Section-A

Q1. Distinguish between Management accounting and financial accounting.

Ans. Financial accounting and management accounting are two major sub-systems of accounting
information system. Both are concerned with revenues n expenses, assets and liabilities and cash
flows. But the major difference between the two arises because they serve different audience.
The main points of difference between the two are as follows:
Basis Financial Accounting Management Accounting
1. External and
internal users
Financial accounting information
is mainly intended for external
users like investor, shareholders,
creditors, govt. authorities etc.
Management accounting
information is mainly meant for
internal users i.e. management.
2. Accounting
method
It is based on double entry systems
for recording business
transactions.
It is not base on double entry
system.
3. Statutory
requirements
Financial accounting is mandatory.
Under company law and tax laws,
financial accounting is obligatory
to satisfy various statutory
provisions.
Management accounting is
optional though its utility makes it
highly desirable to adopt it.
4. Analysis of
cost and profit
Financial accounting shows the
profit/loss of the business as a
whole. It does not show the cost
and profit for individual products,
processes or departments, etc.
Management accounting provides
detailed information about
individual products, plants,
departments or any other
responsibility centre.
5. Past and future
data
It is concerned with recording
transactions which have already
taken place, i.e. it represents past
or historical records.
It is future oriented and
concentrates on what is likely to
happen in future though it may
use past data for future
projections.
6. Periodic
and
continuous
recording
Financial reports, i.e. Profit and
loss account and Balance sheet are
prepared usually on a year to year
basis.
Management accounting reports
are prepared frequently, i.e. these
may be monthly, weekly or even
daily depending on managerial
requirements.
7. Accounting
standards
Companies are required to prepare
financial accounts according to
Accounting Standards issued by
the Institutes of Chartered
Accountants of India.
Management accounting is not
bound by accounting standards. It
may use any practice which
generates useful information


8. Types of
statements
prepared
Financial accounting prepares
general purpose statement Profit
and Loss Account and Balance
Sheet which are used by external
In management accounting special
purpose reports are prepared, e.g.,
performance report of sales
manager or any other department
users. manager which are used by top
level management.
9. Publication and
audit
Financial statements, i.e., P&L A/c
and Balance Sheet are published for
general public use and also sent to
shareholders. These are required to
be audited by the Chartered
Accountants.
Management accounting statements
are for internal use and thus neither
published for general public use
nor these are required to be audited
by the Chartered Accountants.
10. Monetary and
Non-Monetary
measurements
Financial accounting provides
information in terms of money only.
Management accounting may apply
monetary or non-monetary units of
measurements. For example:
information may be expressed in
terms of Rupees or units of
Quantity, machine hours, labour
hours, etc.
Q2. What are the methods by which semi variable cost can be split in its fixed and variable
elements?
Ans. Semi-variable costs are those costs which contain both fixed and variable components and
are thus partly affected by fluctuations in the level of activity, such as telephone bills, gas,
electricity, etc. Such costs can be depicted graphically as follows:

Activity Level
Methods of segregating Semi-variable costs into fixed and variable cost: The segregation of
semi-variable costs into fixed and variable costs can be carried out by using the following
methods:
Variable Cost
Total Cost
Fixed Cost


(a) Graphical Method: Under this method, the following steps are followed:
(i) A large number of observations regarding the total costs at different levels of output
are plotted on a graph with the output on the X-axis (ii) The total cost is plotted on the Y-
axis.
(iii) Then, by judgment, a line of best-fit, which passes through all or most of the
points is drawn
(iv) The points at which this line cuts the Y-axis indicates the total fixed cost
component in the total cost
(v) If a line is drawn at this point parallel to the X-axis, this indicate the fixed cost.
(vi) The variable cost, at any level of output, is derived by deducting this fixed cost
element from the total cost.
The following graph illustrates this:

