BA6113

- ACCOUNTING FOR MANAGEMENT

FINANCIAL ACCOUNTING

B.HARIBALAKRISHNAN,MBA-LECTURER,NPRCET

UNIT I BASIC FINANCIAL ACCOUNTING Accounting Principles - Concepts and Conventions - Accounting Standards Preparation of Journal, Ledger - Trial balance and Final Accounts Trading and Profit and Loss Account and Balance sheet UNIT II FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATIONS Meaning and Types of Financial Statements - Financial Ratio Analysis - Cash Flow and Funds Flow Statement Analysis UNIT III COST ELEMENTS AND MATERIAL CONTROL Costing as an aid to Management - Methods of Costing - Types or Techniques of Costing - Elements of Cost - Cost Sheet - Cost Classification - Techniques of Material Control - Re-Order Level -Minimum and Maximum Level - Danger Level - Average Stock Level - Economic Ordering Quantity - ABC and JIT Inventory System - Methods of Valuing Material Issues - FIFO, LIFO,HIFO, Simple Average and Weighted Average. UNIT IV COST ACCOUNTING SYSTEMS Job Order Costing - Batch Costing - Contract Costing - Process Costing - Activity Based Costing -Target Costing. UNIT V COST ANALYSIS Marginal Costing and Profit Planning - Managerial Applications - Budgetary Control (Classification of Budgets)- Standard Costing Variance Analysis Direct Material Variances Direct Labour Variances - Overhead Variances and Sales Variances.

UNIT I BASIC FINANCIAL ACCOUNTING Accounting Principles - Concepts and Conventions - Accounting Standards Preparation of Journal, Ledger - Trial balance and Final Accounts Trading and Profit and Loss Account and Balance sheet FINANCIAL ACCOUNTING is the information that must be assembled and reported objectively. Thirdparties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP). ACCOUNTING PRINCIPLES(concepts and conventions): derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP. Principle of regularity: Regularity can be defined as conformity to enforced rules and laws. Principle of consistency: This principle states that when a business has once fixed a method for the accounting treatment of an item, it will enter all similar items that follow in exactly the same way. Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company's financial status. Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company. Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, a revenue with an expense, etc. Principle of prudence: This principle aims at showing the reality "as is": one should not try to make things look prettier than they are. Typically, a revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable. Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value .

Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire timespan and not counted for entirely on the date of the transaction. Principle of Full Disclosure/Materiality: All information and values pertaining to the financial position of a business must be disclosed in the records. Principle of Utmost Good Faith: All the information regarding to the firm should be disclosed to the insurer before the insurance policy is taken. Accounting standards is the art of recording transactions in the best manner possible, so as to enable the reader to arrive at judgments/come to conclusions, and in this regard it is utmost necessary that there are set guidelines. These guidelines are generally called accounting policies. The intricacies of accounting policies permitted Companies to alter their accounting principles for their benefit. This made it impossible to make comparisons. In order to avoid the above and to have a harmonised accounting principle, Standards needed to be set by recognised accounting bodies. This paved the way for Accounting Standards to come into existence. Accounting Standards in India are issued By the Institute of Chartered Accountanst of India (ICAI). At present there are 30 Accounting Standards issued by ICAI. Objective of Accounting Standards Objective of Accounting Standards is to standarize the diverse accounting policies and practices with a view to eliminate to the extent possible the non-comparability of financial statements and the reliability to the financial statements. The institute of Chatered Accountants of India, recognizing the need to harmonize the diversre accounting policies and practices, constituted at Accounting Standard Board (ASB) on 21st April, 1977. Compliance with Accounting Standards issued by ICAI Sub Section(3A) to section 211 of Companies Act, 1956 requires that every Profit/Loss Account and Balance Sheet shall comply with the Accounting Standards. 'Accounting Standards' means the standard of accounting

recomended by the ICAI and prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards(NACAs) constituted under section 210(1) of companies Act, 1956. Accounting Standards Issued by the Institute of Chatered Accountants of India are as below: Disclosure of accounting policies: Valuation Of Inventories: Cash Flow Statements Contingencies and events Occurring after the Balance sheet Date Net Profit or loss For the period, Prior period items and Changes in accounting Policies. Depreciation accounting. Construction Contracts. Revenue Recognition. Accounting For Fixed Assets. The Effect of Changes In Foreign Exchange Rates. Accounting For Government Grants. Accounting For Investments. Accounting For Amalgamation. Employee Benefits. Borrowing Cost. Segment Reporting. Related Party Disclosures. Accounting For Leases. Earning Per Share. Consolidated Financial Statement. Accounting For Taxes on Income.

Accounting for Investment in associates in Consolidated Financial Statement. Discontinuing Operation. Interim Financial Reporting. Intangible assets. Financial Reporting on Interest in joint Ventures. Impairment Of assets. Provisions, Contingent, liabilities and Contingent assets. Financial instrument. Financial Instrument: presentation. Financial Instruments, Disclosures and Limited revision to accounting standards. Definition and Explanation: Journal proper is book of original entry (simple journal) in which miscellaneous credit transactions which do not fit in any other books are recorded. It is also called miscellaneous journal. The form and procedure for maintaining this journal is the same that of simple journal. The use of journal proper is confined to record the following transactions:Opening entries Closing entries Transfer entries Adjustment entries Rectification entries Entries for which there is no special journal Entries for rare transactions Opening Entries: When a businessman wants to open the book for a new year, it is necessary to Journalise the various assets and liabilities before the new accounts are opened in the ledger. The journal

entries so passed are called "opening entries". Suppose a businessman opens a new set of books on January 1, 1991 with cash in hand $100, debtors $200, stock in trade $320, machinery $700, furniture $150, bank loan $300, capital $1,070 the respective opening entry in the journal will be: Cash Sundry debtors Stock in trade Machinery Furniture & fitting To Sundry creditors To Bank loan To Capital 100 200 320 700 200 150 300 1,070

(Being the incorporation of assets and liabilities at this date) Closing Entries: When the books are balanced at the close of the accounting period with a view to paper final accounts it is necessary that balance of all the income and expenses accounts must be transferred to trading and profit and loss account. The process of transferring balances to the trading and profit and loss account at the end of year is called closing the books and entries passed at that time are called closing entries. For example on 31st December, 1991 the balance in expenses accounts are: Salary $500; rent $200; Stationary $50; legal charges $100; and income accounts are: commission received $50. These balance will be recorded in profit and loss account though the following closing entries: Profit and loss account To Salary To Rent To Stationary To Legal charges (Being the closing entry) 850 500 200 50 100

Commission received account 50 To Profit and loss account (Being the closing entry) Transfer Entries:

50

When accounts are transferred from one account to another for combination of allied items, it is necessary to pass transfer entry. For example, Drawings $500 is transferred from the drawings account to the capital account to find out the net capital. The transfer entry will be passed as follows: Capital Account To Drawings account (Being the transfer entry) Adjusting Entries: Modification of the accounts at the end of an accounting period is called adjustments. If there be any event affecting the related period of accounts but left out of the books, the same should be incorporated in the books before the preparation of the final accounts. This is done by means of adjusting entries through the journal proper. For example at the end of the year it is found that rent $50 is outstanding. It is not recorded in the books. It will be taken into account by means of adjusting entry which is as follows: Rent account 50 To Outstanding rent account (Being outstanding rent recorded) Rectification Entries: When an error is detected in the books, the same is rectified through an entry in the journal proper; thus is called rectification entry. For example, it was detected that an expenditure of $ 100 on repair to building was charged to building account. It is corrected through the following entry in the journal proper: 50 500 500

Building repair account To Building account

100 100

Entries of Which There is No Special Journal: When a trader cannot record the entries in the above mentioned sub-journals, the same are entered in the journal proper. The common transactions which cannot be recorded in any of the book of original entry are: Distribution of goods as free sample. Distribution of goods as charity. Goods destroyed by fire. Goods stolen away by employees. Exchange of one asset for another asset etc. Entries for Rare Transactions: In a business it may happen sometimes that transactions are usually rare. Journal proper is used for such rare transactions. Definition and Explanation of Ledger: When all the transactions of a given period have been journalised, the next thing is to classify them according to the accounts affected. All similar transactions must be brought together. Advantages of Ledger Difference Between Ledger and Journal: The journal and the ledger are the most important books of the double entry system of accounting Form of Ledger and Method of Posting: One account usually occupies one page in the ledger. But if the account is big one it may extend to two or more pages. The pages of the ledger are vertically divided into two equal halves. The left hand half or side is known as the debit (Dr.) side and the right hand half is the credit (Cr.) side. Abbreviations "Dr." and "Cr." are put on the top left and right hand corners. Definition and Explanation: Having posted all the transactions into the ledger, it is necessary to check the correctness of the work done before

proceeding further. In order to test the arithmetical accuracy of our ledger we should prepare a statement called trial balance. A trial balance is a statement prepared by taking out the debit and credit balances of all accounts appearing in the ledger. Objectives and Advantages of Preparing a Trial Balance: The following are the main objectives of preparing a trial balance. Trial balance helps in knowing the arithmetical accuracy of the accounting entries. Trial balance represents a summary of all ledger balances and, therefore, if the two sides of the trial balance tally, it is an indication of this fact that the books of accounts are arithmetically accurate. Trial balance forms the basis for preparing financial statements such as income statement / Trading and profit and loss account and balance sheet. In case, the trial balance is not prepared, it will be almost impossible to prepare the financial statements. The entire ledger is summarised in the form of a trial balance. Thus the position of a particular account can be judged simply by looking at the trial balance. Proof of Accuracy: If the debit and credit totals of the trial balance are equal and also correspond with the total of journal, we may be satisfied that the posting have been properly made and are arithmetically accurate. How to Prepare a Trial Balance - An Example: The trial balance is usually prepared on a loose sheet of paper. The ruling of trial balance is similar to that of a journal. We may prepare a trial balance in one of the following forms: Total Trial Balance Method Balance Trial Balance Method Total Trial Balance Method: According to total trial balance method two sides of each ledger account i.e., debit and credit side are added up and debit and

credit totals so obtained are placed in the debit and credit columns of the trial balance respectively. Thus we may draw the following trial balance by taking out the debit side total and credit side total of each account in the ledger (see example of ledger page). Trial Balance Ledger Account Cash Account Sundry Debtors Account Sundry Creditors Account Discount Account Purchases Account Sales Account Machinery Account Building Account Capital Account Rent Account Wages Account Salaries Account J.F Total Debits 12,453 43,675 23,654 430 26,670 -10,000 20,000 -3,400 600 1,000 1,141,882 Total Credits 8,436 34,453 31,298 550 -32,145 --35,000 ---1,141,882

One clear defect of this method is that mistakes may be committed more often while preparing the trial balance, because large number of figures would be required to be enlisted. Thus, the process becomes unwieldy and cumbrous. Balance Trial Balance Method: The task of preparing a trial balance under balance - trial balance method is much simplified. There is well known axiom that if equals are subtracted from equals the remainders are equal. On this assumption, in place of writing against each account the debit as well as the credit total the balance alone is written. The difference between the two sides of an account is called the balance. If the debit side of an account is greater than the credit side, the balance falls on the debit side and is known as "debit balance." If the credit side of an account is greater than the debit, the the balance is on the credit side and is called "credit balance."

Rules of Balancing Accounts: Rules of balancing each account is as follows: Add up both sides of the account Find out the difference in a separate slip. Put the difference on the lighter side. Add up both sides again. Rule off. The trial balance prepared above, if prepared with the balance of accounts will appear as under (see example of ledger page): Trial Balance Ledger Account Cash Account Sundry Debtors Account Sundry Creditors Account Discount Account Purchases Account Sales Account Machinery Account Building Account Capital Account Rent Account Wages Account Salaries Account J.F Dr. Balance 4,017 9,222 --26,670 -10,000 20,000 -3,400 600 1,000 74,909 Cr. balance --7,644 120 -32,145 --35,000 ---74,909

The second method has the added advantages and is the one that is generally used. There are comparatively less chances of committing errors. As the magnitude of figures is smaller the process is not cumbrous. It does not appear to be unwieldy. Moreover, in a trial balance, the exact position of any account on the date of trial balance can be determined at a glance. Definition and Explanation: A trading account is an account which contains, " in summarized form, all the transactions, occurring, throughout the trading period, in commodities in which he deals" and

which gives the gross trading result. In short, trading account is the account which is prepared to determine the gross profit or the gross loss of a trader. Items of Trading Account: The following items usually appear in the debit and credit sides of the trading account. Debit Side Items: The value of opening stocks of goods (i.e., the stock of goods with which the business was started). Net purchase made during the year (i.e., purchases less returns). Direct expenses, if any. Credit Side Items: Total sales made during the period less the value of returns, i.e., net sales. The value of closing stock of goods. The difference between the two sides of the trading account represents either gross profit or gross loss. Thus if the credit side is heavier that would mean that the trader has earned gross profit i.e., the excess of selling price of the goods sold over their purchase price. If the debit side is heavier it would mean that the trader has suffered gross loss i.e., purchase price of goods exceeds the selling price. The balance of trading account which represents either gross profit or gross loss is transferred to profit and loss account. Format of Trading Account (T or Account Form): Trading Account For the year ending .......20...... Dr. Cr.

To Opening stock To purchases Less Returns To Carriage inwards To Cartage To dock charges To Wages To Duty To Freight To Clearing charges To Etc. Etc., To Gross profit (Transferred to profit and loss account) .........

........ By Sales Less returns

......... ......... ......... .........

