Learning Outcome

1.1 Demonstrate the ability to understand the application of CVP Analysis

1.2 Understand the basic terminologies used in CVP Analysis
1.3 Understand the underlying assumptions under CVP Analysis
1.4 Demonstrate various methods of determining the BEP
1.5 Solve problems under CVP Analysis

Introduction
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume
affect a company's operating income and net income. In performing this analysis, there are
several assumptions made, including: Sales price per unit is constant. Variable costs per unit are
constant. Total fixed costs are constant. A critical part of CVP analysis is the point where total
revenues equal total costs (both fixed and variable costs). At this break-even point, a company
will experience no income or loss. This break-even point can be an initial examination that
precedes more detailed CVP analysis. CVP analysis can help companies determine their
contribution margin, which is the amount remaining from sales revenue after all variable
expenses have been deducted. The amount that remains is first used to cover fixed costs, and
whatever remains afterward is considered profit.

1.1.1 Definition

CVP analysis is an analysis of three factors such as cost, volume and profit. It examines the
relationship among costs and volumes and their impact on profit.

1.1.2 Objectives

It is the most important tool of profit planning due to the close relationship among C-V-P.

 To forecast the profit accurately.

 To help management in determining the pricing policies.
 To evaluate the performance of the business.
 To facilitate the preparation of flexible budgets.
 To achieve cost control and cost reduction.
 To help management in making decisions.
 To determine breakeven point.

CVP Analysis is a “what if” analysis. It helps in answering questions such as “what if there is a
change in selling price, or volume or sales mix or fixed costs, etc....

1.1.3 Techniques of CVP Analysis

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There are two basic techniques of CVP analysis. They are:

1. Contribution Margin Analysis

2. Break Even Analysis

1.1.3.1 Contribution Margin Analysis

By analysing the contribution margin it is possible to study the relationship among cost, volume
and profit. For this, contribution margin ratio is computed.

What is meant by Contribution?

It refers to excess of sales over variable costs. It’s not the final profit. It’s the marginal profit. It
is also known as contribution margin or gross margin. It covers fixed cost and profit. If
contribution is more than the fixed costs there is a profit. If contribution is less than the fixed
cost there is a loss. It can be expressed as “per unit” or in “total”. Contribution per unit is the
difference between selling price per unit and the variable cost per unit. Total contribution is the
difference between total sales value and total variable cost.

Importance or uses of Contribution

It’s a useful technique in planning and decision making. The following are the advantages of
contribution:

 It helps in fixing selling price.

 It enables to fix breakeven point.
 It helps to determine the key factor.
 It highlights the relationship among cost, sales and profit.
 It helps the management in taking make or buys decision.
 It helps to find out the profitability of various products, departments etc...

Difference between Profit and Contribution

Contribution Profit
This concept is used in marginal costing This is a residual concept used in
accounting.
Includes both fixed cost and profit. Does not include fixed cost.
Useful in managerial decisions Useful in determining the result of business
operation.

Equation

Contribution = Sales – Variable Cost

Or
Contribution = Fixed cost + Profit
Fixed cost = Contribution – Profit
Profit = Contribution – Fixed Cost
Variable Cost = Sales – Contribution
1.1.3.2 Break Even Analysis

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It is the most widely used technique of cost volume profit analysis. It establishes the relationship
between cost and profit with sales volume. It is method of presenting and studying the inter
relationship among cost, volume of sales and profit at various levels of activity. In narrow sense
BEP means finding out of BEP. In broad sense it means a system of analysis which is used to
determine the probable profit at different levels of activity.

According to Car Heyel BEP is defined as “a method for studying the relationship among sales
revenue, fixed costs and variable expenses as to determine the minimum volume at which
production so can be profitable.” This BEP can be expressed in graph such as break even chart
or profit graph or in a statement form as follows:

1.1.3.4 Marginal Cost Statement

Sales xxxxx
Less: Marginal Cost:
Direct Material xxxx
Direct Labour xxxx
Variable Overhead xxxx xxxx
Contribution xxxxx
Less: Fixed Cost xxxx
Profit xxxxx

1.3 Assumptions underlying BEP or CVP Analysis

BEP or CVP analysis based on the following assumptions.

1. All costs can be separated into fixed and variable elements.

2. Variable costs vary in direct proportion to volume of output.
3. Fixed cost will remain constant at all volumes of output.
4. Selling price per unit remains constant.
5. In the case of multiple products, sales mix remains constant.
6. Productivity per worker and efficiency of plant etc remain unchanged.

1.3.1 Advantages

 It is useful in forecasting sales and profit

 It helps in inter-firm comparison of profitability
 It helps to determine the selling price which gives desired profit.
 It is used in profit planning
 It assists in the formulation of price policies.
 It serves as a useful tool for cost control.

1.3.2 Limitations

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  Difficult in separating cost into fixed and variable.
 It assumes that fixed cost remains constant at any level of activity. But actually it will
remain constant only up to a certain level of activity.
 It assumes that variable costs vary in direct proportion to volume of production. But the
variable cost need not necessarily vary in direct proportion of output.
 If numbers of products are manufactured then separate break even charts may be
prepared for each product. This necessitates apportionment of fixed costs on arbitrary
basis.
 The assumption that selling price remains constant is not valid.
 BEP analysis completely ignores the capital employed in business.
 It has a limited application in long range planning.
 Semi-variable costs are completely ignored.
 It is static analysis because it measures C-V-P at a given point of time.

1.4 Break Even Point

The calculation of BEP is the foundation stone in BEP analysis.

BEP is the point or level of activity at which the total cost is equal to total revenue. It is the point
of no profits no loss. Thus it is equilibrium or balancing point. It is point at which losses cease
and profit begin. If sales go beyond the BEP, firm earns profit. If they come down firm incurs a
loss. We can divide the term Break Even Point into three:

1. Break which means Divide

2. Even which means Equal
3. Point which means Place or Position
Thus, BEP is a specific level of activity or volume of sales which breaks the revenues
and costs evenly. Thus at this point there is no profit no loss. BEP may rightly describe
as Bread Earning Point. It is at this point the firm starts earning it bread i.e. profit. It is
magic number that tells the company when its revenue will cover its expenses.

Calculation of B.E.P

There are two methods of calculating B.E.P.

1. Algebraic Method 2. Graphic Method.

1.4.1 Algebraic Method

Under this method B.E.P is ascertained by using mathematical formula. It can be computed in
terms of units or in terms of kina value or as a percentage of installed capacity.

B.E.P in units = Fixed Expenses / Contribution per unit or F / C.p.u.

B.E.P in Kina Value (sales) = Fixed expenses x Sales / Contribution or F x S / C
B.E.P as a percentage of capacity = B.E.P Sales / Capacity Sales x 100 Or
Fixed Cost / Total Contribution at estimated capacity.
Margin of Safety

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Margin of safety is how much output or sales level can fall before a business reaches its
breakeven point. It is the excess of actual or present sales over the BEP sales. It refers to the
amount by which sales revenue can fall before a loss is incurred.

1.4.2 Margin of Safety = Present Sales – BEP Sales.

If it is expressed as a percentage of sales, the formula will be:

Actual sales – BEP Sales / Actual Sales x 100

Importance - It provides a protection for a company. It indicates whether the business is weak
or strong as regards sales. It shows the extent to which sales may fall before the firm suffers a
loss. Larger the margin of safety, the safer is the firm. It shows that even there is a substantial
fall in sales some profits shall be earned. Small margin of safety indicates that the firm is weak.
Even a small reduction in sales may result into a loss. In such a case the firm has to take suitable
measures to improve margin of safety. Thus margin of safety serves as a guide to management.
Above all it is an important measure of risk.

Margin of safety can be increased or improved by:

a. Increasing the selling price

b. Reducing the variable cost
c. Increasing production and sale
d. Reducing the fixed costs
e. Switching the production to more profitable products.

1.4.3 Profit Volume Ratio (P/V Ratio)

As already stated PV ratio is a technique of cost volume profit analysis. It is the ratio of
contribution to sales.

P/V ratio = Contribution / Sales

If it is expressed as percentage of sales, the formula will be: C / S x 100

Uses of P/V ratio

 It helps in comparing the profitability of various products.

 It helps in determination of B.E.P. The formula is:
Fixed Expenses / P.V ratio
Hence fixed expense = BEP x P.V ratio
 It helps in determining sales volume required to earn a given profit. The formula is:
Fixed Expenses + Profit / P.V Ratio
 It helps in calculating margin of safety. The formula is:
Margin of Safety = Profit / P.V Ratio or Profit x Sales / Contribution
 It helps in calculating profit at any volume of sales. The formula will be:
Profit = Sales Volume x P.V Ratio = Contribution – Fixed Cost.
 It helps in determining the required selling price per unit. The formula is:
Selling Price = Variable cost per unit / 100 – P.V. Ratio
P.V ratio can be improved by:

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  Reducing the variable cost per unit
 Increasing the selling price per unit
 Switching the production to more profitable products having high P.V ratio.

1.4.4 Break Even Chart

B.E.P can also be shown graphically through the break even chart. Break even chart is a
graphical presentation of break-even analysis. BEP is the point at which total sales line cuts the
total costs line.

Assumptions

1. Costs can be classified into fixed and variable costs

2. Fixed cost remain constant at all levels of activity
3. Variable costs directly change in proportion to output.
4. Selling price per unit remains constant
5. No change in sales mix
6. Entire units produced are sold i.e. no opening and closing stocks.
7. Level of efficiency and management policy do not change.

Advantages

1. It is used to study the cost volume profit relationship.

2. It shows BEP and also the estimated profit or loss at varying levels of activity.
3. It presents the information in an easily understandable manner.
4. It indicates profitability of products.
5. It shows figures of optimum output.
6. It serves as a tool of cost control.
7. It determines breakeven point.
8. It determines profit-path of a product mix.

Limitations

1. The assumption that fixed costs remain constant will not hold good in the long run.
2. Assumption that all units produced are sold is wrong. In practice the firms shall be
having both opening and closing stocks.
3. Selling price may change with volume. In many cases larger quantities can be sold at
lower prices. Thus sales line is not linear but curvilinear.
4. The assumption that product mix remains same may not hold well in long run.
5. Only limited information can be shown in a single break even chart.
6. It does not consider the capital employed or market conditions etc. These are very
important factors for measuring profitability.
7. It represents a static picture of the business operations.

1.4.5 Calculation of Break Even Chart

1. Sales volume (Units or Percentage of capacity) is plotted on X- axis.

2. Costs and revenue (Kina) are plotted n Y-axis.
3. Draw fixed cost line parallel to the horizontal axis (X- axis)

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 4. Draw the total cost line starting from the point on the Y- axis which represents fixed
cost.
5. Draw the sales line starting from the point of origin (zero)
6. The point at which the total sales line cuts the total cost line is B.E.P.
7. The area between total cost line and total sales line below the BEP represents loss
and above the point represents profit.

1.4.6 Angle of Incidence

It is the angle formed at BEP. In other words, it is the angle between sales line and total cost line
at the BEP. It is also known as theta. It indicates the rate at which profits are being made. Larger
angle indicates higher rate of profit, while smaller angle indicates a lower rate of profit. To
improve this angle, contribution should be increased either by raising the selling price and / or
by reducing variable cost.

1.5 Types of Break Even Chart

1. Simple Break Even Chart – its preparation is simple. It shows total cost line, fixed cost
line and the sales line.
2. Contribution break even chart – in this chart sales line and variable cost lines are
drawn. The difference between sales line and variable cost line represents the
contribution at different levels of activity. Total cost line is drawn parallel to the variable
cost line. Difference between the variable cost line and total cost line shows the fixed
cost.
3. Analytical break even chart – it analyses the variable cost under different elements
such as direct material, direct wages, variable factory overheads, variable office
overheads and variable selling and distribution overheads. Thus this chart gives break-up
of various variable costs. The point where the total cost line and total sales line intersect
each other gives the breakeven point.
4. Control breakeven point – the main purpose of preparing this chart is to show
comparison between actual data and budgeted data (budget variance) in respect sales,
cost and profits.
5. Cash breakeven chart – it is prepared to show the cash breakeven point. It is the point
at which the cash sales (inflow) are equal to cash expenses (outflow). For this purpose,
the expenses are divided into two- cash expenses and non-cash expenses. In the chart the
cash total line is drawn along with the sales line. Cash fixed costs are shown at the base
level. Non cash fixed costs are shown after the cash total cost line. In the absence of
information to the contrary, the entire variable cost is supposed to be paid in cash. The
point at which the sales line intersects the cash total cost line is the cash breakeven point.
6. Profit Volume chart - it shows how profit changes in response to change in the sales
volume. It shows the amount of profit directly.

Construction of Profit Graph

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 1. Profits and fixed costs are represented on the vertical axis.
2. Sales are represented on the horizontal axis.
3. The sales line divides the graph horizontally into two parts. The area above the sales
line is the profit area and the area below the sales line is loss area.
4. The profits and losses at various sales levels are plotted and connected by a line
called profit line. The profit line is drawn from the fixed cost point to the point of
maximum profit. At zero sales the loss will be equal to fixed cost.
5. The BEP is where the profit line cuts the horizontal sales line.
In case of more than one product, a separate profit line for each product may be
drawn.

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Learning Outcome
1.0 Demonstrate the ability to prepare financial reports under variable and absorption costing
1.1 Differentiate between variable and absorption costing
1.2 Understand the advantages and disadvantages of using variable and absorption costing
1.3 Demonstrate the preparation of manufacturing statements and income statements.
Introduction
Absorption costing technique is also termed as Traditional or Full Cost Method. Under this
method, the cost of a product is determined, after considering both fixed and variable costs. The
variable costs, such as direct materials, direct labour, etc. are, directly, charged to the products.
The fixed costs are apportioned on a suitable basis over different products, manufactured during
a period.
Under absorption costing, all costs, both variable and fixed, are charged to the products for cost
determination. Thus, in case of absorption costing, all costs are identified with the products
manufactured. Both Fixed costs and Variable costs are also treated as product costs. The cost
unit is made to bear the burden of full cost, irrespective of the current level of operations.
2.1 Definition
Absorption Costing

Absorption costing, as the name indicates absorbs both variable costs and fixed costs. All
costs are treated as product costs. Under absorption costing, all costs, both variable and
fixed, are charged to the products for cost determination.

