MIS

Management
Information
Study Text
ICAN
Institute of Chartered
Accountants of Nigeria

ICAN
Management information
First edition published by
Emile Woolf International
Bracknell Enterprise & Innovation Hub
Ocean House, 12th Floor, The Ring
Bracknell, Berkshire, RG12 1AX United Kingdom
Email: info@ewiglobal.com
www.emilewoolf.com
© Emile Woolf International, September 2014
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording, scanning or otherwise, without the prior permission in writing of Emile Woolf
International, or as expressly permitted by law, or under the terms agreed with the
appropriate reprographics rights organisation.
You must not circulate this book in any other binding or cover and you must impose the
same condition on any acquirer.
Notice
Emile Woolf International has made every effort to ensure that at the time of writing the
contents of this study text are accurate, but neither Emile Woolf International nor its directors
or employees shall be under any liability whatsoever for any inaccurate or misleading
information this work could contain.
www.icanig.org
© Emile Woolf International ii The Institute of Chartered Accountants of Nigeria

Foundation level
Management Information
C
Contents
Page
Syllabus v
Chapter
1 Scope of cost and management accounting 1
2 Costs and cost behaviour 13
3 Cost estimation 43
4 Inventory valuation 63
5 Accounting for overheads 75
6 Marginal costing and absorption costing 115
7 Activity based costing 137
8 Job, batch and service costing 155
9 Process costing 177
10 Forecasting 227
11 Budgeting 245
12 Cash budgeting and working capital 277
13 Cost-Volume-Profit (CVP) analysis 293
14 Decision making techniques 315
15 Introduction to information technology and information systems 329
16 Networks and communications 359
17 Data management 391
18 Information systems – security 419
© Emile Woolf International iii The Institute of Chartered Accountants of Nigeria

Page
19 Information systems – management and strategy 441
20 Information systems – change management 467
Index 491
© Emile Woolf International iv The Institute of Chartered Accountants of Nigeria

Foundation level
S
Syllabus
FOUNDATION LEVEL
MANAGEMENT INFORMATION
Purpose
Accountants play a vital role in management and management decision-making. Business

information deals with the production of accurate and useful information to support
management and decision-making including costing, management accounting and the
application of quantitative methods in financial management. Business information takes
an integrated approach by developing an awareness of information technology and
systems support.
Content and competencies - Overview
Grid Weighting
Costing/pricing 30
Forecasting, budgeting and decision making 30
Information technology and systems 40
Total 100
© Emile Woolf International v The Institute of Chartered Accountants of Nigeria

Contents and competencies Chapter
1 Costing/pricing
a) Classify costs for different purposes including identifying fixed and 1, 2
variable, product and period, direct and indirect and costs by nature,
function and purpose
b) Identify and calculate the costs of products, services and projects 3 to 9
including process costs
c) Identify and calculate unit costs and the effect of different costing 5
methods on reported financial results using marginal and absorption
costing approaches
d) Select and explain the most appropriate costing approach for a given 3 to 9
product or service for reporting and decision-making purposes
2 Forecasting, budgeting and decision making
a) Compile forecasts for management information purposes 10
b) Compile budgets and extracts from budgets using information 11
provided
c) Select and justify the choice of the most appropriate methods of 11
budgeting for planning and controlling including motivational
considerations, including:
i) Bottom-up and top-down approaches 11
ii) Marginal and absorption approaches 11
iii) Activity based costing 7, 11
iv) Zero-based and incremental approaches 11
v) Budget implementation and monitoring 11
d) Compile and identify and explain the business consequences of a 12
cash budget identifying flows, balances and limits
e) Calculate and explain the working capital and cash cycles of a 12
business
f) Calculate, explain and comment upon the contribution, break-even 13
point and margin of safety for a product or service
g) Calculate, explain and comment upon the best allocation of scarce 14
resources to a product or service based on contribution per unit of
limiting factor
© Emile Woolf International vi The Institute of Chartered Accountants of Nigeria

Syllabus
3 Information technology and systems

a) Explain and distinguish the nature of data, information and knowledge 15
b) Identify and explain the main information technologies that support 15, 16
modern information systems
c) Identify and explain the main information systems used by entities 15
including business process systems, transactions processing systems,
management information systems, decision-support systems and
executive information systems
d) Identify and explain the main risks to the reliability of data and 18
information and how these may be managed and controlled
operationally and through management of systems and technology
including development of new systems
e) Explain, describe or discuss the importance of aligning IT strategy with 19
business strategy
f) Identify and explain the data processing methods that aid in 17
generation of Management information such as:
i) Batch processing 17
ii) Online processing 17
iii) Real time processing 17
iv) Distributed processing 17
v) Multi-tasking/multi-processing 17
g) Professionals accountants and career path in IT environment 19
h) Information technology architecture: Explain, describe or discuss how 15, 17
IT architecture relates to the entity’s business model
i) General systems concepts 15
ii) Transaction processing in business systems 17
iii) Hardware components 15
iv) Software 15
v) Protocols, standards and enabling technologies 16, 17
vi) Data organization and access methods 17
© Emile Woolf International vii The Institute of Chartered Accountants of Nigeria

3 Information technology and systems (continued)

i) Identify and explain the main risks to the reliability of data and 18
information and how these may be managed and controlled
operationally and through management of systems and technology
including development of new systems covering but not limited to:
i) Privacy Issues 18
ii) Secrecy issues 18
iii) Data transfer practices 18
iv) Use of USB and other removable devices 18
v) Virus and worms 18
vi) Access to social networking sites using company time and 18
resources
j) Explain, describe or discuss how IT is managed within an 19
organisation, with a focus on:
i) Accounting systems 19
ii) Performance monitoring, and 19
iii) Change management and procedures for updating hardware 20
and software.
k) Explain the impact of social media on organisations. 18
© Emile Woolf International viii The Institute of Chartered Accountants of Nigeria

Foundation level
CHAPTER
1
Scope of cost and
management accounting
Contents
1 Accounting for management
2 Cost and management accounting versus financial
accounting
3 Chapter review
© Emile Woolf International 1 The Institute of Chartered Accountants of Nigeria

INTRODUCTION
Purpose
application of quantitative methods in financial management. Business information takes an
integrated approach by developing an awareness of information technology and systems
support.
This chapter does not address any specific competencies but provides background
information as a context to the content in later chapters.
Competencies
This chapter does not address any specific competencies but provides background
information as a context to the content in later chapters.
By the end of this chapter you will be able to explain the scope of cost accounting and
managerial accounting and be in a position to compare them with financial accounting.

Chapter 1: Scope of cost and management accounting
1 ACCOUNTING FOR MANAGEMENT
Section overview
 Introduction to accounting information

 Data and information
 Qualities of good information
 Purpose of management information
1.1 Introduction to accounting information

Accounting is one of the key functions for almost any business; it may be handled
by a bookkeeper and accountant at small firms or by sizable finance departments
with dozens of employees at larger companies.
There are many definitions of accounting
Definitions: Accounting
The systematic and comprehensive recording of financial transactions pertaining to
a business and the process of summarizing, analysing and reporting these
transactions.
A systematic process of identifying, recording, measuring, classifying, verifying,
summarizing, interpreting and communicating financial information.
The process of identifying, measuring, and communicating economic information
to permit informed judgements and decisions by users of the information
The main purposes of accounting are to:

 provide a record of the financial value of business transactions, and in
doing so to establish financial controls and reduce the risks of fraud;
 assist with the management of the financial affairs of an entity; and
 provide information - mainly information of a financial nature.
Accounting information is provided for:
 Management, so that managers have the information they need to run the
company
 Other users of information, many of them outside the entity. For example, a
company produces accounting information for its shareholders in the form
of financial statements, and financial statements are also used by tax
authorities, investors, trade union representatives and others.
Cost and management accounting is concerned with the provision of information,
mainly of a financial nature, for management.