......... ........ By Closing stock ......... By Gross loss transferred to ......... profit and loss account ......... ......... ......... ......... ......... .........

.........

.........

Trading Accounts Items: Now we shall discuss the items of trading account one by one. Opening Stock: In case of trading concerns it will consist of only finished goods or goods to be sold without alteration. In manufacturing concerns, the opening stock will consist of three parts (a). Stock of raw materials.

(b). Stock of partly completed goods or work-in-progress. (c). Stock of finished goods. In case of new business there will be no opening stock. Purchases: This item includes both cash and credit purchases of goods bought with the object of sales. Return Outwards or Purchases Returns: It means the goods returned by a trader to his suppliers from out of his purchases. Return outwards reduce the purchases. It is shown by way of deduction from purchases in the trading account. Discount on Purchases: It is also shown by way of deduction from purchases in the trading account. Sales: This item includes total of both cash and credit sales of goods in which businessman deals in. It is credited to trading account. Returns Inwards or Sales Returns: It means goods returned to a trader by his customers from out of goods sold to them. It is shown by way of deduction from sales on the credit side, of the trading account. Discount on Sales: This account has always a debit balance and is shown by deduction from sales in the trading account. Direct Expenses: Direct expenses are those expenses which are incurred to convert raw-materials into finished goods or which may be regarded as a part of the cost of purchasing the goods. e.g., wages paid by a manufacturer to construct furniture out of raw wood, the expenses incurred to bring goods from the place of purchase to the business place of the trader etc. All the direct expenses are charged to the trading account. The items usually included in the direct expenses are:

Wages: This item usually signifies some hourly, daily or piecework remuneration paid to laborers. It is direct expenditure and should be charged to trading account. Manufacturing or Productive Wages: This item usually signifies the wages of factory workmen actually engaged in making or producing something. It is a direct charge on the cost of manufacturer. It is debited to manufacturing account or trading account. Carriage Inward: Carriage means conveyance charges of goods by land. Carriage inward are the conveyance expenses incurred to bring the goods purchased in the godown or shop. It is debited to trading account. In examination questions when the item only "carriage" is given and is not expressly stated to be inward or outward, it should be assumed to be inward and debited to trading account. The reason is that carriage on goods is usually paid by the purchaser. Cartage: The cartage charges on goods purchased are direct expenses and should be debited to trading account. Freight: Freight is the charge made for conveyance of goods by sea. Freight on goods purchased is charged to trading account. Customs Duty, Octroi Duty etc: When goods are purchased from a foreign country import duty will be payable. When goods are received from another city, the municipal corporation may charge octroi duty. All duties on goods purchased should be debited to trading account. Excise Duty: It is a tax levied by the government. If the duty is levied on production it will be treated as manufacturing expenses and debited to trading account. Stores Consumed: This item stores denote lubricating oil, tallow, grease, cotton and jute waste, etc., required for running the machinery of manufacturing concern. The amount of stores consumed is a direct expense and should be charged to trading account. Motive Power: This item includes, coke, gas, water or electric energy consumed in propelling the machinery. It is debited to manufacturing account in the absence of a manufacturing account, it is debited to trading account. Royalty: Royalty is an amount paid to a person for exploiting rights possessed by him it is usually paid to

patentee, author, or landlord for the right to use his patent, copyright or land. If they are productive expenses, they are debited to manufacturing account; but in the absence of a manufacturing account, they are debited to trading account. Manufacturing Expense: All other expenses such as factory rent, factory insurance, factory repair etc., are direct expenses and should be charged to trading account. Closing Stock and its Valuation: Closing stock represents the value of goods lying unsold in the hands of a trader at the end of a trading period. The value of closing stock is ascertained by means of compilation of list of materials, stores and goods actually in possession at the close of the trading period. This work is known as taking the inventory. The inventory or lists of physical stock are then faired and valued. The total of the lists will be closing stock. The closing stock is valued at cost or market price whichever is lower. As this item materially affects the gross profit (or gross loss), it is essential that all possible care should be taken to calculate the closing stock at a proper value. The value of closing stock is taken into consideration only at the time of preparing the trading account and not before. The trial balance is prepared before the preparation of the trading account. Hence the closing stock does not appear in a trial balance. It is brought into account by means of a journal entry debiting stock account and crediting the trading account. Closing Entries for Trading Account: Closing entries are those which are passed at the end of each financial period for the purpose of transferring the various revenues items to the trading and profit and loss account and thus the nominal accounts are closed. I preparing a trading account, the opening stock, purchases, sales, returns both inwards and outwards, direct expenses and closing stock are transferred to it by means of journal entries as follows: Trading Account To Purchases Account To Returns Inwards Account To Direct Expenses Account (wages, carriage etc.) (Being the transfer of the latter accounts to the former.)

Sales Account Returns Outward Account To Trading Account (Sales etc., transferred to trading account)

Closing Stock Account To Trading Account (Being to record closing stock) Advantages of Trading Account: The advantages of the trading account are as follows: A trader can find out the gross profit and thereby can ascertain the percentage of profit he has earned on the cost of goods sold. This percentage of gross profit may serve as his ready guide for the adjustment of future sale price. A trading account help a trader to compare his stock at open with that at the close. He can further find out whether the purchases he has made during the period of account have been judicious. Once can compare the figure of sales with similar figure of the previous year and can find out whether business is improving or declining. If the gross profit disclosed by the trading account is less than expected, an enquiry can be made into the cause responsible for the decline. And if the gross profit is more than was expected, steps can be taken to maintain it. Definition and Explanation: Profit and loss account is the account whereby a trader determines the net result of his business transactions. It is the account which reveals the net profit (or net loss) of the trader. The profit and loss account is opened with gross profit transferred from the trading account (or with gross loss which will be debited to profit and loss account). After this all expenses and losses (which have not been dealt in the trading account) are transferred to the debit side of the profit and loss account. If there are any incomes or gains, these will be credited to the profit and loss account. The excess of the gain

over the losses is called the net profit and that of the loss over the gain is called the net loss. The account is closed by transferring the net profit or loss to capital account of the trader. Format of the Profit and Loss Account: Profit and Loss Account For the year ended .............. xxxx xxxx xxxx xxxx To Gross Loss xxxx xxxx xxxx xxxx xxxx xxxx xxxx ex. xxxx To Salaries xxxx xxxx xxxx By Net Loss (transferred to capital account of the trader) By Gross Profit By Interest Received By Discount Received By Commission Received By Other Receipts By Etc., Etc. xxxx xxxx xxxx xxxx xxxx xxxx xxxx

xxxx

To Rent

To Rent and Rates

To Discount Allowed

To Commission Allowed

To Insurance

To Bank Charges

To Legal Charges

To Repairs

To Advertising

To Trade Expenses

To Office Expenses

To Bad Debts

To Traveling Expenses

To Etc., Etc.

To Net Profit (transferred to capital account of the trader)

Closing Entries for Profit and Loss Account: The following usual entries are passed at the end of each trading period. Transferring all expenses or losses: Profit and loss account To Each of the various expenses or losses (This entry will close the expenses accounts)

Transferring all items of gains etc: Various nominal accounts (representing gains) To Profit and loss account (This entry will close all the remaining nominal accounts)

Transferring net gain to capital account: Profit and loss account To Capital account (This entry closes the P & L account)

Transferring net loss to capital account: Capital account To Profit and loss account (This entry closes the P & L account) Profit and Loss Account in Statement Form/Income Statement: Trading and profit and loss account/income statement may be prepared either in account form (T form) or in report form (statement form). Trading and profit and loss account in both the forms give the same information. The account or T form is traditional and is used widely but in recent years many business houses prefer to present the profit and loss account/income statement in the report form. Format of Profit and Loss Account/Income Statement in Statement Form: Trading and Profit and Loss Account/Income Statement For the year ended 31st December, 199----Income From Sales: Sales Less: Sales returns Sales discount ---------------------

Net Sales

------

Cost of Goods Sold: Merchandise is stock on 1st January Purchases Less: Purchases returns ----------------

Net purchases

------

Cost of goods available for sale Less merchandise in stock on 31st December

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Cost of goods sold

------

GROSS PROFIT

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Operating Expenses: Selling Expenses: Sales salaries Advertising expenses Insurance expense - selling Store supplies expenses Sundry selling expenses Total selling expenses --------------------------

-----General Expenses: Office salaries Taxes Insurance expenses general Office supplies expenses Sundry general expenses --------------------------

Total general expenses

------

Total operating expenses

------

Net profit from operations

------

Other Income: Rent income Other Expenses: Interest expenses -----------

------

NET PROFIT

------

Explanation of Certain Items of Income Statement: Income from sales: The total of all charges to customers for goods sold, both for cash and on credit, is reported in this

section. Sales returns and allowances and sales discounts are deducted from the gross amount to yield net sales. Cost of Goods Sold: Cost of goods sold refers to the cost price of goods which have been sold during a given period of time. In order to calculate the cost of goods sold we should deduct from the total cost of goods purchased the cost of goods at the end of the year. This can be explained with the help of following formula/equation: (Opening stock + Cost of goods purchased) - Closing stock = Cost of goods sold Gross Profit: The excess of the net income from sales over the cost of goods sold is also called gross profit on sales, trading profit or gross margin. It is as gross because all other expenses for the period must be deducted from it to obtain the net profit or net income of the business. Operating Expenses: The operating expenses also called operating costs of a business may be classified under any desired number of headings and sub-headings. In small retail business it is usually satisfactory to classify operating expenses as selling or general. Expenses that are incurred directly in connection with the sale of goods are known as selling expenses. selling expenses include salaries or the salesmen, store supplies used, depreciation of the store equipment, and advertising. Expenses incurred in the general administration of the business are known as administrative expenses or general expenses. Examples of general expenses are office salaries, depreciation of equipment, and office supplied used. Net Profit from Operations: The excess of gross profit on sales over total operating expenses is called net profit or net profit from operations. If operating expenses should exceed gross profit, the excess is designated as net loss or net loss from operations. Other Income: Minor sources of income are classified as other income or non-operating income. In a merchandising business this category often include income from interest, rent, dividends and gains from the sale of fixed assets.

Other Expenses: Expenses that cannot be associated definitely with the operations are identified as other expenses or nonoperating expenses. Interest expense that results from financing activities and losses incurred in the disposal of fixed assets are examples of items reported in this section. The two categories of non-operating items, other income and other expenses, are offset against each other on the profit and loss account. If the total of other income exceeds the total other expenses, the excess is added to net profit from operations; if the reverse is true, the difference is subtracted from net profit from operations. Net Profit: The final figure on the profit and loss account is labeled as net profit (or net loss) or net profit carried to balance sheet. It is the net increase in capital from profit making activities. Definition and Explanation: A balance sheet is a statement drawn up at the end of each trading period stating therein all the assets and liabilities of a business arranged in the customary order to exhibit the true and correct state of affairs of the concern as on a given date. A balance sheet is prepared from a trial balance after the balances of nominal accounts are transferred to the trading account or to the profit and loss account. The remaining balances of personal or real accounts represent either assets or liabilities at the closing date. These assets ant liabilities are shown in the balance sheet in a classified form - the assets being shown on the right side and the liabilities on the left hand side. Grouping and Marshalling: In a balance sheet assets and liabilities should be properly grouped and classified under appropriate headings. The individual balance of each debtor's and creditor's account need not be shown. Debtors and creditors should be shown in total. The grouping together of dissimilar assets will make the balance sheet misleading. The term marshalling means the order in which assets and liabilities are stated on the balance sheet as the balance sheet exhibits the financial position of a concern even to a non technical observer. It is of great importance that the different

assets and liabilities should be arranged in the balance sheet on certain principles. The balance sheet is generally marshaled in three ways: 1. The Order of Liquidity or Realizability: According to this method assets are entered up in the balance sheet following the order in which they can be converted into cash and the liabilities in the order in which they can be paid off. The following is a format of a balance sheet based on this order: Balance Sheet as at .......... Liabilities Bills Payable Loans Trade Creditors Capital Rs. Assets Cash in hand Cash at Bank Investments Bills Receivables Debtors Stock (Closing) Stores Furniture & Fixtures Plant & Machinery Land & Buildings Rs.

2. The Order of Permanence: This method is the reverse of the first method. Under this method the assets are stated according to their permanency i.e., permanent assets are shown first and less permanent are shown one after another. Similarly the fixed liabilities are stated first and the floating liabilities follow. The following is a specimen of a balance sheet based on this order: Balance Sheet as at .......... Liabilities Capital Trade Creditors Loans Bills Payable Rs. Assets Land & Buildings Plant & Machinery Furniture & Fixtures Stores Rs.

Stock (Closing) Debtors Bills Receivables Investments Cash at Bank Cash in hand

3. Mixed Order of Arrangement: This method is the combination of the first two methods. Under this method the assets are arranged in order of realisability and liabilities are arranged in order of permanence. The first method is adopted by sol proprietors, firms and partnership concerns. The second method is adopted by companies and the third method is adopted by banking concerns. Objectives of the Balance Sheet: The function of the correctly prepared balance sheet is to exhibit the true and correct view of the state of affairs of any concern. In a balance sheet as the assets and liabilities are shown in details after being properly valued, a trader can judge the position of his business from it. Classification of Assets: The properties and possessions of a business are called assets and they are classified into the following classes: Fixed assets: Fixed assets are assets which are acquired not for sale but for permanent use in the business e.g., land and buildings, plant and machinery, furniture etc. These assets help the business to be carried on. Current Assets Or Circulating Assets or Floating Assets: Current assets denote those assets which are held for sale or to be converted into cash after some time e.g., sundry debtors. bills receivables, stock of goods etc.

