Monday, June 20, 2011

Marginal costing


Marginal costing: The technique of Marginal Costing is a definite improvement over the technique of Absorption Costing. According to this technique, only the variable costs are considered in calculating the cost of the product, while fixed costs are charged against the revenue of the period. The revenue arising from the excess of sales over variable costs is technically known as Contribution under Marginal Costing.
The following example will help you in understanding the technique.

Example (i) :   From the following data, Let us prepare a statement of cost and profit according to Marginal Costing Technique.

Statement of Cost and Profit
(According to Marginal Costing Technique)


Product A
Product B
Product C

Per Unit
Total
Per unit
Total
Per unit
Total

Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
Direct Material
3
3,000
4
4,000
5
5,000
Direct Labour
2
2,000
3
3,000
4
4,000
Variable overheads
1
1,000
1
1,000
1
1,000
Total marginal cost
6
6,000
8
8,000
10
10,000
Contribution
4
4,000
7
7,000
10
10,000
Selling price
10
10,000
15
15,000
20
20,000

Thus, the total contribution from the three products A, B and C is Rs. 21,000. The profit will now be computed as follows:

Total Contribution:                                                               Rs. 21,000
Fixed costs:                                                                          Rs.   9,000
                                                                                                --------------
Profit                                                                                       Rs. 12,000
                                                                                                ---------------
Example (ii): Let us prepare the statement profit or loss account for the following data by using Marginal costing technique.

Profit loss account for first year
               

Rs.

Rs.
Direct Material
A
B
C

Direct Labour
A
B
C

Variable
Fixed overheads

3,000
4,000
5,000      12,000


2,000
3,000
4,000       9,000
-----------------------------
                3,000
                9,000
Sales
Closing stock
Loss
--
24,000
9,000

               33,000

33,000

Profit loss account for second year

                                                                Rs.                                                          Rs.

                Opening stock                      24,000                   Sales
                Fixed overheads                    9,000                    A                              10,000
                                                                                                B                             15,000
                Profit                                       12,000                   C                             20,000                   45,000
                                                                ---------                                                    --------                     ---------
                                                                45,000                                                                                   45,000
The above statement shows that the company suffers a loss of Rs. 9,000 in the first year because of non-recovery of fixed overheads, while in the second year it makes a profit of Rs. 12,000. It may be seen from the two years ` Profit and Loss Accounts that the fixed cost of one year has not been carried forward to the next year, Thus, the profit and Loss Account gives a correct picture. 

Budgetary control system


Budgetary control system: No system of planning can be successful without having an effective and efficient system of control. Budgeting is closely connected with control. The exercise of control in the organisation with the help of budgets is known as budgetary control. The process of budgetary control includes
(i) Preparation of various budgets
(ii) Continuous comparison of actual performance with budgetary performance and
                                (iii) Revision of budgets in the light of changed circumstances.

A system of budgetary control should not become rigid. There should be enough scope for flexibility to provide for individual initiative and drive. Budgetary control is an important device for making the organisation more efficient on all fronts. It is an important tool for controlling costs and achieving the overall objectives.

Installing A Budgetary Control System: Having understood the meaning and significance of budgetary control in an organisation, it will be useful for you to know how a budgetary control system can be installed in the organisation. This requires first of all, finding answers to the following questions in the context of an organisation:

What is likely to happen?
What can be made to happen?
What are the objectives to be achieved?
What are the constraints and to what extent their effects can be minimised?

Having found answers to the above questions, the following steps may be taken for installing an effective system of budgetary control in an organisation.

Organisation for Budgeting: The setting up of a definite plan of organisation is the first step towards installing budgetary control system in an organisation. A, Budget Manual should be prepared giving details of the powers, duties, responsibilities and areas of operation of each executive in the organisation.

Responsibility for Budgeting: The responsibility for preparation and implementation of the budgets may be fixed as under:

Budget Controller: Although the Chief Executive is finally responsible for the budget programme, it is better if a large part of the supervisory responsibility is delegated to an official designated as Budget Controller or Budget Director. Such a person should have knowledge of the technical details of the business and should report directly to the President of the Chief Executive of the organisation.

Budget Committee: The Budget Controller is assisted in his work by the Budget Committee. The Committee may consist of Heads of various departments, viz., Production, Sales Finance, Personnel, Purchase, etc. with the Budget Controller as its Chairman. It is generally the responsibility of the Budget Committee to submit, discuss and finally approve the budget figures. Each head of the department should have his own Sub-committee with executives working under him as its members.

Fixation of the Budget Period: `Budget period' means the period for which a budget is prepared and employed. the budget period depends upon the nature of the business and the control techniques. For example, a seasonal industry will budget for each season, while an industry requiring long periods to complete work will budget for four, five or even larger number of years. However, it is necessary for control purposes to prepare budgets both for long as well as short periods.

Budget Procedures: Having established the budget organisation and fixed the budget period, the actual work or budgetary control can be taken upon the following pattern:

Key Factor: It is also termed as limiting factor. The extent of influence of this factor must first be assessed in order to ensure that the budget targets are met. It would be desirable to prepare first the budget relating to this particular factor, and then prepare the other budgets. We are giving below an illustrative list of key factors in certain industries. 69 Budgeting and Budgetary Control

Industry
Key factor
Motor Car
Sales demand
Aluminium
Power
Petroleum Refinery
Supply of crude oil
Electro-optics
Skilled technicians
Hydra power generation
Monsoon

The key factors should be correctly identified and examined. The key factors need not be of a permanent nature. In the long run, the management may overcome the key factors by introducing new products, by changing material mix or by working overtime or extra shifts etc.

