Financial Management: Costing Methods, Variance Analysis, and Budgeting Techniques

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Financial Management: Costing Methods, Variance Analysis, and Budgeting Techniques








Financial management






















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Question number 1

Ruislip plc is the manufacturer of lipstick, lip balm and lip gloss and the total cost of manufacturing the above three products. It is asked to ascertain cost under two different costing methods namely absorption costing and activity based costing (Keel et al., 2017). Absorption costing is the process through which overheads are recovered from each department based on any cost centre from output which is called the recovery on the absorption (Leahy et al., 2017).

The following table shows the cost per unit of the three products under the absorption costing method.


Absorption costing

Lipstick

Lip balm

Lip gloss

Total

Quantity in units

30000

35000

3000


Direct labour in hours

3

2

2


Direct labour hours

90000

70000

6000

166000

Overhead rate per direct labour hour = actual overhead / actual labour hours

= 130000/166000

= Rupees 0.78 per direct labour hour


Unit cost

Lipstick

Lip balm

Lip gloss

Direct cost-




Direct labour

15

10

10

Direct material

5

10

10

Production overhead

2.34

1.56

1.56

Total unit cost

22.34

21.56

21.56

Number of unit

30000

35000

3000

Total cost

670200

754600

64680

selling price for each of the items are-

Lipstick = ?22

Lip balm = ?26

Lip gloss = ?24

Therefore profit per unit of the products is as follows:

Lipstick =?22 -22.34

=?0.34 (loss)

Lip balm = ? 26 -21.56

= ? 4.44 (profit)

Lip gloss = ? 24 -21.56

= ?2.44 (profit)

From the above calculation we can see that the selling of lipstick causes a loss while the other two products lip balm and lip gloss are selling at a profit (Childers and Maggard, 2018). Also cost is required to calculate on the basis of activity based costing. The below table shows cost per unit according to activity based costing:


Particulars

Lipstick

Lip balm

Lip gloss

Total

Quantity in units

30000

35000

3000


Weight per unit

1

1

1


Total weight

30000

35000

3000

68000

Machine operation per unit

4

4

4


Total operation

120000

140000

12000

272000

Total setup

10

14

1

25

Electricity rate per machine operations = 65000/272000

= 0.24 machine operation

Setup cost = 120000 / 25

= ?4800

Deliveries = 30000/22

= 1363.64

Dispatch = 15000/50

= 300

Unit costs


Particulars

Lipstick

Lip balm

Lip gloss

Direct cost-




Direct labour

15

10

10

Direct material

5

10

10

Production overhead:




Electricity

0.96

0.96

0.96

Setup cost

48

67.2

48

Deliveries

136.36

13636.3

2727.3

Dispatch

60

60

30


Total unit cost


67.66


868.57


105. 48

Number of units

30000

35000

3000

Total cost

202972

340000

316447


3) The above two methods of calculation we can see that activity based costing provides more profit than the absorption costing method. It has a higher profit percentage as compared to the former method. In absorption costs the found that production of lipstick with activity based accounting it was found that production and selling of all the three products provided profit for the company. Since this costing method focuses on the central cost and assigns the indirect costs to per units it gives a better calculation for the cost per unit. It also gives a precise picture as compared to absorption costing (Nan, 2019).

4) Sensitivity analysis is a method which provides information for assessing the risk involved in any proposed project. It involves calculation of the variances and its impact on different components that can be quantifiable in a project. This helps the manager and the management in identifying the potential pitfalls in the production process. This may also be used by the management to identify the components in a plan even when they are slightly changed, the most impact in the project's outcome. Sensitivity analysis helps in determining the values of any independent variable that affects dependent variables within any given assumption. It is the technique which is used to see how the independent variables impact the dependent variables under certain given assumptions. Usage depends upon various inputs and variables between a specific boundary such as the impact that bonds price will have due to the change in the rates of interest. Also, called the what if analysis it is used for any kind of system or activity. This analysis can be used both for household purposes and also for big corporate organisations. This analysis is used by the managers for decision making of different functional activities. The content that is needed within this decision model can be utilised totally only through repeated application of this analysis. it helps managers to analyse its decisions and also to understand about the consequences and pros and cons of this system. It also works as a predicting tool in determination of different outcomes of the actions taken. It also indicates the riskiness of any strategy and helps in analysing the same.it helps in getting an appropriate insight about the problems that are associated with this model under any reference. Further, it also gives a better idea to the decision maker about sensitivity of the activity and to take optimum solution for any changes that occur within the input.