1.2 Data and information

The terms ‘data’ and ‘information’ are often used as if they have the same
meaning. However, there is a difference between data and information. Data is a
term that refers to facts. It must be turned into information in order for it to
become useful. Information is derived from facts that have been processed,
structured and analysed.
 Data consists of unprocessed facts and statistics.
 Data is collected and processed to produce information.
 Data has no meaning until it has been processed into information.
 Information has a meaning and a purpose. It is produced from ‘data’. It is
processed data that has relevance to a particular useful purpose.
Accounting systems are designed to capture data and process it into information.
Illustration: Data and information

A company engages in many different types of transactions (sales, purchases of
materials, expenses, and so on).
Each of these is processed into individual records (for example, sales are recorded
on sales invoices). This would result in thousands of individual records.
An accounting system summarises these in a meaningful manner to produce
information. This is carried out in a series of steps each of which provides
information based ultimately on the original transactions.
Sales day book – summarises the total sales made in a specified period.
The receivables control account shows the total owed to the company at any point
in time.
The receivables subsidiary ledger shows the total amount owed to the company by
individual customers at any point in time.
The general ledger is the source of information which can be further processed into
periodic reports (financial statements).
A cost accounting system records data about the costs of operations and
activities within the entity. The sources of cost accounting data within an
organisation include invoices, receipts, inventory records and time sheets.
Many of the documents from which cost data is captured are internally-generated
documents, such as time sheets and material requisition notes.
Illustration:
A ship yard may employ hundreds of workers and be building and refitting several
ships at any one time.
Each worker might be required to complete job sheets which specify the length of
time taken by that worker and on which contract.
This would produce many thousands of individual records (data) which are not very
useful until the facts contained in those records are processed into information.
Thus the system might produce reports (information) to show the labour cost, by
type of labour, by week for each ship.

Data is analysed and processed to produce management information, often in

the form of:
 routine reports;
 specially-prepared reports;
 answers to ‘one-off’ enquiries that are input to a computer system.
Information produced from cost accounting data is management accounting
information.
Management accounting systems also obtain information from other sources,
including external sources, but the cost accounting system is a major source of
management accounting information.
1.3 Qualities of good information

Information is only useful to managers if it possesses certain qualities or
attributes.
 Understandable.
 Information should be understandable to the individuals who use it.
 Accounting information must be set out clearly and are properly
explained.
 Purpose and relevance.
 Unless information has a purpose it has no value at all and it makes
no sense to provide it.
 Information must be relevant to this purpose.
 Reliable.
 Users of information must be able to rely on it for its intended
purpose.
 Unreliable information is not useful.
 Information does not have to be 100% accurate to be reliable. In
many cases, information might be provided in the form of an estimate
or forecast.
 Sufficiently complete.
 Information should include all information necessary for its purpose.
 However, information in management reports should not be
excessive, because important information may be hidden in the
unimportant information, and it will take managers too long to read
and understand.
 Timeliness.
 If information is provided too late for its purpose, it has no value.
 With the widespread computerisation of accounting systems,
including cost accounting systems, it might be appropriate for up-to-
date management accounting information to be available on line and
on demand whenever it is needed.

 Comparability.
 In accounting, it is often useful to make comparisons, such as
comparisons of current year results with previous years, or
comparisons of actual results with planned results.
 To make comparisons possible, information should be prepared on
the same basis, using the same methods and the same ‘rules’.
 Communicated to the right person.
 Management information should be communicated to the proper
person.
 This is the person with the authority to make a decision on the basis
of the information received and who needs the information to make
the decision.
 Its value must exceed its cost (Information must be cost effective).
 Management information has a value (if information has no value
there is no point in having it) but obtaining it involves a cost.
 The value of information comes from improving the quality of
management decisions.
 Information is worth having only if it helps to improve management
decisions, and the benefits from those decisions exceed the cost of
providing the additional information.
1.4 Purpose of management information

The purpose of management accounting is to provide information for:
 planning;
 control; and
 decision-making.
Planning
Planning involves the following:
 setting the objectives for the organisation
 making plans for achieving those objectives.
The planning process is a formal process and the end-result is a formal plan,
authorised at an appropriate level in the management hierarchy. Formal plans
include long-term business plans, budgets, sales plans, weekly production
schedules, capital expenditure plans and so on.
Information is needed in order to make sensible plans – for example in order to
prepare an annual budget, it is necessary to provide information about expected
sales prices, sales quantities and costs, in the form of forecasts or estimates.

Control
Control of the performance of an organisation is an important management task.
Control involves the following:
 monitoring actual performance, and comparing actual performance with the
objective or plan;
 taking control action where appropriate;
 evaluating actual performance.
When operations appear to be getting out of control, management should be
alerted so that suitable measures can be taken to deal with the problem. Control
information might be provided in the form of routine performance reports or as
special warnings or alerts when something unusual has occurred.
Decision making
Managers might need to make ‘one-off’ decisions, outside the formal planning
and control systems. Management accounting information can be provided to
help a manager decide what to do in any situation where a decision is needed.

2 COST AND MANAGEMENT ACCOUNTING VERSUS FINANCIAL

ACCOUNTING
Section overview
 Purpose and role of cost accounting, management accounting and financial

accounting
 Comparison of financial accounting and cost and management accounting
2.1 Purpose and role of cost accounting, management accounting and financial
accounting
The terms cost accounting and management accounting are often used as
having the same meaning. However, there are is differences between the two.
Cost accounting
Cost accounting is concerned with identifying the cost of things. It involves the
calculation and measurement of the resources used by a business in undertaking
its various activities.
Cost accounting is concerned with gathering data about the costs of products or
services and the cost of activities. There may be a formal costing system in which
data about operational activities is recorded in a ‘double entry’ system of cost
accounts in a ‘cost ledger’. The cost accounting data is captured, stored and
subsequently analysed to provide management information about costs.
Cost accounting information is historical in nature, and provides information
about the actual costs of items and activities that have been incurred.
Management accounting
Management accounting is concerned with providing information to management
that can be used to help run the business.
 The purpose of management accounting is to provide detailed financial
information to management, so that they can plan and control the
activities or operations for which they are responsible.
 Management accounting information is also provided to help managers
make other decisions. In other words, management accounting provides
management information to assist with planning, control and ‘one-off’
decisions.
Management accounting includes cost accounting as one of its disciplines but is
wider in scope. Management accounting information is often prepared from an
analysis of cost accounting data, although cost estimates and revenue estimates
may be obtained from sources other than the cost accounting system.
Management accounting may be forward-looking, and used to provide
information about expected costs and profits in the future.
Financial accounting
Financial accounting is concerned with providing information about the financial
performance of an entity in a given period and the financial position of the entity
at the end of that period.

The information is often provided to a wider range of stakeholders (those with an

interest in the business) other than those who have access to management
information. The most important of these are the owners of a business who may
not take part in the day-to-day running of the business.
2.2 Comparison of financial accounting and cost and management accounting
Financial accounting
A financial accounting system is used to record the financial transactions of the
entity, such as transactions relating to revenue, expenses, assets and liabilities.
It provides a record of the assets that the company owns, and what it owes and a
record of the income that the entity has earned, and the expenditures it has
incurred.
The financial accounting system provides the data that is used to prepare the
financial statements of the entity at the end of each financial year (the statement
of comprehensive income, statement of financial position, statement of cash
flows, and so on).
Managers might use the information in the financial statements, but the main
purpose of financial reporting is for ‘external purposes’ rather than to provide
management information. The main purpose of the financial statements of
companies is to inform the company’s shareholders (owners) about the financial
performance and financial position of the company. They are also used as a
basis for computation of the tax that the company should pay on its profits.
Financial statements are produced at the end of the financial year. Management
need information much more regularly, throughout the year. They also need
much more detailed information than is provided by a company’s financial
statements. They often need forward-looking forecasts, rather than reports of
historical performance and what has happened in the past.
There is a statutory requirement for companies to produce annual financial
statements, and other business entities need to produce financial statements for
the purpose of making tax returns to the tax authorities.
Managers might find financial statements useful, but the main users of the
financial statements of a company should be its shareholders. Other external
users, such as potential investors, employees, trade unions and banks (lenders
to the business) might also use the financial statements of a company to obtain
information.
Cost and management accounting

Whereas financial statements from the financial accounting system are intended
mainly for external users of financial information, management accounting
information (obtained from the cost accounting system) is prepared specifically
for internal use by management.
An entity might have a cost accounting system as well as a financial accounting
system, so that it has two separate accounting systems in operation. A cost
accounting system records the costs and revenues for individual jobs, processes,
activities and products or services.
 Like the financial accounting system, a cost accounting system is based on
a double entry system of debits and credits.

