Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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LESSON# 17
After preparing estimates of factory overhead for production departments, the next step is to select
a factory overhead absorption base for each production department. The base to be selected for
this purpose should be the principal cost deriver of factory overhead of the department.
Cost Driver is defined as a measure of activity the magnitude of which influences if magnitude of
cost of relevant cost objectives. In other words Factory overhead application base should be a
measure of activity which has causal relation with incurrence of factory overhead.
The most simple and direct measure of activity of a manufacturing concern is number of units
produced. It can be safely regarded as the best cost driver for the purpose of factory overhead
absorption in such situations where there is a mass production of homogeneous units (i.e. process
costing industries) or where a few products are produced in batches (i.e. batch costing industries).
In process costing industries like sugar, cement etc. Kg. or a bag may be regarded as unit of output;
a bottler may use a bottle or a liter as a unit of output. In bate costing industries the activity is
measured "in equivalent number of units produced.
For example, a chip-board factory produces three grades of chip board say A, B, and C and a
square foot is used as the unit to measure out put. Technical estimates reveal that factory overhead
cost of one square foot of grade B and grade C is respectively one-half and one-fourth of grade A.
In other words proportion of factory overhead cost of one square foot of chip board among the
three grades is 4:2:1. Consequently, for the purpose of factory overhead absorption one square
foot of grade A, B, and C shall be regarded as equivalent to 4 Sq, Ft. 2 Sq, Ft. and 1 Sq. Ft.
respectively.
On the other hand in job costing industries each unit of output is quite different from the other.
For example, a furniture manufacturer produces chairs (study chairs, office chairs, easy chairs,
dining chairs), tables. (study tables. office tables, dining tables, dressing tables), beds (doubly beds.
single beds) and many other items, each according to specifications of customers. In such a
situation because of the dissimilarities, a unit of output can neither be used to measure the activity
nor as base for factory overhead absorption. Therefore, some other common denominator should
be adopted to measure the activity and as base for applying factory overhead to the products. Basis
generally selected for this purpose are listed below in descending order of frequency of use:
1. Direct labor cost;
2. Direct labor hours;
3. Machine hours;
4. Direct materials cost;
5. Prime cost.
No hard and fast rule regarding selection of the absorption base can be prescribed. However, two
guiding principles in this respect are: (i) the selected base should give accurate results, and (ii) cost
of operating the base should not be greater than the benefit derived from accuracy.
Many times we find that factory overhead cost fluctuates with time spent on the products or Jobs,
therefore, direct labor hours and machine hours are more suitable cost derivers. But use of direct
labor hours or machine hours as factory overhead absorption base requires additional cost and
clerical efforts to collect data of time spent on each job, Consequently, for the sake of
convenience, management may decide to adopt direct labor cost as base for applying factory
overhead, provided that it also gives approximately correct results. Use of direct materials cost as
factory overhead absorption base is rarely recommended because prices of materials are subject to
violent fluctuation as well as direct materials cost seldom represents a cost driver of factory
overhead. Same is the case with prime cost as a base for factory overhead absorption.
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PRACTICE QUESTION
Units of output as the Absorption Base.
Babul Bottlers produces "Bubble Drink" which is filled in bottles of three sizes i.e. 25 ml. 1 liter
and 5 liters. The firm assigns factory overhead cost to its products by using a predetermined
factory overhead absorption rate calculated on the basis of units of output. Technical studies reveal
that proportion of factory overhead incurred on one bottle of each size mentioned above is 1:2:4
respectively. Estimated production during the coming year is as follow:
Bottle Size
Production
250 ml.
80,000 bottles
1 liter
70,000 bottles
5 liter
20,000 bottles
Estimated factory overhead cost for the coming year is Rs 360.000
Required: Calculate predetermined factory overhead rate for each size of bottle.
Solution:
Bottle
Estimated
Points
Estimated
Estimated  Estimated  Predetermine
Size
output
Assigned
Total
FOH Per
FOH for  FOH rate per
Bottles
Points
Point
Each Size
Bottle
Rs.
Rs
Rs.
250 ml.
