 Last class I just gave you the broad definition of cost and we need to understand that the definition of cost is for a cost object. So what is a cost object? Cost object is just the technical term that we use, just a technical term for the product or for the business activity or an organizational unit or any purpose for which we are measuring the total cost is the cost object and it has a context to it. Suppose we say manufacturing a particular type of car and that particular type of car is a cost object or the total cost involved in running the entire automobile plant in which this car is a part of that can also be a cost object. It can be as broad as the entire plant itself or it can be as narrow as one particular product that comes out of the plant. So the extent to which you either go very narrow or make it broad determines the actual cost that you are going to calculate because the cost object is differing based on your requirement. But whatever the case may be we need to measure the full cost of the cost object, full cost of the cost object. It means all the resources that the cost object consumes in its creation is the full cost of the cost object. In some cases it can be easily measured. Let us say you get into a shop and you purchase a pair of jeans for 1000 rupees. The full cost for you is 1000 rupees that is easily measurable because you just pay that 1000 rupees. Suppose the question is what is the full cost of manufacturing that gene? Then you need to look into various other components that get into the full cost of manufacturing this gene. In this case the genes the pair of gene is the cost object. Now to do that we need to understand that this cost is divided into two broad categories namely the direct cost and the indirect cost. Direct and indirect cost. So the direct cost of a cost object are all the items of cost that can be specifically identified and tagged on to be cost by this cost object. That is the direct cost. For example we are talking about manufacturing a particular type of gene. The fabric or the denim that is used in manufacturing a batch of genes is a direct cost of that batch of genes. As against indirect cost which could be one or more of certain cost types where it is not feasible to trace each of them individually to a cost object. In the same example the salary of the employer or the insurance that is being paid for the gene factory. These are indirect cost. Definitely a part of it goes to this but we cannot trace it in exactitude that it is because of this cost object. But also we must understand that in this example that I have cited the cost object here is explicitly stated that it is a batch of genes. If the cost object let us say changes and say that the cost object is the entire factory where the genes are produced. Then the employer salary the insurance that they pay for the factory is a direct cost because here the cost object is the factory itself and it can be traced to the cost object because the cost object is the factory. So we need a context to define the cost object and all costs that can be traced to this cost object are its direct cost and all costs that are being incurred but not being able to trace to a particular cost object are the indirect cost and we will understand it more when we actually split this into finer components and how do we do that. The most common cost object of any business is a product. Any business engages in delivering a product or rendering a service. So it could be a product or a service that is the most common cost object. So the common cost object for the purpose of our discussion is a product or a service. So product because it is a tangible that could be intangible cost objects if you are rendering a service. So we need to understand the product costing system how costs are allocated to the cost object and the most commonly used or the common components of the cost. I told you before two easily identifiable direct cost components are the material and labor. So direct material cost is that quantity of material that can be specifically identified to the cost object in an economically feasible manner which means that I am able to express it in monetary terms because I know that this much amount of material has been consumed in producing this particular cost object. So that is the direct material cost and invariably you would take the raw materials that you actually use consume to make this cost object as your material cost. And likewise your direct labor cost will be all the labor quantities that can be easily attributable that can be identified specifically for creating this cost object. And how do you monetize this? You just know the total number of hours that has been consumed and what is the rate that you are paying for the labor hours that has been consumed and hence it can be converted into monetary terms. And this you will be specifically able to identify to a particular cost object because you know for this particular cost object you are consuming this amount of labor which costs some amount x per hour or whatever is the unit that you are using. So the most commonly used direct costs are the direct material cost and the labor cost. And other costs in addition to these are the direct cost which invariably we call as overhead cost. The cost of running the unit, the cost that are not easily identifiable in definite measure to a particular cost object. Now typically if you look at this material plus labor plus overhead or your indirect cost, overhead cost with respect to let us say the production activities because there are other overhead costs outside the production activity that is your general selling expenses, administrative expenses that we look at it later. Now this is your conversion cost. So if you look at the cost components, the