Accounting for Managers/Management Accounting (Unit-4) by Dr. Abhay Singh Chauhan

Chapter 4.1
Budgetary Control
By
Dr. Abhay Singh Chauhan

Meaning of Budget
A budget is ‘ a predetermined detailed plan of action
developed and distributed as a guide to current
operations and as a partial basis for the subsequent
evaluation of performance’.
Following are the essentials of a budget:
 It is prepared in advance and is based on a future plan
of action.
 It relates to a future period and is based on objectives
to be attained.
 It is a statement expressed in monetary and/or
physical units prepared for the implementation of
policy formulated by the management.
23/27/2020 By Dr. Abhay Singh Chauhan

Budgetary Control
It is the system of management control and accounting in
which all operations are forecasted and so far as
possible planned ahead, and the actual results
compared with the forecasted and planned ones.
Thus, budgetary control involves :
 Establishment of budgets.
 Continuous comparison of actual with budgets for
target achievement and variance analysis.
 Revision of budgets in the light of changed
circumstances.
The difference between, budgets, budgeting and budgetary
control has been stated as , ‘Budgets are the
individual objectives of a department etc., where as
budgeting may be said to be the act of building
budgets. Budgetary control embraces all and in
addition includes the science of planning the budgets
themselves and the utilization of such budgets to 33/27/2020 By Dr. Abhay Singh Chauhan

Budgetary Control As A Management
Tool
Advantages of Budgetary Control :
 Brings economy in working
 Buck passing is avoided
 Established Coordination
 Decrease in Production Costs
 Adoption of Standard Costing Principles
 Guards against Undue Optimism
 Adoption of Uniform Policy
 Management by Exception
 Finds favour with Credit Agencies
 Optimum Capitalization.

Limitations of Budgetary Control
 Opposition against the very spirit of budgeting : The
opposition is due to human tendency to resist change.
Moreover, any system of budgetary control cannot be
successful unless it has the full support of the top
management.
 Budgeting and changing economy: Preparation of a
budget which gives a realistic position of the firm’s
affairs under inflationary pressures and changing
government policies is very difficult.
 Time factor : Accuracy in budgeting comes through
experience. Management must not expect too much
during the development period.
 Not a substitute for management : It is a management
tool and cannot substitute management.
 Cooperation required : Its success depends upon
willing co-operation and teamwork.

Classification of Budgets
According to time:
 Long term Budget: Designed for a long period,
generally 5 to 10 yrs. Concerned with the planning of
the operations of a firm over a considerably long
period of time.
 Short term Budget : Designed for a period generally
not exceeding 5 yrs.
 Current budgets: Cover a very short period, say a
month or a quarter. They are essentially short term
budgets adjusted to current conditions.
 Rolling Budgets: A new budget is prepared at the end
of each month or quarter for a full year ahead. The
figures for the month or quarter which has rolled down,
are dropped and the figures for the next month or

Classification of Budgets ( Contd )
According to function:
 Sales Budget:
It is a forecast of sales to be achieved in a budget
period. Factors to be considered while preparation of
sales budget include past sales figures and trends,
Salesmen’s estimates, Plant capacity, Orders in hand,
Seasonal fluctuations, Potential market etc.
 Production Budget:
Provides an estimate of the total volume of production
product-wise, with the scheduling of operations by
days, weeks and months and a forecast of the closing
finished product inventory.
 Purchase Budget:
Forecasts the quantity and value of purchases
required for production.
 Capital Expenditure Budget :
Forecasts the amount of capital that may be required
for procurement of capital assets during the budget
period.

 Cash Budget:
Forecasts the estimated amount of cash receipts and
payments and the likely cash balance in hand at the
end of different periods. A cash budget helps the
management in
i) Determining the future cash needs of the firm.
ii) Planning for financing of those needs
iii) Exercising control over cash and liquidity of the firm.
A Cash budget can be prepared in any of the
following three ways:
i. Receipts and Payments Method : Cash receipts and
payments from various sources are estimated and a
budget is prepared using the estimates.
ii. Adjusted Profit & Loss Account Method: Cash budget
is prepared on the basis of opening cash and bank 83/27/2020 By Dr. Abhay Singh Chauhan

projected profit and loss account and the balance of
various assets and liabilities.
iii. Balance Sheet Method: Under this method, at the end
of each period a projected balance sheet is drawn up
listing various assets and liabilities except cash and
bank balances. The balancing figure is taken as the
closing cash/ bank balance.
 Master Budget : It is a summary budget incorporating
all functional budgets in capsule form.

