Costing and Budgeting

Management Accounting: Costing &

Budgeting

HND IN BUSINESS MANAGEMENT

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Costing and Budgeting

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Executive summary

This report provides an understanding of the subject and scope of costing and budgeting.
And this report deals with the tools and techniques that generates information needed to
evaluate and control present and projected performance. Thus forecasting key variables,
recognising uncertainties attached to future events , is a basis for budget construction. The
budget is then used with costing system to evaluate the actual performance.

This report further deals with marginal costing methods within the costing systems, including
and demonstrate the reconciliation of budgeted and actual profit margins. The calculations
and interpretations of materials, sales price, fixed overhead and sales variance .

The report finds that the firm must take considerations of adverse variance in to account to
make the changes in the decisions that they are going to take regarding the production of AB
2010 .

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Table of contents

Contents

Acknowledgement ................................................................... Error! Bookmark not defined.

Executive summary.................................................................................................................... 3

Table of contents ........................................................................................................................ 4

Introduction ................................................................................................................................ 5

Task A ........................................................................................................................................ 6

1.1 Type of cost...................................................................................................................... 6

1.2 basic costing methods ...................................................................................................... 7

Costing principles and techniques ......................................................................................... 8

1.3 Total cost of sales............................................................................................................. 9

1.4 Break even analysis and cost –volume- profit analysis ................................................. 11

1.5 Budgeting ....................................................................................................................... 14

1.6 improving quality ........................................................................................................... 17

Task B ...................................................................................................................................... 17

Variance Analysis ................................................................................................................ 17

Variance analysis causes and corrective actions .................................................................. 20

Reconciliation Budgeted and actual results ......................................................................... 21

Conclusion and Recommendation ....................................................................................... 22

Reference ............................................................................................................................. 23

Works Cited ............................................................................................................................. 23

Bibliography ............................................................................................................................ 24

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Introduction

XYZ Company is a highly successful in Srilankan wood craft manufacturer . as a part of its 5
year strategic plan the top management have decided to diversify its product portfolio it
steel ornaments. Company is planning to make steel ornaments manufacturing a separate
SBU. Since they are new to the market, the board of directors has appointed a task team to
look after the launch and the first year of production of this newly created SBU.

This report below provides an insight of the different costing methods used and marginal cost
were selected and different costing techniques and suggestion were made to improve the
quality of the product as well as reducing the variable and overhead expenses to boost the
sales.

Appropriate budgeting methods were selected to compare the actual results with the budgeted
to amount, variance analysis were calculated to find out the deviation and measures were
proposed to take correctives actions .

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Task A

1.1 Type of cost

Direct cost

Direct costs cover any expenses that can be wholly associated with a particular product or
services. The total of such direct costs- direct material, direct labour, and direct expenses – is
known as prime cost.

Direct material cost

These are materials entering into and becoming constituent elements of a product or saleable
service and which can be identified separately in product cost.

In this case study Iron and Aluminum purchased and used for the particular process molding
and finishing

Direct labour cost

This defined as the cost of remuneration for employees ‘efforts and skills applied directly to a
product or saleable service and which can be identified separately in product cost.’’

In this case study molding finishing, employees are directly involved with manufacture of
AB2010 product .so the wage could charged direct to the product, so their cost is directly
relate to the product.

Direct expenses

These are costs , other than materials or labour , which are incurred for a specific product or
saleable service.

In this case study an example would be electric power to a machine, provided that the power
is metered and the exact consumption by the machine is known, we can then charge the cost
of power direct to the job. More often however, we will know only the electricity bill for the
whole factory, so this will be indirect expenses.

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Overhead

Overhead is the total cost of indirect labour, indirect materials and indirect expenses. In this
case study we couldn’t find any indirect materials. Examples of indirect labour include the
cost of employing Admin and Marketing staff will be the examples could be seen in the case
study. Examples of indirect expenses include lighting, and also other overhead expenses for
ex:- factory expenses, administration expenses.