 However, the accounts in a cost accounting system are different from the
accounts in the financial accounting systems. This is because the two
accounting systems have different purposes and so record financial
transactions in different ways.
There is no legal requirement for a cost accounting system. Business entities
choose to have a cost accounting system, and will only do so if the perceived
benefits of the system justify the cost of operating it.
(In business entities where there is no formal cost accounting system, managers
still need management accounting information to run their business. Some
management accounting information might be extracted from the financial
accounting system, but in much less detail than a cost accounting system would
provide.)
A comparison of financial and cost accounting systems of companies is
summarised in the table below.
Financial accounting system Cost accounting system

Prepared to meet a legal or regulatory Prepared to meet the needs of
requirement. management.
Used to prepare financial statements Used to prepare information for
for shareholders and other external management (internal use only).
users. (Might also provide some
information for management but this is
not their primary purpose).
Content usually specified by a Content specified by the management
regulatory framework. of a company.
Prepared within a time frame specified Prepared within a time frame specified
by a legal or regulatory framework. by management.
Records revenues, expenditure, Records costs of activities and used
assets and liabilities. to provide detailed information about
costs, revenues and profits for specific
products, operations and activities.
Used mainly to provide a historical Provides historical information, but
record of performance and financial also used extensively for forecasting
position. (forward-looking).

3 CHAPTER REVIEW
Chapter review
Before moving on to the next chapter check that you now know how to:
 Explain the scope of cost accounting and managerial accounting and compare
them with financial accounting


Foundation level
CHAPTER
2
Costs and cost behaviour
Contents
1 Introduction to costs
2 Cost classification by type and function
3 Fixed and variable costs
4 Direct and indirect costs
5 Product costs and period costs
6 Chapter review

INTRODUCTION
Purpose
application of quantitative methods in financial management.
Competencies
1(a) Classify costs for different purposes including identifying fixed and variable,
product and period, direct and indirect and costs by nature, function and
purpose
Exam context
This chapter explains different approaches to cost classification. This knowledge is vital in
understanding costing and decision-making techniques covered in later chapters.
By the end of this chapter you will be able to:

 Explain the nature and behaviour of costs
 Explain (with examples) fixed, variable, and semi-variable costs
 Identify and give examples of fixed, variable, and semi-variable costs
 Describe direct and indirect cost
 Identify and give examples of direct and indirect cost
 Explain the terms product cost and period cost

Chapter 2: Costs and cost behaviour
1 INTRODUCTION TO COSTS
Section overview
 Types of organisation
 Cost classification: Introduction
1.1 Types of organisation

The following classification of organisations is useful for the purpose of learning
about costs:
 Manufacturing organisations: and
 Service organisations.
Manufacturing organisations
There are a great many different kinds of manufacturing organisations. They can
be classified by their type of output which in turn implies the type of costing
system they might use.
Type of production Examples Costing system

Identical (similar) Bottles of soft drink Basic manufacturing
products in large Mobile phones costing
numbers Standard costing
Garments
Identical products in Pharmaceuticals Process costing
large amounts by Paint (including joint product
passing the product and by-product costing)
through a series of Petroleum
processes
Identical products in Aircraft (which may vary Job costing
large numbers in internal fit and
customised in some way external painting)
for different customers Own-brand foods for
supermarkets
One-off products to a Ships Job costing
customer’s specification Airport facilities
Roads
Bridges
Service organisations
Similar to the manufacturing industry there are a great many different kinds of
service organisations. For example:
 Training and education
 Healthcare
 Travel and tourism
 Financial services
 Entertainment and leisure

One of the key differences between manufacturing and service industries is the
perishability of product – manufacturing output is generally tangible and can be
stored whereas output from the service industry is generally perishable. The
service is normally consumed at the time of delivery (production). For example, a
patient visiting a doctor consumes the consultation as it is given.
However, some work-in-progress (WIP) may be recorded – for example an
accountant who has spent 10 hours working on a tax advice project that will take
20 hours in total to complete. The first 10 hours would be described as WIP.
Costing systems typically used in service organisations include:
 Standard costing
 For example the standard cost of delivering a doctor’s consultation,
the standard cost of a package holiday, the standard cost of a flight
between Lagos and London
 Job costing
 For example bespoke consultation projects in the financial services
industry or the cost of an architect designing a ship
 The professional will usually apply a standard hourly rate whilst the
total number of hours on each job varies
The need to know about costs

All organisations need to understand their costs.
An organisation needs to know:
 how much it costs to make the products that it produces, or
 how much it costs to provide its services to customers.
For an organisation that is required to make a profit, it is important to know the
cost of items in order to:
 make sure that the product or service is sold at a profit;
 measure the actual profit that has been made; and
 in the case of some companies, such as manufacturing companies, value
inventory at the end of each accounting period.
For an organisation that is not required to make a profit (a ‘not-for-profit
organisation’, such as a government department, state-owned agency or charity),
it is important to know how much items cost, in order to:
 control the entity;
 measure to what extent it is achieving its objectives; and
 plan expenditure for the future.

Terminology
Definitions: Cost object

Cost object: Any activity for which a separate measurement of costs is needed
Examples of cost objects include:

 The cost of a product
 The cost of a service
 The cost of a department
 The cost of a project
Definitions: Cost unit

Cost unit: A unit of product or service for which costs are determined
A cost unit is the basic unit of production for which costs are being measured.
The term cost unit should not be confused with the term unit cost.
Definitions: Unit cost

Unit cost is the cost incurred by a company to produce, store and sell one unit of a
particular product.
Unit cost includes all fixed costs and all variable costs involved in production
Cost objects and cost units should be selected so as to provide management

with the cost information they require.
Here are some examples of cost objects and cost units
Industry/activity Cost object Cost unit

Car manufacture Cars produced A car
Bakery Bread produced A batch of bread items
Steel works Steel produced Tonne of steel
Carpet manufacture Carpets produced Square metre of carpet
Retail operation Cost of items sold An item
Passenger transport Cost of transporting Cost per passenger/mile
service customers (i.e. average cost of
transporting a passenger
one mile)
Road haulage Cost of transporting Cost per tonne/mile
items (i.e. average cost of
carrying one tonne of
items for one mile)
University Cost of teaching Cost per student

Examples: Cost objects and cost units

A company manufactures tinned foods.
It has two products, tinned carrots and tinned beans. In its costing system, it has
two cost objects, carrots and beans.
Cost object Cost unit
1 Carrots Production cost per tin of carrots
2 Beans Production cost per tin of beans
Examples: Cost objects and cost units

A transport company has a bus depot.
The company has a cost accounting system that records and measures the cost
of operating the bus depot.
The costs of operating the depot are measured in three ways, as follows:
Cost object Cost unit
1 Buses Operating cost per bus per month
2 Bus routes Operating cost per month for each bus route
3 Bus drivers Cost of operating the depot per month, per bus driver
employed
1.2 Cost classification: Introduction

Costs can be classified in a number of ways including:
 Type of cost (material, labour, other expenses);
 Function of the cost:
 Production
 Non-production
 Selling
 Distribution
 Administration
 Finance
 Cost behaviour – i.e. how the cost varies at different levels of activity:
 costs may stay constant at different levels of activity - fixed costs; or
 costs may stay vary at different levels of activity – variable costs
 Whether the cost can be directly attributed to units of production.
 Whether a cost is recognised in this period (period cost) or is carried
forward as part of the inventory valuation (product cost).
Each of these will be explained in turn but before that note that the above
classifications are not mutually exclusive.

Illustration: Cost classification

A car maker uses steel:
Steel is material.
Steel is a production cost (you cannot make a car without using steel).
Steel is a cost which varies with the number of cars produced.
Steel can be directly attributable to a car.
Steel is a product cost.

