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CMA

Standard Costs: A standard, as the term is usually used in management accounting, is a budgeted amount for a single unit of output. A standard cost for one unit of output is the budgeted production cost for that unit. Standard costs are calculated using engineering estimates of standard quantities of inputs, and budgeted prices of those inputs. For example, for an apparel manufacturer, standard quantities of inputs are required yards of fabric per jean and required hours of sewing operator labor per jean. Budgeted prices for those inputs are the budgeted cost per yard of fabric and the budgeted labor wage rate. Standard Costing Systems: A standard costing system initially records the cost of production at standard. Units of inventory flow through the inventory accounts (from work-in-process to finished goods to cost of goods sold) at their per-unit standard cost. When actual costs become known, adjusting entries are made that restate each account balance from standard to actual (or to approximate such a restatement). The components of this adjusting entry provide information about the companys performance for the period, particularly with regard to production efficiency and cost control. Reasons for using a Standard Costing System: There are several reasons for using a standard costing system: Cost Control: The most frequent reason cited by companies for using standard costing systems is cost control. One might initially think that standard costing provides less information than actual costing, because a standard costing system tracks inventory using budgeted amounts that were known before the first day of the period, and fails to incorporate valuable information about how actual costs have differed from budget during the period. However, this reasoning is not correct, because actual costs are tracked by the accounting system in journal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to record accumulated depreciation, and entries to record other costs related to production. Hence, a standard costing system records both budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goodssold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. This information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would not be an integral part of the general ledger system. Rather, it might be done, for example, on a spreadsheet program on a personal computer. The advantage of a standard costing system is that the general ledger system itself tracks the information necessary to provide detailed performance reports showing cost variances. Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the previous chapter for using normal costing to average the overhead rate over time, there are reasons to average direct costs. For example, if an apparel manufacturer purchases denim fabric from different textile mills at slightly different prices, should these differences be tracked through finished goods inventory and into cost-of-goods-sold? In other words, should the accounting system track the fact that jeans production on Tuesday cost a few cents more per unit than production on Wednesday, because the fabric used on Tuesday came from a different mill, and the negotiated fabric price with that mill was slightly higher? Many companies prefer to average out these small differences in direct costs. When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This reason, which was discussed in the previous chapter on normal costing, represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing. Costing systems that use budgeted data are economical: Accounting systems should satisfy a cost-benefit test: more sophisticated accounting systems are more costly to design, implement and operate. If the alternative to a standard costing system is an actual costing system that tracks actual costs in a more timely (and more
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expensive) manner, then management should assess whether the improvement in the quality of the decisions that will be made using that information is worth the additional cost. In many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing system is not warranted. Activity-based costing Activity-based costing refines steps #3 and #4 by dividing large heterogeneous cost pools into multiple smaller, homogeneous cost pools. ABC then attempts to select, as the cost allocation base for each overhead cost pool, a cost driver that best captures the cause and effect relationship between the cost object and the incurrence of overhead costs. Often, the best cost driver is a nonfinancial variable. ABC can become quite elaborate. For example, it is often beneficial to employ a two-stage allocation process whereby overhead costs are allocated to intermediate cost pools in the first stage, and then allocated from these intermediate cost pools to products in the second stage. Why is this intermediate step useful? Because it allows the introduction of multiple cost drivers for a single overhead cost item. This two-stage allocation process is illustrated in the example of the apparel factory below. ABC focuses on activities. A key assumption in activity-based costing is that overhead costs are caused by a variety of activities, and that different products utilize these activities in a non-homogeneous fashion. Usually, costing the activity is an intermediate step in the allocation of overhead costs to products, in order to obtain more accurate product cost information. Sometimes, however, the activity itself is the cost object of interest. For example, managers at Levi Strauss & Co. might want to know how much the company spends to acquire denim fabric, as input in a sourcing decision. The activity of acquiring fabric incurs costs associated with negotiating