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ACCOUNTING FOR MANAGERIAL DECISIONS M.

COM 4th SEM

ACCOUNTING FOR MANAGERIAL DECISIONS

UNIT 1

Accounting for Decision making: Scope and Importance, Database for decision-making, Cost-based decision-
making; Concept of marginal cost; Marginal costing and Absorption costing; Income statement under absorption
costing and Variable costing

UNIT 2

Cost-volume Profit and Break-even Analysis: Cost-volume-profit (CVP) analysis; Break-even analysis;
Assumptions and Practical applications of break-even-analysis and CVP analysis. Application of marginal costing
for managerial decision; Problem of key factors, Diversification of products, Product mix decision, Make or Buy
decisions, Effect of changes in selling prices, Shut down, Continue decision, Application of differential cost
analysis.

UNIT 3

Budgeting and Budgetary Control: Meaning of budget, Essentials of budgeting, Types of budgets Functional,
Master, etc, Fixed and flexible budget; Budgetary control; Zero-base budgeting; Performance budgeting.

UNIT 4

Standard Costing and Variance Analysis: Standard costing as a control technique; Setting of standards and their
revision. Variance analysis - Meaning and Importance, Kinds of variances and their uses; Material, Labour and
Overhead variances; Disposal of variances; Relevance of variance analysis to budgeting and Standard costing.

UNIT 5

Divisional Performance Analysis: Decentralized organisations and Responsibility centres-Cost centre, Revenue
centre, Profit centre and Investment centre. Responsibility accounting - Importance, Measuring the performance of
investment centre – ROI, Residual income and EVA methods; Measuring income and Invested capital; Issues
involved in divisional performance evaluation; Rewarding performance of managers.

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ACCOUNTING FOR MANAGERIAL DECISIONS M.COM 4th SEM

ACCOUNTING FOR MANAGERIAL DECISIONS

Created by
Madhu k g
2nd M.com [2016-17]
Shridevi PG centre
Tumkur
Guider
Santhosh . Sir
M.Com
Asst. prof.
Shridevi PG centre
Tumkur

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ACCOUNTING FOR MANAGERIAL DECISIONS M.COM 4th SEM

UNIT 01

ACCOUNTING FOR DECISION MAKING

 Meaning of Accounting

Accounting is the systematic and comprehensive recording of financial transactions pertaining to a business, and it
also refers to the process of summarizing, analysing and reporting these transactions to oversight agencies and tax
collection entities.

 Nature of Accounting

 Accounting is a process
 Accounting is an art
 Accounting is means and not an end
 Accounting deals with financial information and transactions
 Accounting is an information system

 Scopes of accounting
 Business
 Government organizations
 Non-Government organizations
 Individuals

 Objectives or Functions of Accounting


 Maintenance of record of business transactions
 Calculation of profit and loss
 Providing accounting information to its users

 Importance of Accounting

 Profit & Loss Account (Income Statement)


 Balance Sheet or Statement of financial position
 Cash Flow Statement
 Helps in evaluating the performance of business
 Helps to manage and monitor cash flow
 Helps business to be statutory compliant
 Helps to create budget and future projections
 Helps in filing financial statements with regulators, stock exchanges and filing of tax returns
 Recording
 Summarizing
 Reporting
 Analysing

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ACCOUNTING FOR MANAGERIAL DECISIONS M.COM 4th SEM

 Meaning of Decision Making


A decision can be defined as a course of action purposely chosen from a set of alternatives to achieve
organizational or managerial objectives or goals. Decision making process is continuous and indispensable
component of managing any organization or business activities.

 Process of Decision Making [2015 Q.P]


1. Identify the decision
2. Gather relevant information
3. Identify the alternatives
4. Weigh the evidence
5. Choose among alternatives
6. Take action
7. Review your decision & its consequences

 Characteristics of Decision Making [ 2016 Q.P]

 Decision-making is based on rational thinking. The manager tries to foresee various possible effects of a
decision before deciding a particular one.
 It is a process of selecting the best from among alternatives available.
 It involves the evaluation of various alternatives available. The selection of best alternative will be made
only when pros and cons of all of them are discussed and evaluated.
 Decision-making is the end product because it is preceded by discussions and deliberations.
 Decision-making is aimed to achieve organizational goals.
 It also involves certain commitment. Management is committed to every decision it takes.

 Nature of decision-making

 Goal-Oriented Process

 Selection Process

 Continuous Process

 Art as Well as Science

 Responsibilities of Managers

 Positive as Well as Negative

 Future Course of Action

 Importance of decision making [2016 Q.P]

 Implementation of managerial function


 Pervasiveness of decision making
 Evaluation of managerial performance
 Helpful in planning and policies
 Selecting the best alternatives
 Successful; operation of business

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ACCOUNTING FOR MANAGERIAL DECISIONS M.COM 4th SEM

 The Role of Management Information Systems in Decision Making

 Information Access
 Data Collection
 Collaboration
 Interpretation
 Presentation

 Cost
Cost is the monetary value that a company has spent in order to produce something. ... Cost denotes the
amount of money that a company spends on the creation or production of goods or services. It does not
include the mark-up for profit.

 Basic cost elements

1. Raw materials
2. Manual labour
3. expenses/overhead

 Material (Material is a very important part of business)


o Direct material/Indirect material
 Labour
o Direct labour/Indirect labour
 Overhead (Variable/Fixed)
o Production or works overheads Factory Staff
o Administration overheads Office Staff
o Selling overheads - Catalogues, Advertising, Exhibitions and Sales Staff Costs
o Distribution overheads
o Maintenance & Repair (Office equipment/Factory machinery)
o Supplies
o Utilities Gas Electricity Water Rates
o Other Variable Expenses
o Salaries (Payroll - Wages, NI PAYE Pensions)
o Occupancy (Rent)
o Depreciation (Machinery/Office Equipment)
o Other Fixed Expenses

 Classification of Cost
1. Fixed, Variable and Semi-Variable Costs

The cost which varies directly in proportion with every increase or decrease in the volume of output or production
is known as variable cost.

The cost which does not vary but remains constant within a given period of time and a range of activity inspite of
the fluctuations in production is known as fixed cost.

The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known
as semi-variable cost.

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ACCOUNTING FOR MANAGERIAL DECISIONS M.COM 4th SEM

2. Product Costs and Period Costs


The costs which are a part of the cost of a product rather than an expense of the period in which they are incurred
are called as ―product costs.‖
The costs which are not associated with production are called period costs.

3. Direct and Indirect Costs

The expenses incurred on material and labour which are economically and easily traceable for a product, service or
job are considered as direct costs.

The expenses incurred on those items which are not directly chargeable to production are known as indirect costs.

4. Decision-Making Costs and Accounting Costs


Decision-making costs are special purpose costs that are applicable only in the situation in which they are
compiled. They have no universal application.
Decision-making costs are future costs. They represent what is expected to happen under an assumed set of
conditions.

5. Relevant and Irrelevant Costs [2016 Q.P]0


Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected
by the decision.
This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop
or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be
ignored.
6. Shutdown and Sunk Costs
A manufacturer or an organization may have to suspend its operations for a period on account of some temporary
difficulties,
Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in
the past and cannot be changed by any decision that will be made in the future
7. Controllable and Uncontrollable Costs
Controllable costs are those costs which can be influenced by the ratio or a specified member of the undertaking.
The costs that cannot be influenced like this are termed as uncontrollable costs
8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs
Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with
which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated with the
segment. Such costs are merely reallocated if the segment is discontinued.
9. Imputed or Hypothetical Costs
These are the costs which do not involve cash outlay. They are not included in cost accounts but are important for
taking into consideration while making management decisions
10. Differentials, Incremental or Decrement Cost [2015 Q.P]
The difference in total cost between two alternatives is termed as differential cost. In case the choice of an
alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing
the profitability of a proposed change, the incremental costs are matched with incremental revenue.

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ACCOUNTING FOR MANAGERIAL DECISIONS M.COM 4th SEM

 Marginal cost
The cost added by producing one additional unit of a product or service.
In economics, marginal cost is the change in the opportunity cost that arises when the quantity produced is
incremented by one unit, that is, it is the cost of producing one more unit of a good. In general terms,
marginal cost at each level of production includes any additional costs required to produce the next unit.

 Marginal Costing [ 2015 & 2016 Q.P]

Marginal Costing is ascertainment of the marginal cost which varies directly with the volume of production by
differentiating between fixed costs and variable costs and finally ascertaining its effect on profit

―Marginal Costing is the ascertainment, by differentiating between fixed costs and variable costs, of marginal cost
and of the effect of profit of changes in the volume or type of output.‖

 The basic assumptions made by marginal costing are following:


 Total variable cost is directly proportion to the level of activity. However, variable cost per unit
remains constant at all the levels of activities.
 Per unit selling price remains constant at all levels of activities.
 All the items produced by the organisation are sold off.
 Features of Marginal costing:
 It is a method of recoding costs and reporting profits.
 It involves ascertaining marginal costs which is the difference of fixed cost and variable cost.
 The operating costs are differentiated into fixed costs and variable costs. Semi variable costs are also
divided in the individual components of fixed cost and variable cost.
 Fixed costs which remain constant regardless of the volume of production do not find place in the product
cost determination and inventory valuation.
 Fixed costs are treated as period charge and are written off to the profit and loss account in the period
incurred.
 Only variable costs are taken into consideration while computing the product cost.
 Prices of products are based on variable cost only.
 Marginal contribution decides the profitability of the products.

 Advantages of Marginal Costing

(a) Marginal costing is easy to understand. It can be combined with standard costing and budgetary control
and thereby makes the control mechanism more effective.
(b) Eliminating of fixed overheads from the cost of production prevents the effect of varying charges per unit,
and also prevents the carrying forward of a portion of the fixed overheads of the current period to the
subsequent period. As such, costs and profits are not vitiated and cost comparisons become more
meaningful.
(c) The problem of over or under absorption of overheads is avoided.
(d) A clear – cut division of costs into fixed and variable elements makes the flexible budgetary control system
easy and effective and thereby facilitates greater practical cost control.
(e) It helps profit planning through break-even charts and profit graphs. Comparative profitability can easily
be assessed and brought to the notice of the management for decision-making.

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(f) Marginal costing technique is very easy to understand and operate.


(g) The fixed costs are not taken consideration for the cost of production. This avoids complicated and
misleading statements.
(h) Profits are not overstated since fixed costs are not absorbed in unsold stock.
(i) There is no problem of under absorption or over absorption of overheads.
(j) Management can take quality decision with the help of contribution details
(k) The fixed costs are not apportioned on an arbitrary basis.

 Managerial Uses of Marginal Costing

 Cost Ascertainment

 Cost Control

 Decision-Making

 Some of the decision-making problems that can be solved by marginal costing are:

01. Profit planning


02. Pricing of products
03. Make or buy decisions
04. Product mix etc.

 Limitations of Marginal Costing:

(a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a major technical
difficulty arises in drawing a sharp line of demarcation between fixed and variable costs. The distinction
between them hold good only in the short run. In the long run, however, all costs are variable.
(b) In marginal costing, greater importance is attached to the sales function thereby relegating the production
function largely to a secondary position. But, the real efficiency of a business is to be assessed only by
considering the selling and production functions together.
(c) The elimination of fixed costs from the valuation of inventories is illogical since costs are also incurred in
the manufacture of goods. Further, it results in the understatement of the value of stock, which is neither
the cost nor the market price.
(d) Pricing decision cannot be based on contribution alone. Sometimes, the contribution will be unrealistic
when increased production and sales are effected, either through extensive use of existing machinery or by
replacing manual labour by machines. Another possibility is that there is danger of too many sales being
affected at marginal cost, resulting in denial to the business of inadequate profits.
(e) Although the problem of over or under absorption of fixed overheads can be overcome to a certain extent,
the same problems still persists with regard to variable overheads.
(f) The application of the technique is limited in the case of industries in which, according to the nature of
business, large stocks have to be carried by way of work-in-progress

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 Absorption costing [2016 Q.P]

A method of calculating the cost of a product or enterprise by taking into account indirect expenses
(overheads) as well as direct costs

A method of costing a product in which all fixed and variable costs are apportioned to cost centres where
they are accounted for using absorption rates. This method ensures that all incurred costs are recovered
from the selling price of a good or service. Also called full absorption costing

 Advantages of Absorption Costing

(a) It suitably recognises the importance of including fixed manufacturing costs in product cost determination
and framing a suitable pricing policy. In fact all costs (fixed and variable) related to production should be
charged to units manufactured. Price based on absorption costing ensures that all costs are covered. Prices
are well regulated where full cost is the basis.
(b) It will show correct profit calculation in case where production is done to have sales in future as compared
to variable costing.
(c) It helps to conform to accrual and matching concepts which require matching cost with revenue for a
particular period.
(d) It has been recognised by various bodies as FASB (USA), ASC (UK), ASB (India) for the purpose of
preparing external reports and for valuation of inventory.
(e) It avoids the separation of costs into fixed and variable elements which cannot be done easily and
accurately.
(f) It discloses inefficient or efficient utilisation of production resources by indicating under-absorption or
over absorption of factory overheads.
(g) It helps to make the managers more responsible for the costs and services provided to their
centres/departments due to correct allocation and apportionment of fixed factory overheads.
(h) It helps to calculate the gross profit and net profit separately in income statement.
(i) The fixed costs are incurred for production purpose. Hence, the inclusion of fixed costs in the valuation of
closing stock or products costs is justifiable.
(j) If the fixed costs are not included in the valuation of inventory, fictitious loss is shown in the books of
accounts when the goods are not sold and shown excessive profit in the books of accounts when goods are
sold.
(k) Profit fluctuations are less when production is constant but sales fluctuate.
(l) There is a matching of costs and revenue. It is correct to match the costs with revenue.
(m) The inclusion of fixed cost in the calculation of a total cost of a product helps the businessman to fix the
price above the total cost.