Variable Costing

‘The accounting system in which variable costs are charged to cost units and the fixed
costs of the period are written-off in full against the aggregate contribution. Its special
value is in decision making’. (Terminology.)

2.1.1 Objective of Absorption Costing

The management is interested that every product should bear its total cost, be it fixed or variable
cost and leave something towards profits towards return on investment. In the absence of profits,
in the long run, management is not interested to continue that product. Management wants to
ensure a reasonable return on the investment made. Absorption costing facilitates that objective.
The objective of management, under absorption costing, is that each product recovers its full
cost and leaves something towards profit as a return on investment. All products may not give
equal contribution. Selling price of some products may cover the variable cost component, fully,
while they may not cover the fixed cost component, totally. Though full costs are not recovered,
in the short run, management continues production as they leave certain amount in the form of
contribution that would cover the fixed costs, at least, partly. This is only short-term approach.
In the long - run, every firm wants to recover full costs, both fixed and variable, and leave
something towards planned profits, which is the objective of every firm to maximize.

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2.2 Differences between Marginal Costing and Absorption Costing
Objective: Under marginal costing, management is concerned with recovery of variable costs.
This is a short-term objective. Any management for a long period, permanently, cannot sustain,
ignoring recovery of fixed costs. Under absorption costing, management is concerned with
recovery of total costs. Unless total costs are recovered, management does not continue
production of the concerned product. Basically, this is a long-term objective. The objectives of
marginal costing and absorption costing are conflicting with each other.

Marginal costing is appropriate in the short-run and for selecting special orders, while
absorption costing is suited as a long-term objective. The objectives of marginal costing and
absorption costing are not one and the same, in respect of recovery of costs. The differences
between Marginal Costing and Absorption Costing are summarized hereunder:

Basis Marginal Costing Absorption Costing

Fixed costs Fixed costs are considered as Fixed costs are considered as
period costs. Fixed costs are product costs. Fixed costs are
ignored for product costing considered for product
and inventory valuation costing and inventory
valuation
Profitability P/V ratio of different Profitability is influenced by
products judges profitability recovery of full costs.
of different products.
Apportionment of fixed costs Fixed costs are not Subjective apportionment of
apportioned to products. overheads is made to
They are charged to different products. In other
contribution from different words the apportionment is
products. arbitrary and not exact.
Presentation of data Presentation of data is given Presentation of data is on
highest importance to conventional pattern. Net
highlight contribution of profit is determined after
each product and total deducting fixed overheads.
contribution of the firm.

Absorption Costing and Marginal Costing have their own role to play, depending on the
situation. If only variable costs are recovered by the unit cost, when and how fixed costs can be
recovered? When a special export order is under consideration, application of absorption costing
may result in rejection of the order when full cost is not recovered by the unit cost in the
proposed export order.

Marginal costing is the right technique to decide on such special order Application of Marginal
Costing results in acceptance of the special order as the same unit cost results in recovery of
variable costs, totally, and leaves something towards contribution, which results in increased
profits of the firm. The special order may be rejected, if absorption costing is applied for
determining the cost. Depending on the context, suitable application is to be made.

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2.2.1 VALUATION OF CLOSING STOCK UNDER ABSORPTION COSTING AND
MARGINAL COSTING AND IMPACT ON PROFIT

Fixed costs are taken into account in Absorption costing for valuation of cost of production and
closing stock. However, fixed costs are ignored in Marginal costing for valuation of cost of
production and closing stock. Profit calculated between Absorption costing would be different
from the profit calculated under Marginal costing.

2.2.2 IMPACT OF FIXED COSTS ON COST OF PRODUCTION PER UNIT UNDER

ABSORPTION COSTING WOULD BE MISLEADING

The fixed costs are apportioned to the products on some basis. The basis could be a percentage
of direct material or percentage of direct labour or rate per article etc. Whatever be the basis of
apportionment of fixed cost to different products, it cannot be said that the apportionment is
exact and definite. Charging of fixed costs creates certain problems. Cost of production would
be higher in Absorption Costing, compared to Marginal Costing, due to inclusion of fixed cost
component in the former. A simple example would explain the picture better.

Cost sheet of a firm is as under:

Direct materials per unit = K6
Direct Labour per unit = K4
Prime cost per unit = K 10
Fixed overheads = K 1, 00,000
Production capacity of the firm is 10,000 units.
If the firm works to its full capacity, the total cost of production would be as under:
Direct materials = K 60,000
Direct Labour = K 40,000
Fixed costs = K 1, 00,000
Total cost = K 2, 00,000
Total cost per unit = 2, 00,000 / 10,000 = K 20
If the firm produces only 1,000 units, then the cost of production would be as under:
Direct materials = K 6,000
Direct Labour = K 4,000
Fixed costs = K 1, 00,000
Total cost = K 1, 10,000
Total cost per unit = 1, 10,000 / 1,000 = K 110
The total cost per unit, under full capacity, has been only K 20 and it has gone up to K 110,
when the capacity of the firm is partly utilized. There is no increase in the price of raw materials
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or labour. However, the cost of production per unit has gone up by K 90, amounting to 495%
increase, due to lower volume of production. It appears illogical. Some people, therefore, argue
that the fixed costs should not be considered, while computing the cost of product. In Marginal
costing, fixed costs are charged against a fund, arising out of excess of selling price over
variable cost. This is the logic of marginal costing.

2.2.3 EFFECT OF OPENING AND CLOSING STOCK ON PROFITS

Impact of opening stock and closing stock would be as under in Absorption Costing and
Marginal Costing:

1. When sales and production coincide (no opening stock and closing stock situation), profit
would be same under both Absorption costing and Marginal costing.

2. If closing stock were more than the opening stock, profit under Absorption Costing would be
more than profit under Marginal Costing. This is, because, under Absorption Costing, a portion
of fixed overhead is charged to the closing stock and carried over to the next year, instead of
being charged to the current period.

3. If closing stock is less than the opening stock, the profit shown under Absorption Costing will
be lower than the profit under Marginal Costing. This is because a portion of fixed cost relating
to the previous year is charged to the current period. The following examples would explain.

The data below relates to Kishore Co., which makes and sells sweet packets.

January February
Sales 5000 units 10000 units
Production 10000 5000
Selling Price Per Unit K100 K100
Variable Production Cost Per K50 K50
Unit
Fixed Production Cost Per K100000 100000
Unit
Fixed Production Overhead 10 10
Cost Per Unit, being the
predetermined overhead
absorption rate.
Selling, Distribution and 50000 50000
Administration Cost ( all
Fixed)
You are required to present comparative profit statement for each month using

(i) absorption costing;

(ii) marginal costing
(iii) Comment on the reasons for difference in profit, if any.

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Solution

Profit Statement under Absorption Costing

January February
1 Sales 500,000 1,000,000
2 Cost of Goods Sold: Opening Stock 300,000
Variable Cost of Production 500,000 250,000
Fixed Production Overhead 100,000 50,000
Under Absorbed Overhead - 50,000
Total Stock 600,000 650,000
Less: Closing stock 300,000 -
CGM 300,000 650,000
Gross Profit 200,000 350,000
Less:
Selling & Admin Costs 50,000 50,000
Net Profit 150,000 300,000

Note - Apportionment of overhead is made on a planned production of 10000 units. However,

production has been only 5000 units. Hence, under absorbed overhead has been charged.

Working Notes:

Sales = 5000units x 100 = 500000

= 10000units x 100 = 1000000
Variable cost = 10000 x 50 = 500000
= 5000 x 50 = 250000
Fixed cost of production = 10000 x 10 = 100000
= 5000 x 10 = 50000
Closing Stock = 5000 x 60 = 300000

Profit Statement under Marginal Costing

January February
1 Sales 500,000 1,000,000
2 Cost of Goods Sold: Opening Stock - 250,000
Variable Cost of Production 500,000 250,000
Total Stock 500,000 500,000
Less: Closing stock 250,000 -
CGM 250,000 500,000
Contribution 250,000 500,000
Less: Fixed Costs
Production Overhead 100,000 100,000
Selling & Admin OH 50,000 50,000
Net Profit 100,000 350,000

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Note: Net Profit is different due to difference in the valuation of closing stock / opening stock
both under absorption and marginal costing for different months. However, total amount of
profit is same, i.e. K 450000 under both the methods as there is no opening stock and closing
stock, at the end. So, cumulative profit is same under absorption and marginal costing. Working
Notes:

Sales = 5000 x 100 = 500000

= 10000 x 100 = 1000000
Variable Production cost = 10000 x 50 = 500000
= 5000 x 50 = 250000
Closing Stock = 5000 x 50 = 250000

Conclusions

Valuation of stock in absorption costing contains fixed cost element, which is not the case with
Marginal costing. This creates variation in profit between Marginal costing and Absorption
costing. Profit at different situations has been as under:

1. If there is no change in opening stock and closing stock i.e. production is totally sold, profit in
marginal costing and absorption costing would be the same. In the first month, profit is 45,000
in both marginal costing and absorption costing.

2. If closing stock is more than the opening stock, profit in absorption costing would be more
than the marginal costing as stock would contain portion of fixed costs in absorption costing. In
second month, the closing stock is more than the opening stock. Profit in absorption costing is K
38,000, while it is only K 31,000 in marginal costing.

3. If opening stock is more than the closing stock, profit in marginal costing would be more than
the profit in absorption costing. Stock in absorption costing always contain fixed costs
component. As opening stock is more than the closing stock, profit would be less in absorption
costing, compared to marginal costing. It may be noted that fixed costs would not be
apportioned in marginal costing. This situation is evident in the third month, with a profit of K
59,000 in marginal costing and K 52,000 in absorption costing.

4. The profit determined under Marginal Costing is a linear function of sales. In other words,
contribution is exactly proportional to sales. 40% is contribution ratio in all the three months.
Changes in production and sales do not have any impact on contribution. See all the four
columns in Marginal Costing.

5. Profit determined under Absorption Costing is influenced by both production and sales.

2.2.4 Limitations of Absorption Costing

The following are the limitations of Absorption Costing:

1. Cost Data not Useful for Control Purpose: Fixed costs are apportioned on an arbitrary
basis. This reduces the practical utility for the purpose of control.

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2. Fixed Costs: Fixed costs are included in the valuation of closing stock and carried forward to
the next year. In other words, though the fixed costs relate to the current year, they are not
charged to the current year. They are carried forward to the next year to the extent they relate to
closing stock. In a similar manner, opening stock contains fixed costs of the previous year and
they were not charged during the previous year. Normally, costs are to be charged in the year in
which they incur. As, that practice is not followed, it is an unsound practice.

3. Presentation of Data: As fixed costs are apportioned to the products, presentation of data is
not useful for decision-making as overheads obscure cost-profit-volume relationship.

4. Opportunities Get Unnoticed: The behavioural pattern of costs is not highlighted. So,
opportunities, otherwise, available may get unnoticed. An export order may not be considered
worthy for acceptance as its unit cost may not cover the total cost. If accepted, the order may
cover variable costs and leave something towards contribution to boost up profits. Marginal
costing provides the opportunity for acceptance, while Absorption costing ignores the same.

2.3 Presentation of Data

The table given below summarises the difference of presenting the data under absorption costing
and marginal costing.

Absorption Costing Marginal Costing

Sales xxx
Less: Manufacturing
costs of goods Sales: xxx
sold including xxx
fixed
manufacturing
OHs
Less: Admin & Selling Less: Variable cost xx
Expenses xxx of manufacturing
Profit XXXX Less: Admin &
Selling Expenses xx
CONTRIBUTION xxxx
Less: Fixed Costs
Manufacturing xx
Administration xx
Selling xx xxxx
Profit XXXX

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Learning Outcome

3.0 Demonstrate the ability to understand the application of standard costing to products
3.1 Understand the objectives of standard costing
3.2 Understand the methods o determining standard costs for the basic elements of cost
3.3 Understand the determination of variances
3.4 Understand the causes of variances

3.0 Introduction
Standard costing is an important subtopic of cost accounting. Standard costs are usually
associated with a manufacturing company's costs of direct material, direct labour, and
manufacturing overhead. Rather than assigning the actual costs of direct material, direct labour,
and manufacturing overhead to a product, many manufacturers assign the expected or standard
cost. This means that a manufacturer's inventories and cost of goods sold will begin with
amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers, of
course, still have to pay the actual costs. As a result there are almost always differences between
the actual costs and the standard costs, and those differences are known as variances.
Standard costing and the related variances is a valuable management tool. If a variance arises,
management becomes aware that manufacturing costs have differed from the standard (planned,
expected) costs.

 If actual costs are greater than standard costs the variance is unfavourable. An
unfavourable variance tells management that if everything else stays constant the
company's actual profit will be less than planned.
 If actual costs are less than standard costs the variance is favourable. A favourable
variance tells management that if everything else stays constant the actual profit will
likely exceed the planned profit.
The sooner that the accounting system reports a variance, the sooner that management can direct
its attention to the difference from the planned amounts. If we assume that a company uses
the perpetual inventory system and that it carries all of its inventory accounts at standard cost
(including Direct Materials Inventory or Stores), then the standard cost of a finished product is
the sum of the standard costs of the inputs:

1. Direct material
2. Direct labour
3. Manufacturing overhead
1. Variable manufacturing overhead
2. Fixed manufacturing overhead
3.1 Definitions

3.1.1 STANDARD

According to Prof. Erie L. Kolder, “Standard is a desired attainable objective, a performance, a

goal, a model”.

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Standard- it’s a norm or bench mark. It is useful for comparison. It may indicate minimum
quality. E.g. Standard of passing.

3.1.2 STANDARD COSTING

Meaning of ‘standard’ and ‘standard cost’: In the ordinary language, the term ‘standard’ means
a yardstick of measurement. The CIMA terminology defines this term as, “a benchmark
measurement of resources usage, set in defined conditions.” Standard cost is a pre-determined
operating cost calculated from management’s standards of efficient operation and the relevant
necessary expenditure.

3.1.3 STANDARD COST

Standard cost is a predetermined estimate of cost to manufacture a single unit or a number of

units during a future period. Standard Cost an estimated or pre-determined cost of performing an
operation or producing a good or service, under normal conditions. It is used as a basis for cost
control through variance analysis. It is chosen to serve as a benchmark in the standard costing/
budgetary control system. It is a budget for the production of one unit of product or service. It is
a pre-determined cost which is calculated from management’s standards of efficient operation
and the relevant necessary expenditure.

