1

CHAPTER- I

QUESTION NO.1.

BRING ABOUT THE POINTS OF DISTINCTION BETWEEN

INTEGRATED AND NON-INTEGRATED SYSTEM OF ACCOUNTING

WITH THE HELP OF SUITABLE EXAMPLES ? (INCLUDING

MAXIMUM POSSIBLE TRANSACTION)

A )INTEGRATED SYSTEM OF ACCOUNTING

An Integrated Accounting System would be one where only a single set of books would

contain all the information of Financial Accounting as well as Inventory/ Cost

Accounting. Such a system would be very difficult to maintain if accounts are maintained

manually. But most available Computerized Accounting Systems are Integrated

Systems.Here we take the example of an Integrated Accounting System (our own product by

the name: Soft Accounting System) and explain how its functionality differs with Non-

Integrated manual Accounting system.Whereas in manual Financial Accounting, you enter

Cash/Bank transactions in Cash Book and enter all other transactions in General Journal; in

Soft Accounting System, you record Sale/Purchase transactions in Sale Invoice or Purchase

Invoice. In the case of cash purchase/sale, that entry shall automatically be recorded in Cash

Book. And in the case of credit purchase/sale, there will be no need to record it in General

Journal. With a simple entry in sale or purchase invoice, you will not only get all the

Financial Accounting Ledgers and Trial Balance, you will also automatically get your

inventory and cost registers. If yours is a trading Business, then with a simple entry in sales

invoice form, you will also automatically get Cost of that particular Sale calculated on the

basis of both Weighted Average Costing and LIFO Costing methods.If yours is a

manufacturing business, then there is another simple Production Entry Form. You will enter

in it only the basic ongoing production data but as a result, not only you will get detailed

Production Reports, you will also get updated inventory registers of raw-materials and semi-

finished items with a proper breakup of location/process where those semi-finished items

have reached so far. When final production process on semi-finished items have been

performed, then automatically those semi-finished items are removed from semi-finished

inventory registers and go to Finished Goods Inventory Register. And when you will enter

2

new sale invoice, then finished goods stock shall be automatically reduced from the Finished

Goods Inventory Register. Not only this, you will also get detailed automated Direct Labor

Payroll Reports. In addition, you will also get automated costing reports like Batch Cost

Report and like etc. And since Soft Accounting System is an Integrated System, so you will

also get automatically updated information in your Financial Accounting Ledgers and Trial

Balance as well.To record daily expenditure and transactions other than Sale/Purchase (or

Sale/Purchase Returns which are to be recorded in Debit/Credit Notes), there are also Cash

Book and General Journal entry forms. So this is the way an Integrated Accounting System

works.

BENEFITS FROM INTEGRATED ACCOUNTING SYSTEM

The benefits of integrated accounting system are as follows:

A. As only one set of accounting records is kept, the need for reconciliation between the

profits shown by the two records is eliminated.

B. The duplication of work is eliminated, thus the cost of operating this system is reduced.

C. This method is simple to understand and easy to operate. Unnecessary complications are

eliminated.

D. Cost data can be available promptly and regularly.

E. There is a cross checking of various figures in cost as well as financial accounts. This

ensures accuracy of figures of cost and financial data.

F. Use of mechanized accounting methods can be made.

EXAMPLE

PROBLEMS AND SOLUTIONS

1. Journalize the following transactions in the integrated books of account in the books of

XYZ Ltd.

Credit purchases Rs.12, 00, 000

Production wages paid Rs. 7, 00, 000

Stocks issued to production orders Rs. 8, 00, 000

Work expenses charged to production Rs. 4, 50, 000

Finished goods transferred from production orders Rs. 18, 00, 000

Administration expenses charged to production Rs. 1,50, 000

Work expenses outstanding Rs. 1, 20, 000

Work expenses paid Rs. 4, 60, 00

3

JOURNAL ENTRIE

DATE PARTICULARS L/F DEBIT Rs. CREDIT Rs.

1 Store Ledger Control A/c Dr.

To Sundry Creditors A/c

[Being goods purchased on credit]

1200000

1200000

2 Wages Control A/c Dr

To Cash/Bank A/c

[Being wages paid]

700000

700000

3 Work-in-progress Control A/c Dr

To Stores Ledger Control A/c

[Being stores issued against production orders]

800000

800000

4 Work-in-progress Control A/c Dr.

To Production Overhead Control A/c

[Being the work expenses allocated to

production/ job

450000

450000

5 Finished Goods Ledger Control A/c Dr

To Work-in-progress Ledger Control A/c

[Being goods finished during the year

transferred to finished goods account]

1800000

1800000

6 Work-in-progress Control A/c Dr.

To Administration Overhead Control A/c

[Being administrative overheads charged to

production]

150000

150000

7 Production Overhead Control A/c Dr

To Outstanding Works Overheads

[Being outstanding production overheads

recorded in the books]

120000

120000

8 Overhead Control A/c Dr.

To Cash/Bank A/c

[Being the works expenses paid]

460000

460000

4

2. Journalize the following transactions assuming that the cost and financial accounts

are integrated.

Raw materials purchased: Rs.40, 000

Direct materials issued to production: Rs.30, 000

Wages paid [30% direct]: Rs.24, 000

Direct wages charged to production: Rs.16, 800

Manufacturing expenses incurred: Rs.19, 000

Manufacturing overheads charged to production: Rs.18, 400

Selling and distribution costs: Rs.4, 000

Finished products [At cost] : Rs.40, 000

Sales: Rs.58, 000

Closing stock: Nil

Receipts from debtors: Rs.13, 800

Payment to creditors: Rs.22, 000

JOURNAL ENTRIES

DATE PARTICULARS L/F DEBIT Rs.

Credit Rs.

