Unit 2

STANDARD COSTING - DEFINITION

STANDARD COSTING may be defined basically as a technique of cost accounting

which compares the “standard cost” of each product or service with the actual cost, to
determine the efficiency of the operation, so that any remedial action may be taken
immediately.
The “standard cost” is a predetermined cost which determines what each product or
service should cost under given circumstances
.
STEPS IN STANDARD COSTING

Standard costing involves:

™ The setting of standards
™ Ascertaining actual results
™ Comparing standards and actual costs
to determine the variances
™ Investigating the variances and taking
appropriate action where necessary.

STANDARD COSTING
™ Provides a yardstick against which the actual costs can be measured.
™ The setting of standards is involves determining the best materials and methods,
which may lead to economies.
™ A target of efficiency is set for employees to reach, and cost consciousness is
stimulated.
™ Variances can be calculated which enable the principle of “management by
exception” to be operated.

ADVANTAGES OF STANDARD COSTING

™ Costing procedures are often simplified.

™ Provides a valuable aid to management in
determining prices and formulating policies.
™ The evaluation of stock is facilitated.
™ The operation of cost centers defines responsibilities.

VARIANCE ANALYSIS
“Variance” is the difference between a budgeted or standard amount and the actual
amount during a given period. Variance Analysis is defined to be an analysis of the cost
variances into its component parts and the explanation of the same. It is that part of the
process of control which involves the calculation of a variance and interpretation of
results for identifying the causes thereof and also for pinpointing responsibility.
Variances are normallycalculated for all the cost components such as Materials, Labour
and Overheads.
Cost-Volume-Profit (CVP) Analysis

The cost-volume-profit analysis, also commonly known as breakeven analysis, looks to

determine the breakeven point for different sales volumes and cost structures, which
can be useful for managers making short-term business decisions. CVP analysis
makes several assumptions, including that the sales price, fixed and variable costs per
unit are constant. Running a CVP analysis involves using several equations for price,
cost, and other variables, which it then plots out on an economic graph.

The CVP formula can also calculate the breakeven point. The breakeven point is the
number of units that need to be sold or the amount of sales revenue that has to be
generated in order to cover the costs required to make the product. The CVP
breakeven sales volume formula is:

Breakeven Sales Volume=CMFC

where:FC=Fixed costsCM=Contribution margin=Sales−Variable Costs

To use the above formula to find a company's target sales volume, simply add a target
profit amount per unit to the fixed-cost component of the formula. This allows you to
solve for the target volume based on the assumptions used in the model.

CVP analysis also manages product contribution margin. The contribution margin is the
difference between total sales and total variable costs. For a business to be profitable,
the contribution margin must exceed total fixed costs. The contribution margin may also
be calculated per unit. The unit contribution margin is simply the remainder after the
unit variable cost is subtracted from the unit sales price. The contribution margin ratio
is determined by dividing the contribution margin by total sales.

The contribution margin is used to determine the breakeven point of sales. By dividing
the total fixed costs by the contribution margin ratio, the breakeven point of sales in
terms of total dollars may be calculated. For example, a company with $100,000 of
fixed costs and a contribution margin of 40% must earn revenue of $250,000 to break
even.

Profit may be added to the fixed costs to perform CVP analysis on the desired
outcome. For example, if the previous company desired a profit of $50,000, the
necessary total sales revenue is found by dividing $150,000 (the sum of fixed costs
and desired profit) by the contribution margin of 40%. This example yields a required
sales revenue of $375,000.

Special Considerations

CVP analysis is only reliable if costs are fixed within a specified production level. All
units produced are assumed to be sold, and all fixed costs must be stable in CVP
analysis. Another assumption is all changes in expenses occur because of changes in
activity level. Semi-variable expenses must be split between expense classifications
using the high-low method, scatter plot, or statistical regression.

How Is Cost-Volume-Profit (CVP) Analysis Used?