The Chartered Institute of Management Accountants, London, defines “Standard Cost” as, “a
pre-determined cost which is calculated from management’s standards of efficient operation and
the relevant necessary expenditure. It may be used as a basis for price fixing and for cost control
through variance analysis”.

STANDARD COSTING

It is defined by I.C.M.A. Terminology as, “The preparation and use of standard costs, their
comparison with actual costs and the analysis of variances to their causes and points of
incidence”. According to the Chartered Institute of Management Accountants, London Standard
Costing is “the preparation and use of Standard Cost, their comparison with actual costs, and the
analysis of variances to their causes and points of incidence”.

The study of standard cost comprises of:

1. Ascertainment and use of standard costs.

2. Comparison of actual costs with standard costs and measuring the variances.
3. Controlling costs by the variance analysis.
4. Reporting to management for taking proper action to maximize the efficiency.
3.2 BUDGETARY CONTROL AND STANDARD COSTING

Both standard costing and budgetary control aim at maximum efficiency and managerial control.
Budgetary control and standard costing have the common objective of controlling business
operations by establishing pre-determined targets, measuring the actual performance and
comparing it with the targets, for the purposes of having better efficiency and of reducing costs.
The two systems are said to be interrelated but they are not inter-dependent. The budgetary
control system can function effectively even without the system of standard costing in operation
but the vice-versa is not possible.

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3.3 STANDARD COSTING AS A CONTROLLING TECHNIQUE

It is essential for management to have knowledge of costs so that decision can be effective.
Management can control costs on information being provided to it. The technique of standard
costing is used for building a proper budgeting and feedback system. The use of standard costing
to management areas follows.

1. Formulation of Price and Production Policies

Standard Costing acts as a valuable guide to management in the fixation of price and
formulation production polices. It also assists management in the field of inventory pricing,
product, product pricing profit planning and also in reporting to higher levels.

2. Comparison and Analysis of Data

Standard Costing provides a stable basis for comparison of actual with standard costs. It brings
out the impact of external factors and internal causes on the cost and performance of the
concern. Thus, it helps to take remedial action.

3. Cost Consciousness

An atmosphere of cost consciousness is created among the staff. Standard costing also provides
incentive to workers for efficient performance.

4. Better Capacity to anticipate

An effective budget can be formulated for the future by once knowing the deviations of actual
costs from standard costs. Data are available at an early stage and the capacity to anticipate
about changing conditions is developed.

5. Better Economy, Efficiency and Productivity

Better Economy, Efficiency and Productivity machines and materials are more effectively
utilized and thus benefits of economies can be reaped in business together with increased
productivity.

6. Delegation of Authority and Responsibility

The net profit is analysed and responsibility can be placed on the person in charge for any
variations from the standards. It discloses adverse variations and particular cost centre can be
held accountable. Thus, delegation of authority can be made by management to control the
affairs in different departments.

7. Management by ‘Exception’

The principle of “management by exception‟ can be applied in the business. This helps the
management in concentrating its attention on cases which are off standard, i.e., below or above
the standard set. A pattern is provided for the elimination of undesirable factors causing damage
to the business.

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3.4 SETTING THE STANDARD

While setting standard cost for operations, process or products, the following preliminaries must
be gone through:

1. Establish Standard Committee comprising Purchase Manager, Personnel Manager, and

Production Manager. The Cost Accountant coordinates the functions.

2. Study the existing costing system, cost records and forms in use.

3. A technical survey of the existing methods of production should be undertaken.

4. Determine the type of standard to be used.

5. Fix standard for each element of cost.

6. Determine standard costs of r each product.

7. Fix the responsibility for setting standards.

8. Account variances properly.

9. Ascertain the deviations by comparing the actual with standards.

10. Take necessary action to ensure that adverse variances are not repeated.

3.4.1 DETERMINATION OF STANDARD COSTS

The following preliminary steps are considered before setting standards:

(a) Establishment of cost centre

(b) Classification and codification of accounts

(c) Establishment of standards

(d) Ascertainment of actual cost

(e) Comparison of actual cost and standard cost

(f) Analysis of Variance

(g) Reporting of variance to management

(a) Establishment of cost centre - For fixing responsibility and defining the lines of authority,
cost centre is necessary. “A cost centre is a location, person or item of equipment (or group of
these) for which costs may be ascertained and used of the purpose of cost control”. With the
help of cost centre, the standards are prepared and the variances are analysed.

(b) Classification and codification of accounts - Accounts are classified according to different
items of expenses under suitable heading. Each heading may be given codes and symbols.
Coding is useful for speedy collection and analysis.

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(c) Establishment of standards – The success of the standard costing system depends upon the
reliability and accuracy of standards. It is the most difficult task also. The different types of
standards are given below:

(i) Basic standard. It is a fixed and unaltered for an indefinite period for forward
planning. According to I.C.M.A London, it is “an underlying standard from which a current
standard can be developed”. From this basic standard, changes in current standard and actual
standard can be measured.

(ii) Current standard. It is a short-term standard, as it is revised at regular intervals.

I.C.M.A. London refers to it as “a standard which is established for use over a short period of
time and is related to current conditions”. This standard is realistic and helpful to business. It is
useful for cost control.

(iii) Normal standard. It is an average standard, and is based on normal conditions

which prevail over a long period of a trade cycle. I.C.M.A defines it as “the average standard
which, it is anticipated, can be attained over a future period of time, preferably long enough to
cover one trade-cycle”. It is used for planning and decision making during the period of trade
cycle to which it is related. It is very difficult to apply in practice.

(iv) Ideal standard. I.C.M.A. defines it as “the standard which can be attained under
the most favourable condition possible”. It is fixed and needs a high degree of efficiency, best
possible conditions of management and performance. Existing conditions and conditions capable
of achievement should be taken into consideration. It is difficult to attain this ideal standard.

(v) Expected standard. It is a practical standard. I.C.M.A defines it as, “the standard
which, it is anticipated, can be attained during a future specified budget period”. For setting this
standard, due weight age is given for all the expected conditions. It is more realistic than the
ideal standard.

(vi) Historical Standard. This standard is set on the basis of costs incurred in the past.

(d) Ascertainment of actual cost- Another step is to ascertain the actual cost incurred.

(e) Comparison of actual cost and actual cost – In this step actual and standard cost are
compared and variances are calculated.

(f) Analysis of Variance – Variance analysis is the process of analysing variances by sub-
dividing the total variances in such a way that management can assign responsibility for poor
performance.

(g)Reporting of variance to the management – As soon as variances are analysed and

investigated, they are reported to management to take appropriate actions where necessary.

3.4.2 REVISION OF STANDARDS

Standard cost may be established for an indefinite period. There are no definite rules for the
selection for a particular period. If the standards are fixed for a short period, it is expensive and
frequent revision of standards will impair the utility and purpose for which standard is set. At the
same, if the standard is set for a longer period, it may not be useful particularly in the days of
high inflation and large fluctuations of rates in case of materials and labour. Standards have to
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be revised from time to time taking into consideration changing circumstances. The
circumstances may change on account of technical innovations, changed market conditions,
increase or decrease in plant capacity, developing new products or giving up unprofitable
production lines. If variations from actual occur in practice, they may be due to controllable or
uncontrollable causes. Standards should be revised only on account of those causes which are
beyond the control of the management. Changes in product design, supply of labour and
material, changes in market conditions for a long period, trade or cyclical variations would
impel the management to revise the standards. The objective, while comparing the actual
performance with the standard performance and revising standards, is to facilitate better control
over costs and improve the overall working and profitability of the organization. Apart from the
above, basic standards are revised in the course of time under the following circumstances,
when:
1. There are permanent changes in the method of production –designs and specifications.

2. Plant capacity is changed

3. There is a large variation between the standard and the actual.

3.5 BUDGETARY CONTROL AND STANDARD COSTING

The systems of budgetary control and standard costing have the common objective of
controlling business operations by establishing pre-determined targets, measuring the actual
performance and comparing it with the targets, for the purposes of having better efficiency and
of reducing costs. The tow systems are said to be interrelated but they are not inter-dependent.
The budgetary control system can function effectively even without the system of standard
costing in operation but the vice-versa is not true. Usually, the two are used in conjunction with
each other to have most fruitful results. The distinction between the two systems is mainly on
account of the field or scope and technique of operation.

3.5.1 Difference between Budgeting and Standard Costing

Budgeting Standard costing

1. Budgetary control is concerned with the 1. Standard Costing is related with the
operation of the business as a whole and control of the expenses and hence it is more
hence its more extensive intensive
2. Budget is a projection of financial 2. Standard cost is the projection of cost
accounts accounts
3. It does not necessarily involve 3. It requires standardization of products.
standardization of products.
4. Budgetary control can be adopted in part 4. It is not possible to operate this system in
also. parts
5. Budgeting can be operated without 5. Standard costing cannot exist without
standard costing. budgeting.
6. Budgets determine the ceilings of expenses 6. Standards are minimum targets which are
above which actual expenditure should not to be attained by actual performance at
normally rise. specific efficiency level.

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3.5.2 Features of Standard Costing

*It is a technique of costing based on the preparation and use of standard costs.

*It makes a comparison of actual cost with standard cost.

* Main purpose is controlling costs by analysing the causes of variances.

*Variances are reported to the management for the purpose of taking remedial actions.

3.6 VARIANCE ANALYSIS

Variance means difference. It involves the measurement of the deviation of actual performance
form the intended performances. It is based on the principle of management by exception. The
attention of management is drawn not only to the variation in monetary gain but also to the
responsibility and causes for the same.

Favourable and Unfavourable variances

Variances may be favourable (positive or credit) or unfavourable (or negative or adverse or

debit) depending upon whether the actual cost is less or more than the standard cost.

Favourable variance: When the actual cost incurred is less than the standard cost, the deviation
is known as favourable variance. The effect of the favourable variance increases the profit. It is
also known as positive or credit variance.

Unfavourable variance: When the actual cost incurred is more than the standard cost, the
variance is known as unfavourable or adverse variance. It refers to deviation to the loss of the
business. It is also known as negative or debit variance.

Controllable and Uncontrollable variance:

Variances may be controllable or uncontrollable, depending upon the controllability of the

factors causing variances.

Controllable variance: It refers to a deviation caused by such factors which could be

influenced by the executive action. For example, excess usage of materials, excess time taken
by a worker, etc. When compared to the standard cost it is controllable as the responsibility can
be fixed on the in-charge.

Uncontrollable variance: When variance is due to the factors beyond the control of the
concerned person (or department), it is uncontrollable. For example, the wage rate increased on
account of strike, government restrictions, change in market price etc. Only revision of standards
is required to remove such in future.

3.6.1 Managerial Uses or Benefits of Variance Analysis

The variance analysis are important tools of cost control and cost reduction and they generate
and atmosphere of cost consciousness in the organization.

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1. Comparison of actual with standard cost which reveals the efficiency or inefficiency of
performance. The inefficiency or unfavourable variance is analysed and immediate actions are
taken.

2. It is a tool of cost control and cost reduction

3. It helps to apply the principle of management by exception.

4. It helps the management to maximize the profits by analysing the variances into controllable
and uncontrollable; the controllable variances are further analysed so as to bring a cost
reduction, indirectly more profit.

5. Future planning and programmes are based on the variance analysis.

6. Within the organization, a cost consciousness is created along with the team spirit.

3.6.2 Computation of variances

The causes of variance are necessary to find remedial measures; and therefore a detailed study of
variance analysis is essential. Variances can be found out with respect to all the elements of cost,
i.e., direct material, direct labour and overheads. The following are the common variances,
which are calculated by the management. Sub-divisions of variances really give detailed
information to the management in order to control the cost.

1. Material variances

2. Labour variances

3. Overhead variances (a) variable (b) fixed

3.6.3 Material variance:

The following are the variances in the case of materials

a) Material Cost Variance (MCV). - It is the difference between the standard cost of
direct materials specified for the output achieved and the actual cost of direct materials
used. The standard cost of materials is computed by multiplying the standard price with
the standard quantity for actual output; and the actual cost is computed by multiplying
the actual price with the actual quantity. The formula is:
MCV = (Standard cost of materials - Actual cost of materials used) (or)
(Standard Quantity for actual output x Standard Price) - (Actual Quantity x Actual
Rate) (or) (SO x SP) - (AQ x AP)

b) Material Price Variance (MPV). - Material price variance is that portion of the direct
materials cost variance which is the difference between the standard prices specified and the
actual price paid for the direct materials used. The formula is:

MPV = Actual Quantity x (Standard Price – Actual rice) (or)

MPV= AQ (SP-AP)

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C) Material Usage (Quantity) Variance (MUV) - It is the deviation caused by the standards
due to the difference in quantity used. It is calculated by multiplying the difference between the
standard quantity specified and the actual quantity used by the standard price.

Thus material usage variance is “that portion of the direct materials cost variance which is the
difference between the standard quantity specified for the production achieved, whether
completed or not, and the actual quantity used, both valued at standard prices”.

MUV or MQV = Standard Rate or Price (Standard Quantity - Actual Quantity) (or)
MUV = SR (SQ-AQ)

d) Material Mix Variance (MMV).- When two or more materials are used in the manufacture
of a product, the difference between the standard composition and the actual composition of
material mix is the material mix variance. The variance arises due to the change in the ratio of
material and the standard ratio. The formula is:

Material Mix Variance = Standard Rate (Standard quantity – Actual quantity)

Standard is revised due to the shortage of a particular type of material.

The formula is:

MMV = Standard Rate (Revised Standard Quantity - Actual Quantity)

Revised Standard Quantity (RSQ) =

Total weight of actual mix / Total weight of standard mix) x Standard Quantity

After finding out this revised standard mix it is multiplied by the revised standard cost of
standard mix and then the standard cost of actual mix is subtracted from the result.

(e) Material Yield Variance - It is that portion of the direct material usage variance which is
due to the difference between the standard yield specified and the actual yield obtained. The
variance arises due to abnormal contingencies like spoilage, chemical reaction etc. Since the
variance is a measure of the waste or loss in the production, it known as material loss or waste
variance.