1 Stores Ledger Control A/c Dr.

To Sundry Creditors A/c

[Being materials purchased]

40000

40000

2 Work-in-progress ledger control A/c Dr

To Stores Ledger Control A/c

[Being material issued to production]

30000

30000

3 Wages Control A/c Dr.

To Bank A/c

[Being wages paid including 30% indirect

wages]

24000

24000

4 Factory Overheads A/c Dr.

To Wages Control A/c

[Being the indirect wages charged to

production]

7200

7200

5

5 Work-in-progress Ledger Control A/c Dr

To Wages Control A/c

[Being the direct wages charged to the

production]

16800

16800

6 Factory Overheads A/c Dr.

To Bank A/c

[Being the manufacturing overheads

incurred]

19000

19000

7 Factory Overheads A/c Dr.

To Bank A/c

[Being the manufacturing overheads

incurred]

18400

18400

8 Selling and Distribution Overheads A/c Dr

To Bank A/c

[Being selling and distribution costs

incurred]]

4000

4000

9 Finished Stock Ledger Control A/c Dr

To Work-in-progress Ledger Control A/c

[Being cost of production transferred to

Finished Stock Ledger Control A/c

40000

40000

10 Cost Of Sales A/c Dr

To Finished Stock Ledger Control A/c

To Selling And Distribution Overheads A/c

[Being the cost of finished units] *

44000

44000

11 Sales Ledger Control A/c Dr

To Cost of Sales A/c

[Being the amount of Sales]

58000

58000

12 Bank A/c Dr

To Sales Ledger Control A/c

[Being amount received from debtors]

13800

13800

13 Bought Ledger Control A/c Dr

To Bank A/c

[Being the amount paid to sundry

2200

2200

6

creditors]

NON-INTEGRATED SYSTEM OF ACCOUNTING

When we use both financial accounting and cost accounting for recording transactions

separately, at that time , it is called non integral system of accounting. Non integral system of

accounting is just opposite the integral system of accounting. In non-integral system of

accounting, we need to make reconciliation statement for knowing the reasons of difference

in the profit which have been calculated in cost accounting system and financial accounting

system.

Non-Integrated and Integrated Accounting for only the monetary aspects of every business

transaction. You purchase hundreds of inventory items but to record purchase, you only debit

one Purchase Account with purchase value without any mention of quantities involved.

Similarly you sell different trade items and record them by giving credit to only Sales

Account. Consequently your Financial Accounts fail to tell you the complete story of your

business affairs. You get a Trial Balance and Final Accounts. You know your Gross Profit

and Net Profit. You also know financial worth of your business on the Balance Sheet

date. The things you dont know in this way are the details of your inventory items

purchased/ sold, inventory stocks, inventory costs taken up in every sales transactions

(Trading Businesses) or ongoing production activities (Manufacturing Businesses).To

overcome these limitations of Financial Accounting, large businesses usually adopt and

implement another difficult and expensive Accounting System which is known as Cost and

Management Accounting. This is also non-integrated accounting method because it functions

parallel to the Financial Accounting. Small businesses end up in the maintenance of only

some Stock Registers, in addition to the usual Financial Accounting. It means that under

non-integrated accounting systems, Financial Accounting and Inventory/Cost Accounting

books/ ledgers are separately maintained. To explain an Integrated Accounting System, we

here assume that reader already knows the usual procedure of recording transactions where

entries are basically recorded in Cash Book and General Journal, then posted to Ledger, then

summarized in the form of Trial Balance and then results are taken in the form of Final

Accounts.

7

MAINTENANCE OF ACCOUNTS

As maintained above, the fi nance department is responsible for maintaining the fi nancial

ledgers. Thisdepartment maintains the following ledgers.

_ General ledger: It includes all real, nominal and personal accounts except debtors and

creditorsaccounts.

_ Debtors Ledger: It contains the personal accounts of trade debtors.

_ Creditors Ledger: It contains the personal accounts of trade creditors.On the other hand,

the cost accounting department maintains the following cost ledgers.

_ Stores ledger for recording all stores transactions

_ Work-in-progress ledger: Cost of materials, labour and overheads of all jobs, which are in

progress, are posted to this account.

_ Finished goods/stock ledger: This ledger has the record of fi nished goods/stock.

_ Cost ledger: This ledger maintains the accounts relating to income and expenditure. The

following accounts are maintained in this ledger.

A. Cost control accounts: These accounts are maintained to exercise control over the three

subsidiary ledgers maintained above and also to complete the double entry in cost accounts.

The importantcost control accounts are as follows.

I. Stores ledger control a/c

II. Work-in-progress ledger control a/c

III. Finished goods ledger control a/c

IV. General ledger adjustment a/c

B. Other accounts: They include all other impersonal accounts [real as well as nominal]

whicheffect costs, e.g. wages control account, factory overhead accounts, administration

overheadaccount, selling and distribution overhead account, cost of sales account etc.

Depending uponthe requirement, the following additional accounts may also be maintained.

_ Overhead suspense account

_ Capital orders account

_ Service orders account.

Treatment of Elements of Cost

The following treatment is given to the various elements of cost.

_ Materials: Certain transactions relating to material are recorded in the fi nancial accounts

also.

8

Examples of such transactions are purchase of material, return of materials. These

transactions arerecorded in financial as well as cost accounts. On the other hand, certain

transactions like issue ofmaterials from stores, transfer of material from one job to the other

one, return of excess materials tostores are recorded in cost accounts only.

_ Labour: Wages paid are recorded in the cost accounts through wages control account and

the generalledger adjustment account.

_ Overheads: Various types of overheads like production, administration and selling and

distributionare absorbed to the products on some suitable basis. The production overhead

accounts is creditedwith the amount of overheads absorbed and the work in progress account

is credited. In case ofadministrative overhead account, the amount absorbed is credited to the

administrative overheadaccount and finished stock account is debited. Selling and distribution

overheads are credited tothe selling and distribution overhead account and corresponding

debit is given to the cost of sales

account. Finally, the amount of under/over absorbed overheads is transferred to the Costing

Profitand Loss A/c.

IN NON-INTEGRAL SYSTEM OF ACCOUNTING, WE KEEP THE COST

LEDGERS :

1. General Ledger Adjustment Account

This account is opening just for self-balancing. This account represents the personal accounts

in cost accounting's non integral system.