prices with suppliers, issuing purchase orders, receiving fabric, inspecting fabric, and processing payments and returns. ABC in the Service Sector: ABC is as important to companies in the merchandising and service sectors as to manufacturing companies. In fact, although the origination of ABC is generally ascribed to manufacturing companies in the 1980s, by then hospitals were already allocating overhead costs to departments and then to patient services using methods similar to ABC. Hospitals were required to implement relatively sophisticated allocation processes in order to comply with Medicare reimbursement rules. After its inception in the 1960s, Medicare established detailed rules regarding how overhead costs should be grouped into cost pools, and the choice of appropriate allocation bases for allocating overhead costs to departments and then to patients. Within these rules, hospitals were able to maximize revenues by shifting costs from areas such as pediatrics, labor and delivery, and maternity (which have low rates of Medicare utilization) to the intensive care unit, the critical care unit, and surgery (which have higher rates of Medicare utilization). Other non-manufacturing industries that have benefited from ABC include financial services firms and retailers. ABC Implementation Issues: Another refinement in product costing that often accompanies implementation of ABC focuses on step #2 of the five-step product costing sequence: identify the direct costs associated with the cost object. The refinement involves the following. For a given cost object, the company attempts to identify costs currently treated as overhead that have not beenbut can betraced directly to the cost object. In other words, costs are moved from the overhead cost pool to the direct cost category. For example, an accounting firm might take certain office-support expenses formerly treated as overhead, such as printing and copying, and start tracking and assigning these costs to specific jobs (audits, tax engagements, etc.) for internal reporting and profitability analysis (but not necessarily for client billing purposes). The successful implementation of ABC usually requires participation by managers from non-accounting functions, such as production and marketing. Because ABC focuses on activities, and activities often cut across
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departments and functional areas, implementing ABC can improve lines of communication and cooperation within the company. On the other hand, more accurate cost allocation does not, by itself, reduce costs. The initial move from a traditional costing system to ABC usually shifts overhead costs from some products to other products, with some managers winning and some losing. Some companies have found that hiring an outside consulting firm to assist with the ABC adoption facilitates obtaining buy-in by managers and employees throughout the company. Perhaps partly for this reason, ABC implementation has become an important consulting product for accounting firms and for many consulting firms. Although ABC should provide the company more accurate information, it is not a panacea; some companies that invested time and money implementing ABC did not realize the benefits they expected. Some of these companies have reverted to simpler, more traditional costing systems. Standard costing vs budgetary control 1. Budgetary control deals with the operation of a department or the business as a whole in terms of revenue and expenditure. Standard costing is a system of costing which makes a comparison between standard costs of each product or service with its actual cost. 2. Budgetary control covers as a whole in terms of revenue and expenditures such as purchases, sales, production, finance etc. Standard costing is related to a product and its cost only. 3. Budgetary control is applicable to utmost all business organizations. Standard costing is applicable to manufacturing concerns producing standard products and services. 4. Budgetary control is concerned with a specific period and is based on the totals of amounts. Standard costing is concerned with the standard costs, which are worked out generally per unit of production. 5. Budgetary control is not based on standard costing system. Standard costing cannot exist in the absence of a budgetary control system. standard costing vs. estimated cost 1. Estimated costs are the expressions of opinion based upon experience. Standard costs are based upon standard rates that are carefully developed and set as scientifically as possible. 2. Estimated costs are used by those firms that follow historical costing system. Standard costs are used by those organizations that follow standard costing. 3. Estimated costs are based on actual costs and anticipated costs. Standard costs are fixed after scientific analysis of relevant cost elements. 4. Estimated costs are based on approximation. Standard costs are based upon specifications. 5. Estimated costs are normally used as guideline for price determination, quoting the selling price etc. Main purpose of standard costs is to serve as a tool for cost control. standard costing and marginal costing MARGINAL COSTING & DECISION MAKING Managerial decision making is an all pervasive functional area in the organization. The decision making process may involve various stages that lead on into another. This may be over a long term or short term period.
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There are a number of decision making situations that may involve the application of management accounting principles Generally a marginal accounting approach is taken since the decisions may only involve the variable costs. However, where a decision may involve changes in the fixed cost, this will have to be factored in.

