SEBI GRADE A 2020: COSTING: COST CONTROL & ANALYSIS€¦ · Even the selling and distribution cost needs to be classified into fixed, variable and semi-variable costs. Variance Analysis:

SEBI GRADE A 2020: COSTING: COST CONTROL & ANALYSIS

www.practicemock.com 1 [email protected] 011-49032737

http://www.practicemock.com/

mailto:[email protected]

mailto:011-49032737



Table of Content

Table of Content ........................................................................................................... 2

Standard Costing: ......................................................................................................... 4

Features of Standard Costing: ...................................................................................................... 4

Application of Standard Costing: ................................................................................................... 4

Type of Standards: ..................................................................................................................... 4

Setting of Standard Costs: ........................................................................................................... 5

Direct Material Standards: ........................................................................................................ 5

Direct Labour Standards: .......................................................................................................... 5

Factor Overheads Standards: .................................................................................................... 6

Administration Cost Standards: ................................................................................................. 6

Selling and Distribution Cost Standards: ..................................................................................... 6

Variance Analysis:....................................................................................................................... 6

Material Variance Analysis: .......................................................................................................... 7

Labour Variance Analysis: ............................................................................................................ 9

Overheads Variance Analysis: ..................................................................................................... 10

Fixed Overhead Variance: ....................................................................................................... 10

Variable Overhead Variance: ................................................................................................... 12

Accounting Treatment for Variances: ........................................................................................... 12

Marginal Costing: ........................................................................................................ 13

Features of Marginal Costing: ..................................................................................................... 13

Advantages of Marginal Costing: ................................................................................................. 13

Limitations of Marginal Costing: .................................................................................................. 13

Break-Even Analysis/Cost-Volume-Profit Analysis.......................................................................... 14

Objective of Break-Even Analysis/Cost-Volume-Profit Analysis .................................................... 14

Assumptions of Break-Even Analysis: ....................................................................................... 15

Advantages of Break-Even Analysis ......................................................................................... 15

Limitations of Break-Even Analysis .......................................................................................... 15

Use of Cost-Volume-Profit Analysis .......................................................................................... 15

Assumptions of Cost-Volume-Profit Analysis: ............................................................................ 16

Methods for Determining Break-Even Points: ............................................................................ 16

Contribution: ............................................................................................................................ 17

Marginal Cost Equation: ............................................................................................................. 18

Profit-Volume Ratio: .................................................................................................................. 18

Interpretation of Profit-Volume Ratio: ...................................................................................... 18

Significance of Profit-Volume Ratio: ......................................................................................... 18

Margin of Safety: ...................................................................................................................... 19

Application of Marginal Costing: .................................................................................................. 19

Profit planning: ..................................................................................................................... 19

Evaluation of Performance: ..................................................................................................... 19

Make or Buy Decisions: .......................................................................................................... 20



mailto:011-49032737



Closure of a Department or Discontinuance of a Product: ........................................................... 20

Maintaining a Desired Level of Profit ........................................................................................ 20

Offering Quotations: .............................................................................................................. 20

Accepting an Offer or Exporting below Normal Price: .................................................................. 20

Alternative Use of Production Facilities: .................................................................................... 20

Problem of Key Factor: ........................................................................................................... 20

Selection of a Suitable Product Mix: ......................................................................................... 20

Composite Break-Even Point: ..................................................................................................... 21

Absorption Costing: ................................................................................................................... 21

Difference between Absorption Costing and Marginal Costing: ........................................................ 21

Budget, Budgeting and Budgetary Control ....................................................................... 22

Budget: ................................................................................................................................... 22

Budgeting: ............................................................................................................................... 22

Budgetary Control: ................................................................................................................... 22

Forecast and Budget: ................................................................................................................ 22

Objectives of Budgeting: ............................................................................................................ 22

Benefits of Budgeting: ............................................................................................................... 23

Preparation of a Budgetary Control: ............................................................................................ 23

Types of Budgets: ..................................................................................................................... 25

On the basis of Scope: ........................................................................................................... 25

On the basis of Efficiency: ...................................................................................................... 26

On the basis of Conditions: ..................................................................................................... 27

On the basis of Period: ........................................................................................................... 27

Zero Base Budgeting: ................................................................................................................ 27

Applications of Zero Base Budgeting: ....................................................................................... 27

Benefits from Zero Based Budgeting: ....................................................................................... 28

Limitations of Zero Based Budgeting: ....................................................................................... 28

Performance Budgeting: ............................................................................................................ 28

Programme Budgeting: .............................................................................................................. 28



mailto:011-49032737

http://bit.ly/2w8nwoN



Standard Costing: Standard Costing can be defined as “a pre-determined cost which is calculated from management’s standard

of efficient operation and the relevant necessary expenditure. It may be used as a basis for price fixation

and cost control through variance analysis”. The word “Standard Cost” can be broken into two parts, namely

“Standards” which is expressed in respect of quantities and qualities like materials and labour, and “Cost”

which is expressed in values. Thus, it can be said that standard costing is a tool available with the

management that helps to improve management control by providing parameters for comparison of actual

with these parameters.

Features of Standard Costing: The features of standard costing are as follows:

1. The standard cost is pre-planned or pre-determined, meaning that cost is determined even before the

production is commenced.

2. The standard cost is not an estimated cost, even though both of them are future cost. The reason for

this being that estimated cost is a reasonable assessment of what the cost should be in the future, while

the standard cost is a pre-planned cost meaning it is what the cost should be in future.

3. The standard cost is calculated after considering the management’s standard of efficient operation.

Hence, the standard cost fixed on the assumption of 70% efficiency shall be different to the 80%

efficiency.

4. It can also be used to fixed price as well as exercise control over the costs.

5. In this technique, the standards for various cost elements, i.e. Material, Labour and Overheads, are set.

Further, this technique can be effective only if the standards are set carefully. An enterprise may even

choose to set the standards for sales and profits.

6. The purpose of setting a standard is that it will act as a comparison between standard performance and

the actual performance. Hence, the enterprise should continuously record the actual performance against

the standards for proper comparison.

7. The difference between the standard cost and actual cost is termed as variance, which needs to be

analysed further to understand the reason behind such variance, so as to take corrective measures so

that the error is not repeated.

Application of Standard Costing: Standard costing can be very useful to management and so they can use this technique for the following:

1. Estimating the profit of the business at any level of production

2. It can be used in executing management’s function effectively

3. It can help in analyzing the impact of cost if sales volume is increased or decreased by a certain

percentage

4. This technique can help management measure the efficiency of production

5. It can also help management to measure the performance of each of the segments

6. It can help in identifying and measuring variances between the standard and actual costs

7. Standard costing may also help in designing performance measurement systems in order to encourage

employees to participate in the betterment of the company

Type of Standards: This tool is helpful only if the standards sets are realistic and attainable. It should not be something which

is either impossible or too easy to achieve. Similarly, it should neither be too high or too low. Hence, the

following types of standards can be set:

Ideal Standard: It is a standard that can be attained under the most favourable conditions. When standards

are set at ideal levels, it makes no allowance for normal losses, wastage and machine downtime. Ideal

standard can be used if management wishes to highlight and monitor the full cost of factors such as

wastages, normal loss, etc. However, ideal standard will almost always result in adverse variances since a

certain amount of wastage, normal loss, etc., is usually unavoidable.

Normal Standard: It is the average standard which is attainable during the future period of time, generally

long enough to cover a business cycle. The normal standard is revised only after a business cycle is

completed and so frequent revision is not needed. This standard is helpful in case of long-term planning.



mailto:011-49032737



Basic Standard: This standard is established for an unaltered use for an indefinite period of time. In other

words, basic standard is one which is kept unchanged over a period of time and is rarely revised. This

standard is used as the basis for preparing more up-to-date standards for control purposes. Further, a basic

standard may be used to show the trend in costs over a period of time.

Expected Standard: It is anticipated and can be attained during a future specified standard period.

Expected Standard is attainable, consistent and fulfils the purpose of a good standard. This standard

provides an incentive to improve the performance and get the best even from adverse conditions. The best

part about the expected standard is that it is computed after making allowance for the cost of the wastages,

normal loss, idle time, machine breakdown, and any other unavoidable events in the normal course of

business. Owing to its higher accuracy, this standard can help the management in product costing, inventory

valuations, estimates, analyses, performance evaluation, planning, and employee motivation for managerial

decision-making.

Historical Standard: It is also an average standard which has been achieved in the past. This standard

may not be very effective as that there is a possibility that the average past performance includes

inefficiencies, that gets passed to the new standard. But then these standards can be used a basis for setting

the standard in the future.