Credit side

balance b/d - opening balance

Store ledger control account - purchase

work in process control account - special purchase

Wages control account - total wages ( Direct + indirect + administrative + selling department

salaries)

Production overhead control account - Production expenses

administrative overhead control account - administrative expenses

Selling and distribution overhead control account - selling and distribution expenses

Costing profit and loss account - transfer from costing and profit and loss account

Credit

Store ledger control account - Return to suppliers

9

Sales account - total sales

Balance c/d - balancing figure

2. Stores Ledger Control Account

Opening stock in store balance will be debited in this account. New buying of material will

be debited with the name of general ledger adjustment account in stores ledger control

account. Material issued for production will be credited with the name of work in process

control account. Return to supplier will be credited with the name of general ledger

adjustment account in this account. Difference of debit side and credit side will be the closing

stock in store.

3. Wages Control Account

This account is debited with total wage payment ( Direct + indirect + administrative + selling

department salaries). We total all these account and general ledger adjustment account will be

debited in this account. After this, we will credit the direct wage with work in process

account. We will credit indirect wage with production overhead control account. We will

credit salaries of administration department with administrative overhead control account. In

end, we will credit salaries of selling department with selling and distribution overhead

control account

4. Production Overhead Control Account

Production overhead will show all production overheads in its debit side.

Debit Side

Indirect material used - Store ledger control account

Indirect wage - Wages control account

Indirect Expenses - General Ledger Adjustment Account

Credit Side

Production overhead absorbed by production - Work in process control account

Difference of credit side and debit side will go to costing profit and loss account

5. Work in process Ledger Control Account

Debit

Balance b/d Opening balance of work in process

Production overhead control account - production overheads absorbed by production

Wages Control Account - Direct Wages

Store Ledger Control Account - Indirect material used for production

Credit

Finished goods ledger control account - Producing of finished goods during the year.

10

Balance C/d - Closing stock which in production process

6. Administrative Overhead Ledger Control Account

Debit

General Ledger Adjustment Account - Administrative Expenses

Salaries for Administrative department

Credit

Finished Goods Ledger Control Account - Absorption of administrative overhead by finished

goods

balance - Costing profit and loss account

7. Finished Goods Ledger Control Account

Debit

Balance b/d - opening balance of finished goods

work in process control account - production during the year

administrative overhead control account - Absorption of administrative overhead by finished

goods

Credit

Cost of Sale Account - Finished Goods sold at cost

Balance C/d -Closing stock of finished goods

8. Selling and Distribution Overhead Control Account

This account is debited with general ledger adjustment account and wages control account

(payment for sales to employees) and credited with cost of sales. Difference between debit

and credit side will transfer to costing profit and loss account.

9. Cost of Sale Account

This account is debited with finished goods ledger control account and selling and

distribution overhead control account and this account is transferred to sales account.

10. Sales Account

In the debit side, we will show cost of sale account and costing profit and loss account and it

will be transfer to general ledger adjustment account.

11. Costing Profit and Loss Account

This account shows the net profit as per the cost accounting rules. In the credit side, we show,

sales account and production overhead control account In the debit side, we show

administrative overhead control account, selling and distribution overhead control account

11

and difference of credit and debit side will be net profit which will be transfer to general

ledger adjustment account's credit side.

TRANSACTION

DIFFERENCE BETWEEN INTEGRATED AND NON-INTEGRATED ACCOUNTIN

SYSTEM

The journal entries under integral and non-integral accounting systems are given in the

following table.

ITEMS NON-

INTEGRATED

SYSTEM OF

FINANCIAL

BOOK

NON-

INTEGRATED

SYSTEM OF

COST BOOKS

INTEGRATED

SYSTEM

Purchase ofMaterials Purchase A/c Dr To Purchase Ledger To Purchase Ledger Control A/c [or creditors]

Stores Ledger Control A/c Dr. To General Ledger Adjustment A/c

Stores Ledger Control A/c To Creditors A/c

Issue ofmaterials for

Production

No entry Work-in-progress Ledger Control A/c Dr To Stores Ledger Control A/c

Work-in-progress A/c Dr To Stores Ledger Control A/c

Payment ofwages Wages A/c Dr To Cash/bank A/c

Wages A/c/ Wages Control A/c Dr. To General Ledger Adjustment A/c

Wages A/c / Wages Control A/c Dr To Cash A/c

Paymentfor indirect

Expenseslike power,

repairs etc.

Expenses A/c Dr To Cash A/c To Creditors A/c

Factory/Adm/S & D Overhead A/c Dr To General Ledger Adjustment A/c

Factory/Adm/S & D Overhead A/c Dr To Cash A/c To Creditors A/c

Recordingof Factory

Overheadsat pre deter-

mined rates

No entry

Work-in-progress Control A/c Dr To Factory Overheads Control A/c

Work-in-progress Control A/c Dr To Factory Overheads Control A/c

FactoryOverheadsover

absorbed

No entry Factory Overhead Control A/c Dr

Factory Overhead Control A/c Dr

12

To Costing Profi t & Loss A/c

To Costing Profi t & Loss A/c

Jobscompleted No entry Stock Ledger Control A/c Dr To work-in-progress Ledger Control A/c

Stock Ledger Control A/c Dr To work-in-progress Ledger Control A/c

Interest paid

Interest A/c Dr To Cash A/c

No entry Interest A/c Dr To Cash A/c

Rent of ownpremises

Rent of own premises

Works Overhead A/c To General Ledger Adjustment A/c

Works Overhead A/c Dr To Rent [notional]

A/c

Sales [Credit]

Sales Ledger Control A/c Dr To Sales A/c

General Ledger Adjustment A/c Dr To Cost of Sales A/c

Sales Ledger Control A/c Dr To Sales A/c

13

EXAMPLE

NON-INTEGRATED ACCOUNTING SYSTEM

Pass the journal entries in the cost books non-integrated system for the following transaction.

i) Material worth Rs.25000/- returned to the stores from job.

ii) Gross total wages paid Rs. 48000. Employer contribute to P.F. and State insurance

Amounts to Rs. 2000/-. Wages analysis book detailed Rs.20000/-. Towards directs

labour ,Rs. 12000/- towards indirect factory labour Rs.10000/- towards salaries

etc.To office staff and Rs. 8000/- for salaries, etc.To selling and distribution staff.