 Limitations of Absorption Costing:

1. Difficulty in comparison and control of cost:


2. Not helpful in managerial decisions:
3. Cost vitiated because of fixed cost included in inventory valuation:
4. Fixed cost inclusion in cost not justified:
5. Apportionment of fixed overheads by arbitrary methods:
6. Not helpful for preparation of flexible budget:
7. No Control of Fixed Cost

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 Absorption costing v/s Marginal costing [2016 Q.P]

Basis for Comparison Marginal Costing Absorption Costing


1. Meaning A decision making technique for Apportionment of total costs to the
ascertaining the total cost of cost center in order to determine the
production is known as Marginal total cost of production is known as
Costing. Absorption Costing.
2. Cost Recognition The variable cost is considered as Both fixed and variable cost is
product cost while fixed cost is considered as product cost.
considered as period costs.
3. Classification of Fixed and Variable Production, Administration and
Overheads Selling & Distribution

4. Profitability Profitability is measured by Profit Due to the inclusion of fixed cost,


Volume Ratio. profitability gets affected

5. Cost per unit Variance in the opening and Variance in the opening and closing
closing stock does not influence stock affects the cost per unit.
the cost per unit of output.
6. Highlights Contribution per unit Net Profit per unit

7. Cost data Presented to outline total Presented in conventional way.


contribution of each product

 How to Prepare an Income Statement under Absorption & Marginal Costing

 Stylistic Differences

 Product versus Period Costs

 Preparing an Absorption Costing Income Statement

 Preparing a Marginal Costing Income Statement

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 Absorption Costing Income Statement – Format:

 Formula – Absorption Rate per unit:

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 Marginal Costing (Variable Costing) Income Statement – Format:

 Statement to Reconcile Profits under Marginal and Absorption Costing – Format:

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UNIT 02

COST-VOLUME PROFIT AND BREAK-EVEN ANALYSIS

 Meaning Cost-Volume Profit (CVP)

Cost Volume Profit Analysis (CVP) The cost volume profit analysis, commonly referred to as CVP, is a
planning process that management uses to predict the future volume of activity, costs incurred, sales made,
and profits received.

 Objectives of Cost-Volume-Profit Analysis

 This analysis helps to forecast profit fairly and accurately as it is essential to know the relationship between
profits and costs on the one hand and volume on the other.
 This analysis is useful in setting up flexible budget which indicates costs at various levels of activity. We
know that sales and variable costs tend to vary with the volume of output. It is necessary to budget the
volume first for establishing budgets for sales and variable costs.
 This analysis assists in evaluation of performance for the purpose of control. In order to review profits
achieved and costs incurred, it is necessary to evaluate the effect on costs of changes in volume.
 This analysis also assists in formulating price policies by showing the effect of different price structures on
costs and profits. We are aware that pricing plays an important part in stabilizing and fixing up volumes
especially in depression period.
 This analysis helps to know the amount of overhead costs to be charged to the products at various levels of
operation as we know that pre-determined overhead rates are related to a selected volume of production.
 This analysis makes possible to attain target profit by locating the volume of sales required for such profit
and finally achieving such sales volume.
 This analysis helps management in taking number of decisions like make or buy, suitable sales mix,
dropping of a product etc.
 Cost-volume-profit analysis is very much useful for profit planning, cost control and decision-making.
 It helps to determine the maximum sales volume required to avoid losses.
 It helps to determine the sales volume at which the profit goal of the firm will be achieved.
 It helps management to find the most profitable combination of costs and volume.
 It helps in evaluating the effect of change in selling price on profitability.
 It provides a means for assessing the profitability of each product so that the optimum product mix may be
determined.

 Assumptions Underlying Cost-Volume-Profit Analysis:

 Fixed and variable cost patterns can be established with reasonable accuracy and that fixed costs
remain static and marginal costs are completely variable at all levels of output.
 Selling prices are constant at all sales volumes.
 Factor prices (e.g. material prices, wage rates) are constant at all sales volumes.
 Efficiency and productivity remain unchanged.
 In a multi-product situation, there is constant sales mix at all levels of sales.
 Turnover level (volume) is the only relevant factor affecting costs and revenue.
 The volume of production equals the volume of sales.

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 Factors Affecting Cost-Volume-Profit Analysis:

 Volume of production,

 Product mix,

 Internal efficiency,

 Methods of production, and

 Size of plant etc.

 Importance of CVP Analysis


 The CVP analysis is very much useful to management as it provides an insight into the effects and inter-
relationship of factors, which influence the profits of the firm.
 The relationship between cost, volume and profit makes up the profit structure of an enterprise. Hence, the
CVP relationship becomes essential for budgeting and profit planning.
 As a starting point in profit planning, it helps to determine the maximum sales volume to avoid losses, and
the sales volume at which the profit goal of the firm will be achieved.
 As an ultimate objective it helps management to find the most profitable combination of costs and volume.
 A dynamic management

 Technique of Cost-Volume-Profit Analysis:

A. Break-even analysis, and


B. Profit-Volume (P/V) analysis.

A. Break-even analysis,(BEP)

Breakeven analysis is used to determine when your business will be able to cover all its expenses and begin to
make a profit. ... The breakeven point is reached when revenue equals all business costs. To calculate your
breakeven point, you will need to identify your fixed and variable costs.

Fixed Costs ÷ (Price - Variable Costs) = Breakeven Point in Units

 Objectives of BEP

1. In order to forecast profit accurately, it is essential to know the relationship between profits and costs on
the one hand and volume on the other.
2. BEP analysis is useful in setting up flexible budgets which indicate costs at various levels of activity.
3. It is of assistance in performance evaluation for the purposes of control.
4. For reviewing profits achieved and cost incurred the effects on costs of changes in volume are required to
be evaluated.
5. Pricing plays an important part in stabilizing and fixing up volume.

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6. As predetermined overhead rates are related to a selected volume of production, study of BEP relationship
is necessary in order to know the amount of overhead costs which could be charged to product costs at
various level of operation.

 Assumptions of Break-Even Analysis

 The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.
 The cost and revenue functions remain linear.
 The price of the product is assumed to be constant.
 The volume of sales and volume of production are equal.
 The fixed costs remain constant over the volume under consideration.
 It assumes constant rate of increase in variable cost.
 It assumes constant technology and no improvement in labour efficiency.
 The price of the product is assumed to be constant.
 The factor price remains unaltered.
 Changes in input prices are ruled out.
 In the case of multi-product firm, the product mix is stable.

 Advantages of BEP

a. It provides detailed and clearly understandable information.


b. The profitability of different products can be known with the help of break-even charts, besides the
level of no-profit no-loss.
c. The problem of managerial decision regarding temporary or permanent shutdown of business or
continuation at a loss can be solved by break-even analysis.
d. The effect of changes in fixed and variable costs at different levels of production or profits can be
demonstrated by the graph legibly.
e. The break-even chart shows the relative importance of fixed cost in the total cost of a product. If the
costs are high, it induces management to take measures to control such costs
f. The economies of scale, capacity utilization and comparative plant efficiencies can be analysed through
the break-even chart.
g. The operational efficiency of a plant is indicated by the angle of incidence formed at the intersection of
the total cost line and sales line.
h. Break-even analysis is very helpful for forecasting, long-term planning, growth and stability.

 Limitations of break-even analysis

(i) Fixed costs do not always remain constant.


(ii) Variable costs do not always vary proportionately.
(iii) In the break-even analysis, we keep everything constant. The selling price is assumed to be constant
and the cost function is linear. In practice, it will not be so.
(iv) In the break-even analysis since we keep the function constant, we project the future with the help
of past functions. This is not correct.
(v) The assumption that the cost-revenue-output relationship is linear is true only over a small range of
output. It is not an effective tool for long-range use.
(vi) Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.

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(vii) When break-even analysis is based on accounting data, as it usually happens, it may suffer from
various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates and
inappropriate allocation of overheads. It can be sound and useful only if the firm in question
maintains a good accounting system.
(viii) Selling costs are specially difficult to handle break-even analysis. This is because changes in selling
costs are a cause and not a result of changes in output and sales.
(ix) The simple form of a break-even chart makes no provisions for taxes, particularly corporate income
tax.
(x) It usually assumes that the price of the output is given. In other words, it assumes a horizontal
demand curve that is realistic under the conditions of perfect competition.
(xi) Matching cost with output imposes another limitation on break-even analysis. Cost in a particular
period need not be the result of the output in that period.
(xii) Because of so many restrictive assumptions underlying the technique, computation of a breakeven
point is considered an approximation rather than a reality.

B. Profit-Volume (P/V) analysis.

Profit-volume ratio indicates the relationship between contribution and sales and is usually expressed in
percentage.

The ratio shows the amount of contribution per rupee of sales. Since, in the short-term, fixed cost does not change,
the profit-volume ratio also measure the rate of change of profit due to change in the volume of sales.

 The formula to calculate P/V ratio is:

Contribution= Sales Revenue – Variable Cost

Contribution= Fixed Cost + Profit

 Uses of P/V Ratio:

 It helps in the determination of Break-even-point [BEP = Fixed cost ÷ P/V ratio]


 It helps in the determination of profit at any volume of sales

[Sales x P/V ratio = Contribution, Profit = Contribution – Fixed Cost]

 It helps in determining margin of safety [Margin of safety = Profit ÷ P/V ratio]

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 It helps in the determination of sales to earn a desired amount of profit

 Application of marginal costing for marginal decision

a) Contribution ( Per unit) = Sale per unit - Variable Cost per unit
b) Total profit or loss = Total Contribution - Total Fixed Costs

(or) Contribution = Fixed cost +Profit

(Or) Profit = Contribution - Fixed Cost

c) Profit Volume Ratio = Contribution/ Sale X 100 (It means if we sell Rs. 100 product, what will be our
contribution margin, more contribution margin means more profit)
d) Break Even Point is a point where Total sale = Total Cost
e) Break Even Point ( In unit ) = Total Fixed expenses / Contribution
f) Break Even Point ( In Sales Value ) = Break-even point (in units) X Selling price per unit
g) Break Even Point at earning of specific net profit margin= Total Contribution / Contribution per unit

(or) fixed cost + profit / selling price - variable cost per unit

 Diversification product

The process of expanding business opportunities through additional market potential of an existing product.
Diversification may be achieved by entering into additional markets and/or pricing strategies. Often the
product may be improved, altered or changed, or new marketing activities are developed.

Diversification is a corporate strategy to enter into a new market or industry which the business is not
currently in, whilst also creating a new product for that new market.

The term ‗product diversification‘ is sometimes called ‗product differentiation‘. Product diversification is a
part of product line decisions‘. The word diversification means that something new will be added.

 Objectives of Product Diversification

1. To gain stability in the firm‘s earnings and organisation.


2. To attain efficiency in the utilisation of a firm‘s resources — human, physical and financial.
3. To increase sales of basic products and exploit the value of an established trade mark.
4. To increase the profits by offering different types of products.
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5. To meet the demands and convenience of the diversified retailers.


6. To make profitable use of marketing opportunities.

 Forms of Product Diversification

a. Diversification into related product-line,


b. Diversification into unrelated product line, and
c. Product replacement.

 Factors that Motivate Product Diversification

 The development of science and technology offers scope for new products and causes obsolescence
of old and existing products.
 An efficient management of a firm is always on the lookout for doing new things.
 Industrial and economic policies of the Government encourage a firm to invest in its research and
development and this leads to new products as a base for diversification.
 The feeling that the economy (or market) in which the firm is operating is too small and confined to
allow growth may prompt a firm to pursue the policy of product diversification.
 The firm‘s technology, research, and development produce products and by-products which appear
to be outstanding.
 The impact of social changes and development on the consumers‘ behaviour, demand, fashion, and
style motivates a firm towards product diversification.

 Product Mix Decision


Product mix decision refers to the decisions regarding adding a new or eliminating any existing product from the
product mix, adding a new product line, lengthening any existing line, or bringing new variants of a brand to
expand the business and to increase the profitability.

 Product Line Decision - Product line managers takes product line decisions considering the sales and
profit of each items in the line and comparing their product line with the competitors' product lines in the
same markets. Marketing managers have to decide the optimal length of the product line by adding new
items or dropping existing items from the line.
 Line Stretching Decision - Line stretching means lengthening a product line beyond its current range. An
organisation can stretch its product line downward, upward, or both way.

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 Factors Affecting Product Mix

 Profitability

 Objectives and Policy of Company

 Production Capacity

 Demand

 Production Costs

 Government Rules and Restriction

 Demand Fluctuation

 Competition

 Impact of Other Elements of Marketing Mix

 Overall Business Condition or Condition of Economy

 Make or buy Decision


A make-or-buy decision is the act of choosing between manufacturing a product in-house or purchasing it
from an external supplier. In a make-or-buy decision, the most important factors to consider are part of
quantitative analysis, such as the associated costs of production and whether the business has the capacity
to produce at required levels.

 Make Costs

In regards to in-house production, a business must include expenses related to the purchase and maintenance of
any production equipment as well as the cost of production materials. Further costs can include the additional
labour required to produce the items, storage requirements within the facility or if additional storage space must be
purchased, and the proper disposal of any remnants or by products from the production process.

 Buy Costs

Costs relating to purchasing the products from an outside source must include the price of the good itself, any
shipping or importing fees, and applicable sales tax charges. Additionally, the expenses relating to the storage of
the incoming product and labour costs associated with receiving the products into inventory must be factored into
the decision.

 Factors that may influence firms to buy a part externally include:

 Lack of expertise
 Suppliers' research and specialized know-how exceeds that of the buyer
 cost considerations (less expensive to buy the item)
 Small-volume requirements

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 Limited production facilities or insufficient capacity


 Desire to maintain a multiple-source policy
 Indirect managerial control considerations
 Procurement and inventory considerations
 Brand preference
 Item not essential to the firm's strategy

 Elements of the "make" analysis include:

 Incremental inventory-carrying costs


 Direct labour costs
 Incremental factory overhead costs
 Delivered purchased material costs
 Incremental managerial costs
 Any follow-on costs stemming from quality and related problems
 Incremental purchasing costs
 Incremental capital costs

 Cost considerations for the "buy" analysis include:

 Purchase price of the part


 Transportation costs
 Receiving and inspection costs
 Incremental purchasing costs
 Any follow-on costs related to quality or service

 Costs for the make analysis

 Direct labour expenses


 Incremental inventory-carrying expenses
 Incremental capital expenses
 Incremental purchasing expenses
 Incremental factory operating expenses
 Incremental managerial expenses
 Delivered purchased material expenses
 Any follow-on expenses resulting from quality and associated problems

 Advantages of Make or Buy Decision

 Saving Money
 Staying Flexible
 Quality Control
 Scaling for Volume

 Factors influencing “Make or Buy” decision

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1. Size of the company influence Make or Buy decision

2. Difficulties in Manufacturing

3. Quality of goods

4. Profit factor

5. Capacity to manufacture

 Guidelines to “Make or Buy” policy

The following are often an answer to most ―make or buy‖ decisions relating to supplies and services:

1. When a dependable source does not exist outside, it is desirable for the company to produce the goods of the
desired quality, unless some unforeseen circumstances develop. For instance, most big companies prefer to have
their own thermal supply because public power plants are not reliable.

2. When a dependable source exists outside which provides goods at an economical price, it should be used, unless
there is a strong case for not doing so. For instance, under the following conditions, it is always desirable to
depend on their own resources:

a. When an item is required in large quantities which can be produced at a low cost by the company itself;
b. When suppliers are not willing to provide goods of the desired quality or cater to the special needs of their
buyers; and
c. When coordination with suppliers seems to be quite difficult.

