MASTER OF COMMERCE

M. COM.

SEMESTER - II

202 – ADVANCED MANAGEMENT

ACCOUNTING - II
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ii
 LESSON WRITERS GUIDELINES
Dr. A. Narasimha Rao 1 & 11
Dept. of Commerce & Management Studies
Andhra University
VISAKHAPATNAM
Prof. D. Prabhakara Rao 2 to 7
Head, Dept. of Commerce & Management Studies
Andhra University
VISAKHAPATNAM

Prof. Krishnamachari 8 to 10
Dept. of Commerce & Management Studies
Andhra University
VISAKHAPATNAM

Dr. P. Viswanatham 12 to 14
Dept. of Commerce
Andhra University
VISAKHAPATNAM

EDITOR
Prof. D. Prabhakara Rao
Dept. of Commerce & Management Studies
Andhra University
VISAKHAPATNAM

3
 SYLLABUS

Advanced Management Accounting-II

Unit I
Breakeven Analysis of Multi-Product Firm: Assumptions of Break-even Analysis, different types of Break-
even Chart. Differential Costs for Product Decisions: Differential Cost Analysis, Differential costs for
product-mix decisions.
Unit II
Product-Price Strategies: Pricing decisions, Principles of product pricing, pricing strategies. Sell or Process
Further Decision: Joint products and By-products and Apportionment of joint costs.
Unit III
Budgeting: Meaning, objectives of Budgetary control, Limitations of budgetary control, Classification of
budgets and important budgets. Cash Budget: Operating Cash flows and Financial Cash flows.
Unit IV
Production Budget: Meaning, Procedure for preparation of production budget, types of production budget.
Flexible Budgeting: Concept, Preparation of flexible budget: Multi-activity method and Formula method.
Unit V
Performance Budgeting: Application of Performance budgets, planning, programming and budgeting system
(PPBS), the differences between performance budgeting and programming budgeting and Performance
Control Ratios. Zero Based Budgeting: Definitions, Features, Process and application and benefits of Zero
based budgeting.

Suggested Books :
1. I.M. Pandey: Management Accounting, Vikas Publishing House.
2. Horngren,C.T., Introduction to Management Accounting, Prentice Hall of India.
3. Khan and Jain, Management Accounting, Tata Mc Graw Hill, Delhi.
4. Horngren Sundem Stratton, Management Accounting, Prentice Hall of India.
 INDEX

Guideline Title Page No.

No.
1 Breakeven Analysis of Multi-Product Firm 6
2 Differential Costs for Product Decisions 17
3 Differential costs for product-mix decisions 22
4 Principles of product pricing 39
5 Product-Price Strategies 46
6 Sell or Process Further Decision 54
7 Apportionment of joint costs 62
8 Budgeting 74
9 Some important budgets 90
10 Cash Budget 99
11 Production Budget 116
12 Flexible Budgeting 133
13 Performance Budgeting 149
14 Zero Based Budgeting 156
 GUIDELINE-1

BREAK EVEN ANALYSIS OF MULTI PRODUCT FIRM

Structure

1.1. Introduction
1.2. Assumptions of Break-even Analysis
1.3. Break-Even Point in Units
1.4. Break Even Point in Sales Revenue
1.5. Multi-product Break Even Chart
1.6. Procedure for drawing up a multi-product Break-even chart
1.7. Different types of Break-even Chart
1.8. Detailed Break-even Chart
1.9. Cash Break-even Chart
1.10. Control Break-even Chart
1.11. Self – assessment Questions

1.12. Practical Problems

1.13. Suggested Readings

1.1. INTRODUCTION

In real life, a firm produces and sells not one product but several products. A single
product firm is a van phenomenon in the present day world.

A multi-product analysis is dependent upon the product mix which refers to the
relative quantity of each product in relation to the total volume of all products. The
additional assumption is that the product or sales mix revenues, constant throughout the
analysis. That is the quantity of each final product always maintains the same percentage of
total physical output of all products combined. It is on the basis of this assumption of a
specified market bundle that the analysis proceeds.

6
 CVP analysis is best suited for a firm producing single product. In case of multi-
product firm BEP would be lower if the product mix is weighted in favour of a higher profit
product or would be higher if a large portion of sales are of lower-profit product. So,
meaningful BEP cannot be calculated in case of multi-product firm.

Determination of BEP in this manner has serious limitations and it cannot be applied
practically. The Break Even Analysis is a simple and useful concept, but it is based on
certain assumptions which limit the utility and general applicability of the break even
analysis.

1.2. ASSUMPTIONS OF BREAK EVEN ANALYSIS

The break even analysis is based on the following assumptions:

Cost Segregation:

Break even analysis assumes that the cost can be classified into fined and variable
cost. Same of these costs can be easily identified but for the large number of costs, this
concept poses a problem because these costs are semi-variable or semi-fined costs.

Assumption with regard to consistency in final cost:

BEP analysis assumes that fixed cost will remain constant for the entire volume of
output. This may not always hold true because the company may have to increase the
investment in fixed cost with the rise in volume.

Assumption with regard to consistency in revenue and variable costs:

Selling price may remain constant under situations of perfect competition where the
seller is the price taken but in real market situations, monopolistic competition and oligopoly
exist in which the selling price keeps on varying. The same stands for variable cost.

Assumption with regard to multi-product firm:

BEP analysis is best suited for a company producing single product but many
companies are primarily multi-product firms in which break-even point can be calculated
assuming a specific product mix, which changes as we change the product mix.

7
 For example, take that the Camlin Co. Ltd., is producing and selling 3 chemicals x, y,
z with following details:

Product Sales Price/Unit Variable Cost/Unit Mix Ratio

Rs.
X 50 40 5
Y 60 25 2
Z 130 50 1

The fixed cost incurred by the company per month Rs. 2, 00,000 obviously. The
group is a combination of the products x, y, z with an arbitrary total content, but with no
assumed mix. The group have could consist of 8 total units with a mix of 5, 2, 1 units of x, y,
z respectively. If the group is defined to consist of 40 units, the distribution will be 25 units
of A, 10 of B, 5 of C. Once the unit of measure (i.e., unit or group of product-mix) has been
determined, the calculation of break even point follows the same pattern as in single-product
firm.

1.3. BREAK – EVEN POINT IN UNITS

In a multi-product firm, the basic formula of computing BEP in units is:

Fixed Costs
BEP(in Units) 
Contribution Margin Percent

However, since it is a contribution margin case of several products, There will be a

modification and the revised formula will be:

Fixed Costs
BEP(in Units) 
Weighted average contribution per unit of Market Basket

Illustration:

The above example of Camil Co. Ltd., the weighted average contribution margin:

8
 Product Contribution per Production Mix Weighted
Price/Unit Rs. Contribution Rs.
X 10 5 50
Y 35 2 70
Z 80 1 80
8 200

As such, the weighted average contribution margin per unit is

Rs. 200 ÷ 8 = Rs. 25.

Solution:

The BEP, applying the usual formula for sales unit volume,

Fixed Costs

Weighted average contribution margin

Rs. 2,00,000
  8,000 Units
Rs. 25

The product wise distribution will be;

1.3.1. 5,000 Units

1.3.2. 2,000 Units
1.3.3. 1,000 Units

1.4.BREAK – EVEN POINT IN SALES REVENUE

In a multi-product situation, the basic formula for computing the BEP in sales revenue
will be:

BEP (Sales)  Fixed Cost

P/V Ratio

But since it is a case of several products, it is the weighted average contribution

margin ratio or weighted average P/V ratio and the revised formula is:

9
 Fixed Cost
BEP in (Sales) 
Weighted averge P/V Ratio

BEP in sales revenue is generally easier to compute then in units for multi-product
firms in as much as it does not require knowledge of product-mix and the average market
basket. A contribution margin ratio can be developed from the income statement for use in
Break even analysis.

Illustration:

In the above example or Camlin Co. Ltd., the basic data is as below:

Product X Product Y Product Z

Rs. Rs. Rs.
Selling price per Unit 50 60 130
Variable Cost 40 25 50
Contribution margin 10 35 0
Contribution margin ratio 1/5 7/12 8/13
20% 58.33% 61.54%
Product mix 5 2 1

Now, the weighted average P/V ratio. The crucial term in calculation of Break Even
point in sales revenue, is expressed by the equation:

Weighted averge contribution margin

Weighted averge selling price

Solution:

Here, the numerator will be

5 2 1
(Rs.10 x )  (Rs.35 x )  (Rs.80 x )  Rs.25
8 8 8

The denominator will be.

5 )  (Rs.60 x 2 )  (Rs.130 x 1 500

(Rs.50 x )  or 62.5
8 8 8 8

10
 25
P/V Ratio is or 40%
62.5

Fixed Costs
BE Sales revenue Volume =
Weighted average P/V Ratio

Rs. 2,00,000
=
40%

= Rs. 5, 00,000

The breakup of this aggregate sales revenue/product-wise will be as under:

Product Sales Revenue

Rs.
X 2,50,000 (5,000 Units)
Y 1,20,000 (2,000 Units)
Z 1,30,000 (1,000 Units)
Rs. 5,00,000

1.5. MULTI-PRODUCT BREAK - EVEN CHART

When a company deals in a number of products, it is possible and indeed desirable to

show to break even chart for the company as a whole. In such a case, the breakeven point is
where the average contribution line cuts the fined cost time assuring proportions of sales mix
remain unchanged.

1.6. PROCEDURE FOR DRAWING UP A MULTI-PRODUCT B-E CHART

The procedure for drawing up a multi-product break even chart is as follows:

a) Calculate P/V ratio for each product and arrange the products in descending order
on the basis of P/V ratios.

b) ‘X’-axis would represent sales value while Y-axis would represent contribution and
fixed cost.

c) Plot the total fixed cost line.

11
d) Take the product having the highest P/V ratio and plot its contribution against sales;
then take the product having second highest P/V ratio and plot cumulative
contribution against cumulative sales; the process will and with plotting by the
product having the lowest P/V ratio.

e) Obtain the average contribution slope by joining the origin to the end of the last
time plotted.

The BEP is the point of interaction of average contribution line and fixed cost line.

Illustration:

Rao Co. Ltd., produces and sells 3 products A, B, C. From following information
relating to these products for a period, draw up a break even chart to determine the break
even point.

B A C Total
Sales (Rs.) 25,000 40,000 35,000 1,00,000
Variable Cost (Rs.) 15,000 20,000 25,000 63,000
Fixed Cost (Rs.) 18,500

The P/V ratio of each product should be calculated first and then in order of
importance of P/V ratios a table for cumulative sales and contribution should be prepared and
plotted on the graph paper.

(S- V)
P/V ratio  x 100
S

10,000
Product B  x 100  40% `
25,000

20,000
A x 100  50%
40,000

7,000

C x 100  20%
35,000

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 Product P/V ratio Sales Contribution
Productive Cumulative Productive Cumulative
Rs. Rs. Rs. Rs.
B 50% 40,000 40,000 20,000 20,000
A 40% 25,000 65,000 10,000 30,000
C 20% 35,000 1,00,000 7,000 37,000

Thus, the Break Even sales can be read from chart as Rs. 50,000.

Find Cost
Note: BEP (Sales)  x Total Sales
Total Contribution

18,500
 x 1,00,000  Rs. 50,000
37,000

1.7. DIFFERENT TYPES OF BREAK-EVEN CHART

Different Break-Even charts may be prepared to suit different purposes. Some of the
most common types of charts are:

i. Detailed Break-even chart

ii. Cash Break-even Chart
iii. Control Break-even chart

1.8. DETAILED BREAK-EVEN CHART

In this type, details of variable costs like direct materials, direct labour, variable
overheads are plotted in the graph. In addition, profit appropriations like income tax,
preference dividend, equity dividend and retentions are shown.

1.9. CASH BREAK-EVEN CHART

In this type fixed costs are divided into two groups:

i) Fixed costs requiring cash outlay during the period covered by the chart (e.g.
salaries, rent, rates, insurance etc.)

13
 ii) Fixed costs not requiring immediate cash e.g. depreciation, deferred expenses such
as research and development, advertisement etc.

1.10. CONTROL BREAK EVEN CHART

When Budgetary Control and Marginal costing are combined, Break-even chart comparing
budgeted and actual costs, sales, profits and break-even point is prepared. By pinpointing
deviations between budgeted/standard and actual figures it serves as an extremely useful tool
in management control and is known as Control Break-even Chart

1.11. SELF ASSESSMENT QUESTIONS

1. What is meant by “margin of safety”?

2. “The Break-even chart is an excellent planning device” Discuss

3. What are the limitations of a break-even chart?

4. Using imaginary figures explain and illustrate the calculation of break-even point in a
multi-product situation.

1.12. PRACTICAL PROBLEMS

1. A firm has two products X and Y. Below are given some data relating to them:

Product Variable Cost Selling Price

X Rs. 80 per unit Rs. 100 per unit
Y Rs. 60 per unit Rs. 100 per unit
Fixed expenses of the firm are Rs. 500

The sale of units of Product X is three times of units of Product Y

You are required to prepare a chart (graph) showing the break-even point and state the
procedure that you adopt for this purpose.

2. The following figures apply to a manufacturing company, producing a wide range of

products which may be classified into 3 main groups:

14
 Product group Annual Sales Variable Cost
(Rs.) (Rs.)
X 30,000,000 10,00,000
Y 30,00,000 20,00,000
Z 35,00,000 30,00,000

The fixed cost total Rs. 25,00,000, plot on a graph the marginal income slopes of the
product groups in alphabetical order to enable you to plot the average marginal income slope
for in total output.

3. XYZ Ltd. Manufactures and sells 4 types of products under the brand name of A, B, C, and
1 2 2 1
D. The sales-mix in value comprises 33 %, 41 %, 16 %, 8 % of product A,
3 3 3 3
B, C, and D respectively. The total budgeted sales (100%) are Rs. 60,000 per month.
Operating costs are:

Variable Costs: Product ‘A’ 60% of selling price

Product ‘B’ 68% of selling price

Product ‘C’ 80% of selling price

Product ‘D’ 40% of selling price

Fixed cost of Rs. 14,700 per month calculate break-even point for the products on an
overall basis.

4. Following are the details of Natraj Co. Ltd.

Product Contribution Product mix Weighted

permit Contribution
Pencil Rs. 25 5 125
Rubber Rs. 14 2 28
Sharpner Rs. 13 1 13
TOTAL 8 166

15
 Compute weighted average contribution margin per Unit and also calculate Break
Even point.

5. Following data relate to Caramel Ltd.

Products A B C
Rs. Rs. Rs.
Selling price per 100 120 260
Unit
Variable Cost 80 50 100
Contribution margin 20 70 160
Contribution margin 1/5 7/12 8/13
ratio
20% 58.33% 61.54%
Product mix 5 2 1

Calculate BEP in sales and weighted average p/v ratio.

(Note: Contribution per Unit Rs. 25; Rs. 14; s. 13)

1.13. SUGGESTED READINGS

1. Horngren, foster & Datar – Cost Accounting: A Managerial Emphasis (PHI).

2. Jawahar Lal – Cost Management (Tata McGrawhill).
3. Nigam & Sharma – Cost Analysis & Control: A Managerial Emphasis (Himalaya.
4. Horngren, Sundem & Stratton – Introduction to Management Accounting (PHI).
5. Robert Kaplan – Management Accounting (PHI).
6. Banerjee, B. – Cost Accounting (PHI).

16
 GUIDELINE-2
DIFFERENTIAL COSTS FOR PRODUCT DECISIONS
(The objective of this lesson is to learn the differential costs that affect
the pricing decisions)

Structure

2.1. Introduction

2.2. Differential Cost Analysis

2.2.1. Differential Costs
2.2.2. Applications of Differential Costs

2.1. Introduction

Managerial decision making is a process of making choices. If a choice is to be made

among alternatives, there must be differences among the alternatives. Relevant information
should be used by the decision maker in evaluating the alternatives and in making decisions.
Relevant information implies relevant costs and relevant revenues which are useful to
evaluate alternatives, to ascertain the effect of various alternatives on profit and to finally
select the alternative with the greatest benefit.

Relevant revenues and relevant costs are defined as the current and future values that
differ among the alternatives under consideration. The amount of differences between the
alternatives under consideration is called differentials and the (accounting) analysis
concerned with the effect of alternatives on revenues and costs is called differential analysis.
The present chapter discusses differential costs for product mix, product alteration decisions
regarding product additions and product deletions.

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2.2. Differential Cost Analysis:

Differential cost analysis is the process of analyzing a particular decision

making situation considering several alternative choices. It focuses on the future
because every decision deals with selecting course of action for the future. This
analysis provides a decision rule to managers in decision-making which is ‘the
alternative that gives the greatest incremental profit should be selected’. Incremental
profit is the difference between the relevant revenues and relevant costs of each
alternative.

2.2.1. Differential Costs

Differential costs are also known as relevant costs, decision-making costs. It is

the difference in total costs between two volumes. It is the cost that should be
considered when a decision has to be made involving an increase or decrease of say, n
units of output above a specified output. When a decision results in increased cost, the
differential cost may be called as incremental cost. If the cost decreases, then it is
called as decremental cost.

Differential costs vary with the type of decision. The common characteristics
are:

(a) They are expected future costs

(b) They differ between different decision alternatives.

Expected future costs imply that the costs are expected to occur during the period
covered by the decision. For example, new product will need the incurrence of direct
material, direct labour and other costs. The differential cost concept is one of the most useful
in planning and decision making. It provides a tool for testing the profitability of increased
output for an acceptable alternative. In many short-run decisions, only costs, not revenues,
will change. In this case, the most beneficial (profitable) decision will be one with the lowest
cost because the lowest cost alternative will give the highest profit for the business
enterprise, provided all other factors remain constant.

Incremental costs or Differential costs or marginal costs are the increase or decrease
in the total costs that result from choosing different alternative courses of action.

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 2.2.2. Applications of Differential Costs:

The applications of differential costs are in the decision areas relating to the following
problems:

1. Decisions of Pricing ;
2. Pricing on Special Orders;
3. Pricing during Recession/depression;
4. Decisions of Volume;
5. Decision on Idle capacity utilization;
6. Competitive bidding;
7. Decisions of Replacement;
8. Decisions of Sell or Process further;
9. Plant shut-down decisions;
10. Make or Buy decisions;
11. Capacity Expansion Decisions;
12. Diversification Decisions;
13. Product-mix decisions;
14. Addition/deletion of products/markets etc.

Differential cost analysis is a very useful subject in modern cost accounting.

Contribution Analysis, Contribution per unit of constraining factor or critical factor are
considered as most important parameters for making most of the above decisions, besides
incremental cost analysis. The incremental cost benefit analysis coupled with the analysis of
opportunity cost will provide very useful insights into the decision -making process, thus
significantly contribute for more decision efficiency and effectiveness.

Illustration 1:

A company is at present working at 90% of its capacity and producing 13500 units
per annum. It operates a Flexible Budgetary Control System. The following figures are
obtained from its budget:

19
 90% (Rs) 100% (Rs)
Sales 15,00,000
16,00,000
Fixed Expenses 3,00,000
3,00,000
Semi-Fixed Expenses 97,500
1,00,500
Variable Overhead Expenses 1,45,000
1,49,500
Units made 13,500
15,000

Labour and material cost per unit is constant under present conditions. Profit margin is
10 %.

(a) You are required to determine the differential cost of producing 1,500 units by
increasing capacity to 100 %.

(b) What would you recommend for an export price for these 1,500 units taking into
account that overseas prices are much lower than indigenous prices?

Solution:

Rs.

Basic calculation

Sales at 90 % capacity 1500000

Less: Profit at
10% 150000
Cost of goods
sold 1350000

Less: Expenses (Fixed, Semi-fixed and variable) 543000

Cost of material and labour 807000

Labour and material at 100 % capacity = Rs.807000 x 100/90

= 896667

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 Differential cost analysis can now be one as follows:

Capacity levels 90% 100% Differential

Cost

Production (units) 13500 15000 1500

Rs. Rs. Rs.

Material and Labour 807000 896667 89667

Variable overhead
expenses 145000 149500 4500
Semi-fixed
Expenses 97500 100500 3000

Fixed Expenses 300500 300600 100

1350000 1447267 97267

(a) Differential Cost = Rs 97267 (1447267 -1350000)

(b) Minimum price for export = Rs 97267 / 1500

= Rs. 64.84 per unit

At this price there is no addition to revenue; any price above Rs. 64.84 per unit may be acceptable.

21
 GUIDELINE-3
DIFFERENTIAL COSTS FOR PRODUCT - MIX DECISIONS
(The objective of this lesson is to learn the differential costs that affect
the product mix decisions)
Structure

3.1 Differential costs for product – mix decisions

3.2. Decisions Regarding Product Addition and Deletion

3.3. Self-Assessment Questions

3.4. Practical Problems

3.5. Suggested Readings

3.1 Differential costs for product – mix decisions:

When there are multiple products with different contribution margins, the mix of the
product has a direct effect on the fixed costs recovery and total profits of the firm. Different
products have different P/V ratios because of different selling prices and variable costs. Some
products make larger contributions to fixed cost recovery and profit than others. The total
profits depend to some extent upon the proportions in which the products are sold.

For example, assume that a company with fixed costs of Rs.30000 per year
manufactures two products, say, X and Y.

Product X Product Y
Unit selling price Rs. 15 Rs. 25
Variable costs 9 20
Contribution margin 6 5
P/V ratio 40% 20%

With comparatively low variable costs, product X has a relatively high P/V ratio, each
unit of product X sold contributes Rs.6 to fixed costs recovery and profit. Product Y with
comparatively high variable costs, has a low P/V ratio, each unit sold contributes only Rs.5 to
fixed costs recovery and profit. Other things being equal, the sale of product X is more
profitable than that of Y. It is correct to say that profits will decline as the sales-mix shifts
from product X to product Y. This also implies that new analysis of profit – volume
relationship must be made as the product mix changes.

22
 Different combinations of sales-mix will result in different net income for example: if
total sales volume is Rs.100000 equally divided between the two products, the net income
will be Rs. 15000.

Product X Product Y Total

Percent of sales revenue 50% 50% 100%
Sales revenue (Rs.) 50000 50000 100000
P/V ratio 60% 40% 40%
Marginal contribution 30000 10000 40000
Fixed costs 25000
Net income 15000

Break-even point = Fixed cost / P/V ratio

= 25000 / 40%

= Rs. 62500

If sales mix is changed so that product X has 60% of the sales revenue, the profit on
sales of Rs. 100000 would increase to Rs. 19000.

Product X Product Y Total

Percent of sales revenue 60% 40% 100%
Sales revenue (Rs) 60000 40000 100000
P/V ratio 60% 20% 44%
Marginal contribution 36000 8000 44000
Fixed cost 25000
Net income 19000

B.E.P. = 25000 / 44% = Rs. 56818

Sales mix is the relative proportion of each product line to the total sales of various
products sold by an enterprise. As stated earlier if there are no constraints or limitations,
management should try to maximize the sales of the product(s) with higher P/V ratio.
However, a sales mix results because there are limits to the quantities of any given product
that can be produced and there may be certain market limitations on how much can be sold.

Illustration 2:

The Budgeted result of ‘X’ Ltd. is set out below in respect o the various products
processed at the plant.

23
 Product Sales in Rs. Lakhs Variable cost as % of sales value
A 5 60%
B 4 50%
C 8 65%
D 3 80%
E 6 75%
Total 26 65.77%

Fixed costs for the period are estimated at Rs. 9 lakhs. Furnish:

(a) A statement showing the loss that would result.

(b) Recommend a change in sales volume of each product which will eliminate the
expected losses on the basic assumption that the sales of only one product can be
increased at a time.

Solution:

X Limited

Statement Showing Expected Losses

Variable
Product Sales Variable cost cost Contribution P/V
(Rs. Lakhs) as % of sales (Rs. Lakhs) (Rs. Lakhs) Ratio
A 5 60% 3 2 40
B 4 50% 2 2 50
C 8 65% 5.2 2.8 35
D 3 80% 2.4 0.6 20
E 6 75% 4.5 1.5 25
26 65.77% 17.1 8.9 34.23
900000
Total Fixed cost targeted
890000
Less: Total contribution
10000
Loss / Under recovery of fixed cost
= Under recovery of fixed cost
Additional value of sales required

P/V ratio

24
 Rs.
Product
25000
A = 10000/40% =
20000
B = 10000/50% =
28571
C = 10000/35% =
50000
D = 10000/20% =
40000
E = 10000/25% =

The above calculations clearly show that if 'X' Ltd. Can increase the sale of product A by

Rs. 25000 or product B by Rs. 20000 its business operations can be pulled up to

the B/E point.

The P/V ratio for each of the various products has been arrived at as under using the formula

= P/V Ratio
(Sales - Variable cost) x 100

Sales
%
Product
40
A = (5-3)/5 * 100 =
50
B = (4-2)/4 * 100 =
35
C = (8-5.2)/8 *100 =
20
D = (3-2.4)/3 *100 =
25
E = (6-4.5)/6 *100 =

The B/E point on the basis of a change in product mix is valuable in decisions to determine
the relative priorities for various products in a diversified product mix and where there are
production constraints.

25
Illustration 3:

Funtronics is a Delhi-based company that produces and sells FM 121 and FM 131, of
high quality Fax machines. The following information about these two models is given
below:
Cost per Unit (Rs.)
FM 121 FM 131
Direct materials 120 160
Direct Labour (Rs.20 per hour) 50 80
Variable overhead (Rs.5 per machine hour) 20 40
Fixed overhead 20 20
Total costs per unit 210 300
Price per unit (Rs.) 260 400

Demand for the two models has grown rapidly in recent years and Funtronics can no
longer meet the demand with its current production capacity. At present the monthly demand
is 8000 units for FM 121 and 5000 for FM 131. Monthly capacity is limited to 60000
machine hours.

Determine the product-mix that maximizes profits.

Solution:

Contribution Margin per unit:

FM 131
FM 121 (Rs.) (Rs.)

