A2zNotes.com -Best Bcom BBA Bed Study Material # BBA Study Material to Cost Accounting notes Cost Concepts For Decision Making

y   =   3,000  + 95x1  – 65x2  – 1.5x3

where,

x1    =  Number of working days in the month

x=   Average daily temperature (c)

x3 =    Number of employees

The actual electricity Charges in june, 2006 were Rs. 3000. During the month, there were 22 working days, the average daily temperature was 38 degrees Celsius and there were 500 employees.

what is the variance between actual cost and the costs that would have been expected?

Solution

(a) Expected Costs ‘y  =  3,000 + 95(22) – 65(38) + 1.5(500) = Rs. 3,370

(b) Expenditure Variance = Rs. 3,370 – Rs. 3,000  =  Rs. 370(adverse)

##### Assumption in Regression Analysis

The following assumption has to be made while using regression analysis:

• The relationship between the independent variable(x) and the dependent variable(y) is linear, a straight line. When this is not true a linear model it does not fit the data and is there by weaker estimate of the actual relationship. The degree of linearity can be examined in the scatter graph.
• The historical data points used to generate the regression line are normally distributed around the line (i.e. bell shaped) for each ‘x’ value. This assumption can be tested by drawing the regression line on the scatter graph and determining if the coordinates fall predominately closer to the line and then become fewer as you get farther from the line for selected ‘x’ values.
• The dispersion of data points should be the same at the different levels of analysis of the scatter graph which help the user visually determine the degree to which this assumption is met.
• The ‘y’ value should be independent of each other. For example overhead costs reported in July are not dependent on those reported in June. Users can check this assumption based upon their knowledge of the manufacturing operation of the company.
##### Precaution in using Regression Analysis

Users of regression should collect as many observations of the ‘x’ and ‘y’ variables as possible. Data may be examined from many short-time periods points. For example, weekly costs will yield several more observations than would monthly amounts. However, the shorter time periods are in harder to match the values of the ‘x’ and ‘y’ variables within. The user should make sure that the dependent variables and the independent variables are matched to the proper period.  If overhead cost measure are not properly related to the corresponding period of production, the actual underlying relationship will be obscured. Using long time periods also create problems. Obtaining observations from longer periods will require going back to many past periods where observations do not relate well to present conditions. Going further back in time runs the risk of differences due to technology changes, inflation and product modifications. Using this data can cause the cost function not to be descriptive of the product modifications. Using this data can cause the cost function not to be descriptive of the product e relationship between ‘x[‘ and ‘y’. regression analysis should  be rigorously tested before placing a great deal  of reliance on the too. Method of testing could include creating a model in predicting the excluded period. Another option is to use regression along with the present system of cost prediction and compare their performance. In any case, regression along with the present system of cost prediction and compare their performance. In any case, regression analysis can be extremely useful tool for the managerial decision maker. How ever, like all decision models, the analysis should be used with caution and understanding of its limitations to provide optimal service.

## Research and Development Costs

The research and development expenditure is a deferred charge which is in the nature of non-recurring expenditure which are expected to be of financial benefit to several accounting periods of indeterminate total length. It is the expenditure incurred for searching a new product or improved product or new methods of production and improved technologies. The research costs are incurred for carrying basic research or applied research. But the development cost start with decision taken to produce new production methods. The objective in carrying basic research is to improve the existing scientific and /or technical knowledge. But the applied research is carried for a purpose directed towards a specific practical aim or objective. The treatment of research costs is studied under two heads:

• Basic research costs
• Applied research costs

Basic Research Costs

These costs relate to all existing products, methods of operation, techniques of production and therefore, the basic research costs should be treated as production overhead for thr period during which it has been incurred and has to be absorbed into product costs.

#### Applied Research Costs

The applied research costs classification into two for absorption purpose:

• If applied research costs relate to improvement of existing products and methods of production, it should be treated as manufacturing overhead for the period and has to be absorbed to the product cost.
• In case, applied research costs are incurred for searching new products or methods of production etc., then such costs are amortised to the product that is newly invented or new method of production adopted. The whole of such expenditure should not be absorbed in the year in which such expenditure has been incurred but a part of it should be carried over. The expenditure which , though of revenue nature ,is spread over a number of years because its benefit is derived during those years.

When the applied research aimed at improvement of existing product or to invent a new product or development of new technology and if the research works appears failure in getting the desired results, then such applied research expenditure is charged against profit in the costing profit and loss account of one or more year depending upon the size of expenditure incurred.

##### Treatment of Development costs

The development costs begin with the implementation of the decision to produce a new or improved product or to employ a new or improved. Method. The treatment of development costs is similar to that of treatment of applied research costs.