According to Flexibility:
Fixed Budget : According to CIMA London, ‘ a fixed budget
is a budget which is designed to remain unchanged
irrespective of the level of activity actually attained’.
Hence it is unrealistic yardstick incase the level of
activity actually attained does not conform to the one
assumed for budgeting purposes.
Flexible Budget : According to CIMA London, a flexible
budget is , ‘ a budget designed to change in
accordance to the level of activity actually attained’.
A flexible budget can be constructed in any of the three
ways:
 The Multi- Activity Method :Involves computing budget
figures for different levels of activity within a range.

 Formula Method: Involves preparing budgets for the
expected normal level of activity and then working out
ratios showing the relationship of each expenses or
group of expenses per unit level of activity.
 Graphic Method : Costs are classified according to
their variability – fixed, variable or semi variable.
Estimates are then made for different costs at different
levels of activity. The data are then plotted on the
graph paper showing the costs at different levels of
activity.

Performance Budgeting
 According to National Institute of Banking
Management, performance budgeting technique is ‘
the process of analyzing, identifying, simplifying and
crystallizing specific performance objectives of a job to
be achieved over a period ,in the framework of the
organizational objectives, the purpose and objectives
of the job. The technique is characterized by its
specific direction towards the business objectives of
the organization’.
 Thus, performance budgeting lays immediate stress
on the achievement of specific goals over a period of
time. However, in the long run it aims at the
continuous growth of the organization.
 It requires preparation of performance reports which
compare budget and actual data and show any
existing variances. The responsibility of preparing the
performance budget of each department lies on the
respective Departmental Head.

Control Ratios
Ratios that are commonly used by the management to find
out whether the deviations of actual from budgeted
results are favourable or otherwise.
 Activity Ratio : It is a measure of the level of activity
attained over a period of time.
Activity ratio = Standard hrs for actual production x
100
Budgeted hrs
 Capacity Ratio : Indicates whether and to what extent
budgeted hrs of activity are actually utilized.
Capacity ratio = (Actual hrs worked / Budgeted hrs) x
100
 Efficiency Ratio : Indicates the degree of efficiency
attained in production.
Efficiency ratio : Standard hrs for actual production x
100 133/27/2020 By Dr. Abhay Singh Chauhan

Zero Base Budgeting
 The traditional budgeting technique is quite
meaningless under the present dynamic conditions
where the management must review and evaluate
every task in the light of changed circumstances.
 Zero base Budgeting ( ZBB ) examines a programme
or function or responsibility from ‘scratch’. Nothing is
allowed simply because it was being done in the past.
The manager proposing the activity has, therefore, to
prove that the activity is essential and the various
amounts being asked for, are reasonable taking into
account the volume of the activity.

Zero Base Budgeting ( Contd )
Process of Zero Base Budgeting
 Determination of objectives of Budgeting : The
objective may be to effect cost reduction in staff
overheads or analyze and drop the projects which do
not fit in the organizational structure etc.
 Determination of the extent to which ZBB is to be
introduced: Whether it is to be introduced in all areas
of activities or only in a few selected areas on a trial
basis.
 Development of decision units : Decision units refer to
units regarding which a cost benefit analysis will be
done to arrive decide whether they should be allowed
to continue or not. It may be a functional department,
a programme, a product line or a sub-line.

 Development of decision packages: After identification
of decision units, the manager of each decision unit
reviews the activities of his unit and examines
alternative ways of accomplishing the objectives. He
does a cost benefit analysis and selects the best
alternative. He then prepares a decision packages
which effectively summarize his plans and the
resources required to achieve them.
 Review and ranking of decision packages: The
management ranks the decision packages in order of
increasing benefit or importance to the organization.
 Preparation of Budgets: After the choice of decision
package to be implemented is made, resources are
allocated to different decision units and budgets
relating to each unit are prepared.

Advantages of ZBB
 Provides the organization with a systematic way to
evaluate different operations and programmes.
 Ensures that every programme being undertaken by
the manager is essential to the organization and is
being performed in the best possible way.
 No arbitrary cuts or increase in budget estimates are
made. All approvals are made on the basis of cost
benefit analysis.
 Helps identify areas of wasteful expenditure.
 Links budgets with corporate objectives. Nothing will
be allowed simply because it was being done in the
past.
 It can be used for introduction and implementation of
the system of ‘management by objectives’. 173/27/2020 By Dr. Abhay Singh Chauhan

