Important questions and answers of acconting for management

Important questions and answers of acconting for management

Qn No 1;

Define Accounting? What are the principles of accounting?

Ans;

Meaning and Definition of Accounting

“Accounting is a service activity. Its function is to provide quantitative information primarily financial in nature about economic activities that is intended to be useful in making economic decisions.”

“Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part, at least, of a financial character, and interpreting the results there of.”- American Institute of Certified Public Accountants, 1941.

 “Accounting system is a means of collecting, summarizing, analyzing and reporting in monitory terms, information about the business.”- Robert N. Antony                                                                            

Accounting Principles

The term ‘Principles’ refers to fundamental belief or a general truth which once established does not change. AICPA defined the term ‘Principles’ as a guide to action, a settled ground or basis of conduct or practice. Accounting principles can be classified into two categories:

Accounting concepts, and Accounting conventions

Accounting Concepts or Accounting postulates

Accounting concepts may be considered as postulates i.e., basic assumptions or conditions upon which the science of accounting is based.

i)                    Business Entity Concept
This concept implies that a business unit is separate and distinct from the person who supplies capital to it. The accounting equation (i.e. Assets = Liabilities + Capital) is an expression of the entity concept because it shows that the business itself owns the assets and in term owns the various claimants. Business is kept separate from the proprietor so that transactions of the business may also be recorded with him. Thus, in the books of sole trader, a firm or a limited company, only business transactions are recorded and no note is taken of the personal transactions of a sole proprietor, the partners of the firms and the shareholders of the company. But their transactions with the business, (e.g., capital provided to the business, goods and amount withdrawn from the business for the personal use of the sole trader and the partners of the firm, income tax or life insurance premium paid from the business on the taxable income or life of the proprietor etc.) are recorded so that true financial position and profitability of the business may be disclosed. The non business expenses, incomes, assets and liabilities of a sole proprietor are excluded from the business accounts.
ii)                  Money Measurement Concept
Money is the only practical unit of measurement that can be employed to achieve homogeneity of financial data, so accounting records only those transactions which can be expressed in terms of money though quantitative records are also kept. The advantages of expressing business transactions in terms of money is that money serves a common denominator by means of which heterogeneous facts about a business can be expressed in terms of money which are capable of additions and subtractions. The money measurement concept restricts the scope of accounting as it does not record the fact that there is a strike in the factory or the sales manager is not on speaking terms with the production manager.

Accounting therefore, does not give a complete account of the happenings in a business unit. Thus, money measurement concept of accounting and reporting the activities of an enterprise has two major limitations.

a) It restricts the scope of accounting because it is not capable of recordings transactions which cannot be expressed in terms of money.

b) It does not take care of the effects of inflation because it assumes a stability of the money measurement unit.

Generally business entity concept and money measurement concept are called fundamental accounting concepts.

iii)                Going Concern Concept

It is assumed that a business unit has a reasonable expectation of continuing business at a profit for an indefinite period of time. A business unit is deemed to be a going concern and not a gone concern. It will continue to operate in the future. Transactions are recorded in the books keeping in view the going concern aspect of the business unit. This assumption provides much of the justification for recording fixed assets at original cost (i.e. acquisition cost) and depreciating them in a systematic manner without reference to their current realizable value. Fixed assets are acquired for use in the business for earning revenues and are not meant for resale, so they are shown at their book values.

 iv)                Cost Concept

A fundamental concept of accounting closely related to the going concern concept, is that an asset is recorded in the books at the price paid to acquire it and that this cost is the basis for all subsequent accounting for the asset. Asset is recorded at cost at the time of its purchase but is systematically reduced in its value by charging depreciation. The cost concept has the advantages of bringing objectively in the accounts. Information given in the financial statements is not influenced by the personal bias or judgment of those who furnish such statement. To overcome the drawback of cost concept, inflation accounting is advocated which makes a provision for recording all items regularly in the financial statements at their current values. The cost concept raises another problem. The major asset of a highly succeessful firm is the knowledge and skill created as a result of team work and good organisation . This asset will not appear in the accounts , since the firm has paid nothing for it.

    v)        Dual aspect concept

According to this concept, every financial transaction involves a two-fold aspect, (a) yielding of a benefit and (b) the giving of that benefit. There must be a double entry to have a complete record of each business transaction, an entry being made in the receiving account and an entry of the same amount in the giving account. The receiving account is termed as debtor and the given account is called creditor. Thus every debit must have a corresponding credit and vice versa and upon this dual aspect has been raised the whole superstructure of Double Entry System of Accounting.

vi)  Accounting Period Concept

Truly speaking, the measurement of income or loss of a business entity is relatively simple on a whole-life basis. A complete and accurate picture of the degree of success achieved by a business unit cannot be obtained until it is liquidated, converts its assets into cash pays off its debts. But the owners, the investors and overall the Government, all the impatient and do not want to wait, until the dissolution of the concern, to know what has been the results of the business activities. This means that the final accounts must be prepared on a periodic basis rather than waiting till the business is terminated. Under the going concern concept it is assumed that a business entity has a reasonable expectation of containing business for an indefinite period of time. This assumption provides much of the justification that the business will not be terminated so it is reasonable to divide the life of the business into accounting, periods so as to be able to know the profit or loss of each such period and the financial position at the end of such a period .Normally accounting period adopted is one year as it helps to take any corrective action, to pay income tax, to absorb the seasonal fluctuations and for reporting to the outsiders. A period of more than one year reduces the utility of accounting data.

 

vii) Matching concept

This concept is based on the accounting period concept. The determination of profit of a particular accounting period is essentially a process of matching the revenue recognized during the period and the costs to be allocated to the period to obtain the revenue. Revenue is considered to be earned on the date at which it is realized i.e. on the date when the goods are delivered or services rendered to the customer even though payment may be received at some future data. Expenses paid in advance are excluded from the total costs and expenses outstanding are added to the total costs to arrive at the costs attached to the period. Application of matching concept in practice, however, is beset with certain difficulties. There are some expenses like preliminary expenses, share issue expenses, advertisement expenses etc. which are not readily identifiable against the revenue of a particular period.