80,000
1
80,000
1.20
96,000
1.20
1 liter
70,000
2
140,000
1.20
168,000
2.40
5 liter
20,000
4
80,000
1.20
96,000
4.80
300,000
360,000
Notes:
Estimated FOH per point= Total FOH/Total point = Rs. 360.000/300.000 point
Estimated FOH for each size Predetermined FOH rate per bottle=Rs. 1.20 = Estimated FOH per
point or Estimated points of each size = Estimated FOH for each size/Estimated output of each
size
Q. 2
Following figures are presented to you by Alfa Manufacturing Company.
Items
Budgeted Figures for
Actual Figures for operations
operations During 2006
during January 2006
Dept A
Dept B
Dept A
Dept B
Direct materials (Rs ) Direct
6,000,000
2,400,000
50,000
250,000
labor (Rs.)
1,500,000
1,200,000
145,000
105,000
1,200,000
1,800,000
14,000
9,500
Direct labor hours
150,000
100,000
26,000
28,000
Machine hours
300,000
360,000
Required:
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(i) Calculate predetermined factory overhead absorption rates for the departments using five
different bases. (Present your answer by enlisting the rates in descending order of approximate
frequency of their use).
(ii) Calculate total product cost of output during January 2006 under all of the three bases,
Solution:
(i)
Predetermined FOH Absorption Rates
FOH Absorption Bases
Department  Department B
(1) Direct labor cost base
80%
150%
(2) Direct labor hours base
Rs.8
Rs 18
(3) Machine hours base
Rs.4
Rs. 5
(4) Direct materials cost base
20%
75%
(5) Prime cost base
16%
50%
NOTE:
FOH absorption rate =
Estimated FOH for the year x 100 (if base is in Rs)
Estimated base for the year
Total Product Cost for January 2006
(1)
(2)
(3)
Particulars
Direct Labor
Direct Labor
Machine Hours
Cost Base
Hours Base
Base
Department A Direct
Rs. 450,000
Rs. 450,000
Rs. 450,000
materials
Direct labor
145,000
145,000
145,000
116,000
112,000
104,000
Total Department B: Direct
711,000
707,000
699,000
250,000
250,000
250,000
materials
Direct Labor
105,000
105,000
105,000
157,500
171,000
140,000
Total
512,500
526,000
495,000
1,223,500
1,233,000
Total product
cost
NOTES:
Department A:
(1) Rs 145,000 x 80%
= Rs. 116,000
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(2) 14,000 hours x Rs 8
= Rs. 112,000
(3) 26,000 hours x Rs. 4
= Rs, 104,000
Department B:
(1) Rs, 105.000 x 150%= Rs, 157,500
(2) 9.500 hours x Rs. 18
= Rs. 171,000
(3) 28,000 hours x Rs. 5
= Rs. 140,000
Selection of Capacity Level
Capacity Level means ability to produce. The term is synonymous as Activity Level or Volume.
Industries producing homogeneous units may express their capacity level in terms of units of
output, whereas, Job costing industries may measure it in terms of direct labor cost, direct labor
hours, machine hours etc.
For the purpose of calculating predetermined factor overhead absorption rate it is necessary to
select an appropriate capacity level at which the cost and the cost driver should be estimated.
In cost accounting literature we find reference to following types of capacity levels.
Theoretical Capacity
It is the maximum capacity level that could be achieved if there
were 100% utilization of time. This capacity level can never be achieved because of unavoidable
interruptions e.g. Fridays, holidays, repair and maintenance, machine breakdown, electricity
breakdown, shortage of materials, lack of demand etc. Theoretical capacity is the starting point for
measurement of practical capacity.
Practical Capacity  It is the maximum capacity level that can he attained under efficient
working conditions. When loss of time due to unavoidable interruptions as mentioned above, is
deducted from theoretical capacity the remainder is practical capacity.
Expected/Normal Capacity
It is the capacity level expected to be attained during the
accounting, year. Expected/normal capacity is dependent of market demand for the products. It
may be equal to or less than the practical capacity.