Date Particulars Debit Rs. Credit Rs.

1

Store Ledger Control A/C Dr.

To Work In Progress Ledger A/C

[ ToWork In Progress Returned To Store From

The Job.]

25000

25000

2a Wages Control A/C Dr.

To General Ledger Adjustment A/C

[ Being Entry In Cost Books For Gross Wages

And Employer Contribution To P.F]

50000

50000

B WIP Ledger Control A/C Dr.

Factory Overheads A/C Dr.

Administration Overheads A/C Dr.

Selling And Distribution Overheads A/C Dr.

To Wages Control A/C

[ Being The Amount Of Direct Labour To WIP

Control Account And Indirect Expenses

Transferred To Respective Overheads Accounts)

20000

12000

10000

8000

50000

14

Problem . 2

a) Issue of material

Direct 550000

Indirect 150000

b) Allocation of wages and salaries

Direct 200000

Indirect 40000

c) Overheads absorbed in jobes

Factory 150000

Administration 50000

Selling 30000

d) Under/absorbed overheads

Factory (over) 20000

Administration (under) 10000

JOURNAL ENTRIES

NO PARTICULARS DEBIT Rs. CREDIT Rs.

1 Work In Progress Ledger Control A/C Dr.

Factory Overheads Control A/C Dr.

To Stores Ledger Control A/C

550000

150000

700000

2

Work In Progress Ledger Control A/C Dr.

Overheads Control A/C Dr.

To Wages Control A/C

200000

40000

240000

3 Work-In- Progress Ledger Control A/C Dr.

To Factory Overheads Control A/C

150000

150000

15

4 Finished Goods Ledger Control A/C

Dr.

To Administration Overheads Control A/C

50000

50000

5 Cost Of Sale A/C

Dr.

To Selling Overheads Control A/C

30000

30000

6 Factory Overheads Control A/C Dr.

To Costing P&L A/C

20000

20000

7 Costing P&L A/C Dr.

To Administration Overheads Control

A/C

10000

10000

16

CHAPTER- II

Question No.2.

Explain the following concept with the help of graphical

presentation ?

1. Angle of incident

2. Break-Even chart

3. Margin of Safety

4. Profit volume Graph

ANGLE OF INCIDENT

This is the angle between sales line and total cost line. This angle is formed by the

intersection of the total cost line and the sales line (at the BEP). This angle is an indicator of

profit-earning capacity over BEP. Large angle indicates the earning of high margin of profit.

Small angle indicates a low margin of profit which, in turn, suggests that variable costs

constitute a major chunk of cost of sales.

In general, a small angle of incidence indicates that firms are highly stablewith narrow

profit margin, low BEP, high margin of safety, low fixed cost and high variable cost, whereas

a large angle of incidence indicates that firms are highly riskywith high BEP, high fixed

cost, low variable cost and low margin of safety.

It is an angle that is created when the entire sales line intercepts the entire cost line from

below in the breakeven chart. It is inferred that higher the angle, higher is the profit, and

lower the angle lower the profit.

Angle of incidence (0) is the angle between the total cost line and the total sales line. If the

angle is large, the firm is said to make profits at a high rate and vice-versa.

A high angle of incidence and a high margin of safety indicate sound business conditions.

17

BREAK-EVEN CHART

Break Even Point

The concept of Break Even Point is extremely important for decision making in various

areas. This concept is based on the behaviour of costs, i.e. fi xed cost and variable costs. As

discussed earlier, fixedcosts are those costs that remain constant irrespective of the changes in

the volume of production. On theother hand, variable costs are the costs that vary with the

level of production. While fixed cost per unit isalways variable, variable cost per units is

always fi xed. In addition to these two types of costs, there aresemi variable costs that are

partially fi xed and partially variable. Semi variable costs thus have the featuresof both types

of costs. They remain fi xed up to a certain level of production and after crossing that level,

they become variable.The Break Even Point is a level of production where the total costs are

equal to the total revenue, i.e. sales. Thus at the break even level, there is neither profit nor

loss. Production level below the break-even-pointwill result into loss while production above

break-even point will result in profits. This concept can be better understood with the help of

the following table.Break-even analysis is a technique widely used by production

management and management accountants. It is based on categorising production costs

between 1those which are "variable" (costs that change when the production output changes)

and those that are "fixed" (costs not directly related to the volume of production).Total

variable and fixed costs are compared with sales revenue in order to determine the level of

sales volume, sales value or production at which the business makes neither a profit nor a loss

(the "break-even point").

Break even level can also be worked out with the help of the following formulae.

Break even point [in units] = Fixed Cost / Contribution per Unit

Break even point [in Rs.] = Fixed Cost / Profit Volume [P/V] Ratio Break even point can also be shown on the graph paper as follows:

18

Y Total Revenu

Revenue Cost

Total Cost

BEP

Total Fixed Cost

Margin of Safety

Production / sales Volume X

Explanation: On horizontal axis, production and sales volume is shown while on the vertical

axis, salesand costs in amount are shown.

Assumptions of Break Even Point: The concept of break even point is based on the

followingassumptions.

1. Production and sales are the same, which means that as much as is produced is sold out in

the market.

Thus there is no inventory remaining at the end.

2. Fixed cost remains same irrespective of the production volume.

3. Variable cost varies with the production. It changes in the same proportion that of the

production.

Hence it has a linear relationship with the production. In other words, variable cost per unit

remainsthe same.

4. Selling price per unit remains same irrespective of the quantity sold.

Margin of Safety: Margin of Safety is the difference between the actual sales and the break

even sales. As we have discussed, at the break even point there is neither any profi t nor loss.

Hence any firm will alwaysbe interested in being as much above the break even level as

possible. Margin of safety explains precisely

19

this thing and the higher the safety margin the better it is. Margin of safety is computed as

follows.