## Goodness or Fit and Coefficient of Correlation

A cost line, and thus cost behavior pattern can be established using the various methods above from any set of data. Whether the values obtained for unit variable cost and total fixed cost are of practical use depends upon whether there is a clear causal relationship and sufficient evidence of correlation. Whilst it is reasonable to assume that there is a causal relationship between activity and cost,; the question is whether it is as straight forwards as that suggested by linear relationship and by the particular cost function calculated. Even if there is a linear relationship the values produced by the methods illustrated in this section, including the least-squares regression, may be wrong due to any un-representative data used. In regression analysis the squaring process gives considerable prominence to large fluctuations. The cost function determined by regression analysis can be tested to establish how well the estimated relationship explains the variation in the observations. The coefficient of correlation, ‘r’ measures the extent to which the output variable explains the changes in total costs, and may be measured by calculating correlation coefficient and coefficient of determination.

The degree lf correlation between two variables can be measured and we can decide, using actual results or pairs of data, whether two variables are perfectly or partially correlated. if they are partially correlated, we can determine whether there is a high or low degree of partial correlation . This degree of correlation is measured by the correlation coefficient. There are several formulae for ascertainment of correlation coefficient, although each formula should given the same value.  Some of the example of statistical relationship of data is shown in figure.

The following is the standard formula used in measuring correlation coefficient:

Where ‘x’ and ‘y’ represent pairs of data for two variables and ‘n’ is the number of pairs of data for two variables.  The above formula is used in subsequent examples in ascertaining correlation coefficient.

r   =   +1 means that the variable are perfectly positively correlated.

r   =  -1 means that the variables are perfectly negatively correlated.

r  =   0 means that the variables are un-correlated.

Illustration 7

The cost of output at a factory is thought to be dependent on the number of units produced. Data has been collected for the number of units produced per month in the last six month, and their associated costs.

There is perfect positive correlation between the volume of output at the factory and production cost.

Correlation exists in a time series if there is an inter-relationship between the period of time and the recorded value for that period of time, i.e., if there is a trend line. The correlation coefficient is calculated with time as the ‘x’ variable although it is more convenient to use simplified values for ‘x’ instead of year numbers.

Illustration 8

Sales of Product A between 2002 and 2006 were as follows:

There is partial negative correlation between the year of sale and units sold. The value of ‘r’ is close to -1, therefore a high degree of correlation exists, although it is not quite perfect correlation. This means that there is a clear downward in sales, which is close to being a straight downward trend line.

#### Coefficient of Determination

Unless the correlation coefficient ‘r’ is exactly or very nearly +1, -1 or 0, its meaning is a little in exact. For example, if the correlation coefficient for two variables id +0.8, this would tell us that the variable are positively correlated, but the correlation is not perfect. It does not really tell us much else. A more meaningful analysis is available from the square of the correlation coefficient (r2) which is called ‘coefficient of determination’.

What ‘r’ measures is the proportion of the total variation in the value of ‘y’ that can be explained by variations in the value of ‘x’. in the above illustration, r = -0.992l; therefore r= 0.984. this means that over 98% of variations in sales can be explained by other factors. Similarly, if the coefficient for output volume and maintenance cost is 0.9, r2 would be 0.81, meaning that 81% of variations in maintenance costs could be predicted by variations in output volume , leaving only 19% of variations to be explained by other causes (for example age of equipment).in the two illustrations above, it would be reasonable to conclude that there is a high degree of correlation between ‘x’ and ‘y’, and that predicted values of ‘x’ could therefore be used to estimate expected values for ‘y’ with reasonable confidence in the accuracy of the predictions. (if r = 1 , r2  would also be 1, meaning that when there is perfect correlation, variations in ‘y’ can be predicted entirely by variations in ‘x’)

Note, however, that if r2 = 0.81, we would say that 81% of the variations in ‘y’ can be predicted by variations in ‘x’. we do not necessarily conclude that 81% of variations in ‘y’ are necessarily caused by the factor ’x. we must beware of reading too much importance into our statistical analysis. For example, if a company’s sales volume is increasing over time, and ‘r’ for time and sales volume is , say 0.95, we could predict that sales will vary over time, but it would be silly to say that time causes the variation in sales.

## Codification of Costs

CIMA defines a coding “a system of symbols designed to be applied to a classified set of times, to give a brief accurate reference facilitating entry , collation and analysis”

Codification of costs is a system of assigning code numbers to each head, sub-head and category of expense to facilitate the systematic and easy recording, accounting, summarization of cost data for ascertainment of cost, profitability and managerial decision making. The importance of coding is vital with the mechanized and computerised systems of costing. A good coding system should consist of clear, unambiguous and distinctive codes in order to systematize the analysis of costs for accurate cost ascertainment expeditiously and with least cost.