Most of the experts make a slight difference between expected and normal capacity. They are of
the opinion that normal capacity is the average of expected capacity over a number of years. This
average is used to smooth the seasonal, cyclical and trend variations over the years.
Selection of an appropriate capacity level is necessary because:
(1)
Fixed factory overhead absorption rate is inversely related with capacity level i.e. the fixed
rate is higher at a lower capacity level and it is lower at a higher capacity level,
(2)
Amount of unabsorbed fixed factory overhead at the end of an accounting period is used
to denote cost of failing to achieve the target production i.e. cost of unutilized capacity (the idle
capacity variance to be discussed later).
Practical capacity is seldom selected for the purpose of budgeting. It is the expected/normal
capacity that is used to budget or estimate the costs. Long term planning prospective advocates
selection of normal capacity level. However, on account of difficulties in estimating with
reasonable accuracy beyond one year. expected actual capacity is most commonly adopted.
Following practice question shows affects of capacity level on factory overhead, application rate
and on the amount of unabsorbed fixed factory overhead.
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PRACTICE QUESTION
At beginning of the year 2006 Shahbaz & Co. estimated its fixed factory overhead at Rs. 350,000
and variable factory overhead at Rs. 500,000 for a normal volume of 125,000 units. Practical
volume was estimated at 140,000 units per year. During 2006 the company could produce only
100,000 units.
Required: Compute each of the following on the bases of (i) Expected volume and (ii) Practical
volume:
(a) Predetermined factory overhead application rate:
(b) Amount of factory overhead applied during 2006 and
Solution:
(a) Predetermined Factory Overhead Application Rate ;
Estimated Capacity Level
(i) At normal capacity
(Rs. 350,000 Fixed + Rs 500,000 Variable) = Rs 6.80 per unit
125,000 units
(ii) At practical capacity level
(Rs. 350,000 Fixed + Rs. 500,000 Variable) = Rs 6.07 per unit
140,000 units
(b)
Capacity attained x Factory overhead application rate at normal capacity
(i) Using the rate at expected capacity
100.000 units x Rs 6.80 = Rs. 680,000
Blanket Rate
A blanket absorption rate is a single rate of absorption used throughout an organization's
production facility and based upon its total production costs and activity.
The use of a single blanket rate makes the apportionment of overhead costs unnecessary since
the total production costs are to be used. How ever this is not recommended for the following
reasons:
· It relies on a single activity measure being appropriate for the entire production function.
· It does not distinguish between the miming costs of particular activities or departments when
absorbing costs into cost units.
Factory overhead cost includes indirect materials cost, indirect labor cost and other indirect
manufacturing costs.
Most of the factory overhead cost items are recorded (identified) straight away as factory overhead
cost; these include some sort of indirect material items, indirect labor, electricity, insurance, rent,
repair etc. etc. Accounting entry for these costs is:
xxx
Bank/cash/accounts payable a/c
xxx
Some of the factory overhead cost items are allocation or transfer of cost from another accounting
head. Accounting entry for these costs is:
xxx
Depreciation a/c
xxx
Prepaid rent a/c
xxx
Etc. .
xxx
Applied factory overhead is entered in the work in process account. In order to journalize total
applied factory overhead following accounting entry is passed:
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Work in process control a/c
xxx
xxx
The amounts are then posted to relevant ledger accounts.
Actual factory overhead continues to accumulate on debit side of factory overhead control
account throughout the year and applied factory overhead cost on credit side of factory overhead
applied account. At the end of year factory overhead applied account is closed to factory overhead
control account by passing following accounting entry:
xxx
xxx
Actual and applied overhead are never equal. They could be equal only when estimates of factory
overhead cost and the capacity level prepared for calculating the absorption rate are 100% correct.
In practice it is impractical to achieve this much accuracy. As a result, after the close of applied
account, factory overhead control account shows either a debit balance representing under applied
Under applied factory overhead means that factory overhead cost charged to production is less
than the actual factory overhead and the cost of production is understated.
On the other hand over applied factory overhead means that factory overhead charged to
production is more than the actual factory overhead and the cost of production is overstated.
This under or over applied balance is disposed off by adopting anyone of the following four
methods.