Summary
In this chapter you have studied :
 The meaning of budget, budgeting and budgetary
control
 Utility and limitations of budgetary control as a
management tool
 Classification of budgets into different categories
 Difference between fixed and flexible budgeting
 The concept of performance budgeting and control
ratios
 The concept, utility and limitations of Zero base
budgeting

20
Meaning of Standard Costing
According to CIMA London, Standard Costing is, ‘ the
preparation and use of standard costs, their
comparison with actual costs, and the analysis of
variances to their causes and points of incidence’.
Standard Costing discloses the cost of deviations from
standard and classifies these as to their causes, so
that management is immediately informed of the
sphere of operations in which remedial action is
necessary.
Thus Standard Costing is a method of ascertaining costs
whereby statistics are prepared to show :
 The standard costs
 The actual costs
 The difference between these costs which is termed

21
Budgetary Control Vs. Standard Costing
 Concerned with the
operation of the business
as a whole and hence
more extensive.
 Budget is a projection of
financial accounts.
 It does not necessarily
involve standardization of
products.
 Budgetary control can be
adopted in part also.
 Budgeting can be operated
without standard costing.
 Budgets determine the
ceilings of expenses above
which actual expenses
 Related with the control of
expenses and hence it is
more intensive.
 Standard cost is the
projection of cost
accounts.
 It requires standardization
of products.
 It is not possible to
operate this system in
parts.
 Standard costing cannot
exist without budgeting.
 Standards are minimum
targets which are to be
attained by actual

22
Estimated Cost Vs. Standard Cost
 Estimated cost can be
used in any business which
is running under historical
costing system.
 Computation of estimated
costs may be made at any
time for any specific
purpose and may reflect
approximation.
 Primary emphasis is on
ascertainment of costs
which depend on expected
actuals of average of past
performance.
 Estimated costs can be
ascertained for a part of
the business also for a
particular purpose.
 Standard cost can be
applied in a business
operating under the
standard costing system.
 Calculation on scientific
basis is to be made for
arriving at standard costs.
 Cost control is the main
aspect involved under this
system. Standard costs
serve as yardsticks for
performance
measurement.
 Standard costs are to be
fixed in respect of every
element of cost and,
therefore, it incorporates3/27/2020 By Dr. Abhay Singh Chauhan

23
Standard Costing As A Management Tool
The utility of standard costing to management is as under :
 Formulation of price and production policies: Assists
management in the field of inventory pricing, profit
planning and also reporting to higher levels.
 Comparison and Analysis of Data : Provides a stable
and sound basis for comparison of actual with
standard costs, according to different elements
separately, thus indicating places where remedial
action is necessary and how far improvement is
possible in the long run.
 Cost Consciousness: Provides incentives to workers,
middle and top executive personnel for efficient work.
 Better Capacity to anticipate: Data are available at an
early stage and the capacity to anticipate about
changing conditions is developed.3/27/2020 By Dr. Abhay Singh Chauhan

24
Standard Costing As A Management Tool
 Delegation of Authority and Responsibility :The sphere
of operation of adverse variations is disclosed and
particular production department or centre can be held
accountable. The delegation of responsibility and
authority can be made by the management to control
the affairs in different departments.
 Management by ‘Exception’: Management by
exception can be made applicable in the business and
the management can concentrate on cases which are
off standard.
 Better Economy, Efficiency and Productivity:
Managerial review of costs is more effective as the
operations are scrutinized carefully and inefficiencies
are disclosed.

25
Limitations of Standard Costing
 Heavy costs :Fixation of standards may be costly and
may require high skill and competence.
 Frequent Revision Required :Revision of standards is
a tedious and costly process.
 Unsuitable for Non-standardized Products: Industries
dealing in non- standardized products may find the
system unsuitable and costly.
 Fixation of Responsibility Difficult: Responsibility can
be fixed only when controllable and non controllable
factors are distinctly known
 Adverse Psychological Effects: Standards may be
fixed at a high level which is unachievable, resulting in
frustration or building up of resistance.

