Class Notes ACM 602 Unit 4 and 5

ACM 602 Cost Analysis and Control
COST CONTROL
The basic objective of accounting is to provide information which is useful for persons
inside the organisation(i.e. owners, management and employees) and for persons or
groups outside the organization (i.e. investors, creditors, government, consumers
etc.) According to Slavin and Reynolds Professors of Accounting, "Conceptually,
accounting is the discipline that provides information on which external and internal
users of the information may base decisions that result in the allocation of economic
resources in society." The needs of the majority of the users of accounting information
can be satisfied by financial accounting. Financial statements are concerned with the
past whereas management's main interest lies not in past but in future. It is mainly
concerned with planning and controlling. Preparation of various budgets, such as
sales budget, production budget, cash budget, capital expenditure budget etc. is an
important part of tailing and preparing various budgets is an important aspect of Cost
Accountancy. Controlling is the function of seeing that programmers laid down in
various budgets are being actually achieved actual performance is compared with the
budgeted performance, enabling the management to trcisecontrol in case of weak
performance.
Now-a-days managements are facing problems of survival because of acute
competition. Onlje organisations can meet the competition effectively and have a hold
on the market which area position to keep their cost minimum. Cost accounting can
be instrumental in this regard by titillating all inefficiencies and wastages by exercising
cost control. The Chartered Institute of Management Accountants, London defines
cost control as :"The regulation by executive action of the cost of operating an
undertaking particularly pre such action is guided by cost accounting." The
terms 'regulation' and 'executive action' indicate conscious attempt of
regulating the cost on the basis of predetermined leas about what cost should
be.” It is only when costs are predetermined i.e. a system of standard costing is in
operation, that cost control measures can give their best. Thus, cost control aims at
reducing inefficiencies and wastages and setting up predetermined costs and in
achieving . Cost control is exercised through setting standards or norms or targets
and comparing actual performance therewith with a view to ascertaining deviations
from set targets or norms or standards and taking corrective action to ensure that
future performance conforms to the set standards or norms or targets.
Elements of a Cost Control Scheme
The following are the elements (i.e. major steps) of a cost control scheme :
• Set down a norm or standard or target.
• Select a yardstick for measuring the standard or target.
• Ascertain the actual performance by applying *.,"'. yardstick which was used for
measuring the standard or target.
• Compare the actual performance with the standard or target and compute the
variances.
• Analyse the variances by causes and fix responsibility for variances.
• Take corrective action to eliminate the causes of variances so that future
performance conforms to standards or targets laid down and cost may be controlled
to achieve the maximum efficiency.
• Periodically review the standards or targets and revise them in the light of changed
circumstances.
Cost Control Techniques
Among the techniques which have become popular for ensuring cost control are :
(a) Material Control, (b) Labour Control, (c) Overhead Control, id) Budgetary Control,
(e) Standard Costing, if) Control of Capital Expenditure, (g) Responsibility
Accounting, (h) Productivity and Accounting Ratios.
Essentials for Success of Cost Control
The following steps should be taken in an effective system of cost control:
1. For an effective system of cost control, the firm should have a definite plan of
organisation, Authority and responsibility of each executive should be clearly defined.
Targets for performance of work as well as the cost to be incurred for the purpose
should be laid down for each area of responsibility so that responsibility may be fixed
for the deviation of actual cost from the predetermined cost.
2. Costs should be collected for each area of responsibility. One of the recent
developments in the field of managerial accounting is the responsibility accounting
which is helpful in exercising cost control. It tries to control cost in terms of the
persons responsible for their incurrence. It is a method of accounting in which costs
are identified with persons responsible for their control rather than with products or
functions. Reporting of efficiency or inefficiency displayed by each person should be
prompt. Information delayed is information denied. If a considerable time elapses
between happening of events and reporting, opportunity for taking appropriate action
may be lost or some wrong decisions may be taken by management in the absence
of information.
3. The report should draw management's attention to exceptionally good or bad
performance so that management by exception may be carried out effectively. The
aim should be to bring to light the factors leading to increase in cost rather than to
punish people to take the remedial action to improve the performance in future.
4. Good performance should be handsomely rewarded so that workers may be
motivated towards better performance.
5. For an effective system of cost control, there should be effective budgetary control
and there should be proper setting of standards Budgets and standards should be
fixed with realism. Cooperation of all persons who are to achieve the budgeted results
or standards should be secured in preparing budgets or setting up standards to get
their willing involvement in achieving the desired results.
COST REDUCTION
Introduction
Profit is the resultant of two varying factors viz. sales and cost. The wider the gap
between these two factors, the larger is the profit. Thus, profit can be maximized
either by increasing sales or reducing cost. Such conditions cannot, however,
permanently exist. When competition comes into play, it may not be possible to
increase the sale price without its having an adverse effect on the sale volume which,
in turn, reduces profit. Besides increase in price—which, in turn, reduces profit—
increase in prices of products has the ultimate effect of pushing up the raw-materials'
prices, wages of employees and other expenses, all of which tend to increase costs.
In the long run, substitute products may come up in the market, resulting in loss of
business. Avenues have, therefore, to be explored and methods devised to cut down
expenditure and thereby reduce the cost of products. In short, cost reduction should
mean maximisation of profits by reducing costs through economies and savings in
cost of manufacture, administration, selling and distribution.
Meaning of Cost Reduction

Cost reduction is a planned positive approach to reduce expenditure. It is a
corrective function by continuous process of analysis of "ists, functions, etc. for
further economy in application of factors of production.
The Chartered Institute of Management Accountants, London defines cost reduction
asfollows :
"Cost reduction is to be understood as the achievement of real and permanent
reduction in the unit cost of goods manufactured or services rendered without
impairing their suitability for the use intended or diminution in the quality of
the product."
The definition given above brings to light the following characteristics of cost
reduction:
• The reduction must be a real one in the course of manufacture or services
rendered. Real cost reduction comes through greater productivity. Greater
productivity may be through (1) obtaining a large quantity of production from the
same facilities; (2) using materials of lower price and of different quality without,
however, sacrificing the quality of the finished of manufacture without sacrificing the
quality of the finished product; (4) changing features ofthe product suitably without
sacrificing. The reduction should not be at the cost of essential characteristics, such
as quality of the products or services rendered.
Thus, cost reduction must be a genuine one and should aim at the elimination of
wasteful elements in methods of doing things. It should not be at the cost of quality.
Cost reduction is a continuous process of critically examining various elements of
cost and each aspect of the business (i.e. procedures, methods, products,
management including market and finance etc.) is critically examined with a view to
improving the efficiency for reducing costs. Every plan of cost reduction proceeds
with this assumption that there is always scope for cost reduction. A continuous
research is made into various areas for finding out the best possible methods of
performance for ensuring minimum possible costs.
The reduction in costs should be real and permanent. Reduction due to wind falls,
changes in government policy like a reduction in taxes (or duties or due to
temporary) and measures taken for tiding over financial difficulties do not strictly
come under the purview of cost reduction. Broadly speaking reduction in cost per
unit of production may be effected in two ways:
1.By reducing expenditure but the volume of output remains constant.
2. By increasing production viz. increasing the out turn, but the level of expenditure
remains unchanged.
Cost Reduction Programme
Cost reduction aims an improvement of human efforts. In a business organisation
several persons are engaged in diverse activities. It may be a short-term or long-
term under special problems such as reduction in profit, specific inefficiencies in
certain spots (or fall in production). A special cost reduction programme is geared
into action to meet the situation and improve the expenditure. Briefly, a programme
of cost reduction consists of the following:
1. Numerous centres or points where costs are incurred are located and grouped
according to departmental responsibility.
2. Each such point or group or points is then submitted a value analysis scheme to
determine whether optimum efficiency has been achieved in its performance or
whether there is a norm for cost reductions.
3. Suitable techniques are, therefore, applied to reduce costs. No cost reduction
programme can be effective unless a joint effort is made by all the departments
concerned and the plan is linked with responsible management. Allocation of
responsibility of the various cost reduction levels of management is an important
requirement for control of cost reduction of the operation and spheres under his
control. The programme for cost reduction should be clearly defined and
responsibilities delegated. Thus, each executive should be aware of his role in the
over-all scheme of cost reduction and of the function he has to perform.
Essentials for Success of Cost Reduction Programme
1. A cost reduction programme must be appropriate to the organisation.
2. A cost reduction programme should not be taken as a one time activity. It is a
continuous activity aimed at reducing cost continuously by innovating new ideas
from time to time. Cost reduction is a corrective function based on the philosophy
that every human action can be improved by continuous effort.
3. Cost reduction should not be done by arbitrary cost slashing. It should be real and
permanent reduction in cost.
4. To make cost reduction programme acceptable to the employees of the

organisation, the example of cost reduction should be first set by top executives.
The success of cost reduction programme depends upon the co-operation of all
persons involved in the programme.
5. Persons giving innovative ideas for cost reductions should be suitably rewarded
by giving raise in wages and salaries, promotion and special awards.
6. A cost reduction programme should not merely take into consideration reduction
in cost but it should also consider all other factors (i.e. social and legal aspects)
which will be affected by the programme of cost reduction.
7. A cost reduction programme should be evolved with the idea that even the most
efficient firms incur unnecessary costs, that is, there is always scope for cost
reduction in every firm.
8. There should not be any overlap between the cost reduction measures, that is,
there should not be double counting of cost reductions.
Distinction Between Cost Control and Cost Reduction
Cost control involves predetermination of targeted costs measuring the actual costs,
investigating into the causes of variations and instituting the corrective action,
whereas cost reduction is the achievement of real and permanent reduction in unit
cost of goods manufactured or services rendered without impairing their suitability or
diminution in the quality of product. Cost reduction in values saving in unit cost such
saving is of permanent nature and the utility of the goods and services remain
unaffected. Thus cost control and cost reduction are two efficient tools of
management but their concepts and procedures are widely different. The main
points of differences between the two are the following :
1. Aim. Cost control aims at achieving the predetermined costs, whereas cost
reduction aims at reduction of costs by finding new ways or methods to have
continuous economy on costs.
2. Exercise. Cost control is a routine exercise which is carried out for attainment of
operational efficiency whereas cost reduction aims at permanent and real savings by
a continuous search for improvement. Thus, cost control follows a conservative
procedure and lacks a dynamic approach whereas cost reduction is dynamic and
innovative in nature.
3. Concerned with. The process of cost control is to lay down a target, ascertain
actual performance, compare it with the target and take corrective action. On the
other hand, cost reduction is not concerned with maintenance of performance
according to the predetermined standards.
improvements in predetermined standards.
5. Function. The aim of cost control is to see that actual costs do not exceed the
predetermined costs ; so it is a preventive function. On the other hand, cost
reduction is a corrective function because it challenges the predetermined costs and
seeks to improve the performance by reducing cost of increasing production. It is a
continuous function of self-analysis for making more and more improvement in
performance.
6. Applicability. Cost control is generally applicable to items of costs which have
standards where as cost reduction is applicable to every activity of the business.
7. Tools of Techniques. Budgetary Control and Standard Costing are important
tools of cost control whereas cost reduction makes use of techniques like value
engineering/value analysis, work study, operation research, simplification and
standardisation, ABC analysis, etc.
8. When Achieved. Cost control is achieved once the costs do not exceed the
standards whereas cost reduction is never ending. In fact cost reduction begins
when cost control ends.
9. Operation/Research Oriented. Cost control is operation oriented whereas cost
reduction is research oriented, always trying to reduced costs through planned
research.
Fields Covered by Cost Reduction
The critical area of application of cost reduction methods and the lines of approach
in paying out a cost reduction plan are as follows :
1. Product Design
Product design the first step in the manufacture of a product. The impact of any
economies on cost reduction effected at this stage will be felt throughout the
manufacturing of the product in all fieldsviz. production and sales etc. Design
constitutes the most important field where cost reduction may be attempted.
Possibilities of cost reduction should be investigated both when introducing new
designs and when seeking improvements of the existing designs. It is worthwhile
putting in some more care and a little money at the initial stage than to incur losses
and wastage later when production is established. Efficient designing for a new
product and improving the design for an existing product reduce cost in the following
way:
(a) Material cost: Cheaper substitutes, higher yield, less quantity, variety of
materials so that storage cost and investment in inventory are reduced.
(b) Labour cost: Minimum tolerance, reduced time of operation etc.
(c) Standardisation and simplification in variety increases productivity and reduces
cost.
(d) Reduction in after-sales service costs.
2. Organisation
All efforts should be constantly made to reduce the costs by the adoption of new
methods of organisation and new production methods. It is not possible to measure
the cost reduction resulting from an improvement in the organisation. Nevertheless,
economies are bound to be achieved if the following considerations are looked into :
• Definition of each function and responsibility.
• Proper assignment of tasks and delegation of responsibility; overlaping will be
avoided.
• A suitable channel of communication between various management levels.
• Removal of doubts and points of friction.
• Encouragement of employees for cost reduction suggestion.
3. Factory Layout and Equipment
It will influence costs to a large extent. A cost reduction programme should study the
factory layout and the utilization of the exiting equipment to determine whether there
is any scope for cost reduction by elimination of wastage of men, materials, and
maximum utilization of the facilities available. The necessity for replacement of
plants, introduction of new techniques and expansion of facilities should be
considered and various alternatives explored with a view to reduction in cost.Any
concealed bottle-necks and difficulties standing in the way of maximum utilisation of
plants and other facilities should be probed into. For instance, there is no point in
detaining skilled worker to manage number of semi-automatic machines, all at a
time. He is not able to be fully utilised on the machines, although, in the process, is
able to occupy himself fully. It should be rather the other way so that the machine
automatically be fully occupied.
4. Production Plan, Programme and Methods
Production control ensures proper planning of work by installing an efficient
procedure and programme of materials ordering, correct machine loading and
proper utilisation of material and manpower and resources so that there is no waste
of time and money due to waste of components, men, materials etc.
5. Administration
There is ample scope of cost reduction in this area because cost reduction is a top
management problem. Office should be reorganised if there is scope for
improvement in the efficiency of persons engaged in the office. Use of unnecessary
forms should be avoided to save the cost of stationery and
labour cost involved for compiling them. Efforts should be made to reduce the
expenses on telephone, lighting and travelling but not at the cost of efficiency. The
points to be examined in this area will be:
 The extent of use of job evaluation as a basis for reducing staff.
& Systematic supervision of the use of office machinery.
 Possibility of reduction offiles and filing space.
 Expenditure on printing, postage and telephone.
 Use of forms and stationery