1. Adjusting Cost of Entire Production of the Period.
This is the most accurate method and gives correct figures for income determination and for
balance sheet. At the end of a year total production of the year stands divided into
a) cost of goods sold,
b) finished good inventory' and
c) work in process inventory.
An under or over absorbed factory overhead means respectively under or overstated cost of
goods sold, finished goods inventory and work in. process inventory. Therefore
mathematically correct method is to adjust all of these three accounts by distributing under or
over applied overhead to these accounts in the proportion of their respective balances.
Assume that at the end of year factory overhead control account shows an over applied
balance of Rs. 100,000. Balances of cost of goods sold, finished goods and work in process
control accounts are Rs. 1,600,000 .Rs. 300,000 and Rs. 100,000 respectively. The over applied
factory overhead shall be disposed off by passing following entry in general journal.
100,000
Cost of goods sold a/c
80,000
Finished goods a/c
15,000
Work in process a/c
5,000
The above entry closes factory overhead control account and reduces the balance of cost of
goods sold, finished goods, and work in process control accounts by the accounts by which
these are overstated. Had the factory overhead cost under absorbed, the above entry would
have been reversed.
1. Closing the Variance to Cost of Goods Sold.
Posting of under or over applied factory overhead to the subsidiary ledgers of finished goods
and work in process control accounts is a tedious .job requiring much clerical efforts especially
in job-order and batch costing industries, Therefore, when the amount of under or over
absorbed factory' overhead is insignificant. The cost accountants prefer to close it only to cost
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of goods sold. In this case the entry to be passed in general journal to dispose off an over
applied balance is as follow:
xxx
Cost of goods sold a/c
xxx
Obviously the entry to dispose of an under applied balance shall be opposite to the above
entry. This method though theoretically not very sound, is justified on the ground of
convenience.
2. Closing the Variance to Income Statement.
Where factory overhead variance is on account of some abnormal factors e.g. idle capacity
caused by strikes or lockouts, unlawful spending, poor utilization of production facilities,
mismanagement in production etc. the amount of variance is closed to Income
Summary/Profit and Loss Account. The above noted factors result in under absorption of
factory overhead. The general journal entry to dispose off such under applied factory overhead
is as follow:
Income summary/Profit & loss a/c
xxx
xxx
In this case, cost of goods sold at normal is deducted from the net sales. The resulting gross
profit is termed as gross profit at normal. Then from the gross profit at normal amount of
under absorbed factory overhead is deducted and the remainder is called gross profit at actual.
Alternatively this amount of under absorbed factory overhead may also be deducted from the
net profit/income.
PRACTICE QUESTION
City Links Limited applies factory overhead @ 60% of direct labor cost. During the year just
completed following actual costs were recorded:
Direct labor cost
Rs. 580,000
At the end of the year following balances appear in some of the control accounts:
Cost of goods sold
Rs. 1,750,000
Finished goods
Rs.  500,000
Work in process
Rs.  250,000
Required:
a) Determine under or over applied factory overhead.
b) Pass accounting entry to close factory overhead applied account at the end of year.
c) Pass accounting entries to dispose off under or over applied factory overhead in following
cases:
i) The variance is regarded as a significant amount.
ii) The variance is regarded as an insignificant amount.
iii) The variance is regarded as cause by poor scheduling of production and excessive spending.