26
Meaning of Standard Costs
Different meanings may be attached to the term ‘ Standard
Cost’:
 Ideal Costs :These are costs which should be there
under ideal working conditions, ideal management and
ideal plant capacity. Such ideal is a myth, and far from
reality.
 Normal Costs: Such costs can be determined on the
basis of the prevailing conditions of the business. It is
assumed that the plant is working at normal level of
capacity and efficiency, workers are engaged in
production activities performing their normal functions
and the normal efficiency operations are being carried
out. The cost shall thus be an average standard cost
which is normally there in business.
 Cost based on ‘ Average Past performance’: The costs
which have been incurred during the past three or five
years, for instance, are averaged out and the same3/27/2020 By Dr. Abhay Singh Chauhan

27
Meaning of Standard Costs ( Contd )
 Current Costs : These are costs which are currently
being incurred. They are not a useful guide for
standard costs since they are neither in rhythm with
past trends nor are inclusive of factors and conditions
following ahead.
 Expected or Anticipated Costs: These are costs which
closely follow the pattern of present costs, though
adjusted according to past behavioural patterns as
well a future tendencies.
 Reasonably attainable costs: Costs which can be
attained reasonably if the management tries for them
i.e it makes a sincere and integrated effort to achieve
the targets set in, can be regarded as the satisfactory
yardstick or benchmark for standards.

28
Determination of Standard Costs
Preliminaries to setting of Standards:
 Establishment of Cost Centres : Though all the
processes combined together manufacture the final
product, but for measuring productivity and controlling
labour and overheads, classification into cost centres
becomes necessary.
 Classification and Codification of Accounts: Helps in
quick collection and analysis of cost information.
 Period of Use: This involves the length of the
operating period for which standards are to be used.
The standards, which may be long term or short term,
may be categorized as :
a) Basic Standards: Not altered over a long period of
time, revisions are not frequent and there is a stability
and stagnancy in standards fixed.
b) Current Standards: These are short term standards.

29
Determination of Standard Costs ( Contd )
 Reasonable or Desired Level of Attainment :Standards
are to be set assuming efficient working conditions
and reasonable good performance.
 Active Level: The level of activity or performance
required must be decided upon before establishing
any standards. It should be computed keeping in mind
the capacity of the plant and the marketability of the
products.

30
Setting of Standards
The Standard Cost is determined for each and every
element of cost distinctly.
Standards for Direct Material Cost: Here two standards will
have to be fixed up :
 Quantity Standards : The factors that should be
considered while determining the quantity that should
be consumed for manufacturing one unit of
commodity:
- Past experience
- Technical estimates based on mathematical or
scientific computation.
- Test runs and experiments
- Standard bills of materials
 Price Standards: The standards regarding the price at
which material should be available can be fixed by
considering:
- Price prevailing in the past
- Current prices and prevalent market trends3/27/2020 By Dr. Abhay Singh Chauhan

31
Setting of Standards ( Contd )
Standards for Direct Labour Cost:
 Time Standards : The time which a worker should take
in completing a particular job can be fixed up by taking
into consideration:
- Trial Runs
- Time and Motion Studies
- Technical Estimates
- Past Experience
- Experience of Similar Concerns
- Other factors like standardization of products, efficient
plant and equipments, efficient tools to handle,
efficiency and skill of workers etc.
 Rate Standards: The following factors must be
considered:
- Type of labour required for performing a specific job
- Past experience
- Current Market Rates 3/27/2020 By Dr. Abhay Singh Chauhan

32
Standards for Overhead Cost:
 Standard Level Of Activity : It should be carefully fixed
and should represent a reasonably attainable level.
 Fixed, variable and semi-variable overheads:
- Fixed Overheads: Remain constant irrespective of the
quantum of output ex rent, insurance etc.
- Variable Overheads: Vary in proportion with output ex.
Power, selling commission etc.
- Semi-variable overheads: Vary according to output but
not in direct proportion. Include an element of fixed as
well as an element of variable cost ex. Depreciation
and repairs.
 Fixed Overhead Standards: Can be determined on the
basis of past experience and current market trends.
 Variable Overhead Standards: Standards for variable
overheads are fixed on the basis of trial runs, technical
estimates, past experience and experience of other
people in the same line. 3/27/2020 By Dr. Abhay Singh Chauhan

33
Standards for Sales:
 Quantity Standards: Quantity standards regarding
sales will have to be fixed up for each of the products
in which the business deals. Past sales figures, orders
in hand, production capacity, presence of competitors
etc. should be taken into consideration while
determining quantity standards.
 Price Standards: Price standards should be fixed up
regarding each product in which the business deals.
Past experience, current market trends, cost of
product, price at which other manufacturers are selling
the goods etc. should be considered while fixing the
standard.
The standard quantity multiplied by the standard price will
give us ‘Budgeted Sales’. It is different from ‘Standard
Sales’ which stands for actual quantity of sales
multiplied by standard selling price.

34
Summary
 Meaning of Standard Costing
 Difference between budgetary control and standard
costing
 Difference between estimated costing and standard
costing
 Utility of standard costing as a management tool
 Limitations of standard costing
 Meaning of standard costs
 Familiarization with setting of standards for costs and
sales.