Setting of Standard Costs: An enterprise needs to set the standard costs for various cost elements such as material, labour and

overheads, and thereafter compute and analyse the variances. The standard cost for each of the elements

is set by the cost accounting department in collaboration with the other departments like production, sales,

manpower planning, personnel and works study engineer. The setting of standard costs are given below:

Direct Material Standards:

The direct material standard cost is related to quantities (or the usage) and price of the material which will

be used in the production process.

Material Usage Standard: In this case, the objective is to set a standard with regard to the usage of the

material in order to achieve the maximum efficiency in material usage. Hence, it is important to specify the

size and quality of materials followed by an analysis of the materials requirements. Thereafter, a list is

prepared, known as “Standard Materials Specification”, which contains details such as materials size, grade,

quantity, etc. This standard quantity of material is then used per unit production and can be laid down by

one of the following means, after making allowance for normal wastage:

1. With regard to the weight of materials in the final production

2. With regard to the past performance with due allowance for change in conditions

3. On the basis of the test runs conducted under different conditions and then taking an average of quantities

used

Material Price Standard: In this case, the cost accounting department with the help of the purchasing

department fixes the price after looking at the efficiency of purchasing and storekeeping function. The

material price standard is fixed in order to minimise the direct material cost and is done by looking at recent

price, past prices and anticipated future price. While fixing the price, it is important to account for a discount

on purchases and the economy of bulk purchasing as well.

Direct Labour Standards:

This depends on the time spent by the labour and wage rates, and the direct labour standards involved two

related standards, namely:



mailto:011-49032737

https://www.practicemock.com/packages/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SebiGrAPackage&utm_medium=Link&utm_campaign=SebiGrAPackage



Standard Labour Time: In this case, the standard is set with regard to the time (in hours) spent by the

labour of a particular grade to perform a given activity. Hence, the primary objective of this standard is to

get maximum efficiency from the use of labour time and is therefore set on the basis of past performance

after adjusting for change of conditions.

Labour Rate Standard: Here, the standard sets the wage rates that are expected to be paid to different

grades of labour employed in the enterprise. Hence, the objective here is to plan for the actual wages that

are to be paid to the labour for the time spent on any activity. While setting the standard rate for labour,

factors such as past wage rate, the future trend of wages, agreement between the labour and the

management, guaranteed minimum wages and overtime wages should be considered after allowing for any

allowances. Further, the labour employed should be graded on a standard basis.

Factor Overheads Standards:

Here, the objective is to minimize the overhead costs chargeable to the production process, and so an

enterprise may follow the below steps to set a standard rate.

1. Determine the level of activity of production departments and the work to be done by the service

departments.

2. Classify the overheads costs into fixed, variable and semi-variable overheads. Thereafter, the costs

expected to be incurred under each of the three heads for each of the production and service

departments should be computed for the given period. The expected or the standard costs may be put

down in details in the form of cost-budgets based on past experience, present conditions and future

trends.

3. Then, calculate the standard overheads rates for each of the service departments which should be

applied to the production department.

4. The standard overhead rates for the production department can be determined on the basis of direct

labour hour rate, or a machine hour rate, or as a percentage of direct wages. The following ratios can

be used to calculate the rates:

𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝑅𝑎𝑡𝑒 =𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐿𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑎 𝑔𝑖𝑣𝑒𝑛 𝑝𝑒𝑟𝑖𝑜𝑑

𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐻𝑜𝑢𝑟 𝑅𝑎𝑡𝑒 =𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑎 𝑔𝑖𝑣𝑒𝑛 𝑝𝑒𝑟𝑖𝑜𝑑

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝐷𝑖𝑟𝑒𝑐𝑡 𝑊𝑎𝑔𝑒𝑠 =𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐶𝑜𝑠𝑡 𝑑𝑢𝑟𝑖𝑛𝑔 𝑎 𝑔𝑖𝑣𝑒𝑛 𝑝𝑒𝑟𝑖𝑜𝑑

Administration Cost Standards:

Here the objective is to set standard administration cost in order to obtain the maximum quantity and quality

of administrative services at minimum cost. Similar to overheads, administrative costs should be classified

into fixed, variable and semi-variable items before the standard costs are set. The standard quantity of work

to be performed may be set by one or more of the following methods:

1. On the basis of past performance

2. On the advice of organisation and methods team

3. Time and motion studies

4. By choosing appropriate “work units” and fixing standard costs per work-unit

Selling and Distribution Cost Standards:

In order to set the standard cost for selling and distribution, it is important to have sales forecast ready as

the selling and distribution expenses are related to volumes of sales. Even the selling and distribution cost

needs to be classified into fixed, variable and semi-variable costs.

Variance Analysis: Now that it is clear that the primary objective of Standard Costing is to analyze the difference between the

standard cost and actual cost, and that the difference is termed as “Variance”, which provides the key to

cost control for each of the cost items. It also indicates whether and to what extend the standard set has



mailto:011-49032737



been achieved by the enterprise, thus enabling management to take corrective measures. Thus, variance

analysis involves the computation of individual variances, and determination of the cause for each of the

variance, thereby helping the management to identify the following:

1. the amount of variance

2. its occurrence

3. the factors responsible for it

4. the executive responsible for the variance

5. corrective action which should be taken to obviate or reduce the variance.

Variance can be classified into the following:

Favourable and Unfavourable Variance: In case the actual cost is less than the standard cost, then the

difference is termed as Favourable/Positive Variance, as it increases the profit, while if the actual cost is

more than the standard cost then the difference is said to Unfavourable Variance as it results in a reduction

in profit.

Controllable and Uncontrollable Variance: In case a variance with regard to any cost item reflects the

degree of efficiency of an individual or department, then such variance is termed as a controllable variance.

On the other hand, in case of an uncontrollable variance, the variance so arisen is not amenable to control

by individual or department as this variance is caused by external factors such change in market conditions,

fluctuations in demand and supply, etc.

Revision Variance: Any amount by which a budget gets revised but is not incorporated in the standard

cost as a matter of policy is termed as Revision Variance. For instance, the standard costs may change due

to a change in wage rate after wage accords, fiscal policy, etc. Hence, in such a situation, the standard costs

are revised due to these uncontrollable factors. However, it is important to isolate the variance which may

arise out of non-revision so as to analyse the other variances correctly.

Method Variance: This is the difference between the standard cost of the product manufactured or

operation performed by the normal methods and the cost of operation by an alternative method. Generally,

the standards take into account the best method applicable and so any deviation will result in an

unfavourable variance. Therefore, it is important to have such a deviation as few as possible.

Material Variance Analysis: Here the primary objective is to find the difference between the standard cost of material used for actual

production and the actual cost of material used. Hence, the main variance is the cost variance, which is

further broken down into other variances mentioned below:

Material Cost Variance: As already stated above, material cost variance shows the difference between the

standard costs of material consumed for actual production and the actual cost, and is computed using the

formula given below. The variance can be favourable (i.e. when the actual cost of material consumed is less

than the standard cost of material consumed), or unfavourable (i.e. when the actual cost of material

consumed is more than the standard cost of material consumed).

Material Cost Variance = Standard Cost of Material Consumed for Actual Production – Actual Cost

Material Price Variance: It is a portion of the material cost variance which is due to the difference between

the standard price specified and the actual price paid. Material Price Variance measures the difference

between the standard price and actual price with regard to the actual quantity consumed and so it is

computed using the below formula:

Material Price Variance = Actual Quantity [Standard Price – Actual Price]

The material price variance may arise because of the following reasons:

• Changes in the market price of materials used

• Changes in the quantity of purchase or uneconomical size of purchase order resulting in a different price

• No cash and/or trade discounts received which were provided while setting standards

• Rush order to meet the shortage of supply

• Failure to take advantage of off-season price, or failure to purchase when the price is cheaper



mailto:011-49032737



• In case of emergency purchase on the request of the production or sales manager

• In case of a change in issue price due to differences in changes related to store-keeping, materials

handling, carriage inward expenses etc.

• Changes in the amount of taxes and duties

• Changes in quality or specification of materials purchased

• Use of substitute material having a higher or lower unit price

• Changes in the pattern or amount of taxes and duties

Material Quantity (Usage) Variance: It is the difference between the standard quantity of material

consumed for actual production and the actual quantity consumed and the same is multiplied by standard

price and is calculated using the below formula. Further, the total of Price Variance and Quantity Variance

is equal to the Material Cost Variance.