6. Marketing
The various activities which can be brought under the cost reduction programme
include market research, advertisement, packing, warehouse, distribution, after-
sales service etc. Sales performance can be improved by making ABC analysis of
customers. Customers can be classified in three categories A, Band C. A category
customers means customers having about 10% of total
despatches but cover about 70% of sales value, B category customers means
customers having about 20% of total despatches but covering about 25% of sales
value and C category customers means customers having about 70% of total
despatches but covering about 5% of total sales value.
in this way of categorisation of customers, sales efforts will be better focussed and
there will be reduction in marketing cost. The major points that need examination
with a view to cost reduction in this area are :
 Whether the channel of distribution is efficient and economical.
 Whether there is an effective system of sales promotion.
 Whether the market research is adequate.
 Whether there is any possibility of reduction in selling and distributing

expenses without impairing efficiency of sales division.
Personnel Management
The cost reduction programme should explore the following:
 Reduction in labour content of production by suitable work study techniques
and introduction of sound incentive schemes.
 Reduction in labour cost by improving labour relations, welfare measures and
better working conditions.
Material Control
 Effective and economical purchase of materials.
 Adherence to EOQ.
 Keeping low inventory-less investment in stock.
 Effective check on goods received.
 Control over material storage and issues.
 Effective check on materials yield.
1. Cost reduction increases profit. It provides a basis for more dividends to
the shareholders, more bonusto the staff and more retention of profit for
expansion of the business which will create more employment and overall
industrial prospects.
2. 'Cost reduction will provide more money for labour welfare schemes and thus
improve management relationship.
3. Cost reduction will help in making goods available to the consumers at
cheaper rates. This will create more demand for the products, economies
of large scale production, more employment through industrialisation and
all-round improvement in the standard of living.
4. Cost reduction will be helpful in meeting competition effectively.

5. Higher profit will provide more revenue to the government by way of
taxation.
6. As a result of reduction in cost, export price may be lowered which may
increase total
exports.
7. Cost reduction is obtained by increasing productivity.Therefore, a developing
country, like India, which suffers from shortage of resources can develop
faster if it makes the best use of resources by increasing productivity.
8. Cost reduction lays emphasis on a continuous search for improvement which
will improve the image of the firm for long-term benefits.
According to G. Kantharaj, "In the particular context of a developing
economy, it becomespredominantly important to emphasize on Cost
Reduction in agriculture, industry, public administration, etc.Cost Reduction
cannot be ushered in by a magic wand. Cost reduction is everybody's
concern. The motto of every industry and every organisation should be to
produce more goods and to render efficient services. piralling up of prices
and inflationary trends seem to have reached a Point of No Return in the
country. The situation cannot be salvaged, unless every responsible
individual wages a war vehemently to curtail the wastages and delays in his
own jurisdiction."
Self-CheckQuestions
1. What is cost control? Which techniques used for cost control?

COST ANALYSIS FOR SHORT TERM DECISION

MARGINAL COSTING
Objectives
After studying this lesson, you should be able to
 Understand the meaning, benefits and limitations of absorption costing.

 Learn the concept of Marginal Costing
 Differentiate between absorption costing and marginal costing.
MARGINAL COSTING
Introduction
The term cost system refers to the technique and process of determining costs of a
product manufactured and service rendered. As has already been explained in
earlier Units different methods are applied in different organizations to determine the
costs depending upon the nature of the product, production method and business
conditions. Here comes uniform or output costing, job costing, process costing,
contract costing and operating costing. But whatever, the nature of the organization,
type of the product, method of costing adopted; there should be a technique from
cost control point of view which will reflect the relationship between cost, volume and
profit. Where absorption costing includes all costs, fixed and variable while
determining the cost of a product.Marginal costing basis on the principle that the
cost of the product increases only on account of variable cost after a certain stage.
This is so because fixed costs remain constant whatever is the level of production.
Under marginal costing technique, the fixed expenses are not allocated to cost units
but are charged against a ‘fund’ which is excess of the sales value over the total
variable costs.
Absorption Costing
This system of costing includes fixed expenses in cost and thus both fixed and
variable expenses form a part of the total cost of production. This is a conventional
method and is also known as Total Costing, Full Costing. Conventional costing,
Orthodox Costing, Product Costing or Traditional Costing. Here all the costs i.e both
fixed and variable are allocated to cost units and total overheads are absorbed
according to activity level. This term can be applied (a) only when production costs
are considered. Here all the costs i.e. fixed and variable are changed to various
operations, processes or products including work in progress and finished
production. This is usually practiced method and is termed ‘Cost Plus’ costing
wherein a fixed percentage is added to the total cost of the product to arrive at the
selling price.
Advantages of Absorption Costing
Following are the benefits of absorption costing.
a. Here the costs are matched with revenues during an accounting period.
b. Stock valuation complies with accounting standards by covering up even fixed
costs.
c. The analysis of production overheads reflects the proper utilization of
production resources.
d. This avoids segregation of costs into fixed and variable which certain times is
difficult regarding certain items like depreciation.
e. Cost plus pricing ensures coverage of all costs
Limitations of Absorption Costing.
However, absorption costing has the following limitations.
a. Under absorption costing utility of cost data as controlling device is

limited as costs of all types are included, in changes in volume which definitely
results in reduced costs is not reflected in any way.
b. Here fixed costs are not charged in the year they are incurred.
c. A proper cost - volume – Profit relation can not be properly arrived at.
If sales increase the impact of cost on each unit can not be correctly arrived at.
d. Behavioral pattern of costs is not given any importance.
e. The nature of overhead included in costs reduces the accuracy in
determining the selling price.
f. Since fixed costs are included values of inventories both closing and
opening may not show an accurate value thereby the profits.
g. Only production costs are given greater importance but not
administrative and selling and distribution costs.
h. This does not indicate decision oriented costs. Inter product
profitability depends upon the share of allocation of fixed costs on products.
Material decision as to dropping a product, changing a product line can not be
arrived.
i. Opportunity costs are not considered.
j. Budgeting control and standard costing becomes difficult to adopt.
The above limitations advocated a more important device of costing technique i.e.
marginal costing.
Marginal Costing
Unlike various methods of costing like uniform, job, process or contract, this is a
technique which can be used in conjunction with any of the methods which will help
in managerial decision making. Here cost ascertainment is made on the basis of
nature of cost or behavior of the cost and its effect upon the profitability of an
undertaking.
Marginal costing may be defined the ascertainment of marginal cost and the effect
on profit of changes in volume or type of output by differentiation between fixed
costs and variable costs. Marginal cost is defined as “the amount at any given
volume of output by which aggregate costs are changed if the volume of out put is
increased by one unit” thus it can be measured by total variable cost attributable to
one unit. It is the sum of prime cost and variable overhead and relates to a unit
which may be a single article, process, batch, an order, a stage, etc.
Advantages of Marginal Costing
Following are the advantages of Marginal Costing.
a. It is an easy cost controlling exercise.

b. The Marginal cost per unit is constant where as fixed cost as a whole is
constant. Thus pricing decisions can be taken easily by management based on
variable cost. But if fixed cost is included, decision on price fixation becomes
difficult.
c. Under Marginal Costing overheads are recovered as a predetermined
percentage which may be either over absorption or under absorption. Since
fixed costs are not considered under/over absorption of fixed costs can be
avoided.
d. Under Marginal Costing stock is valued based on variable cost, thus shows a
true value thereby profits so arrived also are more realistic.
e. This helps in arriving the break even-analysis which shows the effect of
increasing or decreasing production activity on the profitability of the company.
f. Marginal Costing enables taking number of strategic decision like volume of
production, make or buy introduction or dropping a product line, etc.
g. Segregation of expenses into fixed and variable enables to exercise control over
variable expenses thereby enabling reduction of cost.
h. Here stocks are valued at variable cost and there is no sales volume and
contribution is much easier to explain and to understand.
i. Profit volume analysis is facilitated by the use of break-even charts and profit
volume graphs.
j. The analysis of contribution per key factor or limiting resource is a useful and in
budgeting and production planning.
k. Pricing decisions can be based on the contribution levels of individual products.
l. Responsibility accounting is more effective when based on marginal costing
because managers can identify their responsibilities more clearly when fixed
over head is not charged arbitrarily to their departments or divisions.
Limitations of Marginal Costing
Marginal costing is not a technique without limitations. Following are the drawbacks
which are faced by it.
a. Classification of costs into fixed and variable is not an easy task as certain
expenses are neither fixed nor variable like depreciation.
b. Contribution is to be linked with certain key factor to provide guidance.
c. Certain situations like in depression when prices are set to under cut
competitions may not leave a reasonable contribution margin.
d. The fundamental assumption that variable cost per unit is constant may not hold
good for higher level of activity.
e. In the long run no cost is fixed.
f. Exclusion of fixed overheads from costs may lead to erroneous conclusions. It
may create problems in inter firm comparison, higher demand for salaries and
perks by employees and higher tax by Government.
g. It is not recognized by income tax authorities.
h. Exclusion of fixed over head from stock valuation is not accepted by accounting
practices.
Marginal Costing Vs Absorption Costing
The profit reflected through Marginal Costing are different when compared to those
arrived through Absorption Costing for the following reasons.
The profit remains constant under both the methods when sales and production
levels are constant for any period of time. When production, costs and prices
remain constant and sales fluctuate, the profit as per marginal costing method will
be greater than absorption costing methods. Where sales are constant but
production fluctuates, marginal costing provides for constant profit but profits
fluctuate as per absorption costing.
When production exceeds sales, profits are higher under absorption costing than
marginal costing and vice versa. This is because as fixed costs are treated aa part
of total cost, the value of closing stock is higher which reduces the cost of production
thereby increasing the profits.
A decision as to profitability of the product / department is taken in marginal costing

through the contribution from each of them whereas under absorption costing it is
made depending on the absolute profit figures.
The choice between marginal costing and absorption costing is made depending on
the following factors.
a. System of financial control. For example where Responsibility Accounting