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various

levels of activity shown on the same chart as the variation of income (or sales, revenue) with

the same variation in activity. The point at which neither profit nor loss is made is known as

the "break-even point" and is represented on the chart below by the intersection of the two

lines:

In the diagram above, the line OA represents the variation of income at varying levels of

production activity ("output"). OB represents the total fixed costs in the business. As output

increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.

At low levels of output, Costs are greater than Income. At the point of intersection, P, costs

are exactly equal to income, and hence neither profit nor loss is made.

Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or

output. In other words, even if the business has a zero output or high output, the level of fixed

20

costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result

of investment in production capacity (e.g. adding a new factory unit) or through the growth in

overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates

- Depreciation

- Research and development

- Marketing costs (non- revenue related)

- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent

payment output-related inputs such as raw materials, direct labour, fuel and revenue-related

costs such as commission.

A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production of a

particular product or service and allocated to a particular cost centre. Raw materials and the

wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with

output. These include depreciation (where it is calculated related to output - e.g. machine

hours), maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorising

business costs, in reality there are some costs which are fixed in nature but which increase

when output reaches certain levels. These are largely related to the overall "scale" and/or

complexity of the business. For example, when a business has relatively low levels of output

or sales, it may not require costs associated with functions such as human resource

management or a fully-resourced finance department. However, as the scale of the business

grows (e.g. output, number people employed, number and complexity of transactions) then

more resources are required. If production rises suddenly then some short-term increase in

21

warehousing and/or transport may be required. In these circumstances, we say that part of the

cost is variable and part fixed.

Limitations of Break even Point: Break Even point is extremely useful in decision- making

regarding the production level. It indicates the level of production where there is neither any

profi t nor loss. Howeverthis is based on the assumption that the variable cost per unit, sales

price per unit and the fixed remains the same. If there is any change in these variables, the

break even point will give misleadingresults.

Problems and Solutions:

1. From the following fi gures, fi nd the Break Even Volume

Selling price per ton Rs.69.50

Variable cost per ton Rs.35.50

Fixed Cost Rs.18.02 lakhs

If this volume represents 40% capacity, what is the additional profi t for an added production

of 40%

capacity, the selling price of which is 10% lower for 20% production and 15% lower than the

existing

price, for the other 20% capacity?

Solution: Existing Break Even Sales = Fixed Cost/Contribution per unit

Rs.18.02 lakhs/Rs.69.50 Rs.35.50

Rs.18.02 lakhs/Rs.34 = 53 000 units

Sales Value = 53, 000

_ Rs.69.50 = Rs.36, 83, 500

It is given in the problem that 40% capacity represents 53, 000 units

Hence 80% capacity will represent 1 06 000 units

_ For additional 20% capacity, selling price falls by 10%

_ Revised Selling Price = Rs.69.50 Rs.6.95 = Rs.62.55

Less: Variable Cost = Rs.35.50

Contribution = Rs.27.05

20% capacity = 53, 000 units/2 = 26, 500 units

Profi t if sale price is Rs.62.55 = Contribution per unit

_ Sales units

Rs.27.05

22

_ 26, 500 units = Rs.7, 16, 825

_ Contribution by 20% capacity for which selling price falls by 15%

_ Revised Selling Price = Rs.69.50 Rs.10.425 = Rs.59.075

_ Less: Variable Cost = Rs.35.50

Contribution = Rs.23.575

Profi t is sale price is Rs.59.075 = Contribution per unit

_ Sales units

Rs.23.575

_ 26, 500 units = Rs.6, 24, 737

Additional profi t by 40% sales = Rs.7, 16, 825 + Rs.6, 24, 737 = Rs.13, 41, 562

2. A retail dealer in garments is currently selling 24, 000 shirts annually. He supplies the

following

details for the year ended 31st March 2007.

Selling price per shirt: Rs.800

Variable cost per shirt: Rs.600

Fixed Cost:

Staff salaries: Rs.24, 00, 000

General Office Cost: Rs.8, 00, 000

Advertising Cost: Rs.8, 00, 000

As a Cost Accountant, you are required to answer the following each part independently:

1. Calculate Break Even Point and margin of safety in sales revenue and number of shirts sold. 2. Assume that 30, 000 shirts were sold during the year, fi nd out the net profi t of the fi rm.

3. Assuming that in the coming year, an additional staff salary of Rs.10, 00, 000 is

anticipated, and price of shirt is likely to be increased by 15%, what should be the break even

point in number ofshirts and sales?

Solution:

Break Even Point: [units] = Fixed Cost / Contribution Per Unit =

Rs.40, 00, 000/Rs.200 = 20 000 number of shirts

_ Note: Contribution per units is selling price variable cost per unit Rs.800 Rs.600 =

Rs.200

23

_ Break Even Point [sales value] = 20000 units

_ Rs.800 = Rs.1, 60, 00, 000

_ Margin of safety = Actual Sales Break Even Sales

_ 24, 000 shirts

_ Rs.800 = Rs.1, 92, 00, 000 Rs.1, 60, 00, 000 = Rs.32, 00, 000

_ Margin of safety [units] = 24, 000 shirts 20, 000 shirts = 4000 shirts

2. Amount of profi t if 30, 000 shirts are sold:

_ Sales [units] = Fixed Cost + Profi t / Contribution Per Unit

_ 30, 000 = Rs.40, 00, 000 + Profi t /Rs.200 = Profi t = Rs.20, 00, 000

3. Revised Break Even Point if fi xed cost rise by Rs.10, 00, 000 and selling price

increase by 15%

_ New selling price = Rs.800 + 15% = Rs.920, new fi xed cost = Rs.40, 00, 000 + Rs.10, 00,

000 = Rs.50, 00, 000

_ Revised Break Even Point [number of shirts] = Rs.50, 00, 000 / Rs.920 Rs.600

_ Break Even Point = 15, 625 shirts and 15, 625

_ Rs.920 = Rs.1, 43, 75, 000

4. The following figures are available from the records of Venus Traders as on 31stMarch

MARGIN OF SAFETY

Margin of safety (MOS) is the excess of budgeted or actual sales over the break evenvolume

of sales. It stats the amount by which sales can drop before losses begin to be incurred. The

higher the margin of safety, the lower the risk of not breaking even.