Material Quantity [Usage] Variance = Standard Price [Standard Quantity – Actual Quantity]

The material usage variance may arise because of the following reasons:

1. Lack of due care in the use of materials

2. Defective production necessitating additional materials for correction

3. Abnormal wastage through pilferage or other losses in the use of materials

4. In the case of inefficiency in production due to improper method or lack of necessary skill in workmen

5. Use of a material-mix other than the standard mix

6. Yield from materials in case excess of or less than that provided as the standard yield

7. Purchase of inferior materials or change in the quality of materials

8. Rigid technical specifications and strict inspection leading to more rejections which require more

materials for rectifications

9. Use of substitute material leading to poor quality

10. Improper maintenance of machine leading to breakdowns and more use of materials

11. Poor inspection of raw materials

Material Mix Variance: In case there are two or more types of raw materials mixed together to produce

the final products, then it is important to decide the standard proportion of mixture in advance. For instance,

material X and Y need to be mixed in the ratio of 2:3 in order to produce product Z. This mix is called

Standard Mix. However, it may be possible that at the time of production, the actual proportion may have

been changed due to several reasons like non-availability of a particular material etc. which may then lead

to arise of material mix variance. The formula to compute this variance is given below:

Material Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix

Material Yield Variance: In the most manufacturing process, if not all, there will be some unavoidable

losses that will happen. Since the management always anticipates the normal loss and take into

consideration while determining the standard quantity. This variance will arise when the actual loss is more

or less than the normal loss and is calculated using the below formula:

Material Yield Variance = Standard Yield Rate (SYR) [Actual Yield – Standard Yield]

*Standard Yield

Rate refers to the

standard cost per

unit of standard

output

Note: For

reconciliation

purpose: Quantity

Variance = Mix

Variance + Yield

Variance



mailto:011-49032737



Labour Variance Analysis: Similar to Material variance, labour variance arises because of the difference between the standard labour

cost for actual production and the actual labour cost. In the case of labour variance, the following variances

are calculated:

Labour Cost Variance: It is the main variance in case of labour variance, arising because of the difference

between the standard labour cost for actual production and the actual labour cost. This variance is favourable

when the actual labour cost is less than the standard labour cost and unfavourable when the actual labour

cost is more than the standard labour cost. It can be calculated using the following formula:

Labour Cost Variance = Standard Labour Cost for Actual Production – Actual Labour Cost

Labour Rate Variance: The labour cost variance may arise due to the difference between the standard

rate of wages and actual wages rate and indicates the difference between the standard labour rate and the

actual labour rate paid. Labour Rate Variance will be favourable when the actual rate paid is less than the

standard rate.

Labour Rate Variance: Actual Hours Paid [Standard Rate – Actual Rate]

The labour rate variance may arise because of the following reasons:

1. In case of a change in basic wage structure or change in piece work rate

2. Overtime work in excess of that provided in the standard rate

3. Employment of one or more workers of a different grade than the standard grade

4. Payment of guaranteed wages to workers who are unable to earn their normal wages if such guaranteed

wages form part of direct labour cost

5. New workers not being allowed full normal wage rates

6. Use of the different method of payment i.e. payment of day rates while standards are based on piece

work method of remuneration

7. Higher wages paid on account of overtime for urgent work

8. The composition of a gang as regards the skill and rate of wages being different from that laid down in

the standard

Labour Efficiency Variance: Measuring the efficiency of labour is important, and for doing this the actual

time taken by the workers should be compared with the standard time allowed for the job. The enterprise

decides the standard time allowed for a particular job with the help of time and motion study. Here, the

variance will be favourable when the actual time has taken is less than the standard time, and can be

calculated by the following formula:

Labour Efficiency Variance = Standard Rate [Standard Hours for Actual Output – Actual Hours

worked]

The labour efficiency variance may arise because of the following reasons:

1. Lack of proper supervision or stricter supervision than specified

2. Poor working conditions

3. Defective machinery and equipment

4. Discontentment in workers due to unsatisfactory personnel relations

5. Increase in labour turnover

6. Use of non-standard material requiring more or less operation time

7. Basic inefficiency of workers due to insufficient training, faulty instructions, incorrect scheduling of jobs.

8. Wrong selection of workers



mailto:011-49032737

https://www.practicemock.com/blog/tag/sebi-study-material/


www.practicemock.com 10 [email protected] 011-

49032737

Labour Mix Variance or Gang Composition Variance: While performing a particular job, there may be

some combination of labour force consisting of skilled, semi-skilled and unskilled labours. However, the

composition of labour force may be changed for various reasons, hence this variance tells the management

the quantum of loss or gain caused due to this change. This variance is similar to the material mix variance

and is calculated in the same manner. The following formula can be used to calculate Labour Mix Variance:

Labour Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix

Labour Yield Variance: This variance helps the management to understand the difference between the

actual output and the standard output based on actual hours, i.e. comparing the actual production achieved

with the production that should have been achieved in an actual number of working hours. Labour Yield

Variance is said to be favourable when the actual output achieved is more than the standard output. It can

be calculated using the following formula:

Labour Yield Variance = Average Standard Wage Rate Per Unit [Actual Output – Standard

Output]

Idle Time Variance: This variance helps the management understand the loss caused due to abnormal

idle time. The management generally considers the normal idle time while fixing the standard time, however,

if the actual idle time is more than the standard/normal idle time, then there arises a variance known as

abnormal idle time. Idle Time Variance is always unfavourable and is calculated using the below formula:

Idle Time Variance = Abnormal Idle Time X Standard Rate.

Overheads Variance Analysis: The purpose of overhead variance is to show the difference between the standard overhead cost and the

actual overhead cost. Unlike in the case of direct material and direct labour costs, the overhead costs need

to be divided into fixed and variable, as the direct material and direct labour are variable in nature.

Fixed Overhead Variance:

In the case of fixed overhead variance, the following variances are computed:

Fixed Overhead Cost Variance: The purpose of this variance is to indicate the difference between the

standard fixed overheads for actual production and the actual fixed overheads incurred. It basically indicates

whether fixed overheads are under absorbed (i.e. actual overheads incurred are more than the standard

fixed overheads) or over absorbed (i.e. actual overheads incurred are more than the standard fixed

overheads). This variance can be calculated using the following formula:

Fixed Overhead Cost Variance = Standard Fixed Overheads for Actual Production – Actual Fixed

Overheads

Fixed Overhead Expenditure/Budget Variance: The purpose of this variance is to indicate the difference

between the budgeted fixed overheads and the actual fixed overhead expenses. If the actual fixed overheads

are more than the budgeted fixed overheads then it is said to be unfavourable as there is overspending

compared to the budgeted amount, while in actual fixed actual fixed overheads is less than the budgeted

fixed overheads then it is said to be favourable as there is under-spending compared to the budgeted

amount. This variance can be calculated using the following formula:



mailto:011-49032737

mailto:011-49032737



49032737

Fixed Overhead Expenditure Variance: Budgeted Fixed Overheads – Actual Fixed Overheads

Fixed Overheads Volume Variance: The purpose of this variance is to indicate the under absorption or over

absorption of fixed overheads because of the difference between the budgeted quantity of production and

actual quantity of production. This variance will be favourable if the actual quantity produced is more than

the budgeted one indicating over absorption of fixed overheads, while it is said to be unfavourable if the

actual quantity produced is less than the budgeted one indicating under-absorption of fixed overheads. The

following can be used to calculate this variance:

Fixed Overhead Volume Variance: Standard Rate [Budgeted Quantity – Actual Quantity]

Note: For reconciliation purpose: Fixed Overhead Cost Variance = Expenditure Variance + Volume Variance

Fixed Overhead Efficiency Variance: It refers to the portion of volume variance which arise because of

the difference between the output actually achieved and the output which should have been achieved in the

actual hours worked. The variance is said to be favourable if the actual production is more than the standard

production in actual hours. Below is the formula to calculate this variance:

Overhead Efficiency Variance: Standard Rate [Standard Production – Actual Production]

Fixed Overhead Capacity Variance: It refers to the portion of volume variance arising due to the

difference between the capacity utilization, i.e. the capacity actually utilized and the budgeted capacity. The

variance is said to be favourable if the capacity utilization is more than the budgeted capacity, while it is

unfavourable if the capacity utilization is less than the budgeted capacity. The following formula is used to

calculate the Fixed Overhead Capacity Variance:

Fixed Overheads Capacity Variance: Standard Rate [Standard Quantity – Budgeted Quantity]

Note: For reconciliation purpose: Volume Variance = Efficiency Variance + Capacity Variance

Fixed Overhead Revised Capacity Variance: The purpose of this variance is to indicate the difference in

capacity utilization because of working for more or less number of days than the budgeted one. This variance

is calculated using the following formula:

Fixed Overhead Revised Capacity Variance = Standard Rate [Standard Quantity – Revised

Budgeted Quantity]

Fixed Overheads Calendar Variance: The purpose of this variance is to indicate the difference between

the budgeted quantity of production and the actual quantity of production achieved due to the difference in

the number of days worked and budgeted. The following formula can be used to calculate this variance:

Fixed Overheads Calendar Variance = Standard Rate [Budgeted Quantity – Revised Budgeted