 Effects of changes in selling price

 Price Elasticity
 Substitutions And Competition
 Time
 Pricing Strategies
 Simple Economics
 Revenue and Profit
 Quality Considerations

 Shut down or Continue decision

In economics, a firm will choose to implement a shutdown of production when the revenue received from the sale
of the goods or services produced cannot even cover the fixed costs of production. In that situation, the firm will
experience a higher loss when it produces, compared to not producing at all.

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 In case of decision rendering closure or shut down we consider the following points:

1. Current profit situation has to be maintained, So by analysing the proposal of shut down or outsourcing if
the current income is reduced then shut down will not be allowed unless the product or factory has reached at
the end of its life cycle.

2. In case of outsourcing proposal we can also apply the differential cost concept i.e. saving in cost must be
greater than or equal to out-sourcing fees payment. Here saving in cost i.e. cash inflow is computed from the
concept of relevant cost i.e. by closing down we are saving variable cost of production, and discretionary fixed
cost or shut down cost.

 Application of differential cost analysis [2015 & 2016.Q.P]

Differential costing is a technique where mainly differential costs are considered relevant. Differential cost
is the difference in total costs between two acceptable alternative courses of action.

 Essential Features of Differential Costing:

1. The data used for differential cost analysis are cost, revenue and investments involved in the
decision-making problem.

2. Differential costs do not find a place in the accounting records. These can be determined from the
analysis of routine accounting records.

3. The total cost figures are considered for differential costing and not the cost per unit.

4. Differential cost analysis determines the choice for future course of action and hence it deals with
the future costs but even then historical or standard costs, adjusted to the future requirements may
be used in differential costing.

5. Differential costing involves the study of difference in costs between two alternatives and hence it
is the study of these differences, and not the absolute items of cost, which is important. Moreover,
elements of cost which remain the same or identical for the alternatives are not taken into
consideration.

6. The differences are measured from a common base-point.

7. The alternative which shows the highest difference between the incremental revenue and the
differential cost is the one considered to be the best choice.

 Managerial Applications of Differential Cost Analysis:

1. Determination of the most profitable level of production and price.


2. Introduction of new products.
3. Acceptance of an offer at a lower selling price.
4. Changing the product mix.

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5. Changing the method of product.


6. Discontinuing a product to avoid the losses and increase profits – decision to drop a product line.
7. Make or buy decisions.
8. Decision regarding the depth of processing.
9. Shut -down decisions.
10. Equipment replacement decisions.
11. Determining a suitable price at which raw materials may be purchased.

 Practical Applications of Differential Cost Analysis:

a. Determination of the most profitable levels of production and price


b. Acceptance of special orders – offer at a lower price or offering a quotation at lower selling price in
order to increase the capacity.
c. Sell a product as it is or after further processing
d. Determination of right price at which materials may be purchased
e. Decisions regarding alternative capital investment and plant replacement
f. Decisions such as changing the product mix, method of production, make or buy, adding new product,
etc.

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UNIT 03

BUDGETING AND BUDGETARY CONTROL

 Meaning of Budget [2015 Q.P]

Budget An estimate of income and expenditure for a set period of time

An estimate of costs, revenues, and resources over a specified period, reflecting a reading of future financial
conditions and goals

According to CIMA Terminology, budget is ―a plan quantified in monetary terms prepared and approved prior to a
defined period of time, usually showing planned income to be generated and/or expenditure to be incurred during
that period and the capital to be employed to attain a given objective‖.

 Features of Budget

 It is prepared beforehand based on a future plan of actions;


 It is related to a definite future period and is based on the objectives to be attained;
 It is expressed in financial terms;
 It shows planned income to be generated;
 It shows probable expenditure to be incurred;
 It indicates the capital to be employed during the period;

 Essential of budgeting

 Accurate Forecasting of Business Activities


 Coordinating Business Activities
 Communicating the Budgets
 Acceptance and Cooperation
 Reasonable Flexibility
 Providing a Framework for Evaluation
 An Adequate, Planned and Reliable Accounting System
 Efficient Organisation
 Formation of Budget Committee
 Cleanly defined Business Policies
 Availability of Standard Information
 Support of Top Management
 Good Reporting System
 Motivation

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 Design of Budgeting for its Success

 Measure Output not Input

 Plan First, Budget Later

 Budgeting is for Managers, not Accountants

 Design against Turf Wars

 Build Budget Busting into the System

 Types of Budgets

I. Functional Budgets:

A functional budget is a budget which relates to the individual functions of the organisation like sales, production,
purchase, capital expenditure etc. For each function there is usually a separate budget which is controlled by the
functional manager.

 Normally, the various functional budgets which are drawn up in an organisation are:

1. Sales Budget:

This budget is a forecast of quantities and values of sales to be achieved in a budget period. Generally, sales
budget is the starting point for the preparation of the functional budgets. This budget can be prepared on the basis
of products, sales areas or territories, salesmen or agent wise, types of customers etc.

 A sales budget may be prepared with the help of any one or more of the following methods:
 Analysis of Past Sales
 Market Analysis
 Reports of Salesmen
 General Trade Prospects
 Business Conditions
 Special Conditions

2. Selling and Distribution Cost Budget:

This budget is a forecast of the expenses connected with the selling and distributing the product of a concern
during the budget period. This budget is closely connected with the sales budget. While preparing this budget, a
classification is made according to the variability of cost. This budget is prepared by the sales managers.

3. Production Budget:

After preparing the sales budget, the production budget is prepared. This budget is prepared in physical units. It
shows the number of units of each product that must be produced to satisfy the sales forecasts and to achieve the
desired level of inventory.

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 Thus, production budget is the sales budget adjusted for inventory changes as:

Units to be produced = Budgeted Sales + Desired closing inventory – Opening inventory.

4. Production Cost Budget:

Production cost budget shows in detail the estimated cost of carrying out the production plan and programmes set
out in the production budget. This budget summarizes material cost, labour cost and factory overhead for
production. Factory overheads are usually further subdivided into fixed, variable and semi-variable. Cost are
analysed by departments and/or products.

5. Material Budget:

A Material Budget shows the estimated quantity as well as the cost of each type of direct material and component
required for producing goods as per production budget. There are two stages of preparing material budget. At the
first stage, the quantifies of different types of direct material are estimated.

Afterwards the price of each kind of direct material and component is used to obtain the cost of different types of
materials and components consumed. It is necessary to know unit material utilisation rate for preparing material
budget. The unit material utilisation rate is multiplied by the number of units to be produced in order to determine
the total units of material required for estimated production.

6. Purchase Budget:

Purchase Budget gives the details of the purchases which must be made during the budget period. It includes all
items of purchase, such as, raw materials, indirect material and other equipment.

 The purchase budget for raw materials is the most important and the following factors are required to
be considered in preparing this budget:

 Production or delivery target,


 Quantity and quality of each material needed,
 Present stock position,
 The dates on which different quantities of materials are required,
 Safety stock,
 Orders already placed,
 Sources of supply,
 Storage space available,
 Economic order quantity,
 Price to be paid,
 Finance available,
 Seasonal discounts,
 Transport and receiving arrangement,
 Management policy etc.

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7. Labour Budget:

This budget contains the estimates relating to number of employees and types of employees required for the
budgeted output. Once the classification of labour into its different grades has carried out, the labour requirements
for each type of product can be estimated.

The standard labour hours required for each type of product are then set with the help of time and motion study.
From the total man-hours required for production, labour requirements are determined and, from the estimated rate
per hour, labour cost per unit is determined.

8. Factory Overhead Budget:

Factory overhead budget gives an estimates of all fixed, variable and semi-variable items of factory overhead to be
incurred during the budget period to achieve the production budget.

9. Plant Utilisation Budget:

This budget indicates plant and machinery facility required to meet the budgeted production during the budget
period. Plant capacities/facilities will be expressed in the budget in terms of convenient units such as working
hours or weight or the number of products etc. While preparing this budget allowance must be made for the time
lost in repairs and maintenance, setting-up time etc.

 The main purposes of plant utilisation budget are:


 To determine the load on each process, cost centre or groups of machines for the budget period.
 To indicated the processes or cost centres which are overloaded so that corrective action may be taken such
as shift working, overtime working, sub-contracting, purchase of new machinery etc.
 To indicate the processes or cost centres which are under-loaded—so as to make effort to increase the sales
volume to utilise the surplus capacity.
10. Administration Cost Budget:

This budget represents the estimated cost of formulating policy, directing the organisation and controlling the
business operations. Since most of the administration cost is fixed in nature, the preparation of this budgets does
not present much difficulty. The main budget is divided into separate budget covering separate administrative
activities such as legal, finance, accounting, management information services, internal audit and taxation.

11. Research and Development Cost Budget:

This budget provides an estimates of the expenditure to be incurred on research and development during the
budget period. The expenditure of research depends on the nature of the concern‘s product, economic condition,
extent of competition, technological development in related industry, and the policy of the management.
Generally, a total allowed expenditure provides a base for preparation of this budget.

12. Capital Expenditure Budget:

This budget gives an estimate of the amount of capital that may be needed for acquiring fixed assets required for
achieving the production targets as laid down in the production budget. This budget is based on the requisitions for
capital expenditure from various departments and after considering their profitability, capital expenditure is
sanctioned and incorporated in the budget.

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13. Cash Budget:

A cash budget is a statement of estimated sources and uses of-cash. It compares the estimated cash receipts and
cash disbursements of the concern during the budget period and shows the resultant periodical cash position as the
budget period develops. This budget is prepared after all the functional budgets are prepared.

 The cash budget serves the following purposes:


o It ensures that sufficient cash is available when required for revenue and capital expenditure.
o It shows how much cash can be internally generated to finance capital expenditure.
o It reveals when a shortage of cash is most likely to occur, so that action may be taken in time e.g., bank
overdraft or loan from some other sources may be arranged.
o It indicates the availability of cash for taking advantages of discounts offered.
o It shows the availability of excess funds for short or long-term investments.

 A cash budget is prepared by any of the following methods:


a. Receipts and Payments Method
b. Adjusted Profit and Loss Method
c. Balance Sheet Method

 The purchase budget for raw materials is the most important and the following factors are required to
be considered in preparing this budget:

 Production or delivery target,


 Quantity and quality of each material needed,
 Present stock position,
 The dates on which different quantities of materials are required,
 Safety stock,
 Orders already placed,
 Sources of supply,
 Storage space available,
 Economic order quantity,
 Price to be paid,
 Finance available,
 Seasonal discounts,
 Transport and receiving arrangement,
 Management policy etc.

II. Master Budget:

Master budget is a summary of all the functional budgets and shows the overall budget plan.

According to CIMA terminology:

―A master budget is the summary budget incorporating its component as functional budgets and which is finally
approved, adopted and employed.‖ This budget commonly summarizes functional budgets to produce a budgeted
Profit and Loss Account and a budgeted Balance Sheet at the end of the budget period.

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III. Fixed Budget (Static Budget):

A fixed budget is defined as a budget which is designed to remain unchanged irrespective of the volume of output
or turnover attained. The budget remains fixed over a given period and does not change with the change in the
volume of production or level of activity attained.

Thus, it does not provide for any change in expenditure arising out of changes in the level of activity or capacity.
A fixed budget will, therefore, be useful only when the actual level of activity corresponds to the budgeted level of
activity. But if the level of output actually achieved differs considerably from that budgeted, large variances will
arise and the budgetary control becomes ineffective and meaningless.

IV. Flexible Budget: [2016 Q.P]

A flexible budget is a budget which is designed to change in accordance with the level of activity actually attained.

According to the ICMA Terminology:

―Flexible budget is a budget which, by recognising the difference in behaviour between fixed and variable costs in
relation to fluctuations in output, turnover, or other variable factors such as number of employees, is designed to
change appropriately with such fluctuations.‖

Thus, a flexible budget distinguishes between fixed and variable costs and adopts itself to any level of activity.
This budget also involves the construction of a series of fixed budgets for different levels of activity. The budget
allowance given under this system serves as a standard of what costs should be at each level of activity.

Hence budgeted cost at actual activity is compared with actual cost at actual activity i.e., two things to a like base.
It helps both in profit planning and controlling cost.

 Need for Flexible Budgeting:

 Where level of activity during the year varies from period to period due to the seasonal nature of the
industry.
 Where the business is a new one or introduces new products and it is difficult to foresee the demand.
 Where the level of activity depends upon the availability of a factor of production such as materials,
labour, plant capacity etc. which is short in supply.
 Where an industry is influenced by changes in fashion.
 Where there are general changes in sales.

 Uses of Flexible Budgeting:

 Costs can be ascertained with greater degree of accuracy and under /over-recovery of the overheads can be
successfully minimised.
 It helps management to control costs more effectively because the total costs at different levels of operation
are determined already.
 It helps to implement the technique of management by exception.
 It enables management to keep an eye on the total performance of the organisation ranging from
production to sales and from cost to profit.
 It also helps the management to adjust the production level, the cost structure and the price level as may be
the case.

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 It makes the performance evaluation possible since in the event of change in the level of activity the budget
can be suitable modified.
 Since costs are classified in accordance to their variability, the introduction of marginal costing technique
is facilitated to a great extent. As a result, a firm can avail of the benefit of taking strategic decisions like
make or buy, fixation of selling price, utilisation of spare capacity etc..

 Budgetary control

Budgetary control refers to how well managers utilize budgets to monitor and control costs and operations in a
given accounting period. In other words, budgetary control is a process for managers to set financial and
performance goals with budgets, compare the actual results, and adjust performance, as it is needed.

―According to Brown and Howard, ―Budgetary control is a system of controlling costs which includes the
preparation of budgets, coordinating the departments and establishing responsibilities, comparing actual
performance with the budgeted and acting upon results to achieve maximum profitability.‖ Weldon characterizes
budgetary control as planning in advance of the various functions of a business so that the business as a whole is
controlled.

 Features of budgetary control [2016 Q.P]

 Planning
 Communicating
 Coordination
 Control and performance evaluation.
 Setting attainable objectives;
 Assigning executive responsibility;
 Planning the activities to achieve the objectives;
 Comparing actual results against the plan;
 Taking corrective actions and.
 Reviewing and revising plans in the light of changes.

 Objectives of budgetary control [ 2016 Q.P]


o To ensure planning for future by setting up various budgets, the requirements and expected performance of
the enterprise are anticipated.
o To operate various cost centres and departments with efficiency and economy.
o Elimination of wastes and increase in profitability.
o To anticipate capital expenditure for future.
o To centralise the control system.
o Correction of deviations from the established standards.
o Fixation of responsibility of various individuals in the organization.
o Providing plans for achieving the objectives so defined.
o Coordinating the activities of various departments.
o Operating various departments and cost centres economically and efficiently.
o Increasing the profitability by eliminating waste.
o Centralizing the control system.