viii) Realization Concept

According to this concept associated with recognition of revenue is considered as being earned on the date at which it is realized i.e. on the data when the property in goods passes to the buyer and he becomes legally liable to pay. A customer at Ranchi places an order with a manufacturer at Delhi on 1^st January. On receipt of order, the manufacturer manufacturers goods and delivers them to the customer at Ranchi on 1^st February who makes payment of goods on March ` after enjoying the credit period of one month. In this case, revenue was realized not on January 1, when order was received nor on March 1, when cash was realized but on February 1, when goods were delivered to the customer. In case of hire-purchase sales, the ownership of goods sold on hire-purchase does not pass to the purchaser when the goods are delivered but it passes when the last installment is paid.  

ix)  Objective Evidence Concept

Entries in accounting records and data reported in financial statement must be based on objectively determined evidence. Invoices and vouchers for purchases and sales, bank, statements for amount of cash at bank, physical checking of stock in hand etc. are examples, of objective evidence which are capable of verification. As far as possible, every entry in accounting records should be supported by some objective evidence. Evidence should be such which will minimize the possibility of error and intentional bias or fraud. Evidence is not always conclusively objective for there are numerous occasions in accounting where judgements and other subjective factors play part. In such situation, it should be seen that most objective evidence available should be used. For, example, the Provision for Doubtful Debts Account is an estimate of the losses expected from failure to collect sales made on credit. Estimation of this account should be made on such objective factors as past experience in collecting debtors and reliable forecasts of future business activities.

x) Accrual Concept

The essence of the accrual concept is that revenue is recognized when it is realized, that is when sale is complete or services are given and it is immaterial whether cash is received or not. Similarly, according to this concept, expenses are recognized in the accounting period in which they help in earning the revenue whether cash is paid or not. Thus, to ascertain correct profit or loss for an accounting period and to show the true and fair financial position of the business at the end of the accounting period, we make record of all expenses and incomes relating to the accounting period whether actual cash has been paid or received or not. Therefore, as a result of the accrual concept, outstanding expenses and outstanding incomes are  taken into consideration while preparing final accounts of a business entity.

 

ACCOUNTING CONVENTIONS

i) Convention of Consistency

Accounting rules, practices and conventions should be continuously observed and applied i.e. these should not change from one year to another. The result of different years will be comparable only when accounting rules are continuously adhered to from year to year. Consistency serves to eliminate personal bias because the accountant will have to follow consistent rules, practices and conventions year after year. This convention does not completely prohibit changes. It does not debar from introducing improved accounting techniques. However, if a change becomes desirable, the change and its effect on profits and financial position as compared to the previous year should be clearly stated in the financial statement.Eg various methods for charging depreciation- straight line ,diminishing balance, sinking fund, etc

ii) Convention of Full Disclosure

According to this convention, all accounting statements should be honestly prepared to that end full disclosure of all significant information should be made. All information which is of material interest to proprietors, creditors and investors should be disclosed in accounting statements. The companies Act, 1956 has prescribed the forms in which financial statements are to be prepared. The act makes ample provisions for the disclosure of essential information that there is no chance of any material information being left out. For example, the basis of valuation of fixed assets, investments and stock should be clearly stated in the Balance Sheet because it is of material interest to the proprietors, creditors and prospective investors.

iii) Convention of Conservatism or Prudence

 Conservatism is a policy caution or a safeguard against possible losses. It compels the businessman to wear a “risk-proof’ jacked, for the working rule is : anticipate no-profits but provide for all losses. For example, higher than the cost, the higher amount is ignored in the accounts and closing stock will be valued at cost which is lower than the market price. But if the market price is lower than the cost, the higher amount of cost will be ignored and stock will be valued at market price which is lower than the cost.

iv) Convention of Materiality

Whether something should be disclosed or not in the financial statements will depend on whether it is material or not. Materiality depends on the amount involved in the transaction. For example, minor expenditure of Rs.10 for the purchase of waste basket may be treated as an expense of the period rather than an asset. Customs also influence materiality. For example, only round figures (to the nearest rupee) may be shown in the financial statements to make the figures manageable without affecting the accounting data. Similarly, for income tax purpose the income has to be rounded to nearest ten rupees. The term ‘materiality’ is a subjective term. The accountant should record an item as material even though it is of small amount if its knowledge seems to influence the decision of the proprietors or auditors or investors.

 

Qn No 2;

What is fund flow statement? Explain the steps involved in the prepration of fund flow statement?

Ans;

Funds Flow Statement

The Fund Flow Statement is a financial statement which reveals the methods by which the business has been financed and how it has used its funds between the opening and closing balance sheet date. Thus, a fund flow statement is a report on movement of funds explaining wherefrom working capital originates and where into the same goes during an accounting period.

Preparation of Fund Flow Statement

Generally speaking, the Fund Flow analysis requires the preparation of two statements.  

(a)    Statement of Changes in Working Capital and  (b) Fund Flow Statement
(a) Statement of Changes in Working Capital
A Statement of working capital is prepared to depict the changes in working cagM tal. Working capital represents the excess of Current Assets over Current Liabilities. Since, several items i.e. all current assets and current liabilities are the component of working capital, it is necessary to measure the increase or decrease therein, by preparing a Statement or Schedule of changes in Working Capital. This Statement is prepared with current assets and current liabilities as appearing in the Balance Sheets under
consideration. A form of the Statement is given below

 

STATEMENT OR SCHEDULE OF CHANGES IN WORKING CAPITAL

 

 

 

 

 

Particulars	Amount of Previous year	Amount of current year	Effect on	Working Capital
			Increase		Decrease
			(Dr.)		(Cr.)
	Rs.	Rs.	Rs.		Rs.
Current Assets :
Cash in hand
Cash at Bank
Bills Receivable
Sundry Debtors
Temporary Investments
Stocks/Inventories
Prepaid Expenses
Accrued Incomes etc.
TOTAL CURRENT
ASSETS or (A)

 

 

 

 

 

Current Liabilities : Bills Payable Sundry Creditors Outstanding Expenses Bank Overdraft Short-term Advances Dividends Payable etc. TOTAL CURRENT LIABILITIES Or  (B) working capital (A-B) NET INCREASE/ DECREASE IN WO RKING CAPITAL
TOTAL

 

(b) Fund flow statement

This is second but most important part of Fund Flow Statement. After preparing the Statement of working Capital, the Statement of Sources and Application of Fund is prepared. This statement is prepared with the help of remaining items in the Balance Sheet of the two periods –all non-current assets and non-current liabilities and other information given in the problem. That is, it is prepared on the basis of the changes in Fixed Assets, Long-tern Liabilities and Share Capital ascertained on the basis of values of these items shown in the Balance Sheets. Of course, additional information, if given, must also be considered.

