Budgetary control

Budgetary control

There are two types of control, namely budgetary and financial. This chapter concentrates on budgetary control only. This is because financial control was covered in detail in chapters one and two. Budgetary control is defined by the Institute of Cost and Management Accountants (CIMA) as:
"The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision".
Chapter objectives
This chapter is intended to provide:
• An indication and explanation of the importance of budgetary control in marketing as a key marketing control technique
• An overview of the advantages and disadvantages of budgeting
• An introduction to the methods for preparing budgets
• An appreciation of the uses of budgets.
Structure of the chapter
Of all business activities, budgeting is one of the most important and, therefore, requires detailed attention. The chapter looks at the concept of responsibility centres, and the advantages and disadvantages of budgetary control. It then goes on to look at the detail of budget construction and the use to which budgets can be put. Like all management tools, the chapter highlights the need for detailed information, if the technique is to be used to its fullest advantage.
Budgetary control methods
a) Budget:
• A formal statement of the financial resources set aside for carrying out specific activities in a given period of time.
• It helps to co-ordinate the activities of the organisation.
An example would be an advertising budget or sales force budget.
b) Budgetary control:
• A control technique whereby actual results are compared with budgets.
• Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets.
Budgetary control and responsibility centres;
These enable managers to monitor organisational functions.
A responsibility centre can be defined as any functional unit headed by a manager who is responsible for the activities of that unit.
There are four types of responsibility centres:
a) Revenue centres
Organisational units in which outputs are measured in monetary terms but are not directly compared to input costs.
b) Expense centres
Units where inputs are measured in monetary terms but outputs are not.
c) Profit centres
Where performance is measured by the difference between revenues (outputs) and expenditure (inputs). Inter-departmental sales are often made using "transfer prices".
d) Investment centres
Where outputs are compared with the assets employed in producing them, i.e. ROI.
Advantages of budgeting and budgetary control
There are a number of advantages to budgeting and budgetary control:
• Compels management to think about the future, which is probably the most important feature of a budgetary planning and control system. Forces management to look ahead, to set out detailed plans for achieving the targets for each department, operation and (ideally) each manager, to anticipate and give the organisation purpose and direction.
• Promotes coordination and communication.
• Clearly defines areas of responsibility. Requires managers of budget centres to be made responsible for the achievement of budget targets for the operations under their personal control.
• Provides a basis for performance appraisal (variance analysis). A budget is basically a yardstick against which actual performance is measured and assessed. Control is provided by comparisons of actual results against budget plan. Departures from budget can then be investigated and the reasons for the differences can be divided into controllable and non-controllable factors.
• Enables remedial action to be taken as variances emerge.
• Motivates employees by participating in the setting of budgets.
• Improves the allocation of scarce resources.
• Economises management time by using the management by exception principle.
Problems in budgeting
Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms.
• Budgets can be seen as pressure devices imposed by management, thus resulting in:
a) bad labour relations
b) inaccurate record-keeping.
• Departmental conflict arises due to:
a) disputes over resource allocation
b) departments blaming each other if targets are not attained.
• It is difficult to reconcile personal/individual and corporate goals.
• Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with "empire building" in order to enhance the prestige of a department.
Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs.
• Managers may overestimate costs so that they will not be blamed in the future should they overspend.
Characteristics of a budget
A good budget is characterised by the following:
• Participation: involve as many people as possible in drawing up a budget.
• Comprehensiveness: embrace the whole organisation.
• Standards: base it on established standards of performance.
• Flexibility: allow for changing circumstances.
• Feedback: constantly monitor performance.
• Analysis of costs and revenues: this can be done on the basis of product lines, departments or cost centres.
Budget organisation and administration:
In organising and administering a budget system the following characteristics may apply:
a) Budget centres: Units responsible for the preparation of budgets. A budget centre may encompass several cost centres.
b) Budget committee: This may consist of senior members of the organisation, e.g. departmental heads and executives (with the managing director as chairman). Every part of the organisation should be represented on the committee, so there should be a representative from sales, production, marketing and so on. Functions of the budget committee include:
• Coordination of the preparation of budgets, including the issue of a manual
• Issuing of timetables for preparation of budgets
• Provision of information to assist budget preparations
• Comparison of actual results with budget and investigation of variances.
c) Budget Officer: Controls the budget administration The job involves:
• liaising between the budget committee and managers responsible for budget preparation
• dealing with budgetary control problems
• ensuring that deadlines are met
• educating people about budgetary control.
d) Budget manual:
This document:
• charts the organization
• details the budget procedures
• contains account codes for items of expenditure and revenue
• timetables the process
• clearly defines the responsibility of persons involved in the budgeting system.
Budget preparation
Firstly, determine the principal budget factor. This is also known as the key budget factor or limiting budget factor and is the factor which will limit the activities of an undertaking. This limits output, e.g. sales, material or labour.
a) Sales budget: this involves a realistic sales forecast. This is prepared in units of each product and also in sales value. Methods of sales forecasting include:
• sales force opinions
• market research
• statistical methods (correlation analysis and examination of trends)
• mathematical models.
In using these techniques consider:
• company's pricing policy
• general economic and political conditions
• changes in the population
• competition
• consumers' income and tastes
• advertising and other sales promotion techniques
• after sales service
• credit terms offered.
b) Production budget: expressed in quantitative terms only and is geared to the sales budget. The production manager's duties include:
• analysis of plant utilization
• work-in-progress budgets.
If requirements exceed capacity he may:
• subcontract
• plan for overtime
• introduce shift work
• hire or buy additional machinery
• The materials purchases budget's both quantitative and financial.
c) Raw materials and purchasing budget:
• The materials usage budget is in quantities.
• The materials purchases budget is both quantitative and financial.
Factors influencing a) and b) include:
• production requirements
• planning stock levels
• storage space
• trends of material prices.
d) Labour budget: is both quantitative and financial. This is influenced by:
• production requirements
• man-hours available
• grades of labour required
• wage rates (union agreements)
• the need for incentives.
e) Cash budget: a cash plan for a defined period of time. It summarises monthly receipts and payments. Hence, it highlights monthly surpluses and deficits of actual cash. Its main uses are:
• to maintain control over a firm's cash requirements, e.g. stock and debtors
• to enable a firm to take precautionary measures and arrange in advance for investment and loan facilities whenever cash surpluses or deficits arises
• to show the feasibility of management's plans in cash terms
• to illustrate the financial impact of changes in management policy, e.g. change of credit terms offered to customers.
Receipts of cash may come from one of the following:
• cash sales
• payments by debtors
• the sale of fixed assets
• the issue of new shares
• the receipt of interest and dividends from investments.
Payments of cash may be for one or more of the following:
• purchase of stocks
• payments of wages or other expenses
• purchase of capital items
• payment of interest, dividends or taxation.
Steps in preparing a cash budget
i) Step 1: set out a pro forma cash budget month by month. Below is a suggested layout.
Month 1 Month 2 Month 3
$ $ $
Cash receipts
Receipts from debtors
Sales of capital items
Loans received
Proceeds from share issues
Any other cash receipts
Cash payments
Payments to creditors
Wages and salaries
Loan repayments
Capital expenditure
Taxation
Dividends
Any other cash expenditure
Receipts less payments
Opening cash balance b/f W X Y
Closing cash balance c/f X Y Z
ii) Step 2: sort out cash receipts from debtors
iii) Step 3: other income
iv) Step 4: sort out cash payments to suppliers
v) Step 5: establish other cash payments in the month
Figure 4.1 shows the composition of a master budget analysis.
Figure 4.1 Composition of a master budget
OPERATING BUDGET FINANCIAL BUDGET
consists of:- consists of
Budget P/L acc: get: Cash budget
Production budget Balance sheet
Materials budget Funds statement
Labour budget
Admin. budget
Stocks budget
f) Other budgets:
These include budgets for:
• administration
• research and development
• selling and distribution expenses
• capital expenditures
• working capital (debtors and creditors).
The master budget (figure 4.1) illustrates this. Now attempt exercise 4.1.
Exercise 4.1 Budgeting I
Draw up a cash budget for D. Sithole showing the balance at the end of each month, from the following information provided by her for the six months ended 31 December 19X2.
a) Opening Cash $ 1,200.
19X2 19X3
Sales at $20 per unit MAR APR MAY JUN JUL AUG SEP OCT NOV DEC JAN FEB
260 200 320 290 400 300 350 400 390 400 260 250
Cash is received for sales after 3 months following the sales.
c) Production in units: 240 270 300 320 350 370 380 340 310 260 250
d) Raw materials cost $5/unit. Of this 80% is paid in the month of production and 20% after production.
e) Direct labour costs of $8/unit are payable in the month of production.
f) Variable expenses are $2/unit. Of this 50% is paid in the same month as production and 50% in the month following production.
g) Fixed expenses are $400/month payable each month.
h) Machinery costing $2,000 to be paid for in October 19X2.
i) Will receive a legacy of $ 2,500 in December 19X2.
j) Drawings to be $300/month.
An example
A sugar cane farm in the Lowveld district may devise an operating budget as follows:
• Cultivation
• Irrigation
• Field maintenance
• Harvesting
• Transportation.
With each operation, there will be costs for labour, materials and machinery usage. Therefore, for e.g. harvesting, these may include four resources, namely:
• Labour:
-cutting
-sundry
• Tractors
• Cane trailers
• Implements and sundries.
Having identified cost centres, the next step will be to make a quantitative calculation of the resources to be used, and to further break this down to shorter periods, say, one month or three months. The length of period chosen is important in that the shorter it is, the greater the control that can be exercised by the budget but the greater the expense in preparation of the budget and reporting of any variances.
The quantitative budget for harvesting may be calculated as shown in figure 4.2.
Figure 4.2 Quantitative harvesting budget
Harvesting 1st quarter 2nd quarter 3rd quarter 4th quarter
Labour
Cutting nil 9,000 tonnes 16,000 tonnes 10,000 tonnes
Sundry nil 300 man days 450 man days 450 man days
Tractors nil 630 hours 1,100 hours 700 hours
Cane trailers nil 9,000 tonnes 16,000 tonnes 10,000 tonnes
Imp, & sundries nil 9,000 tonnes 16,000 tonnes 10,000 tonnes
Each item is measured in different quantitative units - tonnes of cane, man days etc.-and depends on individual judgement of which is the best unit to use.
Once the budget in quantitative terms has been prepared, unit costs can then be allocated to the individual items to arrive at a budget for harvesting in financial terms as shown in table 4.2.
Charge out costs
In table 4.2 tractors have a unit cost of $7.50 per hour - machines like tractors have a whole range of costs like fuel and oil, repairs and maintenance, driver, licence, road tax and insurance and depreciation. Some of the costs are fixed, e.g. depreciation and insurance, whereas some vary directly with use of the tractor, e.g. fuel and oil. Other costs such as repairs are unpredictable and may be very high or low - an estimated figure based on past experience.
Figure 4.3 Harvesting cost budget
Item harvesting Unit cost 1st quarter 2nd quarter 3rd quarter 4th quarter Total
Labour
Cutting $0.75 per tonne - 6,750 12,000 7,500 26,250
Sundry $2.50 per day - 750 1,125 1,125 3,000
Tractors $7.50 per hour - 4,725 8,250 5,250 18,225
Cane Trailers $0.15 per tonne - 1,350 2,400 1,500 5,250
Imp. & sundries $0.25 per tonne - 2,250 4,000 2,500 8,750
- $15,825 $27,775 $17,875 $61,475
So, overall operating cost of the tractor for the year may be budgeted as shown in figure 4.4.
If the tractor is used for more than 1,000 hours then there will be an over-recovery on its operational costs and if used for less than 1,000 hours there will be under-recovery, i.e. in the first instance making an internal 'profit' and in the second a 'loss'.
Figure 4.4 Tractor costs
Unit rate Cost per annum (1,000 hours)
($) ($)
Fixed costs Depreciation 2,000.00 2,000.00
Licence and insurance 200.00 200.00
Driver 100.00 per month 1,200.00
Repairs 600.00 per annum 600.00
Variable costs Fuel and oil 2.00 per hour 2,000.00
Maintenance 3.00 per 200 hours 1,500.00
7,500.00
No. of hours used 1,000.00
Cost per hour 7.50
Master budget
The master budget for the sugar cane farm may be as shown in figure 4.5. The budget represents an overall objective for the farm for the whole year ahead, expressed in financial terms.
Table 4.5 Operating budget for sugar cane farm 19X4
1st quarter 2nd quarter 3rd quarter 4th quarter Total $
Revenue from cane 130,000 250,000 120,000 500,000
Less: Costs
Cultivation 37,261 48,268 42,368 55,416 183,313
Irrigation 7,278 15,297 18,473 11,329 52,377
Field maintenance 4,826 12,923 15,991 7,262 41,002
Harvesting - 15,825 27,775 17,875 61,475
Transportation - 14,100 24,750 15,750 54,600
49,365 106,413 129,357 107,632 392,767
Add: Opening valuation 85,800 135,165 112,240 94,260 85,800
135,165 241,578 241,597 201,892 478,567
Less: Closing valuation 135,165 112,240 94,260 90,290 90,290
Net crop cost - 129,338 147,337 111,602 388,277
Gross surplus - 66,200 102,663 8,398 111,723
Less: Overheads 5,876 7,361 7,486 5,321 26,044
Net profitless) (5,876) (6,699) 95,177 3,077 85,679
Once the operating budget has been prepared, two further budgets can be done, namely:
i. Balance sheet at the end of the year.
ii. Cash flow budget which shows the amount of cash necessary to support the operating budget. It is of great importance that the business has sufficient funds to support the planned operational budget.
Reporting back
During the year the management accountant will prepare statements, as quickly as possible after each operating period, in our example, each quarter, setting out the actual operating costs against the budgeted costs. This statement will calculate the difference between the 'budgeted' and the 'actual' cost, which is called the 'variance'.
There are many ways in which management accounts can be prepared. To continue with our example of harvesting on the sugar cane farm, management accounts at the end of the third quarter can be presented as shown in figure 4.6.
Figure 4.6 Management accounts - actual costs against budget costs Management accounts for sugar cane farm 3rd quarter 19X4