Selling price per unit 260 400

Less: Variable cost per unit:

Direct materials 120 160

Direct Labour 50 80

Variable Overhead 20 40

Total Variable cost 190 280

Contribution margin per unit 70 120

26
Contribution margin per unit of scarce resources:

FM 121 FM 131
Contribution margin per unit of
product Rs. 70 Rs. 120

Number of machine hours per unit 20/5 40/5

= 4 hrs = 8 hrs
Contribution margin per machine
hour 70/4 120/8

Rs. = 17.50 = 15

When the capacity is fully utilized, model FM 121 is a more profitable product
because it has higher contribution margin per unit of scarce resource (machine hours)
thanFM 131.
Therefore, Funtronics should first satisfy all the demands for FM 121 and then use the
Remaining machine hours of capacity to manufacture FM 131. The optimum production
Plan is as follows:

Product Hours

8000 units of FM 121 32000 hrs

28000 hrs
3500 units of FM 131 (Remaining)
60000 hrs

27
 3.2. Decisions Regarding Product Addition and Deletion:

Products may be added or eliminated from the process depending upon the
profitability of the product to the firm. If a product is profitable it is retained or added and if
not it is eliminated from the process. It is a special segment or product profitability evaluation.
To evaluate the financial consequences of eliminating a product or introducing a product, it is
necessary to concentrate on the differential or incremental profit effect of the decision. An
important factor to add or drop a product is whether it will increase or decrease the future
income of the business. Appropriate cost and profit measures must be developed for each
alternative.

It should be considered that not only the profitability of the product is analyzed but
also to evaluate the extent to which sales of other products will be adversely affected when
one product is removed or added. An unprofitable product may be part of a line of products
that must be complete in order to attract the customers to more profitable products. It may be
a complementary product to more profitable products, in which case some customers may
buy the more profitable products because the unprofitable product is also available from the
same company. If the expected sales decrease of related products is severe enough, it
probably would be desirable to retain the product being scrutinized.

To illustrate the product elimination decision, assume a company is considering

dropping product B from its line because accounting statements shows that product B is being
sold at a loss.

Income Statement

Product A Product B Product C Total

Rs. Rs. Rs. Rs.
Sales revenue 50000 7500 12500 70000
Cost of sales:
Direct material 7500 1000 1500 10000
Direct Labour 15000 2000 2500 19500
Indirect manufacturing 7500 1000 1250 9750
Cost (50% of direct labour)
30000 4000 5250 39250
Gross margin on sales 20000 3500 7250 30750

28
Administrative expenses
(allocation on arbitratary basis)12500 4500 4000 21000
Net income (Loss) 7500 (1000) 3250 9750

Additional information:

(i) Factory overhead costs are made up of fixed costs of Rs. 5850 and variable costs
of Rs. 3900. Variable costs by products are: product A Rs. 3000. Product B Rs.
400 and product C is Rs. 500.

(ii) Fixed costs and expenses will not be changed if product B is eliminated.

(iii) Variable selling and administrative expenses to the extent of Rs. 11000 can be
traced to the product as follows: A – Rs.7500, B – Rs. 1500,

C – Rs.2000.

(iv) Fixed selling and administrative expenses are Rs. 10000.

29
 The decision to drop product B cannot be reasonable made from the above data
prepared under a conventional income statement. This information together with the
following statement may be helpful to the management.

Product A Product B Product C Total

Rs. Rs. Rs. Rs.
Sales revenue 50000 7500 12500 70000
Less: Variable Cost:
Direct material 7500 1000 1500 10000
Direct Labour 15000 2000 2500 19500
Factory overhead 3000 400 500 3900
Selling and administrative
Expenses 7500 1500 2000 11000
33000 4900 6500 44400
Contribution margin 17000 2600 6000 25600
Less: Fixed costs
Factory overhead 5850
Selling and administrative expenses 10000
Total fixed costs
15850
Net income 9750

This statement shows that product B exceeds its variable costs by Rs. 2600. If the sale
of product B were discontinued, this marginal contribution would be lost and the net income
of the firm would be reduced by Rs. 2600. This is, net income will be Rs. 7150 (Rs.9750 –
Rs.2600). In this illustration it has been assumed that sales of product A and C will not be
increased after product B is dropped. Further, it has been assumed that dropping product B
will not change the fixed costs and expense. If these assumptions are not true, new analysis
must be made. Assume, for example, that after dropping product B, the sales of product A
increase by 10%. The total profit of the firm will not increase by this sales increase. Product
A makes only a marginal contribution of 34%.

Rs. %
Sales revenue 50000 100
Variable costs 33000 66
Marginal contribution 17000 34

30
On additional sales of Rs.5000, the marginal contribution would be Rs. 1700:
Rs.
Sales revenue 5000
Variable cost (66%) 3300
Marginal contribution (34%) 1700

This contribution is less than Rs. 2600 now being realized on the sales of product B. It would
take additional sales of product A of approximately Rs. 7647 to equal the marginal
contribution of Rs. 2600 now being made by product B:

Marginal contribution of product B = 2600 = Rs. 7647

Marginal contribution of product A 34%

It is possible that dropping product B may result in reduction in some of the fixed
costs. Product B now contributes Rs. 2600 towards recovery of fixed costs and expenses.
Only if the fixed costs and expenses can be reduced by more than this amount it will be
advisable to drop product B.

Illustration 4:

A company annually manufactures 10000 units of product Alpha at a cost of Rs 400

per unit and there is market for consuming the entire volume of production at the sale price of
Rs. 425 per unit. In the year 2005, there is a fall in the demand for the product which can
consume 10000 units only at a sale price of Rs. 380 per unit. The analysis of the costs per
10000 units is:

Rs.
Materials 1500000
Wages 1100000
Fixed overheads 800000
Variable overheads 600000

Product Beta is explored and is found that the market can consume 20000 units of the
product if offered at a sale price of Rs. 355 per unit. It is also discovered that for 20000 units
of product Beta, the fixed overhead will increase by 20%. Is it worthwhile to include product
Beta?

31
Solution:
Statement showing the advisability of adding a product

Year 2004 Year 2005

Product Alpha Product Alpha Product Beta Total

Rs. Rs. Rs. Rs.

1500000 1500000 3000000 4500000
Materials
1100000 1100000 2200000 3300000
Wages

Overheads:
800000 800000 160000 960000
Fixed
600000 600000 1200000 1800000
Variable
4000000 4000000 6560000 10560000
Total Cost
250000 -200000 540000 340000
Profit / Loss (-)
4250000 3800000 7100000 10900000
Sales
From the above it is clear that if product B is added the company can attain a profit
Rs. 540000 on product B. This will compensate not only for the loss on account of sale of
product A but will also result in overall profit of Rs.340000.

Thus it is advisable to add the product.

Illustration 5:

Crimson Industries began operations 15 years ago as a manufacturer of athletic

shoes. It later added a successful line of athletic socks, and then introduced a line of athletic
sports wear which has become its most profitable product line. Over the years, competition
from Asia Corporation has forced Crimson to reduce the prices of its athletic shoes to the
point where this product line now consistently has a negative segment margin. Typical
monthly statistics for the three product lines are shown below:

32
 Sports wear Athletic shoes Athletic socks
Rs. % Rs. % Rs. %
Sale 600000 100 350000 100 180000 100
Variable Costs 258000 43 262500 75 90000 50
Contribution margin 342000 57 87500 25 90000 50
Traceable fixed costs 132000 22 105000 30 77400 43
Segment margin 210000 35 (17500) 5 12600 7
Crimson is considering the proposal of discontinuing the manufacture and sale of
athletic shoes. All costs traceable to the product line would be eliminated if the product line is
discontinued. Management estimates that the sale of athletic socks would decline 20% from
this decision because both products are sold to the same customers. Sportswear is sold to
different customers, and sales are not anticipated to decline as a result of the decision.

Required:

1. Prepare a schedule of operating data for Crimson Industries assuming that the athletic
shoe line is discontinued.

2. What is the net effect on Crimson’s segment margin?

3. Would you recommend that Crimson discontinue the athletic shoe product line?

Solution:

1. The schedule of operating data for Crimson Industries, assuming that the athletic shoe
Line is discontinued, is presented below.

Sportswear Socks
Rs. % Rs. %
Sales 600000 100 144000 100
Variable costs 258000 43 72000 50
Contribution margin 342000 57 72000 50
Traceable fixed cost 132000 22 77400 54
Segment margin Loss(-) 210000 35 -5400 -4
Note: As sales of athletic socks are decreased by 20 % the variable costs of the product are
also decreased by 20%.

33
 2. The net effect on Crimson's segment margin is a decrease of Rs. 500, calculated
as follows:
With athletic shoes: Rs. Rs.
Sports wear 210000
Athletic shoes -17500
Socks 12600 205100
Without athletic shoes:
Sports wear 210000
Socks (as above) -5400 204600
Change in segment margin (loss(-)) -500

3. It is recommended that Crimson's Industries should not discontinue the athletic shoes
product line because the segment margin decreases by Rs. 500 if athletic shoes are
eliminated.

3.3. Self-Assessment Questions

1. Define the term differential cost.

2. What are the various applications of differential cost analysis?

3. State the significance of differential cost analysis in managerial decision making.

4. What is product mix? Is it different from sales mix?

5. How product addition decision is analyzed?

6. State the reasons for product deletion decisions and how it is analyzed?

3.4. Practical Problems

1. From the following particulars, find the most profitable product mix and prepare a
statement of profitability of that product mix:

Product A Product B Product C

Units budgeted to be
produced and sold 1800 3000 1200
Selling price per unit (Rs.) 60 55 50
Requirement per unit:
Direct materials 5 kg 3 kg 4 kg

34
 Direct labour 4 hrs. 3 hrs. 2 hrs.
Variable overheads Rs. 7 Rs. 13 Rs. 8
Fixed overheads Rs.10 Rs.10 Rs.10
Cost of direct material per Kg. Rs. 4 Rs. 4 Rs. 4
Direct labour hour rate Rs. 2 Rs. 2 Rs. 2
Maximum possible units of sales 4000 5000 1500

All the three products are produced from the same direct material using the
same type of machines and labour. Direct labour, which is the key factor, is limited to
18600 hours.

2. XYZ Co. is facing a short-term problem of insufficient raw materials to meet next
months budgeted production of its products P, Q, and R. The original budget for the
next month were:

P Q R Total
(Rs. ‘000) (Rs. ‘000) (Rs. ‘000) (Rs. ‘000)
Variable Costs:
Raw materials 34 18 26 78
Direct labour 40 31 58 129
Variable overheads 16 11 12 39
Fixed cost apportionment 60 44 56 160
Total Costs 150 104 152 406
Profit 45 28 36 108
Sales 194 132 188 514

The amount of raw materials available for next month’s total production of all
three products is unlikely to exceed Rs. 50000. You are required:

(a) To calculate the most profitable sales – mix possible in this case, assuming that
the company wants to produce a minimum of 50 % of budget for all three
products.

(b) To state your conclusions and the reasoning behind your approach.

3. A company manufactures three products, the details of which are as follows:

35
 A B C
Capacity engaged 20% 40% 40%
Units produced 2000 5000 6000
Cost per unit: (Rs.) (Rs.) (Rs.)
Material cost 20 32 36
Wages 10 12 16
Variable overheads 7 9 11
Fixed overheads 6 9 10
Total 43 62 73
Selling price per unit 40 75 85
Profit per unit (3) 13 12

The management proposes to discontinue the product line A as for the last few
years it is showing a loss. Future prospects of the other two lines being good, it is
intended to utilize the disengaged capacity in line A, in line B and line C equally.

B C
Expected rise in prices and cost (%)
Material 10% 10%
Wages 5% 5%
Selling price 2% 5%

Fixed overheads shall remain the same. You are required to prepare a
statement of projected profitability and advise the management as to whether the
scheme may be adopted.

Sanatan industries which had no costing system appointed a cost accountant. After
installation of a system of cost data, the cost accountant observed that out of the three
products which were being produced independent of each other, loss were being incurred on
product B. He immediately decides to advise management to discontinue manufacture of this
product supported by the following tabulation:

36
 Product A Product B Product C
Rs. Rs. Rs.
Sales 10000000 6500000 49000000
Variable manufacturing cost 5200000 2600000 14000000
Fixed manufacturing overheads
(apportioned) 650000 1900000 10500000
Variable selling and
administration costs 1800000 1700000 1800000
Fixed selling and
administration costs 460000 460000 400000
Total cost 8110000 6660000 26700000
Net profit 1890000 - 22300000
Net loss - 160000 -

Do you agree with the cost accountant’s conclusions? Argue your own view
on the basis of data.

4. Magnus, a manufacturing company evaluates two products and makes available the
following information.

Product P Product Q
Rs. Rs.
Variable cost per unit 12 14
Sales price per unit 20 20
Total fixed costs pr year 3000000 2100000
Capacity (units) 430000 500000
Anticipated sales 400000 400000
You are required to suggest:

(i) Which product should be chosen?

(ii) If the capacities are changed to Product P as 600000 units and Product Q as
500000 units, what happens?

37
Answers to practical problems:

1. Profit: Rs. 96750).

2. Profit: Rs. 17100).

3. Net profit on discontinuing A is Rs. 170000.

Net profit with all the three products: Rs. 118600).

4. B’s P/V ratio is higher with 34%, Discontinue not advisable).

5. (i) Product B, (ii) Product A).

3.5. Suggested Readings:

1. Charles T. Horngren, GeorgeFaster and Srikant M. Dattar, “Cost Accounting, A

Managerial Emphasis”, Prentice Hall, 2000.

2. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand &

Company Ltd., New Delhi, 2006.

3. Anthony A, Atkinson, R.S. Kaplan, R.D. Banker, “Management Accounting”,

Prentice Hall International, New Jersey, 1997.

4. M.Y. Khan and P.K. Jain, “Management Accounting”.

38
 GUIDELINE- 4

PRINCIPLES OF PRODUCT PRICING

Structure
4.1. Introduction
4.2. Pricing Decisions
4.3. Principles of product pricing
4.3.1. Pricing of an existing product
4.3.2. Pricing of a new product

4.1 Introduction
Management decisions are of basically related to products and their pricing strategies.
These may be of long run or short run and include a choice of alternative activities. Product
decisions include cost and revenue analysis that help management in ‘alternative choice
decisions’ such as make or buy, add or drop product, product mix, sell or process further
operate or shut-down, replace or retain, buy or lease etc. The concept pricing decisions is also
one of the most crucial and difficult decisions which a business firm has to make, and
analyses the significance of cost information to management in framing a suitable pricing
policy. In the present chapter we will study the determinants of pricing decisions, pricing of a

39
 new product and various pricing strategies that are usually followed by the firm or business
concerns in their pricing decisions.

4.2. Pricing Decisions

Pricing decisions are the decisions made to set a suitable selling price for a product or
service utilizing the relevant cost information from various departments of the firm. The price
so set is very useful to the management in knowing the prospective demand for the product
and its profitability. Selling price is the amount for which customers are charged for some
product manufactured or for a service provided to the customer by the firm. The pricing
decisions are usually influenced by certain factors which are known as determining factors /
determinants: These factors are of two types – (i) External and (ii) Internal.

(i) External factors: - External factors are the determinants that are outside the purview
of the company and the company requires special outlook to check these factors.
These may be as follows:

(a) Demand for the product or service and its elasticity.

(b) Nature of the product and its life expectancy.

(c) Type of competition for the product / service and availability of close substitutes.

(d) Type of industry to which the product belongs and future outlook of the industry.

(e) Number of suppliers in the market.

(f) Trends and likely changes in the economical and political system.

(g) Governmental guidelines, etc.

(ii) Internal factors: - Internal factors are the factors that are encountered within the
organisation. These factors may be related to various departments and other related
fields. They are:

(a) Firms profit and other objectives.

(b) Cost data of the product which may be actual, replacement, standard or any other
cost base.

(c) Policy of the firm in regards to pricing decision whether a long term or a short
term decision.

40
 (d) Usage of scarce resources.

(e) Quality of materials and labour inputs, etc.

Among these factors the pricing decisions are majorly influenced by costs, customers
and competitors.

 Costs influence prices as they affect the supply of the product. The lower the cost, the
higher will be the supply of the product. If a product is low priced, i.e., price being
lower than the cost, then the firms resources are automatically drained.

 Customers are very significant in determining the price of a product, as without them
the product has no further life or support. Increasing prices may tend a customer to go
for another‘s i.e., a product of a competitor who is supplying at less expensive
substitute.

 Competitors’ reactions influence the pricing of a product or a service. They act as the
controllers of the prices. Knowledge of competitors’ technology and estimation of
competitors’ cost will certainly help the management in setting a reasonable price for
the product or a service.

A good pricing process should have the tendency to be lower in such a way that a right
combination of price and output can be known to maximize profits.

4.3. Principles of product pricing

Taking the standard products into consideration, the pricing principles are much the
same whether the product is a new one or the one already well established in the market.
However the environmental situation and information base are different.

4.3.1. Pricing of an existing product

Illustration 1:

A manufacturer produces an article at the operated capacity of 10,000 units while the
normal capacity of his plant is 14,000 units. Working at a profit margin of 20 % on sales
realization, he has formulated his budget as under:

41
Units 10,000 14,000
Rs. Rs.
Sales realization 200000 280000
Variable overheads 50000 70000
Semi-variable overheads 20000 22000
Fixed overheads 40000 40000

He gets an order for a quantity equivalent to 20 % of the operated capacity and even
on this additional production profit margin is desired at the same percentage on sales
realization as for production to operated capacity.
Assuming prime cost per unit of production, what should be the minimum price to
realize this objective?
Solution:

(i) Computation of prime cost: Rs. Rs.

The profit margin is 20 % on sales
Therefore, cost of sale is 80 % of Rs. 200000 160000
Variable overheads 50000
Semi-variable overheads 20000
Fixed overheads 40000 110000
Prime cost 50000

(ii) Since an additional production of 4000 units requires an increase of Rs.2000 in semi-
variable expenses, an additional production of 2000 units will require an increase of
Rs.1000 in semi-variable expense.
Computation of differential cost of production of 2000 additional units for determining
minimum price:
Units 10000 12000 Differential cost for 2000
units
Rs. Rs. Rs.
Prime cost 50000 60000 10000
Variable overheads 50000 60000 10000
Semi-variable overheads 20000 21000 1000
Fixed overheads 40000 40000 -
160000 181000 21000

42
 The differential cost for an excess production of 2000 units over the operated capacity is
Rs. 21000 i.e., Rs.10.50 per unit. Profit margin required 20 % on sale i.e., 25% on cost.
Hence the minimum selling price = Rs. 10.50 + Rs. 2.625 = Rs. 13.125.
Illustration 2:
Readers Ltd. manufactures a document reproducing machine which has a variable
cost structure as follows:
Rs.
Material 40
Labour 10
Overhead 4
Selling price is Rs. 90.

Sales during the current year are expected to be Rs. 1350000 and fixed overheads Rs.
140000.

Under a wage agreement, an increase of 10 % is payable to all direct workers from the
beginning of the forthcoming year, while material costs are expected to increase by 7 ½ %,
variable overhead costs by 5 % and fixed overhead costs by 3 %.

Calculate:

i. the new selling price if the current profit / volume ratio is to be maintained; and

ii. the quantity to be sold during the forthcoming year to yield the same amount of profit as
current year assuming the selling price to remain at Rs. 90.

Solution:
(a) Computation of New Selling price
Cost Element Variable cost for Increase for Variable
forthcoming
Current year year cost
Rs. Rs.
Material 40.00 7.50% 43.00
Labour 10.00 10% 11.00
Overhead 4.00 5% 4.20
Total Variable cost 54.00 58.20
Selling price 90.00
Contribution 36.00

Current year's P/V ratio = Contribution per unit * 100 / Selling price per unit
= 36 *100 / 90
= 40

43
 The current year's marginal cost is 60 % of the selling price, viz., Rs. 90. In order to
maintain the current profit volume ratio of 40 % in the forthcoming year, the new selling
price should be:
Rs. 58.20 x 100 / 60 = Rs. 97.00
(b) Computation of quantity to be sold during the forthcoming year at Rs. 90 to yield the
amount of profit as the current year.
Profit for the current year:
Rs.
Contribution (40 % Rs. 1350000) 540000
Less: Fixed cost 140000
Profit 400000
Forthcoming year quantity Rs.
Profit required (as per current year) 400000
Fixed overhead costs
( Rs. 140000 + 3 % of Rs. 140000) 144200
Desired contribution 544200
Per unit contribution = Selling price - Variable cost
= Rs. 90 - Rs. 58.20
= Rs. 31.80
Sales quantity required for desired contribution = Desired
contribution
Contribution per unit
= Rs. 544200
Rs . 31.80
= 17113 machines.

4.3.2. Pricing of a new product

The pricing of a new product is a bigger problem to the management because of
uncertainty involved in the estimation of demand for the product. In order to overcome this
difficulty experimental sales are conducted in different markets using different prices to see
which price is suitable.
For example, a company chooses three different markets and by using the same
amount of sales promotional activities, ascertains what the right price is. In such
circumstances, it may even prove that the highest price yielding the largest unit contributory
margin need not necessarily maximize the profits. A lower price may well do to increase the
profits.
Example:
A company chooses three prices to be charged in three different markets and it can be
seen from the following figures given below:

44
 Particulars Price Price Price
Selling price per unit (Rs.) 1.20 1.50 1.80
Estimated sales (units) 8000 6000 3000
Rs. Rs. Rs.
Sales revenue (a) 9600 9000 5400
Costs:
Manufacturing costs 5200 3900 1950
Selling expenses 1000 500 450
Fixed expenses 1500 1500 1200
Total (b) 7700 5900 3600
Profit {(a) – (b)} 1900 3100 1800

45
 GUIDELINE- 5

PRODUCT PRICE STRATEGIES

5.1. Pricing Strategies

5.1.1. Market-Entry Strategies
5.1.2. Price discounts and differentials
5.1.3. Price discrimination
5.1.4. Geographic Pricing Strategies

5.2.Product-Price Strategies
5.3. Self-Assessment Questions
5.4. Practical Problems
5.5. Suggested readings

5.1. Pricing Strategies

Pricing strategy is defined as a broad plan of action by which an organisation intends
to reach its goal. Suppose, a company may adopt a strategy of expanding product lines that
enjoy substantial brand equity. Another strategy would be to offer quantity discounts to
achieve the goal of increase in sales volume. Since the right amount of volume has to be
selected to optimize profit, sufficient promotional activities are necessary. In some cases it
may even take a long time for the producer to establish. There are various types of pricing
strategies which a firm can adopt. They are:

5.1.1. Market-Entry Strategies:

This type of strategy is followed when a firm enters into the market with a new
product. For this the management has to decide whether to adopt a skimming pricing
strategy or penetrating pricing strategy.
(a) Skimming pricing: - This is a policy of high prices during the early period of a
product’s existence. This can be shown as high promotional expenditure and in the later
years the prices can be gradually decreased. This policy is adopted due to the following
reasons:
i. The demand of the product will be inelastic till the product is established in the
market.

46
 ii. The change of high price in the initial periods serves to skim the cream of the
market that is relatively insensitive to the price. The gradual reduction in the price
in the later years will increase the sales.
iii. The price covers the initial cost of production when it has no demand in the
market, inthe initial period, so this type of pricing is preferred.

(b) Penetration pricing: - This is a policy of low prices during the early period of product’s
existence in order to capture the mass markets. It is quite opposite to skimming pricing
policy. The low price policy is introduced for the sake of long-term survival and
profitability and so it requires absolute care before implementation. In this policy the
management has to go for certain research and forecasting that is necessary before
determining the price to check the scope for market expansion.
Penetrating pricing, means a pricing suitable for penetrating mass market as quickly
as possible through lower price offers. This is used for pricing new product, in order to
popularize it in the market initially. The company may not earn profit through this
policy during the initial stage, but in later stages when the product acquires demand in
the market the price may be increased. It can be adopted at any stage of the product life-
cycle for whose market is approached with low initial price. This pricing policy is also
known as “stay out pricing”.

5.1.2. Price discounts and differentials:

Under this strategy we come across distributors’ discounts, quantity discounts,
cash discounts and time differentials.
(a) Distributors’ discounts: - It means price deductions that systematically make the net
price vary according to buyer’s position in the chain of distribution. These discounts
are given to the distributors in the trade channel such as wholesalers, dealers and
retailers. They are also called functional discounts as they create differential prices for
different customers on the basis of market functions.
Distributors’ discounts can be divided into three categories, such as,
i. Different net prices for different distributor levels
ii. A uniform list price modified by a structure of discounts, each rate so
determined is applied to a different level of distributor
iii. A single discount combined with differing supplementary discounts to
different levelsof distributors.

47
 The economic function of distributors’ discounts is to induce different categories of
distributors to perform their marketing functions, so one should keep in mind the
following points for determining the distributors’ discount:

i. The services to be performed by the distributors at different levels.

ii. Knowledge about distributors’ operating costs.
iii. Discount structure adopted by competitors.
iv. Costs of selling to different channels.
v. Availability of opportunities for market segmentation etc.
(b) Quantity discounts: - Quantity discounts are price reductions related to the quantities
purchased. It may be related to the size of the order which is being measured in terms of
physical units of a particular commodity. This is practicable where the commodities are
homogeneous or identical in nature, or where there may be measured in terms of truck
loads. These discounts are useful in the marketing of materials and supplies but are
rarely used for marketing equipment and components.
The quantity discounts are mainly used to reduce number of small orders and thus
avoids high cost of servicing. Quantity discount system enables the dealer to avail such
discounts by buying larger lots. In certain cases the dealers may find it cheaper to
purchase their requirement f commodities from wholesalers, availing themselves of
these quantity discounts than from the manufacturers directly.
(c) Cash discounts: - Cash discounts are price reductions based on promptness of payment.
It is a convenient device to identify and overcome bad credit risks. In those traders
where credit risk is high, the percentage of cash discount given is also high. If a buyer
decides to purchase goods on credit, he has to pay a higher price by foregoing the cash
discount.
(d) Time differentials: - Charging different price on the basis of time is another kind of
price discrimination. Under time differentials the objective of the seller is to take
advantage of the fact that buyer’s demand elasticity’s vary overtime. Time differentials
can be classified as follows:

i. Clock-time differentials
ii. Calendar – time differentials
iii. Geographical price differentials
iv. Consumer category price differentials.