ICMA, LONDON, it is defined as “ the difference between the standard yield of the actual
material input and the actual yield, both valued at the standard material cost of the produce”. In
case actual yield is more than the standard yield, the material yield variance is favourable and, if
the actual yield is less than the standard yield, the variance is unfavourable or adverse.

(i) When actual mix and standard mix are the same, the formula is:

MYV = Standard Yield Rate (Standard Yield - Actual Yield) or

Standard Revised Rate (Actual Loss - Standard Loss)

Here Standard Yield Rate = Standard cost of standard / Net standard output

Net standard output = Gross output – Standard loss

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(ii) When the actual mix and the standard mix differ from each other, the formula is:

Standard Rate = Standard cost of revised standard mix / Net Standard Output

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

3.6.4 Labour Variances

Labour Variances arise because of (I) Difference in Actual Rates and Standard Rates of Labour
and (Ii) The variation in Actual Time taken y workers and the Standard Time allotted to them for
performing a job. These are computed on the same pattern as that of Material Variances. For
Labour Variances by simply putting the word “Time” in place of “Quantity” in the formula
meant for Material Variances. The various Labour Variances can be analysed as follows:

(A) Labour Cost Variance

(B) Labour Rate Variance

(C) Labour Time or Efficiency Variance

(D) Labour Idle Time Variance

(E) Labour Mix Variance Or Gang Composition Variance

a) Labour Cost Variance (LCV)

This variance represents the difference between the Standard Labour Costs and the Actual
Labour Costs for the production achieved. If the Standard Cost is higher, the variation is
favourable and vice versa. It is calculated as follows:

Labour Cost Variance: = (Standard Cost of Labour - Actual Cost of Labour)

= (Standard Time x Standard Rate) - (Actual Time x Actual Rate)

= (ST x SR) - (AT x AR)

b) Labour Rate Variance (LRV)

It is the difference between the Standard Rate of pay specified and the Actual Rate Paid.
According to ICMA, London, the variance is “the difference between the standard and the actual
direct Labour Rate per hour for the total hours worked. If the standard rate is higher, the
variance is Favourable and vice versa.

Labour Rate Variance = Actual Time (Standard Wage Rate - Actual Wage Rate)

=AT (SR-AR)

C) Labour Time or Labour Efficiency Variance (LEV)

It is the difference between the Standard Hours for the actual production achieved and the hours
actually worked, valued at the Standard Labour Rate. When the workers finish the specific job in

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less than the Standard Time, the variance is Favourable. If the workers take more time than the
allotted time, the variance is Adverse.

Labour Efficiency Variance (LEV): =Standard Rate (Standard Time - Actual Time)
Or =SR (ST-AT)

d) Idle Time Variance: It arises because of the time during which the Labour remains idle due
to abnormal reasons, i.e. power failure, strikes, machine breakdown, shortage of materials, etc. It
is always an adverse variance

Labour Idle Time Variance = Abnormal Idle Time x Standard Hourly Rate

e) Labour Mix Variance or Gang Composition Variance (LMV):

It is the difference between the standard composition of workers and the actual gang of workers.
It is a part of labour efficiency variance. It corresponds to material mix variance. It enables the
management to study the labour cost variance occurred because of the changes in the
composition of labour force. The rates of pay of the different categories of workers-skilled,
semi-skilled and unskilled are different. Hence, any change made in composition of the workers
will naturally cause variance. How much is variance due to the change, is indicated by Labour
Mix Variance.

(i) When the total hours i.e. time of the standard composition and actual composition of workers
does not differ the formula is:

Labour Mix variance= (Standard Cost of Standard Mix) - (Standard cost of Actual Mix)

(ii) When the total hours i.e. time of the standard composition and actual composition of workers
differs, the formula is:

Labour Mix variance

(Total Time of Actual mix / Total Time of Standard mix) x Std cost of Std. mix) - (Std.
cost of Actual Mix)

If, on account of short availability of some category of workers, the standard composition is
itself revised, then Labour Mix Variance will be calculated by taking revised standard mix in
place of standard mix.

Labour Yield Variance (LYV)

It is just like Material Yield Variance. It is the difference between the standard labour output and
actual output of yield. It is calculated as below:

Labour Yield Variance

=Standard cost per unit x {Standard yield - Actual yield}

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 3.6.5 OVERHEAD VARIANCE

Overhead Cost Variance

It is the difference between standard overheads for actual output i.e. Recovered Overheads and
Actual Overheads. It is the total of both fixed and variable overhead variances. The variable
overheads are those costs which tend to vary directly in proportion to changes in the volume of
production. Fixed overheads consist of costs which are not subject to change with the change in
the volume of production. The variances under overheads are analysed in two heads, viz
Variable Overheads and Fixed Overheads:

Overheads Cost Variance= Standard Total Overheads-Actual Total Overheads

The term overhead includes indirect material, indirect labour and indirect expenses and the
variances relate to factory, office or selling and distribution overheads. Overhead variances are
divided into two broad categories: (i) Variable overhead variances and (ii) Fixed overhead
variances. To compute overhead variances, the following terms must be understood:

a) Standard overhead rate per unit = Budgeted overheads / Budgeted output

b) Standard overheads rate per hour = Budgeted overheads / Budgeted hours

c) Standard hours for actual output = Budgeted hours / Budgeted output x Actual output

d) Standard output for actual time = Budgeted output / Budgeted hours x Actual hours

e) Recovered or Absorbed overheads = Standard rate per unit x Actual output

f) Budgeted overheads = Standard rate per unit x budgeted output

g) Standard overheads = Standard rate per unit x Standard output for actual time

h) Actual overheads = Actual rate per unit x Actual output

VARIABLE OVERHEAD VARIANCE

Variable cost varies in proportion to the level of output, while the cost is fixed per unit. As such
the standard cost per unit of these overheads remains the same irrespective of the level of output
attained. As the volume does not affect the variable cost per unit or per hour, the only factors
leading to difference is price. It results due to the change in the expenditure incurred.

(i) Variable Overhead Expenditure Variance:

It is the difference between actual variable overhead expenditure incurred and the standard
variable overheads set in for a particular period. The formula is:-

{Actual Hours Worked x Standard Variable Overhead Rate per hour}-Actual Variable
overheads

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(ii) Variable Overhead Efficiency Variance:

It shows the effect of change in labour efficiency on variable overheads recovery. The formula
is:- Standard Rate (Standard Quantity-Actual Quantity)

Standard Overhead Rate= (Standard Time for Actual output- Actual Time)

(iii) Variable Overhead Variance

It is divided into two: Overhead Expenditure Variance and Overhead Efficiency Variance. The
formula is:-

Variable overhead Expenditure Variance + Variable overhead Efficiency variance

FIXED OVERHEAD VARIANCE (FOV):

Fixed overhead variance depends on (a) fixed expenses incurred and (b) the volume of
production obtained. The volume of production depends upon (i) efficiency (ii) the days for
which the factory runs in a week (calendar variance) (iii) capacity of plant for production.

FOV = Actual Output (Std Fixed Overhead Rate - Actual Fixed Overheads)

(a) Fixed Overhead Expenditure Variance. (Budgeted or cost Variance). It is that portion of
the fixed overhead which is incurred during a particular period due to the difference between the
budgeted fixed overheads and the actual fixed overheads.

Fixed Overhead expenditure variance=Budgeted fixed overhead-Actual fixed overhead

(b) Fixed Overhead Volume Variance. This variance is the difference between the standard
cost of overhead absorbed in actual output and the standard allowance for that output. This
variance measures the cover of under recovery of fixed overheads due to deviation of actual
output form the budgeted output level.

(i) On the basis of units of output:

Fixed Overhead Volume Variance = Standard O.H Rate (Actual Output- Budgeted
Output) OR =Budgeted Cost –Standard Cost) OR

= (Actual Output x Standard Rate)-Budgeted fixed overheads

(ii) On the basis of standard hours:

Fixed Overhead Volume Variance =Standard O.H Rate per hour (Standard Hours of
actual production – Budgeted Hours)

Standard Hour = Actual Output + Standard Output per hour

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Learning Outcome

4.0 Demonstrate understanding on the application of relevant costs for decision making
4.1 Understand the terminology relevant costing
4.2 Understand management decisions involving alternatives

Introduction

Management at all levels within an organisation take decisions. The overriding requirement of
the information that should be supplied by the cost/management accountant to aid decision
making is that of relevance. This chapter therefore begins by looking at the costing technique
required in decision-making situations, that of relevant costing, and explains how to decide
which costs need taking into account when a decision is being made and which costs do not. We
then go on to see how to apply relevant costing to product mix decisions, and make or buy
decisions. Finally, the important area of outsourcing is considered.

Decision Making & Relevant

Costing

Outsourcing

Relevant Costs

Make or Buy
Choice of Product
Decisions
(Product Mix) Decisions

4.1 Definition
Relevant Costing
Relevant costing is a management accounting toolkit that helps managers reach decisions when
they are posed with the following questions:
1. Whether to buy a component from an external vendor or manufacture it in house?
2. Whether to accept a special order?
3. What price to charge on a special order?
4. Whether to discontinue a product line?
5. How to utilize the scarce resource optimally? etc.

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 Relevant costing is an incremental analysis which means that it considers only relevant costs
i.e. costs that differ between alternatives and ignores sunk costs i.e. costs which have been
incurred, which cannot be changed and hence are irrelevant to the scenario.

4.1.1 Relevant costs are future cash flows arising as a direct consequence of a decision.
Decision making should be based on relevant costs.
(a) Relevant costs are future costs. A decision is about the future and it cannot alter what has
been done already. In this context, costs that have been incurred in the past are totally irrelevant
to any decision that is being made 'now'. Such costs are past costs or sunk costs. Costs that have
been incurred include not only costs that have already been paid, but also costs that have been
committed. A committed cost is a future cash flow that will be incurred anyway, regardless of
the decision taken now.
(b) Relevant costs are cash flows. Only cash flow information is required. This means that costs
or charges which do not reflect additional cash spending, such as depreciation and notional
costs, should be ignored for the purpose of decision-making.
(c) Relevant costs are incremental costs. For example, if an employee is expected to have no
other work to do during the next week, but will be paid his basic wage, of say K100 per week,
for attending work and doing nothing, his manager might decide to give him a job which earns
the organisation K40. The net gain is K40 and the K100 is irrelevant to the decision because
although it is a future cash flow, it will be incurred anyway whether the employee is given work
or not.
Example
Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost of
K300, 000 and variable cost of K500 per unit. Its current demand is 600 units which it sells at
K1, 000 per unit. It is approached by Company B for an order of 200 units at K700 per unit.
Should the company accept the order?
Solution
A layman would reject the order because he would think that the order is leading to loss of K100
per unit assuming that the total cost per unit is K800 (fixed cost of K300,000/1,000 and variable
cost of K500 as compared to revenue of K700).
On the other hand, a management accountant will go ahead with the order because in his opinion
the special order will yield K200 per unit. He knows that the fixed cost of K300,000 is irrelevant
because it is going to be incurred regardless of whether the order is accepted or not. Effectively,
the additional cost which Company A would have to incur is the variable cost of K500 per unit.
Hence, the order will yield K200 per unit (K700 minus K500 of variable cost).
Differential Costing
The concept of differential cost is a relevant cost concept in those decision situations which
involve alternative choices. It is the difference in the total costs of two alternatives. This helps in
decision making. It can be determined by subtracting the cost of one alternative from the cost of
another alternative. Differential costing is the change in the total cost which results from the
adoption of an alternative course of action. The alternative may arise on account of sales,
volume, price change in sales mix, etc. decisions. Differential cost analysis leads to more correct
decisions than more marginal costing analysis. In this technique the total costs are considered
and not the cost per unit. Differential costs do not form part of the accounting system while
marginal costing can be adapted to the routine accounting itself. However, when decisions
involve huge amount of money differential cost analysis proves to be useful.

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Special Order Pricing

Special order pricing is a technique used to calculate the lowest price of a product or service at
which a special order may be accepted and below which a special order should be rejected.
Usually a business receives special orders from customers at a price lower than normal. In such
cases, the business will not accept the special order if it can sell all its output at normal price.
However when sales are low or when there is idle production capacity, special orders should be
accepted if the incremental revenue from special order is greater than incremental costs. This
method of pricing special orders, in which price is set below normal price but the sale still
generates some contribution per unit, is called contribution approach to special order pricing.
The idea is that it is better to receive something above variable costs, than receiving nothing at
all.

The following example is used to illustrate special order pricing:

Example
A company is producing, on average, 10,000 units of product A per month despite having 30%
more capacity. Costs per unit of product A are as follows:
Direct Material K8.00
Direct Labor 5.00
Variable Factory Overhead 2.00
Variable Selling Expense 0.50
Fixed Factory Overhead 3.00
Fixed Office Expense 2.00
K20.50
The company received a special order of 2,000 units of product A at K17.00 per unit from a new
customer. Should the company accept the special order, provided that the customer has agreed to
pay the variable selling expenses in addition to the price of the product?
Solution
The increment cost per unit for the special order is calculated as:
Direct Material K8.00
Direct Labor 5.00
Variable Factory Overhead 2.00
K15.00

Since the incremental cost per unit is less that the price offered in the special order, the company
should accept it. Accepting special order will generate additional contribution of K2.00 unit and
K4, 000 in total.