Question number 2

  1. Kappa Company is a producer of Omega, a product made by heating and mixing 3 ingredients namely Alpha, Beta and Gamma. The standard material costing for the production of hundred kg of Omega is produced. And also the actual material cost for the current month is given. It is essential to calculate the material variance to know the cost per unit and total cost. Material usage variance is measured to ascertain the cost incurred in the consumption of materials. The production department is responsible for its calculation and any adverse usage of the same.

Material usage variance = Standard cost of standard quantity for actual production - Standard cost of actual quantity

MUV = ( SQ - AQ )*SP

Material usage variance for Alpha

MUV = (9900* - 2200)*2

= 15400 favourable

Standard quantity = 3960*100/40

= 9900

Material usage variance for Beta

Standard quantity = 15,000 *100/60

= 25000

MUV = (25000 - 2500)*5

= 112500 favourable

Material usage variance for Gamma

Standard quantity = 920 *100/20

= 4600

MUV = (4600 - 920)*1

= 3680 favourable

A favourable indication about the material usage variance shows that the materials are used in a proper manner with the reduced cost. There is no wastage in the production process of Omega.

Material mix variance is the distinction between the actual mix and budgeted mix of the direct material cost that is used in the production process. This variance isolates the total unit cost for individual items excluding the variable cost. This variance is calculated by holding the aggregate input constant with the actual amount (Hojna and Stryckova, 2018).

Material Mix Variance = (Standard cost of actual quantity in standard proportion - Standard cost of actual quantity)

MMV = (RSQ - AQ )*SP

The following table shows the material mix variance of all the three ingredients Alpha, Beta and Gamma required in the production of Omega.


Particulars

Actual quantity

Standard price

Total

Actual input at individual standard materials cost:




Alpha

2200

2

4400

Beta

2500

5

12500

Gamma

920

1

920

Total (A)



17820

Actual input at weighted average of standard materials cost:




5620 *3.33 (B)



18714.6

Total ( A-B )



894.6 unfavourable


We can ascertain that unfavourable mix variance is calculated signifying that the usage of per unit has increased than that which was anticipated. This can be due to a number of causes such as reduction in the quality of materials, scrap value of the materials or spoilage of the products in the process of production.

Material yield variance is the difference between standard output and actual output of the process or material. Calculated on the basis of standard inputs by labour and materials and forms its basis upon the standard cost.

Material yield variance = (Standard cost of standard quantity for actual production - Standard cost of actual quantity in standard proportion)

MYY = (SQ - SP)*( AQ - SP )

= 400 *17820

= 17420 unfavourable

An unfavourable variance signifies that the production is lower than anticipated and has incurred a lot of expenses during the manufacturing process. This would result in a lower quality of the product with increased material cost. Company has used more materials than anticipated (Buono et al., 2018).

2)Variance analysis is an important tool for the organisation's budgetary system and control. It is also important for the management to determine the limitations and disadvantages of this system. The disadvantages that can occur by the implementation of variance analysis for assessing the performance of production managers are listed below.

  • Non-standard production

variance analysis is suitable in the organisation which involves mass production and manufacturing of products in a large quantity. But problems arise when the same is implemented in small enterprises which produce products at small batches or customised products. For each new batch new standards have to be set and developed. The time that is involved in controlling and managing and looking after the entire production process is not feasible and makes the entire working process lengthy when the production cycle is of very short time.