operates absorption costing has no relevance.
b. Where all products have similar attention marginal costing can be preferred and
vice versa.
c. The impact of fixed overhead in cost of the product.
Following illustration brings a demarcation as to the profits arrived.
Illustration:
A company has a production company of 200,000 units per year. Normal capacity
utilization is reckoned at 90% standard variable production costs are Rs.11/- per
unit. Fixed costs are Rs.360000 per year. Variable selling costs are Rs.3 per unit
and fixed selling costs are Rs.270000 per year. Unit selling price is Rs.20/- when
the production was 160000 units and sales 150000 units. Closing inventing was
20000 units. Actual variable production costs are Rs.35000 higher than the
standard. Compute the Profit under (a) Absorption costing (b) Marginal costing.
Solution:
Statement of the Profit for the year ending___________
(Under absorption costing.)
Amount Rs.
Sales 150000 units @ Rs.20 per unit 30,00,000
Less:
Cost of production:-
(Variable production cost (160000 @ 111/-) 17,60,000
Increase in costs 35,000
Fixed costs 3,60,000
------------
21,55,000
Add:
Opening Stock 10000 units @ Rs.13/-
(Sales + Closing Stock – Production)
(150000 + 20000 – 160000) 1,30,000
------------
22,85,000
Less:
Closing Stock (20000) at current cost =
21,55,000
------------- X 20,000 = 2,69,375
1,60,000 -------------
20,13,625 20,13,625
-------------
9,84,375
Less:
Selling Expenses variable 4,50,000
Fixed 2,70,000
-----------
7,20,000 7,20,000
Net Profit 2,64,375
b) Statement of Profit for the year ended ___________
Under Marginal Costing
Amount Rs.
Sales 30,00,000
Less:
Marginal Cost :-
Variable Production Cost 17,60,000
Additional Cost 35,000
Variable cost of opening stock 10000 @ Rs.11/- 1,10,000
-------------
19,05,000
Less:-
Closing Stock 17,95,000
20000 X -------------- = 2,24,375
1,60,000 -------------
16,80,625
Add:
Variable Selling Cost 1,50,000
@ Rs.3/- Contribution 4,50,000
Less:
Fixed Cost:
Production Cost 3,60,000
Selling Cost 2,70,000
------------
6,30,000 6,30,000
Net Profit 2,39,375
Note:- Difference in profit is due to element of fixed cost included in valuation of

opening and closing stock under absorption costing method.
Break-even Analysis:
Break-even analysis which emerges from Marginal Costing gives an idea about the
impact of changing levels of production on profit. Several factors like level of
competition, introduction of a new product, trade cycles, scare resources, change in
the setting product, etc., may necessitate change in the level of production. This
should give a clear idea to management as to such level giving desired profit. One
of the technique used here is marginal costing. Break-even analysis in the narrow
sense mean determining the break-even point i.e. determine the level production
where the total cost is equal to total revenue where costs are just covered up. In the
broader sense, it means the system of analysis which determine the probable profit
at any level of production, thus establishing the relation between cost-volume and
profit.
This can be done (i) Mathematically (ii) Graphically. Four important concepts have
are;
a. Contribution
b. Profit volume Ratio or P/v Ratio or Contribution/Sales.
c. Break-even Point
d. Margin of Safety.
Mathematical Method:
(a) Contribution: - This is the difference between sales and marginal cost and
this contributes to make up fixed cost leaving the balance as profit.
Contribution = Selling Price – Marginal Cost or Fixed Expenses + Profit

Or
Profit = Contribution – Fixed Expenses
(b) Profit-volume Ratio :
Or
Thus if selling price is Rs.25 Marginal cost is Rs.10
then P/VRatio =
Higher profit volume more profit as same amount of fixed expenses are covered up
from any contribution
To improve profit volume ratio it can be done by

(a) Increasing the selling price per unit
(b) Reduce the variable expenses
(c) Switching the production to more profitable products showing higher profit
volume ratio.
Following equations can be arrived at from Profit Volume Ratio
Fixed cost FxS

(i) Break-even Point = -------------- or -------
P/v Ratio S–V
(ii) Value of sales to earn a desired amount of profit =
Fixed cost + Desired Profit

------------------------------------
P/v Ratio
(iii) Variable cost = Sales (I – P/v Ratio)
(iv) Profit = Sales x P/v Ratio – Fixed cost.
(v) Fixed cost = Sales x P/v Ratio - Profit
Profit
(vi) Margin of safety = ------------
P/v Ratio
Illustration (1):
Calculate Profit Volume Ratio from the following information.

(i) Given – Selling price per unit Rs.20/- , Variable cost Rs.12/-
(ii) Given – Profits and sales for two periods as under:
Sales Profit
1st Year 3,00,000 40,000
2nd Year 3,40,000 50,000
C
(i) Profit volume Ratio = ---- x 100
S
S–V 20 -12 8
Or ------- x 100 = --------- x 100 = ---- x 100 = 40%
S 20 20
(ii) Change in profits

----------------------- = Profit volume ratio
Change in sales
10,000
--------- x 100 = 25%
40,000
Illustration (2)
From the following particulars (i) Contribution (ii) P/v Ration (iii) Break-even Point in
units and Rupees (iv) Selling price per unit when break-even point is 25000 units.
Fixed Expenses 1,50,000

Variable cost per unit 10
Selling price per unit 15
Solution:
(i) Contribution = Selling Price per unit – Variable Expenses per unit
15 – 10 = 5
Contribution
(ii) Profit volume Ratio = ----------------- x 100
Sales
5
(ii) Profit volume Ratio = ----- x 100 = 33 1/3 %
15
(iii) Break-even Point (in units)
Fixed Expenses 150000

---------------------------- = ---------- = 30000 units
Contribution per unit 5
Break-even sales = 30000 x 15 = 4,50,000

Or --------------------- = ----------- =
P/v Ratio 33 1/3%
150000 x 3 x 100
---------- = 4,50,000
100
(iv) Revised Break-even Point i.e. 25000

Contribution per unit = ----------------------- = ---------- = 6
Break even point 25000
S–V=C
S = C + V = 6 + 10 = Rs.16
Marginal cost equation can also be used to ascertain the output or sales volume to
get a desired amount of profit by using the following formula.
Fixed Expenses + Desired Profit F+P

Desired output = ------------------------------------------------- or ------------
Selling price – Marginal cost per unit P/v Ratio
Illustration (3):
From the following figures calculate (i) P/v Ratio (ii) Break-even point (iii) Sales to
earn a profit of Rs.2,40,000.
Sales Rs.12,00,000, Variable costs Rs.7,50,000, Fixed cost Rs.3,60,000
Solution:
Contribution 12,00,000 – 7,50,000
(i) Profit volume Ratio = ---------------- x 100 = ---------------------------- x 100=
Sales 12,00,000
Fixed cost
(ii) Break-even point = --------------- =
P/v Ratio
3,60,000 3,60,000 x 200
------------ = -------------------- = 9,60,000
37.5% 75
(iii) Sales to earn a profit of Rs.2,40,000
Fixed cost + Desired Profit

Sales = ------------------------------------
Profit volume Ratio
2,40,000 + 3,60,000
= -------------------------- = Rs.16,00,000
37.5%
(d) Margin of Safety:
Margin of safety is the difference between actual sales and sales at break-even
sales. The assumption of marginal costing is that output will coincide with sales, so
margin of safety is also the excess production over the break-even point’s output.
After break-even, the volume of profit assures safety. Higher the margin of safety
greater the safety levels when can be achieved by increasing the level of production
increasing the selling price, reduction of costs and substituting the less profitable
product with more profitable product.
Profit
Margin of Safety = Actual sales – Break-even sales or ------------
P/v Ratio
Illustration:
The Profit volume Ratio of a company is 50% and margin of safety is 40%. You are
requested to workout the break-even point and the net profit of the sale volume is
Rs.50 lakhs.
Solution:
Sales 5,00,000
Less:
Margin of safety 40% 5,00,000 x 40 / 100 = 20,00,000 20,00,000
30,00,000
Break-even sales
Profit volume Ratio 50%
Contribution or Fixed Expenses at Break-even point
50
i.e. ------ x 30,00,000 = 15,00,000
100
Calculation of net profit at sales of Rs. 50,00,000
Sales x Profit volume Ratio = 50,00,000 x 50
-------------------- = 25,00,000 25,00,000
100
Less:
Fixed Expenses 15,00,000
Profit 10,00,000
(B)Graphical Method:
Break even Chart:
A break-even chart is a graphical representation of marginal costing. This shows

the inter relationship between profit, volume and cost. It shows the break-even point
and also indicates the estimated profit or loss at different levels of activity.
BREAK-EVEN AND PROFIT-VOLUME CHARTS
Break-even Charts
The relevant data for the costs, volume and profit may be plotted o9n a graph to find
out the break-even point. The graphic approach to CVP analysis is based on
reporting total sales revenue and total expenses as a function of sales volume. Unit
sales volume is plotted on the horizontal ‘X’ axis while sales revenue and fixed and
variable costs on the vertical ‘Y’ axis. The graph so resulting is called profit graph or
CVP graph. It is also called as break-even chart because from such a graph, the
break even point could be easily located. It is the point where the total sales line
and total cost line intersect. At any volume, the profit and loss is represented by the
difference between the total sales line and total cost line. The break-even chart
gives a visual picture of the importance of volume cost profit factors, and is a useful
tool in presenting this relationship to management.
The following are the steps to be followed while constructing a break-even chart:
a) Take the output or level of production on the X axis

b) Take the cost and revenues on the Y axis
c) Plot the total fixed costs on the Y axis and draw a parallel line to the X axis up
to the total out put level.
d) Plot the point of total costs (fixed + variable) for the full output and join this
point by a line to the fixed cost point on the Y axis.
e) Plot the point of the total sales revenue for the output and join this point by a
line to zero, the junction of the axis.
f) We find that the total cost line and the sales line both intersect at a particular
point. This intersecting point is called as the break-even point.
g) Drop perpendiculars on to both the axes. The point on the X axis represents
the output or level of production at which the organization will break even.
The point on the Y axis represents the break-even point in value.
Angle of Incidence
This is the angle formed at the break-even point at which the sales line cuts the total
cost line. This angle of incidence is an indication that profits are being made. Large
angle of incidence is an indication that profits are being made at a higher rate. On
the other hand, a small angle indicates a low rate of profit and suggests that variable
costs form the major part of cost of production. A large angle of incidence with a
higher margin of safety indicates the most favorite position of a business and even
the existence of monopoly conditions. `
Graphical Method:
A. Break-even Chart:
Sales
Cost and
Sales (Rs.)
BEP Totalcost
Angle of
Incidence
Fixed Cost
X
O
Volume of output
Profit Volume Graph

This is yet another graphical approach to cost-volume-profit analysis. It is also
called as the profit chart. It focuses mainly on the relationship between volume and
profit. It draws direct attention on how profit change in response to changes in the
operating volume. Many accountants find this profit-volume graph more useful that
the break-even chart because it shows the amount of profit directly rather than as
the difference between the revenue and cost curves. It provides a quick, condensed
comparison of how alternatives on pricing, variable costs or fixed costs may affect
not income as volume changes.
The profit-volume chart is constructed on a graph in which the vertical axis
represents net income in rupees. The Y axis is extended below the origin in order to
show both the net profit and the net loss. The X axis represents volume. The profit
line is straight when both revenue and cost curves are linear and any two points can
be used to plot it. The most commonly used points are (a) the zero production, and
(b) the break-even point. At an output of zero, the loss will be the amount of fixed
costs. The profit line slopes upward to the right and crosses the X axis at the break-
even point. When the profit line crosses the X axis, the cumulative contribution
margin is enough to cover fixed costs. Operations above the point provide an
income to the firm. In this profit-volume graph, separate fixed and variable cost lines
are eliminated, and only the profit sale lines are plotted.
The following are the steps to be followed while constructing a profit-volume graph.
a. Plot the sales values on the X axis.