The margin of safety is the reduction in sales that can occur before the breakeven point of a

business is reached. The amount of this buffer is expressed as a percentage.

The margin of safety concept is especially useful when a significant proportion of sales are at

risk of decline or elimination, as may be the case when a sales contract is coming to an end.

By knowing the amount of the margin of safety, management can gain a better understanding

of the risk of loss to which a business is subjected by changes in sales. The opposite situation

may also arise, where the margin of safety is so large that a business is well-protected from

sales variations.

24

The margin of safety concept does not work well when sales are strongly seasonal, since

some months will yield catastrophically low results. In such cases, annualize the information

in order to integrate all seasonal fluctuations into the outcome.

To calculate the margin of safety, subtract the current breakeven point from sales, and divide

by sales. The formula is:

Current Sales Level Breakeven Point

Current Sales Level

Margin of Safety: Margin of Safety is the difference between the actual sales and the break

even sales. As we have discussed, at the break even point there is neither any profi t nor loss.

Hence any firm will alwaysbe interested in being as much above the break even level as

possible. Margin of safety explains preciselythis thing and the higher the safety margin the

better it is. Margin of safety is computed as follows.

Here are two alternative versions of the margin of safety:

1. Budget based. A company may want to project its margin of safety under a budget for

a future period. If so, replace the current sales level in the formula with the budgeted

sales level.

2. Unit based. If you want to translate the margin of safety into the number of units sold,

then use the following formula instead (though note that this version works best if a

company only sells one product.

3. For example, Lowry Locomotion is considering the purchase of new equipment to

expand the production capacity of its toy tractor product line. The addition will

increase Lowry's operating costs by Rs.100,000 per year, though sales will also be

increased. Relevant information is noted in the following table:

Before Machinery Purchase After Machinery Purchase

Sales Rs.4,000,000 Rs.4,200,000

Gross margin percentage 48% 48%

Fixed expenses Rs.1,800,000 Rs.1,900,000

25

Breakeven point Rs.3,750,000 Rs.3,958,000

Profits Rs.120,000 Rs.116,000

Margin of safety 6.3% 5.8%

The table reveals that both the margin of safety and profits worsen slightly as a result of the

equipment purchase, so expanding production capacity is probably not a good idea.

The margin of safety concept is also applied to investing, where it refers to the difference

between the intrinsic value of a company's share price and its current market value. An

investor wants to see a large variance between the two figures (which is the margin of safety)

before buying stock. This implies that there is substantial upside potential for the stock price -

or at least, it means any error in deriving the intrinsic value must be a big one in order to

erase the margin of safety.

PROFIT VOLUME RATIO

A graphic that shows the relationship between a company's earnings (or losses) and its sales.

The chart tells how different levels of sales affect a company's profits. Companies can use

profit-volume charts to establish sales goals, to analyze whether a potential project is likely to

be profitable and to see the maximum potential profit or loss of a given project, as well as

where the breakeven point lies.

Companies use PV charts in cost-volume-profit analysis along with breakeven charts and

contribution

charts.

26

CHAPTER- III

Question No. 3.

With the help of suitable example explain how the management

takes the following decision?

1. Accept or Rejects special order decision.

2. Make or Buy decision.

3. Keep or Replace decision.

4. Reduces or Maintain the price the decision.

5. Add or Drop the products decision.

6. Operate or Shut-down decision.

7. Expand or Reduce the capacity decision.

8. Sales or Process decision.

9. Key factor and products mix decision

ACCEPT OR REJECTS SPECIAL ORDER DECISION.

When Should Special Orders Be Accepted?

Special orders should be accepted only if:

Incremental revenue exceeds incremental costs

Present sales are unaffected

The company has idle capacity to handle the order

Special orders which do not meet these criteria should generally not be accepted. Of course,

soft-benefits should be considered as well.

Accept or Reject?

If incremental revenues are less than incremental costs, reject the order, unless qualitative

characteristics overwhelmingly impact the decision.

If incremental revenues are greater than incremental costs, accept the order unless qualitative

characteristics overwhelmingly impact the decision.

27

If incremental revenues are equal to incremental costs, focus primarily on qualitative

characteristics to assess the decision.

An Example

Flowers Inc. manufactures silk roses. Bud Company has approached Flowers with a proposal

to buy 2,000 silk roses for 8,000. Flowers has the necessary capacity. The following costs are

associated annually with silk roses when 10,000 units are produced:

Direct material 21,000

Direct labor 13,000

Manufacturing overhead 9,000

Total 43,000

Forty percent of the overhead is variable. All fixed overhead is allocated equally to all

products produced. In good form, prepare an incremental analysis to analyze whether Flowers

should accept the order from Bud Company.

Forty percent of the overhead is variable. All fixed overhead is allocated equally to all

products produced. In good form, prepare an incremental analysis to analyze whether Flowers

should accept the order from Bud Company.

Step 1: Decide what is not relevant. Allocated fixed overhead is not relevant. The total fixed

overhead of 5,400 (60%*9,000) is the same no matter what decision is made, so it is not part

of the analysis.

Step 2: Determine incremental revenue. The amount of 8,000 is given for this problem.

Step 3: Determine incremental costs. The variable material cost must be determined:

21,000/10,000 = 2.10 per unit

You must then multiply unit cost by the total units in the special order:

2.10 * 2,000 = 4,200

Because variable costs are increased by $4,200, profit will decrease by $4,200, so the amount

is shown as a negative in the incremental analysis.

28

Step 4: Direct labor is another incremental variable cost. The variable cost per unit is:

13,000/10,000 units = 1.30 per unit

The labor cost of all 2,000 units = 2,000*1.30 = $2.600

Because variable costs are increased by 2,600, profit will decrease by 2,600, so this amount is

Step 5: Only the variable portion of the fixed shown as a negative in the incremental

analysis. overhead is relevant. First you must determine the variable overhead per unit which

is 9,000/10,000, or 0.90 per unit. Of this amount, 40% is variable amounting to 0.36 per unit.