 

FUND FOW STATEMENT

For the year ended…..

SOURCES OF FUNDS  (inflow)	Rs.	APPLICATION OF FUNDS (Outflow)	Rs.
Trading Profit Issue of Share Capital Issue of Debentures Long term Borrowings Sale of Fixed Assets Non-Trading Incomes Decrease in Working Capital         Total	- - - - - - -       ------------------------	Trading Loss Redemption of Redeemable Preference Shares Redemption of Debentures Repayment of Other Long Term Loans Purchase of Fixed Assets Non-Trading Expenditure Increase in Working Capital   Total	-   - -   - - - -   ----------------------

 

Calculation of Funds from Operation - STATEMENT FORM :

CALCULATION OF FUNDS FROM OPERATION

Net Profit for the current year ADD: Non-Fund and Non-Trading Charges already debited to P & L A/c : Depreciation and Depletion Amortization of Fictitious and intangible assets, i.e. Preliminary Expenses written off Discount on Shares written Premium on Redemption written off Goodwill or Patents written off Appropriation of Retained Earnings, i.e.                                Transfer to General Reserve,                                Sinking Fund etc.                                Proposed Dividend                                Loss on sale of fixed asset written off                                                Total:     Less : Non-Fund Items and Non-Trading Incomes            Already credited to P & L A/c :                         Dividend Received/Receivable                         Excess Provision written back                         Profit on sale of Fixed Asset                         Profit on reevaluation of Fixed Assets   TRADING PROFIT OR FUND FROM OPERATIONS

Rs.     -     - - - -   - - - -             - - - -

Rs. -                           -   -             -   -

 

Qn No 3;

How will you prepare a cash flow statement?

Ans;

Cash flow statement contains details of increase and decrease in operating activities, Investing activities, and net increase or decrease in cash of the above activities. It also shows the net change in cash during the period. With this net change opening cash and cash equivalent are added the total will be the closing balance of cash and cash equivalents.

 

Format of Statement of Cash Flows (Indirect Method)

	Rs.	Rs.
A. Cash Flows From Operating Activities
Net profit before tax		xxxx
Add: Adjustments for:
Depreciation	xxx
Interest Income	xxx
Dividend Income	xxx
Interest Expense	xxx
Provision for tax	xxx
Loss on sale of fixed assets	xxx
Less:          Gain on sale of fixed assets	xxx	xxxx
Other non-cash items Operating profit before working capital changes	­­­­­xxx	xxxx
		xxxx
Add:  Increase in current assets	xxx
Decrease in current assets
Less: Increase in current liabilities              Decrease in current liabilities                       Cash generated from operations    Less: Income tax paid Cash flows before extraordinary items Proceeds from earthquake disaster settlement Net cash from (or lost in) operating activities	xxx	xxxx       xxxx   xxx   xxx
		xxx
B. Cash from Investing Activities
Purchase of fixed assets and investments	xxx
Cash flows from sale of fixed assets and investments	xxx
Cash from interest and dividendsoninvestments  Net cash from (used for) investing activities	xxx	xxx
		xxxx
C. Cash from Financing Activities
Cash from issue of share	xxx
Cash from issue of debenture	xxx
Cash from loan raised	xxx
Redemption of share	xxx
Redemption of debenture	xxx
Payment of interest	xxx
Payment of dividends Net cash from (used for) financing activities Net increase (decrease) in cash and cash equivalents Opening cash and cash equivalents Closing cash and cash equivalents	xxx   xxx	xxxx   xxxx xxx
		xxxx

 

 

 

 

 

 

 

 

Qn No 4;

Differentiate between Fund Flow Statement And Cash Flow Statement?

Ans;

Differences between Fund Flow Statement And Cash Flow Statement

1.      The Fund Flow Statement shows the causes of changes in net working Capital whereas the Cash Flow Statement shows the causes for the changes in cash.

2.      Cash Flow Statement is started with the opening and closing balance of cash while there are no opening or closing balances in Fund Flow Statement.

3.      Cash Flow Statement deals only with cash whereas Fund Flow Statement deals with all the components of Working Capital.

4.      Cash Flow Statement is useful for short-term financing while Fund Flow Statement is useful for long-term financing.

5.      Cash Flow Statement is based on cash basis of accounting while the Fund Flow Statement is based on accrual basis of accounting.

6.      Cash Flow Statement depicts only the changes in cash position, while Fund Flow Statement is concerned with the changes in Working Capital between two Balance Sheet dates.

7.      Cash is a part of Working Capital. Improvement in cash position, as indicated by Cash Flow Statement can be taken as an indicator of improved working capital position. But he reverse is not true. That is, sound Fund position may not necessarily mean sound cash position.

8.      The Fund Flow Statement shows the causes of changes in net working Capital whereas the Cash Flow Statement shows the causes for the changes in cash.

9.      Cash Flow Statement is started with the opening and closing balance of cash while there are no opening or closing balances in Fund Flow Statement.

10.  Cash Flow Statement deals only with cash whereas Fund Flow Statement deals with all the components of Working Capital.

11.  Cash Flow Statement is useful for short-term financing while Fund Flow Statement is useful for long-term financing.

12.  Cash Flow Statement is based on cash basis of accounting while the Fund Flow Statement is based on accrual basis of accounting.

13.  Cash Flow Statement depicts only the changes in cash position, while Fund Flow Statement is concerned with the changes in Working Capital between two Balance Sheet dates.

14.  Cash is a part of Working Capital. Improvement in cash position, as indicated by Cash Flow Statement can be taken as an indicator of improved working capital position. But he reverse is not true. That is, sound Fund position may not necessarily mean sound cash position.

Qn No 5;

What is ratio? What are the advatages and disadvantages of ratio analysis?

Ans;

Robert Anthony defines a ratio as “simply one number expressed in terms of another”. A large number of ratios can be computed from the basic financial statements – Balance Sheet and Profit and Loss Account.

Importance and uses (Advantages or Objectives) of Ratio Analysis

  Ratio analysis is an important and useful technique to check the efficiency with which working capital is being used in the enterprise. Some ratio indicates the trend or progress or downfall of the firm. The trade creditor, bank, lending institution and experienced investor all use ratio analysis as their initial tool in evaluating the firm as a desirable borrower or as potential investment outlet. The following are the important advantages of ratio analysis:
1.       It makes to easy to grasp the relationship between various items and helps in understanding the financial statements.
2.      Ratios indicate trends in important items and thus help in forecasting.
3.      Inter-firm comparisons can be made with the help of ratios, which may help management in evolving future ‘market strategies’.
4.      Standard ratios may be computed. Comparison of actual ratios with standard will help in control.
5.      Ratios can effectively ‘communicate’ what has happened between two accounting dates.
6.      It helps in a simple assessment of liquidity, profitability, solvency and efficiency of the firm.
7.      Ratios may be used as measures of efficiency.
8.      Ratios are very useful for measuring the performance and very useful in cost control.
9.      It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency. They help management in decision making.
10.  It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency. They help management in decision making.

Limitations of Ratio analysis

 Ratios never provide a definite answer to financial problems. There is always the questions of judgment as to what significant should be given to the figures. So one must rely upon one’s own good sense in making ratio analysis and analyst must use this technique keeping in mind the following short comings of this technique:
1.      Ratios can be useful only when they are computed in significantly large number. A single ratio would not be able to convey anything. At the same time, if too many ratios are calculated, they are likely to confuse instead of revealing any meaningful conclusion.
2.      Ratio analysis gives only a good basis for quantitative analysis of financial problems. But it suffers from quantitative aspects.
3.      Ratios are computed from historical accounting records. So they also posses those limitations of financial accounting.
4.      It is not possible to calculate exact and well accepted absolute slandered for comparison.
5.      In ratio analysis arithmetical window dressing is possible and firms may be successful in concealing the real position.
6.      Ratios are only means of financial analysis, but not an end in themselves. They can be affected with the personal ability and bias of the analyst.
7.       It should not also be remembered that ratio analysis helps in providing only a part of the information needed in the process of decision making. Any information drawn from the ratios must be used with the obtained from the other sources so as to ensure a balanced approach in solving the ticklish issues.

 

 

 

 

Qn No 6;

What are the different classifications of ratios?

 Ans;

Classification of Ratios

      Ratios may be classified in a number of ways depending upon one or the other similarity. Some important classifications are given below:

1        Statement wise classification:
This classification is based on the statement from which items are taken.
a)      Balance sheet Ratios: these ratios deal with relationships between two items or groups of items which are both in the Balance Sheet. Eg: Current ratio, acid test ratio, debt-equity ratio, etc.
b)     Income statement ratios: These ratios focus on the relationship between the two items or group items. All of which are drawn from the revenue statement. These ratios are also known as “operating ratios”. Eg: gross profit ratio, stock turnover ratio, net profit ratio etc.
c)      Combined ratios: these ratios depict the relationship between two items, one of which is drawn from the Balance Sheet and the other from the revenue statement. Eg: Debtors’ turnover ratio, assets turnover ratio, returns on capital employed, etc.
2        Classification according to importance
It is evident that some ratios are more important than others. This classification has been recommended by the British Institute of Management.
a)      Primary ratios: As the success of any business undertaking is measured by the quantum of profit earned by it, the ratio which relates the profit to capital employed is turned as primary ratio. Eg: Return on capital employed, operating profit ratio, etc.
b)     Secondary ratio: This classification is effected to facilitate inter firm comparison and to focus on some factors responsible for the success of the unit. When such factors are isolated by means of ratios, they are called secondary ratios.

 

3        Classification according to nature
This mode of classification includes in its fold four different types of accounting ratios which are as follows:
a)      Liquidity ratios: These ratios portray the capacity of the business unit to meet its short-term obligations out of its short-term resource. Eg: Current ratio, acid test ratio, etc.
b)     Leverage ratios: These ratios are also called efficiency ratios. These ratios measure the owner’s stake in the business vis-à-vis that of outsiders. The long term solvency of the business can be examined by using leverage ratios. Eg: Debt-equity ratio, proprietary ratio, etc.
c)      Profitability ratios: The profitability of a business concern can be measured by the profitability ratios. These ratios highlight the end result of business activities by which alone the overall efficiency of a business unit can be judged. Eg: Return of capital employed, gross profit ratio, net profit ratio, etc.
d)     Activity ratios: These ratios evaluate the use of the total resource of the business concern along with the use of the components of total assets. More precisely, they are intended to measure the effectiveness of the assets management. The efficiency with which the assets are used would be reflected in the speed and rapidity with which the assets are converted into sales. The greater the rate of turnover, the more efficient the management would be. Eg: Stock turnover ratio, fixed assets turnover ratio, etc.

 

Qn No 7;

Briefly explain the various classifications of costs?

Ans;

COST CLASSIFICATION

  Cost of classification is the process of grouping costs according to their common characteristics. It is the placement of like items together according to their common characteristics. A suitable classification of costs is of vital importance in order to identify the cost with cost centers or cost units. Cost may be classified according to their nature, i. e, material, labour and expenses and a number of other characteristics. The same cost figures are classified according to different ways of costing depending upon the purpose to be achieved and requirements of a particular concern. The important ways of classification are:

1.      By nature of elements
2.      By functions
3.      By Degree or Traceability to the Product
4.      By Changes in Activity or Volume
5.      By Controllability
6.      By Normality
7.      By Relationship with Accounting Period (Capital and Revenue)
8.      By Time
9.      Accounting to Planning and Control
10.  By Association with the Product
11.  For Managerial Decisions
Now each classification will be discussed in detail.
1.      By Nature or Elements, or Analytical Classification. According to this classification, the costs are divided into three categories i.e., Materials, Labour and Expenses. There can be further sub-classification of each element; for example, material into raw material components, spare parts, consumable stores, packing material etc. this classification is important as it helped to find out the total cost, how such total cost is constituted and valuation of work-in-progress.
2.      By functions (i.e., Functional Classification). According to this classification costs are divided in the light of the different aspects of basic managerial activities involved in the operation of a business undertaking. It leads to grouping of cost according to the board divisions or functions of a business undertaking i. e production, administration, selling and distribution. According to this classification costs are divided as follows:
Manufacturing and production cost. This is the total of costs involved in manufacture, construction and fabrication of units of production.
Commercial Cost. This is the total costs incurred in the operation of a business undertaking other than the cost of manufacturing and production. Commercial cost may further be sub-divided into (a) administrative cost, and (b) selling and distribution   cost. These terms will be explained in a subsequent chapter.
3.      By Degree of Traceability to the Product (Direct and Indirect). According to this classification, total cost is divided into direct costs and indirect costs. Direct costs are those which are incurred for and may be conveniently identified with a particular cost centre or cost unit. Material used and labour employed in manufacturing an article or in a particular process of production are common examples of direct costs. Indirect costs are those costs which are incurred for the benefit of a number of cost centers or cost units and cannot be conveniently identified with a particular cost centre or cost unit. Examples of indirect costs include rent of building, management salaries, machinery depreciation etc. the nature of the business and the cost unit chosen will determine which costs are direct and which are indirect. For example, the hire of a mobile crane for use by a contractor at site would be regarded as a direct cost but if the crane is used as a part of the services of a factory, the hire charges would be regarded as indirect cost because it will probably benefit more than one cost centre. The importance of the distinction of costs into direct and indirect lies in the fact that direct cost of a product or activity can be accurately determined while indirect costs have to be apportioned on certain assumptions as regards their incidence.
4.      By changes in Activity or Volume. According to this classification, costs are classified according to their behavior in relation to changes in the level of activity or volume of production. On this basis, costs are classified into three groups viz., fixed, variable and semi-variable.
(i)                 Fixed costs are commonly described as those which remain fixed in total amount with increase or decrease in the volume of output or productive activity for a given period of time. Fixed cost per unit decreases as production increases and increases as production declines. Examples of fixed cost or rent, insurance of factory building, factory manager’s salary etc. these fixed costs are constant in total amount but fluctuate per unit as production changes. These costs are known as period costs because these are dependent on time rather than on output. Such costs remain constant per unit of time such as factory rent of Rs. 10,000 per month remaining same for every month irrespective of output of every month.
Fixed costs can be classified into following categories:
(a)    Committed Costs. These costs are the result of inevitable consequences of commitments previously made or are incurred to maintain certain facilities and cannot be quickly eliminated. The management has little or no discretion in such type of costs e. g. rent, insurance, and depreciation on building or equipment purchased.
(b)   Policy and Managed Costs. Policy costs are incurred for implementing some management policies as executive development, housing etc. and are often discretionary. Managed costs are incurred to ensure the operating existence of the company e. g., staff services.
(c)    Discretionary Costs. These costs are not related to the operation but can be controlled by the management. These costs arise from some policy decisions, new researches etc. and can be eliminated or reduced to a desirable level at the discretion of the management.
(d)   Step costs. Such costs are constant for a given level of output and then increase by a fixed amount at a higher level of output.
(ii)               Variable Costs are those which vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. Thus, variable costs fluctuate in total amount but tend to remain constant per unit as production activity changes. Examples are direct material costs, direct labour costs, power, repairs etc. such costs are known as product costs because they depend on the quantum of output rather than on time.
(iii)             Semi-variable costs are those which are partly fixed and variable. For example, telephone expenses include a fixed portion of annual charge plus variable according to calls; thus total telephone expenses are semi-variable. Other examples of such costs are depreciation, repairs and maintenance of building and plant etc.
5.      By controllability. Under this, costs are classified according to whether or not they are influenced by the action of a given member of the undertaking. On this basis costs are classified into two categories:
(i)                 Controllable costs are those which can be influenced by the action of a specified member of an undertaking, that is to say, costs which are at least partly within the control of management. An organization is divided into a number of responsibility centers and controllable costs incurred in a particular cost centre can be influenced by the action of the manager responsible for the centre. Generally speaking, all direct cost including direct materials, direct labour and some of the overhead expenses are controllable by lower level of management.
(ii)               Uncontrollable costs are those which cannot be influenced by the action of a specified member of an undertaking, that is to say, which are not within the control of management. Most of the fixed costs are uncontrollable. For example, rent of the building is not controllable and so is managerial salaries. Overhead cost, which is incurred by one service section and is apportioned to another which receives the service, is also not controllable by the latter.
The distinction between controllable and uncontrollable is sometimes left to individual judgment and is not sharply maintained. In fact, no cost is controllable, it is only in relation to a particular level management or an individual manager that we may say whether a cost is controllable or uncontrollable. A particular item of cost which may be controllable from the point of view of one level of management may be uncontrollable from another point of view. Moreover, there may be an item of cost which is controllable from long-term point of view and uncontrollable from short-term point of view. This is partly so in the case of fixed costs.
6.      By Normality. Under this, cost are classified according to whether these are cost which are normally incurred at a given level of output in the conditions in which that level of activity is normally attained. On this basis, it is classified into two categories:
a)      Normal Cost. It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is a part of cost of production.
b)      Abnormal Cost. It is the cost which is not normally incurred at a given level of output in the condition in which that level of output is normally attained. It is not a part of cost of production and charged to Costing Profit and Loss Account.
7.      By Relationship with Accounting Period (Capital and Revenue). The cost which is incurred in purchasing an asset either to earn income or increasing the earning capacity of the business is called capital cost, for example, the cost of a rolling machine in case of steel plant. Such cost is incurred at one point of time but the benefits accruing from it are spread over a number of accounting years. If any expenditure is done in order to maintain the earning capacity of the concern such as cost of maintaining an asset or running a business it is revenue expenditure e. g., cost of materials used in production, labour charges paid to convert the material into production, salaries, depreciation, repairs and maintenance charges, selling and distribution charges etc. the distinction between capital and revenue items is important is costing as all items of revenue expenditure are taken into consideration while calculating cost whereas capital items are completely ignored.
8.      By Time. Costs can be classified as (i) Historical costs and (ii) Predetermined costs.
(i)                 Historical costs. The costs which are ascertained after being incurred are called historical costs. Such costs are available only when the production of a particular thing has already been done. Such cost are only of historical value and not at all helpful for cost control purposes. Basic characteristics of such costs are:
·         They are based on recorded facts
·         They can be verified because they are always supported by the evidence of their occurrence.
·         They are mostly objective because they relate to happenings which have already taken place.
(ii)               Predetermined costs. Such costs are estimated cost i. e., computed in advance of production taking into consideration the previous period’s costs and the factors affecting such costs. Predetermined cost determined on scientific basis becomes standard cost. Such cost when compared with actual costs will give the reasons of variance and will help the management to fix the responsibility and to take remedial action to avoid its recurrence in future.
Historical costs and predetermined costs are not mutually exclusive but they work together in the accounting system of an organization. In competitive age, it is better to lay down standards, so that after comparison with the actual, the management may be able to take stock of the situation to find out as to how far the standards fixed by it have been achieved and take suitable action in the light of such information. Therefore, ever in a system when historical costs are used, predetermined costs have a very important role to play because a figure of historical cost by itself has no meaning unless it is related to some other standard figure to give meaningful information to the management.
9.      According to Planning and Control. Planning and control are two important functions of management. Cost accounting furnishes information to the management which is helpful in the due discharge of these two functions. According to this, costs can be classified as budgeted costs and standard costs.
Budgeted costs : Budgeted costs represent an estimate of expenditure for different phases of business operation such as manufacturing, administration, sales, research and development etc. co-ordinate in a well conceived framework for a period of time in future which subsequently becomes the written expression of managerial targets to be achieved. Various budgets are prepared for various phases, such as raw material cost budget, labour cost budget, cost of production budget, manufacturing overhead budget, office and administration budget etc. Continuous comparison of actual performance (i. e., actual cost) with that of the budgeted cost is made so as to report the variations from the budgeted cost to the management for corrective action.
Standard costs:  Budgeted costs are translated into actual operation through the instrument of standard costs. The Chartered Institute of Management Accountants, London defines standard cost as “the predetermined cost based on the technical estimate for materials, labour and overhead for a selected period of time and for a prescribed set of working conditions”. Thus, standard cost is determination, in advance of production of what should be the cost.
    Budgeted cost and standard costs are similar to each other to the extent that both of them represent estimates for cost for a period of time in future. In spite of this, they differ in the following aspects:
(i)                 Standard costs are scientifically predetermined cost of every aspect of business activity whereas budgeted costs are mere estimates made on the basis of past actual financial accounting data adjusted to future trends. Thus, budgeted costs are projection, of financial accounts whereas standard costs are projection of cost accounts.
(ii)               The primary emphasis of budgeted costs is on the planning function of management where as the main thrust of standard costs is on control because standard cost lay emphasis on what should be the costs.
(iii)             Budgeted costs are extensive whereas standard costs are intensive in their application. Budgeted costs represent a macro approach of business operations because they are estimated in respect of the operations of a department. Contrary to this, standard costs are concerned with each and every aspect of business operation carried in department. Thus, budgeted costs deal with aggregates whereas standards costs deal with individual parts which make the aggregate. For example, budgeted costs are calculated for different functions of the business i. e., production, sales, purchases etc whereas standard costs are complied for various elements of costs i. e, materials, labour and overhead.
10.  By Association with the Product. Under this classification, cost can be product costs and period costs.
Products costs are those costs which are traceable to the product and are included in inventory valuation. Product costs are inventorial costs and they become basis for product pricing and cost plus contracts. They comprise direct materials, direct labour and manufacturing overheads in case of manufacturing concerns. These are used for valuation of inventory and are shown in the Balance Sheet till they are sold because such costs provide income or benefit only after sale. The product cost of goods sold is transferred on the cost of goods sold account.
Period costs are incurred on the basis of time such as rent, salaries etc. These may relate to administration and selling costs essential to keep the business running. Through these are not associated with production and the necessary to generate revenue but cannot be assigned to a product. These are charged to the period in which these are incurred and treated as expense.
The net income of the concern is influenced by both product and period costs. Product costs are included in the cost of production and do not affect income till goods are sold. Period costs are not at all related to production and as such are not inventoried but are charged to the period in which these are incurred.
11.  For Managerial Decisions. On this basis, costs may be classified into the following costs:
(i)                    Marginal cost. Marginal cost s the total of variable costs i. e., prime cost plus variable overheads. It is based on the distinction between fixed and variable costs. Fixed costs are ignored and only variable costs are taken into consideration for determining the cost of products and value of work-in-progress and finished goods.
(ii)                  Out of pocket costs. This is that portion of the cost which involves payment to outsider’s i. e., gives rise to cash expenditure as opposed to such cost as depreciation, which does not involve any cash expenditure. Such costs are relevant for price fixation during recession or when make or buy decision is to be made.
(iii)                Differential cost. The change in cost due to change in the level of activity or pattern or method of production is known as differential cost. If the change increases the cost, it will be called incremental cost. If there is decrease in cost resulting from decrease in output, the difference is known as decremented cost.
(iv)                Sunk cost. A sunk is cost is an irrecoverable cost and is caused by complete abandonment of a plant. It is the written down value of the abandoned plant less its salvage value .Such cost s are historical costs which are incurred in the past and are not relevant for decision making and are not affected by increase or decrease in volume ‘’.Thus ,expenditure which has taken place and is irrecoverable in a situation ,is treated as sunk cost. For taking managerial decisions with future  implications ,a sunk cost is an irrelevant cost .If a decision has to be made for replacing the existing plant ,the book value of the plant less salvage value (if any) will be a sunk cost for taking decision of the replacement of the existing plant. 
(v)                  Imputed or national cost. Imputed costs and national costs have the same meaning. The American equivalent term of the British term ‘notional cost’ is ‘imputed cost’. These costs are national in nature and do not involve any cash outlay. The Chartered Institute of Management Accounts, London defines notional cost as “the value of a benefit where no actual cost is incurred”. Even though such costs do not involve any cash outlay but are taken into consideration while making managerial decisions. Explains of such costs are: notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid. When alternative capital investment projects are being evaluated it is necessary to consider the imputed interest on capital before a decision is arrived as to which is the most profitable project. Actual payment of interest on capital is not made but the basic concept is that, had the funds been invested somewhere else they would have earned interest. Therefore, imputed costs or notional costs can also be described as opportunity costs. Imputed or notional cost is an hypothetical cost to represent the benefit enjoyed by a firm in respect of which actual expenses is not incurred.
(vi)                Opportunity cost. It is the maximum possible alternative earning that might have been earned if the productive capacity or services had been put to some alternative use. In simple words, it is the advantage, in measurable terms, which has been foregone due to not using the facility in the manner originally planned. For example, if an owned building is proposed to be used for a project, the likely rent of building is the opportunity cost which should be taken into consideration while evaluating the profitability of the project.
(vii)              Replacement cost. It is the cost at which there could be purchase of an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.
(viii)            Avoidable and unavoidable cost. Avoidable costs are those which can be eliminated if a particular product or department which they are directly related is discontinued. For example, salary of the clerks employed in a particular department can be eliminated if they department is discontinued. Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager or factory rent cannot be eliminated even if a product is eliminated.

 

Qn No 8;

What do you understant by the term budgetiry control? And what are its benefits and draw backs?

Ans;

Budgetary Control

            “Budgetary control means the establishment of budgets relating to the responsibilities of executives to the requirements of a policy, and continuous comparison of actual with budgeted results either to secure by individual action the objective of that policy or to provide basis for its revision.”

Advantages of budgetary control

1.      Budgets fix the goal and targets, without which operation lacks direction.
2.      Reduction in cost and elimination of inefficiency is achieved automatically.
3.      The budget facilitates to maintain ordered effort and brings about efficiency in results.
4.      An effective system of budgetary control results in co-ordinate effort of all persons involved.
5.      Budgetary control enables the management to decentralize responsibility without losing control of the business since it pin-points inefficiency.
6.      The budgetary control and standard costing go hand in hand and the combination of the two gives the most effective results. It promotes mutual co-operation and team spirits among the persons involved.
7.      Budgetary control ensures that the capital employed at a particular level is kept at a minimum level.
8.      It facilitates and intelligent and planned forecast for future.
9.      It is a good guide to the management for making future plans. It is on the basis of budgetary control, realistic budgets can be drawn.
10.  It aims at maximization of profit through cost control and proper utilization of resources.
11.  It brings to light the inefficiencies and weaknesses on comparing actual performance with budget. Thus management can take remedial measures.
12.  It is a guide to the management in the field of research and development in future.
13.  It evaluates the performance.
14.  Since budget provides advance information, financial crisis can be avoided.
15.  It acts as a safety for the management. It prevents wastages of all types.

Limitations of budgetary control

Budgetary control is a sound technique of control. But it is not a perfect tool. Despite the appreciation, it has its own limitations which are as follows:
1.      Budgets deal with future. Forecasting is necessary for budgeting. Forecasts and estimates are rarely cent per accurate. The success largely depends upon the degree of accuracy of the estimates.
2.      Budgeting is time consuming process. During the preparation period, the business conditions may change and estimates may go wrong by that time.
3.      The successful operation and execution of budgets depends upon the efficiency of the executive personal.
4.      Budgetary control is essentially a tool of decision-making and it helps the management in taking sound decisions. But it cannot replace the management.
5.      Budgeting necessitates the employment of specialized staff and this involves expenditure which small concerns may not afford.
6.      A budget programme should be dynamic, capable of being adapted to changing conditions. But when budgets are prepared with-determined targets, there is a feeling that budgeted figure are final. Thus budgetary programme is bound to become rigid. 
7.      The success of the budgetary control largely depends upon willing, co-operation or team-work of all concerned. If there is no co-operation, the whole system collapses.

 Qn No 9;

Absorption costing is different from marginal costing . How?

Ans;

Absorption costing and Marginal costing

            Absorption costing is the practice of charging all costs, both fixed and variable to operations, process or products. In marginal costing, only variable costs are charged to production. The Institute of Cost and Management Accountants (U. K) defines it as “The practice of charging all costs, both variable and fixed to operations, process or products”. This explains why this technique is also called full costing. Administrative, selling and distribution overheads as much from part of total cost as prime cost and factory burden.

Difference between absorption costing and marginal costing

Absorption costing

1.   All cost-fixed and variable are charged to product.

2.   Profits = Sales-Cost of goods sold

3.   It does not reveal the cost volume profit relationship.

4.   Closing inventories are valued at full cost. Absorption costing reveals more profit since the inclusion of fixed costs in inventories.

5.   Costs are included in the products, this leads to over or under-absorption.

Marginal costing

1.   Only variable costs are charged to products; fixed costs are transferred to Profit & Loss Account.

2.   Contribution margin = S-VC. Profit = Contribution – FC.

3.   Cost volume profit relationship is an important part of marginal costing.

4.   Closing inventories are valued at variable cost. Marginal costing reveals less profit, when compared to absorption cost.

5.   Fixed costs are not included in the product; so it will not lead to the problem of under-absorption.

Qn No 10;

What are the preliminaries should be gone through before a standard costing system is established?

Ans;

Preliminaries to the Establishment of Standard Costs

The following preliminaries should be gone through before a standard costing system is established:

1. Establishment of cost centers; 2.Type of standard; and 3. Setting the standards.
1.      Establishment of Cost Centers. As defined earlier in this book, a cost centre is a location, person or item of equipment for which costs may be ascertained and used for the purpose of the cost control. Establishment of cost centers in necessary for fixing responsibilities for unfavorable variance.
2.      Types of Standards. They are three types of standards:
a)      Current standard. A standard which is related to current conditions and is established for use over a short period of time.
Ideal Standard: This is a standard which can be attained under the most favorable conditions possibly. In other words, this standard is based upon a very high degree of efficiency which is rather impossible to achieve. In this standard, it is assumed that there will be the most desirable conditions of performance and that there will be no wastage of material or time and no inefficiencies in the manufacturing processes. This standard is not likely to be achieved because ideal conditions of performance will not prevail. It is, therefore, a theoretical standard.
The unity of this standard is that it sets a target which, though not attainable in practice, is always aimed at. The criticism of the standard is that when actual costs are compared with such standard costs, large unfavorable variances are shown and these variances become a permanent feature of the concern. The ideal standard will breed frustration among employees because such standard is never to be attained. Nobody will pay serious attention to such standard and setting up of this standard will become a farce.
Expected or Attainable Standard: This is a standard which is anticipated during a future specified budget period. In fixing this type of standard present conditions and circumstances prevailing with in a particular industry are taken into consideration. Beside due weight age is given to the expected changes in the present circumstance and conditions. In setting up this standard, a reasonable allowance is also made for unavoidable (normal) wastages. This standard is, therefore, considered to be more realistic than the ideal standard because this standard is based on the realities rather than on the most ideal conditions. Hence, this type of standard is best suited from control point of view because this standard reveals real variances from the attainable performance.
b)      Basic Standard. It is a standard which is established for use unaltered over a long period of time. This standard is fixed for long periods so as to help foreword planning. Basic standard is established for some base year and is not changed for a long period of time as material prices, labour rates and other expenses change. Deviations of actual cost from basic standards will not serve any practical purpose because basic standards remain unaltered over a long period of time and are not adjusted to current market conditions. Thus, this type of standard is not suitable from cost control point of view. However variances calculated on the basis of basic standards will help in studying the trends in manufacturing costs over a long period of time.
Comparison of Current and Basic Standard Cost. Current standard relate to current conditions and operate only for a short period before they are revised when conditions change. On the other hand, basic standards are set for a long period and there is no need for constant revision for such standards. Deviation of actual costs from basic standard cost will not serve any practical purpose because standards are not adjusted to current market conditions. However such standards will be helpful in studying the trends of variance over a long period of time which is not possible in case of current standards which go on changing. Current standards will take care of inflationary tendencies because they are adjusted to current market conditions. On the other hand, basic standards are static and do not take care of inflationary tendencies.
c)      Normal Standard. This standard is defined as “the average standard which it is anticipated can be attained over a future period of time, preferable long enough to cover one trade cycle’. Such standards are established on the basis of average estimated performance over a future period of time (say 5 years) covering one trade cycle. It is difficult to follow normal standards in practice as it is not possible to forecast performance with a reasonable degree of accuracy for a long period of time. Such standards are attainable under anticipated normal conditions and are not attainable if anticipated conditions do not prevail over a future period of time. That is why; normal standards may not be a useful device for a purpose of cost control.
3.      Developing or Setting the Standards or Establishment of Standard Cost. Just like a budget committee, there should be Standard Committee which should be entrusted with the work of setting standard costs. The committee will include General Manager, Purchase Officer, Production Engineer, Production Manager, Sales Manager, Cost Account, and other functional heads, if any.
Of all the persons, the cost accountant plays a very important role in setting the standards because he is to supply the necessary costs figures and coordinate the activities of the committee so that standards set are as accurate as possible.
It may be noted that standards set should neither be too high nor too low. Nobody will take interest in the standards if these are too high because such standards are not capable of being achieved and employees will always have an opportunity to excuse the failure to reach standards. Such standards are not realistic and, therefore, cannot be used in inventory valuation, product costing and pricing, planning and control, and capital investment decisions. Low standards, on the other hand, will not induce employees and management to put more efforts because they can be achieved very easily. They defeat the objectives of standard costing and fail o disclose inefficiencies because they can be attained by poor performance. As a general rule, currently attainable standards should be set which can be attained if employees and management become more efficient or put some more efforts. Such standards motivate employees and are most appropriate for performance appraisal, cost control and decision making.
According to the National Association of Accountants (U.S.A) “Such standards provide definite goals which employees can usually be expected to reach and also appear to be fair bases from which to measure deviations for which the employees are held responsible. A standard set at a level which is high at still attainable with reasonable diligent effort and attentive to the correct methods of doing the job may also be effective for stimulating efficiency”.
The success of standard costing depends upon the establishment of correct standards. Thus, every possible care should be taken in the establishment of standard and standards should be established for each element of cost as follows:
(a)    Direct Material Cost. Standard material cost for each product should be predetermined. This will be include:
(i)                 Determination of standard quantity of materials needed for the production.
(ii)               Determination of standard price per unit of material.

In ascertaining standard quantity of materials, the standard specification, of materials should be planned by the engineering department after consulting the past records. While setting standards an allowance should be made for the normal wastage of materials. The purpose of determining standard quantities of materials should be to achieve maximum economies in material usage.

The standard prices of materials should be determined for the various types of material needed for the production. This is done by the cost accountant in collaboration with the purchase officer. Standard price for each item of material is established after carefully studying the market conditions and forecasting the trend of prices for a future period. While setting standard material price, the cost of purchasing and storekeeping should also be include in the price of materials. The object of fixing standard price of materials is to increase efficiency in the purchasing so that price of materials may be kept down. Any difference between standard price and actual; price is to be referred to the Purchasing Department of explanation, so before setting standards for material price, it is advisable to see hat purchasing functions are efficiently managed.

Setting up of standard price of materials required is a difficult task because it depends on so many factors beyond anybody’s control. Generally standard prices are based on current price adjusted to expected changes in future.

(b)   Direct Labour Cost. Determination of standard direct labour cost will include determination of:
(i)                 Standard time
(ii)               Standard rate

It become necessary to standardize the time to be taken for each category of labour and for each operation involved. Time and motion study will determine how much time is to be allowed for each operation involved while fixing the standard time to be taken for each category for labour and for each operation involved. While fixing the standard time, due allowance should be made for fatigue, tool setting, receiving instructions and normal idle time.  Standard time can also be determined on the basis of average of the past performance. Though this method is simple, it is not scientific. Thus standard time is established on the basis of time and motion study and this is done in conjunction with the work study engineers. Standard time established according to time and motion study are independent of previous performances. It is good for the development of objective standards. Standard time can also be set by taking trial runs for new products. This method is not satisfactory as real conditions are not available in such runs.

The fixation of standard labour rates is not so difficult as the fixation of standard prices of materials is because labour rates are usually pre-established. Standard rates of pay should be established for every category of labour. Labour rates in the past may not be reliable basis for determination of rates if the labour rates are subject to fluctuating demand and supply of the labour force. Any expected increase in rates should be considered in the determination of standard rates. Establishment of standard rates of pay do not present any problem in those industries where wage rates have been fixed by contracts, Law, Wages Tribunals and Wages Boards. Fixation of standard rates will depend upon the method of wage payment. Standard rates per hour or pay day will be fixed in wages are paid according to time wages system and when the method of wage payment is piece rate, standard wage per piece will be fixed. Personal department will help the cost accountant in determining standard rates of pay.

Overheads: Broadly speaking overheads are segregated into fixed and variable and standard overhead rate should be determined for fixed as well as variable overhead. Standard fixed overhead rates and standard variable overhead rate should also be determined according to the function –wise classification of overheads-manufacturing, administrative and selling and distribution so that exact place of overhead variance may be located and corrective action may be taken. Standard overhead rate is determined keeping in view past experience, present conditions and future trends. Fixation of standard overhead rate involves determination of standard overhead costs, estimation of standard level of production reduced to a common base such as unit of production, direct labour hours, machine hours, etc. and finally determination of standard overhead rate by dividing standard overhead costs by standard level of production. The formula for the calculation of standard rate is:

Standard variable overhead rate:        Standard variable overheads for the budget period

                                                Budget production in units or budgeted hours for the budget period

Standard fixed overhead rate:            Standard fixed overheads for the budget period

                                                Budget production in units or budgeted hours for the budget period

 

 

Standard Hours

            Production is generally expressed in physical units such kilos, tons, gallons, units, dozens etc. but it is difficult to express all the products in one common unit when different types of products which are measured in different units are manufactured in a factory. In such a case, it is essential to have a common unit in which all the products can be measured. Time factor is common to all the products, and, therefore, production can be expressed in standard hours. A standard hour can be defined as an hour which measures the amount of work that should be performed in one hour under standard conditions.