Item Harvesting 3rd quarter Year to date
Actual Budget Variance Actual Budget Variance
Labour
- Cutting 12,200 12,000 (200) 19,060 18,750 (310)
- Sundry 742 1,125 383 1,584 1,875 291
Tractors 9,375 8,250 (1,125) 13,500 12,975 (525)
Cane trailers 1,678 2,400 722 2,505 3,750 1,245
Imp & sundries 4,270 4,000 (270) 6,513 6,250 (263)
28,265 27,775 (490) 43,162 43,600 438
Here, actual harvesting costs for the 3rd quarter are $28,265 against a budget of $27,775 indicating an increase of $490 whilst the cumulative figure for the year to date shows an overall saving of $438. It appears that actual costs are less than budgeted costs, so the harvesting operations are proceeding within the budget set and satisfactory. However, a further look may reveal that this may not be the case. The budget was based on a cane tonnage cut of 16,000 tonnes in the 3rd quarter and a cumulative tonnage of 25,000. If these tonnages have been achieved then the statement will be satisfactory. If the actual production was much higher than budgeted then these costs represent a very considerable saving, even though only a marginal saving is shown by the variance. Similarly, if the actual tonnage was significantly less than budgeted, then what is indicated as a marginal saving in the variance may, in fact, be a considerable overspending.
Price and quantity variances
Just to state that there is a variance on a particular item of expenditure does not really mean a lot. Most costs are composed of two elements - the quantity used and the price per unit. A variance between the actual cost of an item and its budgeted cost may be due to one or both of these factors. Apparent similarity between budgeted and actual costs may hide significant compensating variances between price and usage.
For example, say it is budgeted to take 300 man days at $3.00 per man day - giving a total budgeted cost of $900.00. The actual cost on completion was $875.00, showing a saving of $25.00. Further investigations may reveal that the job took 250 man days at a daily rate of $3.50 - a favourable usage variance but a very unfavourable price variance. Management may therefore need to investigate some significant variances revealed by further analysis, which a comparison of the total costs would not have revealed. Price and usage variances for major items of expense are discussed below.
Labour
The difference between actual labour costs and budgeted or standard labour costs is known as direct wages variance. This variance may arise due to a difference in the amount of labour used or the price per unit of labour, i.e. the wage rate. The direct wages variance can be split into:
i) Wage rate variance: the wage rate was higher or lower than budgeted, e.g. using more unskilled labour, or working overtime at a higher rate.
ii) Labour efficiency variance: arises when the actual time spent on a particular job is higher or lower than the standard labour hours specified, e.g. breakdown of a machine.
Materials
The variance for materials cost could also be split into price and usage elements:
i) Material price variance: arises when the actual unit price is greater or lower than budgeted. Could be due to inflation, discounts, alternative suppliers etc.
ii) Material quantity variance: arises when the actual amount of material used is greater or lower than the amount specified in the budget, e.g. a budgeted fertiliser at 350 kg per hectare may be increased or decreased when the actual fertiliser is applied, giving rise to a usage variance.
Overheads
Again, overhead variance can be split into:
i) Overhead volume variance: where overheads are taken into the cost centres, a production higher or lower than budgeted will cause an over-or under-absorption of overheads.
ii) Overhead expenditure variance: where the actual overhead expenditure is higher or lower than that budgeted for the level of output actually produced.
Calculation of price and usage variances
The price and usage variance are calculated as follows:
Price variance = (budgeted price - actual price) X actual quantity
Usage variance = (budgeted quantity - actual quantity) X budgeted price
Now attempt exercise 4.2.
Exercise 4.2 Computation of labour variances
It was budgeted that it would take 200 man days at $10.00 per day to complete the task costing $2,000.00 when the actual cost was $1,875.00, being 150 man days at $12.50 per day. Calculate:
i) Price variance
ii) Usage variance
Comment briefly on the results of your calculation.
Management action and cost control
Producing information in management accounting form is expensive in terms of the time and effort involved. It will be very wasteful if the information once produced is not put into effective use.
There are five parts to an effective cost control system. These are:
a) preparation of budgets
b) communicating and agreeing budgets with all concerned
c) having an accounting system that will record all actual costs
d) preparing statements that will compare actual costs with budgets, showing any variances and disclosing the reasons for them, and
e) taking any appropriate action based on the analysis of the variances in d) above.
Action(s) that can be taken when a significant variance has been revealed will depend on the nature of the variance itself. Some variances can be identified to a specific department and it is within that department's control to take corrective action. Other variances might prove to be much more difficult, and sometimes impossible, to control.
Variances revealed are historic. They show what happened last month or last quarter and no amount of analysis and discussion can alter that. However, they can be used to influence managerial action in future periods.
Zero base budgeting (ZBB)
After a budgeting system has been in operation for some time, there is a tendency for next year's budget to be justified by reference to the actual levels being achieved at present. In fact this is part of the financial analysis discussed so far, but the proper analysis process takes into account all the changes which should affect the future activities of the company. Even using such an analytical base, some businesses find that historical comparisons, and particularly the current level of constraints on resources, can inhibit really innovative changes in budgets. This can cause a severe handicap for the business because the budget should be the first year of the long range plan. Thus, if changes are not started in the budget period, it will be difficult for the business to make the progress necessary to achieve longer term objectives.
One way of breaking out of this cyclical budgeting problem is to go back to basics and develop the budget from an assumption of no existing resources (that is, a zero base). This means all resources will have to be justified and the chosen way of achieving any specified objectives will have to be compared with the alternatives. For example, in the sales area, the current existing field sales force will be ignored, and the optimum way of achieving the sales objectives in that particular market for the particular goods or services should be developed. This might not include any field sales force, or a different-sized team, and the company then has to plan how to implement this new strategy.
The obvious problem of this zero-base budgeting process is the massive amount of managerial time needed to carry out the exercise. Hence, some companies carry out the full process every five years, but in that year the business can almost grind to a halt. Thus, an alternative way is to look in depth at one area of the business each year on a rolling basis, so that each sector does a zero base budget every five years or so.
Key terms
Budgeting
Budgetary control
Budget preparation
Management action and cost control
Master budget
Price and quantity variance
Responsibility centres
Zero based budgeting