Quantity



mailto:011-49032737

mailto:011-49032737



49032737

Variable Overhead Variance:

In the case of variable overhead variance, the following variances are computed:

Variable Overhead Cost Variance: The purpose of this variance is to indicate the difference between the

standard variable overheads for actual production and the actual variable overheads. This difference will

arise when there is a variation between the budgeted and the actual quantity and is calculated using the

following formula:

Variable Overhead Cost Variance = Standard Variable Overheads for Actual Production – Actual

Variable Overheads

Variable Overheads Expenditure Variance: The purpose of this variance is to indicate the difference

between the standard variable overheads to be charged to the standard production and the actual variable

overheads. This variance is said to be favourable when the actual overheads are less than the standard

variable overheads, while it is unfavourable when actual overheads are more than the standard variable

overheads. This variance can be calculated using the formula:

Variable Overhead Expenditure Variance = Standard Variable Overheads for Standard Production

– Actual Variable Overheads

Variable Overheads Efficiency Variance: The purpose of this variance is to indicate the efficiency by

comparing the output actually achieved with the output that should have been achieved in the actual hours

worked. The variance will be said to be favourable when the actual output achieved is more than the

standard output, while it is unfavourable if the actual output achieved is less than the standard output. To

calculate this variance, the following formula can be used:

Variable Overheads Efficiency Variance: Standard Rate [Standard Quantity – Actual Quantity]

Accounting Treatment for Variances: Any variances which arise in standard costing and record in the cost books can be disposed of in any of the

following ways:

Transfer to costing profit and loss account: As per this method, the stock of work-in-progress, finished

goods and cost of sales are maintained at standard cost and all variances get transferred to the costing

profit and loss account at the end of the accounting period. In this method, the standard costs facilities

prompt inventory valuation and also variances are separated out so as to attract the attention of the

management.

Allocation of variances to finished stock, work-in-progress and cost of sales account: As per this

method, the variances get distributed over stocks of finished goods, work-in-progress and cost of sales

account in proportion to the closing balances of each account depending upon the type of variance.

Transfer to reserve account: As per this method, the favourable variances are carried forward as deferred

credits until they are set-off by adverse variances.



mailto:011-49032737

mailto:011-49032737

https://www.practicemock.com/exams/government/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SignUp&utm_medium=Link&utm_campaign=SignUp



49032737

Marginal Costing:

As per CIMA Terminology, Marginal Costing is the ascertainment of marginal costs and of the effect on profit

of changes in volume or type of output by differentiating between fixed costs and variable costs. In this

technique of costing only variable costs are charged to operations, processes or products leaving all indirect

costs to be written off against profits in the period in which they arise.

Marginal Costing is a technique and not a method of costing wherein only variable manufacturing costs are

considered for determining the cost of goods sold and also for valuation of inventories. It is a well-known

fact that a cost can be classified into fixed and variable, wherein the fixed cost remains constant at all levels

of production but the variable cost keeps changing with the change in production level. This technique helps

the management in deciding on several areas by providing them with relevant information.

In case of marginal costing, the variable costs are charged to cost units and fixed costs of the period are

written-off in full against the aggregate contribution. Thus, it is a technique in which the existing methods

is applied in a particular way to bring out the relationship between profit and volume of output

Features of Marginal Costing: The following are the features of marginal costing:

1. In the case of marginal costing, the costs are separated into fixed and variable elements. Even semi-

variable costs are also differentiated

2. For computing the value of stocks of work-in-progress and finished goods only variable costs are

considered

3. Fixed costs are charged off to revenue wholly during the period in which they are incurred and are not

considered while valuing product cost or inventories

4. The prices may be based on marginal costs and contribution but in normal circumstances prices would

cover costs in total

5. Marginal costing combines the technique of cost recording and cost reporting

6. The profitability of departments or products is calculated in terms of marginal contribution

7. In the case of marginal costing, the unit cost of a product means the average variable cost of

manufacturing the product

Advantages of Marginal Costing: Marginal Costing has the following advantages:

1. The cost-volume-profit relationship data required for profit planning purpose is readily available from

the regular accounting statements

2. There is no change in the profit because of the changes in absorption of fixed expenses resulting from

the building or reducing inventory. Further, the profit moves in the same direction as sales when direct

costing is in use provided the other things such as selling prices, costs, sales mix, etc. remain equal

3. The manufacturing cost and income statements in the direct cost form follow management’s thinking

more closely than does the absorption cost form for these statements

4. Impact of fixed costs on profits is emphasised because the total amount of such costs for the period

appears in the income statement

5. Marginal costing helps in formulating plans for cost control just like the standard costs and flexible budget

6. It also helps in fixing the sales prices as well as tendering for contracts when business is at low

7. Marginal costing can help in ascertaining the break-even point

8. The marginal income figures facilitate relative appraisal of products, territories, classes of customers,

and other segments of the business without having the results obscured by the allocation of joint fixed

costs.

Limitations of Marginal Costing: There are some limitations that marginal costing technique has:

1. Since the costs are classified into fixed and variable, it may be at times difficult to classify them with

precision



mailto:011-49032737

mailto:011-49032737



49032737

2. This technique assumes that the cost behaviours can be represented in a straight line, which means that

the fixed costs remain completely fixed over a period at different levels while the variable costs changes

in a linear pattern, i.e. the costs changes with the change in volume. However, the fixed costs do change

at varying levels of production especially when an extra plant and equipment are introduced and hence

variable costs may not vary in the same proportion as the volume

3. Fixed cost is not included in the value of the stock of finished goods and work-in-progress, which ideally

should form part of. Hence, this leads to under-statement of finished stock and work-in-progress cost,

which in turn affects the profit and loss statement as the profit gets deflated

4. The monthly operating statements, in case of marginal costing, may not be as realistic as under the

absorption costing system. This is because the marginal contribution and profits vary with change in

sales value

5. This technique does not provide complete information, for instance, the production or sales may increase

due to extensive use of existing machinery or by an expansion of the resources or by replacement of

the labour force by machines

6. The marginal costing still does not address the problem of the under absorption or over absorption of

variable overheads, even though it addresses it for the fixed overheads

7. The long-term profit is correctly determined only on the full cost basis as marginal costing can help in

assessing the short-term profitability only

8. This technique does not provide any standard for the evaluation of the performance.

9. Marginal Costing analysis is based on the assumption that the sales price per unit will remain the same

on different levels of production. However, this actually changes in real life and therefore may give

unrealistic results

10.The selling price is fixed on the basis of contribution, which may not be possible in the case of “cost-plus

contracts”

Break-Even Analysis/Cost-Volume-Profit Analysis As per the accounting principles, all revenues and costs must be accounted for and any difference between

the two is the profit or loss. Further, the costs can be classified as either fixed cost (i.e. those costs that is

independent of the level of sales such as rent, salaries, etc.) or variable cost (i.e. those costs that is directly

related to the level of sales such as cost of goods, commissions, etc.)

The categorization of variable and fixed costs and their relationship with sales and profit have been

developed as “Break-Even Analysis” or “Cost-Volume-Profit” analysis. In the case of break-even analysis or

cost-volume-profit (CVP) analysis, the activity level is determined at which all the relevant costs are

recovered and there is a situation of no profit or no loss. This level of activity is termed as break-even point

(BEP), and refer to a point at which the volume of sales equals total expenses or the point at which there is

neither a profit nor loss under varying levels of activity. The BEP helps the manager ascertain the level of

output or activity required before the enterprise starts making a profit.

