss

According to the the calculations, it says that the BEP is 94,963 and the forecasted demand is
71,989. The BEP is higher than the demand and this can say it’s a positive trend for the
company.

Profit Volume chart

 Units Fixed cost Variable cost Total cost Total revenue Profit/Loss
0 2462000 0 2462000 0 -2462000
10000 2462000 1140000 3602000 1400000 -2202000
20000 2462000 2280000 4742000 2800000 -1942000
30000 2462000 3420000 5882000 4200000 -1682000
40000 2462000 4560000 7022000 5600000 -1422000
50000 2462000 5700000 8162000 7000000 -1162000
60000 2462000 6840000 9302000 8400000 -902000
70000 2462000 7980000 10442000 9800000 -642000
80000 2462000 9120000 11582000 11200000 -382000
90000 2462000 10260000 12722000 12600000 -122000
100000 2462000 11400000 13862000 14000000 138000
110000 2462000 12540000 15002000 15400000 398000
120000 2462000 13680000 16142000 16800000 658000
130000 2462000 14820000 17282000 18200000 918000
140000 2462000 15960000 18422000 19600000 1178000
150000 2462000 17100000 19562000 21000000 1438000

This company starts to generate profits after the Break even point of 94,963. Also this company
shows a gross profit of Rs.1,871,714 and the end of the year the company ends up with a net loss
of Rs. 590,286. This may result due to this is a newly started SBU and still it’s in their birth
stage. By taking a corrective action plan, we can avoid these kind of situations.

Discuss the ways of enhancing quality and the value

Do this part…