b. Plot the costs and revenues on the Y axis to show both the profits and the
losses.
c. Plot the point of fixed costs on the Y axis on the loss side. This will be marked
on the Y axis itself, because at nil output the cost incurred is the fixed costs.
d. Plot the point of sales revenue at the total output. This will come in the positive
quadrant.
e. Join the two points plotted, i.e., the fixed cost point and the sales revenue point
by a straight line. As shown in the following graph, the fixed cost incurred at
zero output is Rs.38 (being plotted on the loss side) and the sales revenue
earned for 300 units of sales is Rs.80 (being plotted in the profit area quadrant).
Profit-Volume Graph:
Y
Profit / Loss Line
80
Profits 60
40
20
0 X
20 50 100 150 200 250 300 Sales / Output
40
Losses 60
80
Summary
There are number of methods of costing that are adopted depending on the nature
of the product, service, organization like uniform costing, job costing, process
costing, operating costing and contract costing. But from the cost control point of
view the techniques of costing are marginal costing, budgeting control, standard
costing, etc., Absorption costing includes all the costs, fixed and variable while
ascertaining the cost of the product, Marginal costing is based on the principle that
the variable cost alone will increase the cost of the product after certain stage as
fixed cost is constant for any volume of output. Fixed cost under Marginal costing is
set off against a fund called contribution which is the difference between sales and
variable cost. Absorption costing is cost plus pricing covering all the costs but it
cannot be used as a control device and value of inventing is inflated as fixed costs
are included. In Marginal costing, costs are segregated thus giving way to cost
control techniques. However, a choice between the two can be made depending on
the system of financial control. Profit under both the systems proves to differ due to
change in the value of stocks. Under Marginal costing, the normal equation is S – V
= F + P and this is also called contribution. At the point of break-even S – V = C
which is just sufficient to cover up fixed costs. A relates between profit, volume and
sales is being brought out by P/v Ratio which is equal to contributes/sales. Margin
of safety is the area after the break-even i.e. the difference between actual sales
and break-even sales. A break even analysis is prepared to find out the impact and
incidence of various items and can be arrived either mathematically or graphically.
As a cost controlling device Marginal costing enables management to bring out a
relationship between Profit, volume, sales keeping in view of the changing variable
costs and constant fixed costs.
Self Check Questions
A. State whether the following statements are True or False.
i). Absorption costing includes both fixed and variable costs ( )
ii) Variable cost per unit of output is constant ( )
iii) Fixed costs vary with volume of production ( )
iv) Contribution at break-even point is equal to variable cost ( )
v) Margin of safety is the difference between actual sales and
break-even sales ( )
B. Answer the following in Ten lines.
i) What is Marginal costing?
ii) What are the limitations of absorption costing ?
iii) What is P/v ratio ? What way it is useful ?
iv) Explain (a) margin of safety (b) angle of incidence (c) contribution.
v) What is break-even point?
C. Answer the following
(i) Compare and contrast Absorption costing and Marginal costing.
(II) From the following details determine
(a) P/v Ratio
(b) Break-even point
(c) Margin of safety
(d) Sales to get a profit of Rs.50,000
Sales Rs.1,50,000
Variable cost Rs.1,00,000
Fixed cost Rs. 25,000
(Ans. (1) P/v Ration 33 1/3% (2) BEP – 75,000 (3) MOS 75,000
(a) Sales 2,25,000
(iii) Explain the above data with the help of a Break-even chart.
(iv) ‘Marginal costing is an effective device for cost control’ Explain.
MARGINAL COSTING – A TOOL FOR DECISION MAKING
After studying this lesson, you should be able to
 Understand the utility of marginal costing in decision making.

 Use of marginal costing in determining issues like make or buy,
determining the selling price, dropping a product line, alternative choices,
etc.
Introduction
The technique of Marginal Costing is an effective tool for managerial decision

making. It is the process of choosing among alternative courses of action. It
is the exercise for the future and consists in selecting the optional alternative
from among existing choices. As revising and fixed costs have not much to
brought a change in the short run, it is only the variable costs which have to
be considered in making produce/price choices. The following relevant costs
are to be considered for decision making.
(a) Future costs

(b) Differential costs
Marginal costing with the techniques of breakeven analysis/Profit Volume

analysis assist in making number of decisions in the present competition
world to reduce costs and increase the profits.
Marginal Costing for decision making.
Marginal costing helps in many situations in deciding in a crucial situation.

Following are some of the key areas where marginal costing is used for
strategic decision.
Best Level of activity
The level of activity which yields the maximum amount of profit is one of the
important areas of decision making. Marginal Costing helps in choosing such
level of activity where it is optimum as determined by the marginal cost which
is equal to marginal revenue.
Illustration (1)
The following details relate to a Manufacturer who sells his product at Rs.80/-
per unit. Following details relate to production budget.
Budget (Units) 75,000 85,000 1,00,000

Operating Costs 6,00,000 7,20,000 8,20,000
Advertising and Sales 2,20,000 2,50,000 3,20,000
Promotion
Fixed Factory overheads 10,00,000

Fixed Selling overheads 4,00,000
Direct Material (Units) 30
Direct Labour 10
A rebate of 10% and 15% is offered for purchase contracts of 85,000 units
and 1,00,000 units respectively.
Also a price discount of 5% and 10% need to be offered for the purchase
contract of 85,000 units and 1,00,000 units respectively.
Prepare a statement showing the profitability at various levels of output and

indicate the best level of production.
Statement of Profitability at various levels.
Levels of Output
75,000 Units 85,000 Units 1,00,000 Units
Sales 60,00,000 64,60,000 72,00,000
Less:
Marginal Costs
Material 22,50,000 22,95,000 25,50,000
Labour 7,50,000 8,50,000 10,00,000
Other operating Costs 6,00,000 7,20,000 8,20,000
Advertising 2,20,000 2,50,000 3,20,000
Contribution 21,80,000 23,45,000 25,10,000

Fixed overheads 14,00,000 14,00,000 14,00,000
Profit 7,80,000 9,45,000 11,10,000

Contribution % 36,33% 36.33% 34.86%
Comment:- Though apparently profit is more at 1,00,000 level of production,

contribution percentage is more for the earlier two levels. Of that the second
level i.e., 85,000 units can be opted as it has a higher contribution and also
greater amount of profit promising more employment opportunities.
Dropping a Product Line:
Key and Limiting Factor
When more than one product is being produced and sold, all do not yield, the
same level of profitability. A firm has to choose those products with best
contribution. This may mean some of the products which are Less profitable
or loss yielding should be dropped. But this may mean the diversion of
capacities/resources of the dropped product towards those products which

are more profitable and which are going to be continued. If there is any key
factor like material or labour contribution in terms of the key factor should be
the criterion.
Some of the principles which should be considered before dropping a product

line are that product yielding any contribution should not be dropped and if
there is a key factor, least contribution in terms of key factor should be
dropped.
Illustration
A firm produces 3 products A, B, C for which material is in short supply,

following is the cost data.
Product Selling Price Marginal Cost Material required

product
A 125 100 4 Kg
B 140 125 8 Kg
C 160 140 10 Kg
Which product should be continued.
Statement of Managerial Cost.

A B C
Sales per unit 125 140 160
Less:
Marginal Cost 100 125 140
----- ----- -----
25 15 20
Contribution per Kg 25 15 20
of metal ----- ----- ----
4 8 10
`= 6.25 1.87 2
Suggestion:- Product B with least contribution both in general or from the part
of key factor should be dropped. If these resources are diverted towards A
better performance of the unit is ensured.
Selection of an optimum Product Mix
When a factory produces more than one product a decision has to be made
as to the composition of each product produced. This depends on the profits
produced with each product mix and the one which yields the maximum profit
can be chooses as a suitable mix. The one with maximum contribution and
increased . Profit Volume Ratio is preferred to be the best.
Illustration:
A company produces two products A and B whose cost information is as

follows:
Product A Product B
Rs Rs
Direct Material (P/v) 10 9
Direct wages 3 2
Sales Price (P/v) 20 15
Fixed Expenses 800
Variable Expenses @ 100% on wages
Sales mixtures
(i) 100 units of A and 200 units of B
(ii) 150 units of A and 150 units of B
(iii) 200 units of A and 100 units of B
Recommend the best / suitable product mix.

(i) Statement of Marginal cost
Product A per Product B per

unit unit
Rs Rs
Selling price 20 15
Less:-
Variable cost
Direct Material 10 9
Direct Wages 3 2
Variable Overheads 3 16 2 13
----- ----
Contribution 4 4
Mix C should be adopted as it yields the maximum profit.
Make or Buy Decision.
Another crucial area of decision making for management is whether to

produce the product in its factory or buy it from the market at an intermediary
state and process it. The choice here depends upon the idle capacity existing
in the organization and the availability of such product in the market apart
from financial implications. While taking such make or buy decision emphasis
has to be laid on, the price demanded by the supplier as against the marginal
cost of producing the component parts. If the marginal cost is lower than
price demanded by outside supplier, the product can be manufactured or vice
versa. Fixed costs are not taken as cost of manufacturing as it is presumed
that it is already incurred for other products. For example if the variable cost
of the product is Rs.15/- and fixed cost is Rs.20/- and if the product is
available in the market as Rs.18/- apparently it may look profitable to buy it
but by adopting the technique of marginal costing making of it looks more
profitable. If the product is available at a price less than Rs.15/- it could be

bought in the market provided.
(i) The quality of the product is satisfactory.
(ii) There is no interruption in the supply of the product.
(iii) Facility for wide selection in market.
Illustration:
Following are the cost details of a component manufactured by a company

which manufactures 10000 units
Direct Material Cost Rs. 4,00,000
Direct Labour Cost Rs. 3,00,000
Variable Cost Rs. 1,00,000
Fixed Cost Rs. 1,00,000
The purchase price is Rs. 25/- per unit and there will be cost reduction of Rs.
20,000 of the product is bought from outside in fixed costs.
The factory can be leased out for Rs. 75,000
Solution:
Analysis of Cost
To make To buy @ To buy @
Rs. Rs.25/- per Rs.25/- each
unit and leased out
Variable Cost 8,00,000
Cost of buying from outside 25,00,000 25,00,000
Saving in fixed cost 1,00,000 (20,000) (20,000)
Rent received
- 75,000
9,00,000 24,80,000 24,05,000
It is profitable to make the component than buying it or leasing out the

capacity.
Achieving a Profit Target
Profit planning is one of the key areas for managerial decision making.
Marginal Costing equation here plays a vital role as profits depend on various
elements which determine this equation i.e. S – V = f + p. Thus the factors
that determine profits are sales, variable cost, fixed cost and sales mix if more
than one product is produced.
Illustration:
A firm had a profit goal of 10% on its investment of Rs.15,00,000. The fixed
costs are Rs.4,00,000, Variable cost per unit is Rs.15/-. The firm produces
50,000 units at Rs.25/- each and earns a profit of Rs. 1,00,000. How can
management achieve the profit target by varying different variables like fixed
cost, variable cost, selling price or number of units sold
Solution:
Target Profit = 15,00,000 x 10
------------------ = 1,50,000
100
(a) Change in fixed costs S – V = F + P
50,000 x 25 – 50,000 x 15 = F + 1,50,000

12,50,000 – 7,50,000 – 1,50,000 = F = 3,50,000
Thus fixed costs which are originally 4,00,000 have to be reduced by

Rs.50,000 i.e. 12.5%
(b) Change in variable costs
S–V=F+P
50,000 x 25 – 50,000 x X = 4,00,000 + 1,50,000
12,50,000 – 50,000 X = 55,000 X
12,50,000 – 6,50,000 = 50,000 X
7,00,000 = 50,000 X
X = 7,00,000
----------- = 14
50,000
Variable cost to be reduced by Re.1/-
(c) Change in Selling Price
50,000 x X – 50,000 x 15 = 4,00,000 + 1,50,000

50,000 X – 75,000 = 5,50,000
50,000 X = 5,50,000 + 75,000
X = 13,00,000
------------- = 26/-
50,000
Selling price has to be raise by Re.1/- to achieve the desired level of profit.
(d) Change in the Volume of Sales
S–V=F+P
X c 25 – X x 15 = 4,00,000 + 1,50,000
25X – 15X = 5,50,000
10X = 5,50,000
X = 55,000 units
The number of units produced and sold should be increased to 5000 units.
Introducing New Product Line
This may mean introducing the product line in addition to the existing line of
products and here decision may also involve issues like deciding the Model,
Share or type of the product. The Marginal Cost of new product and also the
likely increase in fixed cost should be kept in view while deciding such
introduction of new product line. Primarily C/S and also net profit of new
product should be ascertained. Also ROI on new product can be compared
with the old product.
Illustration:
A company produces 20,000 units as against the installed capacity of 30,000
units. The present cost structure is as follows:
Variable costs Rs.3,20,000