Cost-volume-profit analysis is used to determine whether there is an economic

justification for a product to be manufactured. A target profit margin is added to the
breakeven sales volume, which is the number of units that need to be sold in order to
cover the costs required to make the product and arrive at the target sales volume
needed to generate the desired profit. The decision maker could then compare the
product's sales projections to the target sales volume to see if it is worth
manufacturing.

What Assumptions Does Cost-Volume-Profit (CVP) Analysis Make?

The reliability of CVP lies in the assumptions it makes, including that the sales price
and the fixed and variable cost per unit are constant. The costs are fixed within a
specified production level. All units produced are assumed to be sold, and all fixed
costs must be stable. Another assumption is all changes in expenses occur because of
changes in activity level. Semi-variable expenses must be split between expense
classifications using the high-low method, scatter plot, or statistical regression.

What Is Contribution Margin?

The contribution margin can be stated on a gross or per-unit basis. It represents the
incremental money generated for each product/unit sold after deducting the variable
portion of the firm's costs. Basically, it shows the portion of sales that helps to cover the
company's fixed costs. Any remaining revenue left after covering fixed costs is the
profit generated. So, for a business to be profitable, the contribution margin must
exceed total fixed costs.

How to calculate a cost-volume-profit analysis

Here are the steps for calculating a cost-volume-profit analysis:

1. Calculate the sum of fixed costs

Calculate the company's total fixed costs by adding up costs like marketing, salaries,
rent and insurance. There's also a simple formula you can use to do this. Start by
distinguishing the fixed and variable costs, then start calculating all the production costs.
Subtract the production costs from the variable costs and multiply that number by the
number of produced units.
Here's the formula to calculate the sum of fixed costs:

Fixed costs = (total cost of production − (variable cost per unit x number of units
produced)

2. Determine the selling price of the product

The cost-volume-profit analysis can help you estimate whether the selling price per
unit can help the company earn the desired profits. You can determine the selling price
of the product by evaluating the variable costs and net sales. Start by calculating the
variable cost per unit, which involves dividing the total variable costs by the number of
units produced during that period. For example, if the business produces 100 tables
monthly and the total variable costs are $10,000, the variable cost per unit would be
$100. Here's the formula for selling price per unit:

Selling price per unit = variable cost per unit + contribution margin per unit

Determine the company's net sales, which is what it earns for selling the product after
subtracting discounts, returns and allowances. You can deduct the total variable cost
from the total net sale and divide this number by the number of units produced to
determine the contribution margin per unit. In the above example, with 100 tables for a
variable cost of $10,000 and net sales of $15,000, the contribution margin would be
$5,000, with a contribution margin per unit of $50. You'd add the variable cost per unit
and the contribution margin to reach the selling price per unit.

Here are the calculations:

Selling price per unit = $100 + $50 = $150

3. Calculate the variable cost per unit

Variable costs can increase or decrease. For example, variable costs increase if the
company produces more products. When it produces fewer products, the variable costs
decrease. You can evaluate the following costs to find the variable costs:

 Direct labor: What the company pays to the employees hourly to create the final
product

 Direct material: The raw materials used for the final product
 Variable manufacturing overhead: The hourly wages the company pays for
shipping, machinery and the manufacturing supervisors

Add these costs together to calculate the variable cost per unit. For example, the
sock company may take $10 in direct material, $10 in direct labor and $20 in
overhead to manufacture one set of socks. The variable cost per unit is $40, the sum
of direct material, direct labor and variable manufacturing overhead.
 4. Calculate the contribution margin ratio and contribution margin

To find the contribution margin, you first subtract the variable cost per unit from the
unit selling price. The difference you get informs you how much profit can remain to
cover the fixed costs. Here's the formula:

Contribution margin = variable costs per unit − unit selling price

To find the contribution margin ratio, divide the contribution margin by the unit selling
price. Here's the formula:

Contribution margin ratio = contribution margin / unit selling price

5. Perform the cost-volume-profit analysis

Use the previous calculations to conduct the cost-volume-profit analysis. There are
multiple formulas you can use to calculate the CVP analysis and determine how
many units a company needs to sell to earn the desired profits. A common formula is
the break-even sales volume formula:

Break-even sales volume = fixed costs / (price − variable costs)

Example cost-volume-profit analysis

Here's an example of how to calculate a cost-volume-profit analysis:

Greg's Socks LLC calculates that its fixed costs are $7,000 every month. The fixed
costs include marketing, rent, insurance, salaries and raw materials. It costs $2.65 to
produce a pair of socks, and each pair sells for $8, earning a profit of $5.35 for each
pair. The company performs a cost-volume-profit analysis:

Break-even sales volume = $7,000 / ($8.00 − $5.35) = 2,641.51

This means that Greg's Socks LLC has to sell a minimum of 2,642 pairs of socks every
month to achieve the break-even point of $7,000.

Marginal Analysis

Marginal analysis is an essential concept in microeconomics. It involves the evaluation

of additional costs and benefits associated with the introduction of a new activity. It is
helpful in the decision-making process of business expansions and regulating the
production scale. Furthermore, it can explain why specific necessities are cheap for
households, but at the same time, luxury items are expensive.
It is not always necessary that every marginal change results in benefit, which is why the
analysis is essential to organizations. There are different types of decisions for which the
analysis considering items like marginal cost and opportunity cost comes into aid, like
the make or purchase, capital expenditure, expansion, contraction, advertising, hiring,
and product line decisions. The analysis provides a projected result based on which
management makes business decisions.

The primary motive of any business or company is to make a profit, and marginal
analysis is an essential technique in identifying potential profit from a slight change in
operations. Two rules are associated with the analysis process focusing on profit
maximization, the equilibrium rule, and the efficient allocation rule. Equilibrium rule
focus on the equilibrium of the marginal revenue and marginal cost. The efficient
allocation rule following the efficiency principle focuses on producing the same
marginal return for each unit of effort.

Examples

Let’s look into some examples for a better understanding:

Example #1

John owns a burger shop. It is a well-established joint and has earned goodwill among
people. He is lately thinking of expanding the production scale. The shop sells 10,000
burgers in a month. The total fixed cost per month is $10,000, and the expense incurred
for a burger is $2. If the number of burgers sold in a month is 10,000 and the total fixed
cost per month is $10,000, then the fixed cost per burger is $1 ($10,000/10,000). Hence
the total cost per burger is $3 ($2+$1).

John plans to increase the output so that the number of burgers sold in a month will be
10,500. John’s decision to increase the output using the existing facilities led to applying
a marginal analysis. As a result, the new fixed cost per burger will be $0.952
($10,000/$10,500), and the new total cost per burger will be $2.952 ($2+$0.952). In this
case, the fixed cost per burger and the total cost per burger decreased. Hence,
increasing production will help John lower costs in this hypothetical marginal analysis
example.

Example #2

A baking company is planning to increase the sales of its baked goods. As a result, they
want to hire five new bakers. Before hiring, they run a marginal analysis to compare the
 additional benefit and costs incurred. The analysis indicates that hiring bakers is
beneficial because the income increase outweighs the cost.

Marginal Analysis Uses

 It gives a data point for making better and rightful business operations decisions and
strategies. Corporate teams, analysts, and other management professionals commonly
use analysis to understand the pros and cons of any project before making any
decisions. Furthermore, without the proper marginal analysis, a company can make loss-
making decisions that are not fruitful for the organization.
 It helps in understanding the cost to be spent and the benefit to gain from the activity.
 It helps to understand the maximum potential and, in some cases, the potential loss
from the unit change in the activity.
 Often, the analysis helps determine the opportunity cost associated with a change in
the business activity.
 The analysis observes if the unit change may bring short-term or long-term benefits for
the company.

Marginal Analysis Limitations

 Marginal analysis in economics is based on projected results, which means the result
and whole activity target are based on a benchmark rather than the actual output.
Therefore, the data and information offered by the assessment are hypothetical and
inaccurate.
 If the assessment is not conducted correctly, any error can induce an unnecessary loss to
the company in terms of cost. Furthermore, the assumptions in the analysis should be
taken carefully. Otherwise, the whole test becomes a failure and useless to the company.