Variance Analysis

Variance Analysis

A variance is the difference between an actual result and an expected result. The process by which the total difference between standard and actual results is analysed is known as variance analysis. When actual results are better than the expected results, we have a favourable variance (F). If, on the other hand, actual results are worse than expected results, we have an adverse (A).
I will use this example throughout this Exercise:
Standard cost of Product A $
Materials (5kgs x $10 per kg) 50
Labour (4hrs x $5 per hr) 20
Variable o/hds (4 hrs x $2 per hr) 8
Fixed o/hds (4 hrs x $6 per hr) 24
102

Budgeted results
Production: 1,200 units
Sales: 1,000 units
Selling price: $150 per unit
ACTUAL Results
Production: 1,000 units
Sales: 900 units
Materials: 4,850 kgs, $46,075
Labour: 4,200 hrs, $21,210
Variable o/hds: $9,450
Fixed o/hds: $25,000
Selling price: $140 per unit


1. Variable cost variances
Direct material variances
The direct material total variance is the difference between what the output actually cost and what it should have cost, in terms of material.
From the example above the material total variance is given by:
$
1,000 units should have cost (x $50) 50,000
But did cost 46,075
Direct material total variance 3, 925 (F)
It can be divided into two sub-variances
The direct material price variance
This is the difference between what the actual quantity of material used did cost and what it should have cost.
$
4,850 kgs should have cost (x $10) 48,500
But did cost 46,075
Direct material price variance 2,425 (F)
The direct material usage variance
This is the difference between how much material should have been used for the number of units actually produced and how much material was used, valued at standard cost
1,000 units should have used (x 5 kgs) 5,000 kgs
But did use 4,850 kgs
Variance in kgs 150 kgs (F)
Valued at standard cost per kg x $10
Direct material usage variance in $ $1,500 (F)
The direct material price variance is calculated on material purchases in the period if closing stocks of raw materials are valued at standard cost or material used if closing stocks of raw materials are valued at actual cost (FIFO).
Direct labour total variance
The direct labour total variance is the difference between what the output should have cost and what it did cost, in terms of labour.
$
1,000 units should have cost (x $20) 20,000
But did cost 21,210
Direct material price variance 1,210 (A)
Direct labour rate variance
This is the difference between what the actual number of hours worked should have cost and what it did cost.
4200hrs should have cost (4200hrs x $5) $21000
But did cost $21210
Direct labour rate variance $210(A)
The direct labour efficiency variance
The is the difference between how many hours should have been worked for the number of units actually produced and how many hours were worked, valued at the standard rate per hour.
$
1,000 units should have taken (x 4 hrs) 4,000 hrs
But did take 4,200 hrs
Variance in hrs 200 hrs
Valued at standard rate per hour x $5
Direct labour efficiency variance $1,000 (A)
When idle time occurs the efficiency variance is based on hours actually worked (not hours paid for) and an idle time variance (hours of idle time x standard rate per hour) is calculated.
2. Variable production overhead total variances
The variable production overhead total variance is the difference between what the output should have cost and what it did cost, in terms of variable production overhead.
$
1,000 units should have cost (x $8) 8,000
But did cost 9,450
Variable production o/hd expenditure variance 1,450 (A)
The variable production overhead expenditure variance
This is the difference between what the variable production overhead did cost and what it should have cost
$
4,200 hrs should have cost (x $2) 8,400
But did cost 9,450
Variable production o/hd expenditure variance 1,050 (A)
The variable production overhead efficiency variance
This is the same as the direct labour efficiency variance in hours, valued at the variable production overhead rate per hour.
Labour efficiency variance in hours 200 hrs (A)
Valued @ standard rate per hour x $2
Variable production o/hd efficiency variance $400 (A)
3. Fixed production overhead variances
The total fixed production variance is an attempt to explain the under- or over-absorbed fixed production overhead.
Remember that overhead absorption rate = Budgeted fixed production overhead
Budgeted level of activity
If either the numerator or the denominator or both are incorrect then we will have under- or over-absorbed production overhead.
• If actual expenditure ± budgeted expenditure (numerator incorrect) » expenditure variance
• If actual production / hours of activity » budgeted production / hours of activity (denominator incorrect) » volume variance.
• The workforce may have been working at a more or less efficient rate than standard to produce a given output » volume efficiency variance (similar to the variable production overhead efficiency variance).
• Regardless of the level of efficiency, the total number of hours worked could have been more or less than was originally budgeted (employees may have worked a lot of overtime or there may have been a strike and so actual hours worked were less than budgeted) » volume capacity variance.
4. The fixed production overhead variances are calculated as follows:
Fixed production overhead variance
This is the difference between fixed production overhead incurred and fixed production overhead absorbed (= the under- or over-absorbed fixed production overhead)
$
Overhead incurred 25,000
Overhead absorbed (1,000 units x $24) 24,000
Overhead variance 1,000 (A)
Fixed production overhead expenditure variance
This is the difference between the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure
$
Budgeted overhead (1,200 x $24) 28,800
Actual overhead 25,000
Expenditure variance 3,800 (F)
Fixed production overhead volume variance
This is the difference between actual and budgeted production volume multiplied by the standard absorption rate per unit.
$
Actual production at std rate (1,000 x $24) 24,000
Budgeted production at std rate (1,200 x $24) 28,800
4,800 (A)
Fixed production overhead volume efficiency variance
This is the difference between the number of hours that actual production should have taken, and the number of hours actually worked (usually the labour efficiency variance), multiplied by the standard absorption rate per hour.
Labour efficiency variance in hours 200 hrs (A)
Valued @ standard rate per hour x $6
Volume efficiency variance $1,200 (A)
Fixed production overhead volume capacity variance
This is the difference between budgeted hours of work and the actual hours worked, multiplied by the standard absorption rate per hour
Budgeted hours (1,200 x 4) 4,800 hrs
Actual hours 4,200 hrs
Variance in hrs 600 hrs (A)
x standard rate per hour x $6
$3,600 (A)
KEY.
The fixed overhead volume capacity variance is unlike the other variances in that an excess of actual hours over budgeted hours results in a favourable variance and not an adverse variance as it does when considering labour efficiency, variable overhead efficiency and fixed overhead volume efficiency. Working more hours than budgeted produces an over absorption of fixed overheads, which is a favourable variance.
Sales
variances
5. Selling price variance
The selling price variance is a measure of the effect on expected profit of a different selling price to standard selling price. It is calculated as the difference between what the sales revenue should have been for the actual quantity sold, and what it was.
$
Revenue from 900 units should have been (x $150) 135,000
But was (x $140) 126,000
Selling price variance 9,000 (A)
Sales volume variance
The sales volume variance is the difference between the actual units sold and the budgeted quantity, valued at the standard profit per unit. In other words it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted.
Budgeted sales volume 1,000 units
Actual sales volume 900 units
Variance in units 100 units (A)
x standard margin per unit (x $ (150 – 102) ) x $48
Sales volume variance $4,800 (A)
KEY.
Don’t forget to value the sales volume variance at standard contribution marginal costing is in use.
Operating Statement
Operating
statements
The most common presentation of the reconciliation between budgeted and actual profit is as follows.
$ $
Budgeted profit before sales and admin costs X
Sales variances - price X
- volume X
X
Actual sales minus standard cost of sales X

Cost variances $ $
(F) (A)
Material price X
Material usage etc __ X
X X X
Sales and administration costs X
Actual profit X
Variances in a standard marginal costing system
• No fixed overhead volume variance
• Sales volume variances are valued at standard contribution margin (not standard profit margin)
Reasons, interdependence and significance
6. Reasons for variances
Material price
• (F) – unforseen discounts received, greater care taken in purchasing, change in material standard
• (A)– price increase, careless purchasing, change in material standard.
Material usage
• (F) – material used of higher quality than standard, more effective use made of material
• (A) – defective material, excessive waste, theft, stricter quality control
Labour rate
• (F) – use of workers at rate of pay lower than standard
• (A) – wage rate increase
Idle time
• Machine breakdown, non-availability of material, illness
Labour efficiency
• (F) – output produced more quickly than expected because of work motivation, better quality of equipment or materials
• (A) – lost time in excess of standard allowed, output lower than standard set because of deliberate restriction, lack of training, sub-standard material used.
Overhead expenditure
• (F) – savings in cost incurred, more economical use of services.
• (A) – increase in cost of services used, excessive use of services, change in type of services used
Overhead volume
• (F) – production greater than budgeted
• (A) – production less than budgeted
7. Interdependence between variances
The cause of one (adverse) variance may be wholly or partly explained by the cause of another (favourable) variance.
• Material price or material usage and labour efficiency
• Labour rate and material usage
• Sales price and sales volume
8. The significance of variances
The decision as to whether or not a variance is so significant that it should be investigated should take a number of factors into account.
• The type of standard being used
• Interdependence between variances
• Controllability
• Materiality
9. Materials mix and yield variances
The materials usage variance can be subdivided into a materials mix variance and a materials yield variance if the proportion of materials in a mix is changeable and controllable.
The mix variance indicates the effect on costs of changing the mix of material inputs.
The yield variance indicates the effect on costs of material inputs yielding more or less than expected.
Standard input to produce 1 unit of product X:
$
Material A 20 kgs x $10 200
Material B 30 kgs x $5 150
350
In period 3, 13 units of product X were produced from 250 kgs of material A and 350 kgs of material B.
Solution 1: individual prices per kg as variance valuation cases
Mix Variance
Kgs
Standard mix of actual use: A: 2/5 x (250+350) 240
B: 3/5 x (250+350) 360
600
===