4.2 Management Decisions Involving Following Alternatives

4.2.1 Make-or-Buy Decision

Make-or-Buy decision (also called the outsourcing decision) is a judgment made by

management whether to make a component internally or buy it from the market. While making

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the decision, both qualitative and quantitative factors must be considered. Examples of the
qualitative factors in make-or-buy decision are: control over quality of the component, reliability
of suppliers, and impact of the decision on suppliers and customers, etc.
The quantitative factors are actually the incremental costs resulting from making or buying the
component. For example: incremental production cost per unit, purchase cost per unit,
production capacity available to manufacture the component, etc.
The following example illustrates the numerical part of a simple make-or-buy decision.
Example: The estimated costs of producing 6,000 units of a component are:

Per Unit Total

Direct Material K10 K60,000
Direct Labor 8 48,000
Applied Variable Factory Overhead 9 54,000
Applied Fixed Factory Overhead 12 72,000
K1.5 per direct Labor dollar
K39 K234,000
The same component can be purchased from market at a price of K29 per unit. If the component
is purchased from market, 25% of the fixed factory overhead will be saved.
Should the component be purchased from the market?
Solution
Per Unit Total
Make Buy Make Buy
Purchase Price K29 K174,000
Direct Material K10 K60,000
Direct Labour 8 48,000
Variable Overhead 9 54,000
Relevant Fixed Overhead 3 18,000
Total Relevant Costs K30 K29 K180,000 K174,000
Difference in Favour of Buying K1 K6,000

4.2.2 Sell - or-Process-Further Decision

A decision whether to sell a joint product at split-off point or to process it further and sell it in a
more refined form is called a sell-or-process-further decision. Joint products are two or more
products which have been manufactured from the same inputs and in a same production process
(i.e. a joint process). The point at which joint products leave the joint process is called split-off
point.
Some of the joint products may be in final form ready for sale, while others may be processed
further. In such cases managers have to decide whether to sell the unfinished goods at split-off
point or to process them further. Such decision is known as sell-or-process-further decision and
it must be made so as to maximize the profits of the business.
A sell-or-process-further analysis can be carried out in three different ways:

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  Incremental (or Differential) Approach calculates the difference between the
additional revenues and the additional costs of further processing. If the difference is
positive the product must be processed further, otherwise not.
 Opportunity Cost Approach calculates the difference between net revenue from further
processed product and the opportunity cost of not selling the product at split-off point. If
the difference is positive, further processing will increase profits.
 Total Project Approach (or the comparative statement approach) compares the profit
statements of both options (i.e. selling or further processing) separately for each product.
The option generating higher profit is chosen. The following example illustrates the
approaches to a sell-or-process-further decision:

Example
Product A and B are produced in a joint process. At split-off point, Product A is complete
whereas product B can be process further. The following additional information is available:
Product A B
Quantity in Units 5,000 10,000
Selling Price Per Unit:
At Split-Off K10 K2.5
If Processed Further K5
Costs After Split-Off K20,000
Perform sell-or-process-further analysis for product B.
Solution
Incremental Approach:
Incremental Revenue K25,000
Incremental Costs 20,000
Increase in Profits Due to Further Processing K5,000
Opportunity Cost Approach:
Sales in Case of Further Processing K50,000
Costs:
Additional Costs 20,000
Opportunity Cost of Not Selling at Split-Off 25,000
Gain on Further Processing K5,000
Total Project Approach:
Split-Off Further
Point Processed
Revenue K25,000 K50,000
Costs 0 20,000
Net Revenue K25,000 K30,000
Gain from Further Processing K5,000

4.2.3 Decision to Add or Drop Product Line

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A decision whether or not to continue an old product line or department, or to start a new one is
called an add-or-drop decision. An add-or-drop decision must be based only on relevant
information.
Relevant information includes the revenues and costs which are directly related to a product line
or department. Examples of relevant information are sales revenue, direct costs, variable
overhead and direct fixed overhead. Such decision must not be based on irrelevant information
such as allocated fixed overhead because allocated fixed overhead will not be eliminated if the
product line or department is dropped.
The following example illustrates an add-or-drop decision:
Example
A company has three products: Product A, Product B and Product C. Income statements of the
three product lines for the latest month are given below:
Product Line A B C
Sales K467,000 K314,000 K598,000
Variable Costs 241,000 169,000 321,000
Contribution Margin K226,000 K145,000 K277,000
Direct Fixed Costs 91,000 86,000 112,000
Allocated Fixed Costs 93,000 62,000 120,000
Net Income K42,000 − K3,000 K45,000

Use the incremental approach to determine if Product B should be dropped.

Solution
By dropping Product B, the company will lose the sales revenue from the product line. The
company will also obtain gains in the form of avoided costs. But it can avoid only the variable
costs and direct fixed costs of product B and not the allocated fixed costs. Hence:
If Product B is Dropped
Gains:
Variable Costs Avoided K169,000
Direct Fixed Costs Avoided K86,000 K255,000
Less: Sales Revenue Lost K314,000
Decrease in Net Income of the Company K59,000

4.2.4 Scarce Resource Utilization Decision

Scarce resource utilization (or allocation) decision is a judgment regarding the best use of scarce
resources so as to maximize the total net income of a business. Scarcity of different resources
puts constraints on the amount of product that can be produced using those resources. For
example, a business may have limited number of machine hours to utilize in production. Scarce
resource allocation decision is also called limiting factors decision.
When resources are abundant, products generating relatively higher contribution margin per unit
are preferred because it leads to highest net income. However when resources are scarce, a
decision in this way is unlikely to maximize the profit. Instead the allocation of a scarce resource
to various products must be based on the contribution margin per unit of the scarce resource
from each product.
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A simple scarce resource allocation decision involves the following steps:

1. Calculate the contribution margin per unit of the scarce resource from each product.
2. Rank the products in the order of decreasing contribution margin per unit of scarce
resource.
3. Estimate the number of units of each product which can be sold.
4. Allocate scarce resource first to the product with highest contribution margin per unit
of scarce resource, then to the product with next highest contribution margin per unit
of scarce resource. A scarce resource decision can be better explained using an
example. A company has 4,000 machine hours of plant capacity per month which are
to be allocated to products A and B. The following per unit figures relate to the
products:
Product A B
Sale Price K300 K240
Costs:
Direct Material 100 70
Direct Labour 65 50
Variable Overhead 20 40
Fixed Overhead 15 30
Variable Operating Expenses 40 20
Total Costs K240 K210
Net Income K60 K30
Machine Hours Required 1.5 1.00
Assuming that the company can sell all its output, determine how many machine hours shall be
allocated to each product.
Solution
Product A B
Sale Price K300 K240
− Variable Cost 225 180
CM Per Unit K75 K60
÷ Machine Hours Required 1.50 1.00
CM Per Machine Hour K50 K60
Since the company can sell all its output, the best decision is to allocate all machine hours (i.e.
scarce resource) to product B.

Learning Outcome

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 5.0 Understand and differentiate between Joint and By products
5.1 Understand the different methods joint cost apportionment over joint products
5.2 Understand the different methods joint cost apportionment over by-products
5.3 Understand the accounting treatment required for joint products and by products

Introduction
Agricultural product industries, chemical process industries, sugar industries, and extractive
industries are some of the industries where two or more products of equal or unequal importance
are produced either simultaneously or in the course of processing operation of a main product.

In all such industries, the management is faced with the problems such as, valuation of
inventory, pricing of product and income determination, problem of taking decision in matters of
further processing of by-products and/or joint products after a certain stage etc. In fact the
various problems relate to

(i) apportionment of common costs incurred for various products and

(ii) Aspects other than mere apportionment of costs incurred up to the point of separation.
Before taking up the above problems, we first define the various necessary concepts.

5.1 Definitions

Joint Products - Joint products represent “two or more products separated in the course of
the same processing operation usually requiring further processing, each product being in
such proportion that no single product can be designated as a major product”.
In other words, two or more products of equal importance, produced, simultaneously from
the same process, with each having a significant relative sale value are known as joint
products. For example, in the oil industry, gasoline, fuel oil, lubricants, paraffin, coal tar,
asphalt and kerosene are all produced from crude petroleum. These are known as joint
products.
Co-Products - Joint products and co-products are used synonymously in common parlance,
but strictly speaking a distinction can be made between two. Co-products may be defined
as two or more products which are contemporary but do not emerge necessarily from the
same material in the same process. For instance, wheat and gram produced in two separate
farms with separate processing of cultivation are the co-products. Similarly timber boards
made from different trees are co-products.
By-Products - These are defined as “products recovered from material discarded in a main
process, or from the production of some major products, where the material value is to be
considered at the time of severance from the main product.” Thus by-products emerge as a
result of processing operation of another product or they are produced from the scrap or
waste of materials of a process. In short a by-product is a secondary or subsidiary product
which emanates as a result of manufacture of the main product. The point at which they
are separated from the main product or products is known as split-off point. The
expenses of processing are joint till the split –off point.
Examples of by-products are molasses in the manufacture of sugar, tar, ammonia and benzole
obtained on carbonization of coal and glycerin obtained in the manufacture of soap.
Distinction between Joint-Product and By-Product - The main points of distinction as
apparent from the definitions of Joint Products and By-Products are:

a) Joint products are of equal importance whereas by-products are of small economic
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 value.
b) Joint products are produced simultaneously but the by-products are produced
incident- tally in addition to the main products.

5.2 Apportionment of joint costs

Joint product costs occur in many industries such as petroleum, oil refinery, meat-making,
textiles, dairy, flour mill, saw mill and many other process industries and top management
of business concerns require the accountants to give their opinion for many managerial
decisions such as to process further or to sell at split-off stage. To answer this question they
require apportionment of joint costs over different products produced.
The main problem faced in the case of joint products/by-products is the apportionment of
the total cost incurred up to the point of separation of joint products/or by products. For
costs incurred after the split off point there is no problem, as these costs can be directly
allocated to individual joint products or by-products. Thus the apportionment of joint costs
over different products produced involves the following two cases.
1. When two or more products are simultaneously produced and there is by-product.
2. When there are both joint products and by-products.

5.3 Method of apportioning joint cost over joint products

Proper apportionment of joint cost over the joint products is of considerable importance, as
this affects (a) Valuation of closing inventory; (b) Pricing of products; and (c) Profit or
loss on the sale of different products.
The commonly used methods for apportioning total process costs upto the point of separation
over the joint products are as follows:
(i) Physical unit method
(ii) Average unit cost method
(iii) Survey method
(iv) Contribution margin method
(v) Market value method :
(a) At the point of separation
(b) After further processing
(c) Net realizable value.

(i) Physical unit method: This method is based on the assumption that the joint products
are capable of being measured in the same units. Accordingly joint costs here are
apportioned on the basis of some physical base, such as weight or measure expressed in
gallons, tones etc. In other words, the basis used for apportioning joint cost over the joint
products is the physical volume of material present in the joint products at the point of
separation. Any loss arising during the stage of processing is also apportioned over the
products on the same basis. This method cannot be applied if the physical units of the
two joint products are different. The main defect of this method is that it gives equal
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 importance and value to all the joint products.
(ii) Average unit cost method: Under this method, total process cost (up to the point of
separation) is divided by total units of joint products produced. On division average
cost per unit of production is obtained.
Average unit cost= Total process cost (up to the point of separation) ÷ Total units of
joint product produced.
This is a simple method. The effect of application of this method is that all joint
products will have uniform cost per unit. If this method is used as the basis for price
fixation, then all the products may have more or less the same price. Under this method
customers of high quality items are benefitted as they have to pay fewer prices on their
purchase.
(iii) Survey method: This method is also known as point value method. It is based on
technical survey of all the factors involved in the production and distribution of
products. Under this method joint cost are apportioned over the joint products, on the
basis of percentage/point values, assigned to the products according to their relative
importance. The percentage or points used for the purpose are usually computed by
management with the help of technical advisers. This method is considered to be more
equitable than other methods.
(iv) Contribution margin method: According to this method, joint costs are segregated
into two parts - variable and fixed. The variable costs are apportioned over the joint
products on the basis of units produced (average method) or physical quantities. In case
the products are further processed after the point of separation, then all variable cost
incurred be added to t h e variable costs determined earlier. In this way total variable
cost is arrived which is deducted from their respective sales values to ascertain their
contribution. The fixed costs are then apportioned over the joint products on the basis of
the contribution ratios.
(v) Market value method: This is the most popular and convenient method because it makes
use of a realistic basis for apportioning joint costs. Under this method joint costs are
apportioned after ascertaining “what the traffic can bear”. In other words, the products are
made to bear a proportion of the joint cost on the basis of their ability to absorb the same.
Market value means weighted market value i.e. units produced × price of a unit of joint
product.

(a) Market value at the point of separation: This method is used for the apportionment of
joint costs to joint products up to the split off point. It is difficult to apply this method if the
market value of the products at the point of separation is not available. It is a useful method
where further processing costs are incurred disproportionately.

To determine the apportionment of joint costs over joint products, a factor known as multiplying
factor is determined. This multiplying factor on multiplication with the sales values of each joint

Joint Cost
Multiplying factor: Total Sales Re venue × 100

product gives rise to the proportion of joint cost.

Alternatively - This joint cost may be apportioned in the ratio of sales values of different joint
products.
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 Market value after processing: Here the basis of apportionment of joint cost is the total sales
value of finished products and involves the same principle as discussed in (a) above.

(b) Net realisable value method: From the sales value of the joint products (at finished stage)
are deducted :

(i) estimated profit margins,

(ii) selling and distribution expenses, if any, and

(iii) Post-split off costs.

The resultant figure so obtained is known as net realisable value of joint products. Joint costs are
apportioned in the ratio of net realisable value.

5.3.1 Methods of apportioning joint cost over by-products

The following methods may be adopted for the accounting of by-products and arriving at the
cost of production of the main product:

(a) Market value or value on realisation: The realisation on the disposal of the by- product
may be deducted from the total cost of production so as to arrive at the cost of the main
product. For example, the amount realised by the sale of molasses in a sugar factory goes to
reduce the cost of sugar produced in the factory.

When the by-product requires some additional processing and expenses are incurred in making it
saleable to the best advantage of the concern, the expenses so incurred should be deducted from
the total value realised from the sale of the by-product and only the net realisations should be
deducted from the total cost of production to arrive at the cost of production of the main product.
Separate accounts should be maintained for collecting additional expenses incurred on:

(i) further processing of the by-product, and

(ii) Selling, distribution and administration expenses attributable to the by-product.

(b) Standard cost in technical estimates: By-products may be valued at standard costs. The
standard may be determined by averaging costs recorded in the past and making technical
estimates of the number of units of original raw material going into the main product and
the number forming the by-product or by adopting some other consistent basis. This
method may be adopted where the by-product is not saleable in the condition in which it
emerges or comparative prices of similar products are not available.

(c) Comparative price: Under this method, the value of the by-product is ascertained with
reference to the price of a similar or an alternative material.

Suppose in a large automobile plant a blast furnace not only produces the steel required for the
car bodies but also produces gas which is utilised in the factory. This gas can be valued at the
price which would have been paid to a gas company if the factory were to buy it from outside
sources.

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(d) Re-use basis: In some cases the by-product may be of such a nature that it can be
reprocessed in the same process as part of the input of the process. In that case the value put
on the by-product should be same as that of the materials introduced into the process. If,
however, the by-product can be put into an earlier process only, the value should be the
same as for the materials introduced into the process.