48
5.1.3. Price discrimination:
Price discrimination is the method of charging different prices to different
customers, for different products at certain place and at certain time. Thus price
discrimination takes various forms depending upon the basis of customer, product,
place or time. This can be known from the following details:
(a) Price discrimination on the basis of customer: Here, the same product is charged at
different prices to different customers. However it is disruptive of customer relations.
(b) Price discrimination on the basis of product: Here, a product even with a slight change
is charged different price regardless of its cost-relationship. For example, a table with
wooden top is sold at Rs. 5000, a table with sunmica top costing Rs.1500 extra is sold
at Rs.6500. The higher premium in the later case does not necessarily reflect the higher
production cost.
(c) Price discrimination on the basis of place: Depending upon the place also the price is
charged at various levels. The best example for this is the price charged for the seats in
a cinema theatre. In this the front seats are charged at lower rates and the back seats are
charged at higher rate. Similarly, the fares of railways and airways are charged
differently.

(d) Price discrimination on the basis of time: Here, as product is charged differently basing
upon the time of its demand. Certain products are sold during off-season also. So, the
prices are differently charged during the season and off-season.
For example, there is a practice if giving off-season concession in sale of fans or
refrigerators just after the summer season.
Price discrimination is possible only when the following conditions are satisfied:
i. The market must be capable of being segmented for price discrimination.
ii. The customers should not be able to resell the product of the segment paying
higherprice.
iii. The chances of competitors’ underselling in the segment of higher prices should not
bepossible.

49
5.1.4. Geographic Pricing Strategies:
In this pricing strategy the geographic limits of a firm’s market, locations of its
production facilities, sources of its raw materials and its competitive strength are
influenced in various geographic markets. Here, the seller must consider the costs of
shipping goods to the buyer. These costs are more important, as freight becomes a
larger part of total variable costs. Pricing policies may be established whereby the buyer
pays all the freight expenses, the seller bears the entire cost, or the seller and buyer
share this expense.
Geographic pricing may be categorized into four types such as:
(a) Point - of – Production Pricing: In this pricing strategy, the seller quotes the selling
price at the point of production and the buyer selects the mode of transportation and
pays all freight costs.
(b) Uniform Delivered Pricing: In this policy, the same delivered price is quoted to all
buyers regardless of their locations. It is used where freight costs are a small part of the
seller’s total cost. This strategy is also used by many retailers who believe “free”
delivery is an additional service that strengthens their market position.
(c) Zone – Delivered Pricing: Zone – delivered pricing divides a seller’s market into a
limited number of broad geographic zones and then sets a uniform delivered price for
each zone.

(d) Freight – Absorption Pricing: under freight – absorption pricing, a manufacturer will
quote to the customer a delivered price equal to its factory price plus the freight costs
that would be charged by a competitive seller located near that customer.

50
5.2. Product-Price Strategies
The Decisions of Product addition or deletion or alteration of product mix are to be
reviewed with an appropriate pricing strategy for optimum results. Any change in the
product-line or mix, when clubbed with a specific pricing option will result in a different set
of profits or losses. Therefore, various choices of product decisions are to be thoroughly
evaluated against different strategies of pricing to arrive at the most profitable solution.

5.3 Self-Assessment Questions:

1 What are pricing decisions?
2 State the determinants of pricing decisions.
3 Explain the process of pricing a new product.
4 Discuss various types of pricing strategies.
5 Explain how a skimming and penetration pricing are determined.
6 What are the different types of price discounts?
7 Explain the price discrimination method.
8 Discuss how a price is determined geographically.

5.4. Practical Problems:

1. Bliss choco Limited, an Australian Chocolate and Soft drink company, is planning to
establish a subsidiary company in India to produce, Choco Mineral Water.
Based on the estimated annual sales of 40,000 bottles of the mineral water, cost
studies produced the following estimates for the Indian subsidiary:
Total Annual Cost (Rs.) % of total annual cost that
is variable
Material 193600 100 %
Labour 90000 70 %
Overhead 80000 64 %
Administration 30000 30 %

The Indian production will be sold by manufacturer’s representatives who will

receive a commission of 8 % of the sale price. No portion of the Australia’s office
expenses is allocated to the Indian subsidiary.
You are required to compute the sale price per bottle to enable management to
realize an estimated 10 % profit on sale proceeds in India.

51
 2. Information regarding a particular product are given as follows:
Direct material cost 50 %
Direct wages cost 20 %
Overheads 30 %
Selling price Rs.80,000
It is anticipated, the next year the direct materials and direct labour costs will increase
by 20 % and 25 % respectively. The effect of the increase in costs will cause a
reduction of 25 % in the amount of profit.

Calculate the selling price required to be fixed for the next year to earn the same
percentage of profit on selling price as at present.

3. SS & sons Limited produce 300000 kgs of P and 600000 kgs of Q from an input of
900000 kgs of raw material Z. The selling price of P is Rs. 8 per kg and that of Q is Rs.
6 per kg.
Processing costs amount to Rs. 54 lakhs per month as under:
Rs.
Raw material Z (900000 kgs @ Rs. 3 per kg) 2700000
Variable processing costs 1800000
Fixed processing costs 900000
Total 5400000

There is an offer to purchase 60000 kgs of Q additionally at a price of Rs. 4 per kg.
The existing market for Q will not be affected by accepting the offer. But the price of P is
likely to be decreased uniformly on all sales. Find the minimum reduced average price for P
to sustain the increased sales.
Answers to practical problems:
1. Rs. 12
2. Rs. 92,000
3. Rs. 7.91

5.5.Suggested Readings:
1. Charles T. Horngren, GeorgeFaster and Srikant M. Dattar, “Cost Accounting, A
Managerial Emphasis”, Prentice Hall, 2000.
2. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand &
Company Ltd., New Delhi, 2006.

52
3. Anthony A, Atkinson, R.S. Kaplan, R.D. Banker, “Management Accounting”,
Prentice Hall International, New Jersey, 1997.
4. M.Y. Khan and P.K. Jain, “Management Accounting”.

53
 GUIDELINE - 6
SELL OR PROCESS FURTHER DECISION

Structure

6.1. Introduction

6.2.Sell or Process Further

6.3. Joint Products and By-Products

6.3.1. Joint Products

6.3.2. By-Products

6.3.3. Differences between Joint product and By-product

6.1. Introduction

Managerial decisions are choices made from a group of alternatives. Alternative decision
making situations help the managers or the manufacturers of the concern to arrive at a particular
decision, so that it helps in smooth running of the business or a firm. Similar is the case of joint
products and by-products where a number of alternative methods are followed to apportion the joint
costs to improve the profitability of the concern. The present chapter deals with the decision making
situations of sell or process further of a product and decision taken in the cases of joint and by-
products.

6.2. Sell or Process Further

The decision whether a product should be sold at the split-off point or processed further is
faced by many manufacturers. The choice between selling a product at split-off or processing it
further is short-run operating decision. Additional processing adds value to a product and increases
its selling price over the amount for which it could be sold at split-off. The decision to process further
depends upon whether the increase in total revenues exceeds the additional cost incurred for
processing beyond split-off.

Generally speaking, there are two general conditions under which a sell or process further
decision could occur.

(1) The company is evaluating the possibility of processing beyond split-off and must incur
certain equipment costs and other fixed costs, if additional processing is to occur.

54
 (2) The company already processes a product beyond split-off and has invested in the
equipment and required personnel.

The first is, really a capital budgeting problem and here it is not sufficient to determine
whether incremental revenues exceed costs. Since new investment in machinery and building are
involved, the rate of return on this investment must also be considered.

In the second situation, the relevant costs are only those costs which relate to the additional
processing of each product beyond the split-off point. The joint costs are relevant to the further
processing decisions. Certain fixed costs such as supervisory salaries are related to additional
processing. If these costs are eliminated by selling products at split-off, they are incremental and
should be included in the decision analysis. If salaried personnel are assigned other duties in the
company when additional processing is discontinued, the salary costs are not incremental since they
are incurred under either decisions alternative. If the equipment used for additional processing sits idle
or can be used in other processes, it should be ignored in the decision analysis. Depreciation expense
is never relevant in short-term operating decisions, since depreciation is an allocation of costs incurred
in a past time period.

In deciding upon which course of action to follow, the company compares the contribution
margin from the sale of the partially processed product with the contribution margin from the sale of
the completely processed product. The revenue to be derived from the sale of the partially processed
product is the opportunity cost attached to the decision of further processing. Assume for example, a
partially processed product can be sold for Rs. 12 per unit which is manufactured at a cost of Rs. 8.

Further processing can be done at an additional cost of Rs. 4 per unit and the final product can be sold
at Rs. 20 per unit. The firm can produce 20,000 units. The analysis is shown below:

Sell Process & Sell

Sales revenue Rs. 2,40,000 Rs. 4,00,000
(20,000 units)
Less: Manufacturing costs 1,60,000 2,40,000

80,000 1,60,000

Net advantage in further processing 1,60,000 – 80,000 = Rs. 80,000

Thus, there is a net advantage of Rs. 80,000 in processing the product further. The
market value of the partially processed product (Rs. 2,40,000) is considered to be the
opportunity cost of further processing. The figure of net advantage of Rs. 80,000 can be
arrived at in the following manner also:

Revenue from sale of final product 4,00,000

(20,000 x 20 )

55
 Less: Additional processing cost 80,000
(20,000 x 4 )
Revenues from sale of intermediate product 240,000 3,20,000

Net advantage in further processing 80,000_

Illustration 1:

Jacky & Co. produces two products, X and Y. As per the existing operations, raw materials
are processed in department 1, and the two products are separated at the end of this processing. For
every unit of product X, 3 units are obtained. X is then finished in department 2 and Y in department
3. Budgeted operating data for year 1 are as follows:

Departments
1 2 3
Units produced and sold:
Product X 100000 100000
Y 300000 300000
Cost incurred: Rs. Rs. Rs.
Direct materials 600000
Direct labour 320000 120000 160000
Variable manufacturing overheads 80000 40000 80000
Fixed manufacturing overhead 360000 100000 140000

All costs are directly traceable to the individual departments.

At present, X sold for Rs. 10 per unit and Y sold for Rs. 5 per unit. Both products are also
readily saleable at the completion of processing in department 1 – product X for Rs. 8 per unit and
product Y for Rs. 3 per unit.

You are required to advise the company when each product should be sold – after final
completion or at the split – off point.

56
Solution:

Incremental profit analysis (sell or process further)

Product X Product Y
Sell Process Differential Sell Process Differential
Now in Dept. 2 costs & Now in Dept. 3 costs &
(Rs) (Rs) revenues (Rs) (Rs) revenues
(Rs) (Rs)
Particulars:
Sales revenue 800000 1000000 200000 900000 1500000 600000
Les: Costs
Department 2 & 3
Direct labour - 120000 -120000 - 160000 -160000
Variable manufacturing
Overheads 40000 -40000 - 80000 -80000
Contribution (incremental) 40000 360000
Less: Fixed costs
(direct / avoidable) - 100000 -100000 - 140000 -140000
Production margin
(incremental)
Profit / Loss (-) -60000 220000

Product X should be sold after the split – off point (that is after processing in department 1).
Product Y should be sold after final completion (that is after processing in department 3).

Notes: 1. Costs of department 1 are joint costs and therefore, irrelevant for the decision - making at
present.

2. Fixed costs are avoidable costs and are relevant costs for decision – making.

Illustration 2:

Somnath Mining Company produces and sells bulk raw coal to other coal companies and
exporters. Somnath mines and stockpiles the coal; it is then passed through a one-step crushing
process before being loaded onto river barges for shipment to customers. The annual output of ten
million tons, which is expected to remain stable, has an average cost of Rs. 20 per ton with an average
selling price of Rs.27 per ton.

57
 Management is currently evaluating the possibility of further processing the coal

By sizing and cleaning in order to expand markets and enhance product revenue. Management has
rejected the possibility of constructing a large sizing and cleaning plant which would require a
significant long term capital investment.

The following statement represents the incremental costs of sizing and cleaning Somnath’s
annual output.

Somnath Mining Company

Sizing and cleaning Process

Incremental costs (Rs.)

Direct labour (Employee leasing) 600000 per year
Supervisory personnel (Employee leasing) 100000 per year
Heavy equipment rental, operating and maintenance costs 25000 per month
Contract sizing and cleaning per ton
Outbound rail freight (per 60 – ton rail car) 240 per car

In addition to the above information, market samples obtained show that electrical utilities
enter into contracts for sized and cleaned coal similar to that mined by Somnath at an expected
average price of Rs.36 per ton.

It was observed that 5% of the raw bulk output that enters the sizing and cleaning process will
be lost as a primary product. Normally, 75% of this product loss can be salvaged as coal fines. These
are small pieces ranging from dust – like particles up to pieces two inches in diameter. Coal fines are
too small for use by electrical utilities but are frequently sold to steel manufacturers for use in blast
furnaces.

Unfortunately the price for coal fines frequently fluctuates between Rs.14 and Rs.24 per ton
(F.O.B. shipping point), and the time of market volume is erratic.

While companies generally sell all their coal fines during a year, it is not unusual to stockpile this
product for several months before making any significant sales.

Required:

A. Prepare an analysis to show whether it would be more profitable for Somnath Mining
Company to continue to sell the raw bulk coal or to process it further through sizing and
cleaning. (Note: Ignore any value related to the coal fines).

58
 B. Taking into consideration any potential value to the coal fines, prepare an analysis to show if
the coal fines would affect the results of your analysis prepared in requirement A.

Solution:

A.
Incremental Sales Revenue: Rs.
Sales Revenue after further processing 342000000
(9500000 x Rs. 36)
Less : Sales Revenue from bulk raw coal 270000000
(10000000 x Rs. 27)
Incremental Sales revenue 72000000
Incremental costs:
Direct Labour 600000
Supervisory personnel 100000
Heavy equipment costs 300000
(Rs. 25000 x 12 months)
Sizing and cleaning 35000000
(10000000 tons x Rs.3.50)
Outbound rail freight 38000000
(9500000 tons / 60 tons) x Rs 240 per ton
Incremental costs 74000000
Incremental Gain / Loss (-) ----------------------------------- 2000000

This analysis show that it would be more profitable for the company to sell raw bulk without

further processing. (This analysis ignores any value related to coal fines.)

B. The following analysis show that the potential revenue from the coal fines by product would
result in additional revenue, ranging between Rs.5250000 and Rs. 9000000, depending on the
marketprice of the fines.
Coal fines = 75% of 5% of raw bulk tonnage

= .75 x (10000000 x .5)

= 375000 tons

Potential additional revenue :

Market Price

Minimum Rs. Maximum Rs.

14 per ton 24 per ton

Additional Revenue 5250000 9000000

59
 Since the incremental loss is Rs 20 lakhs, as calculated in the previous statement, including the

coal fines in the analysis indicates that further processing provides a positive result and is, therefore

favourable.

6.3. Joint Products and By-Products

6.3.1. Joint Products

In certain manufacturing industries, two or more than two products of equal importance and
value are produced simultaneously in a process. Such products are called ‘Joint Products’. Certain
products such as kerosene oil, fuel oil, lubricating oil, wax, tar, etc. are produced from crude
petroleum. Such products are common in agricultural industries, extractive industries, and chemical
industries. Thus joint products are the products separated in course of same processing operations,
usually requiring further processing, each product being in such proportion that no single product
can be designed as a major product.
The characteristics of joint products are:
1. They are produced from the same process with same material
2. They are separated in the course of same process
3. They are of same importance and value
4. They require further processing to finish them into more useful and valuable products.

Joint Products and co-products are used synonymously in common parlance, but sometimes, a
distinction is made between the two. Joint products are like twins born of same mother at the same
time, while co-products are two or more products which are used at a time but are not emerged from
the same material in the same process. For example in an automobile industry, motor cars, tractors,
jeeps, trucks, scooters etc. are co-products. They are produced on the choice of the manufacturer.
This is not the case with the joint products.

6.3.2. By-Products

By-Products are the products recovered from materials discarded in a main process, or from
the production of some major product, where the material value is to be considered at the severance
from the main product. For example, petrol is the main product in an oil refinery, while sulphur
chemical fertilizers, and bitumen are the by-products. In sugar industry, sugar is the main product
and molasses is the by-product. Thus by-products can be identified as those which:

a. come forth as a result of the production of the main product

b. are produced from the discarded material or the scrap of the main product,

60
 c. are of less importance or value as compared to that of main product, and

d. possess a value which can be obtained by the sale thereof.

By-products and secondary products are subsidiary products. By-product arises with the main
product where as secondary product does not arise in the same process. Secondary product is of
comparatively relative importance with the main product whether it arises from the same process or
not.

6.3.3. Differences between Joint product and By-product

Though joint products and by-products arise from the same materials during the process,
they are different in various aspects, like:

1. Joint products are of equal importance where as by-products are of less importance.

2. Joint products are produced all together in the same process, where as by-products are
produced from the scrap or discarded materials of the main product.

3. Joint products are not produced just incidentally, their production is definite, but by-
products emerge incidentally also.

4. Joint products require further processing whereas by-products do not require further process.

In many cases it is difficult to make a clear cut distinction between the joint product and by-
product. It also happens that a product of less importance may be of significant value tomorrow. So
a by-product may become a joint product later.

61
 GUIDELINE - 7
APPORTIONMENT OF JOINT COSTS

7.1. Apportionment of joint costs

7.2. Apportionment of joint costs in case of By-products

7.3. Self-Assessment Questions

7.4. Practical Problems

7.5. Suggested Readings

7.1. Apportionment of joint costs

It is very important that the costs of joint products to be separated correctly so that they
represent the correct value of the product, otherwise the product may be priced very low or high. For
this the costs in case of joint products and by-products are to be apportioned properly. There are
common costs incurred in both the cases up to the point of separation, and after this split-off point the
independent costs are debited to each of them where it requires further processing to make it a
complete product.

This apportionment of joint costs can be in the form of three possibilities, namely,

(i) where two or more products are produced simultaneously and there is no by-product

(ii) where there are both joint and by-products

(iii) where there is a main product and a by-product

The main importance of apportioning the joint costs is that it affects the pricing of the product,
and profit and loss of each product. Thus apportionment is to be done carefully. Usually the following
methods are used to apportion the joint costs:

1. Physical unit method

2. Average unit cost method

3. Market price method

4. Sale value method

5. Point value or survey method.

1. Physical unit method: - Under this method, joint cost is apportioned to the joint products on
the basis of some suitable physical coefficient contained in the products. For example, the

62
 joint cost may be apportioned in proportion to the raw materials contained in each product.
Suppose two products X and Y are produced from a raw material where ‘X’ uses 60% of the
raw material while ‘Y’ uses 40% of raw material. The joint cost can be apportioned in the
ratio of 60:40. The physical coefficient may be expressed in weight, volume, calories etc. This
is however no suitable for the products where one is liquid and one is solid.

2. Average cost unit method: - Under this method, the total pre-separation cost is divided by the
total units of all the products. This gives the average cost per unit of the output as a whole.
This method is good for application where the units are uniform and standardized. It fails if
all the products cannot be expressed in the same physical unit.

3. Market price method: - Under this method the pre-separation cost is apportioned on the basis
of the products. Suppose, P, Q, R are three joint products, and their market prices are Rs.
5000, Rs. 2000 and Rs. 3000 respectively per unit on completion, and if the joint cost, i.e.,
pre-separation costs of these products is Rs. 100000, then separation costs would be Rs.50000,
Rs. 20000, Rs. 30000 respectively. Here, the market price may be either market value of the
product at the split-off point or the market value of the product in the finished stage.

4. Sales value method: - Under this method the joint cost is apportioned in proportion to the total
sale price of each product. Sales value is determined basing upon the selling price and the
quantity sold. So, apportionment can be done on the basis of sales value of the product also.
In this method it is difficult to obtain the sales value at the split-off point when the products
are in semi-finished stage and moreover the market prices are subject to rapid fluctuations.

5. Point value or survey method: - Under this method there is an underlying idea that the
difference in the costs of joint products that arise due to the factors affecting the quantity and
quality of the products. These factors may be quality of materials used, labour operations
performed, time for the operation, direct charges included etc. These terms are given
weightage terms of point values to each product depending upon the factors contained in it,
and the apportionment of joint costs is made on the basis of these point-values of each. For
assigning such point-values of the different factors, a survey is necessary of the production
methods.

Illustration 3:

The joint expenses of three products A, B, C are as follows:

Rs.
Materials 8000
Labour 7500
Overhead 4500
20000

63
Subsequent processing costs are as under:

A B C
Materials 1500 1000 1200
Labour 1000 800 600
Overhead 500 200 200
3000 2000 2000
Total Sales Rs.20000 15000 8000
Estimated profit on sales 30% 20% 25%

Prepare a statement of apportionment of joint costs.

Solution:

Statement of apportionment of joint costs

Profit on Actual joint

Product Total Sales Estimated Subsequent Estimated cost

Sales cost of sales costs joint costs apportioned

% Amount Ratio Amount
A 20000 30% 6000 14000 3000 11000 11/25 8800
B 15000 20% 3000 12000 2000 10000 10/25 8000
C 8000 25% 2000 6000 2000 4000 4/25 3200
Total 43000 11000 32000 7000 25000 20000
Illustration 4:

The total expenses of an orange orchard during 1975 were Rs. 30000. The output for the year
and their selling prices, grade-wise were as follows:

Grade Production Selling price per 100 (Rs.)

I 30000 40
II 50000 36
III 30000 24
IV 40000 20
At the end of the year, the stocks of grade I, II, III and IV were 2500, 5000, 1500 and 3000
oranges respectively. Find out the closing stocks of oranges.

Solution:

64
 1. Physical Measurement Method and Average Unit method:

Grade Quantity Apportioned Cost per Stock Value of stock

No.s cost (Rs.) unit (Rs.) No.s Rs.

I 30000 6000 0.20 2500 500

II 50000 10000 0.20 5000 1000

III 30000 6000 0.20 1500 300

IV 40000 8000 0.20 3000 600

150000 30000 12000 2400

Note:

 Physical measurement method: Cost apportioned in the ratio of oranges produced, i.e., in theratio of 3:5:3:4.

 Average cost per unit method: Average cost per unit is Re.0.20. Cost apportioned @ 0.20 per unit.

2. Market Price Method

Grade Quantity Selling Price Apportione Cost per Stock Value of

d stock
No.s Per unit Rs.) unit (Rs.) No.s
Cost (Rs.) Rs.
I 30000 0.40 10000 0.333 2500 833.33
II 50000 0.36 9000 0.180 5000 900.00
III 30000 0.24 6000 0.200 1500 300.00
IV 40000 0.20 5000 0.125 3000 375.00
150000 1.20 30000 12000 2408.33

 Under this method, the cost has been apportioned in the ratio of selling price, i.e.,

40 : 36 : 24 : 20. The stock has been valued at cost price.

3 Sales Value Method

Value of
Grade Quantity Selling Sales Value Apportioned Stock stock
No.s Priceper Rs. Cost Rs. No.s Rs.
unit (Rs.)
I 30000 0.40 12000 7965 2500 664
II 50000 0.36 18000 11947 5000 1195
III 30000 0.24 7200 4779 1500 239
IV 40000 0.20 8000 5310 3000 398
150000 1.20 45200 30000 12000 2496

 Under this method, cost has been apportioned in the ratio of sales value, i.e., 120 : 180 : 72 : 80 and

65
 the stock has been valued at cost. Here, the costs are apportioned on the 'ability theory' or on the

principle 'what the traffic can bear'.

4 Point Value Method or Survey Method

Grade Quantity Point Weighted Apportioned Stock Value of

No.s Value Output No.s Cost Rs. No.s Stock Rs.

I 30000 4 120000 9730 2500 811

II 50000 3 150000 12162 5000 1216

III 30000 2 60000 4865 1500 243

IV 40000 1 40000 3243 3000 243

150000 370000 30000 12000 2514

Note:

 It is assumed that the survey made reveals the weightage factor ratio to be 4 : 3 : 2 : 1.

 The closing stock has been valued at cost. The apportioned cost of Grade I 30000 oranges

is Rs. 9730. Therefore, the cost of 2500 oranges of the stock would be Rs. 811. Similarly,

the stock values of the grades have been determined.

7.2. Apportionment of joint costs in case of By-products

By-products may be of two types like

(a). those which require no further processing after split-off and can be sold

(b). those which require further processing after separation and sold

As similar to that of joint products, by-products also do have to be apportioned properly in

order to attain the correct value of the by-product. For this both cost and non-cost methods are used.
Non-cost methods are also called ‘Sales value method’ as they are based on the sales values. Cost
methods comprise of the valuation of stock of the by-products done on the basis of cost. So, total cost
of the production is apportioned between main product and by-product. Under this we come across
replacement cost method, standard cost method and joint cost prorating method.

Illustration 5:

A factory producing an article Y also yields P and Q as by-products. The joint cost of
manufacture is:

Material Rs. 10000

Labour Rs. 2000
Factory and office overheads Rs. 8000

66
 Total Rs. 20000
Subsequent separation costs are as follows:
Y P Q
Rs. Rs. Rs.
Material 1500 1300 1000
Labour 200 150 100
Factory and office overheads 800 550 400
Total 2500 2000 1500
Sales Value 20000 15000 10000
Estimated profit on sales values 30% 25% 20%

Assume that the selling and distribution expenses are in proportion to sale values. Show how
you would propose to apportion the joint costs of manufacture and prepare statement of profit of Y, P
and Q.

Solution:

Y Rs. P Rs. Q Rs. Total Rs.

Sales Value 20000 15000 10000 45000
Less: Profit 6000 3750 2000 11750
30% 25% 20% -
14000 11250 8000 33250
Less: Subsequent costs 2500 2000 1500 6000
11500 9250 6500 27250
The difference between Rs. 27250 and the joint cost Rs. 20000 is Rs. 7250 will be treated as selling and
distribution cost which is further apportioned in the ratio of sales values in the threeproducts as under:

Y Rs. P Rs. Q Rs. Total Rs.