Fixed and variable cost

Fixed cost are those which remain constant (in total) over a wide range of output levels. in
this case study examples of fixed cost includes the fixed salaries given to admin, marketing
and finishing workers and overhead expenses for each departments

Variable cost

This is a cost that tends to follow the levels of activity in a business. Examples – piece rate
for molding , finishing and marketing departments

1.2 basic costing methods

The basic costing methods employed by an organization must be devised to suit the methods
by which goods are manufactured or services are produced. The choice is between specific
order costing, function costing and continuous operation/ process costing

Specific order costing

This costing method is applicable where the work consists of separate contracts, jobs or
batches, each of which is authorized by a special order or contract.

The subdivision of specific order costing are:

1. Job costing
2. Batch costing
3. Contract costing

Continuous operation/ process costing

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This is the basic costing method applicable where goods or services are produced by a
sequence of continuous or repetitive operations or processes to which costs are charged
before being averaged over the units produced during the period.

In this case study we can find that for molding and finishing are the two operations will be
used to produced the single unit of a product .

Service / function costing

This is the method used for specific services or functions such as canteens , maintenance or
HR management.

In this case study apart from the main operations we could find there are two more
departments Administration and Marketing apart from two operations.

Costing principles and techniques

Whichever costing method is in use , there is a techniques that may be adopted in presenting
the information to the management.

Absorption costing

This principle involves all costs, including the cost of selling and administration , being
allotted to cost of units. Total overheads are absorbed via the methods thoughts most
appropriate.

Marginal costing

This is a principle where by variable costs only are charged to cost units, and the fixed cost
attributable to the relevant period is written off in full against the “ contribution “ for that
period, contribution being the differences between total sales value and total variable costs.

Variance Accounting

This is a technique whereby the planned activities of an undertaking are quantified in budgets,
standard costs , standard selling prices, and standard profit margins. These are then compared
with the actual results, and note is taken of the differences

Justification

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In this case study I have selected to do the sum based on the marginal costing method
because it’s easy to categorize and compare the expenses. there is absolutely correct answer
to when marginal costing or absorption is preferable. However, it is generally accepted that
marginal costing provide the best information for the purpose of management decision
making . in this case the management attention is concentrated on the more controllable
measure of contribution and apportionment of fixed production overhead to individual unit
is carried out on a purely arbitrary basis, is of little use for decision making and can be
misleading.

1.3 Total cost of sales

Total Variable cost

Variable cost defined as “a cost which varies with a measure of activity. Examples of
variable cost are direct material, direct labor, and variable overheads

In this case study the calculation were done based on the following assumptions

 Assumed budgeted production of 71,000 units based on budgeted material usage

given in part B
 Assumed no stocks are held back, i.e all units produced is sold.

The Variable Cost/ Unit

Iron (4* 5) = 20

Aluminum ( 4* 7) = 28

Salaries: (Piece rate)

Molding = 12

Finishing = 14

Marketing = 0. 08

Total Variable cost = 74.08 Rs.

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Total Fixed costs

Total fixed cost will be calculated by considering the annual salaries of total number of
employees belongs to Administration, Molding and marketing . and also other overhead
expenses for the particular year as well as the total electricity cost of the year.

Fixed costs

Salary:

Admin (25,000 * 2 *12) = 600,000

Molding (7,000 * 5 *12) = 420,000

Marketing (25,000 * 12) = 1,200,000

Other overhead:

Admin = 35,000

Molding = 5,000

Finishing = 6,000

Marketing = 40,000

Electricity (18,000*12 ) = 216,000

Total Fixed costs = 2,522,000

The total fixed cost for the production of AB2010 is Rs, 2,522.00 for the year of 2013.

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1.4 Break even analysis and cost –volume- profit analysis

CVP analysis is the study of the effects on future profit of changes in fixed cost, variable
cost, sales price , quantity and mix .but since break even analysis show the level of activity
that produces neither profit nor loss.

Calculation

Contribution will be defined as the difference between the selling price and the variable cost

The selling price was 142.00 Rs.