### Objectives of Codification

The important objective of codification is given below:

• For apportionment of similar items of expenses on one suitable basis of apportionment.
• It systematizes the recording and accounting of cost data and control of expenses.
• The computerised cost accounting is made easier with codification of accounts
• It will reduce the clerical work in organization with huge number of accounts.
• It facilitates automatic allocation, apportionment and absorption of costs to different cost units or cost centres.

### Requirements of Efficient Coding System

The requirements for an efficient coding system are as follows:

• The codes should be as brief as possible, taking into account the necessity of details of item.
• As far as possible, all codes should be of same length. this helps in computerization of costs and location of errors.
• The code should comprehensive and elastic and should be capable of accommodating new items.
• To minimize errors, the code should incorporate of coding system. Every individual should not be allowed to allocate code numbers.
• The code should be unique and certain. Each item should have only one possible code number and should be able to be identified from the structure of code.
• There be centralized authority in maintenance of coding system. Every individual should not be allowed to allocate code numbers.

### Methods of Codification of Costs

The following methods are used in codification of costs:

• #### Straight Numbering Method

Under this system each item of expenditure is allotted a fixed number. This method is called ‘numerical coding system; for example:

 Factory Rent –          21 Office Rent –          22 Sales Office Rent –          23 etc.

• #### Number Blocks

Under these methods each head of expenditure is given on block of numbers.  This method is slight variation of straight numbering system.

 Depreciation –          1 to 100 Insurance –          101 to 200 Repairs and Maintenance –          201 to 300

The block of numbers allotted will depend on the sub-heads to be accommodated.

• #### Memoric Method

Under this method, alphabets are used as codes to help the memory. For example:

 Depreciation – Office Buildings –          DOB Depreciation – Factory Buildings –          DFB Depreciation – Godown –          DG
• #### Decimal Method

Under this method, numerical codes are allotted to various expenses and cost centres classifying into major, minor and detail account head

• indirect materials
• consumable store
• cotton waste
• lubricants
• loose tool
• indirect labour
• time office
• security
• clerical staff
• indirect expense
• factory rent
• depreciation of plant and machinery
• insurance of factory building

• indirect materials

1 ………………………………

• indirect labour

2 ………………………………….

• indirect expenses

3 …………………………………etc.

• #### Field Method with Numerical Codes

Under this system each code number consists of nine digits. The first two digits represent the variable or fixed nature of expense; the next three digits indicate head of expense, the next two digits stand for the analysis of expense and the last two digits indicate the cost centre. Where expenses have been incurred. For example code 10/100/03/05 represents for.

 Fixed/Production   Labour/Monthly   Salary/Machine Shop
• #### Combination of Symbol and numbers

Under this method, a combination of symbol, alphabet and a number is used to represent a code. For example:

D 1 – Depreciation Factory Building

D 2 – Depreciation Administrative Building

D 3 – Depreciation Plant and Machinery

D 4 – Depreciation Vehicles, etc.

## Allocation of Common Costs

A cost allocation can be defined as “the partitioning of a cost among a set of cost objects”. For this purpose, the cost object could be production units, machines, groups of machines, individual products or groups of products. Companies that price all or a large part of their output on a cost-plus basis certainly need to include overheads in their cost of production. Financial reporting is another reason for allocating costs. In addition, internal management reports frequently use full costs for evaluating the financial performance of individual profit centres. The use of cost allocation in performance evaluation is, however, a very controversial subject. One view suggests that as overhead costs are a joint responsibility, all sections of the organization should be aware of them, furthermore, cost allocation can be used to motivate individual managers to exercise a degree of control over their consumption of central services. The alternative view is that such allocations more costs away from where they are incurred to other parts of the organization where it is more difficult to exercise control.

### Criteria for Allocation of Common Costs

The following are the criteria based on which cost will be allocated:

Neutrality – A cost allocation scheme is neutral if it does not interfere, after or in any way distort the decision making process. Any departure from the principle of neutrality is assumed to lead to economic inefficiency. However, a neutral; allocation scheme will lead to decisions that satisfy marginal optimality conditions. It there by avoids distorting the decision making process. An allocation scheme which is neutral with respect to one decision may not be neutral for all other decisions.

Ability to bear – Costs should be assigned to cost objects in proportion to their ability to bear those costs. Sales revenues, gross profits, total value of assets and total costs are examples of bases used to relate costs to cost objects. The presumption is that ‘larger’ cost objects can afford to bear larger share of overhead costs.

Cause and effect – the cause and effect relationship criterion requires a meaningful casual relationship between the cost objects and the costs to be allocated. Here the basic principle is to allocate costs to those factors which cause the costs. For example, factory maintenance costs might be allocated among divisions in proportion to the hours of maintenance work performed in each division.