Output (in units)
(b) High points and low points method: Under this method, the total cost at highest and
lowest volume is divide by the difference between the sales value at the highest and the
lowest volume. The quotient thus obtained gives us the rate of variable cost in relation to
sales value.
(c) Analytical method: Under this method, an experienced cost accountant tries to judge
empirically what portion of all the semi-variable cost would be variable and what would
be fixed. The degree of variability is ascertained for each item of semi-variable expenses.
For example, some semi-variable expenses may vary to the extent of 20% while others
may vary to the extent of 80%.
(d) Comparison by period or level of activity method: Under this method, the variable
overhead may be determined by comparing two levels of output with the amount of
expenses at those levels. Since the fixed element does not change, the variable element
may be ascertained with the help of a formula:
Change in the amount of expense
30
Semi-variable cost 20
( in rupees ) VariableCost
for this output
10 Fixed Cost


Change in quantity of output
(e) Least squared method: this is the best method to segregate semi-variable costs into its
fixed and variable components. This is a statistical method and is based on finding out a
line of best fit for a number of observations. The method uses linear equation y= mx+c,
where:
m represents the variable element of cost per unit
c represents the total fixed cost
y represents the total cost
x represents the volume of output.
The total cost is thus split into fixed and variable elements by solving this equation. By
using this method, the expenditure against an item is determined at various levels of
output and values of x and y are fitted in the above formula to find out the values of m
and c.
Q3. Medical aid co. manufactures a special product AID. The following particulars were
collected for the year 1998:
Monthly demand of AID 1,000 units
Cost of placing an order Rs. 100
Annual carrying cost per unit Rs 15
Normal usage 50 units per week.
Minimum usage 25 units per weed
maximum usage 75 units per week re-order
usage 4 to 6 week
Compute from the above:
a. re-order quantity
b. re-order level
c. minimum level
d. maximum level
Ans. (i) Re-order quantity of units used = (2AS)/C

= (2*2600*100)/15 (See note below)
= 186 units (approx.)
Where A = Annual demand of input units


S = Cost of placing an order
C = Annual carrying cost per unit
(ii) Re-order level = Maximum re-order period*Maximum usage
= 6 weeks*75 units
= 450 units.
(iii) Minimum level = Re-order level (normal usage*average re-order period)
= 450 units (50 units* (4+6)/2)
= 450 units (50 units* 5 weeks)
= 450 units 250 units
= 200 units.
(iv)Maximum level=Re-order level+Re-order quantity(minimum usage*minimum order period)
= 450 units+186 units-(25 units*4weeks)
= 450 units+186 units-100 units
= 536 units.
Note:
A = Annual demand of input units for 12,000 units of Medical Aid Co.
= 52 weeks* normal usage of inputs per week
= 52 weeks*50 units of input per week
= 2600 units.
Q4. What do you understand by JIT?
Ans. Just In Time is an inventory strategy companies employ to increase efficiency and decrease
waste by receiving goods only as they are needed in the production process, thereby reducing
inventory costs. This method requires that producers are able to accurately forecast demand.
A good example would be a car manufacturer that operates with very low inventory levels,
relying on their supply chain to deliver the parts they need to build cars. The parts needed to


manufacture the cars do not arrive before nor after they are needed, rather do they arrive just as
they are needed.
JIT Purchasing
JIT purchasing refers to the technique of eliminating waste during the purchasing phase with the
help of the mutual understanding with good suppliers. The major elements of JIT purchasing
include locating, choosing and then developing mutual relations with the suppliers the number of
the suppliers should be limited and both the buyer and the supplier should possess mutual
dependence, having long term contracts which results in reduction of the lead time, aiming at
finding solutions to the problems by involving participation of the supplier at an earlier stage
during the decision making process.
JIT Manufacturing
JIT manufacturing refers to the technique of eliminating waste during the manufacturing process.
During the production of the products one important factor to be kept in mind is to fulfill or to
meet the customers requirement in context of the quality. JIT manufacturing aims at eliminating
all those factors or activities that act as a hindrance in the achievement of such goals of quality
maintenance.
Q5. Explain the term administrative overheads and briefly discuss three methods of
treatment thereof in cost accounts.
Ans. Administrative overhead is defined as the sum of those costs of general management and
of secretarial accounting and administrative services, which cannot be directly related to the
production , marketing , research or development functions of the enterprise.
It constitutes the expenses incurred in connection with the formulation of policy directing the
organization and controlling the operations of an undertaking.
ACCOUNTING TREATMENT OF ADMINISTRATIVE OVERHEADS: There are three
distinct methods of accounting of administrative overheads, which are discussed below :
(a) Apportioning administrative overheads between production and sales departments:
According to this method administrative overheads are apportioned over production and
sales departments. The reason for the apportionment of overhead expenses over these
departments, recognizes the fact that administrative overheads are incurred for the benefit
of both of these departments. Therefore each department should be charged with the