The Contribution will be

Contribution/ Unit

Selling Price = 142

Variable cost per unit = ( 74.08)

Total = 67.92

Breakeven Point

Break even point = Fixed cost

Contribution

= 2,522,000 / 67.92

= 37,132 units

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Break Even Chart

Total Revenue

10,000,000 Total Cost

9,000,000

8,000,000

7,000,000 BEP (37,132)

6,000,000

5,000,000

4,000,000

3,000,000 Fixed
cost

2,000,000

1,000,000

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000

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Cost – Volume – Profit Analysis

3,000,000

2,000,000 BEP @ 37,132 units

1,000,000

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 units

1,000,000

2,000,000

3,000,000

The graph depicts clearly the breakeven point of sales needed to break even. The main
advantage of this PV chart is that it is capable of depicting clearly the effect on profit and
breakeven point of any changes in the variables. but since in this case case study it is assumed
sales revenues are assumed to be constant for each unit sold. This may be unrealistic because
of the necessity to reduce the selling price to achieve higher sales volumes. Once again , the
analysis can be adapted for some changes in selling price but too many changes can make
the chart unwieldy.

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1.5 Budgeting
The preparation of budgets and their use in the control of operations are core management
accounting functions. Budgets are widely used in manufacturing , services, public and
voluntary sectors.

Budgets have two main roles:

1. They act as authorities to spend, that is , they give authority to budget mangers to
incur expenditure in their part of the organization
2. They act as comparators for current performance, by providing a yardstick against
which current activities can be monitored , and they may be used as targets to
motivate managers .

The preparation of budgets will defer from organization to organization. However, there are a
number of key requirements in the design of a budgetary planning and control process.

Pro forma Profit & loss account

This is also known as the pro forma income statement which shows the anticipated
profitability of the business.This as been prepared with the current and past data in mind and
adjusted to reflect any possible future event as a guide to project the future performance of an
enterprise. These are based on assumptions about the future and are to that extent vulnerable
to changes and inaccuracies

Proforma Profit & Loss account for the year ended 31st March 2014

Sales ( 71,000 * 142 ) 10,082,000

Variable cost of production

Iron (71,000 * 4 * 5) 1,420,000

Aluminum (71,000 * 4 * 7 ) 1,988,000
Salaries :

Molding (71,000 * 12) 852,000

Finishing (71,000 * 14) 994,000
5,254,000
Variable selling expenses (71,000 * 0 .08 ) 5,680 (5,259,680)
Contribution 4,822,320

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Fixed Salaries:

Admin (25,000 * 2 *12 ) 600,000

Molding (7,000 * 5 *12) 420,000
Marketing (25,000 * 4 *12) 1200,000 2,220,000
Other overheads :

Admin 35,000
Molding 5,000
Finishing 6,000
Marketing 40,000 86,000
Electricity ( 18,000 * 12 ) 216,000
Profit 2,300,320

Cash flow statements

The manufacturer of this company uses aluminium and iron, in its production processes must
watch item prices closely. Failure to do so could increase the company's costs of good sold --
or "cash paid to suppliers," as accountants dub it in the "operating activities" section of the
cash-flow statement. The other two sections of a liquidity report are "cash flows from
investing activities" and "cash flows from financing activities."

If the calculated amount of free cash flow is positive, this amount represents the cash
available to invest in new lines of business, retire additional debt, and/or increase dividends.
If the calculated amount of free cash flow is negative, this amount represents the amount of
cash that must be borrowed (and/or obtained through sales of nonessential assets, etc.) in
order to support the strategic goals of the company. To a large degree, the free cash flow
paradigm parallels the cash flow statement

Proforma cash flow statement for the year ended 31st March 2014

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Pro forma cash flow

Operating cash Flows (+)

Receipts on sales ( assumed all sales based on cash ( 71,000 * 142 ) 10,082,000
Payments (-)
Purchase of raw materials
Iron ( 71,000 *4* 5 ) 1,420,000
Aluminium ( 71,000 * 4 * 7) 1,988,000
Payments to workers salaries
Admin 600,000
Molding 1,272,000
Finishing 994,000
Marketing 1,205,680
Other overheads
Admin 35,000
Molding 5,000
finishing 6,000
Marketing 40,000
Electricity 216,000

Net cash flow 2,300,320

By looking at the cash flow and the profit and loss account we can identify that the company
is expected to generate net profit of 2,300,320 for the next year. Comparatively this is less
income generation from the operational activities of the company . the firm must take
following steps to improve the cash flow position .