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 Principles of Budgetary Control

 Establish a plan or target of performance which coordinates all the activities of the business.
 Record the actual performance.
 Compare the actual performance with that planned.
 Calculate the differences or variances, and analyse the reasons for them.
 Proper action is to be taken immediately to remedy the situation.

 Essentials of Effective Budgetary Control

 Sound forecasting
 Goal orientation
 Proper recording system
 Participation
 Top Management support
 Flexibility
 Enforce timeliness
 Efficient organization
 Proper Co-ordination
 Sound administration
 Constant Review
 Reward and punishment
 Results take time
 Organisation for Budgetary Control
 Budget Centres
 Budget Mammal
 Budget Officer
 Budget Committee
 Budget Period
 Determination of Key Factor

 Advantages of Budgetary Control

 Maximization of Profits
 Co-ordination
 Specific Aims
 Tool for Measuring Performance
 Economy
 Determining Weaknesses
 Corrective Action
 Consciousness
 Reduces Costs
 Introduction of Incentive Schemes

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 Limitations of Budgetary Control


 Uncertain Future
 Budgetary Revision Required
 Discourage Efficient Persons
 Problem of Co-ordination
 Conflict among Different Departments
 Depends Upon Support of Top Management

 Zero-based budgeting [2016Q.P]

Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be justified for each new period.
Zero-based budgeting starts from a "zero-base‖ and every function within an organization is analyzed for its needs
and costs.

 Zero based budgeting steps

1. Identification of a task
2. Finding ways and means of accomplishing the task
3. Evaluating these solutions and also evaluating alternatives of sources of funds
4. Setting the budgeted numbers and priorities

 Zero Based Budgeting Advantages

 Accuracy
 Efficiency
 Reduction in redundant activities
 Budget inflation
 Coordination and Communication

 Zero Based Budgeting Disadvantages

 Time-Consuming
 High Manpower Requirement
 Lack of Expertise
 Implementation Problems
 Formulation Problems
 Ranking Problems

 Performance budget [2016 Q.P]

Performance budget is a budget that reflects the input of resources and the output of services for each unit of an
organization. This type of budget is commonly used by the government to show the link between the funds
provided to the public and the outcome of these services.

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 Advantages of Performance Budget

 Performance budgeting invites performance audit in the firms;


 It helps to attain the objectives of the firm in a scientific manner;
 This budgeting system motivates to improve performance since input-output relationship is maintained.
 Correct steps can easily be taken since continuous comparisons can be made between the target and the
actual performance;
 In case of shortage or insufficient funds, proper allocation of funds can be made to various activities as per
importance.
 All the activities of a firm can easily be analysed and the unimportant activities may be eliminated.

 Disadvantages of Performance Budget:

 The success or failure of performance budgeting depends on a well-established accounting system.


 The workers and employees of an organisation are not interested rather resist it for its introduction as they
are to work hard and more.
 It is not always possible to ascertain appropriate activity in an organisation.
 It invites lots of money and time and energy since various activities are expressed in physical units.

 Steps in Performance Budgeting (PB):

8. To establish a meaningful functional programme and activity classification of Government undertakings.


9. Financial accounting and financial management should be classified according to the classification of PB.
10. Evaluate suitable norms, work units of performance and cost per unit, if possible.

 Stages of Performance Budgeting:

a. Objectives
b. Classification
c. Analysis
d. Evaluation
e. Organisation

 Effectiveness of Performance Budgeting

 It facilitates to adopt performance audit:

 It helps to make progress regarding long-term objectives.

 It also helps to evaluate the progress or otherwise in time-bound activities so that remedial measures may
be adopted to complete such objective.

 It also helps to review the budget and also helps to take decision at all levels of management as far as
possible.

 It matches both the financial aspect and physical aspect of various programmes and activities as well.

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 Operational Steps in PB

 Formulation of objectives of the agency/department


 Identification of various programmes or projects, which will help the agency to achieve its objective
 Evaluation of the programmes in terms of benefits that they produce compared to the resources that they
consume
 Selection of the programmes on the basis of cost benefit analysis in order to utilize the funds in the optimal
manner
 Development of performance criteria for the various programmes (suitable work measurement units,
norms, yardsticks, standards, and other performance indicators)
 Preparation of long-term physical as well as financial plans
 Preparation of the annual budget
 Assessment of performance of each programme and by each responsibility unit and comparison of the
same with the budget
 Undertaking periodical review of programmes with a view to assess the strengths and weaknesses and
make modification, if necessary

 Budgeting as key to planning and control [2015 Q.P]

Planning and budgeting are essential for management control. Effective planning and budgeting require looking at
the organization as a system and understanding the relationship among its components.

 Symptoms of incomplete or inadequate planning and budgeting

 Management activity is largely reactive, stressful and disorganized.


 Authority and accountability for results are unclear or highly centralized.
 Funding and other resource priorities are unclear or non-existent.
 Cash flow problems are common.
 Persons responsible for activities have difficulty obtaining the necessary resources.
 Objectives, schedules, and budgets are not established or are not communicated to persons responsible for
action.
 Performance expectations are not specified or achieved.
 Unexpected workforce reductions or excessive overtime are common.
 Untrained or inadequately trained employees are assigned important tasks.
 The organization has recurring difficulty meeting customer delivery and service requirements.

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UNIT 04

STANDARD COSTING AND VARIANCE ANALYSIS

 Meaning of Standard Costing

It is a method of costing by which standard costs are employed. According to ICMA, London, Standard Costing is
―the preparation and use of standard costs, their comparison with actual cost and the analysis of variances to their
causes and points of incidence‖.

―Standard Costing discloses the cost of deviations from standards and clarifies these as to their causes, so that
management is immediately informed of the sphere of operations in which remedial action is necessary.‖

 Objectives of Standard Costing:

 Cost control
 Management by Exception
 Develops cost conscious attitude
 Fixing prices and formulating
 Fixation of prices
 Management planning
 It helps to implement budgetary control system in operation;
 It helps to ascertain performance evaluation.
 It supplies the ways to utilise properly material, labour and also overhead which will be economic in
character.
 It also helps to motivate the employees of a firm to improve their performance by setting up a ‗standard‘.
 It also helps the management to supply necessary data relating to cost element to submit quotations or to
fix up the selling price of a firm.
 It also helps the management to make proper valuations of inventory (viz., Work-in- progress, and finished
products).
 It acts as a control device to the management.
 It also helps the management to take various corrective decisions viz., fixation of price, make-or-buy
decisions etc. which will be more beneficial to the firm.

 Features of Standard Costing

Standard costing is a technique of cost accounting.

The cost or service or product is predetermined.

The predetermined cost is known as standard cost.

Actual cost of product and service is ascertained.

The comparison is made between standard cost and actual cost and variances are noted.

Variances are analysed to find out the reason.

Variances are reported to management in order to take corrective action.

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 Ways of Developing Standards

The direct materials price standard is based on a vigilant estimate of all possible price increases, changes in
available quantities, and new sources of supply in the next accounting period.

The direct materials quantity standard is based on product engineering specifications, the quality of direct
materials, the age and productivity of machines, and the quality and experience of the work force.

The direct labour rate standard is defined by labour union contracts and company personnel policies.

The direct labour time standard is based on current time and motion studies of workers and machines and records
of their past performance.

The standard variable overhead rate and standard fixed overhead rate are found by dividing total budgeted variable
and fixed overhead costs by an appropriate application base.

 Development of Standard Costing

 Compilation of Historical Cost is very expensive and difficult

 Historical Costs are inadequate

 Historical Costs are too old

 Historical Costs are not typical

 Elements are used to verify a standard cost per unit:

1. Direct materials price standard


2. Direct materials quantity standard
3. Direct labour rate standard
4. Direct labour time standard
5. Standard variable overhead rate
6. Standard fixed overhead rate

 Advantages of Standard Costing:

a. A guide to the management in several management functions


b. More effective cost control
c. Leads to cost reduction.
d. Its measurement helps to detect inefficiencies
e. Mistakes which enable the management to investigate the reasons.
f. Since standard costs are predetermined costs they are very useful for planning and budgeting. It also helps
to estimate the effect of changes in Cost-Price-Volume relationship which also helps the management for
decision-making in future.

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g. As standard is fixed for each product, its components, materials, process operation etc. it improves the
overall production efficiency which also ultimately reduces cost and thereby increases profit.
h. Once the Standard Costing System is implemented it will lead to saving cost since most of the costing
work can be eliminated.
i. Delegation of authority and responsibility becomes effective by setting up standards for each cost centre as
the supervisors or executives of each cost centre will know the standard which they have to maintain.
j. This system also helps to prepare Profit and Loss Account promptly for short period in order to know the
trend of the business which helps the management to take decisions promptly.
k. Standard costing also is used for inventory valuation purposes. Stock can be valued at standard cost which
can reduce the fluctuation of profit for different methods of valuation for the same.
l. Efficiency of labour is promoted.
m. This system creates cost-consciousness among all employees, executives and top management which
increase efficiency and productivity as well.
n. A standard costing is a rule of measurement established by authority, which provides a yardstick for
performance evaluation.
o. Standard costing system minimizes the wastage by detecting variance and suggesting for corrective
actions.
p. Under the standard costing system, cost centres are established and responsibility is assigned to the
concerned departments and persons and thus it helps to increase the effective delegation of authority.
q. A properly developed standard costing system with full participation and involvement creates a positive,
cost effective attitude through all levels of management.
r. The standard system encourages reappraisals of methods, materials and techniques that help to reduce the
unfavourable variances.
s. The standard costing system helps to draw management's attention towards those items which are not
proceeding according to plan.
t. Standard costing system makes the whole organization cost-conscious as it gives the focus to the standard
cost and variance analysis.
u. Standard costing system provides a basis for incentive scheme to workers and supervisors.
v. Standard costing system simplifies the cost control procedures.
w. Standard costing acts as an effective tool for business planning, budgeting, marginal costing , inventory
valuation etc.

 Disadvantages of Standard Costing:

a. Difficulty in setting standards


b. Not suitable to small business
c. Not suitable to all industries
d. Difficult to fix responsibility
e. Technological changes
f. Since Standard Costing involves high degree of technical skill, it is, therefore, costly.
g. The executives are liable for those variances that are found from actions which are actually controllable by
them.
h. Standards are always changing since conditions of the business are equally changing.
i. Standards are either too liberal or rigid since the same are based on average past results, attainable good
performance or theoretical maximum efficiency.

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 Different types of standards under standard costing

 Basic standards
 Normal standards
 Current standards
 Attainable (expected) standards
 Ideal (theoretical) standards

 Standard costing as a control technique


 The Techniques of standard costing:
a. There is a pre-determination of data which are related to production. Thus pre-determination of
materials & labour operations in details which is necessary for each product; pre-determination of
losses which are unavoidable, level of expected efficiency, level of activity etc are involved in standard
costing.
b. For each element i.e., material, labour & overhead, standard costs are setup in detail.
c. Ascertainment of variances, which arises as a result of differences between the actual costs &
corresponding standard cost in detail & element wise; is done by the comparing the actual costs &
performance with corresponding standards.
d. For the purpose of determining the causes for the differences between the actual costs & standard costs,
analysis of variances are done.
e. Presentation is made in a most suitable manner to the appropriate management, of the information
which is available from the above

 Standard setting

Standard setting is the methodology used to define levels of achievement or proficiency and the cut scores
corresponding to those levels. ... For that reason, standard setting is a critical component of the test development
process.

 Standard-Setting Process

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 Variance

The variance measures how far each number in the set is from the mean. Variance is calculated by taking the
differences between each number in the set and the mean, squaring the differences (to make them positive) and
dividing the sum of the squares by the number of values in the set.

 Variance Analysis

Variance analysis, in budgeting (or management accounting in general), is a tool of budgetary control by
evaluation of performance by means of variances between budgeted amount, planned amount or standard amount
and the actual amount incurred/sold. Variance analysis can be carried out for both costs and revenues.

Variance Analysis, in managerial accounting, refers to the investigation of deviations in financial performance
from the standards defined in organizational budgets.

According to S.P.Gupta, ―Variance analysis is the measurement of variances, location of their root causes,
measuring their effect and their disposition‖.

variance analysis: A Four-Step Approach to Controlling Costs

 Types of Variances

A. On the basis of Elements of Cost.

1. Material Cost Variance.


2. Labour Cost Variance.

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3. Overhead Variance.

B. On the basis of Controllability

1. Controllable Variance.
2. Uncontrollable Variance.

C. On the basis of Impact

1. Favourable Variance.
2. Unfavourable Variance

D. On the basis of Nature

1. Basic Variance.
2. Sub-variance.

A. On the basis of Elements of Cost.

1. Material Cost Variance: It is the difference between actual cost of materials used and the standard cost for the
actual output.

 In case of materials, the following may be the variances:


(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage or Quantity Variance
(d) Material Mix Variance
(e) Material Yield Variance
(f) Material Revision Variance

(a) Material Cost Variance (MCV):

It is the difference between the standard cost of materials allowed (as per standards laid down) for the output
achieved and the actual cost of materials used.

Thus, it may be expressed as:

Material Cost Variance = Standard Cost of Materials for Actual Output – Actual Cost of Materials Used

Or Material Cost Variance = Material Price Variance + Material Usage or Quantity Variance

Or Material Cost Variance = Material Price Variance + Material Mix Variance + Material Yield Variance.

In order to calculate material cost variance, it is necessary to know:

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1. Standard quantity of materials which should have been required (as per standards set) to produce actual output.

Thus, standard quantity of materials is:

Actual Output x Standard Quantity of Materials per unit.

Note. In order to find out standard quantity of materials specified, actual output (and not standard output) is to be
multiplied by standard quantity of materials per unit.

2. Standard price per unit of materials.

3. Actual quantity of materials used.

4. Actual price per unit of materials.

(b) Material Price Variance (MPV):

It is that portion of the material cost variance which is due to the difference between the standard cost of materials
used for the output achieved and the actual cost of materials used.

In other words, it can be expressed as:

Material Price Variance:

Actual Usage (Standard Unit Price – Actual Unit Price).

Here, Actual Usage = Actual quantity of material (in units) used

Standard Unit Price = Standard price of material per unit

Actual Unit Price = Actual price of material per unit.

(c) Material Usage (or Quantity) Variance (MQV):

It is that portion of the material cost variance which is due to the difference between the standard quantity of
materials specified for the actual output and the actual quantity of materials used.