Objective of Break-Even Analysis/Cost-Volume-Profit Analysis

The following are the objectives of cost-volume-profit analysis:

1. For forecasting profit, it is important to know the relationship between profits and costs and volume

2. CVP analysis is useful in designing flexible budgets which indicate costs at various levels of activity

3. This can be helpful in performance evaluation for the purpose of control

4. The CVP analysis can help in formulating price policies to suit particular circumstances by projecting the

effect which different price structures will have on costs and profits

5. The CVP study also helps in ascertaining the amount of overhead costs which should be charged to

product costs at various level of operation



mailto:011-49032737

mailto:011-49032737




49032737

Assumptions of Break-Even Analysis:

The following assumptions are made while doing break-even analysis:

1. All costs can be easily classified into fixed and variable components

2. Both revenue and cost functions are linear over the range of activity under consideration

3. Prices of output and input remain unchanged

4. The productivity of the factors of production will remain the same

5. The state of technology and the process of production will not change

6. There will be no significant change in the levels of inventory

7. The company manufactures a single product

8. In the case of a multi-product company, the sales mix will remain unchanged

Advantages of Break-Even Analysis

The following are the advantages of cost-volume-profit analysis:

1. The profitability and BEP of different products can be ascertained with the help of the break-even chart.

Hence, the management may decide whether to continue or shutdown of business, either temporarily

or permanently, with the help of break-even analysis

2. The effect of changes in fixed and variable costs at different levels of production or profits can be

demonstrated by the graph legibly

3. The break-even chart also shows the importance of fixed cost in the total cost of a product, which can

help management in taking cost control measures if they find the cost to be too high

4. Break-even chart can help in the analysis of economies of scale, capacity utilisation and comparative

plant efficiencies

5. This analysis can also be helpful in forecasting, long-term planning, growth and stability

Limitations of Break-Even Analysis

Even though the break-even analysis is a great tool for cost management, there does exist some limitations

of it as discussed below:

1. The fixed costs do not remain constant always, while the variable cost may not always vary

proportionately. Similarly, the revenue also does not change proportionately

2. This analysis may not be very useful when the business is selling many products with different profit

margins

3. This is based on the assumption that income is influenced by the changes in sales and so the change in

inventory will not directly affect income. Hence, in the case of marginal costing, the assumption will hold

good. However, in other cases the changes in inventory will affect the income as the absorption of fixed

costs shall depend on the production and not sales

4. A single break-even chart can present limited information only, and so in order to study the changes in

fixed costs, variable costs and selling prices, a number of charts need to be drawn

5. In case the number of lines or curves depicted in the graphs are large then it may become complex and

difficult to understand for a layman

Use of Cost-Volume-Profit Analysis

CVP analysis can be used for the following:

1. It can help in forecasting costs and profits as a result of a change in volume

2. It can help in fixing sales volume level in order to earn or cover a given revenue, return on capital

employed, or rate of dividend

3. It can help in determining relative profitability on each of the product, line, project or profit plan

4. Assist in inter-firm comparison of profitability

5. It can help in ascertaining the cash requirements at a desired volume of output through the help of cash

breakeven charts

6. It emphasises the importance of capacity utilisation for achieving economy of scale

7. During a severe recession, this analysis can help in ascertaining the comparative effects of loss in case

of a shutdown or continued operation

8. The effect on the total cost of a change in the fixed over-head is more clearly demonstrated through

break-even analysis and cost-volume-profit charts



mailto:011-49032737

mailto:011-49032737



49032737

9. This analysis can help ascertain the effect of change in volume because of plant expansion or acceptance

of an order, with or without an increase in costs. In other words, it can help analyse the profit that should

be generated with the change in the volume of sales

Assumptions of Cost-Volume-Profit Analysis:

The following assumptions are made while doing cost-volume-profit analysis:

1. All variables remain constant per unit.

2. A single product or constant sales mix.

3. Fixed costs do not change.

4. Profits are calculated on a variable cost basis.

5. Total costs and total revenues are linear functions of output.

6. The analysis applies to the relevant range only.

7. Costs can be accurately divided into fixed and variable components.

8. The analysis applies only to the short-term horizon.

Methods for Determining Break-Even Points:

There are multiple ways, given below, to compute the break-even point.

1. Algebraic methods, where some formula is used to compute the BEP:

a. Contribution Margin Approach

b. Equation technique

2. Graphic presentation, where a chart is drawn which shows profit or loss at various levels of

activity

However, the algebraic method is most commonly used to calculate the break-even point. The same is

discussed below:

Contribution Margin Approach

The following formula can be used to compute in units:

𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 (𝑖𝑛 𝑢𝑛𝑖𝑡𝑠) =𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Or, 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

The following formula can be used to compute in value:

𝐵𝑟𝑒𝑎𝑘 − 𝐸𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 (𝑖𝑛 𝑣𝑎𝑙𝑢𝑒) =𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜

Or,

Beak-even points (units) × Selling price per unit

Equation Technique:

It is based on an income equation, where

Sales – Total costs = Net profit

The total cost can be broken down into fixed cost and variable costs, and so the equation in such case will

be as follows:

Sales – Fixed costs – Variable cost = Net profit

Sales = Fixed costs + Variable cost + Net profit

i.e.

SP x S = FC + (VC x S) + P

Where,

SP = Selling price per unit

S = Number of units required to be sold to break-even FC = Total fixed costs



mailto:011-49032737

mailto:011-49032737



49032737

VC = Variable cost per unit P = Net profit (Zero)

Hence, to calculate the break-even point, the profit is assumed to be zero. Hence the equation will be:

SP x S = FC + (VC x S) + P

or, SP x S = FC + (VC x S) + 0

or, (SP x S) - (VC x S) = FC

or, S x (SP – VC) = FC

or,

𝑆 =𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝑆𝑃 − 𝑉𝐶

For calculating the level of sales required to earn a particular level of profit, the following formula shall be

used:

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 (𝑖𝑛 𝑣𝑎𝑙𝑢𝑒𝑠) =𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡𝑠


Graphic Representation:

The BEP can be computed using the above chart as well. On the horizontal axis, the production and sales

volume is shown while on the vertical axis, sales and costs in amount are shown

Contribution: An enterprise having more than one product and following marginal costing will not be able to ascertain the

net profit per product because the fixed overheads are charged in total to the profit and loss account and

not recovered in the product costing. Hence, the contribution of each product is charged to the firm’s total

fixed overheads and profit is ascertained. Contribution is the difference between the selling price and the

variable cost of sales and is considered as some pool of fund from which all the fixed costs are to be met.

In case the contribution is more than the fixed cost then the firm is said to be making a profit, while there

will be a loss in case contribution is less than fixed cost. Generally, the selling price will have some profit in



mailto:011-49032737

mailto:011-49032737




49032737

it but then there can be a situation when the enterprise may have to sell the product either at cost or at

loss. Hence, the contribution will have the following composition in different situations:

• When Selling price contains profit, then Contribution = Fixed cost + Profit

• When Selling price is at cost, then Contribution = Fixed cost

• When Selling price is a loss, then Contribution = Fixed cost - Loss

Marginal Cost Equation: The equation for marginal cost can be written as:

Sales - Variable Cost = Fixed cost + Profit

This equation is derived from the basic equation of Sales – Cost = Profit. Here the Cost can be broken down

into Fixed Cost and Variable, which means Sales – (Fixed Cost + Variable Cost) = Profit. Hence, to get the

marginal cost equation, we take the Fixed Cost to the right, making the equation as Sales – Variable Cost

= Fixed Cost + Profit

Profit-Volume Ratio: Also known as Marginal Income Ratio or Contribution to Sales Ratio, or Variable Profit Ratio is the ratio or

percentage of contribution margin to sales. Profit-Volume Ratio (or P/V Ratio) is expressed in a percentage

form and denotes the rates at which the profit increases with the increase in volume. P/V ratios can be used

to compare different products to find out which product is more profitable. Below is the formula used to

calculate P/V Ratio:

𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 =𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝑆𝑎𝑙𝑒𝑠

or,

𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 =𝑆𝑎𝑙𝑒𝑠 𝑉𝑎𝑙𝑢𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡


or,

𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 = 1 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡


or,

𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 + 𝑃𝑟𝑜𝑓𝑖𝑡


or,

𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 =𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡/𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

Interpretation of Profit-Volume Ratio:

Higher the P/V ratio more will be the profit and lower the P/V ratio, lesser will be the profit. This ratio can

be improved by:

1. Increasing the selling price per unit

2. Reducing direct and variable costs by effectively utilising, men, machines and materials

3. Switching the production to more profitable products showing a higher P/V ratio.

Significance of Profit-Volume Ratio:

This ratio studies the inter-relationships of cost behaviour patterns, levels of activity and the profit that

results from each alternative combination. The following are the significance of P/V Ratio:

1. Helps in ascertaining the profit on a particular level of sales volume

2. Helps to determine the break-even point

3. Helps in the computation of sales required to earn a particular level of profit



mailto:011-49032737

mailto:011-49032737



49032737

4. Helps to estimate the volume of sales required to maintain the existing level of profit in case selling

prices are to be reduced by a certain margin

5. It is useful in developing flexible budgets for cost control purposes

6. It can also help to identify the minimum volume of activity that the enterprise must achieve to avoid

incurring losses

7. It can be handy in fixing the selling price when the volume has a close relationship with the price level

8. Can be used to evaluate the impact of cost factors on profit

Margin of Safety: It is the difference between the actual sales and sales at the break-even point. Any sales beyond the break-

even volume will generate profit for the enterprise, and therefore such sales are said to be the margin of

safety. Having a reasonable margin of safety is important as a reduced level of activity may prove disastrous

for the enterprise. Further, a business considered to be sound if it has a good size of the margin of safety.

A low margin of safety may mean that the enterprise has a high fixed overhead and so the profits won’t be

generated until there is a high level of activity to absorb fixed costs. On the other hand, a high margin of

safety may indicate that the break-even point is quite below the actual sales, so that in case of a fall in

sales, there may still be some profit.