A B
Mix should have been 240 kgs 360 kgs
But was 250 kgs 350 kgs
Mix variance in kgs 10 kgs (A) 10 kgs (F)
x standard cost per kg x $10 x $5
Mix variance in $ $100 (A) $50 (F)
===== ===
50 (A)

Total mix variance in quantity is always zero.
Yield variance
A B
13 units of product X should have used 260 kgs 390 kgs
but actual input in standard mix was 240 kgs 360 kgs
Yield variance in kgs 20 kgs (F) 30 kgs (F)
x standard cost per kg x $10 x $5
$200 (F) $150 (F)
===== =====
$350 (F)
====

Solution 2: budgeted weighted average price per unit of input as variance valuation base.
Therefore, Budgeted weighted average price =$350/50 = $7 per kg
• Mix variance
A B
13 units of product X should have used 260 kgs 390 kgs
but did use 250 kgs 350 kgs
Usage variance in kgs 10 kgs (F) 40 kgs (F)
x individual price per kg – budgeted
weighted average price per kg
$ (10 – 7) x $3
$ (5 – 7) ____ x ($2)
$30 (F) $80 (A)
=== ===
$50 (A)
===

• Yield variance
A B
Usage variance in kgs 10 kg (F) 40 kg (F)
x budgeted weighted average
Price per kg x $7 x $7
$70 (F) $ 280 (F)
=== ====
$350 (F)
====

10. Sales mix and quantity variances
The sales volume variance can be subdivided into a mix variance if the proportions of products sold are controllable.
Sales mix variance
This variance indicates the effect on profit of changing the mix of actual sales from the standard mix.
It can be calculated in one of two ways.
• The difference between the actual total quantity sold in the standard mix and the actual quantities sold, valued at the standard margin per unit.
• The difference between actual sales and budgeted sales, valued at (standard profit per unit – budgeted weighted average profit per unit)
Sales quantity variance
This variance indicates the effect on profit of selling a different total quantity from the budgeted total quantity.
It can be calculated in one of two ways.
• The difference between actual sales volume in the standard mix and budgeted sales valued at the standard margin per unit.
• The difference between actual sales volume and budgeted sales valued at the budgeted weighted average profit per unit.
KEY.
With all variance calculations, from the most basic (such as variable cost variances) to the more complex (such as mix and yield / mix and quantity variances), it is vital that you do not simply learn formulae. You must understand what your calculations are supposed are supposed to show.
VARIANCES ANALYSIS PRACTICE QUESTIONS
Question 1
Standard Cost for Product RBT
£
Materials (10kg x £8 per kg) 80
Labour (5hrs x £6 per hr) ¬ 30
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
195
Budgeted Results
Production 10000 units
Sales 7500 units
Selling Price £300 per unit
Actual Results
Production 8000 units
Sales 6000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £500000
Selling Price £260 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 2
Standard Cost for Product TUH
£
Materials (10kg x £8 per kg) 80
Labour (5hrs x £6 per hr) ¬ 30
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
195
Budgeted Results
Production 11000 units
Sales 7500 units
Selling Price £300 per unit
Actual Results
Production 9000 units
Sales 7000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £410000
Fixed O/Hds £520000
Selling Price £260 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 3
Standard Cost for Product TD
£
Materials (10kg x £5 per kg) 50
Labour (5hrs x £6 per hr) ¬ 30
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
165
Budgeted Results
Production 8000 units
Sales 7500 units
Selling Price £300 per unit
Actual Results
Production 11000 units
Sales 10000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £500000
Selling Price £320 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 4
Standard Cost for Product WXYZ
£
Materials (4kg x £8 per kg) 32
Labour (5hrs x £10 per hr) ¬ 50
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £6 per hr) 30
152
Budgeted Results
Production 10000 units
Sales 7500 units
Selling Price £300 per unit
Actual Results
Production 8000 units
Sales 6000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £500000
Selling Price £260 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 5
Standard Cost for Product RTY
£
Materials (10kg x £8 per kg) 80
Labour (5hrs x £6 per hr) ¬ 30
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
195
Budgeted Results
Production 13000 units
Sales 10000 units
Selling Price £300 per unit
Actual Results
Production 12000 units
Sales 9000 units
Materials 90000 kg Cost £750000
Labour 40000 hrs Cost £350000
Variable O/Hds £500000
Fixed O/Hds £600000
Selling Price £350 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 6
Standard Cost for Product RED
£
Materials (10kg x £7 per kg) 70
Labour (5hrs x £6 per hr) ¬ 30
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
185
Budgeted Results
Production 10500 units
Sales 7800 units
Selling Price £310 per unit
Actual Results
Production 8500 units
Sales 6200 units
Materials 87000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £550000
Selling Price £270 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 7
Standard Cost for Product BUZZ
£
Materials (3kg x £8 per kg) 24
Labour (5hrs x £10 per hr) ¬ 50
Variable O/Hds (5hrs x £9 per hr) 45
Fixed O/Hds (5hrs x £10 per hr) 50
169
Budgeted Results
Production 10000 units
Sales 7500 units
Selling Price £300 per unit
Actual Results
Production 8000 units
Sales 6000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £500000
Selling Price £260 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 8
Standard Cost for Product RST
£
Materials (10kg x £20per kg) 200
Labour (5hrs x £16 per hr) ¬ 80
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
365
Budgeted Results
Production 1000 units
Sales 7500 units
Selling Price £800 per unit
Actual Results
Production 8000 units
Sales 6000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £500000
Selling Price £260 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 9
Standard Cost for Product FGT
£
Materials (10kg x £8 per kg) 80
Labour (5hrs x £6 per hr) ¬ 30
Variable O/Hds (5hrs x £8 per hr) 40
Fixed O/Hds (5hrs x £9 per hr) 45
195
Budgeted Results
Production 10000 units
Sales 7500 units
Selling Price £300 per unit
Actual Results
Production 13000 units
Sales 6000 units
Materials 85000 kg Cost £700000
Labour 36000 hrs Cost £330900
Variable O/Hds £400000
Fixed O/Hds £500000
Selling Price £260 per unit
Calculate
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance
Question 10
Standard Cost for Product White Diamond
£
Materials (7kg x £9 per kg) 63
Labour (6hrs x £9 per hr) ¬ 54
Variable O/Hds (6hrs x £6 per hr) 36
Fixed O/Hds (6hrs x £7 per hr) 42
195
Budgeted Results
Production 12500 units
Sales 8500 units
Selling Price £500 per unit
Actual Results
Production 15000 units
Sales 8000 units
Materials 8750 kg Cost £85000
Labour 5200hrs Cost £52900
Variable O/Hds £25500
Fixed O/Hds £84000
Selling Price £600 per unit
a. Material total variance
b. Material price variance
c. Material usage variance
d. Labour total variance
e. Labour rate variance
f. Labour efficiency variance
g. Variable overhead total variance and all sub- variances
h. Fixed Production overhead total Variance and all sub-variances
i. Selling price variance
j. Sales volume variance