Solution:
(a) Under or Over applied Factory Overhead:
Rs. 428,000
Capacity attained x application rate
Rs. 580,000 x 60%
348,000
Under applied
80,000
(b) Entry to Close Factory Overhead Applied a/c:
348,000
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348,000
Under applied Factory overhead a/c  80,000
80,000
(c) Entries to dispose off under or over applied Factory Overhead:
(i)
Cost of goods sold a/c
56,000
Finished goods a/c
16,000
Work in process a/c
8,000
80,000
Rs. 80,000
x 1,750
=Rs. 56,000
2,500
x 500
=Rs. 16,000
x 250
=Rs. 8,000
(ii)
Cost of goods sold a/c
80,000
80,000
(iii)
Income summary a/c
80,000
80,000
Factory overhead variance means the difference between actual factory overhead incurred and
factory overhead applied during the year. Under applied factory overhead is regarded as an
unfavorable sign because actual factory overhead cost is greater than the factory overhead
absorbed by the production, On the other hand. Over applied factory overhead is considered as
favorable sign because actual factory overhead is less than the factory overhead absorbed. This
total variance is analyzed to determine the causes. The causes of variance lie in the following two
factors:
a) The variance may be due to the difference between capacity level budgeted for calculating
predetermined factory overhead absorption rate and the capacity level actually attained till
the end of year: and
b) The variance may be due to the difference between factory overhead budgeted for capacity
attained and the factory overhead cost actually incurred
If the variance is caused by difference in capacity i.e. the first factor mentioned above, it is called
Capacity Variance or Volume Variance.
On the other hand, if the variance is caused by difference in budgeted and actual costs. i.e. the
second factor mentioned above, it is called Budget Variance or
Spending Variance
In practice the total variance is composed of both of these two factors. The total variance is
decomposed into capacity variance and budget variance in order to determine the magnitude of
variance caused by each of the two factors listed above.
Capacity/Volume Variance
Capacity variance is on account of presence of fixed factory overhead. Predetermined factory
overhead absorption rate is the sum of fixed rate and variable rate. We know that total fixed
factory overhead remains unchanged within a designated range of activity level and the fixed rate
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changes inversely with changes in activity level Assume that for an estimated activity level of
50,000 machine hours budgeted factory overhead is Rs. 150,000 which includes Rs 100.000 of
fixed cost. The absorption rate and its composition in this case is as follow:
FOH absorption rate:
Rs, 150,000/ 50.000 machine hrs
= Rs. 3 per machine hr.
The fixed rate:
Rs. 100,000/50.000 machine hrs
= Rs. 2 per machine hr.
The variable rate:
Rs 3 per machine hr less Rs. 2 per machine hr = Rs. 1 per machine hr.
It is very easily understood that Rs, 100.000 of fixed factory overhead can be absorbed only when
capacity attained till the end of year is 50,000 machine hours If capacity attained is less than the
budgeted capacity it means an unfavorable capacity variance, which will be signified by unabsorbed
fixed factory overhead. Assume that the capacity attained is 48,000 machine hours. At this capacity
level only Rs 96,000 of fixed factory overhead is absorbed (i.e. 48,000 hrs x Rs. 2) and the under
absorbed fixed cost of Rs 4,000(i.e. Rs. 100,000 less Rs. 96,000) represents the portion of factory
overhead variance cause by unfavorable capacity variance. Similarly, where capacity attained is
more than the budgeted capacity it is a favorable capacity variance which will be signified by over
absorbed fixed factory overhead. In other words capacity variance can be computed by multiplying
the difference in capacity (budgeted and attained) by the fixed rate. The same result is obtained by
taking. the difference between absorbed factory overhead and budgeted factor* overhead for
capacity attained.
Budget/Spending Variance
Budget variance is the difference between budgeted factory overhead for capacity attained and
actual factory overhead incurred. It represents either over-spending or under-spending.
If actual factory overhead is more than the budgeted, it is unfavorable budget variance. On the
other hand if actual factory overhead is less than the budgeted it is favorable budget variance.
In order to determine exact causes of budget variance, the difference between actual and budgeted
figures of each item of factory overhead is computed and communicated to the responsible person
for the purpose of control. The budget variance may be due to fixed factory overhead items or it
may be due to the variable items or the both.
Following practice question explains the computation and presentation of the variance and its
analysis.
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PRACTICE QUESTION
Shahzewaz Associates prepared following estimates for the year 2006.
Direct labor hours Actual results for the year 19xx were as follow:
Rs. 450,000
Rs. 600,000
Direct labor hours
200,000
Required: Calculate
(i)
(ii)
Capacity variance.
(iii)
Budget variance.