proportionate share of the same. When this method is adopted, administrative overheads
lose their identity and get merged with production and selling and distribution overheads.
Disadvantages:
(1) It is difficult to find suitable basis of administrative overhead apportionment over
production and sales departments.
(2) Lot of clerical work is involved in apportioning overheads.
(3) It is not justified to apportion total administrative overheads only over production and
sales departments when other equally important department like finance is also there.
(b) Charging to profit and loss account: According to this method administrative overheads
are charged to costing profit and loss account. The reason for charging to costing profit
and loss are firstly, the administrative overheads are concerned with the formulation of
policies and thus are not directly concerned with either the production or the selling and
distribution functions. Secondly, it is difficult to determine a suitable basis for
apportioning administrative overheads over production and sales departments. Lastly,
these overheads are the fixes costs. In view of these arguments, administrative overheads
should be charged to profit and loss account.
Disadvantages:
(1) Costs of products are understated as administrative overheads are not charged to costs.
(2) The exclusion of administrative overheads from cost of products is against sound
accounting principle.
(c) Treating administrative overheads as a separate addition to cost of production/sales:
This method considers administration as a separate function like production and sales
and, as such costs relating to formulating the policy, directing the organization and
controlling the operations are taken as a separate charge to the cost of the jobs or a
product, sold along with the cost of other functions. The basis which are generally used
for apportionment are:
(i) Works cost
(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced
(v) Conversion cost, etc.
Section-B
Q1. How does ABC differ from the traditional costing approach?
Ans. Costing systems helps companies determine the cost of a product related to the revenue it
generates. Two common costing systems used in business are traditional costing and


activitybased costing. Traditional costing assigns manufacturing overhead based on the volume
of a cost driver, such as the amount of direct labor hours needed to produce an item. A cost driver
is a factor that causes cost to incur, such as machine hours, direct labor hours and direct material
hours. Activity-based costing allocates the costs of manufacturing a product according to the
activities needed to produce the item.
Basically, the traditional costing is used commonly by manufacturing companies to assign
manufacturing overheads to the units they produce. Using this, only the products are assigned an
overhead cost by the accountant. The downside of this method of costing is that it neglects to
consider the non-manufacturing costs like administration expenses which are associated with
production. Today, such method is considered outdated because a lot of the manufacturing
companies already use computers and machines for their production. Also business accounting
software is already being used widely. On the brighter side, the traditional costing is easy to use
especially for those companies that have one product.
On the other hand, the activity-based costing (ABC) is a more logical method of assigning
manufacturing overhead costs to products. Unlike traditional costing that simply assigns costs
based on the machine work hours, the ABC assigns costs first to the activities and processes that
cause the overhead. Then, these costs are assigned only to the products that require the activities.
Simply saying, the ABC is typically used as a supplemental costing system for businesses.
The following are the basic differences of the two methods of costing:
1. The traditional costing method focuses on structure rather than on processes while the
ABC is more on the activities than on structure.
2. Traditional costing method is already obsolete especially with the changing technology
trends such as the introduction of the business accounting software.
3. The ABC provides more accurate costs of products.
4. Whereas the traditional costing method has increasingly become obsolete, the ABC
became a rising method since 1981.
Q2. What is service costing? Describe the type of industries in which such a system would
be suitable.
Ans. Service costing is a cost accounting method concerned with establishing the costs of
services rendered.
Despite this definition, we should note immediately that even though we may be dealing with
services that are intangible, the cost accounting methods we use are essentially the same as if we
were making cars, biscuits or televisions.