The cost of the variable overhead for the 2,000 units in the special order equal 2,000*0.36 =

720. This is an increase cost which causes profit to decrease so the amount is shown as a

negative in the analysis.

The analysis should appear in the following format with respective labels as follows:

Incremental revenue 8,000

Incremental costs:

Direct materials (4,200)

Direct labor (2,600)

Variable overhead (720)

Incremental increase in profit if the order is accepted 480

Because profit increases by 480 if the order is accepted, managers should follow through and

accept the order unless qualitative issues warrant otherwise.

THE MAKE OR BUY DECISION

Marginal costing can be applied in the area of fixation of selling price. The next important

area is whether to make or buy decision. When a company has unused capacity and wants to

manufacture some components, it has two alternatives:

(A) to make within the organization or

(B) to buy from the market.

Often, firms face the question whether to outsource production of a component or continue to

make it in the factory. Comparison of the relevant costs of both the alternatives in such cases

will show whether to continue the existing arrangement or change to buying it, discontinuing

29

the current production. The answer depends upon whether the firm has the option to use the

freed capacity, profitably, or not.

Illustration No. 1

Suresh Ltd. is producing a part at a cost of Rs. 11 per unit. The composition of the cost is as

follows:

Materials 3.00

Wages 4.00

OverheadsVariable2.50

- Fixed 1.50

11.00

Presently, the firm has been incurring a total fixed cost of Rs. 15,000 for manufacturing the

current production of 10,000 units. An outsider is offering the same component, in all aspects

identical in features, for Rs. 10 per unit. On enquiry, it is found from the firm that the

machinethat is manufacturing the parts would remain idle as the machinery cannot be

utilized elsewhere.

(A) Should the offer be accepted?

(B) Would your answer would be different, if the outside firm reduces the price to Rs. 9,

after negotiation. What is the impact of the fixed costs in the decision-making process?

Solution:

The variable cost of the product is as under:

(Rs.)

Materials 3.00

Wages 4.00

OverheadsVariable 2.50

Total Variable Cost 9.50

(A) Here, the additional costs (variable costs) for making are Rs. 9.50. The outside market

priceis Rs. 10. The outside offer is on a higher side by Rs. 0.50 per unit, so the offer is to be

rejected. For every unit bought outside, it results in a loss of Rs. 0.50 per unit.

(B) Now, the outside firm is willing to reduce the price to Rs. 9, while the variable cost is

Rs. 9.50. The offer is to be accepted.

30

So far as the fixed costs Rs. 15,000 is concerned, the firm would incur, whether the firm

makes the product itself or buys it outside. In other words, the existing fixed costs are not to

beconsidered, while taking a decision.

KEEP OR REPLACEMENT DECISION

A company is considering replacing an old machine with a new one. Details about the old m

achine and the new machine are as follows:

Old Machine

Original Cost 1,000,000

Depreciated amount 800,000

Remaining useful life3 years Current disposal value 10,000

Disposal value after 3 years Nil

New Machine

Current purchase cost 300,000

Useful life 3 years

Disposal value after 3 years 60,000

The new machine can reduce operating costs by 80,000 per annum.

Solution

CostBenefit Analysis for Replacement

Incremental Benefits of Replacement

Total costs saving (3 x $80,000) 240,000

Disposal value of new machine after 3 years 60,000

Current disposal value of old machine 10,000

310,000

Less: Incremental Costs

Purchase cost of new machine (300,000)

Net Incremental Benefits of Replacement 10,000

Conclusion: Since replacement would make a net incremental benefit, it should be replaced.

ADD OR DROP DECISION

31

A decision whether or not to continue an oldproduct line or department, or to start a new one

is called an add-or-drop decision. An add-or-drop decision must be based only on relevant

information.Relevant information includes the revenues and costs which are directly related

to a product line or department. Examples of relevant information aresales revenue, direct

costs, variable overhead and direct fixed overhead. Such decision must not be based on

irrelevant information such as allocated fixed overhead because allocated fixed overhead will

not be eliminated if the product line or department is dropped.

The following example illustrates an add-or-drop decision:

Example

A company has three products: Product A, Product B and Product C. Income statements of

the three product lines for the latest month are given below:

Product Line A B C

Sales 467,000 314,000 598,000

Variable Cost 241,000 169,000 321,000

Contribution Margin 226,000 145,000 277,000

Direct Fixed Cost 91,000 86,000 112,000

Allocated Fixed Costs 93,000 62,000 120,000

Net Income 42,000 3,000 45,000

Use the incremental approach to determine if Product B should be drop

Solution

By dropping Product B, the company will loose the sale revenue from the product line. The

company will also obtain gains in the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product B and not the allocated fixed costs. Hence:

If Product B is Dropped

Gains:

Variable Costs Avoided 169,000

Direct Fixed Costs Avoided 86,000 255,000

Less: Sales Revenue Lost

314,000

Decrease in Net Income of the Company

59,000

32

SALE OR PROCESS DECISION Folllowing information has been made available from the cost record of company

manufacturing spares parts:

Particulars Per.Unit Direct Material A Rs.8

B Rs.6

Direct Wages

A 4 Hr @ Rs. 2 Per Hr.

B 6 Hr. @ Rs. 2Per Hr.

Variable overheads 150 % of Wages

Fixed overheads Rs. 750

Selling Price of A Rs.30 Selling Price of B Rs.35

The directors want to be acquainted with the desirability of adapting any one of the following altenative sales mixed in the budget for the next period :

1. 250 Units of A and 250 Units of B. 2. 400 units of only B. 3. 400 Units of A and 100 units of B.

4.150 Units of A and 350 Units of B.

State which of The alternative sales mix you would recommend to the management.