It may be expressed as:

Material Usage Variance:

Standard Price per unit (Standard Quantity – Actual Quantity).

Note. Standard quantity means quantity of material which should have been used (as per standard determined) for
the actual output achieved.

Illustration 1:

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The standard material required to manufacture one unit of product X is 10 kgs and the standard price per kg. of
material is Rs. 25. The cost accounts records, however, reveal that 11,500 kgs. of materials costing Rs. 2,76,000
were used for manufacturing 1,000 units of product X. Calculate material variances.

SOLUTION:

Standard price of material per kg. = Rs. 25

Standard usage per unit of product X = 10 kgs.

... Standard usage for an. actual output of 1,000 units of product X = 1,000 x 10 kgs. = 10,000 kgs.

Actual usage of material = 11,500 kgs. Actual cost of materials = Rs. 2, 76,000

Actual price of material per kg. = Rs. 2,76,000/11,500 = Rs. 24

(а) Material Cost Variance:

Standard Cost of Material – Actual Cost of Material

Or Standard Usage x Standard Rate – Actual Usage x Actual Rate

10,000 kgs. x Rs. 25 – 11,500 kgs. x Rs. 24

Rs. 2, 50,000 – Rs. 2, 76,000 = Rs. 26,000 Adverse.

(b) Material Price Variance:

Actual usage (Standard Unit Price – Actual Unit Price)

11,500 kgs. (Rs. 25 – Rs. 24) = Rs. 11,500 Favourable

(c) Material Usage Variance:

Standard Unit Price (Standard Usage – Actual Usage)

Rs. 25 (10,000 kgs. – 11,500 kgs.) = Rs. 37,500 Adverse.

Verification:

Material Cost Variance = Material Price Variance + Material Usage Variance

Rs. 26,000 Adverse = Rs. 11,500 Fav. + 37,500 Adverse

Rs. 26,000 Adverse = Rs. 26,000 Adverse.

(d) Material Mix Variance (MMV):

It is that portion of the material usage variance which is due to the difference between standard and the actual
composition of a mixture. In other words, this variance arises because the ratio of materials being changed from

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the standard ratio set. It is calculated as the difference between the standard price of standard mix and standard
price of actual mix.

In case of material mix variance, two situations may arise:

(i) When actual weight of mix and the standard weight of mix do not differ.

In such a case, material mix variance is calculated with the help of the following formula:

Standard Unit Cost (Standard Quantity – Actual Quantity)

Or Standard Cost of Standard Mix – Standard Cost of Actual Mix.

If the standard is revised due to shortage of a particular type of material, the material mix variance is
calculated as follows:

Standard Unit Cost (Revised Standard Quantity – Actual Quantity),

Or Standard Cost of Revised Standard Mix – Standard Cost of Actual Mix.

Illustration 2:

From the following information, calculate the material mix variance.

Due to shortage of material A, it was decided to reduce consumption of A by 15% and increase that of material B
by 30%.

Solution:

Revised Standard Mix is:

Material A: 200 units – 15% of 200 = 170 units

B: 100 units + 30% of 100 = 130 units

Materials Mix Variance:

(ii) When actual weight of mix differs from the standard weight of mix.

In such a case, material mix variance is calculated as follows:

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This formula is necessitated to adjust the total weight of standard mix to the total weight of actual mix which is
more or less than the weight of standard mix.

Illustration 3:

From the data given below, calculate all materials variances.

(e) Material Yield (or Sub-Usage) Variance (MYV):

It is that portion of the material usage variance which is due to the difference between the standard yield specified
and the actual yield obtained. This variance measures the abnormal loss or saving of materials. This variance is
particularly important in case of process industries where certain percentage of loss of materials is inevitable.

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If the actual loss of materials differs from the standard loss of materials, yield variance will arise. Yield variance is
also known as scrap variance.

This loss may result in the following two situations:

(i) When standard and actual mix do not differ:

In such a case, yield variance is calculated with the help of the following formula:

Yield Variance = Standard Rate (Actual Yield – Standard Yield)

Where Standard Rate = Standard Cost of Standard Mix / Net St. Output (i.e, Gross Output – St. Loss)

(ii) When actual mix differs from standard mix:

In such a case, formula for the calculation of yield variance is almost the same. But since the weight of actual mix
differs from that of the standard mix, a revised standard mix is to be calculated to adjust the standard mix in
proportion to the actual mix and the standard rate is to be calculated from the revised standard mix as follows:

Standard Rate = Standard Cost of Revised Standard Mix/Net Standard Output

Formula for yield variance in such a case is:

Yield Variance = Standard Rate (Actual Yield – Revised Standard Yield).

Illustration 4:

From the following data, calculate material yield variance:

(f) Material Revision Variance:

Once a standard is set for a period, it is usually followed for that period. But sometimes due to seriousness of the
situation such as a sudden rise in the prices of materials, or due to the short supply of a particular material, there
may be need of revision of standard to cope with the situation.

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Standards are revised with the hope that when the current difficulties are over, original standard will continue to
operate. Thus, revision of standards may be for a short period.

Material revision variance is calculated as given below:

Material Revision Variance = St. Price (St. Usage – Revised St. Usage)

For calculation of material usage variance, revised standard usage or quantity will be taken instead of standard
usage or quantity.

Material usage variance will be calculated as given below:

Material Usage Variance = St. Price (Revised St. Usage – Actual Usage)

In case there is material revision variance, material cost variance will be verified as given below:

Material Cost Variance = Material Revision Variance + Price Variance + Usage Variance

Illustration 5:

The standard cost of a chemical mixture is as under:

8 tons of material A at Rs. 40 per ton.

12 tons of material B at Rs. 60 per ton.

Standard yield is 90% of input.

Actual cost for a period is as under:

10 tons of material A at Rs. 30 per ton

20 tons of material B at Rs. 68 per ton

Actual Yield is 26.5 tons.

Compute all materials variances.

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2. Labour Cost Variance: It is the difference between the actual direct wages paid and the direct labour cost
allowed for the actual output to be achieved.

Labour variances can be analysed as follows:

(a) Labour Cost Variance (LCV)


(b) Labour Rate (of Pay) Variance (LRV)
(c) Total Labour Efficiency variance (TLEV)
(d) Labour Efficiency Variance (LEV)
(e) Labour Idle Time Variance (LITV)
(f) Labour Mix Variance or Gang Composition Variance (LMV or GCV)
(g) Labour Yield Variance or Labour Efficiency Sub-variance. (LYV or LESV)
(h) Substitution Variance.

These variances are like material variances and can be defined as follows:

(a) Labour Cost Variance:

It is the difference between the standard cost of labour allowed (as per standard laid down) for the actual output
achieved and the actual cost of labour employed. It is also known as wages variance.

This variance is expressed as:

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Labour Cost Variance = Standard Cost of Labour – Actual Cost of Labour.

(b) Labour Rate (of Pay) Variance:

It is that portion of the labour cost variance which arises due to the difference between the standard rate specified
and the actual rate paid.

It is calculated as follows:

Rate of Pay Variance = Actual Time Taken (Standard Rate – Actual Rate).

(c) Total Labour Efficiency Variance:

It is that part of labour cost variance which arises due to the difference between standard labour cost of standard
time for actual output and standard cost of actual time paid for.

It is calculated as follows:

Total Labour Efficiency Variance (TLEV)

= Standard Rate (Standard Time for Actual Output – Actual Time paid for)

Total labour efficiency variance is calculated only when there is abnormal idle time.

(d) Labour Efficiency Variance:

It is that portion of labour cost variance which arises due to the difference between the standard labour hours
specified for the output achieved and the actual labour hours spent.

It is expressed as:

Labour Efficiency Variance = Standard Rate (Standard Time for Actual output – Actual Time Worked). Here
standard time for actual output means time which should be allowed for the actual output achieved.

Actual Time worked means actual labour hours spent minus abnormal idle hours.

Illustration 6:

Calculate variances from the following data:

SOLUTION:

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First, we calculate standard rate, actual rate, standard time and actual time which are not directly given in the
question.

Standard wages per man per month = Rs. 200

Standard working days in a month = 20

... Standard rate per day = Rs. 200/20 = Rs. 10

Actual wages per man per month = Rs. 198

Actual working days in a month = 18

... Actual rate per day = Rs. 198/18 = Rs. 11

Standard man days for an output of 5,000 units = 100 x 20 = 2,000 man days

... Standard man days for the actual output of 4,800 units = 2,000/ 5,000 x 4,800 = 1,920 man-days.

Actual man days = men x working days = 90 x 18 = 1,620 man days.

(a) Labour Cost Variance:

Labour Cost Variance = Standard Cost of Labour – Actual Cost of Labour.

For. 5,000 units Standard cost of labour = 100 workers @ Rs. 200 = Rs. 20,000.

... For the actual output of 4,800 units, Standard cost of labour = 20,000/5,000 x 4,800 = Rs. 19,200.

Actual Cost of Labour = 90 workers @ Rs. 198 = Rs. 17,820.

... Labour Cost Variance = Rs. 19,200 – Rs. 17,820 = Rs. 1,380 Favourable

(b) Rate of Pay Variance:

Actual Time (Standard Rate – Actual Rate)

1,620 man days (Rs. 10 – Rs. 11) = Rs. 1,620 Unfavourable

(c) Labour Efficiency Variance:

Standard Rate (Standard Time – Actual time)

Rs. 10 (1,920 man days – 1,620 man days) = Rs. 3,000 Favourable

(e) Labour Idle Time Variance:

It is calculated only when there is abnormal idle time. It is that portion of labour cost variance which is due to the
abnormal idle time of workers. This variance is shown separately to show the effect of abnormal causes affecting
production like power failure, breakdown of machinery, shortage of materials etc. While calculating labour

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efficiency variance, abnormal idle time is deducted from actual time expended to ascertain the real efficiency of
the workers.

Labour idle time variance is expressed as:

Idle Time Variance = Abnormal Idle Time x Standard Rate

Idle Time Variance = St. Rate (Actual Hours Worked – Actual Hours Paid)

Total Labour Cost Variance = Labour Rate of Pay Variance + Total Labour Efficiency Variance

Total Labour Efficiency Variance = Labour Efficiency Variance + Labour Idle Time Variance

Illustration 7:

Using the following information, calculate labour variances:

Gross direct wages = Rs. 3,000

Standard hours produced = 1,600

Standard rate per hour = Rs. 1.50

Actual hours paid 1,500 hours, out of which hours not worked (abnormal idle time) are 50.

Illustration 8:

The standard output of ‗X‘ is 25 units per hour in a manufacturing department of a company employing 100
workers. The standard wage rate per labour hour is Rs. 6.

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In a 42 hour week, the department produced 1,040 units of X despite the loss of 5% of the time paid due to
abnormal reason. The hourly rates actually paid were Rs. 6.20, Rs. 6 and Rs. 5.70 respectively to 10, 30 and 60
workers. Compute relevant variances.

Solution:

Basic Calculations:

Standard output of 100 workers working for one hour in a manufacturing department is 25 units.

... St. Time per unit = 100 hours/25 units = 4 hours

St. Time for actual output of 1,040 units @ 4 hours = 4,160 hours

St. Labour cost of actual output cost, rate of Rs. 6 = 4,160 x Rs. 6 = Rs. 24,960

Total Labour Efficiency Variance:

= St. Rate (St. Time for Actual Output – Actual Time Paid)

= Rs. 6 (4,160 hours – 4,200 hours) = Rs. 240 Adverse

Labour Efficiency Variance:

= St. Rate (St. Time for Actual Output – Actual Time Worked)

= Rs. 6 (4,160 hours – 3,990 hours)

= Rs. 1,020 Fav.

Idle Time Variance:

= St. Rate (Actual Hours Worked – Actual Hours Paid)

= Rs. 6 (3,990 – 4,200)

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= Rs. 1,260 Adverse

Labour Cost Variance:

= St. Labour Cost – Actual Labour Cost

= Rs. 24,960 – Rs. 24,528

= Rs. 432 Fav.

Verification:

Labour Cost Variance = Labour Rate Variance + Total Labour Efficiency Variance

Rs. 432 Fav. = Rs. 672 Fav. + Rs. 240 Adverse = Rs. 432 Fav.

or Labour Cost Variance = Rate Variance + Efficiency Variance + Idle Time Variance

Rs. 432 Fav. = Rs. 672 Fav. + Rs. 1,020 Fav. + Rs. 1,260 Adverse = Rs. 432 Fav.

Labour Efficiency Variance can be split into:

(i) Labour Mix Variance or Gang Composition Variance

(ii) Labour Yield Variance or Labour Efficiency Sub-Variance.

(f) Labour Mix Variance or Gang Composition Variance:

It is like materials mix variance and is a part of labour efficiency variance. This variance shows to the management
as to how much of the labour cost variance is due to the change in the composition of labour force.

It is calculated as follows:

(i) If there is no change in the standard composition labour force and total time expended is equal to the total
standard time, the formula is

Labour Mix Variance = Standard Cost of Standard Composition (for Actual Time Taken) – Standard Cost of
Actual Composition (for Actual Time Worked)

Or Labour Mix Variance = Total Actual Labour Hours (Standard Actual per hour of Standard Mix – Standard Rate
per Hour of Actual Mix)

(ii) If the standard composition of labour force is revised due to shortage of a particular type of labour and the total
time expended is equal to the total standard time, the formula is:

Labour Mix Variance = Standard Cost of Revised Standard Composition (for Actual Time Taken) – Standard Cost
of Actual Composition (for Actual Time Worked)

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Illustration 9:

From the following data, calculate labour variances:

The budgeted labour force for producing product A is:

20 Semi-skilled workers @ p. 75 per hour for 50 hours

10 Skilled workers @ Rs. 1.25 per hour for 50 hours

The actual labour force employed for producing A is:

22 Semi-skilled workers @ p. 80 per hour for 50 hours.

8 Skilled workers @ Rs. 1.20 per hour for 50 hours.

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(g) Labour Yield Variance:

It is like material yield variance and arises due to the difference between yield that should have been obtained by
actual time utilised on production and actual yield obtained.

It can be calculated as follows:

Standard Labour Cost per unit [Actual Yield in units – Standard Yield in units expected from the actual time
worked on production].

(h) Substitution Variance:

This is a variance in labour cost which arises due to substitution of labour when one grade of labour is substituted
by another. This is denoted by difference between the actual hours at standard rate of standard worker and the
actual hours at standard rate of actual worker.

This can be denoted as under:

Substitution Variance = (Actual Hours x Std. Rate for Std. Worker) – (Actual Hours x Std. Rate for Actual
Worker)

Illustration 10:

A gang of workers usually consists of 10 men, 5 women and 5 boys in a factory. They are paid at standard hourly
rates of Rs. 1.25, Re. 0.80 and Re. 0.70 respectively. In a normal working week of 40 hours the gang is expected to
produce 1,000 units of output.

