cma unit ii
TRANSCRIPT
PREPARATION OF COST SHEET
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Methods of Costing
The following are the methods of costing.: Job CostingJob Costing Batch CostingBatch Costing Process CostingProcess Costing Operating CostingOperating Costing Contract CostingContract Costing
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Methods of Costing: Job CostingJob Costing This costing method is used in firms which work on the basis
of job work. There are some manufacturing units which undertake job work and are called as job order units.
The main feature of these organizations is that they produce according to the requirements and specifications of the consumers. Each job may be different from the other one.
Production is only on specific order and there is no pre demand production. Because of this situation, it is necessary to compute the cost of each job and hence job costing system is used.
In this system, each job is treated separately and a job cost sheet is prepared to find out the cost of the job.
The job cost sheet helps to compute the cost of the job in a phased manner and finally arrives the total cost of production.
1-4Methods of Costing: Batch Batch CostingCosting
This method of costing is used in those firms where production is made on continuous basis.
Each unit coming out is uniform in all respects and production is made prior to the demand, i.e. in anticipation of demand. One batch of production consists of the units produced from the time machinery is set to the time when it will be shut down for maintenance.
For example, if production commences on 1st January 2011 and the machine is shut down for maintenance on 1st April 2011, the number of units produced in this period will be the size of one batch.
The total cost incurred during this period will be divided by the number of units produced and unit cost will be worked out.
Firms producing consumer goods like television, air-conditioners, washing machines etc use batch costing.
1-5Methods of Costing: Process Process CostingCosting
Some of the products like sugar, chemicals etc involve continuous production process and hence process costing method is used to work out the cost of production.
The meaning of continuous process is that the input introduced in the process I travels through continuous process before finished product is produced. The output of process I becomes input of process II and the output of process II becomes input of the process III. If there is no additional process, the output of process III will be the finished product.
In process costing, cost per process is worked out and per unit cost is worked out by dividing the total cost by the number of units.
Industries like sugar, edible oil, chemicals are examples of continuous production process and use process costing.
1-6Methods of Costing: Operating Operating CostingCosting
This type of costing method is used in service sector to work out the cost of services offered to the consumers.
For example, operating costing method is used in hospitals, power generating units, transportation sector etc.
A cost sheet is prepared to compute the total cost and it is divided by cost units for working out the per unit cost.
1-7Methods of Costing: Contract Contract CostingCosting This method of costing is used in construction industry to
work out the cost of contract undertaken. For example, cost of constructing a bridge, commercial
complex, residential complex, highways etc is worked out by use of this method of costing.
Contract costing is actually similar to job costing, the only difference being that in contract costing, one construction job may take several months or even years before they are complete while in job costing, each job may be of a short duration.
In contract costing, as each contract may take a long period for completion, the question of computing of profit is to be solved with the help of a well defined and accepted method.
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Cost Sheet
Cost Sheet is a statement of cost showing the total cost of production and profit or loss from a particular product or service.
A Cost Sheet shows the cost in a systematic manner and element wise.
A typical format of the Cost Sheet is given below:
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Cost sheet: Sample
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Cost sheet: Sample
RECONCILIATION OF COST & FIANCIAL ACCOUNTS
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‘Reconciliation is a process whereby profitsrevealed by two sets of books are tallied toascertain the reasons for disagreement ofthe two profits’
RECONCILIATION-NEED
Cost & FinancialAccounting
IntegralAccounting
Cost Accounting
Financial Accounting
Non-integratedAccounting System
Separate Books
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Meaning
In business concern where Non-integrated Accounting System is followed. cost and financial accounts are maintained separately, the difference between the end result of these two are required to be reconciled.
‘Reconciliation is a process whereby profits revealed by two sets of books are tallied after ascertaining the reasons for disagreement of the two profits’
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Reasons for Difference
The various reasons which create difference between cost and financial profit or loss shown by the two set of books may be listed under the following heads : (1) Items shown only in Financial Accounts (1) Items shown only in Financial Accounts (2) Items shown only in Cost Accounts (2) Items shown only in Cost Accounts (3) Absorption of Overheads (3) Absorption of Overheads (4) Methods of Stock Valuation (4) Methods of Stock Valuation (5) Abnormal Loss and Gains (5) Abnormal Loss and Gains (6) Methods of Depreciation(6) Methods of Depreciation
1-151. Items shown only in Financial Accounts
Some items of income and expenses which are included only in financial accounts but are not shown in cost accounts and vice versa.