elements of product cost for a finer understanding I will just split these into let us say this is your direct labor cost, this is your overhead cost, this plus this is your conversion cost as I said before, your conversion cost plus let us say this is direct material cost. So this plus this will give you the full cost, direct labor cost, conversion cost, direct material cost. And if you look at your accounting that we learnt before this is what gets and sits as your inventory and it is after you incur some selling cost and some general admin cost. This is also a form of overhead actually all this put together will be your direct labor, this one was your overhead, production overhead, this one was your material cost, selling cost, general administrative cost. So all this put together will be the full cost. So this you just have as an imagery for you to understand that any cost object will have two major components direct cost, indirect cost and very typically cost that are associated with either conception of material or labor can easily be identified to that particular cost object and hence there is direct material cost, direct labor cost. And then the generic overhead cost which will be spread over different cost objects and all this put together will give you the full product cost of the cost object. Now with this understanding let us begin to understand what standard cost is. A standard cost is a measure of how much an item of cost should be, is a measure of how much an item of cost should be as against how much it actually was. It is more or less equivalent to budgeted cost except that standard cost is for a unit cost product whereas budgeted cost is for the total number of such cost products that are being produced. Now let us say we would like to understand what is the standard cost of a cost product, which means I need to understand what is the unit cost, the unit full cost of producing one unit of the cost product that is the standard cost. And typically just like when you see a recipe to cook some dish they would say take so much of this quantity, so much of this quantity do something and finally you prepare something. Just have this in your mind and if the units that are being consumed in making that dish has some monetary value then you are consuming material. And the person who is preparing that also consumes some time and then he is paid for that then there is monetary value in the labor that is being consumed. And the fuel or the place in which he is working has a cost of operation then there is also this overheads to this. So you are able to add directly identifiable material cost, directly identifiable labor cost and that component of an overhead cost and all of them together to produce one unit that is the unit standard cost. And typically if you get into a manufacturing set up I will just give you an example of a standard cost sheet. So if you go to a manufacturing set up you will have a bill of material. Let us say I use this item material X part Y some component Z. So the standard quantity that I would be using to produce one unit of that material I first write. So the standard quantity of material X that I require let us say this is 120 square inch then 6 units and 1 unit of component Z. And all the standard quantity is available for a standard price let us say this is 0.05 this is 2.5 this is 24.5 as a result of which the total cost is 6 15 24.5. So my direct material cost is 45. Then when I get this material I will have to process this material. So let us say I have to do some forming of material X then I attach Y join with Z test and bracket. So these are labor operations. So I am talking about time let us say there is some standard time for this and standard time and standard price for this. Now to form this material I need to consume 0.6 hours at a price of 12.5. So the total cost of labor for this particular operation is 7.5 likewise let us say I am consuming different amounts of time at different rates to calculate the total labor cost that is involved. So this comes to 11.8. Then I said there is an overhead in this case I am just talking about the production overhead which is let us say 17.7 there is a basis for which I calculate this production overhead. This total is 1 hour. So let us say the overhead is for every 1 hour that is being consumed the direct overhead is 17.7 rupees. So the total standard unit cost is 1 plus 2 plus 3 which is 75. Now how did I calculate this total standard unit cost? The standard quantity of each item if you go just this here the standard quantity of each item of material input that is being used to produce this cost object to produce 1 unit of this cost object times the price of each unit of that material that is being consumed and the sum of all gives the material cost. Then similarly you calculate the standard cost of the direct labor input that is required to make 1 unit of the cost product. So the various labor operations that we saw here are listed and the standard time is determined for each of these labor operation which means I expect that to produce 1 unit of a particular cost product I will spend 0.2 hours to attach y 0.6 hours to form material x and these standard times are multiplied by the standard rates. So that they get converted to monetary terms and sum of these amounts of all the operations is a product standard labor cost. So you have the product standard material cost you have the product standard labor cost and by applying a predetermined overhead rate which is pegged to the direct labor hours or labor dollars whatever the case may be you calculate the overhead that is included in the standard cost and in this case the total standard unit cost is 75 rupees. Suppose I manufacture 1000 units I told you the difference between standard cost and budgeted