Total Cost 11500 9250 6500 27250
Less: Selling and distribution
costs 3222 2417 1611 7250
Share in joint cost 8278 6833 4889 20000

Statement of profit of Y, P and Q

Y Rs. P Rs. Q Rs.

Sales 20000 15000 10000

Total Cost

(Joint and subsequent costs)

Transfer from Y main product - 6833 4889

Material 11500 1300 1000

Labour 2200 150 100

67
 Overheads

- Factory and office 8800 550 400

- Selling and distribution 3222 2417 1611

Total 25722 4417 3111

Transfer of share in joint costs to:

- Product P 6833 - -

- Product Q 4889 - -

11722

Profit 6000 3750 2000

Illustration 6:

In a factory producing joint products of two varieties, the following data are extracted from
the books:

Total (Rs.)
Sale of products A and Z 750000
Direct Material 225000
Direct Labour 110000
Variable overhead (150 % on labour) 165000
Fixed overhead 200000

The analysis of sales reveals that the percentage of sale of product A is 66 2/3%.

Management contemplates to process further the joint products so that they could be sold at
higher rates. Facilities for this are available. The additional expenditure for the further process and
total sales anticipated at higher selling prices are given below. Make recommendations presenting the
effect of the proposal.

Product A (Rs.) Product Z (Rs.) Total (Rs.)

Sales after further processing 600000 300000 900000

Additional Material 50000 20000 70000
Additional direct labour 20000 8000 28000

68
 Solution:

Apportionment of Joint Cost on Sale - Value basis

Product A Product Z Total

Rs. Rs. Rs.
Sales 500000 250000 750000
Direct Material 150000 75000 225000
Direct Labour 73333 36667 110000
Variable Overhead (150 % of labour) 110000 55000 165000
Fixed Overhead 133333 66667 200000
Joint Cost 466667 233333 700000
Profit 33333 16667 50000

Position on Further Processing

Product A Product Z Total

Rs. Rs. Rs.
Sales expected 600000 300000 900000
Additional Material 50000 20000 70000
Additional Labour 20000 8000 28000
Variable overhead (150 % of Labour) 30000 12000 42000
100000 40000 140000
Joint Cost Share 466667 233333 700000
Total Cost 566667 273333 840000
Profit 33333 26667 60000

As product Z will yield additional profit of Rs. 10000, the proposal should be accepted.

7.3. Self-Assessment Questions

1. What is split-off point?

2. State the conditions under which a sell / process further decision arises.

3. What are relevant and irrelevant costs? How do they affect the decision of sell / process
further of a particular product?

4. What are joint costs? Explain the importance of these costs in product decisions.

5. What are joint products and by-products?

6. Differentiate joint and by-products.

7. Explain the methods of apportioning joint costs in case of joint products.

8. Explain the methods of apportioning joint costs in case of by-products.

69
7.4. Practical Problems

1. From the following information, find the profit made by each product, apportioning joint
costs on a sales value basis:

A (Rs.) B (Rs.)
Sales 760000 840000
Selling expenses 100000 400000
Joint costs:
Materials Rs. 624000
Process costs Rs. 276000

2. In a manufacturing company, three products P, Q and R emerges at a single split off stage in
department X, product P is further processed in department Y, product Q in department Z and
product R in department T. There is no loss in further processing of any of the three products.
The cost data for a month are as follows:

Rs.
Cost of raw materials introduced in department X 1268800
Direct wages department Rs.
X 384000
Y 96000
Z 64000
T 36000
Factory overheads of Rs. 464000 are to be apportioned to the departments on direct wages
basis.

During the month under reference, the company sold all three products after processing them
further as under:

Products P Q R
Output sold (Kgs) 44000 40000 20000
Selling price per Kg. Rs. 32 24 16
There is no opening or closing stock. If these products were sold at the split off stage, that is,
without further processing, the selling prices would have been Rs.20, Rs.22, and Rs.10 each
per Kg respectively for P, Q and R.

You are required to:

(a) Prepare a statement showing the apportionment of joint costs to joint products.

70
 (b) Present a statement showing product wise and total profit for the month under
reference as per the company’s current processing policy.

3. In Zenith manufacturing concern, product ‘S’ yields by-products ‘P’ and ‘Q’. The joint
expenses of the company are:

Materials Rs. 17000, Labour Rs. 18000, Overheads Rs. 15000.

Subsequent expenses are:

Materials (Rs.) Labour (Rs.) Overhead (Rs.)

S 5000 3800 3000
P 2400 3200 1800
Q 2800 4000 2100
Selling price : S – Rs. 60000 ; P – Rs. 40000 ; C – Rs. 30000 ;

Profit on selling price : S – 40 % ; P – 30 % ; Q – 25 %.

Show how you would apportion the joint expenses and ascertain profit of each product.

4. In the course of manufacture of the main product C, by-product X and Y also emerge. The
joint expenses of manufacturing amount to Rs. 119550. All the three products are processed
further after separation and sold as per details given below:

Main Product By-products

C X Y
Sales (Rs) 90000 60000 40000
Cost incurred after
separation (Rs.) 6000 5000 4000
Profit as % on sales 25 20 15
Total fixed selling expenses are 10 % of total cost of sales which are apportioned to the three
products in the ratio of 20 : 40 : 40.

(i) Prepare a statement showing the apportionment of joint costs to the main product and
the two by-products.

(ii) If the by-product X is not subjected to further processing and is sold at the point of
separation for which there is a market at Rs. 58500 without incurring any selling
expenses, would you advise its disposal at this stage? Show the workings.

5. Inorganic chemicals purchases salt and process it into more refined products such as caustic
soda, chlorine and polyvinyl chloride (PVC). For the month of October 2006, the firm
purchased salt for Rs. 80000, conversion costs incurred were Rs. 120000 up to the split-off

71
 point, at which time two saleable products were produced: caustic soda and chlorine. Chlorine
could be further processed into PVC. Production and other relevant information is as follows:

Production (tonne) Sales (tonne) Sales price per tonne

Caustic soda 2400 2400 Rs. 100

Chlorine 1600 - -
PVC 1000 1000 Rs. 400
The full production of chlorine was further processed at an incremental cost of Rs.
40000 to yield 1000 tonne of PVC. There were no by-products or scrap from this further
processing of chlorine. The organisation did not have any opening or closing stocks of any of
the above commodities for October 2006.

There is a very active market for chlorine. The firm could have sold its entire
production for October 2006, at Rs. 150 per tonne.

You are required to show the:

(a) Statement showing apportionment of joint costs on sale at split-off point, physical
measure (tonne) and estimated net realizable value.

(b) Gross margin percentage of (a) caustic soda and (b) PVC under the three methods
given above.

Answers to practical problems:

1. Joint costs: A: Rs. 540000; B: Rs. 360000.

2. (a) Joint Costs: 880000; 880000; 200000,

Profit: 355200; (35200); 55200.

3. Joint Costs: S: Rs. 20324; P: Rs. 18014; Q: Rs. 11662,

Profit: S: Rs. 24000; P: Rs. 12000; Q: Rs. 7500.

4. Joint Costs: C: Rs. 58510; X: Rs. 37200; Y: Rs. 24020;

Total Profit: Rs. 44000.

5. (a) (i.) Rs. 100000; Rs. 100000 (ii) Rs. 120000; Rs. 80000

(iii) Rs. 80000; Rs. 120000.

(b) (a) Caustic soda: 58.33%; 50%; 66.67%.

(b) PVC: 45%; 70% 60%.

72
7.5. Suggested Readings

1. Charles T. Horngren, GeorgeFaster and Srikant M. Dattar, “Cost Accounting, A Managerial

Emphasis”, Prentice Hall, 2000.

2. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand & Company
Ltd., New Delhi, 2006.

3. Anthony A, Atkinson, R.S. Kaplan, R.D. Banker, “Management Accounting”, Prentice Hall
International, New Jersey, 1997.

4. M.Y. Khan and P.K. Jain, “Management Accounting”.

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 GUIDELINE - 8
BUDGETING
Structure

8.1. Introduction
8.2. Meaning of budget
8.3. Budgets, Budgeting and Budgeting Control.
8.4. Objectives of Budgetary control
8.5. Characteristics of Good Budgeting
8.6. Requisites for a successful Budgetary control system
8.7. Essentials of Budgetary control
8.8. Budgeting Vs. Forecasting
8.9. Advantages of Budgetary control
8.10. Limitations of Budgetary control
8.11. Classification of budgets
8.12. Differences between a fixed and flexible budget.

8.1. INTRODUCTION
Planning is the basic managerial function. It helps in determining the course of action
to be followed for achieving organizational goals. It is decision in advance; what to do, when
to do, how to do and who will do a particular task? Plans are framed to achieve better results.
Control is the process of checking whether the plans are being adhered to or not, keeping a
record of progress, comparing it with the plans and then taking corrective measures for future
if there is any deviation. Every business enterprise needs the use of control techniques for
surviving in the highly competitive and changing economic world. There are various control
devices in use. Budgets are the most important tool of profit planning and control. They also
act as an instrument of co-ordination.
8.2. MEANING OF A BUDGET
A budget is the monetary and quantitative expression of business plans and policies to
be pursued in the future period of time. The term budgeting is used for preparing budgets and
other procedures for planning, co-ordination and control of business enterprise. According to
CIMA, Official Terminology, “A budget is a financial and/or quantitative statement prepared
prior to a defined period of time, of the policy to be pursued during that period for the
purpose of attaining a given objective. “In the words of Crown and Howard, “A budget is a

74
pre-determined statement of management policy during a given period which provides a
standard for comparison with the results actually achieved.”

8.3. BUDGET, BUDGETING AND BUDGETARY CONTROL:

A budget is blue print of a plan expressed in quantitative terms. Budgeting is

technique for formulating budgets. Budgetary control, on the other hand, refers to the
principles, procedures and practices of achieving given objectives through budgets.
Rowland and William have differentiated the three terms as: “Budgets are the
individual objectives of a department, etc., whereas Budgeting may be said to be the act of
building budgets. Budgetary control embraces all and in addition includes the science of
planning the budgets to affect an overall management tool for the business planning and
control”.

8.4. OBJECTIVES OF BUDGETARY CONTROL

Budgetary control is essential for policy planning and control. It also acts as an
instrument of coordination. The main objectives of budgetary control are as follows:
1. To ensure planning for future by setting up various budgets. The requirements
and expected performance of the enterprise are anticipated.
2. To co-ordinate the activities of different departments.
3. To operate various cost centers and departments with efficiency and economy.
4. Elimination of wastes and increase in profitability.
5. To anticipate capital expenditures for future.
6. To centralize the control system.
7. Correction of deviations from the established standards.
8. Fixation of responsibility of various individuals in the organization.

8.5.CHARACTERSTICS OF GOOD BUDGETING

1. A good budgeting system should involve persons at different levels while

preparingthe budgets. The subordinates should not feel any imposition on them.
2. There should be a proper fixation of authority and responsibility. The
delegation ofauthority should be done in a proper way.
3. The targets of the budgets should be realistic, if the targets are difficult to be
achievedthen they will not enthuse the persons concerned.
4. A good system of accounting is also essential to make the budgeting successful.
5. The budgeting system should have a whole-hearted support of the top
management.
6. The employees should be imparted budgeting education. There should be
meetings and discussions and the targets should be explained to the employees

75
 concerned.
7. A proper reporting system should be introduced; the results should be promptly
reported so that performance appraisal is undertaken.

8.6. REQUISITES FOR A SUCCESSFUL BUDGETARY CONTROL SYSTEM

For making a budgetary control system successful, following requisites are required:
(1) Clarifying objectives. The budgets are used to realize objectives of the business.
The objectives must be clearly spelt out so that budgets are properly prepared. In
the absence of clear goals, the budgets will also be unrealistic.
(2) Proper Delegation of Authority and Responsibility. Budget preparation and
control is done at every level of management. Even though budgets are finalized

at top level but involvement of persons from every level of management is

essential for their success. This necessitates proper delegation of authority and
responsibility.
(3) Proper Communication System. An effective system of communication is
required for a successful budgetary control. The flow of information regarding
budgets should be quick so that these are implemented. The upward
communication will help in knowing the difficulties in implementation of budgets.
The performance reports of various levels will help top management in budgetary
control.
(4) Budget Education. The employees should be properly educated about the benefits
of budgeting system. They should be educated about their role in the success of
this system. Budgetary control may not be taken only as a control device by the
employees but it should be used as a tool to improve their efficiency.
(5) Participation of All Employees. Budgeting is done every segment of the
business. It will also require the active participation and involvement of all
employees. In practice the budgets are to be executed at lower levels of
management. Those for whom the budgets are framed should be actively
associated with their preparation and execution. The employees, on the basis of
their past experience, may give more practical and useful suggestions. The success
of budgetary control system depends upon the participation of all employees of
the organization.
(6) Flexibility. Flexibility in budgets is required to make them suitable under changed
circumstances. Budgets are prepared for the future, which is always uncertain.
Even though budgets are prepared by considering the future possibilities but still

76
 some occurrences later on may necessitate certain adjustments. Flexibility will
make the budgets more appropriate and realistic.
(7) Motivation. Budgets are to be implemented by human beings. Their successful
implementation will depend upon the interest shown by the employees. All
persons should be motivated to improve their working so that budgeting is
successful. A proper system of motivation should be introduced for making this
system a success.

8.7. ESSENTIALS OF BUDGETARY CONTROL

There are certain steps which are necessary for the successful implementation of a
budgetary control system. They are as follows.
1. Organization for budgetary control
2. Budget centres
3. Budget officer
4. Budget manual
5. Budget committee.
6. Budget period.
7. Determination of key factor.
1. Organisation for Budgetary Control. The proper organization is essential for the
successful preparation, maintenance and administration of budgets. A Budgetary
Committee is formed which comprises the departmental heads of various
departments. All the functional heads are entrusted with the responsibility of
ensuring proper implementation of their respective departmental budgets. An
organization chart for budgetary control is given below:

77
 ORGANISATION CHART FOR BUDGETARY CONTROL:
Chief Executive
Budget Officer

Budget Committee

Production Sales Finance Accounts Personnel Research&

Manager Manager Manager Manager Manager Development
Manager
a. Production a. Sales a. Receipts Cost Labour
Budget Budget Budget Budget Budget Research
&
b. Plant utilization b. Advertisement b. Payments
Development Budget Cost Budget Budget Budget

The Chief Executive is the overall in charge of budgetary system. He constitutes a

budget committee for preparing realistic budgets. A budget officer is the convener of the
budget committee who co-ordinates the budgets of different departments. The managers of
different departments are made responsible for their departmental budgets.

2. Budget Centers. A budget center is that part of the organization for which the
budget is prepared. A budget center may be a department, section of a
department or any other part of the department. The establishment of budget
centers is essential for covering all parts of the organization. The budget centers
are also necessary for cost control purposes. The appraisal of performance of
different parts of the organization becomes easy when different centers are
established.
3. Budget Manual. A budget manual is a document which spells out the duties and
also the responsibilities of the various executives concerned with the budgets. It
specifies the relations among various functionaries.
A budget manual covers the following matters:
(i) A budget manual clearly defines the objectives of budgetary control
system. It also gives the benefits and principles of this system.
(ii) The duties and responsibilities of various persons dealing with preparation
and execution of budgets are also given in a budget manual. It enables the

78
 management to know of persons dealing with various aspects of budgets
and clarify their duties and responsibilities.
(iii) It gives information about the sanctioning authorities of various budgets.
The financial powers of different managers are given in the manual for
enabling the spending of amount on various expenses.
(iv) A proper table for budget including the sending of performance reports is
drawn so that every work starts in time and a systematic control is
exercise.
(v) The specimen forms and number of copies to be used for preparing budget
reports will also be stated. Budget centers involved should be clearly
stated.
(vi) The length of various budget periods and control points be clearly given.
(vii) The procedure to be followed in the entire system should be clearly stated.
(viii) A method of accounting to be used for various expenditures should also be
stated in the manual.
A budget manual helps in knowing in writing the role of every employee, his
duties, responsibilities, the ways of undertaking various tasks etc. it also helps in avoiding
ambiguity of any time.
4. Budget Officer. The Chief Executive, who is at the top of the organization,
appoints some person as Budget Officer. The budget officer is empowered to
scrutinize the budgets prepared by different functional heads and to make changes
in them, if the situation so demands. The actual performance of different
departments is communicated to the Budget Officer. He determines the deviations
in the budgets and takes necessary steps to rectify the deficiencies, if any. He
works as a co-ordinator among different departments and monitors the relevant
information. He also informs the top management about the performance of
different departments. The budget officer will be able to carry out his work fully
well only if he is conversant with the working of all the departments.
5. Budget Committee. In small-scale concerns, the accountant is made responsible
for preparation and implementation of budgets. In large scale concerns a
committee known as Budget Committee is formed. The heads of all the important
departments are made members of this committee. The committee is responsible
for preparation and execution of budgets. The members of this committee put up
the case of their respective departments and help the committee to take collective

79
 decisions, if necessary. The Budget Officer acts as co-coordinator of this
committee.
6. Budget Period. A budget period is the length of time for which a budget is
prepared. The budget period depends upon a number of factors. It may be
different for different industries or even it may be different for different industries
or even it may be different in the same industry or business. The budget period
depends upon the following considerations:

(a) The type of budget i.e., sales budget, production budget, raw materials
purchase budget, capital expenditure budget. A capital expenditure budget
may be for a longer period i.e., 3 to 5 years; purchase, sale budgets may be for
one year.
(b) The nature of demand for the products.
(c) The timings for the availability of the finances.
(d) The economic situation of the cycles.
(e) The length of trade cycles.
All the above mentioned factors are taken into account while fixing the period of
budgets.
7. Determination of Key Factor. The budgets are prepared for all functional areas.
These budgets are inter-dependent and inter-related. A proper co-ordination
among different budgets is necessary for making the budgetary control a success.
The constraints on some budgets may have an effect on other budgets too. A
factor which influences all other budgets is known as Key Factor or Principal
Factor.
8.8. BUDGETING Vs. FORECASTING
Forecasting may be needed for future planning or budgeting but it cannot be confused
with the later. Forecasts are only well-educated guesses or inferences as to what the future
may be. The management has to make predictions while preparing plans for the future.
According to Henry Fayol, father of modern management, the entire plan is made up of series
of separate plans called forecasts. Forecasting provides a logical basis for preparing the
plans/budgets. The actual performance of the past, the present situation and likely trends in
the future is considered while preparing budgets. A budget is the monetary or/and
quantitative expression of business plans and policies to be pursued in the future period of
time.
The difference between budgeting and forecasting can be summarized as below:

80
 1. Forecasts are merely well-educated estimates or an inference about the future
probable events whereas a budget relates to planned events and is the quantitative
expression of business plans and policies to be pursued in the future.
2. Budgeting begins where forecasting ends. In fact, forecasting provides the logical
basis for preparing the budgets.

3. A budget provides a standard for comparison with the results actually achieved
and, thus, is an important control device for the management, while a forecast
represents merely a probable event over which no control can be exercised.
8.9. ADVANTAGES OF BUDGETARY CONTROL
The budgetary control system helps in fixing the goals for the organization as a whole
and concerted efforts are made for its achievements. It enables economics in the enterprise.
Some of the advantages of budgetary control are:
i. Maximization of Profit. The budgetary control aims at the maximization of profitsof
the enterprise. To achieve this aim, a proper planning and co-ordination of different
functions is undertaken. There is a proper control over various capital and revenue
expenditures. The resources are put to the best possible use.
ii. Co-ordination. The working of different departments and sectors is properly co-
coordinated. The budgets of different departments have a bearing on one another.
The co-ordination of various executives and subordinates is necessary for achieving
budgeted targets.
iii. Specific Aims. The plans, Policies and goals are decided by the top management. All
efforts are put together reach the common goal of the organization. Every
department is given a target to be achieved. The efforts are directed towards
achieving some specific aims. If there is no definite aim then the efforts will be
wasted in pursuing different aims.
iv. Tool for Measuring Performance. By providing targets to various department.
Budgetary control provides a tool for measuring managerial performance. The
budgeted targets are compared to actual results and deviations are determined.
The performance of each department is reported to the top management. This system
enables the introduction of management by exception.
v. Economy. The planning of expenditure will be systematic and there will be economy
in spending the finances will be put to optimum use. The benefits derived for the
concern will ultimately extend to industry and then to national economy. The
national resources will be used economically and wastage will be eliminated.

81
 vi. Determining Weaknesses. The deviations in budgeted and actual performance
will enable the determination of weak sports. Efforts are concentrated on those
aspects where performance is less than the stipulated.
vii. Corrective Action. The management will be able to take corrective measures
whenever there is a discrepancy in performance. The deviations will be regularly
reported so that necessary action is taken at the earliest. In the absence of a
budgetary control system the deviations can be determined only at the end of the
financial period.
viii. Consciousness. It creates budget consciousness among the employees. By fixing
targets for the employees, they are made conscious of their responsibility.
Everybody knows what he is expected to do and he continues with his work
uninterrupted.
ix. Reduces Costs. In the present day competitive world budgetary control has a
significant role to play. Every businessman tries to reduce the cost of production for
increasing sales. He tries to have those combinations of products where profitability
is more.
x. Introduction of Incentive Schemes. Budgetary control system also enables the
introduction of incentive schemes of remuneration. The comparison of budgeted and
actual performance will enable the use of such schemes.
BUDGETARY CONTROL

ADVANTAGES LIMITAIONS
1. Maximization of Profits 1. Uncertain Future
2. Proper co-ordination 2. Revision Required
3. Provides Specific Aims 3. Discourages Efficient Persons
4. Tool for Measuring Performance 4. Problem of co – ordination
5. Economy 5. Conflict among different departments
6. Corrective Action 6. Depends upon support of top
7. Creates Budget Consciousness management
8. Reduced Costs
9. Determines Weaknesses
10. Introduction of Incentive Schemes

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8.10. LIMITATIONS OF BUDGETARY CONTROL

Despite many good points of budgetary control there are some limitations of this
system. Some of the limitations are discussed as follows.
1. Uncertain Future. The budgets are prepared for the future period. Despite best
estimates made for the future, the predictions may not always come true. The future is
always uncertain and the situation which is presumed to prevail in future may change.
The change in future conditions upsets the budgets which have to be prepared on the
basis of certain assumptions. The future uncertainties reduce the utility of budgetary
control system.
2. Budgetary Revisions Required. Budgets are prepared on the assumptions that certain
conditions will prevail. Because of future uncertainties, assumed conditions may not
prevail necessitating the revision of budgetary targets. Will reduce the value of
budgets and revisions involve huge expenditures too.
3. Discourages Efficient Persons. Under budgetary control system the targets are given
to every person in the organization. The common tendency of people is to achieve the
targets only. There may be some efficient persons who can exceed the targets but they
will also feel contented by reaching the targets. So budgets may serve as constraints
on managerial initiatives.
4. Problem of co-ordination. The success of budgetary control depends upon the co-
ordination among different departments. The performance of one department affects
the results of other departments. To overcome the problem of co-ordination a
Budgetary Officer is needed. Every concern cannot afford to appoint
5. Budgetary Officer. The lack of co-ordination among different departments results in
poor performance.
6. Conflict among Different Departments. Budgetary control may lead to conflicts
among functional departments. Every departmental head worries for his department
goals without thinking of business goal. Every department tries to get maximum
allocations of funds and this raises a conflict among different departments.
7. Depends upon Support of Top Management. Budgetary control system depends
upon the support of top management. The management should be enthusiastic for the

83
 success of this system and should give full support for it. If at any time there is a lack
of support from top management then this system will collapse.

8.11. CLASSIFICATION OF BUDGETS

The budgets are usually classified according to their nature. The following are the
types of budgets which are commonly used.
A. Classification According to Time
1 Long –term budgets.
2 Short-term budgets.
3 Current budgets.
B. Classification on the Basis of Functions
1 Operating Budget
2 Financial Budgets
3 Master Budget
C. Classification on the Basis of Flexibility
1 Fixed budget.
2 Flexible budget.
( A) Classification According to Time:
1. Long Term Budgets. The budgets are prepared to depict long term planning of the
business. The period of long term budgets varies between five to ten years. The long
term planning is done by the top level management; it is not generally known to lower
levels of management. Long time budgets are prepared for some sectors of the concern
such as capital expenditure, research and development, long term finances, etc. These
budgets are useful for those industries where gestation period is long i.e., machinery,
electricity, engineering, etc.
2. Short –term Budgets. These budgets are generally for one or two years and are in the
form of monetary terms. The consumer’s goods industries like sugar, cotton, textile,
etc. use short-term budgets.
3. Current Budgets. The period of current budgets is generally of months and weeks.
These budgets relate to the current activities of the business. According to I.C.W.A.
London, “Current budget is a budget which is established for use over a short period of
time and is related to current conditions.”