Liquid Assets: Liquid assets are those assets which are with us in cash or easily converted into cash e.g., cash in hand, cash at bank, investments etc. Wasting Assets: The assets that depreciate through "wear and tear", whose values expire with lapse of time or that become exhausted through working are known as wasting assets. This is a subclass of fixed assets e.g., plant machinery, mines etc. Intangible or Fictitious Assets: There are assets which have no physical existence. Which can neither be seen with eyes not touched with hands. These are called intangible assets or fictitious assets. They do not represent any thing valuable. They include debit balance of profit and loss account, goodwill etc. Contingent Assets: A contingent asset is one which comes into existence upon the happening of a certain event. If that event happens the asset becomes available, otherwise not. For example uncalled capital of a limited company. Outstanding Assets: Expenses paid in advance i.e., prepaid expenses, and income earned but not received are known as outstanding assets. Classification of Liabilities: The liabilities of a business are classified as follows: Fixed Liabilities: These are the liabilities which are payable immediately or in the near future. These liabilities are payable after a long period. Long term loans, capital of the proprietor are the examples of such kind of liabilities. Current Liabilities: These are the liabilities which are payable immediately or in the near future, such as creditors, bank loans etc.

Contingent Liabilities: Contingent liabilities are those liabilities which arise only on the happening of some event. The event may or may not happen. Thus a contingent liability may or may not involve the payment of money. Examples of contingent liabilities are: Liabilities on bills discounted: In case the bill is dishonored by the acceptor, the holder may be called upon to pay the amount to the discounter. Liability under guarantee: In case the debtor fails to fulfill his obligation, the man who has given a guarantee or surety have to make good the loss to the creditor. Liability in respect of a pending suit: A suit pending against a person in a court is a contingent liability because if the decision of the court goes against him, he may thereby become liable to pay compensation. Contingent liabilities are not recorded in the books not they are included in the balance sheet. They are simply referred to by way of foot notes on the balance sheet. Outstanding Liabilities: Outstanding expenses and unearned income are examples of outstanding liabilities. Classification of Capital: The surplus or excess of assets over liabilities is called the capital or the proprietor. Capital may be classified as follows on the basis of the capital fund invested: Trading Capital: The portion of the funds of a concern which is represented by the fixed and floating assets is called the trading capital Fixed Capital: The portion of the funds of a concern which is represented by the fixed assets is called fixed capital. Circulating Capital: The portion of the funds of a concern which is represented by the floating or circulating assets is called the circulating or floating capital.

Working capital: It is the amount which remains for the working of the business after the liabilities for acquiring the fixed assets have been discharged. The excess of the floating assets over the floating liabilities is also called the working capital. Loan Capital: The debentures and other fixed loans are sometimes called loan capital. Watered Capital: It is represented by fictitious assets. Valuation of Assets: In order to exhibit a true financial position of a business , assets are to be valued carefully. The basis upon which the various assets are valued depends to some extent on the nature of the business and the objects for which the assets are held. The following principles, however, will serve as a valuable guide in this respect: Fixed Assets: Fixed assets are valued on the method "going concern." Valuation of the fixed assets must be ascertained from their capacity to earn revenue and that is shy they should be valued for the purpose of the balance sheet at cost price less depreciation which is an estimated loss arising out of the use of the fixed assets in course of the business. Floating Assets: Floating assets are valued on the principle of the "cost or market price whichever is less." They are valued at a figure which they are likely to realize when converted into cash and as such they are valued at cost price or market price if the same is below the cost price at the date of valuation. It is never valued at a price exceeding the cost even if the market price is in excess of the cost price at the date of such valuation. Vertical or Report Form of Balance Sheet ASSETS

Current Assets: Cash-in-hand Cash at bank Debtors (Accounts receivable) Bills receivable (Notes receivable) Stock in trade (Inventory) -----------------------------------------

Total Current Assets Fixed Assets: Furniture and fittings Buildings Plant and machinery Land ---------------------------------

---------

Total Fixed Assets

---------

Total Assets

---------

Liabilities: Current Liabilities: Creditors (Accounts payable) Bills payable (Notes payable) -----------------

Bank overdraft

---------

Total Current Liabilities Fixed Liabilities: Long terms loans Owner's capital Add net income for the year -------------------------

---------

---------

Total Liabilities and Capital

---------

MANAGEMENT ACCOUNTING AND COST MANAGEMENT UNIT II FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATIONS 9 Meaning and Types of Financial Statements - Financial Ratio Analysis - Cash Flow and Funds Flow Statement Analysis Definition and Explanation of Financial Statement Analysis: Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial

decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. Tools and Techniques of Financial Statement Analysis: Following are the most important tools and techniques of financial statement analysis: Horizontal and Vertical Analysis Ratios Analysis 1. Horizontal and Vertical Analysis: Horizontal Analysis or Trend Analysis: Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form. Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years' financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base. Vertical Analysis: Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements. 2. Ratios Analysis: Accounting Ratios Definition, Advantages, Classification and Limitations: The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures

can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. Profitability Ratios: Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under: Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) Ratio Dividend yield ratio Dividend payout ratio Earnings Per Share (EPS) Ratio Price earning ratio Liquidity Ratios: Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most important liquidity ratios. Current ratio Liquid / Acid test / Quick ratio Activity Ratios: Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios: Inventory / Stock turnover ratio Debtors / Receivables turnover ratio Average collection period

Creditors / Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading Long Term Solvency or Leverage Ratios: Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios. Debt-to-equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage ratio Capital gearing ratio Over and under capitalization Financial-Accounting- Ratios Formulas: A collection of financial ratios formulas which can help you calculate financial ratios in a given problem. Click here Limitations of Financial Statement Analysis: Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Click here to read full article. Advantages of Financial Statement Analysis: There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.

Understanding fund or Cash Flow Statement-Format and Sections: Contents: Introduction to cash flow statement Sections of fund or cash flow statement Format of the fund or cash flow statement Introduction to cash flow statement: Three major financial statements are ordinarily required for external reportsan income statement, a balance sheet, and a statement of cash flows. The purpose of the statement of cash flow is to highlight the major activities that directly and indirectly impact cash flows and hence affect the overall cash balance. Managers focus on cash for a very good reasonwithout sufficient cash balance at the right time, a company may miss golden opportunities or may even fall into bankruptcy. The cash flow statement answers questions that cannot be answered by the income statement and a balance sheet. For example a statement of cash flows can be used to answer questions like where did the company get the cash to pay dividend of nearly $140 million in a year in which, according to income statement, it lost more than $1 billion? To answer such questions, familiarity with the statement of cash flows is required. The statement of cash flows is a valuable analytical tool for managers as well as for investors and creditors, although managers tend to be more concerned with forecasted statements of cash flows that are prepared as a part of the budgeting process. The statement of cash flows can be used to answer crucial questions such as the following: Is the company generating sufficient positive cash flows from its ongoing operations to remain viable? Will the company be able to repay its debts? Will the company be able to pay its usual dividends? Why is there a difference between net income and net cash flow for the year? To what extent will the company have to borrow money in order to make needed investments? For the statement of cash flows to be useful to managers and others, it is important that companies employ a common definition of cash. It is also important that a statement be constructed using consistent guidelines for identifying activities that are sources of cash and uses of cash. The proper definition of cash and the guidelines to use in identifying sources are discussed in coming paragraphs.

Definition of Cash: In preparing a statement of cash flows, the term cash is broadly defined to include both cash and cash equivalents. Cash equivalents consist of short term, highly liquid investments such as treasury bills, commercial paper, and money market funds that are made solely for the purpose of generating a return on temporary idle funds. Instead of simply holding cash, most companies invest their excess cash reserves in these types of interest bearing assets that can be easily converted into cash. These short term liquid investments are usually included in marketable securities on the balance sheet. Since such assets are equivalent to cash, they are included with cash in preparing a statement of cash flows

Sections of cash flow statement: The cash flow statement is usually divided into three sections: Operating, investing and financing activities. Operating Activities: Operating activities involve the cash effects of transactions that enter into the determination of net income, such as cash receipts from sales of goods and services and cash payments to suppliers and employees for acquisition of inventory and expenses Investing Activities: Investing activities generally involve long term assets and include (a) making and collecting loans (b) acquiring and disposing of investments and productive long lived assets. Financing Activities: Financing activities involve liability and stock holder's equity items and include obtaining cash from creditors and repaying the amounts borrowed and obtaining capital from owners and providing them with a return on, and a return of, their investment. Below is the typical classification of of cash receipts and payments according to operating, investing and financing activities. Operating Activities: Cash inflows: From sales of goods or services. From return on loans (interest) and on equity securities. dividends

Income Statement Items

Cash outflows: To suppliers for inventories. To employees for services. To government for taxes. To lenders for interest. To others for expenses. Investing Activities: Cash inflow: From sale of property, plant and equipment. From sale of debt or equity securities of other entities. From collection of principles on loans to other entities. Cash Outflows: To purchase property, plant and equipment. To purchase debt or equity securities of other entities. To make loans to other entities. Financing Activities: Cash inflows: From sale of equity securities. From issuance of debt ( bonds and notes ). Cash outflows: To stock holders as dividends To redeem long term debt or reacquire capital stock.

Generally Long Term Asset Items

Generally Long term Liability and Equity Items

Some cash flow relating to investing or financing activities are classified as operating activities. For example, receipts of investment income ( interest and dividend ) and payment of interest to lenders are classified as operating activities. Conversely, some cash flows relating to operating activities are classified as investing or financing activities. For example, the cash received from the sale of property plant and equipment at a gain, although reported in the income statement, is classified as an investing activity, and effects of the related gain would not be included in net cash flow from operating activities. Likewise a gain or loss on the payment of debt would generally be part of the cash out flow related to the repayment of the amount borrowed, and therefore it is financing activity. Format of the cash flow statement: The three activities discussed in preceding paragraphs constitute the general format of the statement of cash flows. The cash flows from operating activities section always appears first, followed by the investing section and then financing activities section. The individual inflows and outflows from investing and financing activities are reported separately. That is, they are reported gross, not netted against one another. Thus, cash outflows from the purchasing of property is reported separately from the cash inflow the sale of property. Similarly, the cash inflow from the issuance of debt is reported separately from the cash outflow from its retirement. The net increase or decrease in cash reported during the period should reconcile the beginning and ending cash balances as reported in the comparative balance sheets. The Skelton cash flow statement is presented as follows: This is also called cash flow statement pro forma. Company Name Cash Flow Statement Format Period Covered Cash Flows From Operating Activities: Net income Adjustment to reconcile net income to net cash provided by operating activities: (List of individual items) Net cash flows from operating activities. Cash Flows From Investing Activities: XXX XX ------XX ------XX ------XXX ------XXX XXX XXX

(List of individual inflows and outflows) Net cash provided (used) by operating activities Cash Flows from Financing Activities: (List of individual inflows and outflows) Net cash provided (used) by financing activities Net increase (decrease) in cash Cash at beginning of period Cash at the end of period Fund Flow Statement

------XXX XXX ------XXX

Fund Flow Statements summarize a firms inflow and outflow of funds. Simply put, it tells investors where funds have come from and where funds have gone. The statements are often used to determine whether companies efficiently source and utilize funds available to them. How to Prepare a Fund Flow Statement Fund flow statements are prepared by taking the balance sheets for two dates representing the coverage period. The increases and decreases must then be calculated for each item. Finally, the changes are classified under four categories: (1) Long-term sources, (2) long-term uses, (3) short-term sources, (4) short-term uses. It is also important to zero out the non-fund based adjustments in order to capture only the changes that are accompanies by flow of funds. However, income accured but received and expenses incurred but not received reckoned in the profit and loss statement should not be excluded from the profit figure for the fund flow statement. Fund flow statements can be used to identify a variety of problems in the way a company operates. For example, companies that are using shortterm money to finance long-term investments may run into liquidity problems in the future. Meanwhile, a company that is using long-term money to finance short-term investments may not be efficiently utilizing its capital. Funds Flow Statement In every concern, the funds flow in form different sources and similarly funds are invested in various sources of investment.

It is continuous process. The study and control of this funds-flow

process (i.e., the uses and sources of funds) is the main objective of financial management to assess the soundness an the solvency of the enterprise. The funds-flow-statement is a report on financial operations changes, flow or movements during the period. It is a statement which shows the sources an application of funds or it shows how the activities of a business is financed in a particulate period. In other words, such a statement shows how the financial resources have been used during a particular period of time. It is, thus, a historical statement showing sources and application of funds between the two dates designed especially to analyse the changes in the financial conditions of an enterprise. In the words of Foulke, it isA statement of Sources and Application of Funds is a technical device designed to analyse the changes in the financial condition of a business enterprises between two dates. Funds Flow Statement is not an income statement . Income statement shows the items of income and expenditure of a particular period, but the Funds flow statement is an operating statement as it summaries the financial activities for a period of time. It covers all movements that involve an actual exchange of assets. Various titles are used for this statement such as 'Statement of sources and Application of Funds', 'Summary of Financial operations,' 'Changes in Financial Position', 'Fund received and Disbursed', 'Funds Generated and Expended', Changes in Working Capital, Statement of Fund' etc. Title of Funds Flow Statement has been modified from time to time. Really it is very difficult to find a short time for such statement which carries much to the readers regarding its contents an functions. A new interpretation of the term 'funds, has now been adopted as to include assets or financial resourceful which do not flow through the working capital accounts. It seems to be the most suitable meaning fort the term 'funds' but the most commonly used interpretation of the term 'funds' is 'working capital' Sources of Funds Transactions that increase working capital are sources of funds. Some of them are:(1) Funds from Operations.