2 COST CLASSIFICATION BY TYPE AND FUNCTION
Section overview
 Cost classification by type

 Cost classification by function
 Production or non-production?
 Usefulness of classifying costs by function
 The importance of separating production and non-production costs
 Reporting profit
2.1 Cost classification by type
Material costs
Material costs are the costs of any material items purchased from suppliers, with
the intention of using them or consuming them in the fairly short-term future.
In a manufacturing company, material costs include the cost of the raw materials
that go into producing the manufactured output.
In an office, costs of materials consumed include the costs of stationery and
replacement of printer cartridges for the office laser printers.
Labour costs
Labour costs are the remuneration costs of all employees employed and paid by
the entity. This includes the wages and salaries of part-time workers and the
costs of any bonuses, pension contributions and other items that are paid in
addition to basic wages and salaries.
Other expenses
Other expenses include the costs of any items that are not material costs or
labour costs. They include the cost of services provided by external suppliers (the
charges made by sub-contractors, charges for repairs by external contractors,
rental costs, telephone costs, insurance costs, costs of energy (gas, electricity),
travelling and subsistence expenses, and depreciation charges for non-current
assets.
In a cost accounting system, all these items of cost must be recorded, and there
needs to be an organised system for recording them. Cost items need to be
grouped into categories of similar costs.

2.2 Cost classification by function

A manufacturing company would classify costs according to their function:
categorised as either:
 production costs (manufacturing costs); and
 non-production costs (non-manufacturing costs).
Production costs
Production costs are the costs incurred in manufacturing finished products, up to
the time that the manufacture of the goods is completed, and the goods are
either transferred to the finished goods inventory or delivered immediately to the
customer.
Production costs include:
 the material cost of the raw materials and components, purchased from
suppliers and used in the production of the goods that are manufactured
 the labour cost of all employees working for the manufacturing function,
such as machine operators, supervisors, factory supervisors and the
factory manager
 other expenses of the factory, such as rental costs for the factory building,
energy costs and the cost of depreciation of factory machinery.
Non-production costs
Non-production costs are any items of cost that are not production costs.
Non-production costs can be further classified according to their function as:
 selling costs;
 distribution costs;
 administration costs;
 finance costs.
Administration costs
Administration costs are the costs of providing administration services for the
entity. They might be called ‘head office costs’ and usually include the costs of
the human relations department and accounting department. They should
include:
 the salary costs of all the staff working in the administration departments
 the costs of the office space used by these departments, such as office
rental costs
 other administration expenses, such as the costs of heating and lighting for
the administration offices, the depreciation costs of equipment used by the
administration departments, fees paid to the company’s solicitors for legal
services, costs of office stationery and so on.
Selling and distribution costs (marketing costs)

Selling and distribution costs are the costs incurred in marketing and selling
goods or services to customers, and the costs of delivering the goods to
customers. The costs of after-sales services, such as customer support services,
are usually included in these costs. Sales and distribution costs include:

 the wages and salary costs of all employees working in the selling and
distribution departments, including sales commissions for sales
representatives
 advertising costs and other marketing costs
 operating costs for delivery vehicles (for delivering finished goods to
customers), such as fuel costs and vehicle repair costs
 other costs, including depreciation costs for the delivery vehicles.
Finance costs
Finance costs include costs that are involved in financing the organisation, for
example, loan interest or bank overdraft charges.
Finance costs might be included in general administration costs. Alternatively,
finance costs might be excluded from the cost accounting system because they
are relevant to financial reporting (and the financial accounting system) but are
not relevant to the measurement of costs.
2.3 Production or non-production?

Some costs might be partly production costs, partly administration costs and
partly sales and distribution costs. For example:
 The salary of the managing director, because the managing director
spends time on all aspects of the company’s operations.
 Building rental costs, when the same building is used by more than one
function. For example administration staff and sales staff might share the
same offices.
When costs are shared between two or more functions, they are divided between
the functions on a fair basis.
For example, the salary of the managing director might be divided equally
manufacturing costs, administration costs and sales and distribution costs.
Dividing shared costs on a fair basis is called apportionment of the cost.
Practice question 1
A company uses three categories of functional cost in its cost accounting
system. These are manufacturing costs, administration costs and sales and
distribution costs.
Identify the functional cost category for each of the following costs:
1 Salary of the chief accountant
2 Telephone charges
3 Cost of office cleaning services
4 Cost of warehouse staff

2.4 Usefulness of classifying costs by function

Separating costs into the costs for each function can provide useful information
for management.
Functional costs show managers what they are expected to spend on each
function (budgeted costs) and how much they are actually spending.
Example:
Functional costs might be used in an income statement to report the profit or loss
of a company during a financial period, as follows:
₦m ₦m
Sales revenue 600
Manufacturing cost of sales 200
Gross profit 400
Administration costs 120
Selling and distribution costs 230
350
Net profit (or net loss) 50
2.5 The importance of separating production and non-production costs

Inventory
It is important to separate production costs from non-production costs in a
manufacturing business for the purpose of valuing closing inventory which will
consist of:
 finished goods that have been produced during the financial period but not
yet sold (finished goods inventory); and
 partly finished production (work-in-progress or WIP).
The costs of finished goods and work-in-progress consist of their production
costs.
Total production costs during a period must therefore be divided or shared
between:
 goods produced and sold in the period;
 goods produced but not yet sold (finished goods);
 work-in-progress.
Non-production costs are never included in the cost of inventory.

2.6 Reporting profit

Profit is the revenue for a financial period minus the costs for the period. The
profit or loss earned during a financial period is reported in a statement of
comprehensive income (also known as an income statement).
In most financial accounting examples the cost of sales figure is built from
purchases as adjusted by inventory movement.
It is comprised of the cost of goods made (instead of purchases) as adjusted by
finished goods inventory movement. The cost of goods made is a more complex
figure than purchases. It comprises direct materials used, direct labour and
production overheads adjusted by movement in work in progress in the year. It is
often constructed in a manufacturing account. The total from this account feeds
into the statement of comprehensive income.
Illustration: Manufacturing account

₦ ₦
Raw materials
Opening inventory 25,000
Purchases 150,000
Raw materials available 175,000
Less: Closing inventory (20,000)
Raw materials consumed 155,000
Manufacturing wages 100,000
Prime cost 255,000
Overheads
Light and power 72,000
Depreciation of production machinery 40,000
Depreciation of factory 50,000
162,000
Manufacturing costs 417,000
Add: Opening work in progress 85,000
Less: Closing work in progress (95,000)
Cost of goods made 407,000
The cost of goods made is transferred to the statement of comprehensive

income.

Illustration: Statement of comprehensive income to show transfer of cost of goods

made.
₦ ₦
Sales revenue 800,000
Less cost of goods sold
Opening inventory of finished goods 50,000
Cost of goods made 407,000
457,000
Closing inventory of finished goods (40,000)
Cost of sales (417,000)
Gross profit 383,000
Administration costs 86,000
Selling and distribution costs 94,000
(180,000)
Net profit for the period 203,000

3 FIXED AND VARIABLE COSTS
Section overview
 Cost behaviour
 Fixed costs
 Variable costs
 Semi-variable costs
 Stepped costs
3.1 Cost behaviour

Cost behaviour refers to the way in which costs change as the volume of activity
changes. The volume of activity may be:
 the volume of sales;
 the volume of production;
 total labour hours worked, machine hours worked;
 the number of production units inspected;
 the number of journeys (for buses or trains) or deliveries, and so on.
As a general rule, total costs are expected to increase as the volume of activity
rises.
Management might want information about estimated costs, or about what costs
should have been. An understanding of cost behaviour is necessary in order to:
 forecast or plan what costs ought to be; and
 compare actual costs that were incurred with what the costs should have
been.
The most important classification of costs for the purpose of cost estimation is the
division of costs into fixed costs or variable costs.
3.2 Fixed costs

Fixed costs are items of cost that remain the same in total during a time period,
no matter how many units are produced, and regardless of the volume or scale of
activity.
Fixed costs might be specified for a given period of time. In such cases the fixed
costs for a longer period would be scaled up.
Examples of fixed costs include:
 The rental cost of a building is ₦40,000 per month. The rental cost is fixed
for a given period: ₦40,000 per month, or ₦480,000 per year.
 The salary costs of a worker who is paid ₦11,000 per month. The fixed cost
is ₦11,000 per month or ₦132,000 per year.
Note that as activity levels increase the cost remains fixed. However, the cost per
unit falls because the cost is being spread over a greater number of units.