1. Must make preventive steps to control or reduce the variable costs of the firm
2. Company must take steps to improve the sales i.e number of units sold in the forth
coming years
3. Discover the methods to improve the trade and reduce the expenses.
4. If the company can find a another supplier who provide materials at a cheaper price it
will help to reduce the variable cost of production but since , must make sure the
quality of product remain the same otherwise firm may tend to lose the customers in
the long run ultimately it will affect the profitability of the firm

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1.6 improving quality

Referring to the case study we can identify certain ways how this firm can improve the
quality of products while reduce the cost of production and up to what extent of pricing
policies they can select to ensure the return as well

The following points clearly says what actions could be taken to maintain the same levels of
quality while reducing the costs

1. Take a careful analysis source of raw materials which minimize the cost as well as
maximize the quality of the product
2. Try to minimize the wastage or unplanned excess materials usage in the production
process
3. Negotiate with the suppliers for the best long term deal so the price reduction could be
offer while buying in bulk amounts.
4. Using new technologies in the production process or automated production techniques
will reduce the cost for labour as well as improve the quality.
5. Try to minimize the other expenses like papers, and ensure that the products offer
what the customer expects exactly

Task B

Variance Analysis
A variance is the different between the expected standard cost and the actual cost incurred.
Variance analysis involves breaking down the total variance to explain how much of it is
caused by usage of resources being different from the standard, and how much of it is caused
by the price of resources being different from the standard .

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Sales price variance

This variance calculated the profit difference which is caused by charging a different selling
price from the standard .

 Sales Price Variance = (Actual Production * Standard Selling Price) – Actual Sales
Revenue

(85,000*139) – 11,390,000 = 417,000 Adverse

The adverse variance indicates that the actual selling price was lower than the standard price
leading to Rs. 417,000 less profit than budgets.

The sales volume profit variance

 Sales Volume Profit Variance = (Budgeted Production * Std. Profit/Unit) – (Actual

Production * Std. Profit/ Unit)

(71,000*28.92) – (85,000*28.92) = 404,880 Favourable

The favourable variance indicates that the increased sales volume could have increased gross
profit

Total sales variance

 Total Sales Variance - 417,000A + 404,880F = 12,120 Adverse

Material Price variance

The direct material price variance reveals how much of the direct material total variance was
caused by paying a different price of materials used.

 Material Price Variance = (Actual Qty of Materials Purchased * Std. Price) – Actual
Cost of Materials Purchased

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((357,000*5) + (333200*7)) – 100320000 = 5,914,600 Adverse

The adverse price variance indicates that the expenditure was 5,914,600 Rs. More than the
standard because a higher than standard price was paid for each unit of materials.

Material usage variance

The direct material usage variance reveals how much of the direct material total variance
was caused by using a different quantity of material , compared with the standard
allowance , for the production achieved .

 Material Usage Variance = (Actual Production * Std. Material cost/unit) – (Actual

Material used * Std. cost/unit of material)

(91,200*48) - ((357,000*5) + (333200*7)) = 260,200 Favorable

The favorable usage variance indicates that expenditure was Rs. 260,200 less than
standard . this was because a lower amount of material was used compared with the
standard expected for this level of output .

Total Material Variance

 Total Material Variance = 5,914,600 A + 260,200 F = 5,654,400 Adverse

Fixed production overhead variance

When we analyze the total fixed production overhead variance we are trying to explain the
reasons for the over or under absorption. factors which could lead to under absorption will
cause adverse fixed overhead variances. Factors which could lead to over absorption will
cause favorable fixed overhead variances

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Fixed production overhead expenditure variance

This is the amount of the total variance which is caused by the expenditure on overheads
being different from the budgeted amount.

 FPOH Expenditure Variance = Budgeted Fixed Overheads – Actual Fixed Overheads

2,522,000 – 2,576,190 = 54,190 Adverse

The adverse fixed production overhead expenditure indicates an under absorption of fixed
overheads.