84
(B) Classification on the Basis of Functions:
1. Operating Budgets. These budgets relate to the different activities or operations of a firm.
The number of such budgets depends upon the size and nature of business. The commonly
used operating budgets are;
a) Sales Budget
b) Production Budget
c) Production Cost Budget
d) Purchase Budget
e) Raw Material Budget
f) Labour Budget
g) Plant Utilization Budget
h) Manufacturing Expenses, Budget, etc.
i) Administrative and Selling Expenses, Budget, etc.
The operating budget for a firm may be constructed in terms of programmes or
responsibility areas, and hence may consist of:
(i) Programme Budget, and
(ii) Responsibility Budget.
(i) Programme Budget. It consists of expected revenues and costs of various products or
projects that are termed as the major programmes of the firm. Such a budget can be prepared
for each product line or project showing revenues, costs and the relative profitability of the
various programmes. Programme budgets are, thus, useful in locating areas where efforts
may be required to reduce costs and increase revenues. They are also useful in determining
imbalances and inadequacies in programmes so that corrective action may be taken in future.
(ii) Responsibility Budget. When the operating budget of a firm is constructed in terms of
responsibility areas it is called the responsibility budget. Such a budget shows the plan in
terms of persons responsible for achieving them. It is used by the management as a control
device to evaluate the performance of executives who are in charge of various cost centers.
Their performance is compared to the targets (budgets), set for them and proper action is
taken for adverse results, if any. The kinds of responsibility areas depend upon the size and
nature of business activities and the organizational structure. However, responsibility areas
may be classified under three broad categories:
(a) Cost/ Expense Centre
(b) Profit center
(c) Investment Centre

85
2. Financial Budgets. Financial budgets are concerned with cash receipts and disbursements,
working capital, capital expenditure, financial position and results of business operations.
The commonly used financial budgets are:
(a) Cash Budget
(b) Working Capital Budget
(c) Capital Expenditure Budget
(d) Income Statement Budget
(e) Statement of Retained Earnings Budget
(f) Budgeted Balance Sheet or Position Statement Budget.
3. Master Budget : Various functional budgets are integrated into master budget. This
budget is prepared by the integration of separate functional budgets. According to I.C.W.A.
London, “The Master Budget is the summary budget incorporating its functional budgets”.
Master budget is prepared by the budget officer and it remains with the top level
management. This budget is used to co-ordinate the activities of various functional
departments and also to help as a control device.
Illustration 1:
Phanindra & Co. manufactures glass items and requires you to calculate and present the budget for
the next year from the following information:
Toughened Glass Rs. 200000
Bent Toughened Glass Rs. 300000
Direct material cost 60% of Sales
Direct wages 10 workers @ Rs. 100 per month.
Factory overheads:
Indirect Labour:
Work Manager Rs. 300 per month
Foreman Rs. 200 per month
Stores and spares 2% on sales
Depreciation on machinery Rs. 6000
Light and power Rs.2000
Repairs and maintenance Rs.4000
Other Sundries 10% on direct wages

Administration, Selling and Distribution expenses Rs. 7000 per year.

86
Solution:
Master Budget for the year ending . . . . .
Particulars Amount Rs. Amount Rs. Amount Rs.
Sales (as per sales budget)
Toughened Glass 200000
Bent Toughened Glass 300000
500000
Less: Cost of Production:
(as per cost of production
budget)
Direct materials 300000
Direct wages 12000
Primary cost 312000
Add: Factory Overhead:
Variable:
Stores and spares 10000
Light and power 2000
Repairs and maintenance 4000 16000
Fixed:
Work Manager's salary 3600
Foreman salary 2400
Depreciation 6000
Sundries 1200 13200 341200
Works Cost 341200
Gross Profit 158800
Less: Administration, Selling and
Distribution Overheads 7000
Net Profit 151800

(C) Classification on the Basis of Flexibility:

1. Fixed Budget. The fixed budget are prepared for a given level of activity, the budget
is prepared before the beginning of the financial year. If the financial year starts in
January then the budget will be prepared a month or two earlier, i.e., November or
December. The changes in expenditure arising out of the anticipated changes will not
be adjusted in the budget. There is a difference of about twelve months in the
budgeted and actual figures, according to I.C.W.A. London, “Fixed budget is a
budgets are suitable under static conditions. If sales, expenses and costs can be
forecasted with greater accuracy then this budget can be advantageously used.
2. Flexible Budgets: A flexible budget consists of a series of budget as for different
level of activity. It therefore, varies with the level of activity attained. A flexible
budget is prepared after taking into consideration unforeseen changes in the
conditions of the business. A flexible budget is defined as a budget, which by

87
 recognizing the difference between fixed semi-fixed, and variable const is designed to
change in relation to the level of activity.
The flexible budgets will be useful where level of activity changes from time to
time. When the forecasting of demand is uncertain and the undertaking operates under
conditions of shortage of materials, labour etc., then this budget will be more suited.

DIFFERENCE BETWEEN A FIXED AND FLEXIBLE BUDGET

Basis of Fixed Budget Flexible Budget
Distinction
1. Rigidity A fixed budget remains the same A flexible budget is recast adjusted
irrespective of changed situations. It to the changed circumstances.
remains inflexible even if volume of Suitable adjustments are made if the
business is changed. situation so demands.
2.Conditions A fixed budget assumes that This budget is changed if level of
conditions will remain constant. activity varies.
3.Cost In fixed budgets costs are not The costs are studied as per their
Classification classified according to their nature nature, i.e., fixed variable, semi-
variable.
4.Changes in If the level of activity changes then The budgets are redrafted as per the
Volume budgeted and actual results cannot be changed volume and a comparison
compared because of change in basis. between budgeted and actual figures
will be possible.
5.Forecating Forecasting of accurate results is Flexible budget budgets clearly show
difficult. the impact of expenses on operations
and it helps in making accurate
forecasts.
6.Cost Under changed circumstances costs The costs can be easily ascertained
ascertainment cannot be ascertained. under different levels of activity.
This helps in fixing prices.

Illustration 2:
The following data is available in a manufacturing company for a yearly period.
Rs. Lakhs
Fixed Expenses:
Wages and salaries 9.00
Rent, rates and taxes 6.00
Depreciation 7.00
Sundry administrative expenses 5.50
Semi-variable expenses:
Maintenance and repairs 4.00
Indirect labour 8.00
Sales department salaries, etc. 4.00
Sundry administrative salaries 3.00
Variable expenses (at 50% capacity):
Materials 24.00

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 Labour 20.50
Other expenses 8.00
99.00
Assume that the fixed expenses remain constant for all levels of production,
semi-variable expenses remain constant between 45% and 60% capacity, increasing by 10%
between 60% and 80% capacity and by 20% between 80% and 100% capacity.
Sales at various levels are: Rs in Lakhs
50% capacity 100
75% capacity 150
90% capacity 180
100% capacity 200

Prepare a flexible budget for the year and forecast the profit at 75%, 90%, and 100% capacity.
Solution:
Flexible Budget for the period . . .
Capacity level 50% 75% 90% 100%
Sales (Rs. In lakhs) 100 150 180 200
Fixed expenses:
- Wages and salaries 9.00 9.00 9.00 9.00
- Rent, rates and taxes 6.00 6.00 6.00 6.00
- Depreciation 7.00 7.00 7.00 7.00
- Sundry administrative expenses 5.50 5.50 5.50 5.50
Total fixed assets (a) 27.50 27.50 27.50 27.50
Semi-variable expenses:
- Maintenance and repairs 4.00 4.40 4.80 4.80
- Indirect labour 8.00 8.80 9.60 9.60
- Sales department salaries, etc. 4.00 4.40 4.80 4.80
- Sundry administrative salaries 3.00 3.30 3.60 3.60
Total semi-variable costs (b) 19.00 20.90 22.80 22.80
Variable expenses:
- Materials 24.00 36.00 43.20 48.00
- Labour 20.50 30.75 36.90 41.00
- Other expenses 8.00 12.00 14.40 16.00
Total variable cost © 52.50 78.75 94.50 105.00
Total cost (a + b + c) 99.00 127.15 144.80 155.30
Sales 100.00 150.00 180.00 200.00
Profit 1.00 22.85 35.20 44.70

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 GUIDELINE - 9
IMPORTANT BUDGETS

9.1. Important budgets

(i) Sales budget
(ii) Production budget
(iii) Material budget
(iv) Labour budget
(v) Factory overhead budget
(vi) Administrative overheads budgets.
(vii) Selling and Distribution overhead budget.
9.2. Self-Assessment Questions
9.3. Practical Problems
9.4. Suggested Readings

9.1. IMPORTANT BUDGETS

(i) Sales budget
The sales budget, generally, forms the fundamental basis on which all the budgets are
built up. The budget is essentially a forecast of sales to be achieved in a budget period. The
sales Manager should be made directly responsible for the preparation and execution of this

budget. He should take into consideration the following factors while preparing the sales
budget:
(a) Past sales figures and trend. The record of previous experience forms the most
reliable guide as to future sales as the past performance is related to actual
business conditions. However, the other factors such as seasonal fluctuations,
growth of market, trade cycle etc., should not be lost sight of.
(b) Salesmen’s estimates. Salesmen, etc., are in a position to estimate the potential
demand of the customers more accurately because they come in direct contact
with them. However, proper discount should be made for over optimistic or too
conservative estimates of the salesmen depending upon their temperament.
(c) Plant capacity. It should be the endeavor of the business to censure proper
utilization of plant facilities and that the sales budget provides an economic and
balanced production in the factory.
(d) General trade prospects. The general trade prospects considerably affect the sales.
Valuable information can be gathered in this connection from trade papers and

90
 magazines.
(e) Orders on hand. In case of industries where production is quite a lengthy
process, orders on hand also have a considerable influence on the amount of sales?
(f) Proposed expansion or discontinuance of products. It affects sales and,
therefore, it should also be considered.
(g) Seasonal fluctuations. Past experience will be the best guide in this respect.
However, efforts should be made to minimize the effects of seasonal vegetations
by giving special concessions or off-season discounts thus increasing the volume
of sales.
(h) Potential market. Market research should be carried out for ascertaining the
potential market for the company’s products. Such an estimate is made on the
basis of expected population growth, purchasing, power of consumers and buying
habits of the people.
(i) Availability of material and supply. Adequate supply of raw materials and other
supplies must be ensured before drafting the sales programme.
(j) Financial aspect. Expansion of sales usually require increase in capital outlay
also, therefore, sales budget must be kept within the bounds of financial capacity.

(k) Other factors:

(i) The nature and degree of competition within the industry;
(ii) Cost of distributing goods;
(iii) Government controls, rules and regulations related to the industry; and
(iv) Political situation- national and international – as it may have an
influence upon the market.
The Sales Manager, after taking into consideration all these factors, will prepare the
Sales Budget in terms of quantities and money, distinguishing between products, periods, and
areas of sales.
Figure 1. depicts the specimen of sales budget.

XYZ Co.Ltd.
Sales Budget for the year ending December, 31,2006.
Products Budgeted sales units Budgeted sales price (Rs.) Total
A 70000 80000 5600000
B 80000 120000 9600000
Total 150000 15200000
Figure 1. Sales Budget

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(ii) Production Budget
This budget provides an estimate of the total volume of production product wise with
the scheduling of operations by days, weeks and month and a forecast of the closing finished
product inventory. Generally the production budget is based upon the sales budget but in
case of companies which find it difficult to forecast sales on account of frequencies changes
in style and fashions, it is based upon past experience. The responsibility of the total
Production Budget lies with Works Manager and that of Departmental production Budgets
with Departmental work Managers.
The production budget may be expressed in quantitative or financial units or both.
The objects its preparation is:
(i) To answer the following questions:
(a) What is to be produced?
(b) When it is to be produced?
(c) How it is to be produced?
(d) Where it is to be produced?
(ii) To chalk down and organize the production programme achieving the sales
target.
(iii) To serve as a basis for preparation of production costs budget e.g., materials cost
budget, labour cost budget, etc.
(iv) To prepare cash forecast.
There are two problem connected with the production budget (i) determining the
annual production required, and (ii) pro-rating throughout the year. The planning of
production programme is easier to have sufficient stock for sales to keep inventories within
reasonable limits and to manufacture goods most economically.
A specimen of production budget can be seen in Figure 2.

XYZ Co. Ltd.

Production budget for the month of August, 2006.
Particulars Product ‘X’
Budgeted sales (units) 70000
Add: Desired closing inventory of finished goods 20000
90000
Less: Opening finished goods inventory 40000
Units to be produced 50000
Figure 2. Production Budget
Cost of Production Budget
After determining the volume of production, it is necessary to determine the cost of
producing this output. Cost of production includes materials, labour and overheads and,
therefore, separate budgets for each of these items will be prepared.
Illustration 3:

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 Prepare a Production Budget for each month and Production Cost Budget for the six months period
ending 31st Dec. 2006 from the following data of product X.
1 The units to be sold for different months are as follows:
July, 2006 1100
August 1100
September 1700
October 1900
November 2500
December 2300
January, 2007 2000
2 There will be no work in progress at the end of any month.
3 Finished units equal to half the sales for the next month will be in stock at the end
of each month (including June, 2006).
4 Budgeted production and production for the year ending 31st December 2006 are:
Production (Units) 22000
Direct material per unit Rs.10
Direct wages per unit Rs.4
Total factory overhead apportioned to product Rs.88000

Solution:

(A) Production Budget (from July to December)

Particulars July Aug Sep Oct Nov Dec Total
Estimated Sales 1100 1100 1700 1900 2500 2300 10600
Add: Closing stock of
finished goods
(half of next month
sales) 550 850 950 1250 1150 1000 1000
1650 1950 2650 3150 3650 3300 11600
Less: Opening stock of
finished goods 550 550 850 950 1250 1150 550
Budgeted production 1100 1400 1800 2200 2400 2150 11050

Working Notes:
Estimated production = Expected sales + Desired closing stock - Estimated opening stock
This is the closing stock June 2006 = 50% sale of July 2006.

(B) Production Cost Budget (from July to Dec.)

Particulars Amount Amount
(Per
(11,050 Units) Unit)
Direct material cost
(at Rs. 10 per unit) 110500 10
Direct Wages
(at Rs.4 per unit) 44200 4
Factory overhead
(88000/22000) * 11050 44200 4
Total Cost of Production 198900 18
Assumed to be variable. If it is fixed, 50% of Rs.88000 (Rs.44000) is to be changed.

(iv) Materials Budget

Materials may be direct or indirect. The materials budget generally deals only with
the direct materials. Indirect materials are generally included in overhead budget. The

93
preparation of materials budget includes the following:
(a) the preparation of estimates of raw material requirements.
(b) The scheduling of purchases in required quantities at the required time.
(c) The controlling of raw material inventories.
Material requirements are estimated regarding each class of products by multiplying the
exact material requirements for each class of product by the number of units of that class. The
total quantity required for the budget period is first estimated and then is further broken down
by component time period (months and quarters) in the materials budget. The breakdown
and length of the period should be in uniformity with the production budget.
Figure 3 depicts the format of direct materials usage budget.

Ratio Company
Direct Materials Usage Budget for the year ending Dec, 2006
Product A Product B Total Rs.
Budgeted production in units 50000 60000
Direct materials requirements
Product A 5 Kg per unit X5
Product B 8 Kg per unit X8
Direct materials usage (Kg) 250000 480000
Cost per Kg Re.1.00 Rs.1.50
Cost of direct material used 250000 720000 970000

Figure 3. Direct material usage budget

(iv) Direct Labour Budget

The direct labour budget tells about the estimates of direct labour requirements
essential for carrying out the budgeted output. In preparation of this budget previous records
of the percentage labour cost in the total cost of each product, group or department will be
considerably helpful. The budget may give details regarding direct labour costs only, or both
direct labour hours and cost. In the former case the cost can be calculated by making an
estimate of cost per unit of production. The cost per unit multiplied by the budgeted units
will give the estimated cost of direct labour. In the latter case estimates will have to be made
about (i) direct labour hours, and (ii) average wage rate. Internal factors such as the method
of wage payment, the type of production process and the available costing records will
determine whether and how it is possible to express production in terms of direct labour

94
hours. The average wages rate payable for a particular product or department will be
calculated on the basis of the historical ratio between wages paid and direct labour hours
worked in the department or for the product after taking into account the current conditions.

Direct Labour Budget (like Direct Materials Budget) may be divided into two
categories: (i) Direct Labour Requirement Budget, and (ii) Direct Labour Procurement
Budget. The former tells about the total direct labour required in terms of quantity or /and
value while the latter will state the additional direct workers to be recruited.
Fig.4 shows the format of direct labour budget.

Ratio Company
Direct Labour Budget for the year ending Dec, 2006
Product A Product B Total Rs.
Budgeted production requirements 40000 80000
Direct labour hours per unit 3 2
Total direct labour hours 120000 160000
Direct labour cost per hours Rs.5 Rs.5
Total direct labour cost (Rs.) 600000 800000 1400000

Figure 4. Direct Labour Budget

(v) Factory Overhead Budget

Manufacturing of Factory overheads includes the cost of indirect labour, indirect
material and indirect expenses. The manufacturing overheads can be classified into three
categories (i) Fixed, i.e., which tend to remain constant irrespective of any change in the
volume of output, (ii) variable, i.e. which tend to vary with the output, and (iii) Semi-
variable, i.e., which are partly variable and partly fixed. The manufacturing overheads budget
will provide an estimate of these overheads to be incurred in the budget period.
(vi) Administrative Overheads Budget
The budget covers the expenses of all administrative offices, and of management
salaries. A careful analysis of the need of all administrative departments of the enterprise is
very necessary. The minimum requirements for the efficient operation of each department
can be estimated on the basis of costs for prior years, and after a study of the plans and
responsibilities of each administrative department for the budget period. The budget for the
entire administrative division will be prepared by totaling the separate budgets of all
administrative departments.
Figure 5. shows the specimen of administration budget.

95
XYZ Co. Ltd.
Administration Expenses Budget for the year ending Dec, 2006
Particulars Amount (Rs.) Amount (Rs.)
(A) Variable administrative expenses:
(i) Supplies 30000
(ii) Clerical Wages 65000
Total variable administrative expenses 95000
(B) Fixed administrative expenses:
(i) Directors remuneration 125000
(ii) Legal charges 25000
(iii) Depreciation 30000
(iv) Salaries 35000
(v) Rent 60000
(vi) Postage, Telephone etc. 43000
Total fixed administrative expenses 318000
Total administrative expenses 413000
Figure 5. Administrative expenses budget.

(vii) Selling and Distribution overhead Budget

The budget includes all expenses relating to selling, advertising delivery of goods to
customers, etc. It is better if such costs are analyzed according to products, types of
customers, territories, and the sales departments in the organization itself. The responsibility
for the preparation of this budget rests with the executives of the sales departments. There
must be a coordination of selling expenses with the volume of sales expected and an effort
should be made to control the costs of distribution. The preparation of the budget would
depend on the analysis of the market situations by the management, advertising policies,
research programmes and the fixed and variable elements.
9.2. SELF ASSESSMENT QUESTIONS
I. Write short answers in not exceeding 10 lines each for the following.
(1) What is budget?
(2) What is budgetary control?
(3) What is flexible budget?
(4) What is master budget?
II. Write the answers for the following questions in 4 pages each.
(1) Explain the Advantages and limitations of budgeting?
(2) Explain the differences between fixed budget and flexible budget.
(3) Write a not on classification of budgets.
9.3. PRACTICAL PROBLEMS:

1. Glorious company limited, has budgeted sales of 1,50,000 units of its product for the
year 2006.
Expected unit costs based on past experience should be:
Direct material Rs.10
Direct labour Rs. 8
Manufacturing overhead Rs. 4

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 Assume no beginning or ending inventory in process.
Company begins the year 2006 with 50,000 units in hand, but the finished inventory is
at 20,000 units
Compute the budgeted cost of production for 2006.

2. Navnirman Co. Ltd., wishes to prepare cash budget from January. Prepare a cash
budget for the first six months from the following estimated revenues and expenses:

Months Total sales Materials Wages Production Selling

& distribution
January 2000000 2000000 400000 320000 80000
February 2200000 1400000 440000 330000 90000
March 2400000 1400000 460000 330000 80000
April 2600000 1400000 460000 340000 90000
May 2800000 1200000 480000 350000 90000
June 3000000 1600000 480000 360000 100000

Cash balance on 1st January was Rs. 1000000. A new machine is to be installed at Rs.
3000000 on credit to be repaid by two instalments in March and April.
Sales commission @ 5% on total is to be paid within the month following actual
sales. Rs. 1000000 being the amount of 2nd call may be received in March.
Share premium amounting to Rs. 200000 is also obtainable with 2nd call.
Period of credit allowed by suppliers – 2 months
Period of credit allowed to suppliers – 1 month
Delay in payment of overhead – 1 month
Delay in payment of wages – ½ month
Assume cash sales to be 50% of total sales.

3. The budgeted cost of a factory specializing in production of a product at an optimum

capacity of 8000 units per annum amounts to Rs.200000. as detailed below:
Fixed cost Rs.25000

Variable cost:
Power Rs. 10000
Repairs Rs. 12000
Miscellaneous Rs. 4000
Direct materials Rs. 56000
Direct Labour Rs. 93000 175000
200000
The company decided to have a flexible budget with a production target of 4000 units
and 6000 units with regard to the impact on sales turnover by the market trends.
Administration, selling and distribution expenses continue to be at Rs.3600.
Prepare a flexible budget for production levels at 50% and 75% capacity.
Assume selling price per unit is maintained at Rs.40 at present and also indicate the
effect on net profit.

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Answers to Practical Problems:
1. Production 1,20,000 units; Cost Rs. 26,40,000.
2.Balance of cash at the end of each month – January – Rs.18,00,000; February –
Rs.29,80,000; March – Rs.20,00,000; April – Rs.6,10,000; May – Rs.8,80,000; June
- Rs.15,20,000.
3. Net Profit: (a) 100% - Rs. 1,16,400
(b) 75% - Rs. 80,150
(c) 50% - Rs. 43,900

9.4.Suggested Readings
1. Charles T. Horngren, GeorgeFaster and Srikant M. Dattar, “Cost Accounting, A Managerial
Emphasis”, Prentice Hall, 2000.
2. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand &
Company Ltd., New Delhi, 2006.
3. Anthony A, Atkinson, R.S. Kaplan, R.D. Banker, “Management Accounting”, Prentice
Hall International, New Jersey, 1997.
4. M.Y. Khan and P.K. Jain, “Management Accounting”.

98
 GUIDELINE -10
CASH BUDGET

Structure

10.1. Introduction

10.2. Cash Budget

10.3. Operating Cash flows

10.4. Financial Cash flows

10.5. Illustrations

10.6. Self-Assessment Questions

10.7. Practical Problems

10.8. Suggested Readings

10.1.INTRODUCTION

We have already studied various types of budgets in the previous chapter that are
related to various operations and functions of a business concern. The present lesson deals
exclusively with the very important budget i.e. the cash budget. Cash budget deals with all
the possible cash receipts from various sources and their disbursements to respective
expenses.

10.2.CASH BUDGET

A cash budget is an estimate of cash receipts and disbursements during a future period
of time. “The cash budget is an analysis of flow of cash in a business over a future, short or
long period of time. It is a forecast of expected cash intake and outlay”.

The cash receipts from various sources are anticipated. The estimated cash collections
for sales, debts, bill receivables, interests, dividends and other incomes and sale of
investments and other assets will be taken into account. The amounts to be spent on purchase

99
of materials, payment to creditors and meeting various other revenue and capital expenditure
needs should be considered. Cash forecasts will include all possible sources from which cash
will be received and the channels in which payments are to be made so that a consolidated
cash position is determined.

The cash budget should be coordinated with other activities of the business. The
functional budgets may be adjusted according to the cash budget. The available funds should
be fruitfully used and the concern should not suffer for want of funds. The principal aim of
the cash budget, as a tool of planning, is to ascertain whether, at any time, there is likely to be
excess or shortage of cash. The preparation of cash budget involves various steps. The first
element of a cash budget is the selection of the period of time to be covered by the budget.
Alternatively; it is referred to as the “planning horizon”. The planning horizon means the
time span and the sub-periods within that time span over which the cash flows are to be
projected. There is no hard and fast rule. The period coverage of a cash budget will differ
from firm to firm depending upon its nature and the degree of accuracy with which the
estimates can be made. As a general rule, the period selected should be neither too long nor
too short. If it is too long, it is likely that the estimates will be upset as we cannot visualize
them at the time of the preparation of the budget. If on the other hand, the time span is too
small, the disadvantages are: (i) Failure to take into account important events which lie just
beyond the period covered by the budget: (ii) Heavy workload in preparation: and (iii)
Abnormal factors that may be operative.

The planning horizon of a cash budget should be determined in the light of the
circumstances and requirements of a particular case. For instance, if the flows are expected to
be stable and dependable, such a firm may prepare a cash budget covering a long period, say,
a year and divide it into quarterly intervals. In the case of a firm whose flows are uncertain, a
quarterly budget divided into monthly intervals may be appropriate. Where flows are
affected by seasonal variations, monthly sub-divided into weekly or even daily budgets may
be necessary. If the flows are subject to extreme fluctuations, a daily budget may be called
for. The idea behind sub-dividing the budget period into smaller intervals is to highlight the
movement of cash from one sub-period to another. The sub-division will provide information
on the fluctuations in the cash reservoir level during the time span covered by the budget.

100
 The second element of the cash budget is the factors that have a bearing on cash
flows. The items included in the cash budget are the cash items only, non-cash items such as
depreciation are excluded. The factors that generate cash flow are generally divided, for
purposes of constructing a cash budget, into two broad categories (a) Operating and (b)
Financial. These two-fold classifications of cash budget items is based on their “nature”
while the former category includes cash flows generated by the operations of the firms and
are known as the “operating cash flows. “ the latter consist of the “financial cash flows.” The
major components of the two types of cash flows are outlined below.

10.3. OPERATING CASH FLOWS

The main operating factors/items which generate cash outflows and inflows over the
time span of a cash budget are tabulated in Exhibit 1.

Exhibit 1.Operating Cash Flow items

Cash inflows/ Receipt Cash outflows/Disbursements

1. Cash sales 1.Accounts payable/Payable payments.

2. Collection of accounts receivable 2. Purchase of raw materials

3. Disposal of fixed assets 3. Wages and salary (pay roll)

4. Factory expenses

5.Administrative and selling expenses

6. Maintenance expenses

7. Purchase of fixed assets

Among the operating factors affecting cash flows, the collection of accounts
receivable (inflows) and accounts payable (outflows) are the most important. The terms of
credit and the speed with which the customers pay would determine the lag between the
creation of the accounts receivable and their collection. Also, discounts and allowances for
early payments, returns from customers and bad debts affect the cash inflows. Similarly,
accounts payables relating to credit purchases are affected by the purchase terms.

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 10.4. FINANCIAL CASH FLOWS:

The major financial factors/items affecting generation of cash flows are depicted in
Exhibit 2

Exhibit 2. Financial Cash Flow items

Cash Inflows/Receipts Cash outflows/ Payments

1. Loans/borrowings 1. Income tax/tax payments

2. Sale of securities 2. Redemption of loan

3. Interest received 3. Re-purchase of shares

4. Dividend Received 4. Interest paid

5. Rent Received 5. Dividends paid

6. Refund of tax

7. Issues of new shares and securities.

After the time span of the cash budget has been decided upon and pertinent operating
and financial factors have been identified, the final step is the construction of the cash budget.