The following items are shown in financial accounts but not in cost accounts:
(A) Items of Incomes: (A) Items of Incomes: Profit on sale of fixed assets Interest received on investment Dividend received on investment Rent, brokerage and commission received Premium on issue of shares Transfer fees received.
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Contd….
(B) Items of Expenditure: (B) Items of Expenditure: Loss on sale of fixed assets, e.g., Plant, Machinery,
Building etc. Interest paid Discount paid Dividend paid Losses due to scrapping of plant and machinery Penalties and fines Expenses of shares' transfer fees Preliminary expenses written off Damages payable at law
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Contd….
(C) Items of Appropriation of profits: (C) Items of Appropriation of profits:
Dividend & Bonus to Share holders Transfer to Gen. Reserve, Sinking Fund Taxes on Income & Profits Excess Provision against Depreciation
1-182. Items shown only in Cost Accounts
There are some items which are recorded only in Cost Accounts but are not included in financial accounts because the amount is not actually spent or paid.
These expenses reduced the profit in cost account while in financial account it may be the reverse effect, such as: Notional interest on capital employed Notional rent of premises owned Salary to proprietor Notional Depreciation
1-193. Under/Over Absorption of Overheads
In financial accounts actual amount of expenses paid are recorded while in cost accounts overheads are charged at predetermined rates.
If overhead charged are not equal to the amount of overhead incurred the under or over absorption of overhead leads to difference in profits of two accounts.
1-203. Under/Over Absorption of Overheads
In financial accounts actual amount of expenses paid are recorded while in cost accounts overheads are charged at predetermined rates.
If overhead charged are not equal to the amount of overhead incurred the under or over absorption of overhead leads to difference in profits of two accounts.
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4. Methods of Stock Valuation
The term stock refers to opening or closing stock of raw materials, work in progress and finished goods.
In financial accounts stocks are valued at cost price or market price whichever is lower.
In Cost Account; stock of raw materials can be valued on the basis of FIFO, LIFO and Simple Average Method etc., and work in progress may be valued at Prime Cost or Work Cost. Finished stocks are generally valued on the basis of cost of production.
Thus, the adaptation of different method of valuation of stock leads to difference in profits of two sets of accounts.
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5. Abnormal Losses and Gains
In cost accounts, abnormal losses and gains are computed and transferred to the Costing Profit and Loss A/c. No such computation is made in the financial accounts. For eample: Abnormal wastage of material Abnormal wastage of labour time or abnormal idle
time Abnormal efficiency
This results in difference between the profits shown by cost accounts and financial accounts.
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6. Different Methods of Depreciation
The depreciation charged is, generally, different in the two sets of books because of the difference in rates charged under both the accounts.
In financial accounts depreciation is charged at the rates prescribed under the Income-tax Act, whereas in cost accounts depreciation is charged at the rates based on the extent of the use of the asset.
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Importance of Reconciliation
Reconciliation of cost and financial account is necessary for the following reasons : To ensure arithmetical accuracy of both set of accounts for
effective cost ascertainment and cost control. To identify the reasons for different results in two sets of
accounts. To evaluate the reasons for variations for effective internal
control. To enable the smooth co-operation and co-ordination
between the activities of cost and financial accounting departments.
To ensure the standardization of policies relating to stock valuation, depreciation and absorption of overheads.
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Methods of Reconciliation
Steps in Reconciliation Process:Steps in Reconciliation Process:The following procedure is adopted for reconciliation:
1. First of all, followings are ascertained:- Items which affect financial profits only and which
are not given in cost accounts. Items which affect cost profits only and which are
not given in financial accounts. Items which affect both financial and cost profits
but with different amounts.
2. Thereafter, profit reconciliation statement is prepared.
1-26Preparation of Reconciliation Statement
The following steps are to be taken for preparing this statement. The starting point may be either profit shown by cost accounts
or financial accounts. If the profit as taken in the beginning is reduced due to the
various causes given, these items should be added in the profits.
If the profit as taken in the beginning is increased due to the various causes given, these items should be deducted from the profits.
After completion of these additions and deductions, we will arrive at the profit as shown by the other system, i.e. if profits as per cost accounts is taken in the beginning, we will arrive at the profit as shown by financial accounts and vice versa.
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Performa: Reconciliation Statement
Reconciliation Statement
PARTICULARS Rs+ Rs _
Profits as per Cost AccountsAdd Incomes not recorded in CA Expenses only recorded in CA Overheads over absorbed in CA Overvaluation of op. stock in CA Undervaluation of Cl. stock in CA
Less Expenses not recorded in CA Overheads Under absorbed in CA Undervaluation of op. stock in CA Overvaluation of Cl. stock in CA
--- ---
Profit as per Profit & Loss A/c (Balance) -----
Costing ProfitIs less
Increase it
Costing ProfitIs More
Decrease it
MARGINAL COSTING&
ABSORPTION COSTING
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Introduction
Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing.