Standing Cost

Standard Cost


Learning Objectives
• To understand the meaning of standard costing, its meaning and definition
• To learn its advantages and limitations
• To learn how to set of standards and determinations
• To learn how to revise standards
Introduction
You know that management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control. It can also be applied to your own daily/monthly expenses, if necessary. These measures should be applied correctly so that performance takes place according to plans. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs. Standard costing is a technique which helps you to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.
Meaning of Standard
When you want to measure some thing, you must take some parameter or yardstick for measuring. We can call this as standard. What are your daily expenses? An average of $50! If you have been spending this much for so many days, then this is your daily standard expense.
The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances.
In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.”
Definition
The CIMA, London has defined standard cost as “a predetermined cost which is calculated from managements standards of efficient operations and the relevant necessary expenditure.” They are the predetermined costs on technical estimate of material labor and overhead for a selected period of time and for a prescribed set of working conditions. In other words, a standard cost is a planned cost for a unit of product or service rendered.
The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures.
Advantages
Standard costing is a management control technique for every activity. It is not only useful for cost control purposes but is also helpful in production planning and policy formulation. It allows management by exception. In the light of various objectives of this system, some of the advantages of this tool are given below:
1. Efficiency measurement-- The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centers. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency. It is not proper to compare costs of different period because circumstance of both the periods may be different. Still, a decision about base period can be made with which actual performance can be compared.
2. Finding of variance-- The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance. It is possible to take corrective measures at the earliest. A regular check on various expenditures is also ensured by standard cost system.
3. Management by exception-- The targets of different individuals are fixed if the performance is according to predetermined standards. In this case, there is nothing to worry. The attention of the management is drawn only when actual performance is less than the budgeted performance. Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and every body tries to achieve his/her targets.
4. Cost control-- Every costing system aims at cost control and cost reduction. The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken. The action taken in spotting weak points enables cost control system.
5. Right decisions-- It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc.
6. Eliminating inefficiencies-- The setting of standards for different elements of cost requires a detailed study of different aspects. The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps.
Limitations of Standard Costing
1. It cannot be used in those organizations where non-standard products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.
2. The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.
3. There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable.
4. The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.
For instance, if the industry changed the technology then the system will not be suitable. In that case, we will have to change or revise the standards. A frequent revision of standards will become costly.
Setting Standards
Normally, setting up standards is based on the past experience. The total standard cost includes direct materials, direct labor and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control.
Various Elements which Influence the Setting of Standards
Setting Standards for Direct Materials
There are several basic principles which ought to be appreciated in setting standards for direct materials. Generally, when you want to purchase some material what are the factors you consider. If material is used for a product, it is known as direct material. On the other hand, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore, it involves two things:
• Quality of material
• Price of the material
When you want to purchase material, the quality and size should be determined. The standard quality to be maintained should be decided. The quantity is determined by the production department. This department makes use of historical records, and an allowance for changing conditions will also be given for setting standards. A number of test runs may be undertaken on different days and under different situations, and an average of these results should be used for setting material quantity standards.
The second step in determining direct material cost will be a decision about the standard price. Material’s cost will be decided in consultation with the purchase department. The cost of purchasing and store keeping of materials should also be taken into consideration. The procedure for purchase of materials, minimum and maximum levels for various materials, discount policy and means of transport are the other factors which have bearing on the materials cost price. It includes the following:
• Cost of materials
• Ordering cost
• Carrying cost
The purpose should be to increase efficiency in procuring and store keeping of materials. The type of standard used-- ideal standard or expected standard-- also affects the choice of standard price.
Setting Direct Labor Cost
If you want to engage a labor force for manufacturing a product or a service for which you need to pay some amount, this is called wages. If the labor is engaged directly to produce the product, this is known as direct labor. The second largest amount of cost is of labor. The benefit derived from the workers can be assigned to a particular product or a process. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages. The time required for producing a product would be ascertained and labor should be properly graded. Different grades of workers will be paid different rates of wages. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labor cost. The setting of standard for direct labor will be done basically on the following:
• Standard labor time for producing
• Labor rate per hour
Standard labor time indicates the time taken by different categories of labor force which are as under:
• Skilled labor
• Semi-skilled labor
• Unskilled labor
For setting a standard time for labor force, we normally take in to account previous experience, past performance records, test run result, work-study etc. The labor rate standard refers to the expected wage rates to be paid for different categories of workers. Past wage rates and demand and supply principle may not be a safe guide for determining standard labor rates. The anticipation of expected changes in labor rates will be an essential factor. In case there is an agreement with workers for payment of wages in the coming period, these rates should be used. If a premium or bonus scheme is in operation, then anticipated extra payments should also be included. Where a piece rate system is used, standard cost will be fixed per piece. The object of fixed standard labor time and labor rate is to device maximum efficiency in the use of labor.
Setting Standards of Overheads
The next important element comes under overheads. The very purpose of setting standard for overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced. The determination of overhead rate involves three things:
• Determination of overheads
• Determination of labor hours or units manufactured
• Calculating overheads rate by dividing A by B
The overheads are classified into fixed overheads, variable overheads and semi-variable overheads. The fixed overheads remain the same irrespective of level of production, while variable overheads change in the proportion of production. The expenses increase or decrease with the increase or decrease in output. Semi-variable overheads are neither fixed nor variable. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. The division of overheads into fixed, variable and semi-variable categories will help in determining overheads.
Determination of Standard Costs
How should the ideal standards for better controlling be determined?
1. Determination of Cost Center
According to J. Betty, “A cost center is a department or part of a department or an item of equipment or machinery or a person or a group of persons in respect of which costs are accumulated, and one where control can be exercised.” Cost centers are necessary for determining the costs. If the whole factory is engaged in manufacturing a product, the factory will be a cost center. In fact, a cost center describes the product while cost is accumulated. Cost centers enable the determination of costs and fixation of responsibility. A cost center relating to a person is called personnel cost center, and a cost center relating to products and equipments is called impersonal cost center.
2. Current Standards
A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year. It is presumed that conditions of production will remain unchanged. In case there is any change in price or manufacturing condition, the standards are also revised. Current standard may be ideal standard and expected standard.
3. Ideal Standard
This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption that favorable conditions will prevail and management will be at its best. The price paid for materials will be lowest and wastes etc. will be minimum possible. The labor time for making the production will be minimum and rates of wages will also be low. The overheads expenses are also set with maximum efficiency in mind. All the conditions, both internal and external, should be favorable and only then ideal standard will be achieved.
Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not practicable and may not be achieved. Though this standard may not be achieved, even then an effort is made. The deviation between targets and actual performance is ignorable. In practice, ideal standard has an adverse effect on the employees. They do not try to reach the standard because the standards are not considered realistic.
4. Basic Standards
A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period. Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions. It is indeed just like a number against which subsequent process changes can be measured. Basic standard enables the measurement of changes in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an increase of 25% in the cost of materials. The changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose because the standard is not revised for a long time. The deviation between standard cost and actual cost cannot be used as a yardstick for measuring efficiency.
5. Normal Standards
As per terminology, normal standard has been defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle. This standard is based on the conditions which will cover a future period of five years, concerning one trade cycle. If a normal cycle of ups and downs in sales and production is 10 years, then standard will be set on average sales and production which will cover all the years. The standard attempts to cover variance in the production from one time to another time. An average is taken from the periods of recession and depression. The normal standard concept is theoretical and cannot be used for cost control purpose. Normal standard can be properly applied for absorption of overhead cost over a long period of time.
6. Organization for Standard Costing
The success of standard costing system will depend upon the setting up of proper standards. For the purpose of setting standards, a person or a committee should be given this job. In a big concern, a standard costing committee is formed for this purpose. The committee includes production manager, purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost accountant acts as a co-coordinator of this committee.
7. Accounting System
Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue item. Codes can be used to have a speedy collection of accounts. A standard is a pre-determined measure of material, labor and overheads. It may be expressed in quality and its monetary measurements in standard costs.
Revision of Standards
For effective use of this technique, sometimes we need to revise the standards which follow for better control. Even standards are also subjected to change like the production method, environment, raw material, and technology.
Standards may need to be changed to accommodate changes in the organization or its environment. When there is a sudden change in economic circumstances, technology or production methods, the standard cost will no longer be accurate. Standards that are out of date will not act as effective feed forward or feedback control tools. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department. If standards are continually not being achieved and large deviations or variances from the standard are reported, they should be carefully reviewed. Also, changes in the physical productive capacity of the organization or in material prices and wage rates may indicate that standards need to be revised. In practice, changing standards frequently is an expensive operation and can cause confusion. For this reason, standard cost revisions are usually made only once a year. At times of rapid price inflation, many managers have felt that the high level of inflation forced them to change price and wage rate standards continually. This, however, leads to reduction in value of the standard as a yardstick. At the other extreme is the adoption of basic standard which will remain unchanged for many years. They provide a constant base for comparison, but this is hardly satisfactory when there is technological change in working procedures and conditions.
Summary
Basically, standard costing is a management tool for control. In the process, we have taken standards as parameters for measuring the performance. Cost analysis and cost control is essential for any activity. Cost includes material labor and overheads. Sometimes, we need to revise the standards due to change in uses, raw material, technology, method of production etc. For a proper organization, it is required to implement this under a committee for the activity. It is a continued activity for the optimum utilization of resources.

PDCA Cycle - Example

Personal Improvement
The PDCA cycle is a valuable process that can be applied to practically anything. In this session, we discuss case related medical student performance, but the PDCA cycle can be used in everything from making a meal to walking your dog. An immediate concern of yours may be improving your study skills.

Example 1: The Student with Poor Grades

Lakshmi is a first-year medical student who has just taken her first set of examinations and is very unhappy with the results.
• What is she trying to accomplish? Lakshmi knows that she needs to improve her studying skills in order to gain a better understanding of the material.

• How will she know that a change is an improvement? Lakshmi considers the most important measure of her study skills to be her exam grades. However, she does not want to risk another exam period just to find out that her skills are still not good. She decides that a better way to measure improvement is by taking old exams.

• What changes can she make that will result in improvement? Lakshmi thinks that she has spent too little time studying. She feels that the best way to improve her study skills is by putting in more hours.
Cycle 1

Plan: Lakshmi decides to add an additional thirty hours per week to her already busy schedule. She resolves that she must socialize less, get up earlier, and stay up later. At the end of the week she will take an old exam to see how she is progressing.

Do: By the end of the week, Lakshmi finds that she was able to add only fifteen hours of studying. When she takes the exam she is dismayed to find that she does no better.

Check: The fifteen extra hours of studying has made Lakshmi feel fatigued. In addition, she finds that her ability to concentrate during those hours is rather limited. She has not exercised all week and has not seen any of her friends. This forced isolation is discouraging her.

Act: Lakshmi knows that there must be another way. She needs to design a better, more efficient way to study that will allow her time to exercise and socialize.
Cycle 2
Plan: Lakshmi contacts all her medical school friends who she knows are doing well yet still have time for outside lives. Many of these friends have similar advice that Lakshmi thinks she can use. Based on her findings, she decides to always attend lectures, to rewrite her class notes in a format she can understand and based on what the professor has emphasized, and to use the assigned text only as a reference.
Do: Lakshmi returns to her original schedule of studying. However, instead of spending a majority of her time poring over the text, she rewrites and studies her notes. She goes to the text only when she does not understand her notes. When Lakshmi takes one of the old exams, she finds that she has done better, but she still sees room for improvement.
Check: Lakshmi now realizes that she had been spending too much time reading unimportant information in the required text. She knows that her new approach works much better, yet she still feels that she needs more studying time. She is unsure what to do, because she doesn't want to take away from her social and physically active life.
Act: Lakshmi decides to continue with her new studying approach while attempting to find time in her busy day to study more.
Cycle 3
Plan: In her search for more time to study, Lakshmi realizes that there are many places that she can combine exercising and socializing with studying. First, she decides to study her rewritten notes while she is exercising on the Stairmaster. Next, she intends to spend part of her socializing time studying with her friends.

Do: Lakshmi's friends are excited about studying together, and their sessions turn into a fun and helpful use of everyone's time. Lakshmi has found that she enjoys studying while she exercises. In fact, she discovers that she remains on the Stairmaster longer when she's reading over her notes. When Lakshmi takes her exams this week, she is happy to find that her grades are significantly higher.

Check: Lakshmi now knows that studying does not mean being locked up in her room reading hundreds of pages of text. She realizes that she can gain a lot by studying in different environments while focusing on the most important points.

Act: Lakshmi chooses to continue with the changes she has made in her studying habits. What Lakshmi initially thought would be an improvement turned out to only discourage her further. Many people who are in Lakshmi's place do not take the time to study their changes and continue them even though they lead down a disheartening path. By using the PDCA cycle, Lakshmi was able to see that her initial change did not work and that she had to find one that would better suit her. With perseverance and the willingness to learn, Lakshmi was able to turn a negative outcome into a positive improvement experience.