10.5. ILLUSTRATIONS

Illustration 1. A company is expecting to have Rs. 32,000 cash in hand on 1-4-2005 and it
requests you to prepare cash budget for the three months, April to June 2005. The following
information is supplied to you :

Month Sales (Rs.) Purchases(Rs.) wages (Rs.) Expenses (Rs.)

February 70,000 44,000 6,000 5,000

March 80,000 56,000 9,000 6,000

April 96,000 60,000 9,000 7,000

May 1,00,000 68,000 11,000 9,000

June 1,20,000 62,000 14,000 9,000

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 Other information :

i. Period of credit allowed by suppliers is two months.

ii. 25% of sales is for cash and the period of credit allowed to customers for
credit sales is one month.

iii. Delay in payment of wages and expenses on month.

iv. Income tax Rs. 28,000 is to be paid in June 2005.

Solution:

Cash Budget

For the months from April to June 2005

April May June

Rs. Rs. Rs.

Receipts :
Opening balance of cash in hand 32,000 57,000 82,000
Receipts from cash sales (25%) 24,000 25,000 30,000
Cash realised from debtors (75% of
Previous month’s sales ) 60,000 72,000 75,000
Total (a) 1,16000 1,54,000 1,87,000
Payments :
Creditors for purchases (Fed. Paid April
and so on ) 44,000 56,000 60,000
wages 9,000 9,000 11,000
expenses 6,000 7,000 9,000
income Tax -- -- 28,000
Total (b) 59,000 72,000 1,08,000
Closing Balance of Cash (a-b) 57,000 82,000 79,000
Illustration 2.

X Y Co. wishes to arrange overdraft facilities with bankers during the period April to
June of a particular year, when it will be manufacturing mostly for stock. Prepare a cash
budget for the above period from the following data, indicating the extent of the bank
facilities, the company will require at the end of each month :

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(a)
Month Sales (Rs.) Purchases (Rs.) Wages (Rs.)
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,26,000 2,68,000 15,000
(b) 50% of the credit sales are realised in the month following the sales and the remaining
sales in second month following

(c ) Creditors are paid in the following month of purchase.

(d) Cash at bank on Ist April Rs. 25,000.

Solution:

CASH BUDGET
For the months from April to June 2005
April May June
Rs. Rs. Rs.
Receipts :
Opening Balance of Cash at Bank/Overdraft 25,000 56,000 -(47,000)
Realised from Debtors2 1,86,000 1,50,000 1,41,000
Total (a) 2,11,000 2,06,000 94,000
Payments :
Creditors for purchases 1,44,000 2,43,000 2,46,000
Wages 11,000 10,000 15,000
Total (b) 1,55,000 2,53,000 2,61,000
Closing Balance of Cash at Bank/Overdraft1 56,000 -(47,000) -(1,67,000)
Note:

1. Figures in brackets indicate bank overdraft.

2. Receipts from debtors:

April : 50% of sales for February + 50% of sales for March = Rs. 90,000+96,000 = Rs.
1,86,000

May : 50% of sales for March + 50% of sales for April = Rs. 96,000 + 54,000 = Rs. 1,50,000

June : 50% of sales for April + 50% of sales for May = Rs. 54,000 + 87,000 = Rs. 1,41,000

Illustration 3. From the following forecasts of income and expenditure, prepare a cash
budget for the months January to April, 2005:

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Months Sales Purchases Wages Manufacturing Administrative
Selling (Credit) (Credit) expenses expenses expenses
Rs. Rs. Rs. Rs. Rs. Rs.
2004 Nov. 30,000 15,000 3,000 1,150 1,060
500
Dec. 35,000 20,000 3,200 1,225 1,040
550
2005 Jan 25,000 15,000 2,500 990 1,100
600
Feb 30,000 20,000 3,000 1,050 1,150
620
Mar. 35,000 22,500 2,400 1,100 1,220
570
April 40,000 25,000 2,600 1,200 1,180
710
Additional information is as following :

1. The customers are allowed a credit period of 2 months.

2. A dividend of Rs. 10,000 is payable in April

3. Capital expenditure to be incurred : Plant purchased on 15th of January for Rs.

5,000 ; a Building has been purchased on 1st March and the payments are to be
made in monthly installments of Rs. 2,000 each

4. The creditors are allowing a credit of 2 months.

5. Wages are paid on the next month.

6. Lag in payment of other expenses is one month.

7. Balance of cash in hand on 1st January, 2005 is Rs. 15,000.

Solution

Cash Budget

For the months from January to April 2005

Details January February March April

Receipts :
Balance b/d 15,000 18,985 28,795 30,975
Cash released from Debtors 30,000 35,000 25,000 30,000
Cash available 45,000 53,985 53,795 60,975

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Payments :

Payments of creditors (for purchases) 15,000 20,000 15,000 20,000

Wages 3,200 2,500 3,000 2,400
Manufacturing 1,225 990 1,050 1,100
Administrative Expenses 1,040 1,100 1,150 1,220
Selling Expenses 550 600 620 570
Payment of Divided - - - 10000
Purchase of Plant 5,000
Installments of Building Loan - - 2,000 2,000
Total Payments 26,015 25,190 22,820 37,290

Closing balance 18,985 28,795 30,975 23,685

Illustration 4. From the following budget data, forecast the cash the cash position at the end
April, May and June 2005 :

Month Sales Purchases Wages Miscellaneous

Rs. Rs. Rs. Rs.

February 1,20,000 84,000 10,000 7,000

March 1,30,000 1,10,000 12,000 8,000
April 80,000 1,04,000 8,000 6,000
May 1,16,000 1,06,000 10,000 12,000
June 88,000 80,000 8,000 6000
Additional Information :

Sales : 20% realised in the month of sales, discount allowed 2%. Balance realised equally in
two subsequent months.

Purchases : These are paid in the month following the month of supply.

Wages : 25% paid in arrears following month.

Miscellaneous expenses. Paid a month in arrears.

Rent : Rs. 1,000 per month paid quarterly in advance due in April.

Income-tax : First installment of advance tax Rs. 25,000 due on or before 15 th June.

Income from investments : Rs. 5,000 received quarterly, in April, July, etc.

Cash in hand : Rs. 5,000 on 1st April, 2005.

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Solution :

Cash Budget
For the months from April to June 2005

Details: April May June

Rs. Rs. Rs.
Receipts :
Opening balance 5,000 5,680 (-) 7,084
Receipts from Debtors and Sales (1) 1,15,680 1,06,736 95,648
Income from Investments 5,000

1,25,680 1,12,416 88,564

Payments:
creditors 1,00,000 1,04,000 1,06,000
wages (2) 9,000 9,500 8,500
Rent 3,000 -- --
Miscellaneous Expenses 8,000 6,000 12,000
Income tax -- -- 25,000

1,20,000 1,19500 1,51,500

Closing Balance 5,680 (-) 7,084 (-)62,936

Working Notes :

(1) Calculation of amount received from debtors and sales

April Rs.
Cash sales (20% on 80,000) 16,000
Less 2% discount 320
15,680
Add 40 % of Rs. 1,30,000 (Sales of March) 52,000
Add 40% of Rs. 1,20,000 (Sales of Feb.) 48,000
1,15,680
May
Cash sales (20% of 1,16,000) 23,200
Less 2% discount 464

22,736
Add 40% of Rs. 80,000 (Sales of April) 32,000
Add 40% of Rs. 1,30,000 (Sales of March) 52,000
1,06,736
June
Cash Sales 20% of 88,000 17,600
Less 2% discount 352

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 17,248
Add 40% of Rs. 1,16,000 (Sales for may) 46,400
Add 40% of Rs 80,000 (Sales of April) 32,000
95,648
(2) Calculation of Payment for Wages
April
25% of Rs. 12000 (Wages for march) 3,000
75% of Rs. 12,000 (Wages of April) 6,000
9000
May
25% of Rs 8,000 (Wages for April) 2,000
75% of Rs. 1.0,000 (Wages of May) 7,500
9,500
June
25% of Rs. 10,000(Wages for April)
2,500 75% of Rs 8,000 (Wages of May)
6,000
8,500
Illustration 5. From the following forecasts of income and expenditure, you are
required to prepare a cash budget for three months ending 30 th November. The bank
balance on 1st September was Rs. 10000
Month Sales Purchases Wages Factory Exp. Office Exp.
Rs. Rs. Rs. Rs. Rs.
July 80,000 40,000 5,600 3,900 10,000
August 76,500 42,000 5,800 4,100 12,000
September 78,000 38,500 5,800 4,200 14,000
October 90,000 37,500 5,900 5,100 16,000
November 95,000 43,000 5,900 6,000 13,000

A sales commission of 4% on sales, due in the month in which sales dues are
collected is payable in addition to office expenses. Fixed assets worth Rs. 65,000 will
be purchased in September to be paid in the following month. Rs. 20,000 in respect of
debenture interest will be paid on October. The period of credit allowed to customers
is two months and one-month credit is obtained from supplies of goods. Wages are
paid twice in a month on 1st and 16th respectively. Expenses are paid in the month in
which they are due.

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 Solution:

Cash Budget
For the Months ending from 30th September to 30th November

September October November

Rs. Rs Rs.
Receipts :
Bank Balance/Overdraft at the beginning of month 10,000 20,800 -(56,210)
Cash realized from debtors 80,000 76,500 78,000
Total (a) 90,000 97,300 21,790
Payments :

Creditors for purchase of goods 42,000 38,500 37,500

Wages 5,800 5,850 5,900
Factory expenses 4,200 5,100 6,000
Office Expenses 14,000 16,000 13,000
Commission on sales (4% of previous 3,200 3,060 3,120
2 month’s sales)
Fixes assets purchased -- 65,000 --
Debenture interest -- 20,000 --
Total (b) 69,200 1,53,510 65,520
Bank/overdraft at the end of month (a-b) 20,800 -(56,210) -(43,730)
Illustration 6. The following details of estimates are obtained in respect of the retail
business of Fancy Ltd. For the months of January to March, 2005.

(i) working Capital as on 1st January, 2005 has been estimated as under :

Rs.
Cash and bank balance 10,900
Debtors 51,400
Creditors 42,200
Outstanding expenses 4,000
Dividend due 9,700
Tax due 6,400
Stock 26,000

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 (ii) Budgeted profit statements for the three months are :
January February March
2005
Rs. Rs. Rs.

Sales 42,000 36,000 34,000

Cost of Sales 32,700 28,100 26,600
Gross profit 9,300 7,900 7,400
Administrative, selling and distribution expenses 6,300 5,400 5,100
Net profit before tax 3,000 2,500 2,300

(iii) budgeted balance at the end o each month :

January February March

2005
Rs. Rs. Rs.
Stock 24,000 22,000 20,000
Debtors 52,000 50,000 47,000
Creditors 40,000 39,000 38,000
Outstanding expenses 4,000 4,000 4,000
Dividend due 9,700 -- --
Tax due 6,400 6,400 6,400
Depreciation amounting to Rs. 1,700 has been included in the budgeted expenditure
of each much. You are required to prepare a month wise Cash Budget for the three
months on receipt and payment basis.

Solution:

Cash Budget
For three months Jan., Feb., and march 2005
January February March
2005
Rs. Rs.. Rs.
Receipts :
Opening balance of cash and bank 10,900 14,800
12,300 Receipts from debtors (1) 41,400 38,000
37,000
52,300 52,800
49,300

Payments :

Payments to creditors for materials and expenses (2) 37,500 30,800 29,000
Dividend paid - 9,700 --
37,500 30,800 29,000
Closing balance of each and bank 14,800 12,300 20,300

110
 Working Notes: January February March
2005
Rs. Rs. Rs.
(1) Calculation of amount received from debtors
Opening balance of debtors 51,400 52,000 50,000
Add : Sales during the month (all credit) 42,000 36,000 34,000
93,400 88,000 84,000
Less ; closing balance of debtors 52,000 50,000 47,000
Amount received from debtors 41,400 38,000 37,000
(2) Payments to Creditors for materials and expenses

Opening balance of creditors 42,200 40,000 39,000

Add : Outstanding expenses (opening balance) 4,000 4,000 4,000
46,200 44,000 43,000
Add : Cash cost of sales (3 belowa0 29,000 24,400 22,900
Administrative, selling and distribution expenses 6,300 5,400 5,100
81,500 73,800 71,000
Less : Closing balance of creditor (40,000) (39,000) (38,000)
Outstanding expenses (closing balance) (4,000) (4,000) (4,000)
Payment to Creditors for materials and expenses 37,500 30,800 29,000
(3) Calculation of cash cost of sales

Cost of sales (given) 32,700 28,100 26,600

Add : closing stock 24,700 22,000 20,000
56,700 50,100 46,600
Less : Opening stock (26,000) (1,700) (22,000)
Depreciation (being non-cash item) (1,700) (1,700) (1,700)
Cash cost of sales 29,000 24,400 22,900

10.6. SELF ASSESSMENT QUESTIONS

I. Write the Answers for the following questions in not less than 10 lines each.

1. What is Cash Budget?

2. What are the sources of cash inflows?

3. What are the sources of cash outflows

II. Write the answers for the following questions in 4 pages.

1. Explain the importance of cash budget.

2. Describe the method of preparing cash budget.

10.7. PRACTICAL PROBLEMS:

1. A new company commences business on 1st July, 2005 and deposits Rs. 10,000 in the
bank. This amount will be inadequate to finance its operations over a period of six

111
 months and you are asked to prepare a Cash Budget up to 31st Dec.2005 to determine the
monthly overdraft limits to seek from the company’s bankers.

The data furnished to you are as thus:

(i) Sales are made to one distributor only on thirty day’s terms, 3% discount and the
cheques are received on the first date of the month following the due date.

(ii) Plant purchases totaling Rs. 5,000 are to be made in July.

(iii) All purchases are made on net thirty day’s terms and cheques are paid to creditors
on the last day of the month due.

(iv) Budget figures are:

July August Sept. Oct. Nov. Dec.

Rs. Rs. Rs. Rs. Rs. Rs.
Purchases 5,000 4,000 3,000 4,000 4,000 5,000
Wages 4,000 5,000 4,000 4,000 5,000 4,000
Cash Expenses 400 500 400 400 500 400
Sales 6,000 7,000 8,000 8,000 9,000 12,000
Also interpret the results as shown by the preparation of Cash Budget.

Hint: Overdraft limits should be calculated without taking into account opening balances

2. From the following data, prepare a Cash Budget for the quarter October – December

a) Sales: For the months of:

Rs.
August 20.000
September 25.000
October 30.000
November 30.000
December 32.000

All the sales are on credit. Half of the dues are collected in the month of sale on which a cash
discount of 20% is allowed and the other half are realized in the next month.

(b) Materials are purchased for cash on which a rebate of 5% is offered by the
supplier. If the company buys on credit payment can be deferred by one month
foregoing the rebate. The purchase budget for the next quarter is October Rs.
12.500 November Rs. 15.000 and December Rs. 18.000

(c) The direct labour Budget is as under:

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 Dept.A Dept.B
Rs. Rs.
October 3.000 4.000
November 3.000 4.000
December 3.200 3.800
(d) The manufacturing Overhead budget is as under:

Dept A Dept. B General

Factory
Rs. Rs. Rs.

October 2.400 1.550 800

November 2.400 1.550 800
December 2.500 1.650 900
The above estimates include the quarter’s provision for depreciation amounting to Rs.
900 for Dept. A and Rs. 750 for Dept. B.

(e)The general overheads for the quarter are Rs. 3,500 (out of which Rs. 200 is for
depreciation reserve. Rs. 300 for bad debts reserve)

(f) An old machinery is to be replaced with an additional outlay of Rs. 7,000 in the
month of December.

(g)The Cash balance on 1st October may be taken Rs. 15,000

3. A large retail store makes 25% of its sales for cash and remainder on 30 days terms.
Due to faculty collection practice, there have been losses from bad debts to the extent of 1%
of credit sales on an average in the past. The experience of the company tells normally 60%
of credit in the month following the sale, 25% in the second following month and 14% in the
third following month. Sales in the proceeding three months of 2005 have been-Jan

Rs.80,000 Feb,Rs.100,000 and March,Rs.1,40,000. Sales for the next three months are
estimated as April.Rs.1,50,000.May.1,10,000 and June,Rs.1,00,000.

Prepare a schedule of the expected cash collections during the month of April. May
and June 2005 for presentation in the Finance Department. What will be cash receipts if the
credit policy is enforced strictly s that there are no overdue accounts and bad debts?

4 A company expects to have Rs. 25.000 in bank on 1 st May 2005 and requires you to
prepare an estimate of cash position during the three months-May, June and July, 2005

The following information is supplied:

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Month Sales Purchases Wages Office Factory Selling
Expenses Expenses Expenses Expenses
Rs. Rs. Rs. Rs. Rs.

March 50.000 30.000 6.000 4.000 5.000 3.000

April 56.000 32.000 6,500 4.000 5.500 3.000
May 60.000 35.000 7.000 4.000 6.000 3.500
June 80.000 40.000 9.000 4.000 7.500 4.500
July 90.000 40.000 9.500 4.000 8.000 4.500
Other Information:

(i) 20% of sales are in cash, remaining amount is collected in the month following
that of sales.

(ii) Suppliers supply goods at two month’s credit.

(iii) Wages and all other expenses are paid in the month following the one in which
they are incurred.

(iv) The company pays dividends to shareholders and bonus to workers of Rs. 10.000
and Rs. 15.000 respectively in the month of May.

(v) Plant has been ordered and is expected to be received in June. It will cost Rs.
80.000 to be paid in June.

(vi) Income tax Rs. 25.000 is payable in July.

114
Answers to practical problems

1. Overdraft limits July – Nil Oct – Rs.610

Aug – Rs. 10,500 Nov – Rs. 1,740
Sept- Rs. 2,580 Dec – Rs. 640

2. Balance: Oct Rs. 15,425; Nov. Rs. 15,975; Dec. Rs. 7,175.

3. April May June

Cash receipts Rs. 1,27,650 Rs. 11,31,750 Rs. 1,17,325

After enforcing credit policy Rs. 1,42,500 Rs. 1,40,000 Rs. 1,07,500

4. Balance - May Rs. 7.800, June Rs. (-) 63,700

10.8. Suggested Readings

1. Charles T. Horngren, George Faster and Srikant M. Dattar, “Cost Accounting, A

Managerial Emphasis”, Prentice Hall, 2000.

2. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand &

Company Ltd., New Delhi, 2006.

3. Anthony A, Atkinson, R.S. Kaplan, R.D. Banker, “Management Accounting”,

Prentice Hall International, New Jersey, 1997.

4. M.Y. Khan and P.K. Jain, “Management Accounting”.

115
 GUIDELINE - 11

PRODUCTION BUDGET

Structure

11.1. Introduction

11.2. Production Budget

11.3. Procedure for preparation of production budget

11.4. Purchase budget

11.5. Direct labour budget

11.6. Manufacturing expenses budget

11.7. Production cost budget

11.8. Self-assessment Questions

11.9. Practical Problems

11.10. Suggested Readings

11.1. INTRODUCTION

A budget is defined as a “Comprehensive and coordinated plan, expressed in financial

terms, for the operations and resources of an enterprise for same specified period in the
future”.

From this definition, the essential elements of a budget are as follows:

(i) Plan
(ii) Operation and resource

116
(iii) Financial terms
(iv) Specified future period
(v) Comprehensiveness
(vi) Coordination

11.2. PRODUCTION BUDGET

Production budget is a forecast of the production for the budget period. It may be
expressed in terms of:

(i) Units, or
(ii) Standard Hours (A standard hour is the quantity of output or amount of work which
should be performed in one hour).

This budget is prepared by production manager based upon:

a) Sales budget
b) Production capacity
c) Budgeted finished goods stock requirements.

According to Blocker and Weltmer, a production budget deals with:

(1) The determination of total estimated volume of production

(2) The division of the estimated output into different types of products.
(3) Scheduling of operations by days, weeks and months
(4) Establishment of finished goods inventory requirements
(5) Storage of finished products until delivery can be made in accordance with sales
orders.

When the production capacity exceeds the sales forecast as set forth in the sales
budget, the compilation of production budget presents no problem. If, however, production
capacity is the limiting factor, considerations should be given to various alternative course of
action, e.g., overtime-working, shift-working, etc., and a budget should then be prepared. On
preparation, the production budget is sent to the budget committee for approval.

117
A production budget may be analyzed according to:

1. Products or groups of products

2. Budget Centers or manufacturing departments
3. Period of production
4. A combination of above.

Advantages of Production Budget:

(a) Plans can be made to keep inventories at reasonable levels consistent with production
and sales requirements.

(b) The requirements of raw materials and the sources of their supply can be selected for
deriving best terms of purchases along with quality.

(c) By maintaining production schedule, the promised delivery dates can be maintained.
This increases the reputation of business.

11.3. PROCEDURE FOR PREPARATION OF PRODUCTION BUDGET

According to Heckert and Wilson the preparation of production budget involves

following steps.

(i) Determine the period of time to be used as a basis for the production budget.
(ii) Ascertain what physical quantities should be produced to meet the sales budget and to
provide properly balanced inventories.
(iii) Determine when the goods should be produced.
(iv) Determine when the goods should be produced.
(v) Determine the manufacturing operations required by the production.
(vi) Establishment standards of production performance for use in meaning production
efficiency.

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11.4.PURCHASE BUDGET

Once the production is prepared, it is necessary to determine the different inputs

required to carry out the production activities. One such input factor is the raw-materials. The
purchase budget shows the number of units of materials (both direct and indirect) and
services to be purchased during the budget period. It may also incorporate the monetary value
of the units of materials to be purchased for producing the goods and services as per its
production budget. In case of a company which purchases finished goods for resale, purchase
budget of the company will include the information about the number of units of finished
goods to be purchased during the budget period.

11.5. DIRECT LABOUR BUDGET

This budget shows the number of employees and/or the number of labour hours
(skilled, semi-skilled and unskilled for production, administration and selling and
distribution) required to produce and/or sell the budgeted output, and/or budgeted sales.
While preparing this budget, it is necessary to consider the budgeted output and sales, capital
expenditure programmes, research and development activities etc. This budget may also
incorporate monetary value.

11.6. MANUFACTURING EXPENSES BUDGET

Manufacturing expenses Budget relates to the expenses forecast in the factory. It

refers to the total manufacturing cost.

11.7. PRODUCTION COST BUDGET

This budget shows the cost of production taking into account the elements of costs
viz., direct material cost, direct labour, cost and production overheads. This budget will be
based upon:

i. Production Budget
ii. Estimated increase or decrease in the price of materials and supplies

119
 iii. Estimated increase or decrease in the rates of wages and salaries and
expenses.

Illustration:

XYZ Ltd., manufactures 3 products X, Y, Z. These are made in 4 production

departments from 4 materials, A, B, C, D.

Following Information is provided:

Materials Used in Cost per Products (Units per product)

Departments material per
cent X Y Z
(Rs.)

A 1 1.00 – 1 2
B 2 0.40 1 – 2
C 3 0.50 2 1 –
D 4 0.30 2 2 1
Normal rejection at the time of final inspection 5 10 10
(per cent)

Budget Details:

Sales for the year (Rs. ‘000) 520 1,160 900

Sales price per Unit 10 20 12
X Y Z
Opening Inventory (finished goods) (Units 5 10 15
in ‘000)
Closing Inventory (finished goods) (Units 10 15 30
in ‘000)

Raw Material Inventory (Thousands Units) :

A B C D
At the beginning of year 30 40 10 60
At the end of the year 40 30 20 50

You are required to prepare (a) Production Budget, (b) Production Cost Budget for
direct material for departments 1, 2, 3, 4.

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Solution: Production Budget (Units) for the year of XYZ Ltd.

X Y Z
Planned sales of the year 52,000 58,000 75,000
(Sales revenue ÷ Sales price per
Unit)
Add : Planned closing inventory 10,000 15,000 30,000
attend of the year
Less : Planned opening inventory at (5,000) (10,000) (15,000)
beginning of year
Units required to be produced 57,000 63,000 90,000
Normal rejection (percent) 5 10 10
Add : Normal rejection 3,000 7,000 10,000
Budgeted production 60,000 70,000 1,00,000
100 100 100
(57,000 x ) (63,000 x ) (90,000 x )
95 90 90
Product Cost budget for direct materials for departments 1, 2, 3, 4.
Materials used (Product Department
wise)
1 2 3 4
Material A : Rs.1. p.u.
Product Y Rs. 70,000 (70,000)
Product Z 2,00,000 (2,00,000)
Material B : Rs. 0.40 p.u.
Product X Rs. 24,000 (60,000)
Product Z 80,000 (2,00,000)
Material C : Rs. 0.50 p.u.
Product X Rs. 60,000 (1,20,000)
Product Y Rs. 35,000 (70,000)
Material D : Rs. 0.30 p.u.
Product X Rs. 36,000 (1,20,000)
Product Y 42,000 (1,40,000)
Product Z 30,000 (1,00,000)
Total Cost 2,70,000 1,04,000 95,000 1,08,000

Note: Figures in brackets represent units of raw material consumed.

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Illustration:

The cost of an article at the capacity level of 5,000 sheets is given under A below.
For a variation of 25% in capacity above or below this level, the individual expenses vary as
indicated under B below:

A (Rs.) B (%)

Material Cost 25,000 100 (variable)

Labour Cost 15,000 100 (variable)
Power 1,250 80 (semi-variable
Repairs & Maintenance 2,000 75 (semi-variable)
Stores 1,000 100 (variable)
Inspection 500 20 (semi-variable)
Administration overheads 5,000 25 (semi-variable)
Selling overheads 3,000 50 (semi-variable
Depreciation 10,000 100 (fined)
Total 62,750 – –
Cost per Unit 12.55 – –

Prepare Production cost budget for 4,000 and 6,000 units respectively.