36
Cost Variances
The deviation of the actual from the standard is known as
variance. Variance may be favourable or adverse.
Cost Variance may be depicted in the following manner:
Cost Variances
Direct Material Direct Labour Over Head
Cost Variance Cost Variance Cost
Variance

37
Direct Material Variance
Direct Material Cost Variance
Direct Material Price Variance Direct Material Usage
Variance
Direct Material Mix Direct Material Yield
Variance Variance
 Direct Material Cost Variance: It is the difference between
the standard cost of direct material specified for the output
achieved and the actual cost of direct material used.
= (Total Standard cost for actual output) – Total Actual
Cost
= ( Std. Price x Std Quantity for _ ( Actual Price x
Actual 3/27/2020 By Dr. Abhay Singh Chauhan

38
Direct Material Variance ( Contd )
 Direct Material Price Variance : That portion of direct
material cost variance which is due to the difference
between the standard price specified and actual price
paid.
= ( Actual Qty used) x ( Std Price – Actual Price )
 Direct Material Usage Variance : That portion of direct
material cost variance which is due to the difference
between the standard quantity specified and the actual
quantity used.
= ( Std. Rate ) x ( Std. qty for actual output – Actual qty )
 Direct Material Mix Variance: That portion of direct
material usage variance which is due to the difference
between the standard and actual composition of a
mixture.

39
Direct Material Variance ( Contd )
where, Revised Std Qty = (Total weight of Actual Mix) x Std.
Qty
( Total Weight of Std. Mix )
 Material Yield Variance : It is that portion of direct
material usage variance which is due to the difference
between the standard yield specified and the actual
yield obtained.
= ( Std. Cost per unit ) x ( Std. Output for Actual Mix
- Actual Output )

40
Direct Labour Variance
Direct Labour Cost Variance
Direct Labour Rate Variance Direct Labour Efficiency
Variance
Direct Labour Mix Direct LabourYield
Variance Variance
 Direct Labour Cost Variance: It is the difference between
standard direct wages specified for the activity achieved
and the actual direct wages paid.
= ( Std. cost for actual output ) - ( Actual Cost )
= ( Std rate x Std Time for Actual Output) –
( Actual rate – Actual Time )

41
Direct Labour Variance ( Contd )
 Direct Labour Rate Variance : That portion of direct
labour cost variance which is due to the difference
between the standard rate of pay specified and the
actual rate paid.
= Actual Time x ( Std. Rate – Actual Rate )
 Direct Labour Efficinecy Variance: That portion of direct
labour cost variance which is due to the difference
between the standard labour hours specified for the
activity achieved and the actual labour hours expended.
= Std Rate x ( Std. Time for Actual Output – Actual
Time)
 Direct Labour Mix Variance : This variance arises if
during a particular period, the grades of labour used in
production are different from those budgeted.

42
Direct Labour Variance ( Contd )
where, Revised Std. Time = (Total Actual Time ) x Std. Time
( Total Std. Time)
 Direct Labour Yield Variance : It is the variance in labour
cost on account of increase or decrease in yield or
output as compared to the relative standard.
= Std. Cost per unit x ( Std. Output of _ Actual
Actual mixture output )
 Total Direct Labour Efficiency Variance : In those cases
where there is an idle time variance ;
Total Direct Labour efficiency variance = ( Idle Time variance
)+
(Direct Labour efficiency
variance)
Idle Time Variance = Idle Time x Std. Rate3/27/2020 By Dr. Abhay Singh Chauhan

43
Overhead Variances
Certain Important terms related to Overhead Variances:
 Standard Overhead rate per unit = Budgeted Overheads
Budgeted Output
 Standard Overhead rate per hr = Budgeted Overheads
Budgeted Hours
 Standard hrs for Actual Output = Budgeted hrs x Actual
Output
Budgeted Output
 Standard Output = Budgeted Output x Actual Hrs
Budgeted hrs
 Recovered Overheads = (Std rate per hr) x (Std hrs for
actual
output)
 Budgeted Overheads = (Std. Rate per unit) x (Budgeted
Output)
 Standard Overheads = (Std. rate per unit) x (Std. Output3/27/2020 By Dr. Abhay Singh Chauhan