3.3 Variable costs

Variable costs are costs that increase, usually by the same amount, for each
additional unit of product that is made or each additional unit of service that is
provided.
The variable cost of a cost unit is also called the marginal cost of the unit.
The variable cost per unit is often the same amount for each additional unit of
output or unit of activity.
This means that total variable costs increase in direct proportion to the total
volume of output or activity.
Examples of variable cost items.
 The cost of buying raw material is ₦500 per litre regardless of purchase
quantity. The variable cost is ₦500 per litre:
 the total cost of buying 1,000 litres is ₦500,000
 the total cost of buying 2,000 litres would be ₦1,000,000.
 The rate of pay for hourly-paid workers is ₦150 per hour.
 400 hours of labour would cost ₦60,000; and
 500 hours would cost ₦75,000.
 The time needed to produce an item of product is 4 minutes and labour is
paid ₦150 per hour.
 direct labour is a variable cost and the direct labour cost per unit
produced is ₦10 (= ₦150 × 4/60).
 The cost of telephone calls is ₦1 per minute.
 The cost of telephone calls lasting 6,000 minutes in total would be
₦6,000.
Note that as activity levels increase the cost per unit remains fixed. However, the
total cost increases as more units are being made.

Cost behaviour graphs: fixed and variable costs

Cost behaviour for items of cost (or for costs in total) can be shown graphically
either showing the total cost incurred at different activity levels or the cost per
item at different activity levels.
Illustration: Cost behaviour graphs for fixed costs and variable costs
3.4 Semi-variable costs

A semi-variable cost, is a cost that is partly fixed and partly variable. A cost
behaviour graph showing the total costs for an item of mixed cost is shown
below.
Illustration: Semi variable costs
An item of cost that is a mixed cost is an item with a fixed minimum cost per
period plus a variable cost for every unit of activity or output.

Example: Semi variable costs

A company uses a photocopier machine under a rental agreement. The
photocopier rental cost is ₦4,000 per month plus ₦2 per copy produced.
The company makes 15,000 copies during a month:
Total cost is as follows:

₦
Fixed cost 4,000
Variable cost (15,000  ₦2) 30,000
34,000
Mixed costs are important in cost and management accounting. It is often

assumed that the total costs of an activity are mixed costs, consisting partly of
fixed costs and partly of variable costs.
For example, it might be assumed that the total selling and distribution costs for a
company each month are mixed costs. If this assumption is used, the total mixed
costs can be divided into two separate parts, fixed costs and variable costs.
If costs can be analysed as a fixed amount of cost per period plus a variable cost
per unit, estimating what future costs should be, or what actual costs should have
been, becomes fairly simple.
Example: Cost forecasting

The management accountant of a manufacturing company has estimated that
production costs in a factory that manufactures Product Y are fixed costs of
₦250,000 per month plus variable costs of ₦30 per unit of Product Y output.
The expected output next month is 120,000 units of Product Y.
Expected total costs are therefore:
₦
Variable costs (120,000 × ₦30) 3.600,000
Fixed costs 250,000
Total costs 3,850,000
Forecasting is covered in more detail in a later chapter.

3.5 Stepped cost

A stepped fixed cost is a cost which:
 has a fixed cost behaviour pattern within a limited range of activity, and
 goes up or down in steps when the volume of activity rises above or falls
below certain levels.
On a cost behaviour graph, step fixed costs look like steps rising from left to right.
Illustration: Stepped cost

Total cost
Activity level
Example: Stepped cost

A company might pay its supervisors a salary of ₦20,000 each month.
When production is less than 2,000 hours each month, only one supervisor is
needed:
When production is between 2,001 and 4,000 hours each month, two supervisors
are needed.
When output is over 4,000 hours each month, three supervisors are needed.
The cost profile is as follows:
Activity level: ₦
2,000 hours or less (1  ₦20,000) 20,000
2,001 to 4,000 (2  ₦20,000) 40,000
Over 4,000 (3  ₦20,000) 60,000
The supervision costs are fixed costs within a certain range of output, but
go up or down in steps as the output level rises above or falls below
certain levels.

Practice questions 2
On the axes provided, on which the vertical axis denotes cost and the
horizontal axis the appropriate level of activity, show the following cost
behaviour graphs:
(a) Fixed costs
(b) Variable costs
(c) Semi-variable costs
(d) Annual rates bill
(e) Direct labour cost
(f) Annual telephone bill
(g) Direct materials cost if bulk discount is offered on all purchases
once the total purchased exceeds a certain level
(h) Supervisory costs
(i) Labour costs if staff are paid a fixed weekly wage for a 35-hour
week and any additional production is completed in overtime, when
staff are paid time and a half.
(a) (b) (c)
(d) (e) (f)
(g)
(h) (i)

Practice question 3
1 From the information in this cost behaviour graph, describe the
behaviour of this item of cost, and calculate the total cost at 10,000
units of output.

4 DIRECT AND INDIRECT COSTS
Section overview
 Introduction
 Direct costs
 Indirect costs (overheads)
 Full cost
4.1 Introduction
Costs may also be classified as:
 direct costs; or
 indirect costs (also known as overheads).
There are direct and indirect material costs, direct and indirect labour costs and
direct and indirect expenses.
4.2 Direct costs
Definition: Direct costs

Direct costs: Costs that can be traced in full to a cost unit.
A direct cost can be attributed in its entirety to the cost of an item that is being
produced.
For example, in a manufacturing company that produces television sets, the

direct cost of making a television consists of direct materials and direct labour
costs, and possibly some direct expenses.
 The direct materials cost is the cost of the raw materials and components
that have gone into making the television.
 The direct labour cost is the cost of the labour time of the employees who
have been directly involved in making the television.
Direct materials
Definition: Direct materials

Direct materials are all materials that become part of the cost unit.
Direct materials are all materials that can be attributed directly in full to a cost
unit.
They are used directly in the manufacture of a product or in providing a service.

Direct materials may consist of either or both:

 raw materials, such as glass, metals and chemicals
 components purchased from an external supplier: for example the direct
materials of a car manufacturer include components purchased from other
suppliers, such as windows, wheels and tyres.
Examples of direct materials include:
Example: Direct materials
Cost unit Direct materials

Pair of shoes Leather, glue, nails, laces
Office chair Wheels, a stand, a seat (with seat cushion), back
rest, arm rests and fabric
Restaurant meal Ingredients
Car Steel, aluminium, windows, lights, gear box,
engine, wheels etc.
House Bricks, wood, cement
Services might also incur some direct materials costs. For example, with catering
and restaurant services the direct materials include the major items of food (and
drink).
Direct labour
Definition: Direct labour

Direct labour is labour time that can be attributed directly in full to a cost unit.
Direct labour costs are the specific costs associated with the labour time spent
directly on production of a good or service.
Labour costs are direct costs for work done by direct labour employees. Direct
labour employees are employees whose time is spent directly on producing a
manufactured item or service.
Example: Direct labour employees
Cost unit Direct labour

Car Machinists working in the machining department
Assembly workers in the assembly department
Workers in the spray painting shop
House Bricklayers are direct labour employees of a
house-building firm
Tonne of coal Miners

Direct labour costs also include the cost of employees who directly provide a
service.
Example: Direct labour employees (service industry).
Cost unit Direct labour

Day of storage Warehouse staff
Audit (other Professional staff
consultancy product)
Teaching day Teachers (tutorial staff at a college)
Direct expenses
Definition: Direct expenses

Direct expenses are expenses that can be attributed directly in full to a cost unit.
Direct expenses are expenses that have been incurred in full as a direct
consequence of making a unit of product, or providing a service, or running a
department.
In manufacturing, direct expenses are not common for manufactured units of

output, and direct costs normally consist of just direct materials and direct labour
costs.
Example: Direct expenses
Cost unit Direct expense

A house Hire of equipment (for example a cement mixer)
Payment of fees to sub-contractors.
Prime cost
The prime cost of an item is its total direct cost.
Definition: Prime cost

The prime cost of a cost unit is the sum of all of the direct costs of making that
unit.
Illustration: Prime cost

₦
Direct material cost X
Direct labour cost X
Direct expenses X
Prime cost X

4.3 Indirect costs (overheads)
Definition: Indirect cost

An indirect cost (overhead cost) is any cost that is not a direct cost.
Indirect costs (overheads) cannot be attributed directly and in full to a cost unit.
Indirect costs include production overheads and non-production overheads. Each

of these might include indirect materials costs, indirect labour costs and indirect
expenses costs.
Indirect material costs