Solution:
(i)
Fixed FOH + Variable FOH
Rs. 450.000 + Rs. 680,000
Rs. 1,130,000
Capacity attained x Absorption rate
220,000 hours x Rs. 5.25
1,155,000
Over applied
25,000
(ii)
Capacity Variance
Absorbed factory overhead (220,000 x 5.25)
Rs. 1.155.000
Budgeted factory overhead for capacity attained
Fixed factory overhead + (Capacity attained x Variable rate)
(Rs. 450,000 + 220,000 hours x Rs. 3)
1,110,000
Favorable
45,000
(iii)
Budget Variance
Budgeted factory overhead for capacity attained
Rs. 1,110,000
1,130,000
Unfavorable
20,000
Supporting Calculations
Absorption rate = (Rs 450.000 + Rs. 600,000)
200.000 direct labor hours
= Rs. 5.25 per direct labor hour
Variable rate
= Rs. 600.000
2,00,0000 direct labor hours
= Rs. 3 per direct labor hour
It should be remembered here that no definite conclusions can be drawn only on the basis of
factory overhead variance analysis, as presented above Analysis of factory overhead variance is a
part of whole process of variance analysis whereby direct materials variance and direct labor
variance are also computed and analysed. Complete study of variance analysis is a part of advanced
courses of cost accounting.
In the above practice question capacity attained in terms of direct labor hours is greater than the
budgeted capacity. This seemingly favorable capacity variance may, in fact, be due to unfavorable
factors. For example, direct labor may be less efficient and as a result same quantity of output is
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produced by working greater number of hours, or it may be due to defective materials which
require more conversion time and as such the hours worked over and above the budgeted capacity
have not resulted in extra output Similarly an unfavorable budget variance may be on account of
higher spending on preventive repairs and maintenance or higher spending on training of workers,
which is in effect beneficial for the organisation.
Here a practice question is discussed to explain High and Low Point Method. This method is a
technique to segregate fixed and variable portions of a total/semi-variable cost.
Practice Question
Predetermined factory overhead absorption rate computed by AI-Nasr Associates Rs. 6 per
machine hour. Budgeted factory overhead for activity level of 150.000 machine hours is Rs.
800,000 and for activity level of 100,000 machine hours it is Rs. 700,000. Actual factory overhead
incurred during the year is Rs. 710,000 at an actual volume of 120,000 machine hours.
Required:
(i)
(ii)
(iii)
Budgeted activity level on which the absorption rate is based
(iv)
Over or under absorbed factory overhead.
(v)
Volume variance
(vi)
Spending variance
Solution:
(i)
Activity Level
Budgeted FOH
(Machine Hours)
(Rs.)
High
150,000
800,000
Low
100,000
700.000
50,000
100,000
For a change of 50,000 machine hour's m activity level there is a change of Rs, 100,000 in
budgeted factory overhead. This change in budgeted factory overhead is due to variable factory
Variable rate
=
Change in budgeted FOH
Change in activity level
Rs 100,000/50,000 machine hours
Rs. 2 per machine hour
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Total FOH for 150,000 machine hours
= Rs. 800.000
Budgeted variable FOH = 150,000 hrs Rs 2
= Rs. 300,000
Budgeted fixed FOH = Rs 800.000 less Rs. 300,000
= Rs. 500.000
OR
Total FOH for 100.000 machine hours
= Rs 700.000
Budgeted variable FOH =100.000 hrs x Rs. 2
= Rs 200.000
Budgeted fixed FOH = Rs, 700.000 less Rs. 200,000
=Rs. 500.000
(iii)Budgeted Activity Level
Budgeted activity level = Fixed FOH
Fixed rate
= Rs. 500.000/ (Rs. 6 less Rs. 2)
=125,000 machine hours
(iv) Over or under absorbed Factory Overhead:
Rs. 710.000
Actual volume x FOH absorption rate
120,000 hrs x Rs. 6
720.000
Over absorbed
10,000
(v) Volume Variance:
Rs. 720,000
Budgeted FOH for actual volume
Fixed FOH + (Actual volume x Variable rate)
Rs, 500.000 + (120.000 hrs, x Rs. 2)
740,000
Unfavorable
20,000
(vi) Spending Variance:
Budgeted FOH for actual volume
Rs. 740,000