When we set up a service cost accounting system, therefore, we would need to keep in mind the
fact that the progression, for example, of a cheque through the banking system, can be treated as
items of raw material passing through a production process. Similarly, we should readily
appreciate that the provision of a transport service has much in common, from the cost
accounting point of view, with the manufacture of the lorry or van that is being used to provide
the service.
Specific Examples:
Transport
Hotels
Tourism
Solicitors
Education
Retail distribution
financial services
Service costing is also applied within a manufacturing setting. For example, a manufacturer
might wish to calculate the costs of the following services:
Transport
Catering
Computing and IT
Accounting
Human resources
Q3. Calculate the cost of each process and total cost production from the data given below:
Process x Process Y Process Z
Materials 2,250 750 300
Labour 1,200 3,000 900
Direct Expenses:
Fuel 300 200 400
Carriage 200 300 100
Work overhead 1,890 2,580 1,875
The indirect expenses Rs. 1,275 should be apportioned on the basis of wages.
Ans.
Particulars Process X Process Y Process Z
Materials 2250 750 300
Labour 1200 3000 900
Fuel 300 200 400
Carriage 200 300 100


Work Overhead 1890 2580 1875
Indirect Expenses 300 750 225
Total Cost 6140 7580 3800
Total cost of production = Total Cost of Process (X+Y+Z)
= Rs. 6140+7580+3800
= Rs. 17520
Q4. What are the advantages of variable costing?
Ans. Variable costing is a managerial accounting cost concept. Under this method manufacturing
overhead is incurred in the period that a product is produced. It is a costing method that includes only
variable manufacturing costs--direct materials, direct labor, and variable manufacturing overhead--in
unit product costs.
Advantages of variable costing system:
1. Variable costing provides a better understanding of the effect of fixed costs on the net profits
because total fixed cost for the period is shown on the income statement.
2. Various methods of controlling costs such as standard costing system and flexible budgets have
close relation with the variable costing system. Understanding variable costing system makes the
use of those methods easy.
3. Companies using variable costing system prepare income statement in contribution margin
format that provides necessary information for cost volume profit (CVP) analysis. This data
cannot be directly obtained from a traditional income statement prepared under absorption
costing system.
4. The net operating income figure produced by variable costing is usually close to the flow of cash.
It is useful for businesses with a problem of cash flows.
5. Under absorption costing system, income of different periods changes with the change of
inventory levels. Sometime income and sales move in opposite directions. But it does not happen
under variable costing.
Q5. What do you mean by break-even analysis and explain its uses and applications? Ans.
Break even analysis is an analysis to determine the point at which revenue received equals the
costs associated with receiving the revenue. Break-even analysis calculates what is known as a
margin of safety, the amount that revenues exceed the break-even point. This is the amount that
revenues can fall while still staying above the break-even point.


Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the sales. It
does not analyze how demand may be affected at different price levels.
Finding break even point of a product or service is an essential tool in choosing the best price per
unit of a product and also helping to determine projected sales. Break even analysis can used for
a number of different applications. Its basic function is to determine when a product or service
will be profitable. This analysis can be applied to many other applications to determine a future
forecast in sales, set a unit price and to target the best strategic options for the company.
Once the break-even figures are determined, the company can then use this information for other
financial projections. The most common break even analysis applications and uses are:
1. Determining the point of profitability
Many things should be considered when finding the break even point for a product's profitability.
A company's goal is to be profitable as quickly as possible, so it is more effective for a company
to run the numbers through a set of break even points to determine where the company will have
the optimal chance of making a profit. Harvard business school provides a break even analysis
toolkit that includes information and analysis tools to determine the break even point of any
product or service. Business Tools provides a guide and calculator to perform basic break even
analysis.
2. Finding the break even point for unit pricing
Performing break even analysis can also lead to the numbers that will help determine a set price
per unit. This is calculated by leaving the cost per unit as the variable in a break even analysis
equation. The most effective unit price will bring quick profitability to the company without the
company spending too much for production and marketing of the product.
Bradley University provides information on all of the equations to determine break even analysis,
including determining the break even cost, break even number of units and for setting the unit
price. Bean Counter explains the relationships between cost, volume and profits in break even
analysis.
3. Using the analysis information to choose the best company strategy
Another use for break even analysis is to use the information from the analysis to help determine
the company's financial strategy. If a company's profitability is determined by the success of one
or more products, using the break even point for each product will provide a timeline for the
company. This can be used to choose a better overall financial strategy that fits the projected
costs and profits.
The Weatherhead School of Management provides information on break even analysis and how
to use this analysis to help make strategic decisions. All Business provides a guide to use break
even analysis for making business decisions and choosing the best strategies.


