MGT402 Short Notes Lectures 23 ~ 45
Lec # 23
PROCESS COSTING SYSTEM
(Opening balance of work in process)
Two methods of cost allocation
(1) The weighted average (or averaging) method
(2) The FIFO method.
Weighted average method
In the weighted average method opening stock values are added to current costs
• It is more complicated to operate
• In process costing, it seems unrealistic to relate costs for the previous period to the current Period of activities
Choosing the valuation method in examinations
In order to use the weighted average or FIFO methods to account for opening work-in-process different information is needed, as follows:
For weighted average An analysis of the opening work-in-process value
Into cost elements (i.e. materials, labor)
For FIFO The degree of completion of the opening work in process for each cost element.
Lec # 25
COSTING/VALUATION OF JOINT AND BY PRODUCTS
Basis of Cost Allocation (For by products)
(1) Physical Quantity Ratio
(2) Selling Price Ratio
(3) Hypothetical Market Value Ratio
Classification of by product
By product can be classified into two categories:
1. Requiting no further process
2. Requiting further processing
Accounting for By Products
(1) Income Approach
(2) Costing Approach
MARGINAL AND ABSORPTION COSTING
(Product costing systems)
Direct Material, Direct Material Factory Overhead Cost
(Variable Cost) (Variable & Fixed Cost)
The cost of a cost unit is presented as the total of direct materials, direct labor, direct expenses and variable overheads (but not fixed overheads)
Marginal cost is the cost the variable cost that changes with the production of each next unit.
(A key concept in marginal costing is that of contribution margin)
Absorption and marginal costing
In absorption costing, fixed manufacturing overheads are absorbed into cost units. Thus stock is valued at absorption cost and fixed manufacturing overheads are charged in the profit and loss account of the period in which the units are sold.
In marginal costing, fixed manufacturing overheads are not absorbed into cost units, Stock is valued at marginal (or variable) cost and fixed manufacturing overheads are treated as period costs and are charged in the profit and loss account of the period in which the overheads are incurred.
(Under absorption costing stock will include variable and fixed overheads whereas under marginal costing stock will only include variable overheads.)
Contribution margin = Sales - variable costs of sales
Contribution margin is short for “contribution to fixed costs and profits
Marginal costing: Profit calculation
Sales Rs X
Less: variable costs (X)
Contribution margin X
Less: fixed costs (X)
In short contribution margin less fixed cost is called profit
Absorption costing: profit calculation
In absorption costing this is effectively calculated in one stage as the cost of sales already includes fixed costs
Less: absorption cost (X)
Marginal or absorption costing can be useful for internal management reporting
If stock levels are rising from opening to closing balance
Absorption Costing profit > Margin Costing profit
(More profit) (Less profit)
If stock levels are falling from opening to closing balance
Absorption Costing profit < Margin Costing profit
(Less profit) (More profit)
(Fixed costs carried forward are charged in this period, under absorption costing)
If stock levels are the same
Absorption Costing profit = Margin Costing profit
(same profit) (Same profit)
Reconciliation formula to learn Rs.
Profit as per absorption costing system xxx
Add Opening stock @ fixed FOH rate at opening date xxx
Less Closing stock @ fixed FOH rate at closing date xxx
Profit as per marginal costing system xxx
(The only difference between using absorption costing and marginal costing as the basis of stock valuation is the treatment of fixed production costs.)
Arguments against absorption costing
In absorption costing the fixed costs do not change as a result of a change in the level of activity. Therefore such costs cannot be related to production and should not be included in the stock valuation
COST – VOLUME – PROFIT ANALYSIS
(Contribution Margin Approach)
CVP stands for COST – VOLUME – PROFIT
CVP analysis may also be used to predict profit levels at different volumes of activity based upon the assumption that costs and revenues exhibit a linear relationship with the level of activity.
Cost-volume-profit analysis determines how costs and profit react to a change in the volume or level of activity, so that management can decide the 'best' activity level.
Following are the assumptions which are used in CVP analysis.
1. Variable costs and selling price (and hence contribution) per unit are assumed to be unaffected by a change in activity level.
2. Fixed costs, whilst not affected in total by a change in the activity level, will change per unit as the activity level changes and there are more (or less) units over which to "share out" the fixed costs if fixed costs per unit change with the activity level, then profit per unit must also change.