cost is just the unit level and the aggregate level. The standard unit cost here is 75. Suppose I want to manufacture 100 units that the budgeted cost is 75 times 100 which is 7500. This is the difference between budget cost and standard cost and for all practical purposes they are used interchangeably because it is a unit level that gets expanded to an aggregate level makes it the budgeted cost. So now you understand that 3 critical elements get into the calculation of standard unit cost. Those 3 are material, labor and overhead. Now why is this important? It is important because I told you management accounting by itself is more internal from a control perspective. I need to understand vis-a-vis the budgeted cost how much was the actual cost that was consumed budget versus actual. Now to do that we need to make a comparison between the actual unit cost and the standard unit cost and if the actual is more than the standard then there is an unfavorable variance. If the actual is less than the standard there is a favorable variance. At a very broad level you need to understand that a favorable variance arises if the actual cost of the resources consumed for a cost product is less than what actually it was budgeted for and as I told you the standard cost represents what the cost should be. So the standard direct material cost is the cost of producing one unit of the product to produce one unit of the product of the cost product how much of material that I am consuming at a given standard price of that material that is for material cost. For labor cost how much of labor I am consuming to produce one unit of the cost product at a given specific labor price. So I just like to make sure that you understand this well to produce one unit of the cost product. How much material you are consuming at standard prices how much labor at standard prices. Remember this is the cost sheet that we saw before this is the cost sheet that we saw before. Now where do you think variance will arise let us go one by one let us say I am talking about direct material cost. Now as per definition the standard cost is before we actually make the operations before we start doing something we assume that to make one unit of this cost product we are going to consume some resources and we are assuming that we can get these resources at this price. So if I am interested in knowing what the direct material variances I should first be interested in knowing what can change from the standard cost that I have estimated what can change when I am actually engaged in making the cost product. Two things can change either the material that I am consuming or the price at which I am procuring the material, material usage or material price and both these cases they may change either favorably or unfavorably. I might end up using more material or less material I might end up buying that material at a higher price than I expected or at a price lower than I expected. But as long as there is a change then there is room for variance between standard and actual. So we need to calculate what this material usage variances what the material price variances and the algebraic sum of these two is the direct material variance. So direct material cost variance will be the algebraic sum of the material usage variance plus material price variance. Now what is the usage variance? Usage variances I end up using a quantity which is different from the standard cost from what I thought I would be using times the standard price. Price variance is I end up paying more or less there is a change in price for the actual quantity that I consume. Now I will just give you an example for you to understand this better. Let us say each unit of product x x is the cost product that we are considering. Now each unit of product x requires 9 grams of some direct material 9 gram of a direct material which cost 4 rupees per gram. Now let us say within a given time period that I produce 100 units 100 units of that material x was made and in making that 100 units I consumed 825 grams of that direct material and it was purchased at the rate of rupees 5 per gram. Now I need to calculate what is the variance direct material cost variance. I can calculate it because now this is standard data. Standard data says to produce one unit of that x I need 9 grams of direct material the raw material and each gram is available at rupees 4 and I am producing 100 units which means I need to consume 900 units and when I see here I just consume 825 units and I have to purchase each unit at 4 rupees per gram here I purchased at 5 rupees per gram. So you can clearly see that there is a change there is a variance both at the material consumption level and at the price level. So which means there is usage variance as well as price variance and we need to calculate how much is usage variance and how much is the price variance. So usage variance is as per our definition delta of the quantity into the standard price. In this case 75 times 4 which is 300. Now is this 300 favorable or unfavorable? Favorable because actually I should have consumed 900 units but I have consumed only 825 units. So this delta quantity is favorable and hence 300 favorable is the usage variance. Now price variance is delta price into actual quantity which is 1 into the actual that we purchased was 825 favorable or unfavorable because it is unfavorable here because actually I should have purchased at 4 rupees per gram but today I mean when I did this I purchased at 5 rupees per gram. So what is the direct material cost variance? It is the algebraic sum of these two 300 favorable plus 825 unfavorable 525 unfavorable. So this is the direct material cost variance. Now why are you saying that are we doing this? As a manager in the organization I need to understand why