1. LIMITING FACTOR A limiting factor exist where a firm produces a number of items and is confronted with a scare supply of a resource, such as raw material, or labour supply. The main issue here is on deciding what is the best product mix, given the scare resource. There are three main steps to be followed when dealing with a limiting factor situation : calculate the contribution per unit for each product convert the contribution per unit for each product to contribution per unit of the scarce resource chose the product mix based on the higher contribution per unit of the scarce resource. 2. MAKE OR BUY The firm may be faced with the option of making its products, or to buy them from an outside source. The main approach here is to decide which is the more profitable option.

Again the variable costs would be the first consideration. However, the impact on the fixed costs should not be overlooked.

e.g. Elmos Swirl produces and sells 5,000 units of Noodle Soup with the following data Selling price $ 25 Variable cost per unit $13 Fixed costs $48,000 Elmo received an offer from Dorothys Do It All who can supply the noodle soup at a cost of $14 per unit. This would result in a cutting back on fixed costs by $16,000. Should Elmo continue to make the soup, or should he buy from Dorothys ? Solution TO MAKE -------------$ Sales Variable Cost 125,000 65,000 ----------Contribution 60,000 Contribution
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TO BUY --------------$ Sales Purchases 125,000 70,000 ---------55,000

Fixed Costs

48,000 -----------

Fixed Costs

32,000 ----------

Net Income

12,000 =======

Net Income

23,000 =======

From this analysis, it would be better to buy from Dorothys at the higher purchase price, since there is a lower fixed cost involved. However, there may be non accounting factors to consider, such as the control over the quality of the soup, as well as the reliability in the supply. Also what will be the impact on the existing staff morale if there should be a cut back in production staff. Additionally, what if Dorothys begin to monopolize the market and then increase its price? 3. DROPPING A PRODUCT LINE A firm that produces a number of products may be faced with a situation where one of the products shows a net loss. Should this product be eliminated ? e.g. Grovers Green Grocery trades in three main items : apples, banana, and carrot, with the following result A Sales Variable Costs 10,000 6,000 --------Contribution Fixed Costs 4,000 3,000 --------Net Income 1,000 ===== B 15,000 8,000 --------7,000 8,000 --------(1,000) ====== C 25,000 12,000 ---------13,000 6,500 ---------6,500 ======

The issue at hand is should the banana line be dropped? It has been ascertained that $6,500 of the fixed costs in B would be eliminated if the department is closed. A comparative analysis of the situation would be helpful Keep Banana Sales Variable Costs 50,000 26,000 ---------------Contribution 24,000
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Drop Banana 35,000 18,000 -------------17,000

Difference (15,000) 8,000 ------------( 7,000 )

Fixed Costs

17,500 ----------------

11,000 -------------6,000 =========

6,500 ------------(500) ========

Net Income

6,500 ==========

From the above, it can be seen that if the Banana line was to be dropped, there would be reduction in the net income by $500. As part of the analysis, it can be seen that the Banana line produces a healthy contribution of $7,000. It would be helpful to determine if the fixed cost allocation is appropriately carried out. Other factors in the issue of dropping a product line are : the effect of the product on the performance of other product, the legal commitment to suppliers or clients, the impact on staff morale, the use of the redundant space and equipment, etc. 4. SPECIAL ORDER A special order situation exist when a client places an order for a supply of goods at a rate outside the regular selling price. This is usually a one off order, and should not conflict with the firms regular trading activities e.g. The Bulla Guinegog is a trader in bulla cakes, with the following details : selling price $10 each, variable cost $5 each, while fixed cost total $40,000. The firm has the capacity to produce 10,000 units. However activities for the year are at 8,500 units. A prospective client has placed a special order to purchase 500 units @$7.50 each. Should this order be accepted.? The analysis here involves several factors. One is the capacity, i.e. can the existing capacity accommodate this special order, or will it require additional outlay, or interfere with existing output. Another factor that is closely associated with the capacity is the fixed cost. At full capacity fixed cost per unit would be $4, making the total cost per unit $9. However, the firm is not at full capacity, and would break even at 8,000 units. Therefore the margin of safety could be valued at a minimum of $5 each, the variable cost. Thus, the special order is within the margin of safety, and within capacity. It could therefore be accepted. The result would be as follows Existing Existing Plan & Special Order

Plan Alone

Sales Variable Cost

85,000 42,500 ---------6

88,750 45,000 -----------

Contribution Fixed Costs

42,500 40,000 ---------

43,750 40,000 ----------3,750 =======

Net Income

2,500 ======

Additional factors that may impact on the consideration include the impact of the lowered price on the existing clients, and the prevention of the special order from exploiting the existing market, the continued request for the goods at the special price. 5. SPECIAL PROJECT Here the firm must chose from one or more projects, which in most cases it is limited to only one. Incorporating the principles from capital budgeting, we take a further look at the analysis of the projects. e.g. Mr. Jacko Haltrade is considering one of two projects vege patties or kiss cakes, Each has different operating requirements but there is a capacity to produce up to 10,000 units. Current constraints allow for the following budgeted activities :

Vege-Patties Sales (6000 @ 20) 120,000

Kiss Cakes Sales (6,000 @ 25) 150,000

Vcosts Material @6 Labour @ 5 Expenses @1

36,000 30,000 6,000 --------

V Costs Material @ 7 Labour @ 3

42,000 18,000

Expenses @ 1.5 9,000 ---------69,000

72,000 ---------Contribution Less F Costs 48,000 25,000 ---------Net Income 23,000 ======
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----------Contribution Less F Costs 81,000 60,000 ---------Net Income 21,000 ======