  • Service organisation

This analysis is difficult to implement in the organisations which provide services due to the fact that it involves only the cost which are involved in overheads and neglect the production expenses. it considers only the direct labour, direct material direct cost and overheads of the manufacturing process which would make it difficult to apply the same in service sectors. Traditional way of variance analysis does not provide much information about the overhead control and its purposes. New approaches towards variance analysis should be adopted for making a more constructive basis towards the overhead analysis in organisations which are related to service providing.

  • Reporting delay

Variance analysis is normally conducted while the preparation of the annual budget. Hence the usefulness of the analysis as a mechanism of control reduces as the time passes by, resulting in delay of preparation of the information and provisions. It also proves to be very costly in terms of the management time and its resources that are required for the implementation of such information systems within the company.

  • Behaviour issues

Variance analysis inherits a tendency of short-term comma quantified results and objectives leading to the encouragement of short-termism. it encourages among the employees a sub-optimal behaviour which leads to the attempt of budget slacks within the organisation. This negative impact of variance analysis can be managed so that the employees do not view the whole process as unfair and unjust would be beneficial for the organisation to base its management system in adopting the range of qualitative and quantitative methods so as to fulfil their long-term objectives.

  • Assigning responsibilities

Variances arise due to a number of factors which range from operational causes to unrealistic standards. Inefficiency in planning for setting faulty standards should be dealt with computerized operational and planning variances also becomes difficult to ascertain the actual cause for the variances and assign responsibilities upon a specific department or individual.


Question number 3

Zero based budgeting is a budgeting method in which approval and justification of all expenses for each period of time is required. This budgeting method starts with the base that is taken as zero at the beginning of each period, analysing the costs and needs of all the functions that occur in the organisation and also allocate the funds accordingly, regardless of the fact that how much cost has been previously budgeted for any given item. It facilitates the implementation of strategic objectives by the top level into a structured budgeting process by using them towards specific functions within the company. In this method, the costs are categorised and measured with the past results and enables the management to make current expectations and allocate funds accordingly. It uses current expenditures instead of historical expenditures. Use of zero based budgeting is different for different sectors. On one hand, the private sector limits this scope only to the administrative overheads of the company. Whereas in the public sector company it is used for optimising all the activities within the organisation. Zero based budgeting implies preparation of budget from the scratch which would indicate that proper attention is given towards each and every activity.it requires certain training and skills which make the departmental managers difficult to construct such budgets used for some other important activities. In large organisations the paperwork that is generated from this method would be unmanageable due to its detailed preparation of budgets.


Incremental budgeting is a type of traditional budgeting where budgets are prepared considering the current periods are the actual performance as their base activity, and considering the incremental amounts being added for the new budgets of the period. This type of incremental amounts includes adjustments for activities such as estimated increase in selling price, inflation and cost. It is considered by most of the students that the main disadvantage of this type of budgeting method is that it restricts the calculation of inflation. This budget is prepared considering the actual performance or the current year's budget as their starting point. Due to its easy preparation and implementation it is mostly allocated to the junior staff for its preparation. Due to its quick preparation the cost of preparation reduces thereby giving a cost benefit to the organisation. It is also easy to understand which means that even a layman can understand the budget and make conclusions. It adopts a consistent approach towards the preparation of budget thereby reducing the problems between departmental managers. The impact of this budget is seen as soon as it is being prepared.

Zero based budgeting requires justification about all the costs, by making it inappropriate for using it why the preparation of the entire budgeting process in any organisation. Why should anyone take so much resources and time just to justify the costs which need to be incurred to meet the basic production costs? Absolutely makes no sense of using such a lengthy process for costing where no specific discretion is exercised. Comparing incremental budgeting with zero based budgeting it is more easy and quick to understand and implement. But, the incremental budgeting often leads to inertia, budgetary slack and inefficiency. it assumes only the current costs and activities that are needed without going into its detail. Departmental managers for trying to reduce cost which may lead to spending more money. The performance targets often become challenging since it is prepared based on some token increase of past performance. Hence the managers do not get motivated to challenge themselves and find inefficiencies from past periods which are carried forward. Concluding neither incremental budgeting nor zero based budgeting can be used as a perfect tool for coordination, planning and control. But each of the methods provide some kind of a positive recommendation of using both and ends up using both the methods for getting optimal solutions for each problem. Best result lies between using both the methods in a suitable manner.