Fixed costs Rs.1,50,000
Fixed costs include Rs.40,000 for depreciation. Product X is sold for Rs.30/-
per unit. It is proposed to produce product Y along with X. The installed
capacity of product Y will be Rs.15,000 units. An additional investment of
Rs.2,50,000 is required over and above existing Rs.5,00,000. A total of
10,000 units of Y will be produced and sold which is sold @ Rs.20/- per unit.
Fixed overheads of Rs.15,000 and 10% depreciation need to be provided,
Rs.50,000 required for additional capital. Cost estimates for Y are Rs.14/- per
unit. Is it advisable to produce Y.
Solution
Statement of Profitability of each product.
Existing Product X New Product Y Total
Rs. Rs Rs.
Sales 6,00,000 2,00,000 8,00,000
Less: Material Cost 3,20,000 1,40,000 4,60,000
Contribution 2,80,000 60,000 3,40,000
Less: Fixed overheads 1,50,000 35,000 1,85,000
(including depreciation)
1,30,000 25,000 1,55,000
Contribution % 46.7% 30% 42.5%
Net Profit % 26% 10% 20%
Recommendation:- Contribution is more in case of product X. The unutilized

Company should be utilized to produce more units of X than for gain towards
Y.
Key or Limiting Factor.
When resources like raw material, labour, machine capacity or working

capital are scarce contribution should be ascertained from the point of
requirement / usage of such scare resource, and thus a decision has to be
taken based on it. If it is sales, however enough goods should be produced
to meet the total demand which can give positive contribution to cover up the
fixed costs and then to yield certain profits.
Accept or Reject
Frequently, the management is offered a special order for one of its products
or an export order when the firm has surplus capacity, when there is an
export order, a decision has to be taken after analyzing the effect of the
incremental costs and incremental revenue on the overall profits of the
business while taking a decision as to accept or reject, the contribution made

is the criteria.
Illustration:
A company produces 1000 units of a product which is sold in the
market at Rs.20/- per unit. It’s installed capacity is 1500 units. It received an
export order for 500 units which can be sold at Rs.15/- per unit. It’s cost
information is as follows;
Material Rs.5/-
LabourRs. Rs.2-50
Variable Costs Rs.3/-
Fixed Expenses Rs.8,000
Write a short report as to the advisability of accepting or rejecting the order.
Solution:
Statement of Marginal Cost and Profitability
Existing position Position after accepting of export

Rs order or Rs
Sales 20,000 20,000+7,500 = 27,500
Les:-
Variable
Expenses
Material 5,000 7,500
Labour 2,500 3,750
Variable costs 3,000 4,500
Contribution 10,500 15,750 15,750
Less: Fixed Costs 8,000 8,000
Profit 2,500 3,750
It is advisable to accept the order as it increasing the profit to an extent of

60% i.e. an absolute amount of Rs.1,250. Apart from it, it enables the unit to
work at full capacity. Thus providing more employment opportunities and also
a market status with its export order.
Suspension of Activities.
It is quite possible for a business concern to close down the activities of

production and selling due to trade depression / recession or on account of
cut throat competition. This suspension of activities may be either temporary
or permanent.
(a) Temporary closure
When trading activity particularly plant operation is suspended for a short

period, it is known as temporary closure. This may be due to changes in
economy or seasonal changes, the period directly related to the span of

such period. The trading activity here should not be suspended as long
as there is some contribution. Here fixed costs are to be analyzed as
avoidable or escapable fixed costs and unavoidable fixed costs or un-
escapable fixed costs. Again, if the plan is shut down to restart it again
further expenditure may be needed which are called special fixed costs.
Un-escapable fixed costs are the ‘Loss factor’. Thus escapable fixed
costs minus special costs known as net escapable fixed costs should be
compared with the contribution
Net Escapable fixed costs

Here Shut down point = ----------------------------------
Contribution per unit
Apart from cost factor other economic and social factors like loss of
employment, reputation, in market should also be considered.
Wherever there are seasonal fluctuations or when raw material is scarce shut
down point is ascertained by using the formula :
Avoidable Expenses
---------------------------------------------
Contribution per unit of raw material
Illustration:
X Ltd operates at 50% of normal capacity expects a fall in sales to the tune of
5000 units per month. The Income statement shows the following position.
Sales (5000 units @ Rs.3/- per unit) Rs.15,000
Less: Variable Cost Rs.10,000
--------------
Rs. 5,000
Less: Fixed Costs Rs. 5,000
--------------
Profit Nil
There is a suggestion to suspend the production till situational recovery.

However a minimum fixed costs of 2000 is inevitable Advice the
management at what level of sales it should think of suspension of
production, if the selling price comes down to Rs.2-80 per unit.
Solution:
Net escapable fixed costs = 5000 – 2000 = 3000

Contribution per unit = 2-80 – 2-00 = 0-80 per unit
3000
Shut down point = ------- = 3,750 units
0-80
Shut down Sales = 3750 x 2.80 = Rs.10,500
Thus plant should shut down when sales decline below Rs. 10,500.
(b) Permanent closure:
Some times a situation may arise demand discontinuance of the unit due
to uneconomical functioning, where minimum return also is not forth
coming. This amount to capital erosion day by day while taking a decision
in this regard the organization the management should compare the
income coming forth from following sources.
a. Income from continuance of business operation.

b. Income from sale or otherwise use of plant, building,etc, in case of
complete closure.
Apart from this the decision, other factors like compensation payable to
employees, loss on sale of plant and other fixed assets also need to be kept
in mind.
Summary
Marginal Costing is an effective tool for managerial decision making. A

decision making is the process of evaluating two or more alternatives leading
to a final choice. It is closely involved with planning further future and is
directed towards a specific objective or a goal, Many goals may be derived
from the basic one of increasing the firm’s income. While taking on an
acceptable level of risk. Marginal costing here plays an important role as it
speaks of contribution level of profitability. Many decisions can be taken with
the help of alternative courses of action like make or buy, accept or reject.
Planning the capacity utilization, price fixation with changes in alternatives,
optimum product mix, optimum sales mix, key or limiting factor, operate or
shut down, dropping a product like adding a product like and at many other
instances marginal costing helps in managerial decision making.
Self Check Questions;
A State whether the following statements are True or False

(a) Marginal costing helps in deciding between alternative choices.
(b) Profit earned is the decision factor for any level of activity.
(c) Net escapable costs are the difference between escapable
fixed costs and special costs.
(d) Wherever limiting factors are there contribution in terms of
limiting
factor should be the criteria for decision making.
(e) If the price for buying in cheaper than the fixed costs then it is
advisable to buy.
B Short Questions
(a) Briefly explain the relevant considerations involved in taking

managerial decisions in respect of (a) Make or buy (b) Accept

or Reject.
(b) A radio manufacturing company while it costs Rs.625/- to make
a component the same is available in the market at Rs.575/-
with one assured supply. The break up of the cost is as follows;
Material Rs.275/-
Labour Rs.175/-
Other variable Cost Rs. 50/-
Fixed Cost Rs.125/-
Should you make or buy the component. What would you
suggest of it is available for Rs.485/-
(c) Differentiate between Marginal Cost and Marginal Costing.
C Essay Questions.
(1) What are the various areas of decision making where marginal
costing is used.
(2) A company has a capacity of producing 1,00,000 units of certain
product in a month. The sales department reports that the
following schedule of sale price is possible.
Volume of Product Selling Price

60% 0.90
70% 0.90
80% 0.75
90% 0.67
100% 0.61
The variable cost is .15 per unit and fixed cost is Rs.40,000.
What volume of production ideal to manufacturer?
(3) The following information is presented to you by XY Ltd which
produces 2 products 1 and 2
1 2
Rs Rs
Direct Material (per unit) 20 18
Direct Labour (per unit) 6 4
Fixed expenses during the period Rs.1600
Variable expenses are allocated to products @ 100% of direct
wages.
Selling Price per unit 40 30
Proposed sales mixes
1. 100 units of 1 and 200 units of 2
Which is the most profitable sales mix? The proposed sales mix
to earn a profit of Rs.300 and Rs.600 with the total sales of 1
and 2 being 300 units.
.
.
STANDARD COSTING
Learning Objectives
 To understand the meaning of standard costing, its meaning and definition
 To learn its advantages and limitations
 To learn how to set of standards and determinations
 To learn how to revise standards
Introduction
The vital aspect of managerial control is cost control. Hence, it is very important to
plan and control costs. Standard costing is a technique which helps to control costs
and business operations. It aims at eliminating wastes and increasing efficiency in
performance through setting up standards or formulating cost plans.
Meaning of Standard
The word standard means a benchmark or yardstick. The standard cost is a

predetermined cost which determines in advance what each product or service
should cost under given circumstances.
In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks
a product or the operation of the process for a period of time should cost, based
upon certain assumed conditions of efficiency, economic conditions and other
factors.”
Definition
The CIMA, London has defined standard cost as “a predetermined cost which is
calculated from managements standards of efficient operations and the relevant
necessary expenditure.” They are the predetermined costs on technical estimate of
material labor and overhead for a selected period of time and for a prescribed set of
working conditions. In other words, a standard cost is a planned cost for a unit of
product or service rendered.
The technique of using standard costs for the purposes of cost control is known as
standard costing. It is a system of cost accounting which is designed to find out how
much should be the cost of a product under the existing conditions. The actual cost
can be ascertained only when production is undertaken. The predetermined cost is
compared to the actual cost and a variance between the two enables the
management to take necessary corrective measures.
Advantages
Standard costing is a management control technique for every activity. It is not only
useful for cost control purposes but is also helpful in production planning and policy
formulation. It allows management by exception. In the light of various objectives of
this system, some of the advantages of this tool are given below:
1. Efficiency measurement-- The comparison of actual costs with standard

costs enables the management to evaluate performance of various cost centers. In
the absence of standard costing system, actual costs of different period may be
compared to measure efficiency. It is not proper to compare costs of different period
because circumstance of both the periods may be different. Still, a decision about
base period can be made with which actual performance can be compared.
2. Finding of variance-- The performance variances are determined by

comparing actual costs with standard costs. Management is able to spot out the
place of inefficiencies. It can fix responsibility for deviation in performance. It is
possible to take corrective measures at the earliest. A regular check on various
expenditures is also ensured by standard cost system.
3. Management by exception-- The targets of different individuals are fixed if

the performance is according to predetermined standards. In this case, there is
nothing to worry. The attention of the management is drawn only when actual
performance is less than the budgeted performance. Management by exception
means that everybody is given a target to be achieved and management need not
supervise each and everything. The responsibilities are fixed and every body tries to
achieve his/her targets.
4. Cost control-- Every costing system aims at cost control and cost reduction.
The standards are being constantly analyzed and an effort is made to improve
efficiency. Whenever a variance occurs, the reasons are studied and immediate
corrective measures are undertaken. The action taken in spotting weak points
enables cost control system.
5. Right decisions-- It enables and provides useful information to the

management in taking important decisions. For example, the problem created by
inflating, rising prices. It can also be used to provide incentive plans for employees
etc.
6. Eliminating inefficiencies-- The setting of standards for different elements

of cost requires a detailed study of different aspects. The standards are set
differently for manufacturing, administrative and selling expenses. Improved
methods are used for setting these standards. The determination of manufacturing
expenses will require time and motion study for labor and effective material control
devices for materials. Similar studies will be needed for finding other expenses. All
these studies will make it possible to eliminate inefficiencies at different steps.
Limitations of Standard Costing
1. It cannot be used in those organizations where non-standard products are

produced. If the production is undertaken according to the customer specifications,
then each job will involve different amount of expenditures.
2. The process of setting standard is a difficult task, as it requires technical

skills. The time and motion study is required to be undertaken for this purpose.
These studies require a lot of time and money.
3. There are no inset circumstances to be considered for fixing standards. The

conditions under which standards are fixed do not remain static. With the change in
circumstances, if the standards are not revised the same become impracticable.
4. The fixing of responsibility is not an easy task. The variances are to be