INDIAN CONTRACT ACT 1872

INDIAN CONTRACT ACT 1872

INTRODUCTION
• The Law of Contract deals with the law relating to the general principles of contract. It is the most important part of Mercantile Law. It affects every person in one way or the other, as all of us enter into some kind of contract everyday.
• Since this law was not happily worded, two subsequent legislations namely Indian Sale of Goods Act – Sections 76 to 123 of the Indian Contract Act 1872 were repealed; and Partnership Act was also enacted and Sections 239 to 266 of the Contract Act were also repealed.
What is ‘Contract‘
• The term ‘Contract‘ is defined in Section 2(h) of the Indian Contract Act, which reads as under
“An agreement enforceable by law is a contracts.”
• The analysis of this definition shows that a contract must have the following two elements:
1. An agreement, and
2. The agreement must be enforceable by law.
• In other words:
Contract = An Agreement + Enforceability (by law)
Agreement (Section 2(e)
Every promise and every set of promises forming the consideration for each other is an agreement.
Promise (Section 2(b))
A proposal when accepted becomes a promise.
• Every agreement is not a contract. When an agreement creates some legal obligations and is enforceable by law, it is regarded as a contract.
2.1 ESSENTIAL ELEMENTS OF CONTRACT
1. Agreement
2. Intention to create legal relationship
3. Free and genuine consent.
4. Parties competent to contract.
5. Lawful consideration.
6. Lawful object.
7. Must be in writing. (Generally, oral contract is not enforceable)
8. Agreement not declared void or illegal.
9. Certainty of meaning.
10. Possibility of performance.
11. Necessary legal formalities.
Ex –
Where ‘A’ who owns 2 cars x and y wishes to sell car ‘x’ for Rs. 30,000. ‘B’, an acquaintance of ‘A’ does not know that’ A’ owns car ‘x’ also. He thinks that’ A’ owns only car ‘y’ and is offering to sell the same for the stated price. He gives his acceptance to buy the same. There is no contract because the contracting parties have not agreed on the same thing at the same time, ‘A’ offering to sell his car ‘x’ and ‘B’ agreeing to buy car or’. There is no consensus-ad-idem.
LAW OF CONTRACT CREATES jus in personam
• The term jus in personam means a “right against or in respect of a specific person.” Thus, law of contract creates jus in personam and not jus in rem. A jus in rem means a right against or a thing.
CLASSIFICATION OF CONTRACTS
1. Classification according to validity or enforceability.
a) Valid
b) Voidable
c) Void contracts or agreements
d) Illegal.
e) Unenforce¬able
2. Classification according to Mode of formation
(i) Express contract
(ii) Implied contract
2. Classification according to Performance
(i) Executed contract
(ii) Executory contract.
(iii) Unilateral Contract
(iv) Bilateral Contract
2.2 OFFER AND ACCEPTANCE
[Sections 3-9]
OFFER
What is ‘Offer/Proposal‘
• A Proposal is defined as “when one person signifies to another his willingness to do or to abstain from doing anything, with a view to obtaining the assent of that other to such act or abstinence, he is said to make a proposal.” [Section 2(a)].
How an Offer is made?
• An offer can be made by
(a) any act or
(b) omission of the party proposing by which he intends to com¬municate such proposal or which has the effect of communicating it to the other (Section 3).
CASE EXAMPLE
In Carbolic Smoke Ball Co. ‘s case, the patent-medicine company advertised that it would give a reward of £100 to anyone who contracted influenza after using the smoke balls of the company for a certain period according to the printed directions. Mrs. Carlill purchased the advertised smoke ball and contracted influenza in spite of using the smoke ball according to the printed instructions. She claimed the reward of £100. The claim was resisted by the company on the ground that offer was not made to her and that in any case she had not com¬municated her acceptance of the offer. She filed a suit for the recovery of the reward. Held: She could recover the reward as she had accepted the offer by complying with the terms of the offer.)
ESSENTIAL REQUIREMENTS OF A VALID OFFER
• An offer must have certain essentials in order to constitute it a valid offer. These are:
I. The offer must be made with a view to obtain acceptance.
2. The offer must be made with the intention of creating legal relations. [Balfour v. Balfour (1919) 2 K.B.57Il
2. The terms of offer must be definite, unambiguous and certain or capable of being made certain. The terms of the offer must not be loose, vague or ambiguous.
4. An offer must be distinguished from (a) a mere declaration of intention or (b) an invitation to offer or to treat.
An auctioneer, at the time of auction, invites offers from the would-be-bidders. He is not making a proposal.
A display of goods with a price on them in a shop window is construed an invitation to offer and not an offer to sell.
Offer vis-a-vis Invitation to offer
 An offer must be distinguished from invitation to offer.
 A prospectus issued by a company for subscription of its shares by the members of the public, is an invitation to offer. The Letter of Offer issued by a company to its existing shareholders is an offer.
5. The offer must be communicated to the offeree. An offer must be communicated to the offeree before it can be accepted. This is true of specific as sell as general offer.
6. The offer must not contain a term the non-compliance of which may be assumed to amount to acceptance.
Cross Offers
• Where two parties make identical offers to each other, in ignorance of each other’s offer, the offers are known as cross-offers and neither of the two can be called an acceptance of the other and, therefore, there is no contract.
TERMINATION OR LAPSE OF AN OFFER
• An offer is made with a view to obtain assent thereto. As soon as the offer is accepted it becomes a con¬tract. But before it is accepted, it may lapse, or may be revoked. Also, the offeree may reject the offer. In these cases, the offer will come to an end.
1) The offer lapses after stipulated or reasonable time
2) An offer lapses by the death or insanity of the offeror or the offeree before acceptance.
3) An offer terminates when rejected by the offeree.
4) An offer terminates when revoked by the offeror before acceptance.
5) An offer terminates by not being accepted in the mode prescribed, or if no mode is prescribed, in some usual and reasonable manner.
A conditional offer terminates when the condition is not accepted by the offeree.
(7) Counter Offer
TERMINATION OF AN OFFER
1. An offer lapses after stipulated or reasonable time.
2. An offer lapses by the death or insanity of the offeror or the offeree before acceptance. 2. An offer lapses on rejection.
4. An offer terminates when revoked.
5. It terminates by counter-offer.
6. It terminates by not being accepted in the mode prescribed or in usual and reasonable manner.
7. A conditional offer terminates when condition is not accepted.
ACCEPTANCE
• Acceptance has been defined as “When the person to whom the proposal is made signifies his assent thereto, the proposal is said to be accepted”.
Acceptance how made
• The offeree is deemed to have given his acceptance when he gives his assent to the proposal. The assent may be express or implied. It is express when the acceptance has been signified either in writing, or by word of mouth, or by performance of some required act.
Ex- A enters into a bus for going to his destination and takes a seat. From the very nature, of the circumstance, the law will imply acceptance on the part of A.]
• In the case of a general offer, it can be accepted by anyone by complying with the terms of the offer.
ESSENTIALS OF A VALID ACCEPTANCE
1) Acceptance must be absolute and unqualified.
2) Acceptance must be communicated to the offeror.
3) Acceptance must be according to the mode prescribed.
Ex- A sends an offer to B through post in the usual course. B should make the acceptance in the “usual and reasonable manner” as no mode of acceptance is prescribed. He may ac¬cept the offer by sending a letter, through post, in the ordinary course, within a reasonable time.
COMMUNICATION OF OFFER, ACCEPTANCE AND REVOCATION
• As mentioned earlier that in order to be a valid offer and acceptance.
(i) the offer must be communicated to the offeree, and
(ii) the acceptance must be communicated to the offeror.
The communication of acceptance is complete:
(i) as against the proposer, when it is put into a course of transmission to him, so as to be out of the power of the acceptor;
(ii) as against the acceptor, when it comes to the knowledge of the proposer.
Ex-
A proposes, by letter, to sell a house to B at a certain price. B accepts A’s proposal by a letter sent by post. The communication of acceptance is complete: (i) as against A, when the letter is posted by B; (ii) as against B, when the letter is received by A.
The communication of a revocation (of an offer or an acceptance) is complete:
(1) as against the person who makes it, when it is put into a course of transmission to the person to whom it is made, so as to be out of the power of the person who makes it.
(2) as against the person to whom it is made when it comes to his knowledge.
Ex-
A revokes his proposal by telegram. The revocation is complete as against A, when the tele¬gram is dispatched. It is complete as against B, when B receives it.
Revocation of proposal and acceptance:
• A proposal may be revoked at any time before the communication of its acceptance is complete as against the proposer, but not afterwards.
Ex-
A proposes, by a letter sent by post, to sell his house to B. B accepts the proposal by a letter sent by post. A may revoke his proposal at any time before or at the moment when B posts his letter of ac¬ceptance, but not afterwards. B may revoke his acceptance at any time before or at the moment when the letter communi¬cating it reaches A, but not afterwards.