Section-C
Q1. Explain advantages and limitations of budgeting.
Ans. Advantages Of Budgeting:
1. Reinforce the management process of planning ahead. In fact, budget compel the
managers to think and anticipate of future challenges, formulate strategies, etc. so as to
achieve the desired companys goals
2. A budget is in reality a set of plan. This plan is created by all the relevant managers to
create a course of action for future action.
3. Create a basis for Performance Evaluation of Managers performance. Incentives are
based on how much have been achieved against the budgeted figures. Hence, if budgets
are set up realistically will assist to motive manager and employees positively.
4. Aid in resource planning and allocation, key or scarce resources or capital expenditure
are carefully review during the establishment of the budgets.
5. Promote continuous improvement. In the budgeting stage, non-value adding activities
shall be eliminated, new or enhanced processes are designed to increase productivity, etc.
6. Budgeting is the best time for all level of manager to co-ordinate together so as to plan
ahead, promotes teamwork, process improvement and goal congruency between the
company and the employees.
7. Delegation of duties, authority limit and responsibility are more properly segregated as
budgets are set up. With budgets, top management feel that they are in control of the
various business activities of the company.
Disadvantages of Budgeting:
1. De-motivation of employees as they feel that the budgeted figures are way too high to
achieve
2. Budgetary slack or padding the budgets as managers will intentionally blow up their
budget figures for fear of top managements reprimanding them
3. A budget tends to emphasize on results and the real reasons are being ignored
4. Unrealistic budgets can lead managers to make decisions that might be detrimental to
the company. A good example of over-ambitious sales budget will lead to disastrous
impact like giving steep discount to increase volume,etc.
5. No matter how well prepared a budget might be, it will never be able to reflect truly the
reality/complexities faced by the company
6. There is a need to revise/update the budget which at the time was based on a certain set
of circumstances/best information.
7. Budgets if not properly buy in by all relevant parties will not get the full cooperation
hence it might lead to the motto: Planning to fail.


Q2. What are transfer prices? What are different types of transfer prices? Ans. Transfer
price is the price at which divisions of a company transact with each other. Transactions may
include the trade of supplies or labor between departments. Transfer prices are used when
individual entities of a larger multi-entity firm are treated and measured as separately run entities.
Different Types of Transfer Prices
1. Market-based Transfer Price
Market conditions which are appropriate for adoption
Are generally appropriate in a perfect market, where there is homogeneous product with only
one price for both sellers and buyers and no buying or selling costs.
In a perfect market, Selling Division (SD) will be operating at full capacity and can sell
whatever quantity of intermediate product it can produce in the external market. In this situation,
internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the
contribution lost (opportunity cost) from sacrificing external sales should be included in the
transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.
TP = MC+OC = MP
In a perfect market, the minimum TP is also the maximum TP. Thus, both SD and BD will
be happy with a transfer price set as the market price
The adoption of market-based transfer price in a perfectly competitive market meet the
criteria of a good transfer price, that is it will promote goal congruent decisions, preserve
divisional autonomy and provide an equitable basis for performance evaluation.
Limitations:
(i) As a result of product differentiation, they may be no comparable product or a single market
price.
(ii) Market price may vary because of over-supply or under-supply, promotions, or product
dumping by foreign competitors.
2. Full-cost based Transfer Price
Market conditions which are appropriate for adoption
In an imperfect market, it may be unwise to always set transfer price exactly at the variable
costs of production, as such prices do not provide for the replacement of fixed assets.