Indirect materials are any materials that are used or consumed that cannot be
attributed in full to the item being costed. Indirect materials are treated as an
overhead cost, and may be classified as production overheads, administration
overheads or sales and distribution overheads.
Indirect materials in production include cleaning materials and any materials used
by production departments or staff who are not engaged directly in making a
product.
Indirect production materials may also include some items of materials that are
inexpensive and whose cost or value is immaterial. These may include nails, nuts
and bolts, buttons and thread, and so on. The effort of measuring a cost for these
materials is not worth the value of the cost information that would be produced;
therefore these ‘direct’ materials are often treated as indirect materials.
Practice question 4
In which of the following types of company would fuel costs be treated as a
direct material cost?
1 Manufacturing company
2 Road haulage (road transport) company
3 Construction company
4 Motorway fuel station
Indirect labour costs

Indirect labour costs consist mainly of the cost of indirect labour employees.
Indirect labour employees are individuals who do not work directly on the items
that are produced or the services that are provided.
Some factory workers do not work directly in the production of cost units but are
necessary so that production takes place. In a manufacturing environment,
indirect labour employees include staff in the stores and materials handling
department (for example, fork lift truck drivers), supervisors, and repairs and
maintenance engineers.
All employees in administration departments and marketing departments (sales
and distribution staff) – including management – are normally indirect employees.

Indirect expenses
Many costs incurred cannot be directly linked to cost units.
For example, the rental costs for a factory and the costs of gas and electricity
consumption for a factory cannot be attributed in full to any particular units of
production. They are indirect production costs (production overheads).
In a manufacturing company, all costs of administration are usually treated as
indirect costs (administration overheads) and all or most sales and distribution
costs are also usually treated as sales and distribution overheads.
4.4 Full cost

The full cost of a unit of product (or the full cost of a unit of service) is a cost that
includes both direct costs and some overheads. The full cost of a unit of product
might be analysed as follows:
Illustration: Full cost

₦
Direct materials cost X
Direct labour cost X
Direct expenses X
Prime cost X
Manufacturing overhead (or production overhead) X
Full production cost X
Non-production costs
Administration overhead X
Selling and distribution overhead X
Full cost of sale X
Notes:
1 Prime cost plus a share of production overheads are the full production cost
or ‘fully absorbed production cost’ of the cost unit.
2 In cost accounting systems, it is common practice to include production
overheads in unit costs and measure the full production cost per unit.
However, administration and selling and distribution overhead costs are not
usually included in the cost of each unit. Instead, they are treated in total as
an expense for the period (‘period costs’ – see below).

5 PRODUCT COSTS AND PERIOD COSTS
Section overview
 Product costs and period costs
5.1 Product costs and period costs

Costs are typically classified as either product costs or period costs when
preparing financial statements.
Definition: Product cost

Product costs are costs associated with goods that are produced or purchased for
resale.
Product costs are accounted for as inventory and held on the balance sheet
(subject to accounting valuation rules) until the inventory is sold. Only when the
inventory is sold are product costs expensed in the profit and loss account.
Product costs include the prime cost (direct materials + direct labour + direct
expenses) plus the production overhead.
Definition: Period cost

Period costs are costs that are deducted as expenses during a particular period.
They do not contribute towards the value of inventory and are therefore not held on
the balance sheet. They are therefore expensed when they occur – i.e. in the period
in which they occurred.
Period costs are the non-production overheads

In summary then
 product costs are expensed when the inventory is sold
 period costs are expensed as soon as they are incurred
Example: A retailer
A retailer owns a shop, employs a shop assistant, invests in sales and advertising
and acquires goods for resale.
The cost of goods purchased for resale is product costs and accounted for as
inventory. These are only expensed when the goods are sold (which may be in a
subsequent accounting period).
The sales and advertising costs and the salary of the shop assistant are period
costs which are expensed immediately in the accounting period in which they were
incurred. Note that the salary of the shop assistant would be called an
administration expense.

6 CHAPTER REVIEW
Chapter review
 Explain the nature and behaviour of costs
 Explain (with examples) fixed, variable, and semi variable costs
 Identify and give examples of fixed, variable, and semi variable costs
 Describe direct and indirect cost
 Identify and give examples of direct and indirect cost
 Explain the terms product cost and period cost

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
1 Chief accountant’s salary. Accounting department costs are an
administration cost, and the salary of the chief accountant is treated in
full as an administration costs.
2 Telephone charges. These are usually treated as administration costs,

unless the charges can be traced directly to telephones in the
manufacturing department or the sales and distribution department.
When charges can be traced directly to telephones in the manufacturing
department, they should be recorded as manufacturing costs.
3 Office cleaning services. These are usually treated as administration

costs, unless the charges can be traced directly to offices used by the
sales and distribution staff, or the production staff.
4 Warehouse staff. These are manufacturing costs when the warehouse is

used to store raw materials and components. They are sales and
distribution costs when the warehouse is used to store finished goods. If
the warehouse stores raw materials and finished goods, the wages costs
should be apportioned between production costs and sales and
distribution costs.
Solutions 2
(a) (b) (c)
(d) (e) (f)
(g) (h) (i)

Solution 3
The cost item is a mixed cost. Up to 5,000 units of output, total fixed
costs are ₦14,000 and the variable cost per unit is ₦(24,000 –
14,000)/5,000 units = ₦2 per unit.
At the 5,000 units of output, there is a step increase in fixed costs of
₦6,000 (from ₦24,000 total costs to ₦30,000 total costs). Total fixed
costs therefore rise from ₦14,000 to ₦20,000. The variable cost per unit
remains unchanged.
At the 10,000 units level, total costs are therefore:
₦
Variable costs (10,000 × ₦2) 20,000
Fixed costs 20,000
Total costs 40,000
Solutions 4
1 Manufacturing company. Fuel costs are an indirect expense. Fuel used in
the company’s vehicles is unlikely to be considered a material cost at all,
but would be treated as an overhead expense.
2 Road haulage company. Since fuel is a major cost of operating a road

haulage service, fuel costs are likely to be treated as a direct material
cost of operations.
3 Construction company. Fuel costs are likely to be an indirect expense,

for the same reasons that apply to a manufacturing company.
4 Motorway service station. This sells fuel to customers. In a retail

operation, items sold to customers are direct costs of sale. The cost of
the fuel sold is therefore a direct material cost (= a cost of sale).


Foundation level
CHAPTER
3
Cost estimation
Contents
1 Cost estimation: high/low method
2 Cost estimation: linear regression analysis
3 Chapter review

INTRODUCTION
Purpose
Competencies
1(b) Identify and calculate the costs of products, services and projects including
process costs
Exam context
This chapter explains the two methods of estimating fixed and variable costs from historical
data.

 Calculate fixed and variable costs by using high-low points method
 Calculate fixed and variable costs by using regression analysis

Chapter 3: Cost estimation
1 COST ESTIMATION: HIGH/LOW METHOD
Section overview
 Cost estimation: analysing fixed and variable costs

 High/low analysis
 High/low analysis and forecasting
 High/low analysis when there is a step change in fixed costs
 High/low analysis when there is a change in the variable cost per unit
1.1 Cost estimation: analysing fixed and variable costs

The previous chapter explained that the importance of semi-variable costs in
accounting.
The total costs associated with a business (or a part of a business, for example a
production line) are the sum of the fixed costs and the variable costs. In other
words, the total is semi variable in nature.
If total costs can be divided into fixed costs and variable costs per unit of output
or unit of activity, a formula for total costs is:
Formula: Total costs

y = a + bx
Where:
y = total costs in a period
x = the number of units of output or the volume of activity in the period
a = the fixed costs in the period
b = the variable cost per unit of output or unit of activity.
The linear cost function equation y = a + bx can be drawn on a cost behaviour

graph as follows.