CVP is a relationship of four variables
Sales -----------à Volume
Variable cost ------------à Cost
Fixed cost ------------à Cost
Net income ------------à Profit
Two approaches of CVP analysis
(1) Contribution margin approach
(2) Break even analysis approach
Contribution Margin Approach & CVP Analysis
Contribution margin contributes to meet the fixed cost. Once the fixed cost has been met the incremental contribution margin is the profit
(Income Statement as per the marginal costing system is used as a Standard format of Income Statement to analyze the Cost-Volume-Profit relationship.)
Variable Cost (xxx)
Contribution Margin xxx
Fixed Cost (xxx)
(1) Physically increase in volume causes an increase in contribution margin and if there is not increase in the fixed cost because of such change, the incremental contribution margin is added in the final profits
(2) Increase in sales price per unit causes an increase in the contribution margin, as there is not change in the volume the fixed will remain unchanged. So the incremental change is contribution margin is included into the profit.
(3) Decrease in sales price per unit causes a decrease in the contribution margin, as there is not change in the volume the fixed will remain unchanged. So the change in contribution margin is subtracted from the profits, which result into a loss
(Normally a decrease in sales price should case an increase in the sales volume).
(4) Decrease in sales price per unit causes a decrease in the contribution margin, as well as an increase in volume is causing an increase in the profit, this results in an increase in profit
1. At zero contribution margin the loss will be equal to the fixed cost
2. Increase in variable cost reduces the contribution margin
3. Sales – Variable cost = Contribution margin
4. Contribution margin + Variable cost = Sales
5. Contribution margin – Fixed cost = Profit
6. Profit + Fixed cost = Contribution margin
7. Sales - Variable cost = Fixed cost + Profit
COST – VOLUME – PROFIT ANALYSIS
Break-even is the point where sales revenue equals total cost.
In case neither a profit nor a loss
Profit (or loss) is the difference between contribution margin and fixed costs.
Thus the break-even point occurs where contribution margin equals fixed costs
Contribution Margin per unit
Selling price per unit less variable costs per unit
Volume x (Selling price per unit less variable costs per unit)
Target Contribution Margin
Fixed costs + Profit target
Target Sales in number of units
Target Contribution Margin
Contribution margin to sales ratio
Contribution to sales ratio(C/S ratio) =Contribution Margin in Rs / Sales in Rs
Break even sales in Rupees
% of required amount
Given Amount x _________________ = Required Amount
% of given amount
Target CM (fixed cost + target profit)
Break even sales in Rupees = _______________________
Contribution to sales ratio ( CM in Rs / Sale in Rs.)
If the target contribution margin is equal to Rs. 1,000 then what would be the sales at this point?
Now the above formula will be applied to calculate breakeven sales:
Target CM is the given amount and its % is 25, so the sale which is 100% will be:
Rs 1,000 x ----- = Rs 4,000 break even sale in Rs.
-------- = Rs. 4,000 break even sale in Rs
Break even Sales in Rs. = -------------
Break even sales in units
Break even sales in Rupees
------------------------------------= number of units
Sales price per unit
Target CM (Fixed costs + Profit target)
CM per unit (Selling price per unit less variable costs per unit)
BREAK EVEN ANALYSIS – MARGIN OF SAFETY
Margin of Safety (MOS)
The margin of safety is the difference between budgeted sales volume and break-even sales volume; it indicates the vulnerability of a business to a fall in demand.
Margin of safety=Budgeted sales – Break-even sales
MOS (margin of safety) ratio
MOS (Margin of safety=Budgeted sales)
MOS (margin of safety) ratio = __________________ x 100
Margin of safety ratio = ________________________ x 100
Budgeted contribution margin
MOS Ratio profit / contribution margin
Different ways of calculation of margin of safety
(1) Based on Budgeted sales
Budgeted sales – Break-even sales
(2) Using Budget profit
_______ _______________ x 100
Budgeted contribution margin
(3) Using profit and contribution ratio
Profit to sales ratio
____________________ x 100
Contribution to sales
BREAKEVEN ANALYSIS – CHARTS AND GRAPHS
The chart or graph is constructed as follows:
• Plot fixed costs, as a straight line parallel to the horizontal axis
• Plot sales revenue and variable costs from the origin
• Total costs represent fixed plus variable costs.
(1) The point at which the sales revenue and total cost lines intersect indicates the breakeven level of output.
(2) By multiplying the sales volume by the unit price at the break-even point the level of revenue needed to break even can be determined.
(3) The chart is normally drawn up to the budgeted sales volume.
(4) The difference between the budgeted sales volume and break-even sales volume is referred to as the margin of safety.
WHAT IS A BUDGET?
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period of time, usually one year.