classified into controllable and uncontrollable variances. Standard costing is
applicable only for controllable variances.
For instance, if the industry changed the technology then the system will not be
suitable. In that case, we will have to change or revise the standards. A frequent
revision of standards will become costly.
Setting Standards
Normally, setting up standards is based on the past experience. The total standard
cost includes direct materials, direct labor and overheads. Normally, all these are
fixed to some extent. The standards should be set up in a systematic way so that
they are used as a tool for cost control.
Setting Standards for Direct Materials
There are several basic principles which ought to be appreciated in setting

standards for direct materials. While purchasing material, the quality and size
should be determined. The standard quality to be maintained should be decided.
The quantity is determined by the production department. This department makes
use of historical records, and an allowance for changing conditions will also be given
for setting standards. A number of test runs may be undertaken on different days
and under different situations, and an average of these results should be used for
setting material quantity standards.
The second step in determining direct material cost will be a decision about the
standard price. Material’s cost will be decided in consultation with the purchase
department. The cost of purchasing and store keeping of materials should also be
taken into consideration. The procedure for purchase of materials, minimum and
maximum levels for various materials, discount policy and means of transport are
the other factors which have bearing on the materials cost price. It includes the
following:
 Cost of materials
 Ordering cost
 Carrying cost
The purpose should be to increase efficiency in procuring and store keeping of

materials. The type of standard used-- ideal standard or expected standard-- also
affects the choice of standard price.
Setting Direct Labor Cost
The second largest amount of cost is labor. The benefit derived from the workers
can be assigned to a particular product or a process. If the wages paid to workers
cannot be directly assigned to a particular product, these will be known as indirect
wages. The time required for producing a product would be ascertained and labor
should be properly graded. Different grades of workers will be paid different rates of
wages. The times spent by different grades of workers for manufacturing a product
should also be studied for deciding upon direct labor cost. The setting of standard
for direct labor will be done basically on the following:
 Standard labor time for producing
 Labor rate per hour
Standard labor time indicates the time taken by different categories of labor force
which are as under:
 Skilled labor
 Semi-skilled labor
 Unskilled labor
For setting a standard time for labor force, normally previous experience, past
performance records, test run result, work-study etc are taken in account. The labor
rate standard refers to the expected wage rates to be paid for different categories of
workers. Past wage rates and demand and supply principle may not be a safe guide
for determining standard labor rates. The anticipation of expected changes in labor
rates will be an essential factor. In case there is an agreement with workers for
payment of wages in the coming period, these rates should be used. If a premium or
bonus scheme is in operation, then anticipated extra payments should also be
included. Where a piece rate system is used, standard cost will be fixed per piece.
The object of fixed standard labor time and labor rate is to device maximum
efficiency in the use of labor.
Setting Standards of Overheads
The next important element comes under overheads. The very purpose of setting
standard for overheads is to minimize the total cost. Standard overhead rates are
computed by dividing overhead expenses by direct labor hours or units produced.
The standard overhead cost is obtained by multiplying standard overhead rate by
the labor hours spent or number of units produced. The determination of overhead
rate involves three things:
 Determination of overheads
 Determination of labor hours or units manufactured
 Calculating overheads rate by dividing A by B
The overheads are classified into fixed overheads, variable overheads and semi-
variable overheads. The fixed overheads remain the same irrespective of level of
production, while variable overheads change in the proportion of production. The
expenses increase or decrease with the increase or decrease in output. Semi-
variable overheads are neither fixed nor variable. These overheads increase with
the increase in production but the rate of increase will be less than the rate of
increase in production. The division of overheads into fixed, variable and semi-
variable categories will help in determining overheads.
Determination of Standard Costs
How should the ideal standards for better controlling be determined?
1. Determination of Cost Center
According to J. Betty, “A cost center is a department or part of a department or an

item of equipment or machinery or a person or a group of persons in respect of
which costs are accumulated, and one where control can be exercised.” Cost
centers are necessary for determining the costs. If the whole factory is engaged in
manufacturing a product, the factory will be a cost center. In fact, a cost center
describes the product while cost is accumulated. Cost centers enable the
determination of costs and fixation of responsibility. A cost center relating to a
person is called personnel cost center, and a cost center relating to products and
equipments is called impersonal cost center.
2. Current Standards
A current standard is a standard which is established for use over a short period of
time and is related to current condition. It reflects the performance that should be
attained during the current period. The period for current standard is normally one
year. It is presumed that conditions of production will remain unchanged. In case
there is any change in price or manufacturing condition, the standards are also
revised. Current standard may be ideal standard and expected standard.
3. Ideal Standard
This is the standard which represents a high level of efficiency. Ideal standard is
fixed on the assumption that favorable conditions will prevail and management will
be at its best. The price paid for materials will be lowest and wastes etc. will be
minimum possible. The labor time for making the production will be minimum and
rates of wages will also be low. The overheads expenses are also set with maximum
efficiency in mind. All the conditions, both internal and external, should be favorable
and only then ideal standard will be achieved.
Ideal standard is fixed on the assumption of those conditions which may rarely exist.
This standard is not practicable and may not be achieved. Though this standard may
not be achieved, even then an effort is made. The deviation between targets and
actual performance is ignorable. In practice, ideal standard has an adverse effect on
the employees. They do not try to reach the standard because the standards are not
considered realistic.
4. Basic Standards
A basic standard may be defined as a standard which is established for use for an
indefinite period which may a long period. Basic standard is established for a long
period and is not adjusted to the preset conations. The same standard remains in
force for a long period. These standards are revised only on the changes in
specification of material and technology productions. It is indeed just like a number
against which subsequent process changes can be measured. Basic standard
enables the measurement of changes in costs. For example, if the basic cost for
material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an
increase of 25% in the cost of materials. The changes in manufacturing costs can be
measured by taking basic standard, as a base standard cannot serve as a tool for
cost control purpose because the standard is not revised for a long time. The
deviation between standard cost and actual cost cannot be used as a yardstick for
measuring efficiency.
5. Normal Standards
As per terminology, normal standard has been defined as a standard which, it is

anticipated, can be attained over a future period of time, preferably long enough to
cover one trade cycle. This standard is based on the conditions which will cover a
future period of five years, concerning one trade cycle. If a normal cycle of ups and
downs in sales and production is 10 years, then standard will be set on average
sales and production which will cover all the years. The standard attempts to cover
variance in the production from one time to another time. An average is taken from
the periods of recession and depression. The normal standard concept is theoretical
and cannot be used for cost control purpose. Normal standard can be properly
applied for absorption of overhead cost over a long period of time.
6. Organization for Standard Costing
The success of standard costing system will depend upon the setting up of proper
standards. For the purpose of setting standards, a person or a committee should be
given this job. In a big concern, a standard costing committee is formed for this
purpose. The committee includes production manager, purchase manager, sales
manager, personnel manager, chief engineer and cost accountant. The cost
accountant acts as a co-coordinator of this committee.
7. Accounting System
Classification of accounts is necessary to meet the required purpose, i.e. function,

asset or revenue item. Codes can be used to have a speedy collection of accounts.
A standard is a pre-determined measure of material, labor and overheads. It may be
expressed in quality and its monetary measurements in standard costs.
Revision of Standards
For effective use of this technique, sometimes we need to revise the standards
which follow for better control. Even standards are also subjected to change like the
production method, environment, raw material, and technology.
Standards may need to be changed to accommodate changes in the organization or

its environment. When there is a sudden change in economic circumstances,
technology or production methods, the standard cost will no longer be accurate.
Standards that are out of date will not act as effective feed forward or feedback
control tools. They will not help us to predict the inputs required nor help us to
evaluate the efficiency of a particular department. If standards are continually not
being achieved and large deviations or variances from the standard are reported,
they should be carefully reviewed. Also, changes in the physical productive capacity
of the organization or in material prices and wage rates may indicate that standards
need to be revised. In practice, changing standards frequently is an expensive
operation and can cause confusion. For this reason, standard cost revisions are
usually made only once a year. At times of rapid price inflation, many managers
have felt that the high level of inflation forced them to change price and wage rate
standards continually. This, however, leads to reduction in value of the standard as
a yardstick. At the other extreme is the adoption of basic standard which will remain
unchanged for many years. They provide a constant base for comparison, but this is
hardly satisfactory when there is technological change in working procedures and
conditions.
Self Check Question

1. Define Standard Costing and explain it Advantage.
2. Describe various types of standards.
3. Explain the scope and limitation of Standard costing.
MATERIAL AND LABOUR VARIANCE

Material Variances
In case of materials, the following may be the variances :
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage or Quantity Variance
(d) Material Mix Variance
(e) Material Yield Variance.
The following chart shows the division and sub-division of material variances:
Material Cost Variance

Material Price Variance Material Usage or Quantity Variance
Material Yield Variance

Material Mix Variance
Now, we proceed to define these variances one by one.

(a) Material Cost Variance (MCV). It is the difference between the standard cost of
materials allowed (as per standards laid down) for the output achieved and the actual cost of
materials used. Thus, it may be expressed as:
= Standard Cost of Materials for Actual Output- Actual Cost of Materials Used
Or
= Material Price Variance + Material Usage or Quantity Variance
Or
= Material Price Variance + Material Mix Variance+ Material Yield Variance.
In order to calculate material cost variance, it is necessary to know :

1. Standard quantity of materials which should have been required (as per standards set) to
produce actual output. Thus, standard quantity of materials is :
Actual Output x Standard Quantity of Materials per unit.
Note. In order to find out standard quantity of materials specified, actual output (and not
standard output) is to be multiplied by standard quantity of materials per unit.
2. Standard price per unit of materials.
3. Actual quantity of materials used.
4. Actual price per unit of materials.
Material Price Variance (MPV).It is that portion of the material cost variance which is dueto
the difference between the standard cost of materials used for the output achieved and the
actualcost of materials used. In other words, it can be expressed as:
Material Price Variance :

Actual Usage (Standard Unit Price - Actual Unit Price).
Here, Actual Usage = Actual quantity of material (in units) used
Standard Unit Price = Standard price of material per unit

Actual Unit Price = Actual price of material per unit.
(c) Material Usage (or Quantity) Variance (MQV). It is that portion of the material con
variance which is due to the difference between the standard quantity of materials specified
for the actual output and the actual quantity of materials used. It may be expressed as:
Material Usage Variance:

Standard Price per unit (Standard Quantity - Actual Quantity).
Note. Standard quantity means quantity of material which should have been used (as per
standard determined) for the actual output achieved.
(d) Material Mix Variance (MMV). It is that portion of the material usage variance
which is to the difference between standard and the actual composition of a mixture.
In other words, this variance arises because the ratio of materials being changed
from the standard ratio set. It is calculated as the difference between the standard
price of standard mix and standard price of actual mix.
In case of material mix variance, two situations may arise :
(i) When actual weight of mix and the standard weight of mix do not differ.
In such a case, material mix variance is calculated .vith the help of the following
formula :
Standard Unit Cost (Standard Quantity - Actual Quantity)
or
Standard Cost of Standard Mix - Standard Cost of Actual Mix.
If the standard is revised due to shortage of a particular type of material, the material
mix variance is calculated as follows :
Standard Unit Cost (Revised Standard Quantity - Actual Quantity),
or
Standard Cost of Revised Standard Mix - Standard Cost of Actual Mix.