there is this direct material cost variance. So I look at this and I find that my people in the shop floor they have been able to reduce the quantity that was used. When actually I should have used 900 I have used 825 and positively contributed to the cost structure whereas my people in the purchasing when they were supposed to have purchased this at rupees 4 they have ended up purchasing this for rupees 5 as a result of which there is an unfavorable variance and that is why I am interested in doing this variance analysis to make sure that it is only those who are responsible for this variance are being asked for explanation. Otherwise in the absence of that you know that there is an unfavorable variance but you do not know who is responsible for it. But at the same time this is just a pointer and indicator for you to quickly go and diagnose the problem. For example let us say somebody ended up in the name of providing a favorable variance you ended up saying that you have favorable price variance let us take an example. You end up buying material at prices lower than actually it was budgeted for but ended up buying poor quality raw material as a result of which more and more raw material was consumed exactly the opposite case I am giving you. Then looking at the variance you will assume that the purchasing department has done a good job the people at the production have done a bad job because they have consumed more of the raw material. When at the first place the reason that I consumed more of the raw material was because I was given poor quality raw material because it was purchased at a price lesser than the standard price just because I had to submit a favorable price variance that is also possible. But a variance analysis is done to attempt at least focus our efforts to address issues where there is unfavorable variance and also to highlight those best practices that result in favorable variances. In the same example suppose I decide to give this as a small piece of a graphical aid let us say this is the quantity this is the price quantity is 0 to 900 and this is the price 0 to 4. So what is the this let us say the area under this is the total standard price standard price is 900 into 4 3600 and same thing actual is 825 quantity price is 5. So 825 into I am just juxtaposing both of these into one figure this is just another way of understanding this quantity 825 900 price 4 5. This will be the usage variance which is 75 times 4 300 favorable this will be price variance which is 75 times 4 300 1 times 825 25 unfavorable. So net variance 525 unfavorable. So now you understand that you can do a variance analysis to measure the difference between the actual and the budgeted in this case we have just talked about the material cost variance and how do we do that we know that direct material variance can arise because of two consequences either there is a difference between the standard or the budgeted conception of material and the actual consumed or there is a difference in the price that was budgeted versus the actual price that it was purchased. At times these variance analysis will be helpful to identify management focus to certain set of operations which have either positively or negatively contributed to the direct material cost variance. Now just as we had direct material cost variance another important component to the direct cost of a cost product is the labor component. So we know how to calculate direct material cost variance likewise we also have something called the direct labor cost variance. And in direct material there were two reasons why a variance arose one at the consumption of material and the second is the procurement of material the prices which was procured. Likewise labor variance also you might have two reasons for variance to arise one you expected that this operation could be completed within this period of time. But when actually it was performed it either consumed more or less time as a result of which there you expected that you paid your laborers this wage. But actually when the laborers were engaged there was a change either you paid them more or paid them less than what actually you thought for. So just as we had favorable and unfavorable variance in material you can also have favorable and unfavorable variance in labor when actually you either consume less or more time than you budgeted for or you paid less or more than you budgeted for. So just as you have a standard unit material cost you also have a standard unit labor cost which tells you that to produce one unit of the cost product you are going to consume certain amount of labor hours which is priced at a certain standard price. And remember when we saw the cost sheet before that total labor hours required to produce one unit of the product times the rate at which this labor hours was engaged is the total standard labor cost the unit labor unit standard labor cost. And if suppose we make thousand units times thousand is the total budgeted labor cost. Now how do we calculate labor variance we need to see the actual labor cost and the budgeted labor cost and see whether there is a difference to understand the variance. Just as we took an example to understand material variance next class I will be taking another example for you to understand labor variance. So that you will get a proper understanding of both material variance labor variance and the third thing is the overhead variance. And all these three put together will be the total variance of a cost product against the budgeted and the actual the difference gives you the total variance. And that will be more useful in channelizing your resources either to improve procurement price or labor efficiency or reduced overhead. So next class when we meet I will start with how to calculate labor