It can be calculated using the following formula:

Margin of safety = Total sales – Break-even sales

Margin of safety can also be calculated with the help of Profit-Volume Ratio, using the following formula:

𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 =𝑃𝑟𝑜𝑓𝑖𝑡


To express Margin of Safety in percentage, the following formula can be used: 𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦

𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑥 100

The margin of safety can be improved by taking the following measures:

1. Reducing the fixed costs

2. Reducing the variable costs in order to improve the marginal contribution

3. Increasing volume of sales in case of unused capacity

4. Increasing the selling price, if market conditions permit

5. Changing the product mix in order to improve the contribution

Application of Marginal Costing: The technique of marginal costing is quite useful and can help the management in taking various decision.

The application of marginal costing are discussed below:

Profit planning:

It is a planning of future operations either to attain the maximum profit or continue generating the existing

level of profit. The contribution ratio, or the ratio of marginal contribution to sales, indicates the relative

profitability of the different segment of the business in case of a change in selling price, variable costs or

product mix. Further, the technique of marginal costing also helps to generate data required for profit

planning and decision-making. An enterprise can improve its profit by either of the ways:

• by increasing volume

• by increasing selling price

• by decreasing variable costs

• by decreasing fixed costs.

Evaluation of Performance:

An enterprise focuses more on departments or product lines which yield more contribution than others, and

so with the help of marginal costing technique (such as CVP Analysis or Contribution Approach), the

performance of each of these sectors could be brought, thus helping the enterprise to make a decision that

will maximise their profits.



mailto:011-49032737

mailto:011-49032737



49032737

Make or Buy Decisions:

Marginal Costing can be handy in taking a decision when it comes to deciding whether the enterprise should

purchase a component or a product from outside sources, or manufacture it by themselves. In case the

enterprise intends to buy from outside then, what is already being made, and the price quoted by the

outsider should be lower than the marginal cost. On the other hand, if they intend to make something that

is being purchased outside, then the cost of making should include all additional costs like depreciation on

a new plant, interest on capital involved, etc., which should then be compared with the purchase price.

Closure of a Department or Discontinuance of a Product:

Marginal Costing can help in deciding whether a product is profitable or not. It also provides the information

in such a way that that tells how much each product contributes towards fixed cost and profit, and that the

product or department which gives the lowest contribution should be discarded except for a short period.

Further, through this technique, the management can decide the product line to continue with on the basis

of the highest contribution, while closing down those that give the least.

Maintaining a Desired Level of Profit

There may be a situation when a company is required to reduce the price of its products, either because of

competition or government regulation or any other reasons. In such a scenario, the contribution per unit on

account of such a reduction in price is reduced while the industry is interested in maintaining a minimum

level of its profits. For instance, in case the demand of a product is elastic then the enterprise can maintain

a maximum amount of profits by pushing up the same and that volume can be computed with the help of

marginal costing technique.

Offering Quotations: A company may be required to quote the lowest possible quotation in order to get an order from a

prospective client. In such situation also, the company may, by using marginal costing technique, can quote

any amount above the marginal cost as it will give them an additional marginal contribution and therefore,

profit.

Accepting an Offer or Exporting below Normal Price:

When an enterprise can increase the volume of output and sales by reducing the normal prices of additional

sale. In such a case, the enterprise needs to be cautious enough to see that the sale below the normal price

in additional markets should not affect the normal market. However, they may sell the product under a

different label of a different brand in order to not affect the sale of the existing product. Further, in case

there is additional sale because of export orders, then the enterprise may sell the goods at a price below

the normal.

Alternative Use of Production Facilities:

In case the company has an alternative use of production facilities or alternative methods of manufacturing

a product, then the contribution analysis can be used to arrive at the final choice. Generally, the alternative

which will yield the highest contribution is selected.

Problem of Key Factor:

An enterprise is required to mobilise the available resources in such a way that contribution generated is

the highest. However, there can be a situation wherein several factors may put a limit on the number of

units to be produced even if the products give the highest contribution. These constraints, also known as

limiting factor or principal budget factors, need to be considered to decide on as these factors may limit the

volume of output at a particular point of time or over a period. The limiting factors could be a sale, raw

material, labour, capacity of the plant, availability of capital. Hence, the extent of influence of these limiting

factors needs to be examined before making any decision. In this case, the contribution per unit of key

factor should be considered and that course of action should be adopted which gives the highest contribution

per unit of key factor.

Selection of a Suitable Product Mix:

When an enterprise manufactures more than one product, then they will have to decide the proportion in

which the products should be produced and sold. Hence, the technique of marginal costing may come handy



mailto:011-49032737

mailto:011-49032737



49032737

in helping the management determine the most suitable product or sales mix. The best product mix will be

one which yields the maximum contribution. But in case the key factor is not available, then the enterprise

may compute the contribution under various mix and then select the one which gives them the highest

contribution.

Composite Break-Even Point: An enterprise may have difference manufacturing establishments with each of them having its own

production capacity, and fixed costs while producing the same product. Further, the enterprise as a whole

is a unit having different establishments under the same management. In such a case, the combined fixed

costs have to be met by the combined BEP sales. This can be done by either of the two approaches:

1. Constant product mix approach, wherein the ratio in which the products of the various establishments

are mixed is constant

2. Variable product mix approach, wherein, the product of that particular establishment will be preferred

where the contribution ratio is higher

Absorption Costing: In the case of absorption costing, all the manufacturing cost (such as Direct Material, Direct Labour, Fixed

and Variable Overheads) are absorbed by the total units produced. Also referred to as full costing or the full

absorption method, it is used for external financial reporting and for income tax reporting.

Difference between Absorption Costing and Marginal Costing: The following is the difference between absorption costing and marginal costing:

Absorption Costing Marginal Costing

It is a cost technique, wherein, both variable

and fixed costs are charged to products, processes or operations

In this case, only variable costs are charged to

products, processes, or operations. The fixed costs are charges as a period costs to the profit and loss statement of the same period in which

they are incurred

Fixed factory overheads are absorbed by the

production units on the basis of a predetermined fixed factory overhead recovery

rate based on normal capacity. Under/over absorbed overheads are adjusted before arriving at the figure of profit for a particular

period

The cost of production under this method does

not include fixed factory overheads and therefore, the value of closing stock comprises

of only variable costs. No part of the fixed expenses is included in the value of closing stock and carried over to the next period

Despite the best possible forecast and

equitable basis of apportionment/allocation of fixed costs, under or over recovery of fixed

overheads generally arises

Since fixed overheads are not included in the

cost of production, therefore the question of their under/over recovery does not arise

Managerial decisions under this costing

technique are based on profit, i.e. excess of sales value over total costs, which may at times lead to erroneous decisions

In the case of Marginal Costing, decisions are

made on the basis of contribution, i.e. excess of sales price over variable costs. This basis of decision making results in optimum profitability



mailto:011-49032737

mailto:011-49032737

https://www.practicemock.com/exams/government/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SebiGrAMock&utm_medium=Link&utm_campaign=SebiGrAMock



49032737

Budget, Budgeting and Budgetary Control

Budget: A budget is a precise statement of the financial and quantitative implications of the course of action which

the management has decided to follow in the defined period of time. The following are the essential features

of a budget:

1. A budget is a statement expressed in monetary and/or physical units prepared for the implementation

of policy formulated by the management

2. It is prepared before the budget period during which it is followed

3. It is prepared for the definite future period

4. The policy to be followed to attain the given objective must be laid before the budget is prepared

Budgeting: It is a complete process of designing, implementing and operating budgets. The main emphasis in this is

short-term budgeting process involving the provision of resources to support plans which are being

implemented.

Budgetary Control: The Chartered Institute of Management Accountants, London, defines Budgetary Control as “the

establishment of budgets, relating the responsibilities of the executive to the requirements of a policy and

the continuous comparison of actual with budgeted results either to secure by individual action the objectives

of that policy or to provide a firm basis for its revision.” Hence, a budgetary control system secures control

over performance and costs in the different parts of a business by:

1. establishing budgets

2. comparing actual attainments against the budgets

3. taking corrective action and remedial measures or revision of the budgets, if necessary.