44
Overhead Variance ( Contd )
Overhead Cost Variance
Variable Overhead Cost Fixed Overhead Cost
Variance Variance
Fixed Overhead Expenditure Fixed Overhead Volume
Variance Variance
Fixed Overhead Efficiency Fixed Overhead Capacity
Variance Variance
 Overhead Cost Variance = Recovered Overheads – Actual
Overheads
 Variable Overhead Cost Variance:
= Recovered Variable Overheads – Actual Variable
Overheads 3/27/2020 By Dr. Abhay Singh Chauhan

45
Variable Overheads ( Contd )
 Fixed Overhead Cost Variance :
= Recovered fixed Overheads – Actual Fixed Overheads
 Fixed Overhead Expenditure Variance:
= Budgeted Fixed Overheads – Actual Fixed Overheads
 Fixed Overhead Volume Variance :
= Recovered Fixed Overheads – Budgeted Fixed
Overheads
 Fixed Overhead Efficiency Variance :
= Std Fixed Overhead x ( Std. Hrs for _ Actual
rate per hour Actual production Hours )
 Fixed Overhead Capacity Variance :
= Std Fixed Overhead x ( Actual Hrs _ Budgeted
Rate per hr Worked Hours )

46
Sales Variance
Sales Variance
With Reference to Turnover With Reference to
Profit
Value Variance
Price Volume
Mixture Quantity
With Reference to Turnover:
 Value Variance = Budgeted Sales – Actual Sales
 Price Variance = Actual Qty Sold x ( Std. Price – Actual
price)
= (Standard Sales – Actual Sales)
 Volume Variance = Std. Price x ( Budgeted Qty – Actual
Qty ) 3/27/2020 By Dr. Abhay Singh Chauhan

47
Sales Variance ( Contd )
 Mix Variance :
- Based On Quantity :
Mix Variance = Std. Price x ( Revised Std. Qty – Actual
Qty.)
= Revised Std. Sales – Std. Sales
- Based on Value :
Mix Variance = Revised Std. Sales – Std. Sales
where,
Revised Std. Sales = Budgeted Ratio of Sales x Std.
Sales
where,
Budgeted Ratio of Sales = Budgeted Sales of a Product
Total Budgeted Sales
 Quantity Variance = Budgeted Sales – Revised Std.
Sales 3/27/2020 By Dr. Abhay Singh Chauhan

48
Sales Variance ( Contd )
With Reference to Profit :
 Value Variance = Budgeted profit – Actual Profit
 Price Variance = Std. Profit – Actual Profit
= Actual Qty Sold x ( Std. Profit – Actual Profit per
unit )
 Volume Variance = Budgeted Profit – Standard Profit
= Std. Rate of Profit x ( Budgeted Qty – Actual
Qty )
 Mix Variance = Revised Std. Profit – Std. Profit
 Quantity Variance = Budgeted profit – Revised Std. Profit

49
Summary
 The concept of different cost and sales variances
 Computation of different types of variances
 Identification of the causes for different types of
variances

Chapter 4.4
Marginal Costing and
Profit Planning

51
Marginal Costing
Marginal Costing is a technique where only the variable
costs are considered while computing the cost of a
product. The fixed costs are met against the total fund
arising out of the excess of selling price over total
variable cost. This figure is known as Contribution in
marginal costing.
Absorption Costing and Marginal Costing
 Incase of absorption costing, both fixed and variable
overheads are charged to production, while in case of
marginal costing, only variable overheads are charged
to production and fixed overheads are transferred in
full to the costing and profit and loss account.
 In case of absorption costing stocks of work-in-
progress and finished goods are valued at works cost
and total cost of production respectively. In case of
marginal costing, only variable costs are considered
while computing the value of work-in- progress or
finished goods. Thus, closing stock in marginal costing3/27/2020 By Dr. Abhay Singh Chauhan

52
Marginal Costing ( Contd )
Marginal Costing and Direct Costing: Direct costing is the
technique where only direct costs are considered
while calculating the cost of the product. Indirect cost
are met against the total margin given by all the
products taken together. While marginal costs deal
with variable costs, direct costs may be fixed as well a
variable.
Marginal Costing and Differential Costing : Differential
costing means , ‘ a technique used in the preparation
of adhoc information in which only the cost and
income differences between alternative courses of
action are taken into consideration’. Thus a
comparison is made between the cost differential and
income differential between two or more situations and
decision regarding adopting a particular course of3/27/2020 By Dr. Abhay Singh Chauhan