Illustration: Linear total cost function
Total gradient of cost function = b

cost (variable cost per unit)
y
cost function
y = a + bx
(total cost line)
a = fixed cost
Volume of activity x
The total cost function can be used to estimate costs associated with different
levels of activities. This is very useful in forecasting and decision-making.
There are two methods of constructing the total cost function equation:
 high/low analysis
 linear regression analysis.
1.2 High/low analysis

High/low analysis can be used to estimate fixed costs and variable costs per unit
whenever:
 there are figures available for total costs at two different levels of output or
activity;
 it can be assumed that fixed costs are the same in total at each level of
activity; and
 the variable cost per unit is constant at both levels of activity.
High/low analysis uses two historical figures for cost:

 the highest recorded output level, and its associated total cost
 the lowest recorded output level, and its associated total cost.
It is assumed that these ‘high’ and ‘low’ records of output and historical cost are
representative of costs at all levels of output or activity.
The difference between the total cost at the high level of output and the total cost
at the low level of output is entirely variable cost. This is because fixed costs are
the same in total at both levels of output.

The method
Step 1: Take the activity level and cost for:
 the highest activity level
 the lowest activity level.
Step 2: The variable cost per unit can be calculated as:
difference in total costs
/difference in the number of units.
Step 3: Having calculated a variable cost per unit of activity, fixed cost can be
calculated by substitution into one of the cost expressions. The difference
between the total cost at this activity level and the total variable cost at this
activity level is the fixed cost.
Step 4: Construct the total cost function.
This is best seen with an example.

Example: High/low method

A company has recorded the following costs in the past six months:
Month Production (units) Total cost (₦)
January 5,800 40,300
February 7,700 47,100
March 8,200 48,700
April 6,100 40,600
May 6,500 44,500
June 7,500 47,100
Step 1: Identify the highest and lowest activity levels and note the costs
associated with each level.
Production (units) Total cost (₦)
March 8,200 48,700
January 5,800 40,300
Step 2: Compare the different activity levels and associated costs and
calculate the variable cost:
March 8,200 48,700
January 5,800 40,300
2,400 8,400
Therefore: 2,400 units cost an extra ₦8,400.

Therefore: The variable cost per unit = ₦8,400/2,400 units = ₦3.5 per unit
Step 3: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 8,200 units:
Fixed cost + Variable cost = ₦48,700
Fixed cost + (8,200  ₦3.5) = ₦48,700
Fixed cost + ₦28,700 = ₦48,700
Fixed cost = ₦48,700  ₦28,700 = ₦20,000
Step 4: Construct total cost function

Total cost = a +bx = 20,000 + 3.5x

Note that at step 3 it does not matter whether the substitution of variable cost is
into the high figures or the low figures.
Example: Cost of other levels of activity

Returning to step 3 above but this time substituting into the low figures.
high or low).
Fixed cost + (5,800  ₦3.5) = ₦40,300
Fixed cost + ₦20,300 = ₦40,300
Fixed cost = ₦40,300  ₦20,300 = ₦20,000
1.3 High/low analysis and forecasting

Once derived, the cost function can be used to estimate the cost associated with
levels of activity outside the range of observed data. Thus it can be used to
forecast costs associated with future planned activity levels.

The company is planning to make 7,000 units and wishes to estimate the total
costs associated with that level of production.
Total cost = ₦20,000 + ₦3.5x
Total cost of 7,000 units = ₦20,000 + (₦3.5  7,000) = ₦44,500

1 A manufacturing company has budgeted to operate for 110,500 hours
in the year, which is 85% capacity. Expected total costs for the year are
₦615,200.
The management accountant has also estimated that at 100%
capacity, total annual costs would be ₦662,000.
Required
Using high/low analysis, estimate the variable cost per hour worked
and the total annual fixed costs.
2 Entity Z is trying to obtain a cost estimate for the costs of repairs. The
following monthly repair costs have been recorded for the past six
months.
Number of
Month machines repaired Cost of repairs
₦
1 38 31,000
2 41 32,700
3 25 26,500
4 21 23,600
5 36 29,900
6 32 28,900
Required
Use high/low analysis to estimate the fixed costs of repairs each
month and the variable cost per machine repaired.
Estimate the expected costs of repairs in a month when 30 machines
are repaired.

1.4 High/low analysis when there is a step change in fixed costs

High/low analysis can also be used when there is a step increase in fixed costs
between the ‘low’ and the ‘high’ activity levels, provided that the amount of the
step increase in fixed costs is known.
If the step increase in fixed costs is given in naira value, the total cost of the ‘high’
or the ‘low’ activity level should be adjusted by the amount of the increase, so
that total costs for the ‘high’ and ‘low’ amounts use the same fixed cost figure.
After this adjustment the difference between the high and low costs is solely due
to variable cost. The variable cost can be identified and cost functions
constructed for each side of the step.
The method
Step 1: Take the activity level and cost for:
 the highest activity level
 the lowest activity level.
Step 2: Make an adjustment for the step in fixed costs;
 add the step in fixed costs to the total costs of the lower level of activity; or
 deduct the step in fixed costs from the total costs of the higher level of
activity.
Step 3: The variable cost per unit can be calculated as:
difference in total costs
/difference in the number of units.
Step 4: Having calculated a variable cost per unit of activity, fixed cost can be
calculated by substitution into one of the cost expressions. (use the unadjusted
pair).
Step 5: Construct the total cost function of the unadjusted level.
Step 6: Construct the total cost function for the adjusted level by reversing the
adjustment to its fixed cost.
This is best seen with an example.

Example: High/low method with step in fixed costs

A company has identified that total fixed costs increase by ₦15,000 when activity
level equals or exceeds 19,000 units. The variable cost per unit is constant over
this range of activity.
The company has identified the following costs at two activity levels. (Step 1)
High 22,000 195,000
Low 17,000 165,000
Step 2: Make an adjustment for the step in fixed costs.

High 22,000 195,000
Low (165,000 + 15,000) 17,000 180,000
High 22,000 195,000
Low 17,000 180,000
5,000 15,000

Therefore: The variable cost per unit = ₦15,000/5,000 units = ₦3 per unit
high or low).
Fixed cost + (22,000  ₦3) = ₦195,000
Fixed cost + ₦66,000 = ₦195,000
Fixed cost = ₦195,000  ₦66,000 = ₦129,000
Step 5: Construct total cost function (unadjusted level) above 19,000 units
Total cost = a +bx = 129,000 + 3x
Step 6: Construct total cost function below 19,000 units

Total cost = a +bx = (129,000  15,000) + 3x
Total cost = a +bx = 114,000 + 3x
The cost functions can be used to estimate total costs associated with a level as
appropriate.


Total cost = ₦129,000 + ₦3x
Total cost of 20,000 units = 129,000 + (₦3  20,000) = ₦189,000
The step increase in fixed costs is given as a percentage amount

When the step change in fixed costs between two activity levels is given as a
percentage amount, the problem is a bit more complex.
The costs associated with a third activity level must be found. This activity level
could be either side of the activity level that triggers the step increase in fixed
costs. This means that there are two activity levels which share the same fixed
cost (though it is unknown).These can be compared to identify the variable cost.
The fixed cost at any level can then be calculated by substitution and the fixed
cost the other side of the step can be calculated from the first fixed cost.


A company has identified that total fixed costs increase by 20% when activity level
equals or exceeds 7,500 units. The variable cost per unit is constant over this
range of activity.
The company has identified the following costs at three activity levels. (Step 1)
High 11,000 276,000
Middle 8,000 240,000
Low 5,000 180,000
Step 2: Choose the pair which is on the same side as the step.
High 11,000 276,000
Middle 8,000 240,000
High 11,000 276,000
Middle 8,000 240,000
3,000 36,000

Therefore: The variable cost per unit = ₦36,000/3,000 units = ₦12 per unit
Step 4: Substitute the variable cost into one of the cost functions
Fixed cost + (11,000  ₦12) = ₦276,000
Fixed cost + ₦132,000 = ₦276,000
Fixed cost = ₦276,000  ₦132,000 = ₦144,000
Step 5: Construct total cost function above 7,500 units

Total cost = a +bx = 144,000 + 12x

Total cost = a +bx = (144,000  100/120) + 12x
Total cost = a +bx = 120,000 + 12x
appropriate.