Sol: Production Cost Budget:

4,000 Units 6,000 Units
(Rs.) (Rs.)
Material Cost 20,000 30,000
Labour Cost 12,000 18,000
Stores 800 1,200
Power 1,050 1,450
Repairs & Maintenance 1,700 2,300
Inspection 480 520
Administration Overheads 4,750 5,250
Selling Overheads 2,700 3,300
Depreciation 10,000 10,000
Total 53,480 72,020
Cost per unit 13.37 12.00

Illustration:

A company is drawing its production plan for next year in respect of products ‘G’ and
‘D’. Company’s policy is to not to carry any closing w-l-p at end of any month. However, it

122
policy is to hold closing stock of finished goods at 50% of anticipated quantity of sales of the
succeeding month. For next year, the company’s budgeted production is 20,000 units of ‘G’
and 25,000 units of ‘D’. Following is estimated cost data :

G D
(Rs.) (Rs.)
Direct Material per Unit 50 80
Direct Labour per Unit 20 80
Other Manufacturing expenses apportionable to each 2,00,000 3,75,000
type of product based on production

The estimated units to be sold in first 7 months of next year are as under:

April May June July August September October

G 900 1100 1400 1800 2000 2200 1800
D 2900 2900 2500 2100 1700 1700 900

You are required to;

(b) Prepare product budget showing month wise no. of units manufactured
(c) Present a summarized production cost budge for half-year ending September 30th.

Solution: (a) Production Budget (unit) for half year ending September 30th.

April May June July August September Total

Product – ‘G’
Budgeted 900 1100 1400 1800 2200 2200 9600
Sales
Add: 550 700 900 110 1100 900 900
Closing
Stock
1450 1800 2300 2900 3300 3100 10500
Less : 450 550 700 900 1100 1100 450
Opening

123
Stock

Budgeted 1000 1250 1600 2000 2200 2000 10050

production

Product – ‘D’

Budgeted 2900 2900 2500 2100 1700 1700 13800

Sales

Add : 1450 1250 1050 850 850 950 950

Closing
Stock

4350 4150 3550 2950 2550 2650 14750

Less : 1450 1450 1250 1050 850 850 1450

Opening
Stock

Budgeted 2900 2700 2300 1900 1700 1800 13300

production

(b) Cost Budget:

‘G’ (10,050 Units) ‘D’ (13,300 Units)

Total Per Unit Total Per Unit
(Rs.) (Rs.) (Rs.) (Rs.)
Direct Material 5,02,500 50 10,64,000 80
Direct Labour 2,01,000 20 3,99,000 30
Other Mfg. Exp. 1,00,500 10 1,99,500 15
8,04,000 80 16,62,500 125

Other Mfg. Expenses appointed on basis of production:

G D
(Rs.) (Rs.)
1. Units to be produced 20,000 25,000
2. Other Mfg. expenses 2,00,000 3,75,000
3. Per Unit ( 2 ÷ 1) 10 15

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Illustration:

From the following information, prepare a Production Budget for Raj Ltd., assuming
that:

(a) There is no loss in production;

(b) Normal loss in production is 2% and 5% for product A & B respectively.(1)
Sales Budget (Units)

A B
Division I 1,920 840
II 3,120 5,280
III 2,640 2,160
Total Units 7,680 8,280
(2) Stock as at 30th June
A – 1,200; B – 2,200

(3) Stock as at 30th June: Estimated to be 10% more in quantity.

Solution:

Production Budget
Product-A Product-B Total Units
(Units) (Units)

Sales requirement as per sales budget 7,680 8,280 15,760

Add : Estimated increase in stock 120 220 340
(10% of 1,200 and 2,200 units)
(a) Production requirements 7,800 8,500 16,300
(b) Production requirements 7,960 8,948 16,908

Note : Since normal loss in process is 2% and 5% for product A and B respectively, it will
be necessary to process 7,960 Units of A and 8,948 Units of B to produce 7,800 finished
units of A and 8,500 finished units of B, i.e.,

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Illustration:

K Co. Ltd. Manufactures two products X and Y. Forecast of the number of units to be
sold in the first seven months of the year is given below:

Product X Product Y
January 1,000 2,800
February 1,200 2,800
March 1,600 2,400
April 2,000 2,000
May 2,400 1,600
June 2,400 1,600
July 2,000 1,800

It is anticipated that:

(i) There will be no work in progress at end of every month

(ii) Finished Units equals to half of the sales for the next month will be in stock at end of
each month (including previous December).

Budgeted production and costs for whole year an as follows :

A B
(Rs.) (Rs.)
Products (Units 22,000 24,000
Direct Material cost per Unit 12.50/- 19/-
Direct Labour cost per Unit 4.50/- 7/-
Total factory overhead apportioned 66,000 96,000

Prepare for six months period ending June 30, 2006 production budget.

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Solution:

Production Budget (in Units)

Jan Feb March April May June July Total
Product ‘A’
Sales of 1,000 1,200 1,600 2,000 2,400 2,400 2,000
Current
Month
Add : 600 800 1,000 1,200 1,200 1,000 –
Closing
Stock
1,600 2,000 2,600 3,200 3,600 3,400 –
Loss : 500 600 800 1,000 1,200 1,200 –
Opening
Balance
1,100 1,400 1,800 2,200 2,400 2,200 – 11,100
Product ‘B’
Sales of 2,800 2,800 2,400 2,000 1,600 1,600 1,800
Current
Month
Add : 1,400 1,200 1,000 800 800 900 –
Closing
Stock
4,200 4,000 3,400 2,800 2,400 2,500 –
Less : 1,400 1,400 1,200 1,000 800 800 –
Closing
Stock
2,800 2,600 2,200 1,800 1,600 1,700 – 12,700

Illustration:

The following is the estimated sales of a company for eight months ending 30-11-
2006.

127
 Months Estimated Sales (Units)
April, 2006 12,000
May 13,000
June 9,000
July 8,000
August 10,000
September 12,000
October 14,000
November 12,000

Closing balance is 50% of estimated sales for the next month.

Prepare production budge for half year ending 30th September, 2006.

Solution:

Production Budget
Month Sales Closing balance Operating Production
50% of estimates balances
sales of next month
April, 2006 12,000 + 6,500 – 6,000 12,500
May 13,000 + 4,500 – 6,500 11,000
June 9,000 + 4,000 – 4,500 8,500
July 8,000 + 5,000 – 4,000 9,000
August 10,000 + 6,000 – 5,000 11,000
September 12,000 + 7,000 – 6,000 13,000
64,000 65,000

128
11.8. SELF-ASSESSMENT QUESTIONS

1. Define Budget and Budgetary control.

2. Define Master Budget. Explain its classification.

3. Distinguish between Sales Budget and Purchase Budget

11.9. Practical Problems

1. From following information, prepare a production budget for SS Ltd., assumingthat

the normal loss in production is 3% and 6% for product X, Y respectively.

(1) Sales budget (Units)

X Y
Division I 3,840 1,680
II 9,360 10,560
III 5,280 4,320
15,360 16,560

(2) Stock as at 30th June

X – 24,00; Y – 4,400

(3) Stock as at 30th June. Estimated to be 10% more in quantity.

2. Siva Company manufactures three products A, B, C. Forecast of the number of

units to be sold in the first 5 months of the year is given below :

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 A B C
January 2,000 4,000 6,000
February 3,000 3,000 2,000
March 1,000 1,200 2,800
April 4,000 4,000 4,000
May 4,800 4,800 4,800

It is anticipated that there will be no W-I-P at end of every month. Finished units
equals to half of the sales for the next month will be in stock at end of each month (including
previous December).

Prepare for 3 months period ending 31 st March, 2006.

Production Budget.

3. The following are the estimated sales of a company for eight months ending 30-08-2006.

Months Estimated Sales (Units)

January 24,000

February 26,000

March 18,000

April 16,000

May 20,000

June 24,000

July 28,000

August 24,000

4. Raana Engineering Company manufactures products and Q. An estimate of number of

units expected to be sold in first 7 months of current year is given below :

130
 P Q
January 500 1,400
February 600 1,400
March 800 1,200
April 1,000 1,000
May 1,200 800
June 1,200 800
July 1,200 900

It is anticipated that:

(a) There will be no W-I-P at end of any month;

(b) Finished units equal to half the anticipated sales for the following month will be in
stock at end of each month (including December, the previous year).

The budgeted production and production costs for the year ending 31st December,
current year are as follows:

P Q
Product (Units) 11,000 12,000
Direct Material per Unit Rs. 12 Rs. 19
Direct Wages per Unit 5 7
Other Manufacturing charges appraisable to each 33,000 48,000
type a product

Prepare:

(a) A production budget showing the number of units to be manufactured each month.
(b) A summarized production cost budget for first six months.

131
5. Prepare a Production Budget of India Limited, Indore for 1983-84 from the following
information:

Products Sales as per Sales 1st July 1983 30th June 1984
Budget(in Units)

AB 2,44,000 16,000 22,000

LM 1,87,500 32,500 45,000

PQ 3,00,000 25,000 25,000

ST 2,00,000 5,000 30,000

11.10. Suggested Readings

1. Charles T. Horngren, GeorgeFaster and Srikant M. Dattar, “Cost Accounting, A Managerial

Emphasis”, Prentice Hall, 2000.
2. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand & Company Ltd.,
New Delhi, 2006.
3. Anthony A, Atkinson, R.S. Kaplan, R.D. Banker, “Management Accounting”, Prentice Hall
International, New Jersey, 1997.
4. M.Y. Khan and P.K. Jain, “Management Accounting”.

132
 GUIDELINE -12
FLEXIBLE BUDGETING

Structure

12.1. Introduction

12.2. Preparation of flexible budget

12.2.1. Multi-activity method

12.2.2. Formula method

12.2.3. Graphic method

12.3. Advantages and limitations of flexible budgets

12.4. Illustrations

12.5. Self-Assessment Questions

12.6. Practical Problems

12.7. Suggested Readings

12.1. INTRODUCTION : Fixed budgets are prepared for one level of activity and one set
of conditions. It is rigid budget and is drawn on the assumption that there will be no
change in the budgeted level of activity. It does not take into consideration any change
in e expenditure arising out of changes in the level of activity. Thus, it does not
provide for changes in expenditure arising out of change in the anticipated conditions
and activity. A fixed budget will, therefore, be useful only when the actual level of
activity corresponds to the budgeted level of activity. But, in practice, the level of
activity and set conditions will change as a result of internal limitations and

133
 external factors like changes in demand and prices, shortage of materials and power,
acute competition etc. As such, fixed budgets cannot be used as realistic yardstick to
cheek the variation between budgeted cost and actual cost for changed activity as they
failed to forecast and incorporate the changes in cost and revenue with the change in
the level of activity. In the dynamic business environment, it is always advisable to
forecast and judge the changes in the level of operation of various business activities
and prepare budget accordingly hence, fixed budgets have limited application in
business. To overcome these limitations, flexible budgets are used as a tool for better
budgetary control.

Flexible budgets:

A flexible budget designed in such a way to give budget costs and revenue for any
level of activity. The Institute of Cost and Works Accountants of England defines a
flexible budget as “a budget which is designed to remain unchanged irrespective the
level of activity attained.”

The flexible budgets are highly useful where level of activity changes from
time to time. These budgets are suited in situation where forecasting of demand is
uncertain or when the firm operates under conditions of shortage of inputs such as
materials, labour etc.,

Flexible budgets are extensively used in the following cases:

1. Where demand fluctuates as per changes in seasons eg: demand for soft
drinks, rain coats etc.,

2. In case of entirely new venture where the estimation of demand is uncertain.

3. Where the business decisions are influenced by external factor such as

government policies, political environment etc.,

The flexible budget provides a logical comparison of budget allowances with

actual costs.

12.2. Preparation of flexible budget: There are three methods ofpreparing

flexible budgets in practice. They are

134
1. Multi activity method

2. Formula method

3. Graphic method

12.2.1 Multi Activity Method: This methods three steps 1) determining different
levels of activities either in term of sales or labour hours or machine hours. 2)
Estimating budget cost for each level of activity. 3) Preparation of flexible budget
for different levels

Illustration I:

Prepare a flexible budget with the following data.

A company produces 2,000 units at 100% capacity and the cost at this level of
operation are:

Fixed cost 5,000

Variable cost Rs 6 per unit

Semi variable cost Rs. 8 per unit (50% variable)

The proposed levels of activities are 80%, 85%, 90% and 100%.

Solution:

Flexible Budget

Level of activity

80% 85% 90% 100%

Fixed cost 5,000 5,000 5,000 5,000

Variable cost 9,600 10,200 10,800 12,000

Semi variable cost

Fixed 8,000 8,000 8,000 8,000

Variable 6,400 6,800 7,200 8,000

Total cost 29,000 30,000 31,000 33,000

135
 Fixed part of semi – variable cost is Rs.8, 000 at 100% capacity i.e. @ Rs, 4/- on
2,000 units. The same cost is taken at all levels.

12.2. 2. Formula method: this method is also known as budget cost allowance
method. It involves two steps

1) A budget is prepared for the expected normal level of activity

2) Ratios are worked out to show the relationship of each expenses or group of
expenses per unit level of activity.

Illustration II:

From the following data prepare flexible budget at 90% and 80% level of activity.

Present level of activity 100%

Out put at this level 1000 units

Variable cost Rs 10,000/-

Fixed cost 5,000/-

Solution:

Fixed cost remains constant at any level of activity.

Variable cost ratio:

For the production at 100% the variable cost is Rs. 10,000

for production of 1% variable cost would Rs.100

Total cost = Fixed cost + (annual unit activity x variable cost per unit of activity)

136
 Flexible budget

80% level of activity 90% level of activity

RS Rs

Fixed cost 5,000 5,000

Variable cost 8,000 9,000

Total cost 13,000 14,000

12.2.3 Graphic method: the diagrammatic representation of data of flexible is done

through graphic method. The budgeted level of activities are recorded on ‘X’ axis.
The estimated fixed, variable and semi variable cost for any level of activity can be
read from the graph so plotted.

Illustration –III:

From the following information for 50% activity, calculate the costs at 85% activity
by the graphic method.

Output 1000 units

Variable cost per unit Rs. 10

Fixed cost Rs. 10,000

Semi variable Cost (50%Fixed) Rs. 10,000

Solution:

137
 Fixed cost Variable cost

Level of activity (including fixed (including semi Total cost

part and seme variable cost)
variable cost)

20%(200 units) 10,000+5,000 2,000+1,000 18,000

40%(400 units) 10,000+5,000 4,0000+2,000 21,000

60%(600 units) 10,000+5,000 6,000+3,000 24,000

80%(800 units) 10,000+5,000 8,000+4,000 27,000

100%(1000units) 10,000+5,000 10,000+5,000 30,000

Cost at different level of activity

Flexible budget graph

30,000 Total cost

27,000
Cost of
,000 variable cost
thousan25
ds of
15,000 Fixed cost
rupees
12,750

10,000

5,000

0 20 40 60 80 85 105

Living activity

At 85% capacity fixed costs – Rs.15,000 (10,000+5,000)

(850 units) variable cost-Rs. 12,750 (8,500+4,250)

Total cost = 27,750

138
12.3 Advantages & Limitations of flexible budgeting
1. Cost for all levels of output can be planned or calculated with the available data.

2. The behaviour of semi- variable cost and variable cost can be analysed at various
levels of activity.

3. A flexible budget can be prepared with standard costing without standard

costing.

4. Where the level of activity during the year varies from period to period eitherdue to
the seasonal nature of the industry or to variation in demand, flexible budgets are
suitable.

5. When business is a new one and it is difficult to foresee the demand, flexible budgets
are quite suitable.

6. Proper budgetary control over costs at various levels of activity can be

exercised with the help of flexible budgets.

7. Better cost control is possible at various levels of outputs

8. It is useful for pricing and preparing quotations for any level of activity

9. flexible are used for estimating cost functions

Limitations:

1. Estimation of cost at various levels of activity is very difficult in practice.

2. Segregation of costs poses many problems.

3. It may involve manipulation of figures.

4. It is difficult to estimate the market conditions to predict the cost estimates

5. It involves cumbersome job.

139
SUMMARY:

A flexible budget is very useful for purposes of budgetary control because it

corresponds with changes in level of activity. It is helpful in assessing the
performance can be judged in relation to the level of activity attained by the
organization . Cost ascertainment at different levels of activity is possible because a
flexible budget is prepared for various levels of activity. So, it is helpful in price
fixation and sending quotations.

12. 4. ILLUSTRATIONS:

Problem I :

From the following data prepare budget for production of 7,000 units and 10,000
units.

Present production level.......................................................... 5,000 units

Per unit
Material cost
Labour 100
Variable over head 40
Fixed overhead (Rs. 1,00,000) 30
Administrative Expenses (5% variable) 20
Selling expenses 20
Distribution Expenses 12
10
Total cost
232

140
 Solution: FLEXIBLE BUDGET

7,000 units 10,000 units

Particulars Per unit Total Per unit Total
Rs. Rs. Rs. Rs.

Material cost
Labour 100.00 7,00,000.00 100.00 10,00,000.00
Prime cost 40.00 2,80,000.00 40.00 4,00,000.00
140.00 9,80,000.00 140.00 14,00,000.00
Factory over heads

Variable over heads

Fixed over heads 30.00 2,10,000.00 30.00 3,00,000.00
Works cost 14.29 1,00,000.00 10.00 1,00,000.00
184.29 12,90,000.00 180.00 18,00,000.00
Administrative
expenses:

Fixed (95%) 13.57 95,000.00 9.50 95,000.00

Variable (50%) 1.00 7,000.00 1.00 10,000.00
Cost of production 198.86 13,92,000.00 190.50 19,05,000.00
Selling expenses
12.00 84,000.00 12.00 1,20,000.00
Distribution Expenses 10.00 70,000.00 10.00 1,00,000.00

Total cost 220.86 15,46,000.00 212.50 21,25,000.00

141
Problem II:

The following information at 50% capacity is given, prepare a flexible budget and
forecast the profit or loss at 60 %, 70% and 80% capacity.

Expenses at 50% capacity

Fixed expenses:
Salaries 1,00,000
Rent and Taxes 80,000
Depreciation 1,20,000
Administrative Expenses 1,40,000
Variable expenses: Rs
Material 4,00,000
Labour 5,00,000
Others 80,000
Semi –variable expenses:
Repairs 2,00,000
Indirect Labour 3,00,000
Others 1,80,000

It is estimated that fixed expenses will remain constant at all capacities, semi variable
expenses will not change between 45% and 60% capacity, will rise by 10 % between
60% and 75% capacity, a future of 55 when capacity crosses 75%.

ESTIMATED SALES AT VARIOUS LEVELS OF CAPACITY

Capacity Sales
Rs.

60% 22,00,000
70% 26,00,000
80% 30,00,000

142
Solution:

FLEXIBLE BUDGET
(Showing profit and loss at various capacities)
Particulars capacities

50% 60% 70% 80%

Rs. Rs Rs. Rs.

Fixed expenses:
Salaries 1,00,000 1,00,000 1,00,000 1,00,000
Rent and Taxes 80,000 80,000 80,000 80,000
Depreciation 1,20,000 1,20,000 1,20,000 1,20,000
Administrative 1,40,000 1,40,000 1,40,000 1,40,000
Expenses
Variable expenses: 4,00,000 4,80,000 5,60,000 7,20,000
Materials 5,00,000 6,00,000 7,00,000 9,00,000
Labour 80,000 96,000 1,02,000 1,44,000
Others
Semi-Variable 2,00,000 2,00,000 2,20,000 2,30,000
expenses:
3,00,000 3,00,000 3,30,000 3,45,000
Repairs
1,80,000 1,80,000 1,98,000 2,07,000
Indirect labour
Others

Total cost 21,00,000 22,96,000 25,60,000 29,86,000

Profit (+) or Loss (-) - 96,000 + 40,000 + 14,000

- 22,00,000 26,00,000 30,,00,000

Problem III:

ABC LTD,. Have prepared the budget for the production of one-lakh units of the
only commodity manufactured by the CO., for a costing period as under:

143
 (Rs. In lakhs)
Raw material 5.14
Direct labour 1.50
Direct expenses 0.20
Works over heads (60% fixed) 4.50
Administrative over heads (80% fixed) 0.80
Selling overheads (50%Fixed) 0.40

The actual production during the period was only 1,20,000 units. Calculate the revised
budgeted cost per unit.

Solution:

Working notes:

1). Works overheads Rs. 4,50,000(1,00,000x4.50)

60% Fixed Rs. 2,70,000

40% Variable 1,80,000

2). Administrative overheads Rs. 80,000(1,00,000 x0.40)

80% Fixed Rs. 64,000

20% Variable 16,000

3). Selling Over heads Rs. 40,000(1,00,000 x0.40)

50% fixed Rs. 20,000

50% variable 20,000

144
 Flexible budget

Particulars Original budget Revised budget

1,00,000 Units 1,20,000 Units
Per unit Total Per unit Total
Rs. Rs. Rs. Rs.

Raw material 5.04 5,04,000 5.04 6,04,800

Direct labour 1.50 1,50,000 1.50 1,80,000
Direct expenses 0.20 20,000 0.20 24,000
Prime cost 6.74 6,74,000 6.74 8,08,800
Works over heads:
Fixed 2.70 2,70,000 2.25 2,70,000
Variable (1) 1.80 1,80,000 1.80 2,16,000
Works cost 11.24 11,24,000 10.79 12,84,800
Administrative –
overheads:
0.64 64,000 0.533 64,000
Fixed
0.16 16,000 0.16 19,000
Variable (2)
12.04 12,04,000 11.483 13,68,000
Cost of production
Selling over heads:
0.20 20,000 0.166 20,000
Fixed
0.20 20,000 0.20 12,000
Variable (3)
12.44 12,04,000 11.85 14,12,000

12.5 SELF-ASSESSMENT QUESTIONS

1. What is fixed budget? What are its characteristics? How is different from
flexible budget?

2. What is flexible budget? Explain its advantages and disadvantages.

3. Explain various methods followed in the preparation of flexible budgets.

145
 4. Illustrate various methods adopted in the preparation of flexible budgets.

5. Explain graphic method of preparing flexible budgets. What are its advantages
and disadvantages?

12.6. PRACTICAL PROBLEMS

Problem I:

The budget expenses for the production of 20,000 units in a factory are furnished
below.

per unit (Rs.)

Material 140
Labour 50
Variable over heads 40
Fixed over heads 20
Direct variable over heads 10
Selling expenses (15% fixed) 26
Distribution expenses (20% fixed) 14
Administrative expenses (Rs.1, 00,000) 300

Prepare a budget production of 16,000 units.

Problem II:

Draw up a flexible budget for overhead expenses on the basis of the following data
and determine the overhead rates at 70%, 80% and 90% plant capacity.

At 70% At 80% At 90%

Capacity Capacity Capacity
Rs Rs Rs
Variable over heads:
Indirect labour --- 24,000 ---
Stores including spares --- 8,000 ---

146
Semi variable over heads:
Power
(60% Fixed, 40% variable) --- 40,000 ---
--- 4,000 ---

Repairs and maintenance

(60% Fixed, 40% variable) --- 22,000 ---
--- 6,000 ---
Fixed over heads: --- 20,000 ---

Depreciation
Insurance
Salaries

Estimated dire labour hours 2,48,000

Problem III:

Production costs of oriental enterprises limited are as follows:

Level of activity
60% 70% 80%
Rs. Rs.
Rs
.

Output (in units) 2,400 2,800

3,200
Direct material cost 48,00 56,000
Direct labour cost 14,400 16,800 64,000

Factory over heads 25,600 27,200 19,200

Works cost 88,000 1,00,000
28,800

1,12,000

147
 A proposal to increase production to 90% level of activity is under the
consideration of management. The proposal is not expected to involve any increase in
fixed factory over heads. Prepare a statement showing the prime cost, total marginal
cost and total factory cost at 90% level of activity.

12.7 SUGGESTED READINGS

1. Robert S. Kaplan and Anthony A. Atkinson - Advanced Management

Accounting, Pearson Educational, New Delhi

2. S.P Jain and K.L Narang - Cost accounting, Kalyani Publishers, New Delhi.

3. S.P. Iyengar - cost accounting - Sulthan Chand and sons Publications,

4. Chaktravarthi and Chakravarthi - Management Accountancy, Oxford

University Press

5. .Shashi K. Gupta, R. K. Sharma - Advanced Management Accounting,

Kalyani Publishers, Newdelhi.

148
 GUIDELINE-13
PERFORMANCE BUDGETING

Structure

13.1 Introduction

13.2. Application of Performance budgets

13.3. Procedure involved in performance budgeting

13.4. Planning, programming and budgeting system (PPBS)

13.5. The differences between performance budgeting and programming

budgeting:

13.6. Performance Control Ratios

13.6. Self-Assessment Questions

13.7. Suggested Readings

13.1. Introduction: Under conventional system of budgeting, a budget represents a

statement of various amounts of provided different kinds of expenditures to be incurred. It
takes the form of what is called as ‘List of appropriations’ and so long as
expenses incurred by the concerned department do not exceed the budgeted amount, there
is no apparent irregularity. Thus, the concerned departments do not exceed the budgeted
amount there is no apparent irregularity. Thus, the conventional budgeting lays emphasis
only on the amount of expenses to be incurred. The performance budgeting, on the other
hand, laysemphasis on the results achieved or the performance rather than the expenditure
incurred. The performance budget as defined in the Report of the Estimates Committee
on budgetary reform reads as follows:

149
 Performance budgeting has been defined as a “budget based on functions,
activities and projects.” Performance budgeting may be described as the budgeting system
in which input costs are related to performance, i.e., end results. It is a system of
budgeting, which provides for appraisal of performance as well as follow up measures.
13.2. Application of performance budgets : “The performance budget is a budget based on
functions, activities and projects which focus attention on the accomplishment, the
general and relative importance of the work to be done and the service to be rendered
rather than upon the means of accomplishments such as personnel, service, supplies,
equipment, etc., under this system, the functions of various organisational units would be
split onto programmes of activities, sub programmes and components schemes, etc. and
estimates would be presented for each.”