(2) Funds from issue of Share Capital. (3) Funds from Issue of Debentures, Acceptance of Public Deposits and other Long-term Loans. (4) Sale of Fixed Assets. Applications of funds: Loss from operations. Loss from operations either decreases the current assets or increases the current liabilities or in other words reduces the funds. It may either be shown as application of funds in the Funds Statement or as a reduction in sources of funds. Purchase of Fixed Assets. If any fixed asset like building, machinery, furniture or investments is purchased, it will reduce the current asset (cash) without any corresponding decrease in current liability. It is, thus, an application of funds. Purchase of asset against issue of share capital is not application of funds. (3) Repayment of loans, Redemption of Debentures or preference share capital. Any such repayment including the payment of premium on redemption of debentures or preference shares is an application of funds because it reduces the current assets. (4) Payment of Dividend. Payment of dividend (and not proposed dividend) is an application of fund if paid in cash. If bonus shares are issued, it shall not be treated application of funds. (5) Other Applications. Any loss such as embezzlement, compensation, donations etc. involving cash, is an application of fund. (6) increase in Working Capital. Increase in working capital (as per schedule of changes in working capital) represents investment in current assets hence it is an application of funds. In other words, the excess of sources over application of funds is increase in working capital.

Important two marks questions: Meaning of financial statements Mention the uses of financial statements Mention the management ratios and its uses Explain cash flow and fund flow statement What is working capital and how its to be calculated? Explain why we need common size and comparative income statements? Important 16 mark questions:
Common Size Comparative Balance Sheet December 31, 2002, and 2001 (in thousands) Common-Size Percentages 2002 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses 1,200 6,000 8,000 300 -----------Total current assets 15,500 -----------Property and equipment: Land Building and equipment 4,000 12,000 -----------Total property and equipment 16,000 -----------Total assets 31,500 ====== Liabilities and Stockholders' Equity Current liabilities: Accounts payable Accrued payable Notes payable, short term $ 5,800 900 300 -----------Total current liabilities 7,000 -----------Long term liabilities: $ 4,000 400 600 -----------5,000 -----------18.4% 2.9% 1.0% -----------22.2% -----------13.8% 1.4% 2.1% -----------17.3% -----------4,000 8,5000 -----------12,500 -----------28,970 ====== 12.7% 38.1% -----------50.8% -----------100.0% ====== 13.8% 29.3% -----------43.1% -----------100.0% ====== 2,350 4,000 10,000 120 -----------16,470 -----------3.8% 19.0% 25.4% 1.0% ----------49.2% -----------8.1% 13.8% 34.5% 0.4% -----------56.9% -----------2001 2002 2001

Bonds payable, 8%

7,500 ------------

8,000 -----------13,000 -----------2,000 6,000 1,000 -----------9,000 6,970 -----------15,970 -----------28,970 ======

23.8% -----------46.0% -----------6.3% 19.0% 3.2% -----------28.6% 25.4% -----------54.0% -----------100.0% ======

27.6% -----------44.9% -----------6.9% 20.7% 3.5% -----------31.1% 24.1% -----------55.1% -----------100.% ======

Total liabilities

14,500 ------------

Stockholders' equity: Preferred stock, $100, 6%, $100 liquidation value Common stock, $12 par Additional paid in capital 2,000 6,000 1,000 -----------Total paid in capital Retained earnings 9,000 8,000 -----------Total stockholders equity 17,000 -----------31,500 ======

UNIT III COST ELEMENTS AND MATERIAL CONTROL 9 Costing as an aid to Management - Methods of Costing - Types or Techniques of Costing - Elements of Cost - Cost Sheet - Cost Classification - Techniques of Material Control - Re-Order Level Minimum and Maximum Level - Danger Level - Average Stock Level - Economic Ordering Quantity - ABC and JIT Inventory System - Methods of Valuing Material Issues FIFO, LIFO,HIFO, Simple Average and Weighted Average. In management accounting, cost accounting establishes budget and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds. Managers use cost accounting to support decisionmaking to cut a company's costs and improve profitability. As a form of management accounting, cost accounting need not to follow standards such as GAAP, because its primary use is for internal managers, rather than outside users, and what to compute is instead decided pragmatically. Costs are measured in units of nominal currency by convention. Cost accounting can be viewed as translating the supply chain (the series of events in the production process that, in concert, result in a product) into financial values. There are various managerial accounting approaches: standardized or standard cost accounting

lean accounting activity-based costing resource consumption accounting throughput accounting marginal costing/cost-volume-profit analysis Classical cost elements are: raw materials labor indirect expenses/overhead

THE BASICS OF COSTING METHODS FIXED COSTS. One of the key issues in conventional costing methods (i.e., process costing and job-order costing) is distinguishing among types of costs. A basic distinction is made between fixed and variable costs. Fixed costs are those costs that are invariant with respect to changes in output and would accrue even if no output were produced. Such costs might include interest payments on the purchase of plant and equipment, rent, property taxes, and executive salaries. The notion of fixed costs is restricted within a certain time frame, since over the long run fixed costs can vary. For example, a manufacturer may decide to expand capacity in the face of increased demand for its product, requiring a higher level of expenditure on plant and equipment. VARIABLE COSTS. Variable costs change proportionately to the level of output. For manufacturers, a key variable cost is the cost of materials. In terms of total costs at increasing output levels, fixed costs are constant and variable costs are increasing at a constant rate. In terms of unit costs at increasing output levels, fixed costs are declining, and

variable costs constant. Manufacturers are vitally interested in unit costs with respect to changes in output levels, since this determines profit per unit of output at any given price level. The characteristics of fixed and variable costs indicates that as output increases, unit costs will decline, since there is constant variable cost and lesser fixed cost embodied in each unit. These costing methods thus suggest that it is in manufacturers' interest to run, within the limits of plant design, at high capacity levels. DIRECT COSTS. Costing methods distinguish between the direct and indirect costs of any costed object. Direct costs are those costs readily traceable to the costed object, whereas indirect costs are less-readily traceable. Direct costs typically include the major components of any manufactured good and the labor directly required to produce that good. Direct costs are often subdivided into direct material costs and direct labor costs. Direct costs are also referred to as prime costs. INDIRECT COSTS. Indirect costs include plant-wide costs such as those resulting from the use of energy and fixed capital, but indirect costs may also include the costs of minor components such as solder or glue. While all costs are conceivably traceable to a costed object, the determination of whether to do so depends on the cost-effectiveness with which this can be done. Indirect costs of all kinds are sometimes referred to as overhead, and in this sense prime costs can be distinguished from overhead costs. ESTIMATING TOTAL COSTS Several methods are used in manufacturing to estimate total cost equations, in which total costs are determined as a function of fixed costs per time period, variable costs per unit of output, and the level of output. These methods include account analysis, the engineering

approach, the high-low approach, and linear regression analysis. In all these methods, the central issue is how total costs change in relation to changes in output. ACCOUNT ANALYSIS. In account analysis, all costs are classified as either strictly fixed or variable. This has the advantage of ease of computation. However, some costs may be semivariable costs or step costs. Utility bills are typically semivariable in that they contain fixed and variable components. Step costs increase in discrete jumps as the level of output increases. In account analysis, such costs are typically categorized as either fixed or variable depending which element predominates. Thus, the accuracy of account analysis depends in large part on the proportion of costs that are not strictly fixed or variable. For many manufacturing firms, account analysis provides a sufficiently accurate estimation of total costs over a range of output levels. ENGINEERING APPROACH. The engineering approach infers costs from the specifications of a product. The approach works best for determining direct material costs and less well for direct labor costs and overhead costs. The advantage of the engineering approach is that it enables manufacturers to estimate what a product would cost without having previously produced that product, whereas the other methods are based on the costs of production that has already occurred. HIGH-LOW APPROACH. In the high-low approach, a firm must know its total costs for previous high and low levels of output. Graphing total costs against output, total costs over a range of output are estimated by fitting a straight line through total cost points at high and low levels of

output. If changes in total costs can be accurately described as a linear function of output, then the slope of the line indicates changes in variable costs. The problem with the high-low approach is that the two data points may not, for whatever reasons, accurately represent the underlying total cost-output relationship. That is, if additional total cost-output points were plotted, they might lay significantly wide of the line connecting the two initial high-low points. LINEAR REGRESSION. Linear regression analysis addresses the shortcomings of the high low approach by fitting a line through all total cost-output points. The line is fitted to minimize the sum of squared differences between total cost-output points and the line itself, in standard linear regression fashion. The drawback of this approach is that it requires more data points than the other approaches. STANDARD COSTS The relation of total costs to output levels is combined in the idea of standard costs. Standard costs are estimates of unit costs at targeted output levels, including direct materials costs, direct labor costs, and indirect costs. Standard costs are used to prepare budgets for planned production and to assess production that has occurred. The estimation of standard costs requires the separate estimation of standards for direct materials, direct labor, and overhead. DIRECT MATERIALS. Direct material standards are the easiest to estimate. Costs are determined from the prices of all necessary material inputs into the product, plus sales tax, shipping, and other related costs. Unanticipated price changes complicate this otherwise straightforward process. Since standard costs are a measure of unit costs, it is also necessary to determine the quantity of materials per unit. This can be done using an engineering approach.

DIRECT LABOR. Direct labor standards are somewhat more difficult to estimate. The determination of costs must account for wages, though if workers in a production process are earning different wages, it is necessary to estimate a weighted average of wage costs. The cost of benefits, employment related taxes, and overtime pay must also be accounted for. As with direct material standards, the quantity of direct labor required to produce a unit of output can be estimated with an engineering approach. Average set-up time and downtime must also be included in the estimation. Many union contracts codify labor time standards, which can make budgeting easier. OVERHEAD. Overhead standards are the most difficult to estimate, and they are typically accounted for in an approximate manner. The problem of accounting for overhead costs per unit of output was noted aboveit is often difficult to trace indirect costs to a particular product. The problem is made more complicated if these costs are highly centralized within a plant and if multiple products are produced within a plant. Overhead standards are typically estimated by taking total overhead costs and relating them to a more readilyknowable measure, such as direct labor hours, direct labor costs, or machine hours used. Direct labor hours was traditionally the most widely-used measure for determining overhead standards, but the growth of automated plants resulted in a shift to machine hours used. DETERMINING PROFITABILITY THROUGH CVP ANALYSIS Cost equations are combined with revenue equations to determine profitability at different levels of output. This is referred to as costvolume-profit(CVP) analysis. That is, net income equals total

revenue minus total cost; total cost, as noted above, equals average variable cost times the quantity of output plus fixed cost; and total revenue equals price times the quantity of output sold. Combining cost and revenue equations reveals that net income equals price times quantity of output sold minus average variable cost times the quantity of output minus fixed costs. That is, where P = price, Q = quantity of output, AVC = average variable cost FC = fixed costs This is referred to as the cost-volume-profit equation, and is one of the most widely-used of cost accounting tools. CVP analysis allows a firm to determine a breakeven point, the level of output at which total revenue equals total cost. That total cost and total revenue functions will be equal at some nonzero level of output is assured by the fact that at zero units of output, total costs will be positive as a result of fixed costs and total revenues will be zero. This is based on the assumption that the unit price for which a product can be sold is greater than the unit cost, so that total revenue increases faster than total cost as output increases. In addition to estimating profitability across a range of output levels, firms use CVP analysis to determine whether projected sales are sufficiently beyond the breakeven point to warrant production. Economic theory also concerns itself with changing costs as a function of changing output within a given plant. This is an analog to the slope of an accountant's cost function curve and is referred to as marginal cost. In his essay, "Economic Concepts in Cost Accounting," Shillinglaw describes the relationship between mainstream economic theory and cost accounting as follows: "Cost accounting springs mainly from the needs of managers and others to

make decisions affecting the allocation of economic resources. This might suggest that cost accounting is based directly on a fairly welldefined set of concepts drawn from economic theory. The truth is something else. The uneasy and ambiguous relationship between cost accounting and economics is nowhere more apparent than in the application of the concept of short-run marginal cost." In mainstream economic theory, marginal costs are generally assumed to be decreasing at lower levels of output, more or less flat over medium levels, and increasing at an accelerating rate at higher levels. As noted above, cost accountants generally base their calculations on the assumption that costs change at a constant rate with respect to output. FUTURE OF COST ACCOUNTING EXPANSION AND INTEGRATION OF ABC. Widespread corporate interest in activity-based costing (ABC), which started in the late 1980s and has continued through the late 1990s, has created dueling cost accounting systems for some companies. Managers want the analytic power of an ABC system, yet may also require some of the conventional abilities and rigor of a traditional system like process or job costing. The failure to integrate these competing needs has caused some firms to abandon or at least reconsider ABC initiatives, which can be expensive and time-consuming to implement in a large operation. Some managers have viewed it as an either-or dilemma, and often ABC is eyed with some suspicion, as indeed early formulations of it were not effective substitutes for conventional costing methods. However, many successful ABC implementations use it as a supplement to, rather than a replacement for, standard methods. Advocates of ABC have begun to formulate ways in which ABC can be better integrated with conventional methods so that companies can enjoy the benefits of both. In 1999 the Institute of Management Accountants (IMA), the

leading professional organization for managerial accountants, published renewed guidelines for companies wishing to implement ABC practices, following a series of previous statements on using ABC dating back to the early 1990s. The IMA's statements included a number of cautions against potential pitfalls in establishing an ABC system. TARGET COSTING. A related practice that has also enjoyed quite a bit of attention since the mid-1990s is target costing, which is a method of engineering a product and its manufacturing process from the start with a specific cost model in mind. This approach, which is essentially an elaboration of the engineering costing approach, attempts to create an optimally efficient process from the startwith a profitable yet marketable selling price in mindrather than waiting until a product is already being manufactured and then setting prices and looking for cost savings. Some implementations of target costing actually don't involve accountants as much as they invlolve product marketing managers, engineers, and others who are part of the actual design and production processes. IMA guidelines also exist for target costing systems Materials and Inventory Cost Control: Materials control is the system that ensures the provision of the required quantity and quality at the required time with in the minimum of investment. It covers the following functions: Stock control Scheduling of requirements Purchasing Receiving and inspecting Storing and issuing

Need for Materials Control:

One of the first step in the installation of cost and management accounting system is planning the proper control of materials and supplies from the time orders are placed with supplier until they have been consumed in the plant and office operation or have been sold as merchandise. Requirements of a System of Materials control: There are many requirements to implement an adequate satisfactory system of materials control. Stock Control: The materials purchased by a concern may be classified as stock items which are taken into store and held until required, or as direct deliveries to the point of consumption. The control of those materials which are stock items is known as stock control. Inventory Quantity Standards: Ordering Level or Ordering Point or Re-order Level: This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. Minimum Level or Minimum Limit: The minimum level or minimum stock is that level of stock below which stock should not be allowed to fall. Maximum Level or Maximum Limit: The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. Danger Level: Some enterprise also calculate danger level. When this level of stock is reached, then emergency steps are taken by the management to acquire material supplies. Economic Order Quantity EOQ: Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost ABC analysis ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control.

ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost,while also providing a mechanism for identifying different categories of stock that will require different management and controls. When carrying out an ABC analysis, inventory items are valued (item cost multiplied by quantity issued/consumed in period) with the results then ranked. The results are then grouped typically into three band. These bands are called ABC codes. ABC codes "A class" inventory will typically contain items that account for 80% of total value, or 20% of total items. "B class" inventory will have around 15% of total value, or 30% of total items. "C class" inventory will account for the remaining 5%, or 50% of total items. ABC Analysis is similar to the Pareto principle in that the "A class" group will typically account for a large proportion of the overall value but a small percentage of the overall volume of inventory. Another recommended breakdown of ABC classes: "A" approximately 10% of items or 66.6% of value "B" approximately 20% of items or 23.3% of value "C" approximately 70% of items or 10.1% of value Just-in-time (business)

Just-in-time (JIT) is an inventory strategy that strives to improve a business's return on investment by reducing in-process inventory and associated carrying costs. Just In Time production method is also called the Toyota Production System. To meet JIT objectives, the process relies on signals or Kanban ( Kanban) between different points in the process, which tell production when to make the next part. Kanban are usually 'tickets' but can be simple visual signals, such as the presence or absence of a part on a shelf. Implemented correctly, JIT can improve a manufacturing organization's return on investment, quality, and efficiency. Quick notice that stock depletion requires personnel to order new stock is critical to the inventory reduction at the center of JIT. This saves warehouse space and costs. However, the complete mechanism for making this work is often misunderstood.

For instance, its effective application cannot be independent of other key components of a lean manufacturing system or it can "...end up with the opposite of the desired result." In recent years manufacturers have continued to try to hone forecasting methods (such as applying a trailing 13 week average as a better predictor for JIT planning,however some research demonstrates that basing JIT on the presumption of stability is inherently flawed Different methods of Stock Issue !!! One of the problems that arise in costing is the pricing of the issues. This is due to the fact that generally the goods are purchased at different lots at different points of time. When issues are made it is difficult to keep track of the issue lot and link with the purchases. Hence a method of pricing the issue has to be selected. Let us now examine different methods of pricing the issues and see one problem in this regard. A..FIFO-First in First- Out Method 1. It is based on the assumption that the materials which are purchased first are issued first. 2. Accordingly the Stock will be valued at the latest purchases. Advantages: 1. Closing stock is valued at the latest price. 2. Materials are priced at actual cost and hence no unrealized profit arises. 3. Charge to production is at the oldest price of materials. 4. Easy and Simple. Disadvantages: 1. Since the materials issued are valued at old prices the cost of

production may not reflect the latest prices. 2. Comparisons become tough. 3. Complex calculation. 4. In period of rising prices the FIFO produces higher profit and increases tax liability. B.LIFO-Last in First out Method. 1. It is based on the assumption that the materials which are purchased last are issued first. 2. Accordingly the Stock will be valued at the oldest purchases unissued. Advantages: 1. Materials charged to production are at latest cost. Hence in times of rising prices the companys product quotation will be competitive. 2. This method does not result in unrealized profit or loss like FIFO 3. Simple to operate at the time of steady prices. 4. In period of rising prices the profit and tax liability under LIFO will be lower than under FIFO as the cost of production will be valued at the lower cost (old cost). Disadvantages: 1. The physical flow is different from logical flow. 2. Closing stock will not represent the current economic value and be valued at old prices. 3. Comparison of different jobs becomes difficult.

4. Complex to operate. . C .Average cost Method: It is based on the assumption that the materials kept together lose their identity and has to be valued at average price. C1. Simple Average Method. Simple average represents the average of prices. The average prices of all the materials in stock is calculated .It does not take into account the quantities.For example if there are three different rate of products in stock say 21 , 23 , 25 then the simple average is (21+23+25)/3 =23 The simple average method operated with FIFO method. The prices of stocks issued fully as per FIFO method is not taken into account for computation. Advantages. 1. Simple Disadvantages: 1. Unscientific. 2. Results in unrealized profit and loss. D. Weighted average Method. This method takes into account the quantities. The price is calculated by dividing the total cost of material in stock calculated at actual purchase price for each lot (present in stock) by the total quantity of materials in stock.

Advantages: 1. Smoothens out the effect of fluctuations and hence useful at the time of fluctuating prices. 2. The work load is reduced as it does not necessitate the calculation of issue price at the time of each issue. 3. No unrealized profit or loss arises in this method. Disadvantages : 1. Issue price may not be at the current market price. 2. When there are several lots of purchases the work load increases. 3. Excessive high or low prices are reflected in the average even after their total consumption. E.Replacement Price Method. The issues are valued at the price at which the materials would be replaced. Advantages: 1. Simple to operate 2. Production reflects the current market price. 3. When the company has bought the goods at a cheap prices earlier in a large stock and the benefit need not be passed on to the customer ,then this method will reflect profit as the production will reflect the current prices . Disadvantages: 1. The stock valuation is not at the current prices. 2. Unrealised profit or loss will arise.

3. It involves finding the replacement price at each issue and hence a little difficult to operate. F.Standard Price Method. Under this method the prices are issued at standard prices. Standard prices are fixed for a definite period. In the time of fluctuating prices the standard prices has to be fixed for short term period and changed constantly. Receipts will be at actual cost of purchase only. The difference between the standard and actual prices is transferred to Material Price variance account. Standard price is a notional price and not actual price .It is fixed taking into several factors liked Market condition, fluctuation in prices, trends, discounts etc. This method can be used in connection with standard costing system or without standard costing system. Advantages: 1 .No cumbersome calculations at the time of each issue. 2. When standards are fixed correctly it makes the task simple. Disadvantages. 1. It results variance in profit. 2. If not fixed correctly it can affect the valuation of stock and cost of production. G.Highest in First _Out (HIFO) Method. The materials are issued at the highest price of material in stores. Once the highest price material in stock is exhausted the next highest price will be used.

Advantages : 1. Production is at the high cost of production and during fluctuating prices the highest cost is recovered first . 2. Inventory value is kept low and results in secret reserve. 3. Used in cost plus contracts. Disadvantage 1. Results in secret reserve. 2. Unrealised profit or loss arises. 3. Production is not valued at current prices. H.Next in-First-out (NIFO) method. This is more similar to replacement price method except that the issues are priced at the price at which an order (purchase order) has been placed and will be received next in store. Advantages : 1. Production reflects the current market trend. Disadvantages : 1. It results in unrealized profit or loss. I .Specific price or Identifiable cost method. When materials are purchased and set aside for a specific job order then issue of that material should be at the price at which (the specific price) it has been purchased. Other issues can be at FIFO, LIFO or other methods. Advantages : 1. The job is costed at the actual material puchase cost.

2. Useful for Job costing . Disadvantages : 1. The material should be carried separately till it is issued fully.

J. Base Stock Method. This method assumes that a minimum base stock is always held in stock and is not issued. This is considered as a fixed cost and carried at original cost. The quantities in excess of base stock are valued by using FIFO or LIFO etc. Advantages 1. Simplification of valuation of inventory as the base stock values is fixed. 2. Merits of other methods (FIFO, LIFO Etc) of valuation which is used along with this will be reflected here. Disadvantages 1. It is not an independent method. 2. This is rarely used. 3. Demerits of other valuing methods that is used along with this method will be reflected here. UNIT IV COST ACCOUNTING SYSTEMS Job Order Costing - Batch Costing - Contract Costing - Process Costing - Activity Based Costing -Target Costing. Definition and Explanation of Job Order Costing System: A job order costing system is used in situations where many different products are produced each period. For example clothing factory would typically made many different types of jeans for both men and women during a month. In a job order

costing system, costs are traced to the jobs and then the costs of the job are divided by the number of units in the job to arrive at an average cost per unit. Job order costing system is also extensively used in service industries. Hospitals, law firms, movie studios, accounting firms, advertising agencies and repair shops all use a variety of job order costing system to accumulate costs for accounting and billing purposes. The details here deal with a manufacturing firm, the same concept and procedures are used by many service organizations. The record keeping and cost assignment problems are more complex in a job order costing system when a company sells many different products and services than when it has only a single product or service. Since the products are different, the costs are typically different. Consequently, cost records must be maintained for each distinct product or job. For example an attorney in a large criminal law practice would ordinarily keep separate records of the costs of advising and defending each of her clients. And a clothing factory would keep separate track of the costs of filling orders for particular styles, sizes, and colors of jeans. A job order costing system requires more effort than a process costing system. Companies classify manufacturing costs into three broad categories:(1) direct materials, (2) direct labor, (3) manufacturing overhead. (See manufacturing and nonmanufacturing costs page) As we study the operation of a job costing system, we will see how each of these three types of costs is recorded and accumulated. Measuring Direct Materials Cost in Job Order Costing System: At the beginning of production process a document known as "bill of materials" is used for standard products. A bill of materials is a document that lists the type and quantity of each item of materials needed to complete a unit of standard product. In case where it is not possible to use a bill of materials because the product is not a standard product the production staff determines the materials requirements from the blueprints submitted by the customer. Click here to read full Article. Measuring Direct Labor Cost in Job Order Costing System: Direct labor cost is handled in much the same way as direct materials cost. Direct labor consists of labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced directly to any job are treated as part of manufacturing overhead. The later category of labor cost is

known as indirect labor and includes tasks such as maintenance, supervision, and cleanup. Workers use time tickets to record the time they spend on each job and task. At the end of the day, the time tickets are gathered and accounting department enters the direct labor hours and costs on individual job cost sheets. Click here to read full Article Application of Manufacturing Overhead: Manufacturing overhead must be included with direct labor on the job cost sheet since manufacturing overhead is also a product cost. However, assigning manufacturing overhead to units of product can be a difficult task. There are three reasons for this: Manufacturing overhead is an indirect cost. This means that it is either impossible or difficult to trace these costs to a particular product or job. Manufacturing overhead consists of many different items ranging from the grease used in machines to the annual salary of production manager. Even though output may fluctuate due to seasonal or other factors, manufacturing overhead costs tend to remain relatively constant due to the presence of fixed costs. Given these problems, about the only way to assign overhead costs to production is to use an allocation process. Click here to read full Article. Job Order Costing System--The Flow of Costs: To understand the flow of costs in job order costing system, we shall consider a single month's activity for a company, a producer of product A and product B. The company has two jobs in process during April, the first month of its fiscal year. Job 1, of 1000 units of product A was started in march. By the end of march, $30,000 in manufacturing costs had been recorded for the job 1. Job 2 an order for 10,000 units of product B was started in April. Click here to read full article. Multiple Predetermined Overhead Rates: When a single predetermined overhead rate is used for entire factory it is called plant wide overhead rate. This is fairly common practice--particularly in smaller companies. But in large companies, multiple predetermined overhead rates are often used. Click here to read full article Problems of Overhead Application:

We need to consider two complications relating to overhead application. These are: Under-applied overhead and over-applied overhead calculation. Disposition of any balance remaining in the manufacturing overhead account at the end of a period. Predetermined Overhead Rate and Capacity: Companies typically base their predetermined overhead rates on the estimated, or budgeted, amount of allocation base for the upcoming period. This is the method that is used in the chapter, but it is practice that is recently come under severe criticism. Click here to read full article. Recording Non-manufacturing Costs: In addition to manufacturing costs, companies also incur marketing and selling costs. These costs should be treated as period expenses and charged directly to the income statement and therefore should not go into the the manufacturing overhead account. Click here to read full Article. Recording Cost of Goods Manufactured and Sold: When a job has been completed, the finished out put is transferred from the production department to the finished goods. warehouse. By this time, the accounting department will have charged the job with direct materials and direct labor cost and manufacturing overhead will have been applied using the predetermined overhead rate. Click here to read full article. Job Order Costing in Services Companies: Job order costing is also used in service organizations such as law firms, movie studios, hospitals, and repair shops, as well as manufacturing companies. In a law firm, for example, each client represents a "job," and the costs of that job are accumulated day by day on a job cost sheet as the client's case is handled by the firm. Click here to read full article. Use of Information Technology in Job Order Costing: Bar code technology can be used to record labor time--reducing the drudgery in that task and increasing accuracy. Bar codes also have many other uses. In a company with a welldeveloped bar code system, the manufacturing cycle begins with the receipt of a customer's order in electronic form.: Advantages and Disadvantages of Job Order Costing System:

One of the primary advantages of job order costing system is that the management team has ready access to all the costs incurred for each job being completed. This allows the team to examine each cost incurred, finding out why it happened, and determine how it can be controlled better in the future, thereby contributing to better ongoing levels of profitability. For example, a proper job record contains any special reworking costs, which a manager can then use to trace back to the specific reason why the rework was needed. Similarly, overhead allocations based on machine usage reveal problems with excess use, which might be the result of lengthy machine setups or break downs as well as longer than expected machine cycle times. Another reason for using job order costing system is that it yields ongoing results for each job. In today's world of fully computerized production tracking data bases, one can use a job order costing system to track costs as they are added rather than waiting until the job has been completed. This gives a company several advantages. One is that the accounting staff can monitor job accounts to see if costs are being posted to the wrong accounts and correct them right away, rather than waiting until the job closes and having to frantically review records to see why the results are different from expectations. Another advantage is that a company can monitor the costs incurred for longer jobs and have enough time to make changes before they close, based on the costing information revealed by the job costing system. For example, a lengthy new product development project might be over budget after just 25% of the work has been completed; If the management team is made aware of this costing problem early in the project, it will still have 75% of the project in which to make corrections and bring costs back down to budgeted levels. Yet a third advantages is that changes in the cost of a job can result in negotiations with cost-plus customers who are paying for all the costs incurred, so that they are fully aware of cost overruns well in advance and are prepared to pay the additional amounts. All these factors are the main advantages of using job order costing system in a computerized environment. There are also several problems with job order costing system. One is that it focuses attention primarily on products rather than on departments or activities. This is not an issue if there are supplemental systems in place that record information about these other cost categories, but it leaves management

with inadequate information if this is not the case. An other difficulty is that overhead is generally allocated based on rates that are changed only about once a year. Considerable fluctuation in overhead costs over the course of a year can result both in over and under allocation of overhead costs to jobs during that period. Another problem is specific to the use of normal costing. This practice involves the use of standards overhead rate rather than one that is based on actual costs and requires adjustment from time to time. If it is management's intention to charge individual jobs for the variance between standard and actual overhead rates, this may not be possible if some jobs have already been closed by the time the variance allocation takes place. This is not just a technical accounting issue, for some jobs are fully reimbursed by customers who pay on a cost plus basis; if the overhead variance is a positive one, a company may not be able to charge its customers for the added costs if the related job have already been closed. Another issue is that job costing has little relevance in some environments. For example, the soft ware industry have high development costs but almost zero direct costs associated with the sale of its products. The use of a job order costing system to records these costs makes little sense if the associated costs represent only a few percent of the total revenue gained from each one. The same problem arises in service industries, such as retailing, where there is no discernible product. These situations limit the most effective use of job order costing system to two areas--production and professionals services. The first case, production is an obvious use for the concept since there are high material costs that can be specifically identified with a job. The same is true of professional services, but here the main cost is direct labor rather than direct materials. In most other cases job costing does not provide management with sufficient quantity of information to be useful. The most important problem with job order costing is that it requires a major amount of data entry and data accuracy in order to yield effective results. Data related to materials, labor, overhead, indirect labor, scrap, spoilage, and supplies must be entered into system capable of accurately assigning these costs to the correct jobs every time. In reality such systems are rife with mistakes due to the sheer volume of data transactions, keying errors, misidentification of jobs, and the like. Problems can be resolved with a sufficient amount of error tracing by the

accounting staff, but there may be so many that there are not enough staff members to keep up with them. Though these issues can to some degree be resolved through the use of computerized data entry system outweighs the benefits to be gained from it. A final issue is that a large proportion of the costs assigned to a job, frequently more 50%, comes from allocated overhead. When there is no fully proven method for accurately allocating overhead, such as through an activity based costing system the results of the allocation yield meaningless information. This has been a particular problems for the companies that persist in allocating overhead costs based on the direct labor used by each job, Since a small amount of labor is generally being used to allocate a much larger amount of overhead, resulting in large shifts in overhead allocations based on small amount of labor is generally being used to allocate a much larger amount of overhead, resulting in large shifts in overhead allocations based on small changes in labor costs. Some companies avoid this problem by ignoring overhead for job order costing purposes or by reducing overhead cost pools to include only overhead directly traceable at the job level. In this way, many costs are not allocated to jobs at all, but those that are allocated are fully justifiable. Clearly, one must weigh the pros and cons of using a job order costing system to see if the benefits outweigh the costs. This system is a complex one that is prone to error, but it does yield good information about production-specific costs. Batch Level Activities Definition: Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch. The amount of resource consumed depends on the number of batches run rather than on the number of units in the batch.

Meaning of Contract Costing

Contract costing is that method of costing in cost accounting which is used to collect and identify all the expenses relating to

a specific contract. For this purpose, Contractor has to maintain contract ledger in which he has to show contract account.

Contract here means an agreement to complete construction of building or any other engineering work which need many days, months or years to complete.

Contract Account

Contact account is that account who shows all the expenses in its debit side. Credit side of this account, we show value contract price or work certified value. Difference between debit and credit side of will show notional profit or loss.

Following are main Contract Expenses and Costs which shows in Contract Account under Contract Costing :-

1. Material Cost

Material or raw material which is used for construction is the main expense or contract cost and it will be debited in contract account. It is supplied from store or purchased from market directly. If material is transferred from any other contract, then its cost will be adjusted on the basis of material transfer note.

2. Labor Cost

On the basis of wages analysis sheet, labor cost is calculated for a specific contract order. If same labourer is used more than one contract, then time devoted to each contract is calculated and on this basis, labor cost is allocated.

3. Direct Expenses

We also add direct expenses, if any.

4. Overheads

Overheads can be allocated on the basis of some % on cost of material, wages or prime cost or MHR or LHR.

5. Sub- Contract Cost

It will also include in contract cost, if to complete subconstruction for main construction.

6. Cost of Extra Work. Importance of Contract Costing

Contract costing is important because with this method, we can calculate cost of big jobs. If we do n't know contract costing and calculating of profit under this method, we will use job costing method and result will not be awesome because many items like value of work certified, notional profit, contract price are not used in job costing. So, it is better for us to learn all things which is in contract costing. Sub-contract: The contractor may entrust certain types of specialized work such as electrical, plumbing, painting, carpentry, special flooring, etc. to a subcontractor. The sub-contractor is responsible to the main contractor in terms of performing the work and he will get the payment from the main contractor. The cost of such sub-contract is debited to contract account. Retention Money: Usually the contractee stipulates in the contract deed that he would withhold a part of the contract price to be paid at a later stage after completion of the contract. This is to make sure that the contractor has performed all work relating to contract on the most satisfactory manner and that no repair work arises within a prescribed time limit. The amount so withheld by the contractee is known as retention money. It safeguards the interest of the contractee against the contractor, who may at time perform sub-standard work and gain therefrom. Escalation Clause: Sometimes, owing to fluctuation in the prices of materials and labour costs, the contract price is altered so that neither party suffers the loss arising out of the change in price level. To protect his interest against the rise in prices, the contractor inserts a clause known as the 'escalation clause', under which, the contractee will be obliged to pay the enhanced price of the contract because of increase in the rates of materials, labour and other expenses. Similarly, to protect the interest of the contractee against the fall in the rates of materials, labour and overheads, a 'descalation clause' is inserted. However, it is to be noted that the terms and conditions under which the contract price is to be altered is to be specifically mentioned. The reasons which give rise to change in price level is to be stipulated. There should be no ambiguity in the wordings of this clause. The essentials of the escalation clause are as follows: (a) The elements of costs on the basis of which quotation price is submitted must be specified. (b) The elements in relation to which escalation clause applies should be specified. (c) The escalation clause should apply to only those factors which are beyond the control of contractor.

(d) The escalation clause should mention the date from which the rise in price of the contract comes into effect. (e) The records of the contractor is to be made available to the contractee for inspection. (f) The provision for alteration of contract price must relate only to change in design, or any major alteration of the work but not on account of defective work. Cost-plus Contract It is a modified method of contract costing. This method of costing is resorted to when it is not possible to determine the cost of the contract in advance with a reasonable degree of accuracy. Under such circumstance, the contractee agrees to pay to the contractor, the actual cost incurred together with an agreed amount of profit which the contractor earns in the usual course of business. This type of contract is mostly followed during the period of urgency when certain types of products are to be manufactured and supplied as in the case of defence products, component parts and so on. Work Certified and Work Uncertified Work certified represents that portion of the contract that has been duly approved by the architect of the contractee. This is denoted in terms of money value in contract account and appears on the credit side of the contract account. Work uncertified refers to that portion of work completed by the contractor but disapproved by the architect on the ground that it has not reached a stipulated stage. The value of work uncertified also appears on the credit side of the contract account. Profit on Uncompleted Contract As regards profit on a completed contract, it may be safely taken to profit and loss account. This is so because it is the actual profit earned on a contract which is taken for granted to be the profit earned on a completed contract. But in case of incomplete contract the profit made on it cannot be taken to be the actual profit. Since the completion of contract in the subsequent years may be subjected to risk of loss, a prudent contractor will not consider the profit on incomplete contract to be the actual profit. Instead, it is treated as notional profit and necessary provision is made in anticipation of probable losses. The question is what percentage of notional profit is to be transferred to profit and loss account on an incomplete contract in an accounting year. There are no hard and fast rules laid down to calculate a proportionate amount of profit to be taken into profit and loss account. However, the following rules are followed in practice as laid down by contractors of yester years. (a) When the work completed is less than 25 per cent of the contract : Under this situation no profit is transferred to profit and loss account. The entire amount of profit is carried forward in the form of reserve. (b) When the work completed is more than 25 per cent but less than 50 per cent : In this case of the notional profit is transferred to profit and loss

account and the balance is carried forward in the form of reserve. The following formula is used : x Notional profit x Cash received/Work certified (c) When the amount of work completed is more than 50 per cent but not nearing a stage of completion : Under such situation of notional profit is transferred to profit and loss account and the balance to work-in-progress account. (d) When the contract is nearing the stage of completion : In this case, the cost of completing the contract is estimated. Then the estimated profit is calculated by deducting the total estimated cost from the contract price. For calculating the profit to be taken to profit and loss account, the following formula is adopted : Estimated profit x Work certified/Contract price Contractee's Account The contractee's account is prepared by the contractor in his books. When the various instalments of contract price is received from the contractee, the following entry is passed : Cash a/c To contractee's a/c Dr.

When the contract account is fully completed, the following entry is passed : Contractee's a/c Dr. To contract a/c Thus it is clear that the contractee's account will show a debit balance indicating the amount due from him to the contractor till it is paid fully. Definition and Explanation: Cost accumulation procedures used by manufacturing concerns are classified as either job order costing or process costing. The Job Order Costing System chapter deals with the procedures applicable to job order costing. It is important to understand that, except for some modifications, the accumulation of materials costs, labor costs, and factory overhead also applies to process costing system. Process costing method is used for industries producing chemicals, petroleum, textiles, steel, rubber, cement, flour, pharmaceuticals, shoes, plastics, sugar, and coal. Process costing system is also used by firms manufacturing items such as rivets, screws, bolts, and small electrical parts. A third type of industry using process costing system is the assembly type industry which manufactures such things as typewriters,

automobiles, airplanes, and household electric appliances (washing machines, refrigerators, toasters, irons, radios, television sets, etc.). Finally certain service industries, such as gas, water, and heat, cost their products by using process costing system. Thus, process costing is used when products are manufactured under conditions of continuous processing or under mass production methods. In fact, process costing procedures are often termed "continuous or mass production cost accounting procedures". The type of manufacturing operations performed determines the cost procedures that must be used. For example, a company manufactures custom machinery will use job order costing, whereas a chemical company will use process costing. In the case of machinery manufacturer, a job order cost sheet is prepared for each order, accumulating the costs of materials, labor, and factory overhead. In contrast the chemical company cannot identify materials, labor, and factory overhead with each order, since each order is part of a batch or a continuous process. The individual order identity is lost, and the cost of a completed unit must be computed by dividing total cost incurred during a period by total units completed. The summarization of the costs takes place via the cost of production report, which is an extremely efficient, economical, and timesaving device for the collection of large amounts of data. The entire process costing discussion is presented in this chapter and other two chapters (Process Costing System Addition of Materials, Average and FIFO Costing and By-Products and Joint Products Costing). This chapter considers the (1) cost of production report, (2) calculation of departmental unit costs, (3) costing of work in process, (4) computations of costs transferred to other departments or to the finished goods storeroom, and (5) effect of lost units on unit costs. Chapter Process Costing System - Addition of Materials, Average and FIFO Costing deals with (1) special problems involved in adding materials in departments other than the first, (2) problems connected with the beginning work in process, and (3) the possibility of using costing methods. Chapter By-Products and Joint Products Costing discusses the costing of by-products and joint products. Characteristics and Procedures of Process Costing System: The characteristics of process costing system: A cost of production report is used to collect, summarize and compute total and unit costs.

