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MGT402 Cost & Management Accounting Short Notes Lectures 23 To 45

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Production budget

This budget provides an estimate of the total volume of production distributed product-wise with the scheduling of operations by days, weeks and months and a forecast of the inventory of finished products.

Generally, the production budget is based on the sales -budget.


The production budget is prepared after taking into consideration several factors like:

(i)               Inventory policies.

(ii)             Sales requirements

(iii)          Production stability

(iv)          Plant capacity

(v)             Availability of materials and labor

(vi)          Time taken in production process, etc.



FLEXIBLE BUDGET (not completed)



The preparation of a flexible budget results from the development of formulas for each department and for each account within a department or cost center. The formula for each account indicates the fixed amount and/or a variable rate. The fixed amount and variable rate remain constant within prescribed ranges of activity. The variable portion of the formula is a rate expressed in relation to a base such as direct labor hours, direct labor cost or machine hours.






Capacity and volume


The terms "capacity" and "volume" (or activity) are used in connection with the construction and use of both fixed and flexible budgets.


Capacity is that fixed amount

Volume is the variable factor in business.



Theoretical Capacity

The theoretical capacity of a department is its capacity to produce at full speed without interruptions


Expected Actual Capacity


Expected actual capacity is based on a short-range outlook. The use of expected actual capacity is feasible with firms whose products are of a seasonal nature» and market and style changes allow price adjustments according to competitive conditions and customer demands.







Analysis of Cost Behavior

The success of a flexible budget depends upon careful study and analysis of the relationship of expenses to volume of activity or production and results in classifying expenses as fixed, variable, and semi variable,



Fixed Expenses

A fixed expense remains the same in total as activity increases or decreases.


In the short run, some fixed expenses, some times called programmed fixed expenses, will change because of changes in the volume of activity or for such reasons as changes in the number and salaries of the management groups.




Variable Expenses

A variable expense is expected to increase proportionately with an increase in activity and decrease proportionately with a decrease in activity.




Variable expenses include the cost of supplies, indirect factory labor, receiving, storing, rework, perishable tools, and maintenance of machinery and tools. A measure of activity – such as direct labor hour or dollars.











Cash Budget

Determining the future is a summary of the firm's expected cash inflows and outflows over a particular period of time.



 Cash budget is to enable the firm to meet all its commitments in time

And at the same time prevent accumulation at any lime of unnecessary large cash balances with it:



Format of Cash Budget




Cash budget

For the month of XXX – XXX


 Opening balance

Add Receipts (Anticipated cash

Receipt from all sources)

Less Payments (Anticipated utilization of cash)

Excess / Deficit

Bank barrowing / Overdraft

Closing balance









Flexible budget

The Flexible Budget is designed to change in accordance with the level of activity attained. Such a budget is prepared after considering the fixed and

Variable elements of cost and the changes that may be expected for each item at various levels of Operations








Controlling ratios                

Budget is a part of the planning process.



                (1) Activity Ratio

                (2)   Capacity Ratio

                (3) Efficiency Ratio



If the ratio works out to 100 per cent or more, the trend is taken as favorable, if the ratio is less than 100 per cent, the indication is taken

as unfavorable.




Activity Ratio:



                                Standard hours for actual production

Activity Ratio = ___________________________________ x 100

                                                  Budgeted hours





Capacity Ratio:



                              Actual hours worked

Capacity Ratio = ____________________ x 100

                                   Budgeted hours






Efficiency Ratio:



                                    Standard hours for actual production

Efficiency Ratio = ____________________________________ x 100

                                                   Actual hours worked


Performance budgeting

A performance budget presents the operations of an organization in terms of functions, programmers, activities, and projects.


The primary purpose of traditional budget particularly in government administration is to ensure financial control and meet the requirements of legal accountability, that is, to ensure that appropriation.



Objectives of PB


(1)         to coordinate the physical and financial aspects

(2)        To improve the budget formulation, review and decision-making at all levels of management

        (3) To facilitate better appreciation and review by controlling Authorities (legislature, Board of Trustees or Governors, etc.) as the presentation is more

Purposeful and intelligible


      (4)To make more effective performance audit possible


      (5) To measure progress towards long-term objectives which are envisaged in a development plan


Zero base Budgeting


Zero base Budgeting technique suggests that an organization should not only make decisions about the proposed new programmers, but should also, from time to time, review the appropriateness of the existing.


The concept of Zero base Budgeting has been accepted for adoption in the departments of the Central Government and some State Governments.