References

Beredugo, S.B., Azubike, J.U. and Okon, E.E., 2019. Comparative Analysis of Zero-Based Budgeting and Incremental Budgeting Techniques of Government Performance in Nigeria.

Buono, J.L., Carson, R.T. and Flores, N.M., 2017. Health-related quality of life, work productivity, and indirect costs among patients with irritable bowel syndrome with diarrhea. Health and quality of life outcomes, 15(1), pp.1-8.

Childers, C.P. and Maggard-Gibbons, M., 2018. Understanding costs of care in the operating room. JAMA surgery, 153(4), pp.e176233-e176233.

Clark, C., Menifield, C.E. and Stewart, L.M., 2018. Policy diffusion and performance-based budgeting. International Journal of Public Administration, 41(7), pp.528-534.

Geiszler, M., Baker, K. and Lippitt, J., 2017. Variable Activity?Based Costing and Decision Making. Journal of Corporate Accounting & Finance, 28(5), pp.45-52.

Herman, J. and Usher, W., 2017. SALib: an open-source Python library for sensitivity analysis. Journal of Open Source Software, 2(9), p.97.

Hojna, R. and Stryckova, L., 2018. ABSORPTION COSTING ANALYSIS AND ITS USE BY CZECH MANUFACTURING COMPANIES. In 5th International Multidisciplinary Scientific Conference on social sciences and arts SGEM 2018 (pp. 19-26).

Ibrahim, M., Ashigar, A., Bello, B.M. and Mamuda, A.U., 2017. Zero-Based Budgeting is a Panacea to Fiscal Distress: Do the Perceived Benefits Significantly Influence its Adoption in Borno State?. Saudi Journal of Business and Management Studies, 2(10), pp.943-950.

Ibrahim, M.M., 2019. Designing zero-based budgeting for public organizations. Problems and Perspectives in Management, 17(2).

Kami?ski, B., Jakubczyk, M. and Szufel, P., 2018. A framework for sensitivity analysis of decision trees. Central European journal of operations research, 26(1), pp.135-159.

Keel, G., Savage, C., Rafiq, M. and Mazzocato, P., 2017. Time-driven activity-based costing in health care: a systematic review of the literature. Health Policy, 121(7), pp.755-763.

Leahy, M.F., Hofmann, A., Towler, S., Trentino, K.M., Burrows, S.A., Swain, S.G., Hamdorf, J., Gallagher, T., Koay, A., Geelhoed, G.C. and Farmer, S.L., 2017. Improved outcomes and reduced costs associated with a health?system–wide patient blood management program: a retrospective observational study in four major adult tertiary?care hospitals. Transfusion, 57(6), pp.1347-1358.

LIU, B. and PAN, H.Q., 2018. Comparative Study of Absorption Costing and Variable Costing. Journal of Qiqihar University (Philosophy & Social Science Edition), p.06.

Myers, G.M., 2019. Responsibility center budgeting as a mechanism to deal with academic moral hazard. Canadian Journal of Higher Education/Revue canadienne d'enseignement supérieur, 49(3), pp.13-23.

Nan, N., 2019. Comparative Analysis of Marginal Costing Method and Absorption Costing Method.

Ouassini, I., 2018. An introduction to the concept of Incremental Budgeting and Beyond Budgeting. Available at SSRN 3140059.

Saltelli, A., Aleksankina, K., Becker, W., Fennell, P., Ferretti, F., Holst, N., Li, S. and Wu, Q., 2019. Why so many published sensitivity analyses are false: A systematic review of sensitivity analysis practices. Environmental modelling & software, 114, pp.29-39.

VanderWeele, T.J. and Ding, P., 2017. Sensitivity analysis in observational research: introducing the E-value. Annals of internal medicine, 167(4), pp.268-274.

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