2.3 CAPACITY TO CONTRACT
(Sections 10-12)
WHO ARE NOT COMPETENT TO CONTRACT
• The following are considered as incompetent to contract, in the eye of law: -
(1) Minor: -
(i) A contract with or by a minor is void and a minor, therefore, cannot, bind himself by a contract.
(ii) A minor’s agreement cannot be ratified by the minor on his attaining majority.
(iii) If a minor has received any benefit under a void contract, he cannot be asked to refund the same.
(iv) A minor cannot be a partner in a partnership firm.
(v) A minor’s estate is liable to a person who supplies necessaries of life to a minor.
CASE EXAMPLE
In 1903 the Privy Council in the leading case of Mohiri Bibi v. Dharmodas Ghose (190,30 Ca. 539) held that in India minor’s contracts are absolutely void and not merely voidable.
The facts of the case were:
Dharmodas Ghose, a minor, entered into a contract for borrowing a sum of Rs. 20,000 out of which the lender paid the minor a sum of Rs. 8,000. The minor executed mortgage of property in favour of the lender. Subsequently, the minor sued for setting aside the mortgage. The Privy Council had to ascertain the validity of the mortgage. Under Section 7 of the Transfer of Property Act, every person competent to contract is competent to mortgage. The Privy Coun¬cil decided that Sections 10 and 11 of the Indian Contract Act make the minor’s contract void. The mortgagee prayed for refund of Rs. 8,000 by the minor. The Privy Council further held that as a minor’s contract is void, any money advanced to a minor cannot be recovered.
(2) Mental Incompetence
 A person is said to be of unsound mind for the purpose of making a contract, if at the time when he makes it, he is incapable of understanding it, and of forming a rational judgement as to its effect upon his interests.
 A person, who is usually of unsound mind, but occasionally of sound mind, may make a contract when he is of sound mind.
Ex- A patient, in a lunatic asylum, who is at intervals, of sound mind; may contract during those intervals.
A sane man, who is delirious from fever or who is so drunk that he cannot understand the terms of a contract or form a rational judgement as to its effect on his interest, cannot contract whilst such delirium or drunkenness lasts.
(3) Incompetence through Status
(i) Alien Enemy (Political Status)
(ii) Foreign Sovereigns and Ambassadors
(iii) Company under the Companies Act or Statutory Corporation by passing Special Act of Parliament (Corporate status)
(iv) Insolvent Persons
2.4 FREE CONSENT
(Sections 10; 13-22)
What is the meaning of ‘CONSENT‘ (SECTION 13)
• When two or more persons agree upon the same thing in the same sense, they are said to consent.

Ex-
A agrees to sell his Fiat Car 1983 model for Rs. 80,000. B agrees to buy the same. There is a valid contract since A and B have consented to the same subject matter.
What is meant by ‘Free Consent‘
• Consent is said to be free when it is not caused by¬
Causes affecting contract Consequences
1. Coercion
2. Undue influence
2. Fraud
4. Misrepresentation
5. Mistake –
(i) of fact
(a) Bilateral
(b) Unilateral
(ii) of Fact Contract voidable
Contract voidable
Contract voidable
Contract voidable


Void
Generally not invalid
Void
Ex -
(i) A railway company refuses to deliver certain goods to the consignee, except upon the pay¬ment of an illegal charge for carriage. The consignee pays the sum charged in order to obtain the goods. He is entitled to recover so much of the charge as was illegally excessive.
(ii) The directors of a Tramway Co. issued a prospectus stating that they had the right to run tramcars with steam power instead of with horses as before. In fact, the Act incorporating the company provided that such power might be used with the sanction of the Board of Trade. But, the Board of Trade refused to give permission and the company had to be wound up. P, a shareholder sued the directors for dam¬ages for fraud. The House of Lords held that the directors were not liable in fraud because they honestly believed what they said in the prospectus to be true. [Derry v. Peek (1889) 14 A.C. 337].
2.5 CONSIDERATION
[Sections 2(d), 10,23-25, 148, 185]
Definition
• Consideration is what a promisor demands as the price for his promise. In simple words, it means ‘something in return.’
• Consideration has been defined as
“When at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or promises to abstain from doing some¬thing, such act or abstinence or promise is called a consideration for the promise.”
IMPORTANCE OF CONSIDERATION
• A promise without consideration is purely gratuitous and, however sacred and binding in honour it may be, cannot create a legal obligation.
• A person who makes a prom¬ise to do or abstain from doing something usually does so as a return or equivalent of some loss, damage, or inconvenience that may have been occasioned to the other party in respect of the promise. The benefit so received and the loss, damage or inconvenience so caused is regarded in law as the consideration for the promise.
KINDS OF CONSIDERATION
• A consideration may be:
1. Executed or Present
2. Executory or Future
2. Past
2.6 LEGALITY OF OBJECT
(Sections 23, 24)
• An agreement will not be enforceable if its object or the consideration is unlawful. According to Section 23 of the Act, the consideration and the object of an agreement are unlawful in the following cases:
What consideration and objects are unlawful – agreement VOID
1. If it is forbidden by law
2. If it is of such a nature that if permitted, it would defeat the provisions of any law.
2. If it is fraudulent. An agreement with a view to defraud other is void.
4. If it involves or implies injury to the person or property of another. If the object of an agree¬ment is to injure the person or property of another it is void.
5. If the Court regards it as immoral or opposed to public policy. An agreement, whose object or consideration is immoral or is opposed to the public policy, is void.
Ex-
A partnership entered into for the purpose of doing business in arrack (local alcoholic drink) on a licence granted only to one of the partners, is void ab-initio whether the partnership was entered into before the licence was granted or afterwards as it involved a transfer of licence, which is forbidden and penalised by the Akbari Act and the rules thereunder [Velu Payaychi v. Siva Sooriam, AIR (1950) Mad. 987].
2.7 VOID and VOIDABLE Agreements
(Sections 26-30)
Void agreement
1. The following are the additional grounds declaring agreements as void: -
(i) Agreements by person who are not competent to contract.
(ii) Agreements under a mutual mistake of fact material to the agreement.
(iii) Agreement with unlawful consideration.
(iv) Agreement without consideration. (Exception – if such an agreement is in writing and registered or for a past consideration)
(v) Agreement in restraint of marriage.
(vi) Agreement in restraint of trade
(vii) Agreements in restrain of legal proceedings,
(viii) Agreements void for uncertainty (Agreements, the meaning of which is not certain, or capable of being made certain)
(ix) Agreements by way of wager (a promise to give money or money’s worth upon the determination or ascertainment of an uncertain event)
(x) Agreements against Public Policy
(xi) Agreements to do impossible act.
Voidable agreements
• An agreement, which has been entered into by misrepresentation, fraud, coercion is voidable, at the option of the aggrieved party.
2.8 CONTINGENT CONTRACTS
(SECTIONS 31-36)
• A contingent contract is a contract to do or not to do something, if some event, collateral to such con¬tract does or does not happen.
When a contingent contract may be enforced
• Contingent contracts may be enforced when that uncertain future event has happened. If the event becomes impossible, such contracts become void.
ESSENTIAL ELEMENTS OF A CONTINGENT CONTACT
1. There must be a valid contract.
2. The performance of the contract must be conditional.
3. The even must be uncertain.
4. The event must be collateral to the contact.
5. The event must be an act of the party.
6. The event should not be the discretion of the promisor.
2.9 QUASI CONTRACTS
[SECTIONS 68- 72]
• The term ‘quasi contract‘ may be defined as a ‘ contract which resembles that created by a contract.‘ as a matter of fact, ‘quasi contract‘ is not a contract in the strict sense of the term, because there is no real contract in existence. Moreover, there is no intention of the parties to enter into a contract. It is an obligation, which the law creates in the absence of any agreement.
CIRCUMSTANCES OF QUASI CONTRACTS
• Following are to be deemed Quasi-contracts.
(i) Claim for Necessaries Supplied to a person incapable of Contracting or on his account.
(ii) Reimbursement of person paying money due by another in payment of which he is inter¬ested. Obligation of a person enjoying benefits of non-gratuitous act.
(iii) Responsibility of Finder of Goods
(iv) Liability of person to whom money is paid, or thing delivered by mistake or under coercion
Ex-
A, who supplies the wife and children of B, a lunatic, with necessaries suitable to their con¬ditions in life, is entitled to be reimbursed from B’s property.
2.10 PERFORMANCE OF CONTRACTS
[SECTIONS 37-67]
Offer to perform or tender of performance
• According to Section 38, if a valid offer/tender is made and is not accepted by the promisee, the promisor shall not be responsible for non-performance nor shall he lose his rights under the contract. A tender or offer of performance to be valid must satisfy the following conditions:
1. It must be unconditional.
2. It must be made at proper time and place, and performed in the agreed manner.
WHO MUST PERFORM
• Promisor - The promise may be performed by promisor himself, or his agent or by his legal representative.
• Agent - the promisor may employ a competent person to perform it.
• Legal Representative - In case of death of the promisor, the Legal representative must perform the promise unless a contrary intention appears from the contract.