The Supply Division (SD) will want to base the transfer price on total absorption cost to
ensure that it will provide a contribution to cover the fixed overheads.
Full-cost based transfer price is widely used because managers require an estimate of long-
run marginal cost for decision-making. However, traditional absorption costing systems tend to
provide poor estimates of long-run marginal cost for decision-making. ABC will provide better
estimates of long run MC.
Limitations:
(i) It can lead buying division (BD) to make sub-optimal decisions because BD regards the
transfer price (which includes the fixed costs) as a wholly variable cost.
3. Negotiated Transfer Price
Market conditions which are appropriate for adoption
In an imperfect market (different selling costs for internal and external sales, differential
market prices), transfer prices set at the prevailing or planned market price are not optimal i.e.
will not induce SD and BD to adopt optimal output level. Central/corporate management
intervention is necessary in order to ensure that optimal output levels are set but this process may
undermine divisional autonomy.
In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers
had been provided with all the information and were educated to use information correctly, it is
likely that a negotiated solution would have emerged which would have been acceptable to both
the divisions and the group.
When there is unused capacity, the transfer price range for negotiations generally lied
between the minimum price at which SD is willing to sell (its marginal cost) and the maximum
price BD is willing to pay (the external supplier price net off any external purchase related costs).
Limitations:
(i) Can lead to sub-optimal decisions
(ii) Time-consuming
(iii) Strongly influenced by the bargaining skills and power of the divisional managers(iv)
Inappropriate in certain circumstances (e.g. no market for the intermediate product or an
imperfect market exists as the SD will have a bargaining disadvantage).
Q3. Define expense centre. What is the suitability of the measure of performance in an
expense centre?
Ans. Expense centers are responsibility centers for which inputs, or expenses are measured in
monetary terms, but for which outputs are not measured in monetary terms. There are two
general types of expense centers:


1. Engineered expense centers are expense centers in which all or most costs are
engineered costs. Engineered costs are elements of cost for which the right or proper
amount of costs that should be incurred can be estimated with a reasonable degree of
reliability. Cost incurred in a factory for direct labor, direct material, components,
supplies, and utilities are examples.
2. Discretionary expense centers are expense centers in which all, or most, costs are
discretionary. Discretionary costs/managed costs are those for which no such engineered
estimate is feasible the amount of costs incurred depends on managements judgment
about the amount that is appropriate under the circumstances.
Performance measures
1. Minimize total cost for a selected level of output.
2. Maximize total output for a given budget.
In several cases, the output (revenue) of a responsibility centre cannot be reliably measured in
financial terms such as legal departments, accounting department, public relation departments,
personnel departments, etc. Each of these centers/divisions has a conceptually identifiable output.
Their output cannot be expressed in monetary terms. The only measurable performance is there
efficiency in the use of inputs. If production centre is producing one single product, then its
performance can be measured in efficiency & effectiveness. The output cannot be expressed in
monetary terms but cost per unit would be efficiency of department. An expense centre can also
be suitably employed to measure performance if the responsibility of the departmental manager
is to produce a stated quantity of outputs at the lowest feasible cost.
Q4. Differentiate between sunk and avoidable costs. What is the relevance of such a
distinction for short-run decisions?
Ans. A relevant cost (also called avoidable cost or differential cost) is a cost that differs
between alternatives being considered. In order for a cost to be a relevant cost it must be:
Future
Cash Flow
Incremental
It is often important for businesses to distinguish between relevant and irrelevant costs when
analyzing alternatives because erroneously considering irrelevant costs can lead to unsound
business decisions. Also, ignoring irrelevant data in analysis can save time and effort. For
example: A construction firm is in the middle of constructing an office building, having spent $1
million on it so far. It requires an additional $0.5 million to complete construction. Because of a
downturn in the real estate market, the finished building will not fetch its original intended price,