Making a Forecast: A forecast is an estimate of the future financial conditions or operating results. Any estimation is based on consideration of probabilities. An estimate differs from a budget in that the latter embodies an operating plan of an organisation. A budget envisages a commitment to certain objectives or targets, which the management seeks to attain on the basis of the forecasts prepared. A forecast on the other hand is an estimate based on probabilities of an event. A forecast may be prepared in financial or physical terms for sales, production cost, or other resources required for business. Instead of just one forecast a number of alternative forecasts may be considered with a view to obtaining the most realistic, overall plan.

Preparing Budgets: After the forecasts have been finalised the preparation of budgets follows. The budget activity starts with the preparation of the sales budget. Then production budget is prepared on the basis of sales budget and the production capacity avail-able. Financial budget (i.e. cash or working capital budget) will be prepared on the basis of sales forecast and production budget. All these budgets are combined and coordinated into a master budget. The budgets may be revised in the course of the financial period if it becomes necessary to do so, in view of the unexpected developments, which have already taken place or are likely to take place. Choice between Fixed and Flexible Budgets: A budget may be fixed or flexible. A fixed budget is based on a fixed volume of activity. It may lose its effectiveness in planning and controlling if the actual capacity utilisation is different from what was planned for any particular unit or time e.g. a month or a quarter, The flexible budget is more useful for changing levels of activity as it considers fixed and variable costs separately. Fixed costs, as you are aware, remain unchanged over a certain range of output. Such costs change when there is a change in capacity level. The variable costs change in direct pro-portion to output. If  flexible budgeting approach is adopted, the budget controller can analyse the variance between actual costs and budgeted costs depending upon the actual level of activity attained during a period of time. This will be explained in detail a little later.

Performance budgeting:


Performance budgeting: Budget in the ordinary sense of the term, denotes the facts related to the planned income and expenditure prepared for a specific future date. It is prepared in the form of a statement expressed either in monetary terms or only in numbers, or both. Performance budgeting involves evaluation of the performance of the organisation in the context of both specific, as well as, overall objectives of the organisation. It presupposes a crystal clear perception of organisational objectives in general, and short-term business objectives as stipulated in the budget, in particular by each employee of the organisation, irrespective of his level. It thus, provides a definite direction to each employee and also a control mechanism to higher management.

As per ICMA, “ The budget is a financial and or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursed to be during that period for the purpose of attaining a given objective.

As per the National Institute of Bank Management, Bombay the performance budget technique is “The processes of analysis, identifying, simplifying and crystallising specific performance objective of a job to be achieved over a period, within the framework of organisational objectives, the purposes and objectives of job. The technique is characterised by its specific direction towards the business objectives of the organisation.”

The Main objectives of PB are: (i) to coordinate the physical and financial aspects; (ii) to improve the budget formulation, review and decision-making at all levels of management (iii) to facilitate better appreciation and review by controlling authorities (legislature, Board of Trustees or Governors, etc) as the presentation is more purposeful and intelligible; (iv) to make more effective performance audit possible; and (v) to measure progress towards long-term objectives which are envisaged in a development plan. In performance budgeting (PB), precise detainment of job to be performed or services to be rendered is done. Secondly, the budget is prepared in terms of functional categories and their sub-division into programmes, activities, and projects. Thirdly, the budget becomes a comprehensive document. Since the financial and physical results are interwoven, it facilitates management control. Performance budgeting (or programme budgeting) has been designed to correct the shortcomings of traditional budgeting by emphasizing management's considerations/ approaches. Both the financial and physical aspects are incorporated into the budget. A performance budget presents the operations of an organisation in terms of functions, programmes, activities, and projects. The traditional (also known as line-item or object-account) budget in government enumerates estimated expenditures by type (and quantity) for a specified period of time, usually one year. The expenditure is classified by object; the personnel are listed by type of position; the budget is divided into sections according to organisational units, department sections; and the types of expenditure are listed by category. The necessity for linking the expenditures (or inputs in financial terms) to outputs (in physical terms), facilitating the evaluation of outcomes (or result of activities) cannot be overemphasized. Performance budgeting requires preparation of periodic performance reports. Such reports compare budget and actual data, and show variances. Their preparation is greatly facilitated if the authority and responsibility for the incurrence of each cost element is clearly defined within the firm's organisational structure. In addition, the accounting system should be sufficiently detailed and coordinated to provide necessary data for reports designed for the particular use of the individuals or cost centres having primary responsibility for specific cost. The responsibility for preparing the performance budget of each department lies on the respective Department Head. Each Department Head will be supplied with a copy of the section of the master budget appropriate to his sphere. For example, the chief buyer will be supplied with the copy of the materials purchase budget so that he may arrange for purchase of necessary materials. Periodic reports from various sections of a department will be received by the departmental head that will submit a summary report about his department to the budget committee. The report may be daily, weekly or monthly, depending upon the size of business and the budget period. These reports will be in the form of comparison of budgeted and actual figures, both periodic and cumulative. The purpose of preparing these reports is to promptly inform about the deviations in actual and budgeted activity to the person who has the necessary authority and responsibility to take necessary action to correct the deviations from the budget.

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updated till june 2011