In a certain week, the gang consisted of 13 men, 4 women and 3 boys. Actual wages were paid at the rates of Rs.
1.20, Re. 0.85 and Re. 0.65 respectively. Two hours per week were lost due to abnormal idle time and 960 units of
output were produced. Calculate various labour variances.

Solution:

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Wages Revision Variance:

Sometimes, it becomes necessary to calculate wages revision variance to show to the management the effect of
revision on account of award or settlement with trade unions.

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It is calculated as follows:

Standard labour cost of actual output at original standard rate—Standard labour cost of actual output at current
standard rate.

Illustration 11:

The original standard rate of pay in a factory was Rs. 4 per hour. Due to settlement with trade unions, this rate of
pay per hour is increased by 15%. During a particular period, 5,000 actual hours were worked whereas work done
was equivalent to 4,400 hours. The actual labour cost was Rs. 24,000. Calculate labour variances.

Illustration 12:

KGJ Industries turns out only one article, the prime cost standards for which have been established as
follows:

The production schedule for the month of July, 2006 required completion of 5,000 pieces. However, 5,120 pieces
were actually completed.

Purchases for the month of July 2006 amounted to 30,000 lbs. of material at the total invoice price of Rs. 1,35,000.

Production records for the month of July, 2006 showed the following actual results.

Calculate appropriate material and labour variances.

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Illustration 13:

From the following records of Bonus-crew Ltd., you are required to compute the material and labour
variances:

1 tonne of material input yields a standard output of 1 lakh units.

Number of employees is 200.

The standard wage rate per employee per day is Rs. 6.

Standard price of material is Rs. 20 per kg.

Actual quantity of material issued by production department 10 tonnes.

Actual price of material is Rs. 21 per kg.

Actual output is 9 lakh units.

Actual wage rate per day is Rs. 6.50.

Standard daily output per employee is 100 units.

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Total number of days worked is 50.

Idle time paid for and included above is ½ day. (C.A.—Inter)

SOLUTION:

(а) Material Cost Variance:

Standard Cost of Materials – Actual Cost of Materials

or Standard Quantity x Standard Unit Cost – Actual Quantity x Actual Unit Cost

= 9,000 kilos x Rs. 20 – 10,000 kilos x Rs. 21

= Rs. 1,80,000 – Rs. 2,10,000 = Rs. 30,000 Adverse.

Standard quantity for 1,00,000 units is 1 tonne or 1,000 kilos, hence standard quantity for 9,00,000 units is 9,000
kilos.

(b) Material Price Variance:

Actual Quantity (Standard Unit Price – Actual Unit Price)

10,000 kilos (Rs. 20 – Rs. 21) = Rs. 10,000 Adverse,

(c) Material Usage Variance:

Standard Unit Cost (Standard Quantity – Actual Quantity)

Rs. 20 (9,000 kilos – 10,000 kilos) = Rs. 20,000 Adverse.

Labour Variances:

(a) Labour Cost Variance:

Standard Cost of Labour – Actual Cost of Labour

or Standard Time x Standard Rate – Actual Time x Actual Rate

= 9,000 man days x Rs. 6 – 10,000 man days x Rs. 6.50

= Rs. 54,000 – Rs. 65,000 = Rs. 11.000 Adverse.

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Standard time for 100 units is 1 man day, thus standard time for actual output of 9,00,000 units is 9,000 man days.
Every employee has worked for 50 days, so 200 employees have actually worked for 10.000 man days (i.e., 50 x
200).

(b) Labour Rate Variance:

Actual time (Standard Rate – Actual Rate) 10,000 man days (Rs. 6 – Rs. 6.50) = Rs. 5,000 Adverse.

(c) Labour Efficiency Variance:

Standard Rate (Standard Time – Actual Time) Rs. 6 (9,000 man days – 9,900 man days) = Rs. 5,400 Adverse.

Here actual time is that time which is worked in the factory. Idle time of 200 workers day per worker has not been
utilised on production. Therefore, this time has been excluded from 10,000 man days worked to get the actual time
utilised.

(c) Idle Time Variance:

Idle Time x Standard Rate

100 man days x Rs. 6 = Rs. 600 Adverse

Every worker has not worked for ½ day, so idle time for 200 workers is 100 man days.

3. Overhead Variance: Overhead variance is the difference between the standard cost of overhead allowed for
actual output (in terms of production units or labour hours) and the actual overhead cost incurred.

Overhead cost variance can be defined as the difference between the standard cost of overhead allowed for the
actual output achieved and the actual overhead cost incurred. In other words, overhead cost variance is under or
over absorption of overheads.

The formula for the calculation is:

Overhead Cost Variance:

Actual Output x Standard Overhead Rate per unit – Actual Overhead Cost or Standard Hours for Actual Output x
Standard Overhead Rate per hour – Actual Overhead Cost Overhead cost variance can be classified as:

(1) Variable Overhead Variance

(2) Fixed Overhead Variance.

1. Variable Overhead Variance:

It is the difference between the standard variable overhead cost allowed for the actual output achieved and the
actual variable overhead cost. This variance is represented by expenditure variance only because variable overhead

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cost will vary in proportion to production so that only a change in expenditure can cause such variance. It is
expressed as:

Actual Output x Standard Variable Overhead Rate – Actual Variable Overheads or St. Hours for Actual Output x
St. Variable Overhead Rate per hour – Actual Variable Overheads

Some accountants also find out variable overhead efficiency variance just like labour efficiency variance. Variable
overhead efficiency variance can be calculated if information relating to actual time taken and time allowed is
given.

In such a case variable overhead variance can be divided into two parts as given below:

(а) Variable Overhead Expenditure Variance or Variable Overhead Budget Variance

= Actual hours worked x Standard variable overhead rate per hour – Actual variable overhead or Actual Hours
(Standard Variable Overhead Rate per Hour – Actual Variable Overhead Rate per Hour)

Variable overhead expenditure variance is calculated in the same way as labour rate variance is calculated.

(b) Variable Overhead Efficiency Variance:

= Standard time for actual production x Standard variable overhead rate per hour – Actual hours worked x
Standard variable overhead rate per hour or Standard Variable Overhead Rate per Hour (Standard Hours for
Actual Production – Actual Hours)

Variable overhead efficiency variance resembles labour efficiency variance and is calculated like labour efficiency
variance.

Illustration 14:

From the following data, calculate variable overhead variances:

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2. Fixed Overhead Variance:

It is that portion of total overhead cost variance which is due to the difference between the standard cost of fixed
overhead allowed for the actual output achieved and the actual fixed overhead cost incurred.

The formula for the calculation of this variance is:

Actual Output x Standard Fixed Overhead Rate per Unit – Actual Fixed Overheads, or Standard Hours Produced x
Standard Fixed Overhead Rate per Hour – Actual Fixed Overheads (Standard Hours Produced = Time which
should be taken for actual output i.e., Standard Time for Actual Output)

Or Fixed Overheads Absorbed – Actual Fixed Overheads

This variance is further analysed as under:

(а) Budget or Expenditure Variance:

It is that portion of the fixed overhead variance which is due to the difference between the budgeted fixed
overheads and the actual fixed overheads incurred during a particular period.

It is expressed as:

Expenditure Variance = Budgeted Fixed Overheads – Actual Fixed Overheads Expenditure

Variance = Budgeted Hours x Standard Fixed Overhead Rate per Hour – Actual Fixed Overheads.

(b) Volume Variance:

It is that portion of the fixed overhead variance which arises due to the difference between the standard cost of
fixed overhead allowed for the actual output and the budgeted fixed overheads for the period during which the
actual output has been achieved. This variance shows the over or under absorption of fixed overheads during a
particular period.

If the actual output is more than the budgeted output, there is over-recovery of fixed overheads and volume
variance is favourable and vice versa if the actual output is less than the budgeted output. This is so because fixed
overheads are not expected to change with the change in output.

This variance is expressed as:

Volume Variance = Actual Output x Standard Rate – Budgeted Fixed Overheads

or Standard Rate (Actual Output – Budgeted Output)

or Volume Variance = Standard Rate per hour (Standard Hours Produced — Actual Hours)

Standard hours produced means number of hours which should have been taken for the actual output as per the
standard laid down.

Volume variance can be further subdivided into three variances as given below:

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(i) Capacity Variance:

It is that portion of the volume variance which is due to working at higher or lower capacity than the budgeted
capacity. In other words, this variance is related to the under and over utilisation of plant and equipment and arises
due to idle time, strikes and lock-out, break-down of the machinery, power failure, shortage of materials and
labour, absenteeism, overtime, changes in number of shifts. In short, the variance arises due to more or less
working hours than the budgeted working hours.

It is expressed as:

Capacity Variance = Standard Rate (Revised Budgeted Units – Budgeted Units)

or Capacity Variance = Standard Rate (Revised Budgeted Hours – Budgeted Hours)

(ii) Calendar Variance:

It is that portion of the volume variance which is due to the difference between the number of working days in the
budget period and the number of actual working days in the period to which the budget is applicable. If the actual
working days are more than the standard working days, the variance will be favourable and vice versa if the actual
working days are less than the standard days.

It is calculated as:

Calendar Variance = Increase or decrease in production due to more or less working days at the rate of budgeted
capacity x Standard rate per unit.

(iii) Efficiency Variance:

It is that portion of the volume variance which is due to the difference between the budgeted efficiency of
production and the actual efficiency achieved.

This variance is related to the efficiency of workers and plant and is calculated as:

Standard Rate per unit (Actual Production (in units) – Standard Production (in units)) or Standard Rate per hour
(Standard Hours Produced — Actual Hours)

Here, standard production or hours means budgeted production or hours adjusted to increase or decrease in
production due to capacity or calendar variance.

Suppose, budgeted production is 10,000 units, 5% capacity is increased and factory works for 27 days instead of
25 days during the month.

Standard production in this case should be 11,340 units calculated as follows:

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Total Overhead Cost Variance can be analysed as follows:

Two Variance, Three Variance and Four Variance Methods of Analysis Overhead Variances:

Analysis of overhead variance can also be made by two variance, three variance and four variance methods. The
analysis of overhead variances by expenditure and volume is called two variance analysis. When the volume
variance is further analysed to know the reasons of change in output, it is called three variance analysis.

Change in output occurs due to:

(i) Change in capacity i.e., change in working hours per day giving rise to capacity variance.
(ii) Change in number of working days giving rise to calendar variance.
(iii)Change in the level of efficiency resulting into efficiency variance.

Thus, three variance analyses include:

(i) Expenditure variance

(ii) Volume variance further analysed into:

(a) Capacity variance,

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(b) Calendar variance, and


(c) Efficiency variance.

 Four Variance Analysis includes:

(i) Expenditure Variance or Spending Variance


(ii) Variable Overhead Efficiency Variance
(iii)Fixed Overhead Capacity Variance
(iv) Fixed Overhead Efficiency Variance.

Illustration 15:

From the following data, calculate overhead variances:

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Illustration 16: From the following data, calculate overhead variances:

Actual man hours per day = 5,500

Actual output per man hour = 1.9

... Actual output = 27 x 5,500 x 1.9 = 2,82,150 units.

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(1) Fixed Overhead Variance:

Actual Output x Standard Rate – Actual Overheads

2,82,150 x Rs. 1.50 – Rs. 3,77,500 = Rs. 4.23,225 – Rs. 3,77.500 = Rs. 45,725 Favourable.

(2) Expenditure Variance:

Budgeted Overheads – Actual Overheads

Rs. 3,75,000 – Rs. 3,77,500 = Rs. 2,500 Unfavourable.

(3) Volume Variance:

Actual Output x Standard Rate – Budgeted Overheads

2,82,150 units x Rs. 1.50 – Rs. 3,75,000

= Rs. 4,23,225 – Rs. 3,75,000 = Rs. 48,225 Favourable

(4) Capacity Variance:

Standard Rate (Revised Budgeted Units – Budgeted Units)

Revised Budgeted Units:

Volume Variance = Capacity Variance + Calendar Variance + Efficiency Variance

Rs. 48,225 (Favourable) = Rs. 40,500 (Fav.) + Rs. 30,000 (Fav.) – Rs. 22,275 (Unfav.)

= Rs. 48,225 Favourable = Rs. 48,225 Favourable.

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Illustration 17:

The following information has been obtained from the records of a manufacturing organization using the
standard costing system.

You are required to calculate the following overhead variances:

(i) Variable overhead variance

(ii) Fixed overhead variance

(a) Expenditure variance

(b) Volume variance

(c) Efficiency variance

(d) Calendar variance.

Also prepare a statement reconciling the Standard Fixed Overheads worked out by using the Standard Overhead
Rate and the Actual Fixed Overheads.

(i) Variable Overhead Variance:

Actual output x Standard variable overhead rate – Actual variable overhead

3,800 x Rs. 3 – Rs. 12,000 = Rs. 600 Adverse

(ii) Fixed Overhead Variance:

Actual output x Standard fixed overhead rate – Actual fixed overhead

3,800 x Rs. 10 – Rs. 39,000 = Rs. 1,000 Adverse

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(a) Expenditure Variance:

Budgeted fixed overhead – Actual fixed overhead

Rs. 40,000 – Rs. 39,000 = 1,000 Favourable

(b) Volume Variance:

Standard fixed overhead rate per unit (Actual output – Budgeted output)

Rs. 10 (3,800 – 4,000) =Rs. 2,000 Adverse

(c) Efficiency Variance:

Standard fixed overhead rate per unit (Actual production – Standard production in actual days)

Rs. 10 (3,800 units – 4,200 units) = Rs. 4,000 Adverse

(Standard production for 21 actual working days @ 200 units per day = 4,200 units)

(d) Calendar Variance:

Standard fixed overheads per day (Actual days – Budgeted days)

Rs. 2,000 (21 – 20) = Rs. 2,000 Favourable

Note:

For reconciliation efficiency variance and calendar variance have been taken which are part of volume variance.
Therefore, volume variance has not been considered for reconciliation purpose.

An Alternative Method of Analysis of Fixed Overhead Variance:

Some accountants analyse fixed overhead variance into three classifications as given below:

(a) Expenditure Variance


(b) Efficiency Variance
(c) Volume Variance.

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(a) Expenditure Variance:

It is that portion of fixed overhead variance which is due to the difference between the budgeted fixed overhead
and the actual fixed overhead incurred during a particular period.

(b) Efficiency Variance:

It is that portion of fixed overhead variance which is due to the difference between the standard recovery of fixed
overhead and the standard fixed overhead for actual hours.

It is calculated as follows:

Standard fixed overhead rate per hour (Standard hours for actual production – Actual hours).