Performance budgeting seeks to establish relationship between inputs (costs) and

their direct outputs. According to National Institute of Bank Management, performance
budgeting is, “the process of analysing, identifying, simplifying and crystallising specific
performance objectives of a job to be achieved over a period, in the framework of the
organisational objectives, the purpose and objective of the job. The technique is
characterised by its specific direction towards the business objectives of the organization.”
13.2.1.Procedure involved in performance budgeting
Performance budgeting involves:
i. Development of performance criteria for various programmes
ii. Assessment of performance of each programme and by eachresponsibility unit
iii. Comparison of the actual performance with the budget
iv. Undertaking periodic review of the programme with a view to make
modifications as required.
The following illustration explains the procedure of preparing a performance budget for
an organization
Illustration 1. The following data relates to a company which has a profit plan approved
for selling 5000 units per month at an average selling price of Rs. 10 per unit. The
budgeted variable cost of production was Rs. 4 per unit and fixed costs were budgeted at
Rs. 20,000, planned income being Rs. 10,000 per month because of shortage of raw

150
materials the plant could produce only 4000 units and the cost of production was
increased by 0.50 per unit. Consequently the selling price was raised by re.1.00 per unit, to
modify production processes in order to meet material shortage, the company incurred an
expenditure of Rs.1000 in research and development. Set out a performance budget and a
summary report.
Solution:
Performance budget for the mount of ………
Budget Actual
Units Amount Total Units Amount Total
per unit Amount per unit Amount
(Rs.) (Rs.) (Rs.) (Rs.)
Sales 5.000 10.00 50.000 4.000 11.00 44.000
Less: variable 5.000 05.00 20.000 4.000 05.50 18.000
cost 06.00 30.000 06.50 26.000
contribution 20.000 21.000
Less: fixed cost 10.000 5.000

Summary report of profit plan

Rs
Planned income 10.000
Selling price variance (due to increase in selling price, 4000 x 1) 4.000 (F)
Variable cost variance (due to increase in cost of production 4000 2.000(A)
x 0.50) 6.000(A)
Activity variance (loss of contribution due to shortage of raw
material 1000 x 6) 1000 (A)
Fixed cost variance (due to research and development which had 5000
to be taken – to modify production process)
Actual income
13.3. Planning, programming and budgeting system (PPBS)
Programme budgeting, also known as planning, programming and budgeting
system (PPBS), is a budgetary process that is aimed at making government operation more
efficient and more effective. PPBS were first introduced in the U.S Department of Defence
in 1961. In Britain, it is termed as “Output Budgeting”. The purpose of programme
budgeting is to reform the assignments of funds within the public sector and to improve
the allocation of funds between the private and the public sectors. PPBS treat budgeting as
an allocative process and considers budget as a statement of policy. It is not an annual
exercise like a conventional revenue budget but a long-term programme say for 3 to 5
years. In PPB system, expenditure is classified according to the objectives rather than
functions.

151
Though the concepts of both programme and performance budgeting lay grater emphasis
economy and efficiency aspects of programme planning and management, the two systems
differ from each other as bellow:
13.4. The differences between performance budgeting and programming budgeting
Performance budgeting Programming budgeting
1. Retrospective in out look Prospective in out look
2. Evaluative in the sense of Con notes planning
measuring
3. Concerned with the process of Concerned with the purpose of work
work
4.Activity analysis aimed to achieve Output analysis aimed to achieve social
results objectives
5.Focuses on work programmes Focuses on process of allocating funds
6.Relevent to the problems of lower Relevant to the problems of top level
and middle levels of management management
Illustration II: The good city policies department traditionally has prepared a functional
budget and now there is a discussion about using a performance budget in an effort to
control activities better and do a better job of securing resources from the state
government. Below are the proposed functional budgets for the next year and estimated
data concerning the percentage of functional item costs assignable to each of the four
major programmes of the police department?
Goods city police department proposed functional budget:
(Rs)
Salaries 5,25,000
Vehicle costs 2,50,000
Supplies 1,25,000
Utilities 50,000
Miscellaneous 44,000
Total 9,94,000
Percentage of cost assigned to each programme:
Crime Criminal Criminal Traffic
prevention investigation proceedings movements
Salaries 60% 20% 10% 10%
Vehicle costs 70% 20% 02% 8.5%
Supplies 20% 30% 20% 30%
Utilities 10% 60% 20% 10%
Miscellaneous 30% 25% 20% 25%

152
Required: prepare a programme budget for the next year.
Functional Crime Criminal Criminal Traffic Total
programme prevention investigation proceedings movements Rs.
Salaries 3,15,000(60%) 1,05,000(20%) 52,500(10%) 52,500(10%) 5,25,000
Vehicle costs 1,75,000(70%) 50,000(20%) 5,000(02%) 20,000(8.5%) 2,50,000
Supplies 25,000 (20%) 37,500(30%) 25,000(20%) 37,500(30%) 1,25,000
Utilities 05,000(10%) 30,000(60%) 10,000(20%) 5,000(10%) 50,000
Miscellaneous 13,200(30%) 11,000(25%) 8,800(20%) 11,000(25%) 44,000
Total 5,32,500 2,33,500 1,01,300 1,26,000 9,94,000
Good city police department programme budget
Rs.
Crime prevention 5,32,200
Crime investigation 2,33,500
Criminal procedure 1,01,300
Traffic movement 1,26,000
Total budget amount 9,94,000

13.5. Performance Control Ratios

The management wants to know whether performance of its business is going as

per schedule or not. With this purpose in view some control ratios are calculated. If the
rations are more than 100%, then the performance will be favourable but if these are less
than 100%, then the performance will be unfavourable or unsatisfactory. The following
control ratios are calculated:
Actual hours worked
Capacity ratio = X 100
Budgeted hours
This ratio indicates how much budgeted hours have been actually utilised. If the ratio is
80%, then, it means that 80% budgeted hours have been utilised and the remaining 20%
capacity remains ideal.

Standard hours for actual production

Activity ratio = X 100
Budgeted hours
This ratio shows the level of activity attained during the period.

Standard hours for actual production

Efficiency ratio = X 100
Actual hours worked

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This ratio shows the level of efficiency attained during a particular period. If this ratio is
130% then it shows that the efficiency is more by 30% or it has gone up by 30%.
Number of actual working days in a period
Calender Ratio = X 100
Number of working days in the budgeting period
This ratio shows whether actual working days available are more or less than the budgeted
working days. If the ratio is more than 100% then actual working days are more than the
budgeted number of working days and vice- versa if the ratio is less than 100%.
Illustration III: Product X takes 5 hours to make and Y requires 10 hours. In a month of
25 effective days of 8 hours a day, 1000 units of X and 600 units of Y were produced. The
company employe 50 workers in the production department. The budgeted hours are
1,02,000 for the years. Calculate capacity ratio, activity ratio and efficiency ratio.
Solution:
Standard hours for Actual production:
Product X: 1,000 x 5 = 5,000 hours
Product Y: 600 x 10 = 6,000 hours
11,000 hours

Budgeted hours (Monthly) (1,02,000 12) = 8,500 hours

Actual hours worked = 50 x25 x 8 = 10,000

Actual hours worked

(i) Capacity ratio = X 100
Budgeted hours
Standard hours for actual production
(ii) Activity ratio = X 100
Budgeted hours

Standard hours for actual production

(iii) Efficiency ratio = X 100
Actual hours worked

13. 6. Self-Assessment questions

(i) Define performance budgeting. What are its objectives? How is it different
from conventional budgeting?

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 (ii) What do you understand by the term PPBS? How is it different from
performance budgeting?
(iii) Explain the application and need of the performance budgeting in
government organizations.
(iv) From the following data, caluculate:
(a) activity ratio
(b) capacity ratio
(c) efficiency ratio
A factory manufactures two products A and B standard time to manufacture product A is
2 hours and product B 10 hours. The budgeted and actual production in December were as
follows:
Budgeted production Actual production
Product A 125 units 100
Product B 30 units 24 units
Total actual hours worked were 660

13.7. Suggested Readings

1. Robert S. Kaplan and Anthony A. Atkinson - Advanced Management Accounting,

Pearson Educational, New Delhi
2. S.P Jain and K.L Narang - Cost accounting, Kalyani Publishers, Newdelhi.
3. S.P. Iyengar - cost accounting - Sulthan Chand and sons publications,
4. Chaktravarthi and Chakravarthi - management accountancy, oxford university
press
5. Shashi K. Gupta, R. K. Sharma - Advanced management accounting, Kalyani
Publishers, Newdelhi.

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 GUIDELINE-14
ZERO BASED BUDGETING

Structure

14.1 Introduction:

14.2. Limitations of the Traditional Budgeting Technique

14.3. Evolution of Zero-Based Budgeting

14.4. Zero Based Budgeting

14.5. Definitions of ZBB

14.6. Features of Zero-Base Budgeting

14.7. Process of Zero Base Budgeting

14.8. 14.8Application of Zero Base Budgeting

14.9. ZBB vs. Traditional budgeting

14.10. Benefits of Zero-Base Budgeting

14.10.1.Benefits of Improvements in Plans and Budgets

14.10.2.Benefits realized during operating period

14.10.3.Benefits from a Skilful Management Team

14.10.4.Other Benefits

14.11. Limitations of ZBB

14.12. Self-Assessment Questions

14.13. Suggested Readings

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14.1 Introduction

In any corporate planning and control exercise, budgeting constitutes the most crucial
and vital part. The corporate objectives and priorities, determination of departmental and unit
goals, formulation of programmes and policies, development of product and market
strategies, are all set or fixed by writing details of operational plans and procedures. These
are the essential steps involved in arriving at a complete and perfectly planned effort. The
means by which these planning efforts are translated into a common language of business
‘rupee’ is the ‘budgeting’.

A budget is a comprehensive and coordinated plan expressed in financial terms, for

the operations and resources of an enterprise for some specific period in the future. The
process of preparing and using budgets in order to achieve objectives is called budgeting.
Thus, budgeting is the process by which management allocates corporate resources, evaluates
the financial outcomes of its decisions, and establishes the financial and operational profit
against which future results are measured.

14.2.Limitations of the Traditional Budgeting Technique

Traditional budgeting system is also known as incremental base budgeting, where the
previous year forms the base and increments or additions are made to any expansion of the
current activities or insertion of the new activities. This type of budgeting process takes into
account that allocation of financial resources in the past are correct and will continue in the
future as well. The management has not to focus on how to divide the total activities rather on
how to divide the additional activities. In other words, the traditional approach does not
promote operational efficiency as a result of the following inherent defects can be found:
(1) In traditional budgeting prior year’s inefficiencies and waste are carried forward
in the budgeting because last year’s levels are taken into account.
(2) Budgeting requests exceed availability of funding which forces the management
to recycle the budget process. The traditional approach usually aggravates the
problem. The managers usually inflate their budget requests because they know
that their initial budget requests will be slashed.
(3) Key problems and decision areas are not highlighted.

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 (4) Difficulty in adjusting budgets and operations readily to changing situations
because workloads are not clearly identified in majority of the cases nor are
priorities established throughout the organization.
(5) The approach does not require a rigorous analysis of all proposed cost and
benefits that is incremental as well as of the prior year; therefore, management has
a lack of information for rational decision-making.
(6) The approach does not encourage managers to identify and evaluate alternative
means of accomplishing the same activity.
(7) It is also very difficult to identify the impact of eliminating programmes or
programme funding levels.
(8) The approach fails to provide information which a manager requires to evaluate
budget presented to him for approval nor do they provide a satisfactory bases for
evaluating judgment performance in two vital areas, such as, discretionary
overheads and non-capitalized development expenses.

Thus under the traditional approach, items of activities which are of little value and
inefficient remain unidentified. Therefore, with incremental changes or additions to previous
budgeting levels seems quite meaningless under the conditions of dynamic changes where
management needs to review and re-evaluate every task in the light of new conditions. The
solution for this problem which can overcome the shortcomings of this traditional budgeting
is Zero-Base Budgeting, a management tool that enables the top management to focus on key
problems, alternatives and priorities throughout the organization.
14.3. Evolution of Zero-Based Budgeting
The origin of the concept of Zero Base Review or Zero Base Budgeting (ZBB) can be
traced back to the year 1924 when the noted English authority Mr. E. Hilton Young stressed
the need for annual re-justification of budget programmes. Those were the days of PPBS
where cost benefit considerations are used. With the demise of PPBS (Planning Programming
Budgeting System), the concept of zero base budgeting was popularized and thus the
systematic budgeting technique came into being in the United States of America.

In 1964, the United States Department of Agriculture prepared their budget based on
zero-base budgeting with ground up budgeting technique. It was an additional exercise on top

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of the normal process of budgeting. Zero base budgeting required voluminous documentation
and a great deal of departmental time and energy.

Peter A. Pyhrr is known as the father of zero-base budgeting, as he coined the term
‘ZBB’ while working as a staff control manager with the Texas basic framework in 1970. He
successfully developed and implemented it in his company at the private sector and
popularized its wider use.

14.4. Zero Based Budgeting:

Zero Based Budgeting is a method of budgeting whereby all activities are evaluated
each time a budget is formulated. It is an approach to budget review and evaluation that
requires a manager to justify the resources requested for all activities and projects, including
on-going activities and projects, in rank order. Zero Based Budgeting was first introduced in
Texas Instruments.

ZBB is a revolutionary concept of planning the future activities and there is a

sharp contradiction from conventional budgeting. ZBB may be termed as “De-nova
Budgeting” or budgeting from the beginning without any reference to any base – past budgets
and actual happening. ZBB may be defined as a planning and budgeting process which
requires each manager to justify his entire budget request in detail from scratch (hence zero-
base) and shifts the burden of proof to each manager to justify why he should spend money at
all. The approach requires that all activities be analyzed in decision packages which are
evaluated by systematic analysis and ranked in order of importance.

However, the term zero-base does not mean that every ones position is automatically
zeroed or that we must reinvent the wheel, which should be entirely unrealistic in a
programmatic world. What is it exactly means is that one must re-evaluate all activities to see
if they should be eliminated; funded at a reduced level, funded at similar level or increase is
appropriate. It will be determined by the priorities established by top management and by the
availability of total funding.

The function of budgeting starts from scratch or zero and not on the basis of trends or
historical figures adjusted for inflation and other conditions. It starts from the basic premise

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that the budget for the next year is zero and every process or expenditure has then to be
justified in its entirety in order to be included in the next year’s budget. Under this system, a
number of alternatives for each activity are identified, costed and evaluated in terms of the
benefit to be obtained from them. The basic requirements for application of ZBB are as
follows:
 There must have to be a budgeting system within the organisation.
 It requires managers to develop qualitative measures for use in performance evaluation.

14.5. Definitions of ZBB

There are a series of definitions that highlight the conceptuality of Zero-Base

Budgeting. The following are some of the definitions:
Perry Moore, defined Zero-Based Budgeting as:
“Zero base budgeting is a management process that provides for systematic
consideration of all programmes and activities in conjunction with the formulation of
budget requests and programme planning.”
 F.D. Draper and V.T. Pitsvada defined Zero-Base Budgeting as:
“ZBB is a system whereby each governmental programme, regardless of
whether it is a new or existing, must be justified in its entirety each time a new budget
is formulated.”
 Peter A Phyrr defined Zero-Base Budgeting as:
“An operating planning and budgeting process which requires each manager to
justify his entire budget request in detail from scratch (hence zero base). Each
manager states why he should spend any money at all. This approach requires that all
activities be identified as decision packages, which will be evaluated by systematic
analysis ranked in order of importance.”
 F.A.K. Gul defines Zero-Base Budgeting as:
“ZBB is a technique which complements and links the existing planning,
budgeting and review processes. It identifies alternative and efficient methods of
utilizing limited resources management approach which provides a credible rationale
for reallocating resources by focusing on the systematic review and justification of the
funding and performance levels of current programmes or activities.

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 Thus, under ZBB there is a continuous re-evaluation of the activities of the
organization to ascertain that the activities are absolutely necessary for the organization, so
that they have to be funded within the limited funds available to the organization. The
definitions so discussed above are result a number of features of zero-base budgeting.

14.6. Features of Zero-Base Budgeting

ZBB is based on the premise that every rupee of expenditure requires justification. It
assumes that responsibility centre manager has had no previous expenditure. The features of
ZBB are:
 Concentration of efforts is not simply of “how much” a unit will spend but “why” it needs
to be spent.
 Choices are made on the basis of what each unit can offer for a specific cost.
 Involve managers who have discretion over direction at all levels in the budget and
operational process.
 Individual unit objects are linked to corporate targets.
 Quick budget adjustments can be made if; during the operating year costs are required to
maintain expenditure level.
 Assess alternative ways of accomplishing the objectives.
 Participation of all levels in decision-making.
 Use decision packages as a major tool for budgeting review, analysis, and decision-
making.
 Rank programmes, activity funding levels and re-allocate resources in order of priority.

14.7. Process of Zero Base Budgeting

Internal zero base budgeting procedures are developed within an agency /

organization using the following steps in the ZBB process:
A. Identification of agency’s organizational structure, objectives, management
andDecision Units.
B. Analysis of decision units and developing the Decision Packages.
C. Review and Rank Decision Packages.
D. Allocation of organizational resources and preparation of detailed
Budget. ZBB can be implemented successfully with these stages:

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1. Defining the Decision units: A decision unit is a tangible activity or group of activities
for which single manager has the responsibility for its successful performance. The
decision unit concept is important to that of the responsibility centre, a group of people or
even a project may be a decision unit.
2. Defining objectives: of each of the decision unit in clear and specific terms and in
conformity with the enterprise objectives and goals.
3. Identifying activities in the form of a decision package: For any given activity, there may
be several alternative decision packages, each describing different level of effort and cost
benefit relationship. There are two types of decision packages – mutually exclusive
packages and incremental packages.
4. Ranking of alternatives: It is done in order of decreasing benefit to the organisation, using
cost benefit analysis technique. Large volume of decision packages is expected in zero
based budgeting in the early years. All the packages presented for funding generally
would fall into three categories, those with
i. high priority and high probability of funding;
ii. marginal priority and funded or non-funded depending on the resources
available;
iii. low priority and low probability of funding.
5. Forwarding the ranked decision packages to the next higher organizational units: for
review, merger with other comparable decision packages and for re-ranking. Due to this,
the perspectives and objectives are broadened.
6. Finalization of budget proposed as well as preparation of budgets for each decision unit.
These have to be finally approved by the top management. Before the approval, the top
management will be guided by benefit cost ratios in allocating resources.

14.8. Application of Zero Base Budgeting

In the first sight ZBB can be used on any activities, functions or operations where a
cost benefit relationship can be identified howsoever, this evaluation may be subjective. Thus,
ZBB is a package which employs concepts which may be used in any organization however
small.

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 Essentially, it is a structured technique for applying management techniques to large
and complex organization structures. For this reason, the formal use of ZBB may be most
effective in larger organization where an extensive middle management structure exists.

In addition to this, it is equally suitable in private / public sector and in profit making
or non-profit making organizations. ZBB gives management an effective operating tool to use
in the areas (service and support activities) such as maintenance, supervision, production,
planning, industrial engineering, material handling quality control, etc. which impact profits
far in excess of their relative proportion of total rupees budget. ZBB can be also applied in
government organizations.

14.9. ZBB vs. Traditional budgeting

ZBB reverses the working process of traditional budgeting. Traditional

budgeting starts with previous year expenditure level as a base and then discussion is focused
to determine the ‘cuts’ and ‘additions’ to be made in the previous year spending. In ZBB, no
reference is made to previous level of expenditure. A proper case is made for each decision
unit to justify the budget allotment of resources for that activity during the period under
consideration and the available resources are allocated to different activities in order of its
importance to optimize the results. The differences between ZBB and traditional budgeting
may be studied as follows:

 ZBB makes a decision oriented approach, whereas traditional budgeting is accounting

oriented where the main stress is on the previous level of expenditure.
 A rational analysis of budget proposal is attempted in ZBB. In traditional budgeting, some
managers inflate their budget request so that they get what they want.
 In ZBB, a decision unit is broken into decision packages which are ranked according to
the importance to enable top management to focus only on a decision package which
enjoys priority. In traditional budgeting, first reference is made to past level of spending
and then demand is made for inflation and new programme.

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 In ZBB, responsibility shifts from top management to manager of decision unit whereas in
traditional budgeting it is for the top management to decide why particular amount should
be spent on a particular decision.
 ZBB is very clear and responsive than traditional budgeting.
 ZBB makes a very straight forward approach and immediately spotlights the decision
packages enjoying priority over others whereas traditional budgeting makes a routing
approach.

14.10. Benefits of Zero-Base Budgeting

Zero base budgeting call for a closer participation of all managers in the management
hierarchy in its process. The idea of involving all managers at all levels in this process is to
establish the significance of the lower level operating managers who actually spend the
money and thus contribute to a great extent in the accomplishment of organizational goals.
These managers are of course experts on their activities and are more familiar with the actual
operations. A need is gradually felt that these managers should be involved in the process of
planning and budgeting so that communication gaps can be removed and they can familiarize
themselves with the process. In this way they can accept their responsibilities for evaluating
their own cost effectiveness. Opportunities must be given to them to make analysis and
recommendations of the organization’s operations so that top management can derive
benefits from such recommendations. Therefore, the major benefits of ZBB results from the
harnessing of the budgets and talents of managers throughout each organization.
1. Benefits of Improvements in Plans and Budgets
2. Benefits Realized during the Operational Period
3. Benefits from a Skilful Management Team
4. Other Benefits.

14.10.1.Benefits of Improvements in Plans and Budgets

This gives top management a great flexibility in reallocating resources and allowing
greater budget shifts among organization because of a consolidated ranking of activities and
organization. In addition to this, high priority new programmes can be funded totally or in
part by eliminating or reducing current activities which are not very essential.

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1. Those decisions packages which are approved for funding purposes provide a basis
for detail budgeting control in the manufacturing over-head activities and in the
preparation of other documents. ZBB strengths data base and evaluation process from
which detailed documents are prepared. The technique does not require any
fundamental change to the normal accounting or control procedures rather it enhances
the effective control.
2. Since ZBB links planning, budgeting and review into a single process requiring detailed
and rigorous scanning of each activity. It results in an integrated approach for the entire
organization in its quest for the most effective allocation of resources. The technique
stresses that each item in the budget must be evaluated and appraised on its own merit
and desirability.
3. Decision packages and rankings provide the managers some basic information and
analysis at all organizational levels. Top level managers have to review packages at the
margin and this saves effort and time of top management.
4. Duplication of effort among organizational units will be identified which can be
resulted in elimination or centralization of these functions.

14.10.2.Benefits realized during operating period

i. Managers can be measured against the goals performance and benefits to which they
have committed themselves as identified in the decision packages and their budgets.
ii. It facilitates identification of those activities which are poorly operated and managed
and any follow up reviews, and top management can initiate action which it deems
necessary to eliminate these problems.
iii. Although ZBB does not require a continuous evaluation and appraisal of the
operations, efficiency and cost effectiveness of the operating managers, yet the
managers have a tendency to initiate studies and improvements during the operating
years. This is so because these managers know that the process would be exercised
next year and hopefully ZBB trains managers to continually, think along the lines of
the analysis that the process requires.

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14.10.3. Benefits from a Skilful Management Team
1. Managers who are developing and formulating decision packages may seek
assistance from their sub-ordinates and this encourages them to dedicate towards
the organization’s accomplishment of goals.

2. It creates a more vibrant and interactive management team of talented and skilful
people.

3. Better communication among managers is enhanced by greater participation of

personnel in formulating and ranking process.

14.10.4. Other Benefits

i. Inefficient and obsolete operations are identified and removed during the process
of ZBB.
ii. It helps in close monitoring of cost behaviour patterns in order to decide the effect
of alternative courses of action.
iii. The documentation required enables a coordinated in-depth knowledge of an
organization’ operations to be available to all management.
iv. ZBB is not based on incremental approach, so it promotes operational efficiency
as it requires manager to review and justify their activities or funds requested.
v. It motivates employees to avoid wasteful expenditure.
vi. It is a planning tool for management which helps in identification of wasteful and
obsolescent items of expenditure.
vii. The scarce resources will be allocated more efficiently to the activities and
departments of the organisation according to priority of programmes.
viii. Responsibility at all levels of management in successful execution of budgetary
system can be ensured as it requires participation of all managers in preparation of
budgets.
ix. It is useful especially for service departments where it can be difficult to identify
output.

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14.11. Limitations of Zero-Base Budgeting
There are also certain limitations of zero-base budgeting that are encountered during
the process of budgeting. These can be grouped as follows:
i. Implementation problems
ii. Decision package formulation problems
iii. Ranking problems.
However these problems can be summarized as follows:
i. ZBB leads to enormous increase in paper work created by the decision packages.
The assumptions about costs and benefits should be continually updated.
ii. ZBB is criticized for emphasis of short-term benefits to the detriment of long-term
benefits.
iii. ZBB does not offer any significant control advantage as the objectives are very
difficult to quantify as in R&D or general administration.
iv. It may encourage the false idea that all decisions have to be made in the budget.
v. Difficulty arises in defining the decision units and decision packages.
vi. ZBB requires a lot of training for managers to make understand the concept for its
successful implementation.
ZBB poses difficulty in ranking process depending upon the number of packages,
types of activity, etc.

14.12. Self-Assessment Questions:

1. Discuss the limitations of traditional budgeting.

2. Explain the evolution of ZBB.
3. Define Zero-Base Budgeting. What are its features?
4. Discuss the applications of ZBB.
5. Explain the process of ZBB.
6. Differentiate ZBB with traditional budgeting.
7. State the benefits of ZBB.
8. What are the limitations of ZBB?

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14.13. Suggested Readings

1. Robert N. Anthony, “Management Accounting – Principles”, Homewood, RD Irwin,

1965.
2. Robert N. Anthony and J.S. Reece, “Management Accounting”, Illinois, 1975.
3. Peter A Phyrr, “Zero Base Budgeting: A Practical Management Tool for Evaluating
Expenses, NewYork, Willey & Sons, 1973.
4. Jawaharlal, “Advanced Management Accounting – Text and Cases”, S. Chand &
Company Ltd., New Delhi, 2006.

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