5.4 Treatment of By-Product Cost in Cost-Accounting

By-product cost can be dealt in cost accounting in the following ways:

(a) When they are of small total value: When the by-products are of small total value, the
amount realised from their sale may be dealt in any one the following two ways :

1. The sales value of the by-products may be credited to the Profit and Loss Account
and no credit be given in the Cost Accounts. The credit to the Profit and Loss
Account here is treated either as miscellaneous income or as additional sales revenue.

2. The sale proceeds of the by-product may be treated as deductions from the total costs.
The sale proceeds in fact should be deducted either from the production cost or from
the cost of sales.

(b) When the by-products are of considerable total value: Where by-products are of
considerable total value, they may be regarded as joint products rather than as by-products.
To determine exact cost of by-products the costs incurred up to the point of separation,
should be apportioned over by-products and joint products by using a logical basis. In this
case, the joint costs may be divided over joint products and by-products by using relative
market values; physical output method (at the point of split off) or ultimate selling prices (if
sold).

(c) Where they require further processing: In this case, the net realisable value of the by-
product at the split-off point may be arrived at by subtracting the further processing cost
from the realisable value of by-products.

If total sales value of by-products at split-off point is small, it may be treated as per the
provisions discussed above under (a).

In the contrary case, the amount realised from the sale of by-products will be considerable and
thus it may be treated as discussed under (b).

Learning Outcome

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 6.0 Demonstrate the ability to understand the preparation of different budgets
6.1 Understand the term budget
6.2 Understand the features of budget
6.3 Understand the purpose of budget
6.4 Understand the classification budget
6.5 Understand the problems of budgeting
6.6 Understand the factors affecting budget period
6.7 Understand the term master budgets and its components.

Introduction

Historically, especially in what now is referred to as the non-profit sector, most activities were
managed on a cash basis. Activities and service levels varied based on the presence or absence
of adequate resources. By the late 1800s, public administration had evolved to the point where
revenues were anticipated; this information was then used to develop expenditure plans. Budgets
provided a mechanism for dealing with both known and anticipated financial problems in an
organized manner. Even before adopting full accrual accounting—which measures revenues
when earned (rather than when cash is collected) and expenses when incurred (rather than when
paid)—budgets proved valuable in eliminating the uncertainty that comes with pure cash
accounting. Given that needs always exceeded resources, the relatively recent advent of
planning and budgeting helped institutions set priorities.

To achieve the organizational objectives, an enterprise should be managed effectively and

efficiently. It is facilitated by chalking out the course of action in advance. Planning, the primary
function of management helps to chalk out the course of actions in advance. But planning is to
be followed by continuous comparison of the actual performance with the planned performance,
i. e., controlling. One systematic approach in effective follow up process is budgeting.
Different budgets are prepared by the enterprise for different purposes. Thus, budgeting is an
integral part of management.

6.1 Definition

The term budget is derived from the French word ‘Bougette’ which means a leather bag into
which funds are appropriated to meet the anticipated expenses.

A budget is a map, expressed in financial terms, guiding an institution on a

journey as it carries out its mission. A budget is not a plan; it is a product of the planning
process.

It is a plan expressed in monitory terms covering a future period. In business a budget may be
defined as a statement showing the expected income and expenditure for a definite future period.
According to ICMA London, “Budget is a financial and / or quantitative statement,
prepared and approved prior to a defined period of time, of the policy to be pursued
during that period for the purpose of attaining a given objective.”

6.2 Features of Budget

 It is an estimate or a plan.
 It is a financial statement.
 It is prepared in advance.

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  It relates to a specified future period.
 It is a statement in terms of money or quantity or both.
 Its purpose is to attain a given objective.
6.2.1 Meaning and definition of Budgeting

Budgeting simply means preparing budgets. It is process of preparation, implementation and the
operation of budget. According to J Batty, “the entire process of process of preparing the
budgets is known as budgeting.” In short, budgeting is the act of preparing the budgets. It is a
planning function and their implementation is a control function.

6.2.2 Definition of Budgetary Control

CIMA, London defines budgetary control as, “the establishment of the budgets relating to the
responsibility of executives to the requirements of a policy and the continuous comparison of
actual with budgeted result either to secure by individual action the objectives of that policy or
to provide a firm basis for its revision”

“Budgetary Control is a planning in advance of the various functions of a business so that the
business as a whole is controlled”. (Wheldon)

“Budgetary Control is a system of controlling costs which includes the preparation of budgets,
coordinating the department and establishing responsibilities, comprising actual performance
with the budgeted and acting upon results to achieve maximum profitability”. (Brown and
Howard)

6.2.3 Elements of budgetary control:

1. Establishment of budgets for each function and division of the organization.

2. Regular comparison of the actual performance with the budget to know the variations from
budget and placing the responsibility of executives to achieve the desire result as estimated in
the budget.
3. Taking necessary remedial action to achieve the desired objectives, if there is a variation of
the actual performance from the budgeted performance.
4. Revision of budgets when the circumstances change.
5. Elimination of wastes and increasing the profitability.

Budget, Budgeting and Budgetary Control:

A budget is a blue print of a plan expressed in quantitative terms. Budgeting is a technique for
formulating budgets. Budgetary Control refers to the principles, procedures and practices of
achieving given objectives through budgets.

According to Rowland and William, „Budgets are the individual objectives of a department,
whereas Budgeting may be the act of building budgets. Budgetary control embraces all and in
addition includes the science of planning the budgets to effect an overall management tool for
the business planning and control‟.

6.2.4 Objectives of Budgetary Control

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Budgetary Control assists the management in the allocation of responsibilities and is a useful
device to estimate and plan the future course of action. The general objectives of budgetary
control are as follows:

1. Planning:

(a) A budget is an action plan as it is prepared after a careful study and research.
(b) A budget operates as a mechanism through which objectives and policies are carried out.
(c) It is a communication channel among various levels of management.
(d) It is helpful in selecting a most profitable alternative.
(e) It is a complete formulation of the policy of the concern to be pursued for attaining given
objectives.
2. Co-ordination:

It coordinates various activities of the business to achieve its common objectives. It induces the
executives to think and operate as a group.

3. Control:

Control is necessary to judge that the performance of the organization confirms to the plans of
business. It compares the actual performance with that of the budgeted performance, ascertains
the deviations, if any, and takes corrective action at once.

6.2.5 Installation of Budgetary Control:

There are certain steps necessary to install a good budgetary control system in an organization.
They are as follows:
1. Determination of the Objectives
2. Organization for Budgeting
3. Budget Centre
4. Budget Officer
5. Budget Manual
6. Budget Committee
7. Budget Period
8. Determination of Key Factor

1. Determination of Objectives:
It is very clear that the installation of a budgetary control system presupposes the determination
of objectives sought to be achieved by the organization in clear terms.

2. Organization for Budgeting:

Having determined the objectives clearly, proper organization is essential for the successful
preparation, maintenance and administration of budgets. The responsibility of each executive
must be clearly defined. There should be no uncertainty regarding the jurisdiction of executives.

3. Budget Centre:
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It is that part of the organization for which the budget is prepared. It may be a department or any
other part of the department. It is essential for the appraisal of performance of different
departments so as to make them responsible for their budgets.

4. Budget Officer:

A Budget Officer is a convener of the budget committee. He coordinates the budgets of various
departments. The managers of different departments are made responsible for their department’s
performance.

5. Budget Manual:

It is a document which defines the objectives of budgetary control system. It spells out the duties
and responsibilities of budget officers regarding the preparation and execution of budgets. It also
specifies the relations among various functionaries.

6. Budget Committee:

The heads of all important departments are made members of this committee. It is responsible
for preparation and execution of budgets. The members of this committee may sometimes take
collective decisions, if necessary. In small concerns, the accountant is made responsible for the
same work.

7. Budget Period:

It is the period for which a budget is prepared. It depends upon a number of factors. It may be
different for different concerns/functions. The following are the factors that may be taken into
consideration while determining budget period:

a. The type of budget,

b. The nature of demand for the products,

c. The availability of finance,

d. The economic situation of the cycle and

e. The length of trade cycle

8. Determination of Key Factor:

Generally, the budgets are prepared for all functional areas of the business. They are inter related
and inter dependent. Therefore, a proper coordination is necessary. There may be many factors
that influence the preparation of a budget. For example, plant capacity, demand position,
availability of raw materials, etc. Some factors may have an impact on other budgets also. A
factor which influences all other budgets is known as Key factor. The key factor may not remain
the same. Therefore, the organization must pay due attention on the key factor in the preparation
and execution of budgets.

6.3 Purpose or Uses of Budgets

1. Planning
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 2. Evaluating performance
3. Co-ordinating and control activities
4. Communication and motivation

6.4 Classification of Budgets

Budgets can be classified in many ways. The following are the most important among them:

1. Classification according to time factor

2. Classification according to function
3. Classification according to flexibility factor

6.4.1 Classification according to time factor

a. Long-term Budgets
These budgets are related to planning the operation of a firm for a period of 5 to 10
years. For e.g. Capital expenditure budget, R&D budget etc...
b. Short-term Budgets
These budgets are drawn usually for a period of one or two years. Eg: Cash budget,
material budget etc...
c. Current Budgets
These budgets cover a period of one month or so. These are related to current conditions.
d. Rolling Budget
It is also known as Progressive Budget. Under this method, a budget for a year in
advance is prepared. A new budget is prepared after the end of each month/quarter for a
full year ahead. The figures for the month/quarter which has rolled down are dropped
and the figures for the next month/quarter are added. This practice continues whenever a
month/quarter ends and a new month/quarter begins

6.4.2 Classification according to Function

a. Functional Budget
These are those budgets which are prepared by heads of functional departments for their
respective departments. It is one which relates to the function of a business. Functional
budgets are prepared for each function and are subsidiary to the master budget. Eg: Sales
budget, material budget, production budget, purchases budget, labour budget, cash
budget etc.

 Sales Budget:
The budget which estimates total sales in terms of items, quantity, value, periods, areas,
etc is called Sales Budget.
 Production Budget:
It estimates quantity of production in terms of items, periods, areas, etc. It is prepared on
the basis of Sales Budget.
 Cost of Production Budget:
This budget forecasts the cost of production. Separate budgets may also be prepared for
each element of costs such as direct materials budgets, direct labour budget, factory

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 materials budgets, office overheads budget, selling and distribution overheads budget,
etc.
 Purchase Budget:
This budget forecasts the quantity and value of purchase required for production. It gives
quantity wise, money wise and period wise particulars about the materials to be
purchased.
 Personnel Budget:
The budget that anticipates the quantity of personnel required during a period for
production activity is known as Personnel Budget.
 Research Budget:
The budget relates to the research work to be done for improvement in quality of the
products or research for new products.
 Capital Expenditure Budget:
The budget provides a guidance regarding the amount of capital that may be required for
procurement of capital assets during the budget period.
 Cash Budget:
This budget is a forecast of the cash position by time period for a specific duration of
time. It states the estimated amount of cash receipts and estimation of cash payments and
the likely balance of cash in hand at the end of different periods.

b. Master Budgets
The managers of various departments prepare functional budgets and submit them to the
budget committee. The committee will make necessary adjustments, incorporate all the
functional budgets and prepare a master budget. So, master budget is defined as “the
summary budget incorporating the functional budgets which is finally approved, adopted
and employed.” Thus master budget is overall budget. It is also called operating budget.

6.4.3 Classification according to Flexibility Factor

 Flexible Budget
CIMA define flexible budget as “a budget designed to change in accordance with the
level of activity actually attained.” It shows estimated costs and profits at different levels
of output. Flexible budget is used in the following cases:
 Where sales cannot be accurately predicted because of the nature of the business.
 Where the firm is suffering from shortage of materials, labour, plant capacity
etc...
 Where production during the year changes from period to period, due to seasonal
nature of business.
 Where it is difficult to forecast demand accurately.

Steps in preparing Flexible Budget

1. Identify the relevant range of activity

2. Classify costs according to variability (i.e. variable, fixed and semi variable costs)
3. Determine variable costs
4. Determine fixed costs
5. Determine semi variable costs
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 6. Prepare the budget for selected levels of activity.
 Fixed Budget
This budget which is designed to remain unchanged irrespective of the level of activity
attained. It doesn’t change with change in level of activity. It is prepared for one level of
activity for a definite period of time. This type of budget is most suited for fixed
expenses. It is also called static budget. It is a single budget with no analysis of cost.

Limitations of Fixed Budget

1. It cannot be used for comparing actual cost and budgeted cost.

2. It cannot be used as a tool for effective cost control.
3. It cannot be used for cost ascertainment and price fixation.
4. It does not involve detailed analysis of cost into fixed, variable and semi variable
elements.
5. Generally actual level of activity is different from expected level of activity.
Difference between Fixed Budget and Flexible Budget

Fixed Budget Flexible Budget

1. Based on the assumptions that business 1. Based on the assumptions that business
conditions does not change. conditions will change.
2 Comparisons between actual and budgeted 2 Comparisons between actual and budgeted
costs is not possible. costs is possible.
3 Costs are not classified according to the 3 Costs are classified according to the
variability. variability.
4 Prepared for a single level of activity. 4 prepared for a range of activities.
5 not useful for control, price fixation etc... 5 Useful for cost control, pricing decisions
etc...

6.5 Limitations or Problems associated with Budgeting

Following are the usual problems associated with budgeting:

 Accuracy of estimates
 Adverse reactions from employees
 Amount of work involved in developing a good budget
 Limits flexibility
 An expensive tool and implementation is not automatic

6.6 Factors for determining the budget period

Following are the factors which will decide the budget period:

+ Nature of demand for the product.

+ The length of the production cycle.

+ The functional areas covered by the budget.

+ The time interval necessary for financing production well in advance of actual needs.

+ The accounting period.

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6.7 Master Budget

A master budget is the set of interconnected budgets of sales, production costs, purchases,
incomes etc... And it also includes pro forma financial statements. A master budget is a planning
and control tool to the management since they can plan the business activities during the period
on the basis of master budget. At the end of each period, actual results can be compared with the
master budget and necessary control actions can be taken.

6.7.1 Components

Master budget has two major sections which are the operational budget and the financial budget.
They have following components.