(c) Volume Variance:

It is that portion of fixed overhead variance which is due to the difference between the standard fixed overhead for
actual hours and the budgeted hours.

It is calculated as given below:

Standard fixed overhead rate per hour (Actual hours – Budgeted hours)

The analysis of fixed overhead variance according to the above method is made clear in the example given below:

B. On the basis of Controllability

1. Controllable Variance: A variance is controllable whenever an individual or a department or section or


division may be held responsible for that variance.

According to ICMA, London,

―Controllable cost variance is a cost variance which can be identified as primary responsibility of a specified
person‖.

2. Uncontrollable Variance: External factors are responsible for uncontrollable variances. The management has
no power or is unable to control the external factors. Variances for which a particular person or a specific
department or section or division cannot be held responsible are known as uncontrollable variances.

C. On the basis of Impact

1. Favourable Variances: Whenever the actual costs are lower than the standard costs at per-determined level of
activity, such variances termed as favourable variances. The management is concentrating to get actual results at
costs lower than the standard costs. It shows the efficiency of business operation.

2. Unfavourable Variances: Whenever the actual costs are more than the standard costs at predetermined level of
activity, such variances termed as unfavourable variances. These variances indicate the inefficiency of business
operation and need deeper analysis of these variances.

D. On the basis of Nature

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1. Basic Variances: Basic variances are those variances which arise on account of monetary rates (i.e. price of raw
materials or labour rate) and also on account of non-monetary factors (such as physical units in quantity or time).
Basic variances due to monetary factors are material price variance, labour rate variance and expenditure variance.
Similarly, basic variance due to non-monetary factors is material quantity variance, labour efficiency variance and
volume variance.

2. Sub Variance: Basic variances arising due to non-monetary factors are further analysed and classified into sub-
variances taking into account the factors responsible for them. Such sub variances are material usage variance and
material mix variance of material quantity variance. Likewise, labour efficiency variance is subdivided into labour
mix variance and labour yield variance. At the same time, variable overhead variance is sub-divided into variable
overhead efficiency variance and variable overhead expenditure variance.

 Sales Variances:

The analysis of variances will be complete only when the difference between the actual profit and standard profit
is fully analysed. It is necessary to make an analysis of sales variances to have a complete analysis of profit
variance because profit is the difference between sales and cost.

Thus, in addition to the analysis of cost variances, i.e., materials cost variance, labour cost variance and overheads
cost variance, an analysis of sales variances should be made. Sales variances may be calculated in two different
ways. These may be computed so as to show the effect on profit or these may be calculated to show the effect on
sales value.

The first method of calculating sales variances is profit method of calculating sales variances and the second is
known as value method of calculating sales variances. Sales variances showing the effect on profit are more
meaningful, so these would be considered first.

Profit Method of Calculating Sales Variances:

The sales variances according to this method can be analysed as:

(1) Total Sales Margin Variance (TSMV):

Actual Profit – Budgeted Profit

or Actual Quantity of Sales x Actual Profit per unit- Budgeted Quantity of Sales x Budgeted Profit per unit

(2) Sales Margin Variance (SMV) due to Selling Price:

It is that portion of total sales margin variance which is due to the difference between the actual price of quantity
of sales effected and the standard price of those sales.

It is calculated as:

Standard Costing and Variance Analysis:

Actual Quantity of Sales (Actual Selling Price per unit – Standard Selling Price per unit).

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(3) Sales Margin Variance (SMV) due to Volume:

It is that portion of total sales margin variance which arises due to the number of articles sold being more or less
than the budgeted quantity of sales.

It is calculated as:

Standard Profit per unit (Actual Quantity of Sales – Budgeted Quantity of Sales)

Sales margin variance due to volume can be divided into two parts as given below:

(i) Sales margin variance due to sales mixture.

(ii) Sales margin variance due to sales quantities.

Sales Margin Variance (SMV) due to Sales Mixture (SM):

It is that portion of sales margin variance due to volume which arises because of different proportion of actual
sales mix. It is taken as the difference between the actual and budgeted quantities of each product of which the
sales mixture is composed, valuing the difference of quantities at standard profit. It is calculated as given below:

Standard Profit per unit (Actual quantity of sales – Standard proportion for actual sales) or Standard Profit –
Revised Standard Profit.

Sales Margin Variance (SMV) due to Sales Quantities (SQ):

It is that portion of sales margin variance due to volume which arises due to the difference between the actual and
budgeted quantity sold of each product.

It is calculated as:

Standard Profit per unit (Standard proportion for actual sales – Budgeted quantity of sales) or Revised Standard
Profit – Budgeted Profit.

Value Method of Calculating Sales Variances:

Sales variances calculated according to value method show the effect on sales value and enable the sales manager
to know the effect of the various sales efforts on his overall sales value figures.

Sales variances according to this method may be as follows:

(1) Sales Value Variance (SVV):

It is the difference between the standard value and the actual value of sales effected during a period.

It is calculated as:

Sales Value Variance = Actual Value of Sales – Budgeted Value of Sales.

Sales value variance arises due to one or more of the following reasons:

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(1) Actual selling price may be higher or lower than the standard price. This is expressed in sales price variance.

(ii) Actual quantity of goods sold may be more or less than the budgeted quantity of sales. This is expressed in
sales volume variance.

(iii) Actual mix of various varieties sold may differ from the standard mix. This is expressed in sales mix variance.

(iv) Revised standard sales quantity may be more or less than the budgeted quantity of sales. This is expressed in
sales quantity variance.

(2) Sales Price Variance (SPV):

It is that portion of sales value variance which arises due to the difference between actual price and standard price
specified.

The formula for the calculation of this variance is:

Sales Price Variance = Actual Quantity Sold (Actual Price – Standard Price)

(3) Sales Volume Variance (S.Vol. V):

It is that portion of the sales value variance which arises due to difference between actual quantity of sales and
standard quantity of sales.

The variance is calculated as:

Sales Volume Variance = Standard Price (Actual Quantity of Sales – Budgeted Quantity of Sales)

Sales volume variance can be divided into two parts as follows:

(a) Sales Mix Variance (SMV):

It is a part of sales volume variance and arises due to the difference in the proportion in which various articles are
sold and the standard proportion in which various articles were to be sold.

It is calculated as:

Sales Mix Variance = Standard Value of Actual Mix – Standard Value of Revised Standard Mix.

(b) Sales Quantity Variance (SQV):

It is that part of sales volume variance which arises due to the difference between revised standard sales quantity
and budgeted sales quantity.

It is calculated as:

Standard Selling Price (Revised Standard Sales Quantity – Budgeted Sales Quantity).

Illustration 18:

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From the following particulars calculate all sales variances according to (A) Profit Method and (B) Value
Method.

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 Advantages of Variance analysis

1. The reasons for the overall variances can be easily find out for taking remedial action.
2. The sub-division of variance analysis discloses the relationship prevailing between different variances.
3. It is highly useful for fixing responsibility of an individual or department or section for each variance
separately.
4. It highlights all inefficient performances and the extent of inefficiency.
5. It is used for cost control.
6. The top management can follow the principle of management by exception. Only unfavorable variances are
reporting to management.
7. Sometimes, the variances can be classified as controllable and uncontrollable variances. In this case,
controllable variances are taken into consideration for further action.
8. Profit planning work can be properly carried on by the top management.
9. The results of managerial action can be a cost reduction.
10. It creates cost consciousness in the minds of the every employee of business organization.

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 Disposal of variances

There is difference of opinion among accountants as regards disposal of cost variance. However, the following
methods are usually used to close the Standard Cost Variances:

i. Transfer to profit and loss account.


ii. Allocation of finished stock, work in progress, and cost of sales;
iii. Transfer to Reserve Account i.e., to carry forward to the next financial year and to be set off in the
subsequent year of years

The standard cost is also incorporated in the accounting system so as to increase its statistical utility. The
following are the methods for accounting based on standard costing.

i. Partial plan method,


ii. Single plan method and
iii. Dual plan method.

 Causes and Disposition of Variances Analysis

1. Materials Price Variance:

(a) Causes:

Change in market price, delivery costs; purchase of non-standard materials, emergency purchases, incorrect
shipping instruction, loss of discount, etc.

(b) Disposition:

If all or a portion of the price variance is the result of inefficiencies or a saving has resulted from efficient
purchasing, the amount may be adjusted to P&L account. If it is due to incorrect standards or change in market
price the amount may be adjusted to inventories and cost of goods sold.

2. Materials Usage Variance:

(a) Causes:

Poor quality of materials; change in material mix, product or production methods; careless handling; excessive
waste or scrap; incorrect setting of standards.

(b) Disposition:

The amount of usage variance resulting in inefficiency in handling and processing materials is transferred to profit
and loss account. The amount of usage variance due to incorrect standards is apportioned to work in progress,
finished goods and cost of goods sold.

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3. Direct Wages Rate Variances:

(a) Causes:

General rise due to award or agreement, non-standard grade, abnormal overtime or payment above or below
standard rates during seasonal or emergency operations.

(b) Disposition:

The amount of variance arising out of inefficiency can be controlled if transferred to profit and loss account. The
amount of variance resulting from the use of out-of-date standards or from conditions beyond the control of
management is adjusted to work-in-progress, finished goods and cost of goods sold, on the basis of wages or time.

4. Direct Labour Efficiency Variance:

(a) Causes:

Poor working conditions, abnormal idle time i.e., power failure, breakdown, go-slow technique, quality of
supervision, non-standard grade of material, or employees‘ non-co-operation in service departments.

b) Disposition:

The amount of variance attributed to various forms of inefficiency which are controllable is transferred to profit
and loss account. The amount of variance resulting from improperly prepared standards and from conditions
beyond the control of management may be adjusted to work-in-progress, finished goods and cost of goods sold.

5. Overhead Expenditure Variance:

(a) Causes:

Under or over utilisation of a service; seasonal conditions; inefficiency in the use of a service (e.g. electricity in
lieu of gas).

(b) Disposition:

The amount of variance due to seasonal conditions should be treated as a deferred item. The amount arising out of
inefficiency which is controllable is transferred to profit and loss account.

The amount resulting from incorrectly prepared standard and from conditions beyond control is adjusted to work-
in-progress, finished goods and cost of goods sold.

6. Overhead Cost of Capacity Variance:

(a) Causes:

Calendar variations, abnormal idle time such as strikes, breakdowns absenteeism, labour shortage, etc.

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(b) Disposition:

The amount of seasonal variations is reasonably a deferred item. The amount arising from inefficient operations
controllable by management is transferred to profit and loss account. The amount of variance arising out of
abnormal idle time and beyond control of management is transferred to profit and loss account.

 Relevance of variance analysis to budgeting and standard costing

Basis for Comparison Standard Costing Budgetary Control

1. Meaning The costing method, in which evaluation Budgetary Control is the system in which
of performance and activity is done by budgets are prepared and continuous
making a comparison between actual and comparisons are made between the actual
standard costs, is Standard Costing. and budgeted figures to achieve the
desired result.

2. Basis Determined on the basis of data related to Budgets are prepared on the basis of
production. management's plans.

3. Range It is limited to cost details. It includes cost and financial data.

4. Concept Unit Concept Total Concept

5. Scope Narrow Wide

6. Reporting of Yes No
Variances

7. Effect of temporary The short term changes will not influence The short term changes will be shown in
changes in conditions the standard costs. the budgeted costs.

8. Comparison Actual costs and standard cost of actual Actual figures and budgeted figures
output

9. Applicability Manufacturing concerns All business concerns

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Standard Costing and Variance Analysis

Standard costing is the establishment of cost standards for activities and their periodic analysis to determine the
reasons for any variances. Standard costing is a tool that helps management account in controlling costs.

For example, at the beginning of a year a company estimates that labor costs should be $2 per unit. Such standards
are established either by historical trend analysis of the cost or by an estimation by any engineer or management
scientist. After a period, say one month, the company compares the actual cost incurred per unit, say $2.05 to the
standard cost and determines whether it has succeeded in controlling cost or not.

This comparison of actual costs with standard costs is called variance analysis and it is vital for controlling costs
and identifying ways for improving efficiency and profitability. If actual cost exceeds the standard costs, it is an
unfavourable variance. On the other hand, if actual cost is less than the standard cost, it is a favourable variance.

Variance analysis is usually conducted for

 Direct material costs (price and quantity variances);


 Direct labour costs (wage rate and efficiency variances); and
 Overhead costs.

Analysis of variance in planned and actual sales and sales margin is also vital to ensure profitability.

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UNIT 05

DIVISIONAL PERFORMANCE ANALYSIS

 Meaning Divisional Performance Analysis

Divisional means relating to an organizational or administrative division.

Performance Analysis is the process of studying or evaluating the performance of a particular scenario in
comparison of the objective which was to be achieved. Performance analysis can be do in finance on the basis of
ROI, profits etc. In HR, performance analysis can help to review an employee‘s contribution towards a project or
assignment, which he/she was allotted.

 Decentralized organization

A decentralized organization is one in which most decisions are made by mid-level or lower-level managers,
rather than being made centrally by the head of the company. It's the opposite of a centralized organization, in
which all decisions are made at the top.

 Advantages of a Decentralized Organizational Structure

 Empowering Employees
 Relieving the Burden
 More Efficient Decision-Making
 Ease of Expansion
 Preparing for Emergencies
 Facilitating Growth
 Improved Ownership Focus
 More Input, Better Results
 Time for Bigger Things
 Accelerated Decisions
 Spotting the Problem Is Easy

 Disadvantages of a Decentralized Organizational Structure

 The Big Picture is Blurred


 Not A Good Choice For Some
 Promotes Unhealthy Competition
 Less Control
 Fragmentation
 Inexperience Is A Problem

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 Responsibility Centres

A responsibility center is a part or subunit of a company for which a manager has authority and responsibility. The
company's detailed organization chart is a logical source for determining responsibility centres. The most common
responsibility centres are the departments within a company.

 Characteristics of Responsibility Centres


 It has a well-defined type of activity through its statute or its founding contract, having competences in
keeping, developing, replacing and reducing the assets;
 It administers an asset;  it has an organizational, functional and productive structure, with competence in
defining it;
 It plans and changes its own set of rules for organization and functioning;
 It has its own tasks in production;  it devises its own expense budget;
 It evaluates and administers its own budget resources;
 It emphasizes its own financial results;
 It devises monthly accounting balances or, if necessary, the final balance;
 It emphasizes its own savings and/ or profit;
 It takes responsibility for the results obtained;
 It is not responsible for the unprofitable activities of other centres within the entity;  it cooperates with
other centres to accomplish activities by signing collaborative conventions;
 It uses its resources to get performance;
 It may attract partners but it does not have competence in signing economic agreements;
 It has a manager who is responsible for the performances of the responsibility centre.