Forecast and Budget: A forecast is different than the budget in the following ways:

Forecast Budget

It is a mere estimate of what is likely to happen in future. In other words, it is a statement of probable events which are likely to happen

under anticipated conditions during a specified period of time

It states the policy and programme to be followed in a future period under planned conditions

Since it is related to future events, no control can be exercised over it

It is a tool of control since it represents actions which can be shaped as per need so that it can

be suited to the conditions which may or may not happen

It is a preliminary step for budgeting and ends

with the forecast of likely events

Budget can be prepared only after forecasting

has ended. A forecast can be converted into budgets

It has a wider scope since it can be made in those spheres also where budgets may not

interfere

It has limited scope and is made of a phenomenon which is non-capable of being

expressed quantitatively

Objectives of Budgeting: Having a good budgeting system is important for the success of any business and has the following

objectives which can help in achieving overall efficiency and effectiveness of the business organization.



mailto:011-49032737

mailto:011-49032737



49032737

Planning: It is necessary to do some planning before starting any work and so a well-prepared plan will

help the enterprise to use the scarce resources efficiently so that it can achieve the predetermined targets

becomes easily. A budget automatically facilitates planning since it is prepared for the future period and it

lays down targets regarding various aspects such as purchase, production, sales, manpower planning, etc.

Co-ordination: Merely planning may not be sufficient to achieve the pre-determined objectives. A well-

coordinated effort is also required and budgeting facilitates as budgets cannot be developed in isolation. For

instance, to develop a production budget, the production manager will have to discuss with the sales

manager for a sales forecast and purchase manager for the availability of the raw material.

Control: While preparing a budget, detailed planning is required but at the same time there needs to be a

proper system of controlling to ensure that the work is progressing as per the plan. A budget provides the

basis for such controlling in the sense that the actual performance can be compared with the budgeted

performance and any deviation between the two can be found out and analysed to ascertain the reasons

behind the deviation so that necessary corrective action can be taken.

Benefits of Budgeting: Budgeting can help in the allocation of scarce resources to the most productive use and therefore ensuring

overall efficiency in the organization. The following are the benefits associated with budgeting:

1. It facilitates in the planning of various activities and ensures that the organization is working in a

systematic and smooth manner

2. It facilitates coordination among various department as no budget can be prepared in isolation

3. Since budgeting is a coordinated exercise, it, therefore, combines the ideas of different levels of

management in the preparation of the same

4. It can help in planning and controlling income and expenditure in order to achieve higher profitability

while also acting as a guide for various management decisions

5. Budgeting can help to ensure that sufficient working capital and other resources are available

6. Since budgeting helps in directing the resource to the most productive use, it also means that fewer

wastages and losses will happen

7. Budgeting can also help in evaluating the actual performance with predetermined parameters

Preparation of a Budgetary Control: Budgetary Control can be very useful for planning and control provided a solid foundation is laid down. In

view of this the following aspects are of crucial importance:

Budget Committee: In any organization, a budget committee is required for the successful implementation

of a budgetary control system. In case of a small or a medium-sized organization, the chief Accountant may

carry out the budget-related work as there may not be any problem in the implementation of the budgetary

control system. However, in case of a large size organization, a budget committee will be required consisting

of the chief executive, budget officer and heads of main departments in the organization. The budget

committee’s primary function is to get the budgets prepared and then review the same, lay down broad

policies regarding the preparation of budgets, approve the budgets, suggest revisions, monitor the

implementation and recommend the action to be taken in a given situation.

Budget Centres: A budget centre refers to a group of activities or sections of the organization for which

the budget will be developed. For instance, the budget centre can be related to manpower planning budget,

research and development cost budget, production and production cost budget, labour hour budget, etc. It

is important to define the budget centre clearly and explicitly so that budget preparation is easy.

Budget Period: The period for which the budget is to be prepared should be certain and defined. Further,

this period should be decided in advance. Hence, a budget may be prepared for three years, one year, six

months, one month or even for one week depending on the need of the management. Generally functional

budgets such as sales, purchase, production, etc. are prepared for a year and then broken down on a

monthly basis, while budgets like capital expenditure are prepared for a period ranging from 1 to 3 years.



mailto:011-49032737

mailto:011-49032737



49032737

Preparation of an Organization Chart: An organization chart should be prepared that clearly shows the

defined authorities and responsibilities of various executives. In other words, this chart should define the

roles and responsibilities related to the budget preparation for each of the executive along with his

relationship with other executives. Further, the organization chart may be adjusted so as to ensure that

each budget centre is controlled by an appropriate member of the staff.

Budget Manual: As per ICMA, a budget manual is “a document which sets out the responsibilities of the

person engaged in, the routine of and the forms and records required for budgetary control.” Hence, a

budget manual is a schedule, document or booklet, containing different forms to be used, procedures to be

followed, budgeting organization details, and set of instructions that need to be followed in the budgeting

system. Besides this, it also lists out details of the responsibilities of different persons and the managers

involved in the process. Generally, a budget manual contains the following:

1. Objectives and managerial policies of the business concern

2. Internal lines of authorities and responsibilities

3. Functions of the budget committee including the role of budget officer

4. Budget period

5. Principal budget facto

6. Detailed program of budget preparation

7. Accounting codes and numbering

8. Follow up procedures

Principal Budget Factor or Key Factor: Also known as Contrast Factor is that factor the extent of whose

influence must first be assessed in order to prepare the functional budgets. Generally, Sales is the key factor

but then other factors like production, purchase, skilled labour, etc. may also be the key factors. The key

factor imposes restrictions on the other functions and therefore it is important that it is considered carefully

in advance, thus making a continuous assessment of the business situation necessary. It is mostly the key

factor which is the starting point in the process of preparation of budgets. Below is the list of some of the

key factors:

• Sales: Consumer demand, shortage of sales staff, inadequate advertising

• Material: Availability of supply, restrictions on import

• Labour: Shortage of labour

• Plant: Availability of capacity, bottlenecks in key processes

• Management: Lack of capital, pricing policy, shortage of efficient executives, lack of know-

how, faulty design of the product, etc.

Establishment of Adequate Accounting Records: It is important to ensure that accounting system is

able to record and analyse the transaction involved, and therefore, a chart of accounts should be maintained

which may correspond with the budget centres for the establishment of budgets and finally control through

budgets.

Budget Reports: Having budgets will not be useful if there is no comparison made regularly between the

actual expenditure and the budgeted allowances, with the results being reported to the management. Hence,

a budget report should be prepared periodically and promptly to show the comparison between the actual

and budgeted expenditure. Further, the report should reveal the responsibility of the department or an

executive and give full reasons for the deviation, if any, so that corrective measures can be taken. A budget

report should be followed up until the final desired results are achieved.



mailto:011-49032737

mailto:011-49032737




49032737

Types of Budgets:

On the basis of Scope:

On the basis of scope or area of operation, budgets can be divided into the following:

Functional Budget: A functional budget is prepared for each function of an organization, and is generally

prepared for a period of one year and then broken down into each month. The following are the principal

functional budgets:

Sales Budget: The sales budget is a forecast of expected total sales in the future period, expressed in

quantity and value terms. This budget may be prepared by product, territories/area/country, by customer

group, by salesmen as well as by time such as quarterly, monthly, weekly, etc. For preparing a Sales Budget,

past sales should be analysed, estimates from sales personnel should be considered, analysis to understand

the marketing potential should be done and other dependent factors should be analysed.

Production Budget: A production budget is a forecast for the production for the budgeted period and is

prepared both in quantity and monetary terms. While preparing a production budget, the following steps

are considered: production planning, consideration of capacity, integration with sales forecasts, inventory-

policies, and management’s overall policies. A production budget helps the organization in optimizing the

available resources for production and ensuring that goods are produced as per schedule so as to meet the

delivery dates.

Production Cost Budget: An extension of the production budget, but is expressed in monetary terms. It

is prepared by multiplying the production targets with the budgeted production cost per unit. This type of

budget may be classified into the following:

• Material Budget: Also known as Material Requirement Budgets, this budget help the purchasing

department in planning the purchases, fixing the maximum and minimum levels of materials,

components, etc. It can be prepared in both quantity and value terms. While preparing a material budget,

the availability of storage space, financial resources, various levels of materials like maximum, minimum,

re-order and economic order quantity should be taken into consideration.

• Labour Budget: This budget estimates the requirement for labour for smooth and uninterrupted

production. This budget, basically, tells the management about the number of each type or grade of

workers required during each of the period for achieving the budgeted output, budgeted cost of such

labour, period-wise and period of training necessary for different types of labour.



mailto:011-49032737

mailto:011-49032737



49032737

• Plant Budget: This budget helps in estimating the plant capacity to meet the budgeted production

during the budgeted period. Generally expressed in working hours or other convenient units, plant

budget or plant utilisation budget forecasts the plant capacities available for fulfilling production

requirements as specified in the production budget.

Overheads Budget: An overhead budget can be classified into the following budgets:

• Manufacturing Overheads Budget: A budget prepared for the planning of the factory overheads that

are to be incurred during the budget period is known as Manufacturing Overheads Budget. Here, the

overheads should be shown department-wise so that the responsibility can be fixed on proper persons.