6.7.1.1 Operational Budget

 Sales Budget - The budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget. Sales budget is the first basic component of
master budget and it shows expected number of sales units of a period and the expected
price per unit. It also shows total sales which are simply the product of expected sales
units and expected price per unit.
 Production Budget- It estimates quantity of production in terms of items, periods, areas,
etc. It is prepared on the basis of Sales Budget. The production budget follows from the
sales budget and uses information regarding the type, quantity, and timing of units to be
sold. Sales information is used in conjunction with beginning and ending inventory
information so that managers can schedule necessary production.
 Direct Material Purchases Budget- Direct material is essential to production and must
be purchased each period in sufficient quantities to meet production needs. In addition,
the quantities of direct material purchased must be in conformity with the company’s
desired ending inventory policies. It shows budgeted beginning and ending direct
material inventory, the quantity of direct material that will be used in production, the
amount of direct material that must be purchased and its cost during a specific period.
Direct material purchases budget is a component of master budget and it is based on the
following formula:
Budgeted Direct Material Purchases in Units = Budgeted Beginning Direct material
in units + Direct material in units needed for production – budgeted ending direct
material in units.
Direct material needed for production = Budgeted production during the period x
Units of direct material required per unit.
 Direct Labour Budget - Direct labor budget shows the total direct labor cost and
number of direct labor hours needed for production. It helps the management to plan its
labor force requirements. Direct labor budget is a component of master budget. It is
prepared after the preparation of production budget because the budgeted production in
units figure provided by the production budget serves as starting point in direct labor
budget.

Following are the calculations involved in the direct labor budget:

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 Planned Production in units x Direct Labor Hours Required per Unit= Budgeted
Direct Labor Hours Required x Cost per Direct Labor Hours = Budgeted Direct
Labor Cost
 Overhead Budget - The factory overhead budget shows all the planned manufacturing
costs which are needed to produce the budgeted production level of a period, other than
direct costs which are already covered under direct material budget and direct labor
budget. The overhead budget is an operational budget contained in the master budget of a
business. It has two sections, one for variable overhead costs and other for fixed
overhead costs. Total variable overhead may be calculated as the product of estimated
variable cost per unit (also called variable overhead rate) and the budgeted production
units (obtained from production budget). However most businesses will prefer to prepare
a detailed overhead budget showing individual variable costs such as electricity, fuel,
supplies etc.. The fixed overhead costs are calculated as the sum of individual fixed
overhead costs for example rent, depreciation, etc. which are planned for the period. It is
also useful to calculate the expected cash disbursements for factory overhead costs at the
end of overhead budget.
 Selling and Administrative Expenses Budget - Selling and administrative expense
budget is a schedule of planned operating expenses other than manufacturing costs. It is a
component of master budget and it is prepared by all types of businesses (i.e.
manufacturers, retailers and service providers) before the preparation of budgeted
income statement. Usually it is divided in two sections: the selling expenses and the
administrative expenses. Both selling expenses and administrative expense may be fixed
or variable (see cost behaviour). For example sales commission and freight cost on sales
are variable selling expenses where as sales salaries are fixed selling expenses. Similarly
depreciation and rent on office building are fixed administrative expenses whereas office
supplies and utilities expense are variable administrative expenses. Different variable
selling and administrative expenses vary with different types activities. For example
sales commission vary with number of units sold, entertainment expenses with number
of employees in the organization etc., therefore an accurate selling and administrative
expenses budget can be made by using activity based costing.
 Cost of Goods Manufactured Budget - Cost of goods manufactured budget is an
operational component of master budget. It is prepared to calculate the manufacturing
costs that are expected to be incurred on budgeted finished goods. The cost of goods
manufactured budget is based on direct material purchases budget, direct labor cost
budget and factory overhead budget.
The figures from direct labor budget and overhead budget are directly used in the
preparation of cost of goods manufactured budget but the direct material purchase cost
needs to be adjusted as shown below:
Direct Material Purchases + Direct Material Beginning Inventory − Direct Material
Ending Inventory = Cost of Direct Material Used in Production
The next step is to calculate the budgeted cost of goods manufactured as follows:
Cost of Direct Material used in Production + Direct Labor Cost + Factory
Overhead Cost = Manufacturing Cost + Beginning Work in Process − Ending
Work in Process= Cost of Goods Manufactured
6.7.1.2 Financial Budget

 Schedule of Expected Cash Receipts from Customers - Schedule of expected cash

collections from customers shows the budgeted cash collections on sales during a period.
It is a component of master budget and it is prepared after the preparation of sales budget
and before the preparation of cash budget. The calculation of expected cash collections is
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 based on the total sales figure obtained from sales budget. The management estimates the
proportion in which sales are expected to be collected in the current and following
periods. This is used to determine how much sales are expected to be collected during a
period.
 Schedule of Expected Cash Payments to Suppliers - Schedule of expected cash
payments to suppliers shows the budgeted cash payments on purchases during a period.
The schedule of expected cash payments is a component of master budget and it is
prepared after direct material purchases budget but before cash budget. The expected
cash collections during a period is calculated on the basis of total purchases figure, that is
obtained from direct material purchases budget, and on the percentage / proportion in
which purchases are to be paid for in the current and following periods
 Cash Budget
 Budgeted Income Statement
 Budgeted Balance Sheet

Note that all of the above components need not be included in the master budget. It depends
upon the nature of business.
6.8 Order of components of master budget
As we said earlier, the components of master budget are interconnected, which means that
numbers from one component budget flow to another one. For example sales budget numbers
are used in schedule of cash receipts from customers and unless the sales budget is prepared we
are unable to prepare schedule of receipts from customers because of lack of information. This
means that components of master budget must be prepared in a specific order. We have ordered
the above list in such a way that the necessary information needed by any component budget is
provided by a preceding component.

Flow Chart of Master Budget and Organizational Budgetary Control

SALES BUDGET
(Prepared by Sales / Marketing Dept: Demand Driven)

Finished Goods A Direct Labour Budget

Inventory Level
PRODUCTION BUDGET
Factory O.H Budget
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 Capital Budget
Raw Material B

Inventory Level

PURCHASING BUDGET
For Direct and Indirect Materials
(Prepared by Purchase Dept.)

A B

Non Factory Expense Budget

(Prepared by Administrative & Sales Staff)

A B

Cash Balance Proforma Financial

Receivables Balance Statements
Cash Budget
Payables Balances (Prepared by
Investments Balances (Prepared by Treasurer)
Accounting Dept.)
Stockholders Equity
Balances

Learning Outcome

7.0 Demonstrate ability to understand on the application of capital budgeting for decision making
7.1 Understand the term capital as limited resources
7.2 Understand the terminology capital budgeting
7.3 Understand capital budgeting decisions
7.4 Understand capital budgeting classifications
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 7.5 Understand factors affecting investment decisions
7.6 Understand types of capital budgeting
Introduction

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a financial manager
must be able to decide whether an investment is worth undertaking and be able to choose
intelligently between two or more alternatives. To do this, a sound procedure to evaluate,
compare, and select projects is needed. This procedure is called capital budgeting. Capital
budgeting decisions are of paramount importance in financial decisions, because efficient
allocation of capital resources is one of the most crucial decisions of financial management.
Capital budgeting is budgeting for capital projects. It is significant because it deals with right
kind of evaluation of projects. The exercise involves ascertaining / estimating cash inflows and
outflows, matching the cash inflows with the outflows appropriately and evaluation of
desirability of the project. It is a managerial technique of meeting capital expenditure with the
overall objectives of the firm. Capital budgeting means planning for capital assets. It is a
complex process as it involves decisions relating to the investment of current funds for the
benefit to be achieved in future. The overall objective of capital budgeting is to maximize the
profitability of the firm / the return on investment.

7.1 CAPITAL IS A LIMITED RESOURCE

In the form of either debt or equity, capital is a very limited resource. There is a limit to the
volume of credit that the banking system can create in the economy. Commercial banks and
other lending institutions have limited deposits from which they can lend money to individuals,
corporations, and governments. In addition, the Federal Reserve System requires each bank to
maintain part of its deposits as reserves. Having limited resources to lend, lending institutions
are selective in extending loans to their customers. But even if a bank were to extend unlimited
loans to a company, the management of that company would need to consider the impact that
increasing loans would have on the overall cost of financing.

In reality, any firm has limited borrowing resources that should be allocated among the best
investment alternatives. One might argue that a company can issue an almost unlimited amount
of common stock to raise capital. Increasing the number of shares of company stock, however,
will serve only to distribute the same amount of equity among a greater number of shareholders.
In other words, as the number of shares of a company increases, the company ownership of the
individual stockholder may proportionally decrease. The argument that capital is a limited
resource is true of any form of capital, whether debt or equity (short-term or long-term, common
stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known
firm in an industry or a community can increase its borrowing up to a certain limit. Once this
point has been reached, the firm will either be denied more credit or be charged a higher interest
rate, making borrowing a less desirable way to raise capital. Faced with limited sources of
capital, management should carefully decide whether a particular project is economically
acceptable. In the case of more than one project, management must identify the projects that
will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in
essence, is the basis of capital budgeting.

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7.2 Definition

Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product line
or other projects.
“Capital budgeting is long-term planning for making and financing proposed capital outlay”.
- Charles T. Horngreen
“Capital budgeting involves the planning of expenditure for assets, the returns from which
will be realized in future time periods”. - Milton H. Spencer
7.2.1 Capital Expenditure
A capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the
benefits of which are expected to be received over a number of years in future. The following
are some of the examples of capital expenditure.
1. Cost of acquisition of permanent assets such as land & buildings, plant & machinery,
goodwill etc. 2. Cost of addition, expansion, improvement or alteration in the fixed
assets. 3. Cost of replacement of permanent assets. 4. Research and development project
cost etc. 5. Capital expenditure involves non-flexible long term commitment of funds.
The long-term activities are those activities that influence firms operation beyond the one
year period. The basic features of capital budgeting decisions are:
 There is an investment in long term activities
 Current funds are exchanged for future benefits
 The future benefits will be available to the firm over series of years.
7.2.2 Need for Capital Investment
The factors that give rise to the need for capital investments are:
 Expansion
 Diversification
 Obsolescence
 Wear and tear of old equipment
 Productivity improvement
 Learning – curve effect
 Product improvement
 Replacement and modernization
The firm’s value will increase in investments that are profitable. They add to the shareholders’
wealth. The investment will add to the shareholders’ wealth if it yields benefits, in excess of the
minimum benefits as per the opportunity cost of capital. It is clear from the above discussion
what capital investment proposals involve
a) Longer gestation period b) Substantial capital outlay c) Technological considerations d)
Irreversible decisions e) Environmental issues
7.2.3 Capital Budgeting – Significance
1. Capital budgeting involves capital rationing. This is the available funds that have to be
allocated to competing projects in order of project potential. Normally the individuality of
project poses the problem of capital rationing due to the fact that required funds and available
funds may not be the same.
2. Capital budget becomes a control device when it is employed to control expenditure. Because
manned outlays are limits to actual expenditure, the concern has to investigate the variation in
order to keep expenditure under control.
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3. A firm contemplating a major capital expenditure programme may need to arrange funds
many years in advance to be sure of having the funds when required.
4. Capital budgeting provides useful tool with the help of which the management can reach
prudent investment decision.
5. Capital budgeting is significant because it deals with right mind of evaluation of projects. A
good project must not be rejected and a bad project must not be selected. Capital projects need
to be thoroughly evaluated as to costs and benefits.
6. Capital projects involve investment in physical assets such as land, building plant, machinery
etc. for manufacturing a product as against financial investments which involve investment in
financial assets like shares, bonds or mutual funds. The benefits from the projects last for few to
many years.
7. Capital projects involve huge outlay and last for years.
8. Capital budgeting thus involves the making of decisions to earmark funds for investment in
long term assets yielding considerable benefits in future, based on a careful evaluation of the
prospective profitability / utility of such proposed new investment.
7.2.4 Capital Budgeting Process
The important steps involved in the capital budgeting process are (1) Project generation, (2)
Project evaluation, (3) project selection and (4) project execution.
1. Project Generation. Investment proposals of various types may originate at different levels
within a firm. Investment proposals may be either proposals to add new product to the product
line or proposals to expand capacity in existing product lines. Secondly, proposals designed to
reduce costs in the output of existing products without changing the scale of operations. The
investment proposals of any type can originate at any level. In a dynamic and progressive firm
there is a continuous flow of profitable investment proposals.
2. Project evaluation. Project evaluation involves two steps: i) estimation of benefits and costs
and ii) selection of an appropriate criterion to judge the desirability of the projects. The
evaluation of projects should be done by an impartial group. The criterion selected must be
consistent with the firm’s objective of maximizing its market value.
3. Project Selection. There is no uniform selection procedure for investment proposals. Since
capital budgeting decisions are of crucial importance, the final approval of the projects should
rest on top management.
4. Project Execution. After the final selection of investment proposals, funds are earmarked
for capital expenditures. Funds for the purpose of project execution should be spent in
accordance with appropriations made in the capital budget.
7.3 Factors Influencing Investment Decisions
The main factors which, influence capital investment are:
1. Technological change
In modem times, one often finds fast obsolescence of technology. New technology, which is
relatively more efficient, takes the place of old technology; the latter getting downgraded to
some less important applications. However, in taking a decision of this type, the management
has to consider the cost of new equipment vis-a-vis the productive efficiencies of the new as
well as the old equipments. However, while evaluating the cost of new equipment, the
management should not take into, account its full accounting cost (as the equipment lasts for
years) but its incremental cost. Also, the cost of new equipment is often partly offset by the
salvage value of the replaced equipment.

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2. Competitors ‘strategy
Many a time an investment is taken to maintain the competitive strength of the firm; If the
competitors are installing new equipment to expand output or to improve quality of their
products, the firm under consideration will have no alternative but to follow suit, else it will
perish. It is, therefore, often found that the competitors’ strategy regarding capital investment
plays a very significant role in forcing capital decisions on a firm.
3. Demand forecast
The long-run forecast of demand is one of the determinants of investment decision. If it is found
that there is a market potential for the product in the long run, the dynamic firm will have to take
decisions for capital expansion.
4. Type of management
Whether capital investment would be encouraged or not depends, to a large extent, on the
viewpoint of the management. If the management is modern and progressive in its outlook, the
innovations will be encouraged, whereas a conservative management discourages innovation
and fresh investments.
5. Fiscal policy
Various tax policies of the government (like tax concessions on investment income, rebate on
new investment, and method of allowing depreciation deduction allowance) also have
favourable or unfavourable influence on capital investment.
6. Cash flows
Every firm makes a cash flow budget. Its analysis influences capital investment decisions. With
its help the firm plans the funds for acquiring the capital asset. The budget also shows the timing
of availability of cash flows for alternative investment proposals, thereby helping the
management in selecting the desired project.
7. Return expected from the investment
In most of the cases, investment decisions are made in anticipation of increased return in future.
While evaluating investment proposals, it is therefore essential for the firm to estimate future
returns or benefits accruing from the investment.