Production is accumulated and reported by departments.. Costing By Departments: The nature of manufacturing operations in firms using process or job order cost procedures is usually such that work on product takes place in several departments. Product Flow: A product can flow through a factory in numerous ways. Three product flow formats associated with process costing sequential, parallel, and selective. Click here to read full article. Procedure for Materials, Labor and Factory Overhead Costs in a Process Costing System: In process costing, materials, labor, and factory overhead costs are accumulated in the usual accounts, using normal cost accounting procedures. Costs are then analyzed by departments or processes and charged to departments by appropriate journal entries. Cost of Production Report (CPR): A departmental cost of production report (CPR) shows all costs chargeable to a department. It is not only the source for summary journal entries at the end of the month but also a most convenient vehicle for presenting and disposing of costs accumulated during the month. Definition and Explanation of Activity Based Costing System: Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore "fixed cost". Click here to read full article Treatment of Manufacturing, Non-manufacturing and Idle Capacity Costs Under Activity Based Costing System: In traditional cost accounting system, only manufacturing costs are assigned to products. Selling, general, and administrative expenses are treated as period costs and are not assigned to products. How ever, many of these non-manufacturing costs are also part of the costs of the producing, selling, distributing, and servicing products. Click here to read full article Activity Based Costing And Top Management: Experts agree on several essential characteristics of any successful implementation of activity based costing. First, the initiative to implement activity based costing must be strongly

supported by top management. Second, the design and implementation of activity based costing system should be the responsibility of cross functional team rather than of the accounting department. Click here to read full article Activity Based Costing System and External Reports: Since activity based costing generally provides more accurate product costs than traditional costing methods, why isn't it used for external reports? Some companies do use activity based costing in their external reports, but most do not. Click here to read full article Designing and Implementing Activity Based Costing System: For designing and implementing activity based costing system, management should carefully study the existing cost accounting system and review the articles in professionals and trade journals. In most of the organizations, the new activity based costing system supplement, rather than replace, the existing cost accounting system, which continues to be used for external financial reports. Targeting Process Improvements (Activity Based Costing + Activity Based Management) Activity based costing can be used to identify areas that would benefit from process improvements. Indeed, managers often cite this as the major benefit of activity based costing. Activity based management (ABM) is used in conjunction with the activity based costing to improve processes and reduce costs. Click here to read full article. Advantages or Benefits | Disadvantages or Limitations of Activity Based Costing System: Activity based costing system help managers manage overhead and understand profitability of products and customers and therefore is a powerful tool for decision making. However activity based costing is not without limitations Advantages of Activity Based Costing System: Activity based costing system has the following main advantages / benefits: More accurate costing of products/services, customers, SKUs, distribution channels. Better understanding overhead. Easier to understand for everyone.

Utilizes unit cost rather than just total cost. Integrates well with Six Sigma and other continuous improvement programs. Makes visible waste and non-value added activities. Supports performance management and scorecards Enables costing of processes, supply chains, and value streams Activity Based Costing mirrors way work is done Facilitates benchmarking Disadvantages or Limitations of Activity Based Costing System: Activity based costing system help managers manage overhead and understand profitability of products and customers and therefore is a powerful tool for decision making. However activity based costing has a number of limitations or disadvantages. These limitations or disadvantages are briefly discussed below: Implementing an ABC system is a major project that requires substantial resources. Once implemented an activity based costing system is costly to maintain. Data concerning numerous activity measures must be collected , checked, and entered into the system. ABC produces numbers such as product margins, that are odds with the numbers produced by traditional costing systems. But managers are accustomed to using traditional costing systems to run theirs operations and traditional costing systems are often used in performance evaluations. Activity based costing data can be easily misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant. Before making any significant decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand. Reports generated by this systems do not conform to generally accepted accounting principles (GAAP). Consequently, an organization involved in activity based costing should have two cost systems - one for internal use and one for preparing external reports.

Definition, Explanation and Formula of Target Costing: Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. A number of companies-primarily in Japan--use target costing, including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC, and Toyota etc. The target costing for a product is calculated by starting with the product's anticipated selling price and then deducting the desired profit. Following formula or equation further explains this concept: [Target Cost = Anticipated selling price Desired profit] The product development team is then given the responsibility of designing the product so that it can be made for no more than the target cost. Following set of activities further explains the concept of target costing technique: TARGET COSTING PROCESS DIAGRAM Determine Customer Wants and Price Sensitivity Planned Selling Price is Set Target Cost is Determined As: Selling Price Less Desired Profit Teams of Employees from Various Areas and Trusted Vendors Simultaneously Determine Manufacturing Process Determine Necessary Raw Materials

Design Product

Costs are Considered Throughout this Process. The Process Requires Trade-offs to Meet Target Costs Once Target Cost is Achieved the Manufacturing Begins and Product is Sold Reasons for Using Target Costing Technique: The target costing approach was developed in recognition of two important characteristics of markets and costs. The first is that many companies have less control over price than they would like to think. The market (i.e., supply and demand) really determines prices, and a company that attempts to ignore this does so at its peril. Therefore, the anticipated market price is taken as a given in target costing. The second observation is that most of the cost of a product is determined in the design stage. Once a product has been designed and has gone into production, not much can be done to significantly reduce its cost. Most of the opportunities to reduce cost come from designing the product so that it is simple to make, uses inexpensive parts, and is robust and reliable. If the company has little control over market price and little control over cost once the product has gone into production, then it follows that the major opportunities for affecting profit come in the design stage where valuable features that customers are willing to pay for can be added and where most of the costs are really determined. So that it is where the effort is concentrated--in designing and developing the product. The difference between target costing and other approaches to product development is profound. Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained. Advantages and Disadvantages of Target Costing Approach: Target costing has the following main advantages or benefits: Proactive approach to cost management. Orients organizations towards customers. Breaks down barriers between departments. Implementation enhances employee awareness and empowerment. Foster partnerships with suppliers. Minimize non value-added activities. Encourages selection of lowest cost value added activities. Reduced time to market.

Target costing approach has the following main disadvantages or limitations: Effective implementation and use requires the development of detailed cost data. its implementation requires willingness to cooperate Requires many meetings for coordination May reduce the quality of products due to the use of cheep components which may be of inferior quality. In Business | Target Costing Approach--An Iterative Process: Target costing Technique is widely used in Japan. In the automobile industry, the target cost for a new model is decomposed into target costs for each of the elements of the car--down to a target cost for each of the individual parts. The designers draft a trial blueprint, and a check is made to see if the estimated cost of the car is within reasonable distance of the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This process continues until there is sufficient confidence in the design to make a prototype car according to the trial blueprint. If there is still a gap between the target cost and estimated cost, the design of the car will be further modified. After repeating this process a number of times, the final blueprint is drawn up and turned over to the production department. In the first several months of production, the target costs will ordinarily not be achieved due to problems in getting a new model into production. However after that initial period, target costs are compared to actual costs and discrepancies between the two are investigated with the aim of eliminating the discrepancies and achieving target costs. UNIT V COST ANALYSIS Marginal Costing and Profit Planning - Managerial Applications - Budgetary Control (Classification of Budgets)- Standard Costing Variance Analysis Direct Material Variances Direct Labour Variances - Overhead Variances and Sales Variances. Marginal costing - definition Marginal costing distinguishes between fixed costs and variable costs as convention ally classified. The marginal cost of a product is its variable cost. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads. Marginal costing is formally defined as: the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making. (Terminology.)

The term contribution mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus MARGINAL COST = VARIABLE COST DIRECT LABOUR + DIRECT MATERIAL + DIRECT EXPENSE + VARIABLE OVERHEADS CONTRIBUTION SALES - MARGINAL COST The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context. Note Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing. Theory of Marginal Costing The theory of marginal costing as set out in A report on Marginal Costing published by CIMA, London is as follows: In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost. The theory of marginal costing may, therefore, by understood in the following two steps: If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of $3,000 and if by increasing the output by one unit the cost goes up to $3,002, the marginal cost of additional output will be $.2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is $1,045, the average marginal cost per unit is $2.25. It can be described as follows: Additional cost = Additional units $ 45 = $2.25 20

The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods. For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300280). The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output. There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing. Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, 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. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales. The principles of marginal costing The principles of marginal costing are as follows. 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.

Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. 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. 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. Features of Marginal Costing The main features of marginal costing are as follows: 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. 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. 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. Advantages and Disadvantages of Marginal Costing Technique Advantages Marginal costing is simple to understand. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.

Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making. Disadvantages The separation of costs into fixed and variable is difficult and sometimes gives misleading results. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer. Presentation of Cost Data under Marginal Costing and Absorption Costing Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making. The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.

Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques: MARGINAL COSTING PRO-FORMA Sales Revenue xxxxx Less Marginal Cost of Sales Opening Stock (Valued @ marginal cost) xxxx Add Production Cost (Valued @ marginal cost) xxxx Total Production Cost xxxx Less Closing Stock (Valued @ marginal cost) (xxx) Marginal Cost of Production xxxx Add Selling, Admin & Distribution Cost xxxx Marginal Cost of Sales (xxxx) Contribution xxxxx Less Fixed Cost (xxxx) Marginal Costing Profit xxxxx ABSORPTION COSTING PRO-FORMA Sales Revenue xxxxx Less Absorption Cost of Sales Opening Stock (Valued @ absorption cost) xxxx Add Production Cost (Valued @ absorption cost) xxxx Total Production Cost xxxx Less Closing Stock (Valued @ absorption cost) (xxx) Absorption Cost of Production xxxx Add Selling, Admin & Distribution Cost xxxx Absorption Cost of Sales (xxxx) Un-Adjusted Profit xxxxx Fixed Production O/H absorbed xxxx Fixed Production O/H incurred (xxxx) (Under)/Over Absorption xxxxx Adjusted Profit xxxxx Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Marginal Costing Profit xx ADD xx (Closing stock opening Stock) x OAR = Absorption Costing Profit xx Where OAR( overhead absorption rate) = Budgeted fixed production overhead Budgeted levels of activities

Marginal Costing versus Absorption Costing After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the same because of the following reasons:

1. Over and Under Absorbed Overheads In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits. 2. Difference in Stock Valuation In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts. The profit difference due to difference in stock valuation is summarized as follows: When there is no opening and closing stocks, there will be no difference in profit. When opening and closing stocks are same, there will be no difference in profit, provided the fixed cost element in opening and closing stocks are of the same amount. When closing stock is more than opening stock, the profit under absorption costing will be higher as comparatively a greater portion of fixed cost is included in closing stock and carried over to next period. When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period. The features which distinguish marginal costing from absorption costing are as follows. In absorption costing, items of stock are costed to include a fair share of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will: include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period; exclude some fixed production overhead costs incurred in the current period by including them in closing stock values. In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.)

In absorption costing, actual fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume). In absorption costing, however, the effect on profit in a period of changes in both: production volume; and sales volume; is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit. Limitations of Absorption Costing The following are the criticisms against absorption costing: You might have observed that in absorption costing, a portion of fixed cost is carried over to the subsequent accounting period as part of closing stock. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs pertaining to the previous period and vice versa. Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per unit changes due to the existence of fixed overhead. Unless fixed overhead rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison and control. The cost to produce an extra unit is variable production cost. It is realistic to the value of closing stock items as this is a directly attributable cost. The size of total contribution varies directly with sales volume at a constant rate per unit. For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system. Summary Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all mangers, even those

who do not have preliminary knowledge and implications of the subjects of cost and management accounting. Absorption costing and marginal costing are two different techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used for managerial decision-making and control.