Further, the budget needs to classify the factory overheads into fixed and variable components.

• Selling and Distribution Budget: This budget is a forecast of selling and distribution expenses for the

budgeted period, and accounts for all items of expenditure on the promotion, maintenance and

distribution of finished products. This budget is very closely related to the sales budget. Further, the

budget should classify the selling and distribution expenses into fixed and variable with regard to the

volume of sales.

Research and Development (R&D) Budget: An important tool for planning and controlling research and

development cost, this budget helps the management to plan for the research and development activities

well in advance and also about the fairness of the expenditure. Besides this, the R&D Budget can also help

in planning the number of staffs required to carried out the R&D activity.

Financial Budget: A financial budget can be classified into the following budget:

• Cash Budget: It is an estimate of cash receipts and cash payments prepared for each month. While

preparing a Cash Budget, all the expected payments, revenues (both capital and revenue in nature) are

considered. Hence, it can be said that this budget can help predict the cash receipts and payments so

that the company is aware whether the cash balance at the end of the budget period is in surplus or

deficit. This, in turn, will help the management to decide whether they should invests the surplus or

raise the necessary fund to finance its deficit. Although there are many ways to prepare a cash budget

with the most popular one being the Receipt and Payment method.

• Capital Expenditure Budget: This budget plans the proposed outlay on fixed assets and is very closely

related to the cash budget. Since capital forecasting a continuous process and is a long-term function,

this forecast should be made for several years. However, the management should also have a short term

forecast to cover the general budget period under consideration. Further, the importance of this budget

lies in the fact that it not only plans the expenditure but also evaluates the same, thereby, helping in

making a decision. A capital expenditure budget should be integrated with the operational budgets so

that they form an integral part of the overall plan.

Master Budget: A master budget is a consolidated summary of the various functional budgets which is

finally approved, adopted and employed. This budget shows the projected Profit and Loss Account and

Balance Sheet of the business organization. In order to prepare this budget, all the functional budgets are

combined and then the relevant figures are incorporated for preparing the projected Profit and Loss Account

and Balance Sheet. Hence, the master budget is prepared as a whole for the company and not for any

individual department of functions.

On the basis of Efficiency:

On the basis of the efficiency or capacity utilization, budgets can be divided into the following:

Fixed Budget: A budget designed to remain unchanged with the change in the level of activity is called a

fixed budget. Hence, a fixed budget is designed for a specific planned output level and does not get adjusted

to the level of activity attained at the time of comparison between the budgeted and actual costs. The fixed

budget prepared can be established only for a small period of time when the actual output is not expected

to differ much from the budgeted output. But there can be some revision in a fixed budget if the business



mailto:011-49032737

mailto:011-49032737



49032737

conditions undergo some change or due to any other reasons, the actual operations differ widely from that

of planned in the fixed budget. This type of budget is suited for fixed expenses having limited application

and is, therefore, ineffective as a tool for cost control.

Flexible Budget: As per CIMA, a flexible budget is one which by recognising different cost behaviour

patterns, is designed to change as the volume of output changes. In other words, a flexible budget is one

which gives the budgeted cost for any level of activity. A flexible budget recognises the difference between

fixed, semi-fixed and variable cost and changes in relation to the activity attained. Flexible budgeting is

generally used in the following cases:

• In case the level of activity during the year varies from period to period, be it due to the seasonal nature

of the industry or due to variation in demand

• In case the business is a new one and is difficult to foresee the demand

• In case the undertaking is suffering from a shortage of a factor of production such as materials, labour,

plant capacity, etc.

While preparing a flexible budget, it is important to analyse each of the cost items individually so as to

understand how different items of cost behave to change in volume. Hence, in-depth cost analysis and cost

identification are required while preparing a flexible budget. A flexible budget has the following features:

1. A flexible budget is prepared for a range of activity and not for a single level

2. It provides a dynamic basis for comparison as they are automatically geared to changes in volume

3. It provides a tailor-made budget for a particular volume

4. A flexible budget is based upon adequate knowledge of cost behaviour pattern

On the basis of Conditions:

On the basis of conditions, budgets can be divided into the following:

Basic Budget: A budget prepared for use unaltered over a long period of time is called a Basic Budget. This

type of budget does not consider the current conditions and therefore, can be attainable under standard

conditions.

Current Budget: A budget which is related to the current conditions and is prepared for use over a short

period of time is called a Current Budget. This type of budget is slightly more useful than the basic budget

as the target it lays down will be corrected to current conditions.

On the basis of Period:

On the basis of period or time, budgets can be divided into the following:

Long Period Budget: It is a type of budget which is prepared for a period longer than a year. This type of

budget can be helpful in business forecasting and forward planning. However, due to uncertainty very few

budgets are prepared for a long period.

Short Period Budget: It is a type of budget which is prepared for a period of less than a year. These

budgets are helpful to lower levels of management for control purposes. Generally, functional budgets are

prepared for a period of one year and then it is broken down month wise.

Zero Base Budgeting: A Zero Base Budgeting (ZBB) is a method of budgeting wherein all the activities are re-evaluated each time

a budget is formulated and every item of expenditure in the budget is fully justified. Hence, a ZBB is prepared

from scratch or zero. In a ZBB, all activities need to be justified and prioritised before decisions regarding

the allocation of resources are made.

Applications of Zero Base Budgeting: In case of a Zero base Budgeting, the following stages/steps are involved in the application:

• The organization needs to identify each activity separately and is called as a decision package. The

decision package is a document which identifies and describes an activity in a manner that can be

evaluated by the management and rank against other activities competing for limited resources and

decide whether to sanction the same or not

• Every decision package needs to be justified in the sense it should be ascertained whether the package

is consistent with the goal of the organization or not

• In case the package is consistent with the overall objectives of the organization, then the cost of

minimum efforts required to sustain the decision shall be determined



mailto:011-49032737

mailto:011-49032737



49032737

• Alternatives for each decision package are considered in order to select better and cheaper options.

• The decision package selected should be based on the cost and benefit analysis and resources are

allocated to the selected package

Benefits from Zero Based Budgeting:

A Zero Base Budgeting has the following benefits:

1. It reviews most of the activities from scratch and a detailed cost-benefits study is conducted for each

activity. Hence, an activity will be continued only if the cost-benefits analysis is favourable

2. Performing detailed cost-benefits analysis results in the efficient allocation of resources, while also

helping in eliminating wastages and obsolescence

3. For evaluating cost and benefits arising from an activity, a lot of brainstorming may be required. Hence,

this may result in the generation of new ideas staff may feel the sense of belongingness

4. Zero base budgeting helps in improving communication and coordination amongst the staff

5. Zero Base Budgeting leads to record building as detailed documentation is required for implementing

this system

Limitations of Zero Based Budgeting:

A Zero Base Budgeting has the following limitations:

1. ZBB is quite a time consuming task and a lot of paperwork is involved in the same

2. The cost involved in preparation and implementation of ZBB is very high

3. In case a particular activity is discontinued, then the morale of the staff may become low as they might

feel threatened

4. Ranking of activities and decision-making may become subjective at times.

5. In the case of non-financial considerations, this method may not be suitable as this will dictate rejecting

a budget claim on low ranking projects

Performance Budgeting: In this type of budgetary system, the input costs are related to the performance or the end results. This

type of budget is generally used by the Government and Public Sector Undertaking. Basically in this type of

budget, the Government activities and expenditure are projected for the budget period and generally starts

with the broad classification of expenditure according to functions such as education, health, irrigation,

social welfare, etc. Thereafter, each of the functions is classified into programs and sub-classified into

activities or projects. Following are the main purpose of preparing a performance budget:

• It helps measure progress towards the short-term and long-term objectives

• Inter-relate physical and financial aspects of every programme, project or activity

• Facilitate effective performance audit

• Assess the effect of decision-making of supervisor to the middle and top-managers

• Bring out the annual plans and budgets in line with the short and long-term plan objectives

A performance budgeting does have some limitations such as difficulty in classifying programmes and

activities, problems of evaluation of various schemes, relegation to the background of important

programmes. Further, the budgeting technique enables only quantitative evaluation scheme and therefore,

the needed results may not be possible to measure.

Programme Budgeting: It is a type of budget that is designed for a specific activity or a program and includes only the revenue and

expenses for the specific program. This type of budget is used by many organizations including businesses

and schools. In case of a program budget, only the proposed capital expenditures for the specific program

is included. It allocated funds to major program areas so as to focus on the desired results of services and

activities that will be carried out.



mailto:011-49032737

mailto:011-49032737


Documents

SEBI GRADE A 2020: COSTING: COST CONTROL & ANALYSIS€¦ · Even the selling and distribution cost needs to be classified into fixed, variable and semi-variable costs. Variance Analysis: