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An overdose of theory

P. V. Ratnam examines the December 1999 CS (Intermediate) paper on cost and management accounting

ANSWER Question 1, which is compulsory, and any two of the rest from this part.

1) Attempt any four of the following:

i) Write a short note on `bill of materials'.

ii) Explain `pre-determined rate of recovery of overheads' and state five bases usually adopted for such pre-determination.

iii) Distinguish between `joint-product' and `by-product'.

iv) Enumerate the practical applications of profit-volume ratio.

v) State the advantages of and criticisms against zero-based budgeting (ZBB). (5 marks each)

2(a) Differentiate between `bin card' and `stores ledger'. (5 marks)

b) ABC company buys in lots of 125 boxes, which is three months' supply. The cost per box is Rs. 125 and the ordering cost is Rs. 250 per order. The inventory carrying cost is estimated at 20 per cent of unit value per annum. You are required to ascertai n:

i) What the total annual cost of the existing inventory policy is?

ii) How much money would be saved by employing the economic order quantity (EOQ)? (10 marks)

3(a) In a certain period, the results were as follows: output -- 6,500 units; wages paid -- Rs. 48,750 for 16,250 hours; and material -- Rs. 34,000 for 4,000 kg.

Variances: labour rate -- Rs. 1,875 (adverse); labour efficiency -- Rs. 1,275 (favourable); labour idle time -- Rs. 700 (adverse); material price -- Rs. 1,850 (favourable); and material usage -- Rs. 1,200 (favourable).

Calculate the standard prime cost per unit. (10 marks)

b) Explain the difference between `cost sheet' and `production account'. (5 marks)

4(a) Explain `budget centre'. (3 marks)

Suggested answers

The paper is loaded with theory questions. Instead, there should have been more problem-oriented questions so as to test the students' grasp of the theoretical concepts. On the whole, an easy paper to tackle.

A look now at the suggested answers.

1(i) Bill of materials: Of the five `R's, purchase of right quality is possible as per the specification of materials -- otherwise called bill of materials. It is a complete schedule of component parts and raw materials required for a particular jo b or work-order prepared by the drawing office along with the necessary blue-prints of the drawings. The schedule contains the details of nuts, bolts and screws, as also their weights and sizes. Purchase requisitions are prepared by the production/maintenance department only on this basis. These are then sent to the purchase department for procurement of materials. A system of symbols or codes for materials can be used in the bill of materials depending on the size of the organisation.

ii) Predetermined rate of recovery of overheads is computed by dividing the budgeted overheads by the budgeted base for the accounting period. This rate is used for absorption of overheads, as it is more practical and useful for cost accounting purpose. Thus, it helps in quick preparation of cost estimates and fixing of selling prices.

Formula: Predetermined rate = factory overheads budgeted/basis

The five bases are direct labour-hour method, direct wages percentage, machine-hour rate, units of output and prime cost percentage.

iii) The differences between joint products and by-products are as follows:

Joint products: i) two or more products are simultaneously produced; ii) these have equal economic importance, that is, each having a sufficiently high value to merit recognition as a main product; iii) costs up to split-off point, that is, joint costs a re apportioned; and iv) some of them may be sold without processing further.

By-products: i) are recovered incidentally from the materials used in the manufacture of recognised main products; ii) their value is relatively low in comparison with the saleable value of the main product; iii) joint costs are not apportioned; and iv) some of the them may require further processing.

iv) Applications of PV ratio: It may be applied to: i) determine the variable cost for any volume of sales, the break-even point and margin of safety, the profit or loss for a particular volume of sales, and the sales volume/value for a desired amount of profit; ii) fix selling prices; iii) select the most profitable line or lines of products when there is no key factor; iv) determine the sales-mix in order to maintain the present profit in the event of price reduction or maximise the profits; and v) ma ke comparisons by calculating the PV ratios for a) line of products, b) sales area, c) method of sales, d) individual factories, and e) separate companies.

v) Advantages of ZBB: i) Provides a basis for evaluating decision packages on the basis of cost-benefit considerations;

ii) Reduces inefficiency and achieves a high level of effectiveness;

iii) Is a logical extension of programme budgeting where ranking can be done in the order of priorities;

iv) Has application in private and government organisations as well as profit-making and non-profit-making organisations;

v) In the government sector, it is helpful in identifying and improving the services;

vi) It can be applied to cost-reduction programmes;

vii) It ensures thorough examination of every function or activity;

viii) Scarce resources can be utilised effectively;

ix) The performance of line managers can be judged against their commitments and performance thereof;

x) Long-range goals and plans can be linked with annual budgets through the ZBB. Similarly, five-year plans are linked with annual budgets of the Government; and

xi) ZBB integrates planning, budgeting and control into a single process. It facilitates rational analysis, decision-making and discards low-priority activities, as the decision packages are ranked in the order of importance arrived at on the basis of co st-benefit analysis. It sharpens the planning and control functions.

Disadvantages of ZBB: i) It is not suitable for all the activities in an organisation;

ii) Has limited application in a profit-making organisation (for example, in workers' welfare measures);

iii) Not advantageous for application in R&D activities, where it is difficult to define the objectives and goals;

iv) Not a panacea for curing all management ills;

v) Is indifferent to whether the total budget is increasing or decreasing;

vi) In case of a large number of decision packages, the ranking becomes an unwieldy process; this can be avoided by using computer;

vii) More paperwork is involved;

viii) Takes more time and effort;

ix) Managers often justify the current level as the minimum level of funding; and

x) There is also the human angle, that is, resistance to change on the part of managers.

2(a): Bin card: i) it is a record of quantities only; ii) is kept inside the stores; iii)

is maintained by the store-keeper; iv) is posted before the transaction takes place; v) each transaction is individually posted; vi) the balance in the bin card is compared with the physical quantity; vii) it can be eliminated to avoid duplication; and v iii) there is no need of reconciliation with the general ledger, as it contains quantities only.

Stores ledger card: i) it is a record of both quantities and values; ii) is kept in the costing department; iii) is maintained by the cost accountant; iv) is posted after the transaction takes place; v) transactions are summarised and posted monthly; vi) balance in the stores ledger card is compared with the bin card quantity; vii) cannot be eliminated, as it contains values also; and viii) the total value of all these cards should be reconciled with the general ledger.

2(b) (i) Buying quarterly, that is, four orders in a year at Rs. 250, amounts to Rs. 1,000

Carrying cost of average inventory = 125+0/2 x (20 per cent of 125) = 62.50 x 25 = Rs. 1,562.50

Total annual cost of the existing inventory policy = Rs. 2,562.50

ii) Annual consumption = 4 x 125 = 500 boxesEOQ = square root of (2AO/C) = square root of (2x500x250)/25 = square root of 10,000 = 100 units

Ordering cost = 500/100 = five orders at Rs. 250 = Rs. 1,250

Carrying cost = (100+0)/2 x 25 = Rs. 1,250

Total cost if EOQ is followed = Rs. 2,500

Total cost at present = Rs. 2,562.50

Saving by employing EOQ = Rs. 62.50

3(a) Calculation of standard prime cost per unit:

Materials (4,000 x 8.50) = Rs. 34,000

Add: Material price variance = Rs. 1,850 F

Material usage variance = Rs. 1,200 F

Sub-total = Rs. 37,050

Wages paid = Rs. 48,750

Add: Labour efficiency variance = Rs. 1,275 F

Sub-total = Rs. 50,025

Less: Labour rate variance = (-) 1,875 A

Idle-time variance = (-) 700 A

Sub-total = Rs. 47,450

Standard prime cost = Rs. 84,500

Standard prime cost per unit(Rs. 84,500/6,500 units) = Rs. 13

3(b) Production account: i) it is a ledger account on the basis of double entry system; ii) consists of two parts -- the first part shows the cost of components and the total production cost, and the second part shows the cost of sales a nd profit for the period; iii) facilitates comparison with financial accounts; and iv) is not useful for preparing estimates for tenders or quotations.

Cost-sheet: i) it is in the form of a statement; ii) shows the prime cost, works cost, production cost, cost of goods sold and the cost of sales, that is, the total cost; iii) facilitates comparison of cost in an analytical manner for cost control purpos e; and iv) can be prepared on the basis of estimates, and is useful for submitting tenders/quotations.

4(a) Budget centre: Costs are best controlled at the point at which they are incurred. For this, suitable areas of control at the foreman or head-of-department levels have to be selected. The areas should not be too large and the span of control must be limited. The selection should be on the basis of responsibilities of foreman, supervisors, executives, heads of departments, production manager, general managers, and so on. Such areas are known as budget/responsibility centres. A budget which relates to a budget centre is called department budget.

In addition, there are functional budgets. For budgetary control, such systems as management by exception (MBE) and management by objectives (MBO) are usually followed. Only the exceptions are reported to the management so that corrective action can be t aken to achieve the objective laid down by the management. Budgetary control is another example of MBE.

(To be concluded)