Cost & Management Accounting

Answer 1:

Introduction:

In life and in business even a simple decision changes the outcome of an event hence decision-
making process is an essential and an integral part of any organization.

The management have to make correct decisions on an ongoing basis. Needless to say, bad
decisions can cause significant damage to an organization, for example Nokia was once the king
of mobile phone market, but few wrong decisions and they are not even among the top 10
manufacturer now(https://straitsresearch.com/blog/worlds-largest-top-10-smartphone-companies-
in-2020) on the other hand a set of good decisions stand to make a fortune for the company.

Good decision making is rarely done by intuition rather it’s a product of diligent
collection/evaluation of information and a formal decision-making process at place. Such process
acts as a framework for management in making sound business decision.

Concept:

A formal decision-making process at a firm involves 3 key elements: -

Planning Directing Controlling

Let us discuss these 3 key elements in detail to understand the significance of them.

Planning
What does it mean to plan? Planning is about deciding a course of action to realize a desired
outcome.

Managers must focus on this preliminary step in the decision-making process. It involves finding
answers to important questions such as: -

What is to be done?

How is it to be done?

What is the desired outcome if the decision is implemented?

What is the budget? So on and so forth.

Managers must take into consideration all these fundamental questions and develop a framework
for decision making.

Planning includes the plan of 3 core components:

 Planning

Strategic Positioning Budgets

Planning has to occur at all levels. First planning occurs at strategy level which then moves to
broad based plan on how to establish the position to maximize the goal realization considering the
financial realities and budgets

A. Strategic planning:
Management should invest considerable time and effort in developing strategy. The best
strategic alternative will be superior in terms of cost, quality and will ensure a sustainable
competitive advantage and will define the organizations direction and purpose.

B. Positioning:

Positioning involves choosing the best alternative for product placement in terms of
geographic coverage and planning how to best use the resources to bring more cost-
effectiveness and efficiency and thus competitive advantage. It may also involve CVP
analysis and assessing branding, competition pricing etc.

C. Budgets:
Budgets are prepared considering the organisational goals. Now these can be short or medium
term operational, capital, and financing budgets prepared based on past data.

Directing
Numerous plans can be developed, but not all of them can be realized. For realization, proper
direction of managers is necessary. Managers are the foremost responsible persons for the
successful implementation of a plan. Directing also has 3 components: -

Directing

Costing Production Analysis

A. Costing:
Costing is an extensive part of management accounting, so much so, that many a times
management accountants are referred as Cost accountants. Costing involves management
providing directions for cost optimization and improvement of business efficiency. Here they
have to develop and adopt appropriate costing technique such as job costing method, process
costing method, ABC and must understand absorption and direct cost concepts.
 B. Production:

Production is a hands-on process and frequently involves dealing with tangible parts of the
business. Production management follow “Lean” business philosophy where cost must be
minimized and efficiency is maximized while achieving better quality and output. Under
production management, management of inventory is extremely crucial as overstocking and
overproduction of goods leads to slippage of cost and obsolescence. In order to better manage
the inventory/production management is expected to JIT and EOQ techniques well.

C. Analysis:

Analysis involves analysis of various facets of the business which include comparison of
actual vs. planned numbers, production vs. outsourcing decisions, whether it makes business
sense to consider special offers and establishing the level of production and pricing going
forward.

Controlling
Controlling has 2 components: -

1.Monitor:

A business is like a car and the management is akin to driver of it. A car cannot run on cruise
control perpetually, the driver has to constantly monitor the surrounding and control the car.
Similarly, the management has to monitor where the business is heading by monitoring the cost,
variances, and to ensure if the desired goals are achieved in time. Often companies hire a
controller/comptroller for effective monitoring and control. The controller can monitor the
variations by adopting any of the below-mentioned methods:

a. Prepare a budget for all the expenses.

b. Compute the standard cost.
c. Compare the actual price incurred with the expected cost.
d. Analyze the variances and their reasons.
e. Prepare a scorecard for evaluating the elements which are essential to the organization.

2.Scorecard:
Traditionally measurement of organizational performance has focused more on financial aspects.
Increasingly, companies are realizing that only financial measures alone are not sufficient and for
better monitoring and control balance scorecard approach has to be adopted as it not only takes
into account the financial perspective but also the customer’s, internal and learning and growth
perspective.

Conclusion:

In order to take complete benefit of COVID-19 opportunity the management of Excellent

Clothing Company shall consider the abovementioned points and carefully plan, direct, and
control its decision to produce masks.

Using this framework, the management can assess if producing masks makes strategic sense for
their business, how they will position their product, the amount to be spent, the costs involved etc.

A decision based on intuition alone may not always produce the best outcome, hence having a
strong decision-making framework is extremely important in this day and age where one
uncareful decision and set the business back significantly or worse endangers its existence.

Answer 2:

Introduction:

Both Marginal costing and Absorption costing are 2 different techniques used for inventory
valuation.

Marginal costing is a technique used to analyze the relationship between volume, cost, and profit.
As the word “marginal” suggests, Marginal cost can be described as a change in total cost of
production of one additional unit of output. This method advocates the theory of incremental cost
of production this means with every rise in the amount of production, the cost of production will
increase.

Absorption costing, on the other hand, is a method which considers both fixed costs and variable
costs as product cost; i.e., all variable and fixed manufacturing costs are charged to the product.
For this reason, it is also known as full costing. This costing method is essential, particularly for
reporting purposes as it gives a fair picture of the costs and companies usually follow this method
since it is GAAP compliant.
Concept:

Let us look at the differences between Marginal and Absorption costing: -

Marginal Costing Absorption Costing

#1 Cost application
Under Marginal Costing, only variable costs Under Absorption Costing, both fixed and
are considered as a cost of production. Fixed variable costs are considered in calculating the
costs are treated as period costs. The product product cost and valuation of inventories. The
cost is charged to cost unit, while fixed costs fixed overhead costs are also absorbed in the
or the period costs are charged to the Profit & production costs under absorption costing.
Loss account and expensed out.

#2 Classification of costs
Marginal costing classifies the costs into two Absorption costing method classifies the costs
categories of overheads. i.e., fixed overheads based on their functions. That is production
and variable overheads. Under this method the overheads, administration overheads, selling
expenses are classified based on their nature. overheads, and distribution overheads. While
In preparing the income statement under preparing the income statement under this
marginal costing method, all the variable costs method, production cost includes the fixed
are pooled together and subtracted from manufacturing and other overheads.
revenues. The balance amount then takes into
account the fixed costs to arrive at the final net
profit.

#3 Measurement
Marginal Costing determines the cost of
production of the next additional unit. It
advocates the theory of incremental cost of
production. i.e., the cost of production
increases with the rise in output of production.
This cost data represents the contribution of
each product or department. By further
calculation we can determine the contributions
margins as well. This method provides the
contribution per unit.
Under absorption costing, the cost is
determined for all units produced by the
company. This method follows the
conventional way of determining costs and
profits. Profits are derived by subtracting the
variable and fixed overheads from the sales
figure and by further analysis we can
determine the gross margin. This method
provides the net profit per unit.
 #4 Effect of opening and closing stock
Under Marginal costing, since the emphasis is
on the incremental unit, there is no effect of
opening and closing inventory on the cost of
production. Variances in the opening and
closing stock does not influence the cost per
unit of output.
Under absorption costing method, since the
emphasis is on each unit, the profit changes
with the change in opening and closing
inventory of the product. Variances in the
opening and closing stock affects the cost per
unit. A portion of fixed overheads will be
considered in the valuation of closing
inventory and will not affect the company's
profit and loss account in the current period.

#5 Profitability
Under Marginal costing, the profitability of The profitability will appear to be lower under
each individual sale will appear to be higher as absorption costing as fixed costs are also
profitability is measured by Profit Volume considered in the cost of production.
Ratio.

Conclusion:

Both Marginal and Absorption costing approaches have different methods of calculating the cost
per unit and calculating the units’ profit.

Both methods of costing have their own set of advantages and disadvantages. However, most of
the accountants prefer applying the absorption costing method in determining the profitability and
for reporting purposes as it gives a fair picture of the production costs. Whereas Marginal costing
method is often used by the management in short term profit planning by profitability and break-
even analysis and it also highlights the comparative profitability and performance between 2 or
more products and departments/divisions.
Answer 3.A:

Introduction

Under conventional method of costing, the fixed costs are assigned or allocated to the product
based on the volume of the product. i.e., the number of units produced or the number of hours of
direct labor, etc.