Costs appropriate to a specific management decision


The amount by which costs increase and benefits decrease as a direct result of a specific management decision’ Relevant benefits are ‘the amounts by which costs decrease and benefits increase as a direct result of a specific management decision’



Incremental costs

An incremental cost can be defined as a cost which is specifically incurred by following a course of action and which is avoidable if such action is not taken.




Non-incremental costs

These are costs, which will not be affected by the decision at hand. Non-incremental costs are non-relevant costs because they are not related to the decision at hand


The labor cost is non-relevant


Opportunity costs (relevant cost)

An opportunity cost is a level of profit or benefit foregone by the pursuit of a particular course of action.



Sunk cost(non-relevant cost)

A sunk cost is a cost that the already been incurred and cannot be altered by any future decision

Sunk costs are the opposite of opportunity costs in that they are not incorporated in the decision making process even though they have already been recorded in the books and records of the enterprise.




Q: why companies close down temporarily?

 ANS:      Companies are often faced with the problem of whether to close down temporarily a part of the plant during periods of low demand.

Arguments against shut-down

(a) If the company continues operation, expenses that would be incurred with the closing down of the plant will be saved; e.g. an increase in factory security.


(b) Continued operation means saving (he expenses that will otherwise be incurred if the plant is reopened again at a later stage.


(c) A shut-down for a short period of fine will not eliminate all costs. Rent, rates, depreciation and insurance will have to be incurred during the shutdown period.


(d) If the factory is shut down, this will affect not only morale but also its market standing if it cannot meet consumer demand.


The role of fixed costs

If the decrease or increase in the level of activity affects fixed costs then these costs should be considered differential costs.

It is generally accepted that if the plant has excess capacity then new or additional volume may be accepted if the selling price ii greater than variable costs. In such a situation, fixed costs arc not relevant if they remain fixed at an increased level of output



The role of variable costs

In differential cost studies, if the plant is not operating at practical capacity owing to lack of orders, variable costs usually represent the differential cost whether they are incremental or avoidable. The term refers to those costs that will change. It is often assumed that the variable cost per unit will remain constant regardless of the level of activity.







Relevant Costs


Decision making should be based on relevant costs.


  • • Relevant costs are future costs
  • • Relevant costs are cash flows
  • • Relevant costs are incremental costs



Differential Costs and Opportunity Costs

Relevant costs are also differential costs and opportunity costs.

  • • Differential cost is the difference in total cost between alternatives.


For example, if decision option A costs Rs. 300 and decision option B costs Rs. 360, the differential costs is Rs. 60.


  • • An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in preference to an alternative.



Controllable and Uncontrollable Costs


Controllable costs are items of expenditure which can be directly influenced by a given manger within a given time span.


As a general rule, committed fixed costs such as those costs arising form the possession of plant, equipment and buildings (giving rise to deprecation and rent) are largely uncontrollable in the short term because they have been committed by longer-term decisions.




Fixed and Variable Costs


  • • Variable costs will be relevant costs.
  • • Fixed costs are irrelevant to a decision



Attributable Fixed Costs

There might be occasions when a fixed cost is a relevant cost, and you must be aware of the distinction ‘specific’ or ‘directly attributable’ fixed costs, and general fixed overheads



Absorbed Overhead and fixed overhead

Absorbed overhead is a national accounting cost and hence should be ignored for decision making purposes.

 It is overhead incurred which may be relevant to a decision.


General fixed overheads are those fixed overheads which will be unaffected by decisions to increase or decreased the scale of operations, perhaps because they are an apportioned share of the fixed costs of items which would be completely unaffected by the decision.

 General fixed overheads are not relevant in decision making.






          Make or Buy Decisions and Limiting Factors

In a situation where a company must subcontract work to make up a shortfall in its won production capability, its total costs are minimized if those components/products subcontracted are those with the lowest extra variable cost of buying per unit of limiting factor saved by buying.






Shut Down Decisions


(1)   Whether or not to shut down a factory, department, or product line either because it is making a loss or it is too expensive to run.

(2)   If the decision is to shut down, whether the closure should be permanent or temporary.




The decision to accept or reject a contract should be made on the basis of whether or not the contract increases contribution and profit.


Other factors to consider in the one-off contract decision.

A. The acceptance of the contract at a lower price may lead other customers to demand lower prices as well.


B. There may be more profitable ways of using the spare capacity.


C. Accepting the contract may lock up capacity that could be used for future full-price business.


D. Fixed costs may, in fact, if the contract is accepted.







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