However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing
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Marginal Costing: Definition
“The ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.” -------------- ICMA London
“Marginal costing is a technique of determining the amount of change in aggregate cost due to an increase in one unit over the existing level of production” ------------ D. Joseph
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Introduction contd……
Marginal costing is an alternative to absorption costing.
In Marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated.
Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost.
Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.
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Contribution
An important measure in marginal costing Is the difference between the sales value and the
marginal or variable cost of sales Contribution may be defined as the profit before
the recovery of fixed costs Contribution goes toward the recovery of fixed
cost and profit, and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point.
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Contribution (contd…..)
Thus, contribution may be viewed from two angles viz., wherefrom contribution emanates and how is it applied. These two views can be expressed in equations forms as under:
a) From the view point where it comes:
Contribution = Sales – Variable Cost
C = S - V
b) From the view point of how is it applied:
Contribution = Fixed Cost + Profit
C = F + P
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Contribution Analysis
The above equations give rise to the following salient points of the Contribution Analysis: If Contribution is zero, only marginal cost is covered, the
loss is equal to Fixed Cost (period cost), viz.,
C = zero, there is a loss equal to F
If Contribution is negative, the loss will be more than Fixed Cost, because Marginal Cost will not be covered viz.,
C = Negative, Loss > F
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Contribution Analysis (Contd….) When Contribution is positive and more than Fixed Cost,
there will be profit because Fixed Cost will be fully recovered and the balance will represent profit, viz.,
C > F , there will be profit When Contribution is positive but less than Fixed Cost,
there will be loss but at any rate, it will be less than Fixed Cost, because some portion of Fixed Cost will be recovered, viz.,
C < F , there will be loss but less than F When Contribution is positive but equal to Fixed Cost, there
will be neither profit nor loss (i.e., Break-even-point), because Contribution will just be sufficient to absorb Fixed Cost leaving no surplus, viz.,
C = F , No Profit No Loss or BEP
1-36The Principles of Marginal Costing
The principles of marginal costing are as follows:-
(a) For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service the following will happen. Revenue will increase by the sales value of the
item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution
earned from the extra item.
1-37The Principles of Marginal Costing (Cont..)
(b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
(c) Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
(d) When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
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Features of Marginal Costing The main features of marginal costing are as follows: 1.1. Cost Classification: Cost Classification: The marginal costing technique makes a
sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.
2.2. Stock/Inventory Valuation: Stock/Inventory Valuation: Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.
3.3. Marginal Contribution: Marginal Contribution: Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
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Marginal Costing- Advantages Easiness Proper valuation of Closing Stock Helpful in Profit Planning Meaningful Managerial Reporting Profitability appraisal Useful to Standard and Budgetary Costing Convenience in computing Fixed Overheads Role in Cost Control Helpful in Managerial Decisions e.g: Make or
Buy, decision of expansion etc..
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Marginal Costing- Disadvantages Difficulties in Divisions of Costs Ignoring time element Role of fixed expenses with development of
technology Problem in Valuation of Stock Not suitable for all concerns Availability of other better techniques of
cost control Inappropriate basis of pricing
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Absorption Costing: Definition
A method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or a number of overhead absorption rates. .................(CIMA)
Absorption costing calculates the unit cost of an item taking into account all costs, fixed and variable, direct and indirect. Indirect/fixed costs are allocated to or absorbed by the products made.