(ii)When actual weight of mix differs from the standard weight.
In such a case material mix variance is calculated as follows:
This formula is necessitated to adjust the total weight of standard mix to the total
weight of actual mix which is more or less than the weight of standard mix
(e) Material Yield (or Sub-usage) Variance (MYV). It is that portion of the material
usage variance which is due to the difference between the standard yield specified
and the actual yield obtained. This variance measures the abnormal loss or saving
of materials. This variance is particularly important in case of process industries
where certain percentage of loss of materials is inevitable. If the actual loss of
materials differs from the standard loss of materials, yield variance will arise. Yield
variance is also known as scrap variance. This loss may result in the following two
situations :
(i) When standard and actual mix do not differ. In such a case, yield variance is
calculated with the help of the following formula :
Yield Variance= Standard Rate (Actual Yield - Standard Yield)
ii) When actual mix differs from standard mix. In such a case, formula for the
calculation of yield variance is almost the same. But since the weight of actual mix
differs from that of the itandard mix, a revised standard mix is to be calculated to
adjust the standard mix in proportion to i actual mix and the standard rate is to be
calculated from the revised standard mix as follows :
Formula for yield variance in such a case is :

Yield Variance= Standard Rate (Actual Yield - Revised Standard Yield).
(f) Material Revision Variance. Once a standard is set for a period, it is usually followed for
that period. But sometimes due to seriousness of the situation such as a sudden rise in the
pricesof materials, or due to the short supply of a particular material, there may be need of
revision of standard to cope with the situation. Standards are revised with the hope that when
the current difficulties are over, original standard will continue to operate. Thus, revision of
standards maybe for a short period. Material revision variance is calculated as given below :
Material Revision Variance = St. Price (St. Usage - Revised St. Usage) For calculation of
material usage variance, revised standard usage or quantity will be taken in stead of standard
usage or quantity. Material usage variance will be calculated as given below:
Material Usage Variance = St. Price (Revised St. Usage - Actual Usage) Other material
variances will be calculated in the same way as explained earlier. In case there is material
revision variance, material cost variance will be verified as given below:
Material Cost Variance = Material Revision Variance + Price Variance + Usage Variance
ILLUSTRATION.The standard cost of a chemical mixture is as under : 8 tons of material A

at Rs. 40 per ton. 12 tons of material B at Rs. 60 per ton. Standard yield is 90% of input.
Actual cost for a period is as under :
10 tons of material A at Rs. 30 per ton
20 tons of material B at Rs. 68 per ton
Actual Yield is 26.5 tons. Compute all materials variances.
SOLUTION
Workings :
Raw Standard Cost Actual Cost Revised Standard Standard

Cost of
Materials Cost Actual Mix
Tons Rate Total Tons Rate Total Tons Rate Total
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (3)x (5)
Rs. Rs. Rs. Rs. Rs. Rs. Rs.
A 8 40 320 10 30 300 12 40 480 400
B 12 60 720 20 68 1,360 18 60 1,080 1,200
20 1,040 30 1,660 30 1560
Loss 2 — 3.5 — 3 —
18 1,040 26.5 1,660 27 1,560 1,600
(a) Materials Cost Variance

Standard Cost of Materials - Actual Cost of Actual Materials
(c) Materials Price Variance

Actual Usage (St. Price - Actual Price)
Materials A : 10 tons (Rs. 40 - Rs. 30) = Rs. 100 (F)
Materials B : 20 tons (Rs. 60 - Rs. 68) = Rs. 160 (A)
Materials Price Variance = Rs. 60 (A)
Material Usage Variance
Standard Price (Standard Usage – Actual Usage)
Material A:
Material B:
Material Usage Variance = 69 (A)

Verification
Materials Cost Variance = Materials Price Variance + Materials Usage Variance
Rs. 129 Unfav. = Rs. - 60 - Rs. 69 = Rs. 129
Unfav. Materials Usage Variance = Materials Mix Variance + Materials Yield Variance
Rs. 69 Unfavourable = - Rs. 40 - Rs. 29 = Rs. 69 Unfavourable.
Normally it is taken that labour is a variable cost but at times it becomes fixed cost as it is
not possible to remove or retrench in case of fall/ stoppage in production Labour Rate
Standard and Grades of Labour - This is basically dependent on the agreement with the | far
unions or rate prevalent in the particular area or industry.
Cost Variance
Rate Varience Efficency Variance
Mix Variance Yield Variance Idle Time Variance

OR
Idle Time Variance

Net Efficiency Variance
labour Efficiency Standard

The labour (quantities) efficiency means the number of hours that the appropriate grade of
writer will take to perform the necessary work. It is based on actual performance of worker
or group of workers possessing average skill and using average effort while performing
manual operations or working on machine under normal conditions. The standard time is
fixed keeping inmind the past performance records or work study. This is on the basis that is
acceptable to the worker as well as the management.
labour Cost Variance
He labour cost variance is also called 'labourtotalvariance'is the difference between the
standard direct labour cost and the actual direct labour cost incurred for the production
achieved.
(Standard labour hours produced X Standard rate per hour) - (Actual direct labour hours X
Actual rate per hour)
or
Standard cost for actual output - Actual cost
Labour Rate Variance
The labour rate variance is the difference between the actual direct labour rate per hour and
the standard direct labour rate per hour, multiplied by the actual hours paid, i.e., the rate per
hour paid the direct labour force more or less than standard use of higher/lower grade of
skilled workers than planned or wage inflation causes this variance.
Actual time (Standard rate - Actual rate)
labour Efficiency Variance
labour efficiency variance is the difference between the actual hours taken to produce the
actual output and the standard hours that this output should have taken, multiplied by
thestandard rate per hour. The possible cause for this variance is due to use of higher/ of
skilled workers than planned or the quality of material used, errors in allocating time to job.
Standard rate (Standard time for actual output - Actual time)
The labour efficiency variance can be segregated into the following:

Labour Mix Variance
The labour mix variance arises due to change in composition of labour force.
Labour Mix Variance
Standard rate (Revised standard time - Actual time)
Revised Standard Time
Labour Yield Variance

The labour yield variance arise due to the difference in the standard output specified and the
actual output obtained.
Standard cost p.u. (Standard output for actual time - Actual output)
Idle Time Variance
The idle time variance represents the difference between hours paid and hours worked, ie,Mij
hours multiplied by the standard wage rate per hour. This variance may arise due to illness,|
machine breakdown, holdups on the production line because of lack of material.
Idle hours X Standard rate
Net Efficiency Variance
This variance is calculated after deducting idle hours from actual hours. The efficiency
varianctless idle time variance is called 'net efficiency variance'.
Standard rate ( Standard time for actual output - Actual time worked)
or Standard rate (Standard time - Actual hours paid - Idle time)
Illustration 20.2
100 skilled workmen, 40 semiskilled workmen and 60 unskilled workmen were to work
for30weeksio get a contract job completed. The standard weekly wages were Rs. 60, Rs. 36
and Rs. 24 respective The job was actually completed in 32 weeks by 80 skilled, 50
semiskilled and 70 unskilled workmen who I were paid Rs. 65, Rs. 40 and Rs. 20
respectively as weekly wages.
Find out the labour cost variance, labour rate variance, labour mix variance and labour
efficiency variance.
Solution
Basic Data for Calculation of Labour Variances
Category of Standard Actual
workmen
Weeks Rate Amount Weeks Rate Amount
(Rs.) (Rs.) (Rs.) (Rs.)
Skilled 3,000 60 1,80,000 2,560 65 1,66,400

Semiskilled 1,200 36 43,200 1,600 40 64,000
Unskilled 1,800 24 43,200 2,240 20 44,800

6,000 2,66,400 6,400 2,75,200
Calculation of LabourVarience
Direct Labour Cost Variance
Std. cost for actual output - Actual cost
2,75,20O - 2,66,400 = Rs. 8,800 (A)
Direct Labour Rate Variance

Actual time (Std. rate - Actual rate)
Skilled = 2,560 (60 - 65) = Rs. 12,800 (A)
Semiskilled = 1,600(36-40) = Rs. 6.400(A)
I Unskilled = 2,240 (24 - 20) = Rs. 8.960(F)= Rs. 10,240 (A)
Direct Labour Efficiency Variance
Std. rate (Std. time for actual output - Actual time)
Skilled = 60(3,200- 2,560) =Rs. 26,400 (F)
Semiskilled = 36(1,200- 1,600) = Rs. 14,400 (A)
Unskilled = 24 (1,800 - 2,240) = Rs. 10,560 (A)= Rs. 1,440 (F)
SkliedLabour Efficiency Variance can be further analyzed into:
1(A) DIRECT LABOUR MIX VARIANCE
Std. rate (Revised std. time* - Actual time)

Skilled =60(3,200- 2,560) = Rs. 38,400 (F)
Semiskilled =36(1,280- 1,600) = Rs. 11,520 (A)
Unskilled = 24 (1,920- 2,240 ) = Rs. 7.680(A) = Rs. 19,200 (F)
* Revised std. time.

(b) Direct Labour Revised Efficiency Variance

Std. rate (Std. time for actual output - Revised std. time)
Skilled = 60 (3,000-3,200) = Rs. 12,000 (A)
Semiskilled = 36(1,200- 1,280) = Rs. 2,880 (A)
Unskilled = 24 (1,800 - 1,920) = Rs. 2,880 (A) = Rs. 17,760 (A)
Summary or Labor variances(Ks.)
Rate variance 10,240 (A)
Efficiency variance
a) Mix variance 19,200 (F)
b) Revised efficiency variance 17.760(A) 1.440 (F)
Direct labour cost variance 8,800 (A)
Self Check Question
1. The standard material cost for 100 kgs. of Chemical D is made up of—
Chemical A — 30 kgs. @ Rs. 4 per kg.
Chemical B — 40 kgs. @ Rs. 5 per kg. and
Chemical C — 80 kgs. @ Rs. 6 per kg.
In a batch, 500 kgs.of Chemical D was produced from a mix of—
Chemical A - -140 kgs.at a cost of Rs. 588
Chemical B — 220 kgs.of a cost of Rs. 1,056
Chemical C — 440 kgs.at a cost of Rs. 2,860
Calculate all variances in the actual cost per 100 kgs. of chemical D over the standard cost.
Ans1(a) Rs. 10 (A); (b) Rs. 20(A); (c) Rs. 70 (F)]
2.From the following particulars find out: (a) Material price variance. (6) Material
usage variance and (c) Material cost variance.
Quantity of material purchased 3,000 units
Value of material purchased Rs. 9,000
Standard quantity of material required per tonne of finished product 25 units
Standard rate of material Rs. 2 per unit
Opening stock of material Nil Closing stock of material 500 units
Finished production during the year 80 tonnes
Also explain the possible causes of these variances.
[Material Price Variance = Rs. 2,500 Adverse ; Material Usage Variance = Rs. 1,000
Adverse ; Material Cost Variance = Rs. 3,500 Adverse]
3. A manufacturing concern which has adopted standard costing furnishes the

following information : Standard :
Material for 70 kg.finished product 100 kgs.
Price of material Re. 1 per kg.
Actual:
Output 2,10,000kgs.
Material used 2,80,000kgs.
Cost of material Rs. 2,52,000
Calculate :(a) Material Usage Variance, (b) Material Price Variance and (c) Material
Cost Variance. [Material Usage Variance = Rs. 20,000 Fav. ; Material Price
Variance Rs. 28,000 Fav.; Material Cost Variance Rs. 48,000 Fav.]
4. Calculate variances from the standard for a particular month as disclosed from the
following figures
Standard In a particular month
Number of workers employed 600 550
Average wages per worker per month Rs. 250 Rs. 264
Number of working days in a month 25 24
Output in units 30,000 28,000
[Labour Cost Variance = Rs. 5,200 Adverse ; Rate of Pay Variance = Rs. 13,200 Adverse :
Efficiency Variance = Rs. 8,000 Favourable]
5. A contract job is scheduled to be completed in 30 weeks with a labour complement of 100

skilled operatives, 40 semi-skilled operatives and 60 unskilled operatives. The standard
weekly wages of each type of operatives are—skilled Rs. 60, semi-skilled Rs. 36 and
unskilled Rs. 24. The work is actually completed in 32 weeks with a labour force of 80
skilled, 50 semi-skilled and 70 unskilled operatives and the actual weekly wages rates
average Rs. 65 for skilled, Rs. 40 for semi-skilled and Rs. 20 for unskilled labour. Analyse
the variances in the labour cost due to various reasons. [Rate of Pay Variance = Rs. 10,240
Adverse ;Labour Efficiency Variance = Rs. 1,440 Favourable; Labour Cost Variance = Rs.
8,800 Adverse]
6. The standard hours for manufacturing two products M and N are 15 hours per unit and 20
hours per unit respectively. Both products require identical kind of labour and the standard
wage rate per hour is Rs. 5. In the year 2001, 10,000 units of M and 15,000 units of N were
manufactured. The total labour hours actually worked were 4,50,500and the actual wage bill
came to Rs. 23,00,000. This included 12,000 hours paid for @ Rs. 7 per hour and 9,400
hours paid for @ Rs. 7.50 per hour, the balance having been paid at Rs. 5 per hour. You are
required to compute the labour variances.
Ans. (Total Labour Cost Variance Rs. 50,000 Adverse ;Labour Rate Variance Rs. 47,500
Adverse ; Labour Efficiency Variance Rs. 2,500 Adverse)
7. From the following records of Apollo Bolt Nut Manufacturing Company, you are required
to compute material and labourvariances :
An input of 100 kgs.of material yields a standard output of 10,000 units. Standard price per
kg.of material = Rs. 20.
Actual quantity of material issued and used by production department 10,000 kgs. Actual
price per kg.of material = Rs. 21 per kg. Actual output = 9,00,000 units Number of
employees = 200
Standard wage rate per employee per day = Rs. 40 Standard daily output per employee = 100
units Total number of days worked = 50 days
(Idle time paid for and included in the above half day for each employee) Actual wage rate
per day = Rs. 45.
Ans.[MCV = Rs. 30,000 (A); MPV = Rs. 10,000 (A) MQV = Rs. 20,000 (A), LCV = Rs.
90,000 (A); LRV = Rs. 50,000 (A), LEV = Rs. 36,000 (A) ITV = Rs. 4,000 (A)].
OVERHEAD VARIANCE
Variable Overhead Variance
For fixation of costs for overheads, a survey of overheads will be necessary and with the data
available for budgetary control, the overheads will be charged to various cost
centres/products etc. on the basis of standard costs. For this, after dividing the overheads into
fixed and variable the calculation of standard overhead rate for each cost centre / product is
done. The number of hours representing the capacity to manufacture is to be reduced by
various idle facilities, etc. The chlaof method of absorption (direct wage rate or machine
hour) will depend upon the circumstances. The main object is to establish a normal overhead
rate based on total factory overhead at normal capacity volume.
CLASSIFICATION OF VARIABLE OVERHEAD VARIANCES