Solution

1) Statement of Contribution (Per Uuit) PARTICULARS A B

Selling Price 30 35

Variable Expenses

Direct Material 8 6

Direct Wages 8 12

Variable Overheades 12 28 18 36

Contribution 2 -1

2) Evaluation Of

Alternative

33

PARTICULARS

A 250 Units of A &

250Units of B

B 400Units

of B

C 400 Units of A & 100 units Of B

D 150 Units of A & 350 Units of

B.

Contribution of A 500 - 800 300

Less: Contribution Of B -250 -400 -100 -350

Total Contribution 250 -400 700 -50

Less: Fixed Overheads 750 750 750 750

Profit / (Loss) -500 -1150 -50 -800

Alternatively ( c) with 400 units of A and 100 Units of B is recommended to the management as the loss as the loss is minimum ( or the least)

REDUCES OR MAINTAIN THE PRICE THE DECISION

The Price structure of an Electric Fan made by the Vijay Elcetric Company Ltd. Is as follows

PARTICULRSA PER FAN

Material 600

Labour 200

Variable Overheads 200 1000

Fixed Overheads 500

Profit 500 Selling Price 2000

This cost is based on Manufature of 1,00,000/- fan p.a. The company excwpt due to competition, they will have to reduce the sellin price

However,they want to keep the total profit intact.

Your required to prepare a statement showing the position, if

1. Selling price reduce by 10% and

2.Selling price is reduced y 20%.

Solution- Profit at predest = 100000fans x Rs. 500 per fan = Rs. 5 Crores.

fixed cost at present = Rs.5 Crores.

1. If selling price is reduced by 10% P/V Ratio = contribution/Sales x 100 = 1000-200/2000-200= 44.44%

Therefore, sales requried for Profit of Rs. 5 Crores. Fixed cost + desired profit/ P.V Ratio = RS.5 Crores + RS.5

Crores/44.44%= Rs. 22.50 Crores

34

Number of Fans to be sold= 225000000/RS. 1800 Per fan = 125000 Fans

2. If sellin price is reduced by 20% P.V Ratio= contribution/Sales X 100 = 1000-400/2000-400 X 100=37.5%

Sales required for Profit of Rs. 5 Crores Fixed cost + Desired Profit / P.V Ratio = Rs. 5Crores + Rs. 5 Crores /

37.5% =Rs. 262666667/-

Number of Fans to be sold = 266666667/Rs. 1600 Per Fan = 166667 fans.

Statement of sale and Profit for April

Particulras i) Selling Price Reduced by 10% (1,25,000 fans )

ii) Selling Price reduced by 20% ( 166667 fans)

Rs Per Fan

Rs. Rs.

Per Fan Rs.

Sales 22,50,00,000 1800 22,66,67,200 1600

Less : Material 7,50,00,000 600 10,00,00,000 600

Labour 2,50,00,000 200 3,33,33,400 200

Variable Overheads 2,50,00,000 200 3,33,33,400 200

Contribution 10,00,00,000 800 6,00,00,400 600

Less: Fixed Overheads 5,00,00,000 400 5,00,00,000 300

Contribution 5,00,00,000 400 1,00,00,400 300

KEY FACTOR AND PRODUCT MIX DECISIONS

From the following particulars find the most profitable product mix and prepare a statement of profitability of that product mix.

Particulars Product A Product B Product

C

Units Budgeted to be produced and sold 1800 3000 1200

selling price per units Rs 60 55 50

Requirement per units

Direct Material 5kg 3 Kg 4 Kg

Direct Labour 4 Hrs. 3 Hrs. 2 Hrs.

Variable Overheads Rs 7 Rs. 13 Rs.8 Fixed Overheads Rs.10 Rs.10 Rs.10 Cost of direct Material Per (K.G) Rs.4 Rs.4 Rs.4 Direct labour hr. Rate Rs.2 Rs.2 Rs.2

Maximum possibale units of Sales 4000 5000 Rs.1500

All the three products are poroduced from the same direct material using the same type of machine and labour.Direct Materil Which is the Key Factor Iimited to 18600Hrs.

35

Solution

Statement of Most Profitable Product Mix

Particulars A Rs. B Rs. C Rs.

Selling Price per Units (i) 60 55 50 Variable Cost Direct Material 20 12 16

Direct Labour 8 6 4

Variable overheads 7 13 8

totla veriable cost (ii) 35 31 28

Contribution Per Unit (I - ii) 25 24 22

Contribution Per hrs.( WN 1) 6.25 8 11 Ranking of most profitable Product Mix III II I

Statement of Profitability of the most Profitable Product Mix

Particulrs Products Total

A B C

Ranking III II I

1.Units Produced and sold (WN 2) 150 5000 1500

2.contribution per units per Units Rs. 25 24 22

3.Total contricbution units of sold (Rs) (1 X2) 3750 120000 33000 156750

4.Less: fixed Cost (Rs.) (WN 3) 60000

5.Profit (Rs.) (3-4) 96750

Working Notes. WN 1

Particulrs Products

A B C

1.Contribution Per Units Rs. 25 24 22

2. Direct Labour Hours Per Units 4 3 2 3.Contribution per hrs.(Rs) (1/2) 6.25 8 11

WN 2

36

Here direct labour hrs. is the key factor and only 18600 hrs. are avaliable to produced the three products. The available 18000 hrs. are utilised hrs are in order of the ranking assigned i.e. first of all products see then [products B and lastly product A will be produced. the number of which products to be Produced will be depend upon the maximum possible od sale each products the details of the products to be produced keeoping in view of avalibale hrs. and their ranking are as below.

Products

Total hrs.Utilised

(Rs)

C 1500 Units x 2 hrs. 3000

B 5000 units x 3000 15000

A 150 units X 4 Hrs 600

Total Hrs. 18600

WN 3

PARTICULARS PRODUCTS TOTAL

A B C 1. Budgeted units to be produced sold : 1800 3000 1200

2. Fixed Overheads (Rs) Per unit 10 10 10 3. Total fixed Overheads (Rs) (1 X 2) 18000 30000 12000 60000

37

BIBILIOGRAPHY

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ADVANCE COST ACCOUNTING BOOKS AUTHOER NAME :

DR. VARSHA M. AINAPURE