53
Segregation of Semi Variable Costs
Marginal Costing requires segregation of costs into fixed
and variable. This means that semi variable costs will
have to be segregated into fixed an variable elements.
Various methods for segregation are :
 Level of output compared to level of expenses method
: Output at two different levels is compared with the
corresponding level of expenses . Since the fixed
expenses remain constant, the variable overheads are
arrived at by the ratio of change in expense to change
in output.
 Range Method : Similar to the previous method except
that only the highest and lowest points of output are
considered.
 Degree of Variability Method : Degree of variability is
noted for each item of semi variable expense ex some3/27/2020 By Dr. Abhay Singh Chauhan

54
Segregation of Semi Variable Costs ( Contd )
 Scatter Graph Method : The data is plotted on a graph
paper, with volume of production on the x-axis and the
corresponding costs on the y- axis. A line of best fit is
drawn, which is the total cost line. The point at which
this line intersects the y-axis is taken to be the amount
of fixed element.
 Method of Least Squares : This method is based on
the mathematical technique of fitting an equation with
the help of observations.

55
Cost Volume Profit Analysis
Cost Volume Profit ( CVP ) analysis is an important tool of
profit planning. It provides information about :
- The behaviour of cost in relation to volume.
- Volume of production or sales where the business will
break even.
- Sensitivity of profits due to variation in output.
- Amount of profit for a projected sales volume.
- Quantity of production and sales for a target profit
level.
Thus CVP analysis is an important media through which
the management can have an insight into effects on
profit and loss account, of variations in costs ( fixed
and variable ) and sales ( value and volume ) to take
appropriate decisions. 3/27/2020 By Dr. Abhay Singh Chauhan

56
Break Even Analysis
Break even analysis is a widely used technique to study CVP
relationship. Certain basic important terms are :
 Contribution : Excess of Selling Price over Variable Cost
Contribution = Selling Price – Variable Cost
= Fixed Price + Profit
 Profit Volume Ratio ( P/V ratio): Establishes relationship
between contribution and sales value.
P/ V Ratio = Contribution / Sales
= ( Sales – Variable Cost) / Sales
 Break-even Point :It is the point which breaks the total
cost and selling price evenly to show the level of output
at which there shall be neither profit nor loss.
Break-even Point ( Output) = Fixed Cost/ Contribution
per unit
Break-even Point ( Sales ) = Fixed Cost x Selling price
per unit
Contribution per unit3/27/2020 By Dr. Abhay Singh Chauhan

57
Break Even Charts
Break-even chart depict the level of activity at which there will
be neither loss nor profit and also shows the profit or loss
for various levels of activity.
Forms of Break-even Chart :
 Simple break-even chart : Depicts the quantity of
production at which break even occurs.
 Contribution break-even chart : Helps in ascertaining the
amount of contribution at different levels of activity,
besides the break-even point.
 Profit chart : Depicts the profit at different levels of
activity. The break even point is the point at which profit
is zero.
 Analytical break even chart : It is prepared to show
different elements of cost and appropriation of profits.
 Cash break-even chart : It is prepared to show the
volume at which cash breaks even.3/27/2020 By Dr. Abhay Singh Chauhan

58
Break Even Charts ( Contd )
Advantages of break even charts :
 Provides detailed and clearly understandable
information.
 Profitability of products and business can be known.
 Effect of changes in cost and selling price can be
demonstrated.
 Cost control can be demonstrated.
 Economy and efficiency can be effected.
 Forecasting and planning is possible.
Limitations of break even charts:
 Limited information can be presented in a single chart.
 No necessity : There is no necessity of preparing break
even charts because:
- Simple tabulation is sufficient
- Conclusive guidance is not provided
- No basis of comparative efficiency3/27/2020 By Dr. Abhay Singh Chauhan

59
Utility of CVP Analysis
 Fixation of Selling Price: The cost of the product and the
desired profitability are two important factors which
govern the fixation of selling price.
 Maintaining a desired level of profit: In the face of price
cuts, in case the demand for the company’s product is
elastic, the minimum level of profit can be maintained by
pushing up the sales. The volume of such sales can be
found out by the marginal costing technique.
 Accepting of price less than total cost: Sometimes prices
have to be fixed below the total cost of the product. In
such a scenario, a price less than the total cost but above
the marginal cost may be acceptable because in such
periods any material contribution towards recovery of
fixed costs is acceptable rather than no contribution at all.

60
Utility of CVP Analysis ( Contd )
 Decisions involving alternative choices: The technique of
marginal costing helps in making decisions involving
alternative choices ex. Discontinuance of a product line,
changes of sales mix, make or buy, own or lease,
exapand or contract etc. The technique used is
differential costing, which is an extension of the
technique of marginal costing.