Applications of Marginal Costing Marginal Costing is an accounting system technique for decision making in management. To go further with this Profit Planning Evaluation of Performance Decision Making Fixation of selling prices In house make or buy decisions Selecting production with Key or limiting factor Effect of change in sales price Maintaining a desired level of profits Selection of a suitable product mix Alternative methods of production Diversification of products Accepting an additional order Dropping a product Closing down or suspending activities Alternative course of action Level of activity planning 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 excercised. Fixation of Selling Prices Under normal circumstances In times of competition In times of trade depression

In accepting additional orders for utilizing idle capacity In exporting and exploring new markets Selling Price below the Marginal Cost When a new product is introduced in the market When foreign market is to be explored to earn foreign exchange When the concern has already purchased large quantities of materials At the time of closure of business When the sales of one product at a price below the marginal cost will push up the sales of other profitable products When employees cannot be retrenched When the goods are perishable nature In house make or buy decisions In some cases, in spite of lower variable cost of production, there may be an increase in the fixed costs. It becomes essential to find out the minimum requirements of volume in order to justify the making instead of buying. The formula is Increase in Fixed Costs -----------------------------------------------------------------------------------------------------Contribution per Unit (i.e. Purchase Price Variable Cost of Production) Selecting production with Key Factor 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. 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 be that contribution per unit will be reduced. Selection of Suitable Product Mix When a company manufactures more than one product, a question may arise as to which product mix will give the maximum profits. 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 effect of sales mix can also be seen by comparing the P/V ratio and breakeven point. The new sales mix will be favorable if it increases the P/V ratio and reduces the breakeven point. Alternative Methods of Production The method which gives the greatest contribution is to be adopted keeping the limiting factor in view. 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. Closing down or suspending activities The decision to close down or suspend its activities will depend whether products are making contribution towards fixed costs or not. ie. 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.
Fixed costs may be general or specific

General fixed costs may nor may not remain constant while specific costs will be directly affected by closing down of the operations. Besides, obsolescence if any, retaining the customers, relationship with the suppliers, non-collection of dues from customers or interest on overdraft for closing down the operations must be taken into consideration. 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. Level of activity planning Maximum contribution at a particular level of activity will show the position of maximum profitability
Definition and Explanation of Profit Planning and Budgeting: Profit planning: Profit planning can be defined as the set of steps that are taken by firms to achieve the desired level of profit. Planning is accomplished through the preparation of a number of budgets, which, when brought through, from an integrated business plan known as master budget. The master budget is an essential management tool that communicates management's plan throughout the organization, allocates resources, and coordinates activities. Budgeting: A budget is a detailed plan for acquiring and using financial and other resources over a specified period of time. It represents a plan for the future expressed in formal quantitative terms. The act of preparing a budget is called budgeting. The use of budgeting to control a firm's activities is called budgetary control. Master budget is a summary of a company's plan that sets specific targets for sales, production, distribution, and financing activities. It generally culminates in cash budget, a budgeted income statement, and a budgeted balance sheet. In short, it represents a comprehensive expression of management's plans for the future and how these plans are to be accomplished. Difference Between Planning and Control: The term planning and control are often confused, and occasionally these terms are used in such a way as to suggest that they mean the same thing. Actually, planning and control are two quite different concepts. Planning involves developing objects and preparing various budgets to achieve those budgets. Control involves the steps taken by management to increase the likelihood that the objectives set down at the

planning stage are attained and that all parts of the organization are working together toward that goal. To be completely effective, a good budgeting system must provide for both planning a control. Good planning without control is time wasting. Advantages and Disadvantages of Budgeting: Companies realize many advantages / Benefits from a budgeting program. Among these benefits are the following: Budgets provide a means of communicating management's plans through the organization. Budgets force managers to think about and plan for the future. In the absence of the necessity to prepare a budget, many mangers would spend all of their time dealing with daily emergencies. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively The budgeting process can uncover many potential bottlenecks before they occur . Budgets coordinates the activities of the entire organization by integrating the plans of the various parts of the organization. Budgeting helps to ensure that everyone in the organization is pulling in the same direction. Budgets provide goals and objectives that can serve as benchmark for evaluating subsequent performance. Disadvantages / Limitations of Budgeting: Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms. Budgets can be seen as pressure devices imposed by management, thus resulting in: a) bad labor relations b) inaccurate record-keeping. Departmental conflict arises due to: a) disputes over resource allocation b) departments blaming each other if targets are not attained.

It is difficult to reconcile personal/individual and corporate goals. Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with "empire building" in order to enhance the prestige of a department. Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs. Managers may overestimate costs so that they will not be blamed in the future should they overspend. Responsibility Accounting: The concept of responsibility accounting is very important in profit planning. The basic idea behind responsibility accounting is that a manager should be responsible for those items that the managers can actually control to a significant extent. Each line item (i.e., revenue or cost) in the budget is made the responsibility of a manager, and that manager is held responsible for subsequent deviations between budgeted goals and actual results. Someone must be held responsible for each cost or else no one will be responsible, and the cost will inevitably grow out of control. Being held responsible for costs does not mean that the manager is penalized if the actual results do not measure up to the budgeted goals. However, the manager should take the initiative to correct any unfavorable discrepancies, should understand the source of significant favorable or unfavorable discrepancies, and should be prepared to explain the reasons for discrepancies to higher management. The point of an effective responsibility system is to make sure that nothing "falls through the cracks" that the organization reacts quickly and appropriately to deviations from its plans, and that the organization learns from the feedback it gets by comparing budgeted goals to actual results. The point is not to penalize individuals for missing targets. choosing a Budget Period: operating budgets ordinarily cover one year period corresponding to the company's fiscal year. Many companies divide their budget year into four quarters. The first quarter is then divided into months, and normally budgets are developed. These near term figures can often be established with considerable accuracy. The last three quarters may be carried in the budget at quarterly totals only. As the year progress, the figures of the second quarter is broken down into

monthly amounts, then the third quarter figures are broken down, and so forth. This approach has the advantage of requiring periodic review and reappraisal of budget data through out the year. Continuous or perpetual budgets are used by a significant number of organizations. A continuous or perpetual budget is a 12 month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. In other words, one month (or quarter) is added to the end of the budget as each month (or quarter) comes to a close. This approach keeps managers focus at least one year ahead. This approach keeps managers focused on the future at least one year ahead. Advocates of continuous budgets argue that with this approach there is less danger that managers will become too narrowly focused on short-term results. UNIT V COST ANALYSIS Marginal Costing and Profit Planning - Managerial Applications - Budgetary Control (Classification of Budgets)- Standard Costing Variance Analysis Direct Material Variances Direct LabourVariances - Overhead Variances and Sales Variances. Standard Costing and Variance Analysis: Learning Objectives: Explain how direct materials standard and direct labor standards are set. Compute the direct materials price and quantity variances and explain their significance. Compute the direct labor rate and efficiency variance and explain their significance. Compute the manufacturing overhead spending and efficiency variance.

In this section of the website we study management control and performance measures. Quite often, these terms carry with them negative connotations - we may have a tendency to think of performance measurement as something to be feared. And indeed, performance measurements can be used in very negative ways - to cast blame and to punish. However, that is not the way they should be used. Performance measurement serves a vital function in both personal life and in organizations. Performance measurement can provide feedback

concerning what works and what does not work, and it can help motivate people to sustain their efforts. In this section we see how various measures are used to control operations and to evaluate performance. Even though we are starting with the lowest levels in the organization, keep in mind that performance measures should be derived from the organization's overall strategy. For example, a company like Sony that bases its strategy on rapid introduction of innovative consumer products should use different performance measures than a company like Federal Express where on-time delivery, customer convenience, and low cost are key competitive advantages. Sony may want to keep close track of the percentage of revenues from products introduced within the last year; whereas Federal Express may want to closely monitor the percentage of packages delivered on time. Later in this section when we discuss the balance scorecard, we will have more to say concerning the role of strategy in the selection of performance measures. But first we will see how standard costs are used by managers to help control costs. Company in highly competitive industries like Federal Express, Southwest airlines, Dell Computer, Shell Oil, and Toyota must be able to provide high quality goods and services at low cost. If they do not, they will perish. Stated in the starkest terms, managers must obtain inputs such as raw materials and electricity at the lowest possible prices and must use them as effectively as possible - while maintaining or increasing the quality of the output. If inputs are purchased at prices that are too high or more inputs are used than is really necessary, higher costs will result. How do managers control the prices that are paid for inputs and the quantities that are used? They could examine every transaction in detail, but this obviously would be an inefficient use of management time. For many companies, the answer to this control problem lies at least partially in standard costing system. Standard Costs and Management By Exception: A standard cost is the predetermined cost of manufacturing a single unit or a number of product units during a specific period in the immediate future. It is the planned cost of a product under current and/or anticipated operating conditions. Click here to read full article. Setting Standard Costs - Ideal Versus Practical Standards:

Setting price and quantity standards requires the combined expertise of all persons who have responsibility over input prices and over effective use of inputs. In a manufacturing firm, this might include accountants, purchasing managers, engineers, production supervisors, line mangers, and production workers. Past records of purchase prices and input usage can help in setting standards. However, the standards should be designed to encourage efficient future operations, not a repetition of past inefficient operations. Direct Materials Standards and Variance Analysis: Direct Materials Price and Quantity Standards: Standard price per unit of direct materials is the price that should be paid for a single unit of materials, including allowances for quality, quantity purchased, shipping, receiving, and other such costs, net of any discounts allowed.. Direct Materials Price Variance: Direct materials price variance is the difference between the actual purchase price and standard purchase price of materials. Direct materials price variance is calculated either at the time of purchase of direct materials or at the time when the direct materials are used. Direct Materials Quantity Variance: Direct materials quantity variance or Direct materials usage variance measures the difference between the quantity of materials used in production and the quantity that should have been used according to the standard that has been set. Although the variance is concerned with the physical usage of materials, it is generally stated in dollar terms to help gauge its importance.. Direct Labor Standards and Variance Analysis: Direct Labor Rate and Efficiency Standards: Direct labor price and quantity standards are usually expressed in terms of a labor rate and labor hours. The standard rate per hour for direct labor includes not only wages earned but also fringe benefit and other labor costs. Direct Labor Rate | Price Variance: Direct Labor price variance is also termed as direct labor rate variance. This variance measures any deviation from standard

in the average hourly rate paid to direct labor workers. Click here to read full article. Direct Labor Efficiency | Usage | Quantity Variance: The quantity variance for direct labor is generally called direct labor efficiency variance or direct labor usage variance.. Manufacturing Overhead Standards and Variance Analysis: Manufacturing Overhead Standards: Procedures for the establishing and using standard factory overhead rates are similar to the methods of dealing with the estimated direct and indirect factory overhead and its application to jobs and products.. Factory Overhead Variances: Jobs or processes are charged with cost on the basis of standard hours allowed multiplied by the standard factory over head rate. The standard overhead rate or predetermined overhead rate is discussed in detail at our job order costing system page. The standard hours allowed figure is determined by multiplying the labor hours required to produce one unit (the standard labor hours per unit) times the actual number of units produced during the period. The units produced are the equivalent units of production for the departmental factory overhead cost being analyzed. At the end of the month, overhead actually incurred is compared with the expenses charged into process using the standard factory overhead rate. The difference between these figures is called the overall or net factory overhead variance. overall or net factory overhead variance needs further analysis to reveal detailed causes for the variance and to guide management toward remedial action. This analysis may be made by using (1) the two variance method, (2) the three variance method, or (3) the four variance method. The two variance method: When an overall or net factory overhead variance is further analyzed by using two variance approach, the following two variances are calculated: Controllable variance Volume variance The three variance method: When an overall or net factory overhead variance is further analyzed by using three variance approach, the following three variances are calculated:

Spending variance Idle capacity variance Efficiency variance The four variance method: When an overall or net factory overhead variance is further analyzed by using four variance approach, the following four variances are calculated: Spending variance Variable efficiency variance Fixed efficiency variance Idle capacity variance Mix and Yield Variance - Definition and Explanation: Basically, the establishment of standard product cost requires the determination of price and quantity standards. In many industries, particularly of the process type, materials mix and materials yield play significant parts in the final product cost, in cost reduction, and in profit improvement. Calculation of Mix and Yield Variances: Materials Mix and Yield Variance Labor Yield Variance Factory Overhead Yield variance Variance Analysis and Management By Exception: Variance analysis and performance reports are important elements of management by exception. Simply put, management by exception means that the manager's attention should be directed toward those parts of the organization where plans are not working out for reason or another. Managerial importance and usefulness of variance analysis: Costs of production are effected by internal factors over which management has a large degree of control. An important job of executive management is to help the members of various management levels understand that all of them are part of the management team.. Advantages and Disadvantages of Standard Costing System: The use of standard costs is a key element in a management by exception approach. If costs remain within the standards, Managers can focus on other issues.

Standard Costing Discussion Questions and Answers: Find answers of various important questions about standard costing system.. Standard Costing and Variance Analysis Formulas: A collection of variance formulas / equations which can help you calculate variances for direct materials, direct labor, and factory overhead. This is a collection of variance formulas / equations which can help you calculate variances for direct materials, direct labor, and factory overhead. Direct materials variances formulas Direct labor variances formulas Factory overhead variances formulas Direct Materials Variances: Materials purchase price variance Formula: Materials purchase price variance = (Actual quantity purchased Actual price) (Actual quantity purchased Standard price) Materials price usage variance formula Materials price usage variance = (Actual quantity used Actual price) (Actual quantity used Standard price) materials quantity / usage variance formula Materials price usage variance = (Actual quantity used Standard price) (Standard quantity allowed Standard price) Materials mix variance formula (Actual quantities at individual standard materials costs) (Actual quantities at weighted average of standard materials costs) Materials yield variance formula (Actual quantities at weighted average of standard materials costs) (Actual output quantity at standard materials cost) Direct Labor Variances: Direct labor rate / price variance formula: (Actual hours worked Actual rate) (Actual hours worked Standard rate) Direct labor efficiency / usage / quantity formula: (Actual hours worked Standard rate) (Standard hours allowed Standard rate)

Direct labor yield variance formula: (Standard hours allowed for expected output Standard labor rate) (Standard hours allowed for actual output Standard labor rate) Factory Overhead Variances: Factory overhead controllable variance formula: (Actual factory overhead) (Budgeted allowance based on standard hours allowed*) Factory overhead volume variance: (Budgeted allowance based on standard hours allowed*) (Factory overhead applied or charged to production**) Factory overhead spending variance: (Actual factory overhead) (Budgeted allowance based on actual hours worked***) Factory overhead idle capacity variance formula: (Budgeted allowance based on actual hours worked***) (Actual hours worked Standard overhead rate) Factory overhead efficiency variance formula: (Actual hours worked Standard overhead rate) (Standard hours allowed for expected output Standard overhead rate) Variable overhead efficiency variance formula: (Actual hours worked Standard variable overhead rate) (Standard hours allowed Standard variable overhead rate) Variable overhead efficiency variance formula: (Actual hours worked Fixed overhead rate) (Standard hours allowed Fixed overhead rate) Factory overhead yield variance formula: (Standard hours allowed for expected output Standard overhead rate) (Standard hours allowed for actual output Standard overhead rate)

*Fixed overhead budgeted + Standard hours allowed Standard variable overhead rate **Standard hours allowed for actual production Standard overhead rate ***Fixed overhead budgeted + Actual hours worked Standard variable overhead