Fixed production overhead volume variance

This is the amount of the total variance which is caused by the volume of output being
different from the budget

 FPOH Volume Variance = (Actual Production * OAR) - Budgeted Fixed Overheads

(91,200*36) – 2,522,000 = 761,200 Favourable

This favorable fixed production overhead volume indicates an over absorption of fixed
overheads

Variance analysis causes and corrective actions

Selling price variance

The selling price variance. Indicates a adverse Rs.417,000 results . this is because of the low
selling price than the budgeted results. The actual selling price was Rs.134/- (11,398,000/
85,000 = 134.09 ) this will increase the number of units sold in the particular year , but on the
other hand it will reduce the sales revenue gradually .

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Sales volume profit variance

This variance shows an favorable balance of 404,880Rs. . This is due to increase in the
number of units that were sold , due to the reduction in selling price which made the profits to
increase. Its better if the company can increase further the units to be sold , the profit variance
will have a favourable balance in future years as well.

Material usage variance

This variance shows a favorable balance of Rs. 260,200 .this due to the efficient employees
who are employed in the organization and usage of better quality raw materials . in order to
maintain this favorable balance the firm can use a different substitution grade material in the
production process as well and maintain a lower incidence of scrap of materials and also
quality of the product might increase if higher quality raw materials are used , increase in the
level of productivity .

Material price Variance

This variance indicates a adverse result of Rs. 5,914,600. This is due to higher prices paid for
the materials and the company might have purchased better quality of raw materials. Since
the SBU ran into loss manner, in order to prevent this company must find out different source
of suppliers who provide materials at cheaper price levels.

Fixed production overhead expenditure variance and volume variance

This variance indicate an adverse value of Rs. 54,190 . this is due to the increase in the
electricity bill and other over head expenses foe marketing, finishing, molding division and
extra salaries paid to molding staff. FPOH volume variance indicates a favorable value Rs.
761,200. This is because overhead absorbed was less than budgeted overhead of 2,522,000/=

Reconciliation Budgeted and actual results

Rs. Rs.

Budgeted Profit 2,300,320

Sale Price Variance (417,000)

Sales Volume Variance 404,880 (12,120)

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Std. Profit on actual sales 2,288,200

Cost Variances

Material Price Variance (5,914,600)

Material Usage Variance 260,200

FPOH Expenditure Variance (54,190)

FPOH Volume Variance 761,200

Variable OH total Variance 6800

Labour Total Variance 2,371,200 (2,569,390)

(281,190)

The actual demand for the product 2009 for 72450, but they sold 85000 units of products in
the previous year , comparatively if the company can reduce the adverse variance of materials
and overheads the New SBU can still continue the productions. The price of materials are
higher so if the SBU unit can find a news supplier who provide cheaper materials firm can
reduce the materials cost , but then if the firm concentrating on cheaper raw materials it will
affect the quality of the final output will drop. so the usage variance is higher than it will
show the adverse variance The SBU cannot take any decision based on the budgeted results
since it is not reliable, and in the case study no proper detail were given about the
labors .thought all these critics if the firm can make measures to improve the adverse variance
it can continue with the production of AB2010 product.

Conclusion and Recommendation

It has been discussed in the first part of the assignment the different cost involved in the
production of the AB2010 production, and marginal costing method was used to make the
decision regarding as to whether to continue the production of Ab2010 production or not.
Break even analysis and cost and profit volume analysis were used to find out the breakeven
point, so that to calculate the margin of profits to ensure the return of investment.

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In light of the above conclusions , the organization, we have investigated must take into
consideration about heir adverse variances to make decisions regarding whether to continue
with production or not. But if the company can make certain changes a in their technologies
bring down the cost of production and material cost and reduce overhead expenses, they can
achieve the expected results and continue with the production

Reference

Works Cited

http://www.financedoctors.net/Notes/133.pdf

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http://www.managers-net.com/plowman/managingoverheadcosts.html

http://www.globusz.com/ebooks/Costing/00000012.htm

http://crownyou.hubpages.com/hub/Marginal-Costing

http://www.hkiaat.org/images/uploads/articles/AAT%20P3%20Absorption%20costing.pdf

Bibliography

Bob Scarlett ,2009, PI- Performance Operations, ist ed CIMA , publishing , 30 corporate
drive , suite 400, Burlington , MA 01803, USA

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