CONTRACTS, WHICH NEED NOT BE PERFORMED
I. If the parties mutually agree to substitute the original contract by a new one or to rescind or alter it
2. If the promisee dispenses with or remits, wholly or in part the performance of the promise made to him or extends the time for such performance or accepts any satisfaction for it.
2. If the person, at whose option the contract is voidable, rescinds it.
4. If the promisee neglects or refuses to afford the promisor reasonable facilities for the performance of his promise.
2.11 DISCHARGE OF CONTRACTS
[Sections 73-75]
• The cases in which a contract is discharged may be classified as follows:
A. By performance or tender
B. By mutual consent
 A contract may terminate by mutual consent in any of the following ways: -
a. Novation (substitution)
b. Recession (cancellation)
c. Alteration
C. By subsequent impossibility
D. By operation of law
E. By breach
2.12 REMEDIES FOR BREACH OF CONTRACT
(SECTIONS 73-75)
• As soon as either party commits a breach of the contract, the other party becomes entitled to any of the following reliefs: -
a) Recession of the contract
b) Damages (monetary compensation)
c) Specific performance
d) Injunction
e) Quantum meruit
Ex –
A, a singer contracts with B, the manager of a theatre, to sing at his theatre for two nights in every week during the next two months, and B engages to pay her Rs. 100 for each night’s performance. On the sixth night, A wilfully absents herself from the theatre and B in consequence, rescinds the contract. B is entitled to claim compensation for the damages for which he has sustained through the non-fulfilment of the contract.
2.13 CONTRACTS OF INDEMNITY
[SECTIONS 124-125]
What is contract of indemnity
• A contract of indemnity is a contract whereby one party promises to save the other from loss caused to him by the conduct of the promisor himself or by the conduct of any other party.
• A contract of indemnity may arise either (1) by an express promise or (2) by operation of law i.e. the duty of a principal to indemnify an agent from consequences of all lawful acts done by him as an agent.
RIGHTS OF INDEMNIFIED (THE INDEMNITY HOLDER)
• The indemnity holder is entitled to recover from the promisor
a) All the damages which may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies
b) All costs of suit which he may have to pay to such third party provided in bringing or defending the suit (i) he acted under the authority of the indemnifier or (ii) he did not act in contravention of the orders of the indemnifier and in such a such as a prudent man would act in his own case.
c) All sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the indemnifier, and was one which it would have been prudent for the promisee to make.
RIGHTS OF INDEMNIFIER
• The Contract Act makes no mention of the rights of the indemnifier. It has been held in Jaswant Singh Vs. Section of State 14 Bom 299 that the indemnifier becomes entitled to the benefit of all the securities, which the creditor has against the principal debtor whether he was aware of them, or not.
2.14 CONTRACT OF GUARANTEE
[SECTION 126]
What is Contract of Guarantee
• A contract of guarantee is defined as a contract to perform the promise or discharge the liability or a third person in case of his default.
• The person who gives the guarantee is called the “Surety”, the person from whom the guarantee is given is called the “Principal Debtor” and the person to whom the guarantee I given is called the “Creditor”.
Requirement of two contracts
• It must be noted that in a contract of guarantee there must, in effect be two contracts, a principal contract - the principal debtor and the creditor ; and
(i) a secondary contract - the creditor and the surety.
Ex –
When A requests B to lend Rs. 10,000 to C and guarantees that C will repay the amount within the agreed time and that on C failing to do so, he will himself pay to B, there is a contract of guarantee.
Essential and legal rules for a valid contract of guarantee
(i) The contract of guarantee must satisfy the requirements of a valid contract
(ii) There must be someone primarily liable
(iii) The promise to pay must be conditional
Kinds of guarantee
(i) Specific Guarantee
(ii) Continuing Guarantee
RIGHTS AND OBLIGATIONS OF THE CREDITOR
Rights
• The creditor is entitled to demand payment from the surety as soon as the principal debtor refuses to pay or makes default in payment.
Obligations
• The obligations of a creditor are:
1) Not to change any terms of the Original Contract.
2) Not to compound, or give time to, or agree not to sue the Principal Debtor
3) Not to do any act inconsistent with the rights of the surety
RIGHTS OF SURETY
• Rights of a surety may be classified under three heads:
1. Rights against the Creditor
In case of fidelity guarantee, the surety can direct creditor to dismiss the employee whose honesty he has guaranteed, in the event of proved dishonesty of the employee.
2. Rights against the Principal Debtor
(a) Right of Subrogation (stepping into the shoes of the original)
Where a surety has paid the guaranteed debt on its becoming due or has performed the guaranteed duty on the default of the principal debtor, he is invested with all the rights, which the creditor has against the debtor.
(b) Right to be indemnified
The surety has the right to recover from the principal debtor, the amounts which he has rightfully paid under the contract of guarantee.
2. Rights of Contribution
Where a debt has been guaranteed by more than one person, they are called as co-sureties. When a surety has paid more than his share, he has a right of contribution from the other sureties who are equally bound to pay with him.
LIABILITIES OF SURETY
• The liability of a surety is called as secondary or contingent, as his liability arises only on default by the principal debtor.
• But as soon as the principal debtor defaults, the liability of the surety begins and runs co-extensive with the liability of the principal debtor, in the sense that the surety will be liable for all those sums for which the principal debtor is liable. The creditor may file a suit against the surety without suing the principal debtor.
• Where the creditor holds securities from the principal debtor for his debt, the creditor need not first exhaust his remedies against the securities before suing the surety, unless the contract specifically so provides.
DISCHARGE OF SURETY
1. By notice of revocation
2. By death of surety
2. By variance in terms of contract
4. By release or discharge of Principal Debtor
5. By compounding with, or giving time to, or agreeing not to sue, Principal Debtor
6. By creditor’s act or omission impairing Surety’s eventual remedy
7. Loss of Security
2.15 CONTRACT OF BAILMENT AND PLEDGE BAILMENT
[SECTIONS 148 –181]
What is ‘Bailment‘
• When one person delivers some goods to another person under a contract for a specified purpose and when that specified purposes is accomplished the goods shall be delivered to the first person, it is known as Bailment
• The person delivering the goods is called the “Bailor”, and the person to whom goods are delivered is called the “Bailee”.
CHARACTERISTICS OF BAILMENT
1. Delivery of Goods - it may be express or constructive (implied).
2. Contract.
2. Return of goods in specie.
KINDS OF BAILMENTS
• Bailment may be classified as follows: -
1. Deposit - Delivery of goods by one man to another to keep for the use of the bailor.
2. Commodatum - Goods lent to friend gratis (free of charge) to be used by him.
2. Hire - Goods lent to the bailee for hire, i.e., in return for payment of money.
4. Pawn or Pledge - Deposit of goods with another by way of security for money borrowed.
5. Delivery of goods for being transported by the bailee - for reward.
DUTIES OF BAILOR
1. To disclose faults in the goods
2. Liability for breach of warranty as to title.
2. To bear expenses in case of Gratuitous bailments
4. In case of non-gratuitous bailments, the bailor is held responsible to bear only extra-ordinary expenses.
Ex-
A horse is lent for a journey. The ordinary expenses like feeding the horse etc., shall be borne by the bailee but in case horse falls ill, the money spent in his treatment will be regarded as an extra-ordinary expenditure and borne by the bailor.
DUTIES OF THE BAILEE
1. To take care of the goods bailed
2. Not to make unauthorised use of goods
2. Not to Mix Bailor’s goods with his own
4. To return the goods bailed
5. To return any accretion to the goods bailed
RIGHTS OF BAILEE
1. The bailee can sue bailor for
(a) claiming compensation for damage resulting from non-disdosure of faults in the goods;
(b) for breach of warranty as to title and the damage resulting therefrom; and
(c) for extraordinary expenses.
2. Lien
2. Rights against wrongful deprivation of injury to goods
RIGHTS OF THE BAILOR
1. The bailor can enforce by suit all duties or liabilities of the bailee.
2. In case of gratuitous bailment (i.e., bailment without reward), the bailor can demand their return whenever he pleases, even though he lent it for a specified time or purpose.
TERMINATION OF BAILMENT
1. On the expiry of the stipulated period.
2. On the accomplishment of the specified purpose.
2. By bailee’s act inconsistent with conditions.

FINDER OF LOST GOODS
• Finding is not keeping. A finder of lost goods is treated as the bailee of the goods found as such and is charged with the responsibilities of a bailee, besides the responsibility of exercising reasonable efforts in finding the real owner.
• However, he enjoys certain rights also. His rights are summed up hereunder¬
1. Right to retain the goods
2. Right to Sell -the finder may sell it:
(1) when the thing is in danger of perishing or of losing the greater part of its value;
(2) when the lawful charges of the finder in respect of the thing found, amount to 2/3rd of its value.
2.16 PLEDGE
• A pledge is the bailment of goods as security for payment of debt or performance of a promise. The person who delivers the goods, as security is called the ‘pledgor’ and the person to whom the goods are so delivered is called the ‘pledgee’. The ownership remains with the pledgor. It is only a qualified property that passes to the pledgee.
• Delivery Essential - A pledge is created only when the goods are delivered by the borrower to the lender or to someone on his behalf with the intention of their being treated as security against the advance. Delivery of goods may, however, be actual or constructive.
2.17 CONTRACT OF AGENCY
[SECTION 182 – 238]
Who is an ‘Agent‘
• An agent is defined as a “person employed to do any act for another or to represent another in dealings with third person”. In other words, an agent is a person who acts in place of another. The person for whom or on whose behalf he acts is called the Principal.
• Agency is therefore, a relation based upon an express or implied agreement whereby one person, the agent, is authorised to act for another, his principal, in transactions with third person.
• The function of an agent is to bring about contractual relations between the principal and third par¬ties.
WHO CAN EMPLOY AN AGENT
• Any person, who is capable to contract may appoint as agent. Thus, a minor or lunatic cannot contract through an agent since they cannot contract themselves personally either.
WHO MAY BE AN AGENT
• In considering the contract of agency itself (i.e., the relation between principal and agent), the contractual capacity of the agent becomes important.
HOW AGENCY IS CREATED
• A contract of agency may be created by in any of the following three ways: -
(1) Express Agency
(2) Implied Agency
(3) Agency by Estoppel
(4) Agency by Holding Out
(5) Agency of Necessity
(6) Agency By Ratification
DUTIES OF AGENT
1. To conduct the business of agency according to the principal’s directions
2. The agent should conduct the business with the skill and diligence that is generally possessed by persons engaged in similar business, except where the principal knows that the agent is wanting in skill.
3. To render proper accounts.
4. To use all reasonable diligence, in communicating with his principal, and in seeking to obtain his instructions.
5. Not to make any secret profits
6. Not to deal on his own account
7. Agent not entitled to remuneration for business misconducted.
8. An agent should not disclose confidential information supplied to him by the principal [Weld Blundell v. Stephens (1920) AC. 1956].
9. When an agency is terminated by the principal dying or becoming of unsound mind, the agent is bound to take on behalf of the representatives of his late principal, all reasonable steps for the protection and preservation of the interests entrusted to him.
RIGHTS OF AN AGENT
1. Right to remuneration
2. Right Of Retainer
2. Right of Lien
4. Right of Indemnification
5. Right to compensation for injury caused by principal’s neglect
PRINCIPAL’S DUTIES TO AGENT
• A principal is:
(i) bound to indemnify the agent against the consequences of all lawful acts done by such agent in exercise of the authority conferred upon him;
(ii) liable to indemnify an agent against the consequences of an act done in good faith.
(iii) The principal must make compensation to his agent in respect of injury caused to such agent by the principal’s neglect or want of skill.
TERMINATION OF AGENCY
1. By revocation by the Principal.
2. On the expiry of fixed period of time.
2. On the performance of the specific purpose.
4. Insanity or Death of the principal or Agent.
5. An agency shall also terminate in case subject matter is either destroyed or rendered unlawful.
6. Insolvency of the Principal. Insolvency of the principal, not of the agent, terminates the agency.
7. By renunciation of agency by the Agent.