Benefits – This criterion is primarily concerned with allocating costs in proportion to the benefit received by each cost object. The premise is that cost objects should be charged for the amount of service they receive. For example, the costs of a power plant might be allocated in proportion to the consumption of power by the different departments or divisions.

Equity or Fairness – it implies that the scheme should produce an allocation which is just and fair to all partied involved. Each party should bear an equitable of the allocated costs.

Service department may exist to provide services of various kinds to other departments. In some instances the service department’s mat even consumes part of their services themselves.

Illustration 9

PH Ltd. which is presently Marketing two Products A and B has prepared the following budget estimate for the year 2007:

The management desires that efforts should be made to achieve fuller utilisation of the capacity of 12,000 direct labour hours. Accordingly the three proposals put forth by the marketing manager came up for consideration. They are:

(a) A government department has invited tenders of the supply of 200 units of product ‘C’ whose particulars are: Raw materials Rs. 30 per unit. Direct labour hours 10 per unit.

(b) The company has received an export order for the supply of 250 units of product ‘D”. The product data are: Direct material Rs. 20 per unit.  Direct labour hours 4 per unit. Export price offer received Rs. 40 per unit.

(C) The holding company has received an order for a specialised product for which a new component has been designed by them. As the component is a non-standard items, the holding company desires that is should be manufactured by PH Ltd. The holding company is prepared to by the component at Rs. 160 per unit and its annual requirement is 100 units. The direct material cost of the component is Rs. 60 and it takes 16 direct labour hours to manufacture one unit.

Required:

1. Calculate the budgeted overhead recovery rates separately for variable and fixed overheads for the year 2007.
2. State, with workings, the minimum tender price which should be offered to the government department for the supply of product ‘C’.
3. Evaluate the other two proposals contained in (b) and (C) above and advise on the acceptance or otherwise of these proposals.
4. Assuming that the order given for product ‘C’ is accepted by the government department, prepare a statement of profitability for 2007 incorporating the said order and your decision on (3) above.

Solution

Calculation of Total Direct Labour Hours Budgeted

## Summary

• The basic classification of costs are made element wise and are categorised into four element viz. direct materials, direct labour , direct expenses and overheads.
• Direct costs can be easily identifiable with and attributable to a unit of operation or costing unit or cost centre. These are also called as ‘traceable costs’.
• Indirect costs are not traceable to any unit of operation or costing unit or cost centre, but which can be apportioned.
• Based on the functions in the organisation, costs can be classified into production cost, administration cost, marketing cost, distribution cost.
• Imputed cost is a cost which does not involve cash outlay but is taken into consideration for decision making and performance appraisal. For example, interest on cost of capital.
• Notional cost is a hypothetical cost considered in evaluation of a decision, when the benefit enjoyed by the concern for which actual expense is not incurred.
• Product costs re the aggregate of cash incurred for the goods produced or purchased for resale and are initially identifiable as part of inventory.
• Period costs are incurred dependent on time and are not dependent on the level of output or activity.
• Controllable costs are cost which can be influenced by a person in whom the control of the cost or profit centre is vested.
• Explicit costs necessitate outflow of cash which require immediate payment of cash like salaries, establishment expenses. These costs are also called as ‘out-of-pocket costs’.
• Implicit costs do not require cash payment for example depreciation. These costs are also called as ‘imputed costs’.
• Sunk costs are those which have been expended in the past as a result of decision taken in the past. The sunk costs are not relevant for the decision making.
• Pre-production costs are incurred when a trail-run production is conducted for commercial launch of the product. The uncapitalised costs are treated as ‘Deferred revenue expenditure’.
• The variable costs are the costs that tend to vary with level of activity and there is a linear relationship between volume and variable costs. These costs are also called as ‘engineered costs’.
• The fixed cost is unaffected by changes in the levels of activity and there is an inverse relationship exists between volume and fixed cost per unit.
• The costs which are neither perfectly variable nor perfectly fixed are called as ‘semi variable costs or semi-fixed costs’. These costs change in the same direction as of level of activity, but the direct proportion does not exist.
• The variability of costs can be determined by experience and examination of cost behaviour of cost items.
• Under high and low method the highest and lowest volumes of output and relevant cost figures are taken into consideration (incremental cost/incremental output).
• The regression analysis is a statistical technique used to segregate semi-variable cost into variable and fixed components, by taking one variable, the regression line can be used to find out the values of dependent variable. When we plot the variables on a scatter diagram ,’line of best fit’ which passes through the plotted points, this line is called ‘regression line’.
• The regression equation is y =a +bx where ‘y’ represents the total cost, ‘a’ represents the fixed element of total cost, ‘b’ represent the variable component and ‘x’ represents the number of units.
• When there are two or more independent variable exists, the problem is solved through multiple regression analysis.
• Codification is a system of assigning code numbers to each head, sub-head and category of expenses to facilitate recording, collection and analysis.