 Responsibility Centres/ Types of Responsibility Centres

1. Cost centres
2. Revenue centres
3. Profit centres
4. Investment centres

1. Cost centres

A cost centre is a part of an organization to which costs may be charged for accounting purposes.

A cost centre ―is a location, person or item of equipment or group of these, for which cost may be ascertained and
used for the purpose of cost control.‖

According to E. L. Kohler, a cost centre is ―an organisational division, department or self-division, a group of
machines, men or both. It includes any unit of activity into which a manufacturing plant or other operating
organisation is divided for purposes of cost assignment and allocation‖.

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 A cost centre is a place to which costs can be traced or segregated.

A cost centre could be:

 A subsidiary company
 A division
 A department
 A team
 A person
 A production line
 A project
 A machine

The head of a cost centre will be responsible for costs only: not revenue or profits

Examples of cost centres can include: the IT department, quality control department, the accounting department,
the manufacturing facility.

 Types of Cost Centre:

(a) Personal Cost Centre: When a Cost Centre deals with a person or group of persons, it is known as Personal
Cost Centre.
(b) Impersonal Cost Centre: When a Cost Centre deals with a location or equipment or both, it is called
Impersonal Cost Centre.
(c) Production Cost Centre: When a Cost Centre deals with a product/manufacturing work e.g. machine shop, it
is called Production Cost Centre.
(d) Service Cost Centre: When a Cost Centre deals with or is engaged in rendering services to the Production
Cost Centre, it is called Service Cost Centre.
(e) Operation Cost Centre: It is applicable in case of manufacturing concerns. It consists of machines or persons
which follow similar activities.
(f) Process Cost Centre: It is also applicable in case of manufacturing concerns. Process Cost Centre is applied
in case of particular or specific process of a manufacturing enterprise.

 Purposes of Cost Centre:

 Cost Centre brings responsibility and, as such, it is also called Responsibility Centre. In other words, for
controlling cost of a centre, the manager of that cost centre is, no doubt, responsible for the purposes.
 Cost Centre helps to recover the overhead expenses.

2. Revenue centres

In business, a revenue centre or revenue center is a division that gains revenue from product sales or service
provided. The manager in revenue centre is accountable for revenue only

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3. Profit centres

A profit centre is a part of an organization with assignable revenues and costs and hence ascertainable profitability.

A profit center is a section of a company treated as a separate business. Thus profits or losses for a profit center are
calculated separately. A profit center manager is held accountable for both revenues, and costs (expenses), and
therefore, profits.

A profit center is a business unit or segment that generates revenues and incurs costs. It's a department that uses
company resources to generate income.

 A profit centre is a place where both costs and revenues are identified.

As above, a profit centre could be:

 A subsidiary company
 A division
 A department
 A team
 A person
 A production line
 A project
 A machine

The difference is that here, in addition to being responsible for costs, the head of a profit centre will also be
responsible for revenues.

4. Investment centres

An investment center is a classification used for business units within an enterprise. The essential element of an
investment center is that it is treated as a unit which is measured against its use of capital, as opposed to a cost or
profit center, which are measured against raw costs or profits.

An investment centre is a place where costs, revenues and capital investment are identified.

Because costs, revenue and capital expenditure all have to be identified separately an investment centre would
normally be:

 A subsidiary company
 A division

The head of an investment centre will be responsible for costs revenues and capital expenditure. In effect, that
person has responsibility for all financial aspects of the investment centre.

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 Responsibility accounting

An accounting system that collects, summarizes, and reports accounting data relating to the responsibilities of
individual managers. – an accounting system which tracks and reports costs, expenses, revenues, and operational
statistics by area of responsibility or organizational unit.

Charles, T. Horngreen:
―Responsibility accounting is a system of accounting that recognizes various responsibility centres throughout the

organisation and reflects the plans and actions of each of these centres by assigning particular revenues and costs

to the one having the pertinent responsibility. It is also called profitability accounting and activity accounting‖.

According to this definition, the organisation is divided into various responsibility centres and each centre is
responsible for its costs. The performance of each responsibility centre is regularly measured.

 Features of Responsibility Accounting


 Inputs and Outputs or Costs and Revenues
 Planned and Actual Information or Use of Budgeting
 Identification of Responsibility Centres
 Relationship between Organisation Structure and Responsibility Accounting System
 Assigning Costs to Individuals and Limiting their Efforts to Controllable Costs
 Transfer Pricing Policy
 Performance Reporting
 Participative Management
 Management by Exception
 Human Aspect of Responsibility Accounting

 Role of Responsibility Accounting


 Decentralization
 Performance Evaluation
 Motivation
 Transfer Pricing
 Drop Or Continue Decision

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 Steps for Achieving Goals of Responsibility Accounting:


1. The organisation is divided into various responsibility centres each responsibility centre is put under
the charge of a responsibility manager.
2. The targets of each responsibility centre are set in.
3. The actual performance of each responsibility centre is recorded and communicated to the executive
concerned and the actual performance is compared with goals set and it helps in assessing the work of
these centres.
4. If the actual performance of a department is less than the standard set, then the variances are conveyed
to the top management.
5. Timely action is taken to take necessary corrective measures so that the work does not suffer in future.

 Principles of Responsibility Accounting:


 A target is fixed for each responsibility centre and is communicated to the concerned level of management.
 Actual performance is compared with the target.
 The variances from the budgeted plan are analysed to fix responsibility on the responsibility centre.
 Corrective action is taken by the higher management and is communicated to the individuals responsible.
 All apportioned costs and policy costs are excluded in determining the responsibility for costs.

 Advantages of Responsibility Accounting:


 Easy Identification
 Motivational Benefits
 Data Availability
 Ready-hand Information
 Planning and Decision Making
 Delegation and Control
 It establishes a sound mechanism for control.
 It forces the management to consider the organisational structure and examines who is responsible for
what and fix the delegation of power.

 It encourages budgeting with which actual achievement can be compared.

 It increases interest and awareness of the officers as they are called upon to explain about the

deviations for which they are responsible.

 The exclusion of items which are beyond the scope of the individual‘s responsibility simplifies the
structure of the reports and facilitates promptness in reporting.

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 Limitations of Responsibility Accounting:

01. The prerequisites for a successful responsibility accounting system are:


(a) A sound organisational structure where divisions can be identified clearly as responsibility centre.

(b) Proper delegation of work and responsibility.


(c) A proper system of reporting.

If these conditions are absent it is difficult to have a responsibility accounting system.

02. The traditional way of classification of expenses needs to be subjected to a further analysis which becomes

difficult.

03. In introducing the system certain managers may require additional classification particularly if the
responsibility reports are different from routine reports.
04. Classification of costs
05. Inter-departmental Conflicts
06. Delay in Reporting
07. Overloading of Information
08. Complete Reliance will be deceptive

 Measuring the performance of income centre


1. Return on investment [ROI]
2. Residual income
3. Economic value added [EVA] Methods

1. Return on investment [ROI]


ROI is usually expressed as a percentage and is typically used for personal financial decisions, to compare a
company's profitability or to compare the efficiency of different investments.
The return on investment formula is:
ROI = (Net Profit / Cost of Investment) x 100.

 How it works (Example):

The ROI calculation is flexible and can be manipulated for different uses. A company may use the calculation to
compare the ROI on different potential investments, while an investor could use it to calculate a return on a stock.

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For example, an investor buys $1,000 worth of stocks and sells the shares two years later for $1,200. The net profit
from the investment would be $200 and the ROI would be calculated as follows:

ROI = (200 / 1,000) x 100 = 20%

The ROI in the example above would be 20%. The calculation can be altered by deducting taxes and fees to get a
more accurate picture of the total ROI.

The same calculation can be used to calculate an investment made by a company. However, the calculation is
more complex because there are more inputs. For example, to figure out the net profit of an investment, a company
would need to track exactly how much cash went into the project and the time spent by employees working on it

 Advantages of ROI
 Better Measure of Profitability
 Achieving Goal Congruence
 Comparative Analysis
 Performance of Investment Division
 ROI as Indicator of Other Performance Ingredients
 Matching with Accounting Measurements
 Focus management‘s attention upon earning the best profit possible on the capital (total assets) available.
 Serve as a yardstick in measuring management‘s efficiency and effectiveness in managing the company as
a whole and its major divisions or departments.
 Tie together the many phases of financial planning, sales objectives, cost control, and the profit goal.
 Afford comparison of managerial results both internally and externally.
 Develop a keener sense of responsibility and team effort in divisional and departmental managers by
enabling them to measure and evaluate their own activities in the light of the results achieved by other
managers.
 Aid in detecting weaknesses with respect to the use or non-use of individual assets particularly in
connection with inventories.

 Disadvantages of ROI
 Satisfactory definition of profit and investment are difficult to find.
 While comparing ROI of different companies, it is necessary that the companies use similar accounting
policies and methods in respect of valuation of stocks, valuation of fixed assets, apportionment of
overheads, treatment of research and development expenditure, etc.
 ROI may influence a divisional manager to select only investments with high rates of return (i.e., rates
which are in line or above his target ROI).
 Difficulties and misunderstandings
 Lack of agreement
 The accounting and cost system might not give such needed details.
 A single measure of performance

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2. Residual income

Residual income is the amount of income that an individual has after all personal debts and expenses, including a
mortgage, have been paid. This calculation is usually made on a monthly basis, after the monthly debts are paid.

Residual income can have two different definitions or applications. The first definition, a less common
application of residual income, is the money that is left after monthly debts are paid. This calculation is
particularly important when a person is seeking financing or a loan based on their income and available money to
cover the additional debt. In this scenario, the residual income is calculated by this formula:

Residual Income =Monthly Net Income - Monthly Debts

Some perfect examples of residual income include:

 Rental income from a home, apartment, or commercial space


 Royalties earned for creating intellectual property like books, recordings, music, photographs, movies,
television shows, etc.
 Subscription services including media, online, or on-going services
 Interest earned on savings or loans made to others
 On-going income such as retirement, alimony, disability, etc.

3. Economic value added [EVA] Methods


Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth
calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.

 Calculation of EVA

EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of
capital and the economic capital. The basic formula is:

EVA = (ROIC – WACC) * (Total assets – current liability)

EVA = NOPAT – WACC *(Total assets – current liability)

where:

 ROIC = NOPAT/ Total assets – current liability, is the return on invested capital;
 WACC is the weighted average cost of capital (WACC);
 (Total assets – current liability )is the economic capital employed (total assets − current liability);
 NOPAT is the net operating profit after tax, with adjustments and translations, generally for the
amortization of goodwill, the capitalization of brand advertising and other non-cash items.

EVA calculation:

EVA = net operating profit after taxes – a capital charge [the residual income method]

Therefore EVA = NOPAT – (c × capital), or alternatively

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EVA = (r × capital) – (c × capital) so that

EVA = (r − c) × capital [the spread method, or excess return method]

Where

r = rate of return, and

c = cost of capital, or the weighted average cost of capital (WACC).

NOPAT is profits derived from a company‘s operations after cash taxes but before financing costs and non-cash
bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to
the firm.

Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of
interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs).

The capital charge is the cash flow required to compensate investors for the riskiness of the business given the
amount of economic capital invested.

The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for
bearing risk, their opportunity cost.

Another perspective on EVA can be gained by looking at a firm‘s return on net assets (RONA). RONA is a ratio
that is calculated by dividing a firm‘s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital)
after making the necessary adjustments of the data reported by a conventional financial accounting system.

EVA = (RONA – required minimum return) × net investments

If RONA is above the threshold rate, EVA is positive.

 Measuring income and invested capital

Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for
those who have provided capital, i.e. bondholders and stockholders. ROIC tells us how good a company is at
turning capital into profits.

How it works (Example):

The general equation for ROIC is: ( Net income - Dividends ) / ( Debt + Equity )

ROIC can also be known as "return on capital" or "return on total capital."

For example, Manufacturing Company MM lists $100,000 as net income, $500,000 in total debt and $100,000 in
shareholder equity. Its business operations are straightforward -- MM makes and sells widgets.

We can calculate MM's ROIC with the equation:

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ROIC = (Net income - Dividends ) / ( Debt + Equity )

= (100,000 - 0) / (500,000 + 100,000) = 16.7%

Note that for some companies, net income may not be the profitability measure you want to use. You want to
make sure that the profit metric you put in the numerator is giving you the information you need.

 Issues involved in divisional performance evaluation

 Rewarding Performance

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The mesolimbic dopamine pathway is thought to play a primary role in the reward system. It connects the
ventral tegmental area (VTA), one of the principal dopamine-producing areas in the brain, with the nucleus
accumbens, an area found in the ventral striatum that is strongly associated with motivation and reward.

 Performance management system design


A great performance system does not only recognize and motivate high performers, but also cultivate a
performance-driven culture to meet future competition. PwC Taiwan‘s performance consultation
incorporates MBO methodology and emphasizes the linkage between performance and the reward system
to maximize business performance.

 Reward system design


Reward systems are much more than just bonus plans and stock options. While they often include both of
these incentives, they can also include awards and other types of recognition, promotions, reassignment, or
other non-monetary bonuses. PwC Taiwan provides a complete reward system model, linked with the
performance system, to help clients create a fair reward system to encourage employees to maximize their
contributions.

 Reward system can be classified as:

 Monetary Rewards (directly, indirectly or un-related to actual performance outcomes)


 Monetary equivalent Rewards
 Non-monetary rewards

 Guidelines for Designing An Effective Reward System

 Performance payoff must be a major, not minor, piece of total compensation package.
 Incentive plan should extend to all managers & employees.
 System must be administered with scrupulous care & fairness.
 Incentives must be linked tightly to achieving only performance targets in strategic plan.
 Performance targets each person is expected to achieve must involve outcomes person can personally
affect.

 How Reward System Helps The Organization?

1. Reward can act as the 'catalyst' for improved performance and better productivity.
2. Rewards are generally reckoned to improve productivity by somewhere of the order of 20 to 30 per
cent. This is nearly twice as much as that attained by goal setting or job-redesign.
3. It helps to link to strategic direction and business goals.
4. They can actively engage and renew the overall sense of community and mission of an organization.
5. It increases the frequency of an employee action.
6. Rewards increase the chances that a performance will be repeated.
7. Rewards help to create a more pleasant work environment, one where rewards are used more frequently
than discipline to manage employee behaviour.
8. Through reward system individuals feel acknowledged for their accomplishments, contributions, and
performance. The staff will be motivated and inspired to continuously strive for excellence.
9. An effectively designed and managed reward program can drive an organization's change process by
positively reinforcing desired behaviours.
10. Rewards act as reinforces for a variety of individual behaviour.

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