Two basic classes of budget
(1) Cash budget
(2) Operating budget
Capital budgets are directed towards proposed expenditures for new projects
And often require special financing.
The operating budgets are directed towards achieving short-term operational goals of the organization, for instance, production or profit goals in a business firm. Operating budgets may be sub-divided into various departmental or functional budgets.
Characteristics of a budget
It is prepared in advance and is derived from the long, term strategy of the organization.
It relates to future period for which objectives or goals have already been laid down.
It is expressed in quantitative form, physical or monetary units, or both.
Different types of budgets
(1) Sales. Budget
(2) Production Budget
(3) Administrative Expense Budget
(4) Raw material Budget, etc
All these sectional budgets are afterwards integrated into a master budget- which represents an overall plan of the organization
A budget helps in following ways
1. It brings about efficiency and improvement in the working of the organization.
2. way of communicating the plans to various units of the organization. By establishing the divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus minimizes the possibilities of buck-passing if the budget figures are not met.
3. Way or motivating managers to achieve the goals set for the units.
4. It serves as a benchmark for controlling on going. Operations.
5. It helps in developing a team spirit where participation in budgeting is encouraged.
6. It helps in reducing wastage's and losses by revealing them in time for corrective action.
7. It serves as a basis for evaluating the performance of managers.
8. It serves as a means of educating the managers.
The exercise of control in the organization with the help of budgets is known as budgetary control.
Process of budgetary control
(i) preparation of various budgets
(ii) (ii) continuous comparison of actual performance with budgetary
(iii) Revision of budgets in the light of changed circumstances.
The Chief Executive is finally responsible for the budget programmed, it is better if a large part of the supervisory responsibility is delegated to an official designated as Budget Controller or Budget Director.
Fixation of the Budget Period
Budget period' means the period for which a budget is prepared and employed. The budget period depends upon the nature of the business and the control techniques.
A forecast is an estimate of the future financial conditions or operating results.
A forecast may be prepared in financial or physical terms for sales, production cost, or other resources required for business. Instead of just one forecast a number of alternative forecasts may be considered with a view to obtaining the most realistic overall plan.
After the forecasts have been finalized the preparation of budgets follows. The budget activity starts with the preparation of the said budget.
Production budget: on the basis of sales budget and the production capacity available
Financial budget (i.e. cash or working capital budget): will be prepared on the basis of sale forecast and production budget.
(All these budgets are combined and coordinated into -a master budget)
Fixed and Flexible Budgets
A fixed budget is based on a fixed volume of activity, 11 may
lose its effectiveness in planning and controlling if the actual capacity utilization is different from what was planned for any particular unit of time e.g. a month or a quarter.
The flexible budget is more useful for changing levels of activity, as it considers fixed and variable costs separately. Fixed costs, as you are aware, remain unchanged over a certain range of output such costs change when
There is a change in capacity level. The variable costs change in direct proportion to output.
(If flexible budgeting approach is adopted, the budget controller can analyze the variance between actual costs and budgeted costs depending upon the actual level of activity attained during a period of time.)
Objective of Budget
(1) Profit maximization
(2) Maximization of sales
(3) Volume growth
(4) To compete with the competitors
(5) Development of new areas of operation.
(6) Quality of service
(7) Work-force efficiency.
Division of Budgets
(1) Functional Budget
(2) Master Budget
! ! !
! ! !
Raw material Labor Factory overhead
! ! !
! ! !
!_______________________ ! ______________________!
Cost of goods sold
! ! !
! ! !
Selling general & financial
Distribution administrative charges
Expenses expenses budget budget
PRODUCTION & SALES BUDGET
Budgets can be classified into different categories on the basis of Time, Function, or Flexibility.
Budget for a year in advance will always be there. Immediately after a month, or a quarter, passes, as-the case may be, a new budget is prepared for a twelve months. The figures for the month/quarter, which has rolled down, are dropped and the figures for the next month /quarter are added.
If a budget has been prepared for the year 19X7, after the expiry of the first quarter ending 31st March 19X7, a new budget forth full year ending 31ft March, 19X8 will be prepared by dropping the figures for the quarter which has past (i.e. quarter ending 31st March 19X7) and adding-the figures for the new quarter-ending 31st March 19X8.
Sales Budget generally forms the fundamental basis on which all other budgets are built the budget is based on projected sales to be achieved in a budget period. The Sales Manager is directly responsible for the preparation and execution of this budget.
PRODUCTION & SALES BUDGET (Contd.)
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.
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.
FLEXIBLE BUDGET (Contd.)
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,
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.
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.