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Absorption Costing: The three As AllocationAllocation: : charging to a cost centre those overheads
which result solely from the existence of that cost centre
ApportionmentApportionment:: the charging to a cost centre of a fair share of an overhead on the basis of the benefit received by the cost centre from the facilities provided by the overhead
Absorption:Absorption: when all production overheads have been allocated and apportioned to a product cost centre, the total has to be charged to specific units of production
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Absorption Costing- Advantages Fixed costs are recovered - fixed costs are incurred
in order to make output so it is only fair to charge all output with a share of these costs
Ensures that costs are fully recovered Encourages cost consciousness It is fair in that it uses appropriate methods for
each overhead Identifies total costs - this is useful where pricing
is on a cost plus basis Identifies the profitability of different products
and services Conforms with SSAP9 on the valuing of stocks
1-44Absorption Costing- Disadvantages
All methods are arbitrary - no method of diving up fixed costs is satisfactory
Absorption cost is true only at the level of activity at which it was calculated
Danger of under or over absorption of overheads Complex, time consuming and expensive Potentially misleading guide to profitability of products The capacity levels chosen for overhead absorption
rates are based on historical information and are open to debate
It does not provide information which aids decision-making in a rapidly changing market environment
Difference between Absorption and
Marginal costing
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Absorption vs Marginal costing
Rest Bar Total Rest Bar Total
Material cost (food and drink) 1.000 2.000 3.000 1.000 2.000 3.000
Direct labour cost 3.000 4.000 7.000 3.000 4.000 7.000
Total direct/variable cost 4.000 6.000 10.000 4.000 6.000 10.000
Overhead absorbed 4.000 5.000 9.000
Total cost 8.000 11.000 19.000
Revenue (from sales) 10.000 12.000 22.000 10.000 12.000 22.000
Profit 2.000 1.000 3.000
Contribution 6.000 6.000 12.000
Total overhead 9.000
Profit 3.000
Overheads absorbed
Absorption costing
Overheads not absorbed
Marginal costing
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Absorption Costing approach
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Marginal Costing approach
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Absorption costing Marginal costing
Treatment for Treatment for fixed fixed manufacturing manufacturing overheadsoverheads
(Product v/s (Product v/s Period)Period)
Fixed manufacturing overheads are treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads
Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decision-making.
Fixed manufacturing overheads will be incurred regardless there is production or not
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Absorption costing Marginal costing
Value of Value of closing stockclosing stock
High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock
Lower value of closing stock that included the variable cost only
Basis of Basis of Managerial Managerial DecisionsDecisions
Based on Profit Based on Contribution and P/V Ratio
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Absorption costing Marginal costing
ApplicationApplication It is well suited for determining long-term cost and long-term principal policy
Used for solving various managerial decisions, planning and control
Cost per unitCost per unit Cost per unit decreases as the production increases
Cost per unit remains the same
Under and Under and over recovery over recovery of Fixed Costof Fixed Cost
It is adjusted in P/L account
It is not done in this method
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Absorption costing Marginal costing
Reported Reported profitprofit
If the production = Sales, AC profit = MC Profit
If Production > Sales, AC profit > MC profit
As some factory overhead will be deferred as product costs under the absorption costing
If Production < Sales, AC profit < MC profit
As the previously deferred factory overhead will be released and charged as cost of goods sold
1-53Comparison between absorption and marginal costing
Absorption costing Marginal costing
+
• Possible to see the profitability of the individual businesses
• All cost are absorbed somewhere so the complete cost of a line of business can be clearly seen
• The full cost information can be used to assess the level of revenue required to run the line of business
• The contribution from each business is shown
• Avoids the problem of ‘arbitrary’ overhead contribution
• Marginal costing has build-in break-even analysis
-• Method may be inaccurate based
on the criteria chosen, thus might show unfair results for a line of business
• Not possible to compare profitability of individual lines of business
Presentation of costs on income statement
1-55Income Statement: Absorption Costing
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Income Statement: Marginal Costing
MANAGERIAL APPLICATIONS
OF MARGINAL COSTING
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Introduction Marginal Costing is an extremely valuable
technique with the management. The cost-volume-profit relationship has served as
a key to locked storehouse of solutions to many situations.
It enables the management to tackle many problems which are faced in the practical business.
All the introduction of marginal cost principles does is to give the management a fresh, and perhaps a refreshing, insight into the progress of their business
1-59Application Areas of Marginal CostingThe concept of marginal costing is practically applied in the following situations:
Evaluation of Performance : The evaluation of the performance of various departments or products can be evaluated with the help of marginal costing which is based on contribution generating capacity.
Profit Planning : This technique through the calculation of P/V Ratio helps the management to plan the activities in such a way that the profit can be maximised.
Cost Control : Marginal Costing is a technique of cost classification and cost presentation which enable the management to concentrate on the controllable costs.
Flexible Budget preparation: As the marginal costing particularly classifies costs as fixed and variable costs which facilitates the preparation of flexible budgets.
Decision Making Process : Marginal cost analysis helps the management in decision making process.
1-60Decision making areas of Marginal Costing As mentioned in the introduction section, this
article will mainly focus on the Decision making processes.
Marginal Costing tool is considered as an important technique used for Decision making in management.
The following sections will describe the key areas in which decision making has been proven to be required and exercised.
1-61Application Areas of Marginal CostingMarginal Costing helps the management in decision-making in respect of the
following vital areas :
1. Fixation of selling price.2. In house make or buy decisions3. Selecting production with Key or limiting factor4. Effect of change in sales price5. Maintaining a desired level of profits6. Selection of a suitable product mix7. Alternative methods of production8. Diversification of products9. Accepting an additional order10. Closure of Department11. Alternative course of action12. Level of activity planning
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1. Fixation of Selling Price
The selling price must be fixed above the total cost of a particulars product.