Variable Overhead Cost Variance
Variable Overhead Cost

Variance
Variable Overhead Variable Overhead

Expenditure Variance Efficiency Variance
Variable Overhead Cost Variance

The variable overhead cost variance represents the difference between the standard cost of
variable overhead allowed for actual output and the actual variable overhead incurred during
the period. The variance represents the under absorption or over absorption of variable
overhdi
(Actual output X Standard variable overhead rate p.u.) - Actual variable overhead cost
or
(Standard hours for actual output X Standard variable overhead rate per hour) -Actual
variable overhead cost
Variable Overhead Expenditure Variance
It is the difference between the actual variable overhead rate per hour and the standard
variable overhead rate per hour multiplied by the actual hours worked. The actual hours
worked mustkused not the actual hours paid because the latter may include idle time and it is
usually assumed that variable overhead will not be recovered in idle time.
(Standard variable overhead rate X Budgeted output) - Actual variable overheads
or (Standard hours for budgeted output X Standard variable overhead rate per hour) ■
Actual variable overheads
or Budgeted variable overheads - Actual variable overheads
Variable Overhead Efficiency Variance
The variable overhead efficiency variance is calculated by taking the difference in standard
output and actual output multiplied by the standard variable overhead rate.
Standard variable overhead rate (Standard output - Actual output)

Illustration
The budgeted variable overheads for March are Rs. 3,840. Budgeted production for the
month is 38,400 units. The actual variable overheads incurred were Rs. 3,830 and actual
production was 38,640 units,
Calculate variable production overhead variance.
Solution
Working
Standard Variable Overhead p.u.
Total standard Variable Overhead= Actual quantity X Std. variable overhead p.u.
= 38,640 units X Re. 0.10 = Rs. 3,864
Variable Production Overhead = Standard variable overhead - Actual variable overhead
= Rs. 3,864 - Rs. 3,830 = Rs. 34 (F)
Fixed Overhead Variances
Fixed overhead represents all items of expenditure which are more or less remain constant
irrespective of the level of output or the number of hours worked. The fixed overheads
variances are classified as follows:
Cost Variance
Expenditure Variance Volume Variance
Efficiency Variance Capacity Variance
Revised Fixed OH Capacity Calendar Variance

Variance
Fixed Overhead Cost Variance
Fixed overhead cost variance represents the under/over absorbed fixed production overhead in
the period. This under/over absorbed overhead may be due to differences between actual and
budgeted fixed overheads, i.e., expenditure variances, and/or differences between the actual
and budgetedlevels of activity i.e., volume variances.
(Actual output X Standard fixed overhead rate p.u.) - Actual fixed overheads
Or
(Standard hours for actual output X Standard fixed overhead rate per hour) -Actual fixed
overheads
Or
Recovered fixed overheads - Actual fixed overheads
Fixed Overhead Expenditure Variance
This variance is also called 'budget variance', obtained by comparing the total fixed overhead
cost actually incurred against the budgeted fixed overhead cost.
Budgeted fixed overheads - Actual fixed overheads
Fixed Overhead Volume Variance
The volume variance is computed by taking the difference between overhead absorbed on
actual output and those on budgeted output.
(Actual output X Standard rate) - Budgeted fixed overheads or Standard rate (Actual
output - Budgeted output) or Standard rate per hour (Standard hours produced - Budgeted
hours)
Fixed Overhead Efficiency Variance
The efficiency variance arise due to the difference between budgeted efficiency to
production and the actual efficiency is achieved.
Standard rate (Actual output in units - Standard output in units) or Standard rate per hour
(Actual hours worked - Standard hours for actual output)
Fixed Overhead Capacity Variance
The capacity variance represents the part of volume variance which arise due to working at
higher or lower capacity than standard capacity.
Standard rate (Budgeted quantity - Standard quantity)
Revised Fixed Overhead Capacity Variance
The revised capacity variance is calculated as follows:
Standard fixed overhead rate (Revised budgeted quantity - Standard quantity)
Fixed Overhead Calendar Variance
The calendar variance arise due to the volume variance which is due to the difference
between the number of working days anticipated in the budget period and the actual working
days in the period to which the budget is applied.
Standard fixed overhead rate (Budgeted quantity - Revised budgeted quantity)
Illustration
From the following prepare variance analysis of a particular department for a month:
Variable overhead items : (actual)
Materials handling 8,325
Idle time 850
Re-work 825
Overtime premium 250
Supplies 4,000
14,250
Fixed overhead items: (actual) (Rs.)

Supervision 1,700
Depreciation –Plant 2,000
Depreciation-Equipment 5,000
Rates 1,150
Insurnace 350
Total 10,200
Normal capacity 10,000 standard hours, budgeted rate Rs. 1.70 per standard hour for variable
overhead and Re. 1 per standard hour for fixed overhead. Actual level 8,000 standard hours.
Solution
Calculation of Variable and Fixed Overhead Variances
l) Variable Overhead Cost Variance
Recovered variable overheads - Actual variable overheads
= (8,000 X 1.70) - 14,250 = Rs. 650 (A)
(2) Fixed Overhead Cost Variance

Recovered fixed overheads - Actual fixed overheads
= (8,000 X 1) - 10,200 = Rs. 2,200 (A)
3)Fixed Overhead Expenditure Variance
Budgeted fixed overheads - Actual fixed overheads
= (10,000 X 1) - 10,200 = Rs. 200 (A)
4) Fixed Overhead Volume Variance
Recovered fixed overheads - Budgeted fixed overheads
= 8,000 - 10,000 = Rs. 2,000 (A)
= Rs. 15.077 p.u.

SELF CHECK QUESTION
1. Calculate overhead variances from the following data
Standard Actual
Fixed overheads (Rs.) 8,000 8,500
Variable overheads (Rs.) 12,000 11,200
Output in units 4,000 3,800
Ans. [Overhead Cost Variance Rs. 700 Adverse ; Variable Overhead Variance Rs. 200 Fav. ;
Fixed Overhead Variance Rs. 900 Adverse; Volume Variance Rs. 400 Adverse ; Fixed
Overhead Expenditure Variance Rs. 500 Adverse]
2. From the following, compute the different overhead variances :
In a factory 10,000 units are budgeted to be produced in a month with budgeted fixed
expenses being Rs. 15,000 i.e. Rs. 1.50 per unit. The actual output during the month was
11,000 units and actual fixed expenses being Rs. 15,500. The increase in output was due to
5% increase in capacity. The budgeted working days were 25 but factory worked for 27
days.Ans. [Overhead Variance Rs. 1,000 Fav. ; Expenditure Variance Rs. 500 Adverse ;
Volume Variance Rs. 1,500 Fav. ; Calendar Variance Rs. 1,200 Fav. ; Capacity Variance Rs.
810 Fav. ; Efficiency Variance Rs. 510 Adverse]
3. A manufacturer operating a standard costing system had the following data in respect of a
month :
Standard Actual
Number of working days 25 27
Man hours per month 5,000 5,400
Output in units 500 525
Fixed Overheads (Rs.) 2,500 2,400
Calculate fixed overhead variances for the month.
Ans.[Total Fixed Overhead Variance Rs. 225 Favourable; Volume Variance Rs. 125
Favourable ; Expense
Variance Rs. 100 Favourable; Capacity Variance Nil ; Calendar Variance Rs. 200
Favourable ; Efficiency Variance Rs. 75 Adverse]
4. From the following data, calculate : (a) efficiency variance, (6) capacity variance, (c)
calendar variance, (d) volume variance and (e) expenditure variance.
Item Budgeted Actual
No. of working days 20 22
Man hours per day 8,000 8,400
Output per man hour in units 1.0 0.9
Overhead (Rs.) 1,60,000 1,68,000
Ans.(a) Rs. 18,480 Unfav.; (6) Rs. 8,800 Fav.; (c) Rs. 16,000 Fav.(d) Rs. 6,320 Fav. ; and (e)
Rs. 8,000 Unfav.]

Class Notes ACM 602 Unit 4 and 5

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ACM 602 Cost Analysis and Control

Meaning of Cost Reduction

4. To make cost reduction programme acceptable to the employees of the

 Possibility of reduction offiles and filing space.

 Expenditure on printing, postage and telephone.

 Use of forms and stationery

 Whether there is an effective system of sales promotion.

 Whether the market research is adequate.

 Whether there is any possibility of reduction in selling and distributing

4. Cost reduction will be helpful in meeting competition effectively.

1. What is cost control? Which techniques used for cost control?

COST ANALYSIS FOR SHORT TERM DECISION

After studying this lesson, you should be able to

 Understand the meaning, benefits and limitations of absorption costing.

Advantages of Absorption Costing

Following are the benefits of absorption costing.

Limitations of Absorption Costing.

However, absorption costing has the following limitations.

a. Under absorption costing utility of cost data as controlling device is

Advantages of Marginal Costing

Following are the advantages of Marginal Costing.

a. It is an easy cost controlling exercise.

Limitations of Marginal Costing

Marginal Costing Vs Absorption Costing

A decision as to profitability of the product / department is taken in marginal costing

a. System of financial control. For example where Responsibility Accounting

Statement of the Profit for the year ending___________

(Under absorption costing.)

b) Statement of Profit for the year ended ___________

Under Marginal Costing

Net Profit 2,39,375

Note:- Difference in profit is due to element of fixed cost included in valuation of

Contribution = Selling Price – Marginal Cost or Fixed Expenses + Profit

(b) Profit-volume Ratio :

Thus if selling price is Rs.25 Marginal cost is Rs.10

To improve profit volume ratio it can be done by

Fixed cost FxS

(ii) Value of sales to earn a desired amount of profit =

Fixed cost + Desired Profit

(iii) Variable cost = Sales (I – P/v Ratio)

(iv) Profit = Sales x P/v Ratio – Fixed cost.

(v) Fixed cost = Sales x P/v Ratio - Profit

Calculate Profit Volume Ratio from the following information.

(ii) Change in profits

Fixed Expenses 1,50,000

Selling price per unit 15

(iii) Break-even Point (in units)

Fixed Expenses 150000

Break-even sales = 30000 x 15 = 4,50,000

Fixed Expenses 150000

(iv) Revised Break-even Point i.e. 25000

Fixed Expenses 150000

Fixed Expenses + Desired Profit F+P

Sales Rs.12,00,000, Variable costs Rs.7,50,000, Fixed cost Rs.3,60,000

Fixed cost + Desired Profit

Break even Chart:

A break-even chart is a graphical representation of marginal costing. This shows

BREAK-EVEN AND PROFIT-VOLUME CHARTS

a) Take the output or level of production on the X axis

Profit Volume Graph

a. Plot the sales values on the X axis.

MARGINAL COSTING – A TOOL FOR DECISION MAKING

After studying this lesson, you should be able to