Which project should Mr. Haltrade chose? The answer lies beyond the current plan which would tend to indicate that the vege-patties seem more profitable. Remember that the firm has additional capacity, and would not necessarily increase fixed costs with additional output. At present the kiss cakes has variable costs of $11.50 while the vege patties have a variable cost of $12. In the long run the kiss cakes would be more profitable since the contribution per unit is $13.50, while that for the vege patty is only $8.00 NON FINANCIAL FACTORS In making decisions, the firm should look beyond the profit line, and incorporate such non financial factors as - the impact of a decision on staff morale - the impact on quality and quantity of output - competition in the market - legal or contractual obligations - impact of one product on the success of other products

. Advantages Of Cost Audit To The Management 1. Cost audit provides reliable cost data for managerial decisions. 2. Cost audit helps management to regulate production. 3. Cost audit acts as an effective managerial tool for the detection of errors, frauds and irregularities so that reliable and smooth functioning of the system is continued. 4. Cost audit reduces the cost of production through plugging loopholes relating to wastage of material, labor and overheads. 5. Cost audit can fix the responsibility of an individual wherever irregularities or wastage are found.

6. Cost audit improves efficiency of the organization as a whole and costing system in particular by constant review, revision and checking or routine procedures and methods. 7. Cost audit helps in comparing actual results with budgeted results and points out the areas where management action is more needed. 8. Cost audit also enables comparison among different units of the factory in order to find out the profitability of the different units. 9. Cost audit exercises moral influence on employees which keeps them efficient and alert. 10. Cost audit ensures that the cost accounts have been maintained in accordance with the principles of costing employed in the industry concerned.

B. Advantages Of Cost Audit To The Shareholders 1. Cost audit ensures that proper records are maintained as to purchases, utilization of materials and expenses incurred on various items i.e wages and overheads etc. It also makes sure that the industrial unit has been working efficiently and economically. 2. The cost audit enables shareholders to determine whether or not they are getting a fair return on their investments. It reflects managerial efficiency or inefficiency. 3. Cost audit ensures a true picture of company's state of affairs. It reveals whether the resources like plant and machinery are being properly utilized or not. C Advantages Of Cost Audit To The Society 1. Cost audit tells the true cost of production. From this the consumer may know whether the market price of the article is fair or not. The consumer is saved from the exploitation. 2. Cost audit improves the efficiency of industrial units and thereby assists in economic progress of the nation. 3. Since price increase by the industry is not allowed without justification as to increase in cost of production, consumers can maintain their standard of living. D. Advantages Of Cost Audit To The Government 1. Cost audit assists the 'Tariff Board' in deciding whether tariff protection should be extended to a particular industry or not. 2. Cost audit helps to ascertain whether any particular industry should be given any subsidy in order to develop that industry. 3. Cost audit provides reliable data to the government for fixing up the setting prices of the various commodities. 4. Cost audit helps the government to take necessary measures to improve the efficiency of sick industrial units. 5. Cost audit can reveal the fraudulent intentions of the management. 6. Cost statements may be helpful to authorities in imposing tax or duty at the cost of finished products. 7. Cost audit facilitates settlement of trade disputes of the companies.
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Objectives The following are some of the objectives for which cost audit is under taken: 1. To establish the accuracy of costing data. This is done by verifying the arithmetical accuracy of cost accounting entries in the books of accounts. 2. To ensure that cost accounting principles are governed by the management objectives and these are strictly adhered in preparing cost accounts. 3. To ensure that cost accounts are correct and also to detect errors, frauds and wrong practice in the existing system. 4. To check up the general working of the costing department of the organization and to make suggestions for improvement. 5. To help the management in taking correct decisions on certain important matters i.e to determine the actual cost of production when the goods are ready. 6. To reduce the amount of detailed checking by the external auditor if effective internal cost audit system is in operation. Management audit A detailed audit that concentrates on analysis and evaluation of management procedures and the overall performance of an organization. A management audit is undertaken to discover weaknesses and to institute improvements within the organization. Also called operational audit, performance audit. equivalent units of production A term used in cost accounting to arrive at the cost per unit. The term is associated with the units that are not completed at the end of an accounting period. For example, if 500 units are completed as far as materials, but are only 40% completed as far as direct labor and manufacturing overhead, the equivalent units are 500 for materials and 200 (40% of 500) for direct labor and manufacturing overhead. Decision to Add or Drop Product Line A decision whether or not to continue an old product line or department, or to start a new one is called an addor-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.

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