and is expected to sell for only $1.2 million. If, in deciding whether or not to continue
construction, the $1 million sunk cost were incorrectly included in the analysis, the firm may
conclude that it should abandon the project because it would be spending $1.5 million for a
return of $1.2 million. However, the $1 million is an irrelevant cost, and should be excluded.
Continuing the construction actually involves spending $0.5 million for a return of $1.2 million,
which makes it the correct course of action.
Whereas a sunk cost is a retrospective (past) cost that has already been incurred and cannot be
recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs
that may be incurred or changed if an action is taken. Both retrospective and prospective costs
may be either fixed (continuous for as long as the business is in operation and unaffected by
output volume) or variable (dependent on volume) costs. For example, if a firm sinks $1 million
on an enterprise software installation that cost is "sunk" because it was a one-time expense and
cannot be recovered once spent. A "fixed" cost would be monthly payments made as part of a
service contract or licensing deal with the company that set up the software. The upfront
irretrievable payment for the installation should not be deemed a "fixed" cost, with its cost
spread out over time. Sunk costs should be kept separate. The "variable costs" for this project
might include data centre power usage, etc.
Short-run decision making involves choosing among alternatives and tends to be short-run in
nature with an immediate end in view. Sound short-run decision making results in decisions that
achieve an immediate objective and serve the overall strategic goals of the organization.
The costs which should be used for decision making are often referred to as "relevant costs".
CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management
decisions'.
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are
common to all alternatives that we may choose.
b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a
decision. Any costs which would be incurred whether or not the decision is made are not said
to be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant.
Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.
Other terms:


d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or
rates on a factory would be incurred whatever products are produced.
e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed
assets, development costs already incurred.
f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is
taken now, e.g. contracts already entered into which cannot be altered.
Q5. The details regarding composition and the weekly wage rate of labour force engaged on
a job scheduled to be completed in 30 weeks are as follows:
Standard Actual
Category of No. of Weekly wage No. of Weekly wage
Workers Laborers Rate Laborers Rate
Skilled 75 60 70 70
Semi-skilled 45 40 30 50
Unskilled 60 30 80 20
The work is actually completed in 32 weeks. Calculate the various labour cost variances.
Ans. Basic calculations:
Category
of workers
Standard Actual
Weeks (no.
of
workers*
No. of
weeks)
Rate (In
Rupees)
Amount (In
Rupees)
Weeks (no.
of
workers*
No. of
weeks)
Rate (In
Rupees)
Amount (In
Rupees)
Skilled 75*30=
2250
60 135000 70*32=
2240
70 156800
Semi-
skilled
45*30=
1350
40 54000 30*32=
960
50 48000
Unskilled 60*30=
1800
30 54000 80*32=
2560
20 51200
Total 5400 243000 5760 256000
Calculation of variances:
(i) Labour cost variance = Standard cost Actual cost
= Rs.243000-Rs.256000
= Rs.13000 (A)
(ii) Labour rate variance = (Standard rate Actual rate) * Actual time


Skilled = (60-70)*2240 = Rs.22400 (A)
Semi-skilled = (40-50)*960 = Rs. 9600 (A)
Unskilled = (30-20)*2560 = Rs. 25600 (F)
Total Labour rate variance = Rs.6400 (A)
(iii) Labour efficiency variance = (Standard time Actual time) * Standard rate
Skilled = (2250-2240)*60 = Rs.600 (F)
Semi-skilled = (1350-960)*40 = Rs. 15600 (F)
Unskilled = (1800-2560)*30 = Rs. 22800 (A)
Total Labour efficiency variance = Rs.6600 (A)
(iv) Labour mix variance = (Revised standard time Actual time) * Standard rate
Skilled = (2400-2240)*60 = Rs.9600 (F)
Semi-skilled = (1400-960)*40 = Rs. 19200 (F)
Unskilled = (1920-2560)*30 = Rs. 19200 (A)
Total Labour mix variance = Rs.9600 (F)
Revised standard time calculated as under:
Revised standard time = Standard time of grade * Total Actual time
Total standard time
Skilled = 2250 *5760 = 2400 weeks
5400
Semi-skilled = 1350 * 5760 = 1440 weeks
5400
Unskilled = 1800 * 5760 = 1920 weeks
5400
(v) Labour revised efficiency variance = (Std. time Revised Std. time) * Standard rate
Skilled = (2250-2400)*60 = Rs.9000 (A)
Semi-skilled = (1350-1440)*40 = Rs. 3600 (A)
Unskilled = (1800-1920)*30 = Rs. 3600 (A)
Total Labour revised efficiency variance = Rs.16200 (A)
Check:
(i) Labour cost variance = Labour rate variance + Labour efficiency variance