7.4 Kinds of Capital Budgeting Decisions

The overall objective of capital budgeting is to maximise the profitability of a firm or the return
on investment. This objective can be achieved either by increasing the revenues or by reducing
costs. Thus, capital budgeting decisions can be broadly classified into two categories:
(a) Those which increase revenue, and
(b) Those which reduce costs
The first category of capital budgeting decisions is expected to increase revenue of the firm
through expansion of the production capacity or size of operations by adding a new product line.
The second category increases the earnings of the firm by reducing costs and includes decisions
relating to replacement of obsolete, outmoded or worn out assets. In such cases, a firm has to
decide whether to continue with the same asset or replace it. Such a decision is taken by the firm
by evaluating the benefit from replacement of the asset in the form of reduction in operating
costs and the cost/cash outlay needed for replacement of the asset. Both categories of above
decisions involve investment in fixed assets but the basic difference between the two decisions

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lies in the fact that increasing revenue investment decisions are subject to more uncertainty as
compared to cost reducing investment decisions.
Further, in view of the investment proposals under consideration, capital budgeting decisions
may also be classified as.
(i) Accept / Reject Decisions
(ii) Mutually Exclusive Project Decisions
(iii) Capital Rationing Decisions.
(i) Accept / Reject Decisions - Accept / reject decisions relate to independent project
which do not compete with one another. Such decisions are generally taken on the
basis of minimum return on investment. All those proposals which yield a rate of
return higher than the minimum required rate of return or the cost of capital are
accepted and the rest are rejected. If the proposal is accepted the firm makes
investment in it, and if it is rejected the firm does not invest in the same.
(ii) Mutually Exclusive project Decisions
Such decisions relate to proposals which compete with one another in such a way that
acceptance of one automatically excludes the acceptance of the other. Thus, one of the proposals
is selected at the cost of the other. For example, a company may have the option of buying a new
machine, or a second hand machine, or taking an old machine on hire or selecting a machine out
of more than one brand available in the market. In such a case, the company may select one best
alternative out of the various options by adopting some suitable technique or method of capital
budgeting. Once one alternative is selected the others are automatically rejected.
iii) Capital Rationing Decisions
A firm may have several profitable investment proposals but only limited funds to invest. In
such a case, these various investments compete for limited funds and, thus, the firm has to
ration them. The firm effects the combination of proposals that will yield the greatest
profitability by ranking them in descending order of their profitability.
7.5 Evaluation of Capital Projects
Capital budgeting is a managerial technique of planning capital expenditure in consonance with
the overall objectives of the firm. Capital budgeting is a double-edged tool that analyses
investment opportunities and cost of capital simultaneously while evaluating worthwhile of a
project. A wide range of criteria has been suggested to judge the worthwhile of investment
projects. Capital projects need to be thoroughly evaluated as to costs and benefits. The costs of
capital projects include the initial investment at the inception of the project. Initial investment
made in land, building, plant and machinery, equipment, furniture, fixtures etc. generally gives
the installed capacity.
7.5.1 Investment Evaluation Criteria
The capital budgeting process begins with assembling of investment proposals of different
departments of a firm. The departmental head will have innumerable alternative projects
available to meet his requirements. He has to select the best alternative from among the
conflicting proposals. This selection is made after estimating return on the projects and
comparing the same with the cost of capital. Investment proposal which gives the highest net
marginal return will be chosen.
Following are the steps involved in the evaluation of an investment:
1) Estimation of cash flows
2) Estimation of the required rate of return

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3) Application of a decision rule for making the choice
7.5.2 Features required by Investment Evaluation Criteria
A sound appraisal technique should be used to measure the economic worth of an investment
project. Porter field, J.T.S. in his book, Investment Decisions and Capital Costs, has outlined
some of the features that must be had by sound investment evaluation criteria.
 It should consider all cash flows to determine the true profitability of the project.
 It should provide for an objective and unambiguous way of separating good projects
from bad projects.
 It should help ranking of projects according to their true profitability.
 It should recognise the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects that project which
maximizes the shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable investment project
independent of others.
7.5.3 Techniques of Investment Appraisal
1. Discounted Cash Flow (DCF) Criteria
a. Net present value (NPV)
b. Internal rate of return (IRR)
c. Profitability index (PI)
2. Non-discounted Cash Flow Criteria
a. Pay-back period
b. Discounted payback period
c. Accounting rate of return (ARR).
Non-discounted Cash Flow Criteria
a. Payback period Method
This method is popularly known as pay off, pay-out, recoupment period method also. It gives
the number of years in which the total investment in a particular capital expenditure pays back
itself. This method is based on the principle that every capital expenditure pays itself back over a
number of years. It means that it generates income within a certain period. When the total
earnings (or net cash-inflow] from investment equals the total outlay, that period is the payback
period of the capital investment. An investment project is adopted so long as it pays for itself
within a specified period of time — says 5 years or less. This standard of recoupment period is
settled by the management taking into account a number of considerations. While there is a
comparison between two or more projects, the lesser the number of payback years, the project
will be acceptable.
The formula for the payback period calculation is simple. First of all, net-cash-inflow is
determined. Then we divide the initial cost (or any value we wish to recover) by the annual
cash-inflows and the resulting quotient is the payback period. As per formula:
Payback period = Original Investment / Annual Cash-inflows
If the annual cash-inflows are uneven, then the calculation of payback period takes a cumulative
form. We accumulate the annual cash-inflows till the recovery of investment and as soon as this
amount is recovered, it is the expected number of payback period years. An asset or capital
expenditure outlay that pays back itself early comparatively is to be preferred.
Payback Method – Merits
The payback period method for choosing among alternative projects is very popular among
corporate managers and according to Quirin even among Soviet planners who call it as the
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recoupment period method. In U.S.A and U.K. this method is widely accepted to discuss the
profitability of foreign investment. Following are some of the advantages of pay back method:
1. It is easy to understand, compute and communicate to others. Its quick computation makes it a
favourite among executive who prefer snap answers.
2. It gives importance to the speedy recovery of investment in capital assets. So it is useful
technique in industries where technical developments are in full swing necessitating the
replacements at an early date.
3. It is an adequate measure for firms with very profitable internal investment opportunities,
whose sources of funds are limited by internal low availability and external high costs.
4. It is useful for approximating the value of risky investments whose rate of capital wastage
(economic depreciation and obsolescence rate) is hard to predict. Since the payback period
method weights only return heavily and ignores distant returns it contains a built-in hedge
against the possibility of limited economic life.
5. When the payback period is set at a large “number of years and incomes streams are uniform
each year, the payback criterion is a good approximation to the reciprocal of the internal rate of
discount.
Payback Method – Demerits
This method has its own limitations and disadvantages despite its simplicity and rapidity. Here
are a number of demerits and disadvantages claimed by its opponents:
1. It treats each asset individually in isolation with the other assets, while assets in practice
cannot be treated in isolation.
2. The method is delicate and rigid. A slight change in the division of labour and cost of
maintenance will affect the earnings and such may also affect the payback period.
3. It overplays the importance of liquidity as a goal of the capital expenditure decisions. While
no firm can ignore its liquidity requirements but there are more direct and less costly means of
safeguarding liquidity levels. The overlooking of profitability and over stressing the liquidity of
funds can in no way be justified.
4. It ignores capital wastage and economic life by restricting consideration to the projects’ gross
earnings.
5. It ignores the earning beyond the payback period while in many cases these earnings are
substantial. This is true particularly in respect of research and welfare projects.
6. It overlooks the cost of capital which is the main basis of sound investment decisions.
In perspective, the universality of the payback criterion as a reliable index of profitability is
questionable. It violates the first principle of rational investor behaviour-namely that large
returns are preferred to smaller ones. However, it can be applied in assessing the profitability of
short and medium term capital expenditure projects.
b. Accounting Rate of Return Method
It is also known as Accounting Rate of Return Method / Financial Statement Method/
Unadjusted Rate of Return Method also. According to this method, capital projects are ranked in
order of earnings. Projects which yield the highest earnings are selected and others are ruled out.
The return on investment method can be expressed in several ways a follows:
(i) Average Rate of Return Method

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 Under this method we calculate the average annual profit and then we divide it by the total
outlay of capital project. Thus, this method establishes the ratio between the average annual
profits and total outlay of the projects.
As per formula,
Rate of Return = (Average Annual Profits / Outlay of the Project) x 100
Thus, the average rate of return method considers whole earnings over the entire economic life
of an asset. Higher the percentage of return, the project will be acceptable.
(ii) Earnings per unit of Money Invested
As per this method, we find out the total net earnings and then divide it by the total investment.
This gives us the average rate of return per unit of amount (i.e. per rupee) invested in the project.
As per formula:
Earnings per unit of investment = - Total Earnings / Total Outlay of the Project
The higher the earnings per unit, the project deserves to be selected.
(iii) Return on Average Amount of Investment Method
Under this method the percentage return on average amount of investment is calculated. To
calculate the average investment the outlay of the projects is divided by two.
Accounting Rate of Return Method – Merits
This approach has the following merits of its own:
1. Like payback method it is also simple and easy to understand.
2. It takes into consideration the total earnings from the project during its entire economic life.
3. This approach gives due weight to the profitability of the project.
4. In investment with extremely long lives, the simple rate of return will be fairly close to the
true rate of return. It is often used by financial analysis to measure current performance of a
firm.

Accounting Rate of Return Method – Demerits

1. One apparent disadvantage of this approach is that its results by different methods are
inconsistent. 2. It is simply an averaging technique which does not take into account the
various impacts of external factors on over-all profits of the firm.
3. This method also ignores the time factor which is very crucial in business decision.
4. This method does not determine the fair rate of return on investments. It is left to the
discretion of the management.
Discounted Cash flows Techniques
Another method of computing expected rates of return is the present value method. The method
is popularly known as Discounted Cash flow Method also. This method involves calculating the
present value of the cash benefits discounted at a rate equal to the firm’s cost of capital. In other
words, the “present value of an investment is the maximum amount a firm could pay for the
opportunity of making the investment without being financially worse off.” The financial
executive compares the present values with the cost of the proposal. If the present value is
greater than the net investment, the proposal should be accepted. Conversely, if the present value
is smaller than the net investment, the return is less than the cost of financing. Making the
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investment in this case will cause a financial loss to the firm. There are four methods to
judge the profitability of different proposals on the basis of this technique
a. Net Present Value Method
This method is also known as Excess Present Value or Net Gain Method. To implement this
approach, we simply find the present value of the expected net cash inflows of an investment
discounted at the cost of capital and subtract from it the initial cost outlay of the project. If the
net present value is positive, the project should be accepted: if negative, it should be rejected.
NPV = Total Present value of cash inflows – Net Investment
If the two projects are mutually exclusive the one with higher net present value should be
chosen.
(ii) Internal Rate of Return Method
This method is popularly known as time adjusted rate of return method/discounted rate of return
method also. The internal rate of return is defined as the interest rate that equates the present
value of expected future receipts to the cost of the investment outlay. This internal rate of return
is found by trial and error. First we compute the present value of the cash-flows from an
investment, using an arbitrarily elected interest rate. Then we compare the present value so
obtained with the investment cost. If the present value is higher than the cost figure, we try a
higher rate of interest and go through the procedure again. Conversely, if the present value is
lower than the cost, lower the interest rate and repeat the process. The interest rate that brings
about this equality is defined as the internal rate of return. This rate of return is compared to the
cost of capital and the project having higher difference, if they are mutually exclusive, is
adopted and other one is rejected. As the determination of internal rate of return involves a
number of attempts to make the present value of earnings equal to the investment, this approach
is also called the Trial and Error Method.
(iii) Profitability Index Method
One major disadvantage of the present value method is that it is not easy to rank projects on the
basis of net present value particularly when the cost of projects differs significantly. To compare
such projects the present value profitability index is prepared.
The index establishes relationship between cash-inflows and the amount of investment as per
formula given below:
PV Index = (NPV / Investment) x 100 or (GPV / Investment) x 100

(iv)Terminal Value Method

This approach separates the timing of the cash-inflows and outflows more distinctly. Behind this
approach is the assumption that each cash-inflow is re-invested in other assets at the certain rate
of return from the moment, it is received until the termination of the project. Then the present
value of the total compounded sum is calculated and it is compared with the initial cash-outflow.
The decision rule is that if the present value of the sum total of the compounded re-invested cash
inflows is greater than the present value of cash-outflows, the proposed project is accepted
otherwise not. The firm would be different if both the values are equal.
This method has a number of advantages. It incorporates the advantage of re-investment of cash-
inflows by compounding and then discounting it. Further, it is best suited to cash budgeting
requirements. The major practical problem of this method lies in projecting the future rates of
interest at which the intermediate cash inflows received will be re-invested.

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Discounted Cash flow Techniques – Merits
1. This method takes into account the entire economic life of an investment and income there
from. It gives the rate of return offered by a new project.
2. It gives due weight to time factor of financing. In the words of Charles Horngreen “Because
the discounted cash-flow method explicitly and routinely weights the time value of money, it is
the best method to use for long-range decisions.
3. It permits direct comparison of the projected returns on investments with the cost of
borrowing money which is not possible in other methods.
4. It makes allowance for differences in the time at which investment generate their income.
5. This approach by recognising the time factor makes sufficient provision for uncertainty and
risk. It offers a good measure of relative profitability of capital expenditure by reducing the
earnings to the present values.
Discounted Cash flow Techniques – Demerits
This method is criticized on the following grounds:
1. It involves a good amount of calculations. Hence it is difficult and complicated one. But this
criticism has no force.
2. It is very difficult to forecast the economic life of any investment exactly.
3. The selection of cash-inflow is based on sales forecasts which are in itself an indeterminable
element.
4. The selection of an appropriate rate of interest is also difficult.

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