61
Summary
 The concept of marginal costing
 Difference between Marginal costing and absorption
costing, direct costing and differential costing
 Different methods of segregation of semi-variable
costs
 Utility of CVP Analysis
 Types, advantages and limitations of break-even
charts

Chapter 4.5
Decisions Involving
Alternative Choices

63
Decision Making
Decision making is the essence of management since it
may make or mar the success of the business as a
whole. It is the process of choosing among alternative
courses of action, since if there is no choice, there is
no decision to make.
Steps in decision making :
 Defining the problem
 Identifying alternatives
 Evaluating quantitative factors
 Evaluating qualitative factors
 Obtaining additional information
 Selection of an alternative
 Appraisal of the results

64
Relevant Costs
Costs are relevant if they guide the executive towards the
decision that harmonizes with the top management’s
objectives. Two fundamental characteristics of relevant
costs are :
 They are future costs: Past costs are the result of past
decisions and no current or future decision can
change what has already happened. In forward
decision making, data regarding historical or standard
cost is useful only as a basis for estimating future
costs.
 They differ between alternatives: Only such future
costs ( fixed or variable ) are relevant which may
be expected to differ between alternatives. Those
costs which do not change between different
alternatives are to be ignored.3/27/2020 By Dr. Abhay Singh Chauhan

65
Alternative Choices
 Determination of Sales Mix : Assuming that fixed costs
will remain unaffected, decision regarding sales mix is
taken on the basis of contribution per unit of product.
The product which gives the highest contribution
should be given highest priority and vice versa.
 Exploring New Markets : Decision regarding selling
new products in a new market should be taken after
considering :
- Whether the firm has surplus capacity to meet the new
demand.
- What price is being offered by the new market.
- Whether the sale of goods in the new market will affect
the present market for the goods.

66
Alternative Choices ( Contd )
 Discontinuance of a Product Line : The following
factors should be considered :
- The contribution given by the product.
- The capacity utilization of the firm
- Availability of product to replace the product which the
firm wants to discontinue.
- The long-term prospects in the market for the product.
- The effect of discontinuance on the sale of other
products.
 Make or Buy Decisions: The most important
consideration is the cost differential between the two
alternatives. Other considerations, in case the firm
decides to get the product manufactured from outside,
are :
- Whether the supply is in a position to maintain the
quality.

67
 Equipment Replacement Decision :The firm should
take into account the resultant savings in operating
costs and the incremental investment in the new
equipment. In case the savings due to replacement
are more than the cost of raising additional funds, the
proposal should be accepted. Besides this, the firm
must take into account the benefits the firm is likely to
derive in the long run by replacing old and obsolete
equipment.
 Change Versus Status Quo : The management must
keep in view the long term interests of the firm ex it
may be disadvantageous to sell a product blow its
variable cost but sometimes the management may
have to resort to this practice for the survival of the
firm. The following items may be taken into account
while deciding:
- Increase in operating costs
- Increase in fixed overhead costs
- Increase in contribution 3/27/2020 By Dr. Abhay Singh Chauhan

68
 Expand or Contract : Expansion of operations results
in economies of scale, greater flexibility, lower fixed
costs and greater capacity to meet customer
specifications. It also brings with it many
organizational and communication problems. Control
and monitoring becomes more complex an delegation
of authority and responsibility becomes more
confused.
Since profit maximization is the firm’s primary goal,
decision to expand should be taken after considering
this aspect. Expansion results in heavy fixed costs, it
means sales volume will have to be increased for
meeting such costs though there may be increase in
per unit contribution due to economies of scale. The
management must, therefore, make sure that the
market will absorb the additional volume of required3/27/2020 By Dr. Abhay Singh Chauhan

69
 Shut down or Continue :
Temporary Shut down : The following should be considered
while deciding about temporary shut down :
- Effect on Fixed overhead costs
- Packing and storing of plant and equipment costs
- Setting – up costs
- Loss of goodwill / market
- Lay-off or retrenchment compensation to workers
- Avoiding operating losses
- Saving in indirect costs such as repairs and
maintenance, indirect labour, heat and light costs etc.
Permanent Closing down : A comparison should be made
between the revenue from continued operations and
revenue from complete closing down and sale of plant.
The business should be closed down if the revenue in
the latter event is greater than the revenue from
continued operations. 3/27/2020 By Dr. Abhay Singh Chauhan

70
Summary
 The concept of decision making
 The concept of relevant costs
 The steps to be taken for rational decision making
 Applying the above steps to different managerial
problems

Accounting for Managers/Management Accounting (Unit-4) by Dr. Abhay Singh Chauhan

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