Rs. 13000(A) = Rs. 6400(A) + Rs. 6600(A)
(ii) Labour efficiency variance=Labour mix variance+Labour revised efficiency
variance
Rs. 6600(A) = Rs. 9600(F) + Rs. 16200(A)


Case Study1
A Ltd. furnishes the following data relating to the year 2008:
1
st
half of the year 2
nd
half of the year
Sales (Rs.) 45,000 50,000
Total cost (Rs.) 40,000 43,000
Assuming that there is no change in prices and variable cost and that the fixed expenses are
incurred equally in the two half year period, calculate:
1. P/V Ratio
2. Fixed expenses
3. Break even sales
4. Percentage of margin of safety to total sales.
Ans. Profit = Sales- Total cost
Profit (1
st
half of the year) = 45000-40000 = Rs.5000
Profit (2
nd
half of the year) = 50000-43000 = Rs.7000
(i) P/V Ratio = Difference in Profit
Difference in Sales
= 2000
5000
= 40%
PV Ratio will remain same for each half year.
(ii) Fixed Expenses = (Sales*P/V Ratio) - Profit
Fixed expenses (1
st
half of the year) = (45000*40%) 5000
= Rs. 13000
Fixed expenses (2nd half of the year) = (50000*40%) 7000
= Rs. 13000
Total Fixed Expenses = Rs. 13000+ Rs.13000
= Rs. 26000
(iii) Break even sales = Fixed Cost
P/V Ratio
Break even sales (1
st
half of the year) = 13000


40%
= Rs.32500
Break even sales (2
nd
half of the year) = 13000
40%
= Rs.32500
Total Break even sales = Rs. 32500+ Rs.32500
= Rs. 65000
(iv) Percentage of margin of safety to total sales = Total Profit
P/V Ratio
(1
st
half of the year) = 5000
40%
= Rs.12500
(2
nd
half of the year) = 7000
40%
= Rs. 17500
Total Percentage of margin of safety to total sales = Rs.12500+Rs.17500
= Rs. 30000


Case Study2
Goodluck Ltd. is currently operating at 75% of its capacity. In the past two years, the level
of operations were 5f5% and 65% respectively. Presently, the production is 75,000 units.
The company is planning for 85% capacity level during 2013 2014. The cost details are
as follows:
55% 65% 75%
Rs. Rs. Rs.
Direct Materials 11,00,000 13,00,000 15,00,000
Direct labour 5,50,000 6,50,000 7,50,000
factory overheads 2,00,000 2,00,000 2,00,000
Selling overheads 3,10,000 3,30,000 3,50,000
Administrative overheads 3,20,000 3,60,000 4,00,000
-------------- --------------- ---------------
24,40,000 28,00,000 31,60,000
-------------- --------------- ----------------
Profit is estimated @ 20% on sales.
The following increases in costs are expected during the year.
In percentage
Direct material 8
Direct labour 5
Variable selling overheads 8
Fixed factory overheads 10
Fixed selling overheads 15
Administrative overheads 10
Required: Prepare flexible budget for the period 20X120X2 at 85% level of capacity. Also
ascertain profit and contribution.
Ans. Flexible budget for the period 20X1-20X2 at 85% level of capacity:
Particulars Amount (Rs.)
Direct Material (20*108%*85000) 1836000
Direct Labour (10*105%*85000) 8925000
Factory Overheads (200000*110%) 220000
Selling Overheads
Fixed (200000*115%) 230000
Variable (2*108%*85000) 183600
Administration Overheads
Fixed (100000*110%) 110000
Variable (4*110%*85000) 374000
Total Cost 11878600


Profit (25% of Total Cost) 26969659
Sales 14848250
Contribution = Fixed cost + Profit
= Direct material + Direct Lobour + Factory overheads + Fixed Selling Cost +
Fixed Administration Cost + Profit
= 1836000+ 8925000+ 220000+ 230000+ 110000 + 2969650
= Rs. 14290650