Any organization knowing its fixed cost and profits (expected profit) can decide the selling price of its products.
To determine the optimum selling price of any product or service is big challenge for a manager of any company because company wants to profit of each unit of any product or service.
In marginal costing technique, fixed cost will not be changed at any level of production.
Only variable cost is changed for getting optimum selling price where company can achieve expected profit.
1-632. In house make or buy decisions
It may be happened that the organization is producing a product which is a combination of many parts or sub parts.
The organization can produce all sub components or if possible it can purchase there sub components from other organizations, if it finds cost saving.
When it buy the finished sub components sub decisions are called make or buy component.
1-643. Selecting production with Key or limiting factor A key factor is that factor which puts a limit on production
and profit of a business. Usually this limiting factor is sales. A company may not be able to sell as much as it can produce.
Sometimes a company can sell all it produces but production is limited due to the shortage of materials, labor plant capacity or capital.
A decision has to be taken regarding the choice of the product whose production is to be increased, reduced or stopped.
When there is no limiting factor, the choice of the product will be on the basis of the highest P/V ratio.
When there are scarce or limited resources, selection of the product will be on the basis of contribution per unit of scarce factor of production.
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4. Effect of change in sales price
Management is confronted with the problem of cut in price of products from time to time on account of competition, expansion programs or government regulations.
The effect of a cut in selling price per unit will directly reduced the contribution per unit.
1-665. Maintaining a desired level of
profits By fluctuating the sales price of its product
on account of competition, Government regulation and other compiling reasons the organization can maintain a particular level of profits.
The profits can be maintain either by decreasing the price for increase in sales or by increasing the sales prices to restrict to a particular segment.
1-676. Selection of a suitable product
mix Sometimes an organization is involved in manufacturing and
distributing more than one product, the management has to deride about the product mix or sales mix which can maximize the profits for the organization.
Marginal cost can provide a strong basis for such decision by calculating total contribution of each alternative product mix. The best product mix is that which yields the maximum
contribution. The products which give the maximum contribution are to
be retained and their production should be increased. The products which give comparatively less contribution
should be reduced or closed down altogether. The new sales mix will be favorable if it increases the P/V
ratio and reduces the breakeven point.
1-687. Alternative methods of
production Marginal Costing is also used in comparing the
alternative methods use for manufacturing e.g. Machine work v/s Hand work, which machine should be used instead of other etc.
The cost structure may vary from one alternative to another thus the organszation keeping in mind the demand of the market should adopt those alternative which are most efficient in terms of cost.
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8. Diversification of products In order to decide about the profitability of the new
product, it is assumed that the manufacture of the new product will not increase fixed costs of the concern.
If the price realized from the sale of such product is more than its variable cost of production it is worth trying.
If the data is presented under absorption costing method, the decision will be wrong.
If with the introduction of new product, there is an increase in the fixed costs, then such specific increase in fixed costs must be deducted from the contribution for making any decision.
General fixed costs will be charged to the old product/products.
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9. Accepting an additional order Large scale purchasers may demand the
product at lower cost than the market price – a decision has to be taken by the organization whether to accept lower cost order or not.
Such decisions can be taken by comparing the profit situation before and after accepting the large scale order.
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10. Closure of Department The decision to close down or suspend its activities will depend
whether products are making contribution towards fixed costs or not. i.e. Whether the contribution is more than the difference in fixed costs (by working at normal operations and when the plant or product is closed down or suspended)
If the business is closed down: There may be certain fixed costs which could be avoided. There will be certain expenses which will have to be incurred
at the time of closing the operations like redundancy payments, necessary maintenance of the plant or overhauling of plant on reopening training of personal etc.
Such costs are associated with closing down of business and must be taken into consideration before taking any decision.
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11. Alternative course of action Whatever course of action is adopted,
certain fixed expenses will remain unaffected.
The criterion is the effect of alternative course of action upon the marginal (variable) costs in relation to the revenue obtained.
The course of action which yields the greatest contribution is the most profitable to be followed by the management.
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12. Level of activity planning It is concerned with optimum utilization of
available resources. Sometime in many organization some resources
are left idle or in other words the organization is not using its full capacity, it is always important to achieve optimum level of activities in order to maximize the profit of organization, as different levels of activities have different rate of return.
Thus an organization should utilize its capacity up to the point where it gets the positive rate of return.