Concept and Application:

Companies need accounting systems to keep track of the costs incurred. It can be done by
following the traditional method of costing as it is relatively easy to use and can be implemented
quickly.

Advantages of Traditional method of costing:

• Easy to use and implement.

• Is inexpensive as compared to other forms of fancier costing.
• The output is fairly easy to understand and that is why this method is often used for
external reporting purposes (not necessarily financial reporting but COGS)
• It can trace direct costs.
• Applies one rate for allocating the overhead to the entire operations.
Disadvantages of Traditional method of costing:

• Accuracy of the cost details is not at par with other sophisticated methods as it gives one
plant wide overhead rate.
• Does not work well when multiple products are manufactured by a company.
• Does not considers SD&A expenses in product cost
The traditional method gives an optimum result only when the manufacturing process is labor
driven.

Here, WRITER’s Company incurs a monthly fixed overhead cost in the form of Rent of
₹300,000/- and produces two different products.

Total number of units produced per month(both fountain and ball pens) = 10,000 + 20,000 =
30,000 units per year

Calculation of rent cost per unit for Writers’ company = Rent/number of units produced

= 300,000/30,000
=10

Rent cost per unit = ₹10

Calculation of cost per unit for Writers’ company

Particulars Fountain Pen Ball Point
Direct Variable Cost 32.00 25.00
Direct Fixed Cost 10.00 8.00
Rent Cost per unit (Indirect) 10.00 10.00
(Rent Amount / No. of units)
Total Cost per unit in INR 52.00 43.00

Conclusion:

The traditional method of costing hence can be adapted and followed quickly. It is among the
simplest method of calculating the cost price of the product as is visible in this calculation.

Answer 3.B:

Introduction:

Activity-based costing (ABC) is a sophisticated costing method used to find total cost of activities
necessary to make a product.

Concept and Application:

Activity-based costing identifies the activities that cause the cost to be incurred leading to find the
cost drivers.

Advantages of using this method in determining the cost per unit of the product are:

• Provides a fair and accurate costing information of products and services as it considers
multiple activity rates.
• Logical allocation of Fixed overheads.
• Helps the management develop better pricing as the cost is derived accurately.
• Useful in organizations where there are multiple products and product lines.
Disadvantages of Activity-Based Costing:

• Not feasible for small organizations with a single product as the cost driver identification
is slightly complex and it is difficult to implement.
• More expensive as compared to the traditional method of costing.
• The selection of appropriate cost drivers may not be possible at all times.
• Some indirect costs, such as office staff and management salaries, are difficult to assign to
a product.
• Is not used for external reporting as ABC costing is often subjective and the auditors
might not share the same view.
Stages in implementing Activity-Based Costing:

• Identifying all the activities required to create the product.

• Divide the activities into cost pools, which includes individual costs related to an activity
• Calculate the total overhead of each cost pool. Assign each cost pool activity cost drivers,
such as hours or units.
• Calculate the activity cost-driver rate for each activity.

The formula for calculating the activity-based costing is as follows:

Activity based costing formula = Cost pool in total / Cost driver

In the given question, WRITER’s Company has incurred a fixed cost of ₹300,000/-The same is to
be assigned to the products based on cost driver, which is the area of operations in this case.

Particulars Fountain Pen Ball Point

Direct Variable Cost
320,000 500,000
(Direct Variable Cost per unit * number of units)
Direct Fixed Cost
100,000 160,000
(Direct Fixed Cost per unit * number of units)
Rent Cost 140,000 160,000

[Rent Amount * (Area occupied by product/ Total Area of

operations)]

Total Cost of operations 560,000 820,000

No. of units 10,000 20,000
Cost per unit 56 41

Conclusion:

The costs derived from activity-based costing provide more accurate costing of the product. It
helps the management to make a better pricing decision. It can be effectively used to market the
product and improve the efficiency and profitability of the business organization.
Here the difference in cost is clearly visible w.r.t traditional costing method. Earlier the cost of
fountain pen came out to be 52 and cost of ball pen was 43, there was barely any difference in the
cost of the products but when we calculate the same cost with ABC we find that earlier the cost of
fountain pen was understated by 4 rupees and on the other hand the cost of ball point pen was
overstated by 2 rupees. With this new information management can develop better pricing and
decide on the future course of action.