1.5 High/low analysis when there is a change in the variable cost per unit
High/low analysis can also be used when there is a change in the variable cost
per unit between the ‘high’ and the ‘low’ levels of activity. The same approach is
needed as for a step change in fixed costs, as described above.
When the change in the variable cost per unit is given as a percentage amount, a
third ‘in between’ estimate of costs should be used, and the variable cost per unit
will be the same for:
 the ‘in between’ activity level and
 either the ‘high’ or the ‘low’ activity level.
High/low analysis may be applied to the two costs and activity levels for which
unit variable costs are the same, to obtain an estimate for the variable cost per
unit and the total fixed costs at these activity levels. The variable cost per unit at
the third activity level can then be calculated making a suitable adjustment for the
percentage change.


A company has identified that total fixed costs are constant over all levels of
activity but there is a 10% reduction in the variable cost per unit above 24,000
units of activity. This reduction applies to all units of activity, not just the additional
units above 24,000..
The company has identified the following costs at three activity levels. (Step 1)
High 30,000 356,000
Middle 25,000 320,000
Low 20,000 300,000
Step 2: Choose the pair which is on the same side as the change.
High 30,000 356,000
Middle 25,000 320,000
High 30,000 356,000
Middle 25,000 320,000
5,000 36,000

Therefore: The variable cost per unit above 24,000 units
= ₦36,000/5,000 units = ₦7.2 per unit
Therefore: The variable cost per unit below 24,000 units
= ₦7.2 per unit  100/90 = ₦8 per unit
Step 4: Substitute the variable cost into one of the cost functions
Fixed cost + (30,000  ₦7.2) = ₦356,000
Fixed cost + ₦216,000 = ₦356,000
Fixed cost = ₦356,000  ₦216,000 = ₦140,000
Step 5: Construct total cost function above 24,000 units

Total cost = a +bx = 140,000 + 7.2x

Total cost = a +bx = 140,000 + 8x
appropriate.

2 COST ESTIMATION: LINEAR REGRESSION ANALYSIS
Section overview
 The purpose of linear regression analysis

 The linear regression formulae
 Linear regression analysis and forecasting
2.1 The purpose of linear regression analysis

Linear regression analysis is a statistical technique for calculating a line of best fit
from a set of data:
y = a + bx
The data is in ‘pairs’, which means that there are a number of different values for
x, and for each value of x there is an associated value of y in the data.
Linear regression analysis can be used to estimate fixed costs and the variable
cost per unit from historical data for total costs. It is an alternative to the high-low
method.
Linear regression analysis can also be used to predict future sales by projecting
the historical sales trend into the future (on the assumption that sales growth is
rising at a constant rate, in a ‘straight line’).
Regression analysis and high-low analysis compared

There are important differences between linear regression analysis and the high-
low method.
 High-low analysis uses just two sets of data for x and y, the highest value
for x and the lowest value for x. Regression analysis uses as many sets of
data for x and y as are available.
 Because regression analysis calculates a line of best fit for all the available
data, it is likely to provide a more reliable estimate than high-low analysis
for the values of a and b.
 In addition, regression analysis can be used to assess the extent to which
values of y depend on values of x. For example, if a line of best fit is
calculated that estimates total costs for any volume of production, we can
also calculate the extent to which total costs do seem to be linked (or
‘correlated’) to the volume of production. This is done by calculating a
correlation co-efficient, which is explained later.
 Regression analysis uses more complex arithmetic than high-low analysis,
and a calculator or small spreadsheet model is normally needed
In summary, linear regression analysis is a better technique than high-low
analysis because:
 it is more reliable and
 its reliability can be measured.

2.2 The linear regression formulae

Linear regression analysis is a statistical technique for calculating a line of best fit
where there are a number of different values for x, and for each value of x there
is an associated value of y in the data.
The linear regression formulae for calculating a and b are shown below.
Formula: Regression analysis formula

Given a number of pairs of data a line of best fit (y = a + bx) can be constructed by
calculating values for a and b using the following formulae.
∑y b∑x
a= −
n n
∑ − ∑ ∑
=
∑ − (∑ )
Where:
x, y = values of pairs of data.
n= the number of pairs of values for x and y.
= A sign meaning the sum of. (The capital of the Greek letter
sigma).
Note: the term b must be calculated first as it is used in calculating a.
Approach
 Set out the pairs of data in two columns, with one column for the values of
x and the second column for the associated values of y. (For example, x for
output and y for total cost.
 Set up a column for x², calculate the square of each value of x and enter
the value in the x² column.
 Set up a column for xy and for each pair of data multiply x by y and enter
the value in the xy column.
 Sum each column.
 Enter the values into the formulae and solve for b and then a. (It must be in
this order as you need b to find a).
Linear regression analysis is widely used in economics and business. One
application is that it can be used to estimate fixed costs and variable cost per unit
(or number of units) from historical total cost data.
The following example illustrates this use

Example: Linear regression analysis

A company has recorded the following output levels and associated costs in the
past six months:
Month Output (000 Total cost
of units) (₦m)
January 5.8 40.3
February 7.7 47.1
March 8.2 48.7
April 6.1 40.6
May 6.5 44.5
June 7.5 47.1
Required: Construct the equation of a line of best fit for this data.
Working:
x y x2 xy
January 5.8 40.3 33.64 233.74
February 7.7 47.1 59.29 362.67
March 8.2 48.7 67.24 399.34
April 6.1 40.6 37.21 247.66
May 6.5 44.5 42.25 289.25
June 7.5 47.1 56.25 353.25
41.8 268.3 295.88 1,885.91
= x = y = x2 = xy
n ∑ xy − ∑ x ∑ y 6(1,885.91) − (41.8)(268.3)
b= =
n ∑ x − (∑ x) 6(295.88) − (41.8 )
11,315.46 − 11,214.94 100.52
= = = 3.585
1,775.28 − 1,747.24 28.04
This is the cost in millions of naira of making
1,000 units
∑y b∑x 268.3 3.585(41.8)
a= − a= −
n n 6 6
a = 44.72 − 24.98 = 19.74
Line of best fit: = +
= 19.74 + 3.585

2.3 Linear regression analysis and forecasting

Once derived, the cost function can be used to estimate the cost associated with
levels of activity outside the range of observed data. Thus it can be used to
forecast costs associated with future planned activity levels.
Example: Linear regression analysis

= 19.74 + 3.585
= 19.74 + 3.585 × 9
= 52.00
Linear regression analysis can also be used to forecast other variables (e.g.
demand, sales volumes etc.).
This is done by constructing an equation to describe a change in value over time.
Regression analysis is carried out in the usual way with time periods identified as
the independent variable. The dependent variable under scrutiny can then be
estimated for various periods into the future.
This rests on the assumption that a linear trend in the past will continue into the
future.

3 CHAPTER REVIEW
Chapter review
 Calculate fixed and variable costs by using high-low points method
 Calculate fixed and variable costs by using regression analysis


Solutions 1
1 110,500 hours = 85% capacity.
Therefore 100% capacity = 110,500 hours/85% = 130,000 hours.
hours ₦
High: Total cost of 130,000 = 662,000
Low: Total cost of 110,500 = 615,200
Difference: Variable cost of 19,500 = 46,800
Therefore the variable cost per hour = ₦46,800/19,500 hours = ₦2.40.
Substitute in high equation Cost

₦
Total cost of 130,000 hours 662,000
Variable cost of 130,000 hours ( ₦2.40) 312,000
Therefore fixed costs 350,000
2 hours ₦
High: Total cost of 41 = 32,700
Low: Total cost of 21 = 23,600
Difference: Variable cost of 20 = 9,100
Therefore variable cost per unit repaired = ₦9,100/20 hours = ₦455.
Substitute in low equation Cost

₦
Total cost of 21 units 23,600
Variable cost of 21 units ( ₦455) 9,555
Therefore fixed costs per month 14,045
Cost estimate for 30 units Cost

₦
Fixed costs 14,045
Variable cost of 30 units (x ₦455) 13,650
Estimated total costs 27,695
If this estimate is used to prepare a budget for a period, it might be rounded

to a convenient number, say ₦27,700.

Foundation level
CHAPTER
4
Inventory valuation
Contents
1 Valuation of inventory
2 Comparison of methods
3 Chapter review

INTRODUCTION
Purpose
Competencies
process costs
Exam context
This chapter explains the measurement of inventories of items.

 Measure inventory at the lower of cost and net realisable value
 Explain and apply FIFO
 Explain and apply AVCO

Chapter 4: Inventory valuation
1 VALUATION OF INVENTORY
Section overview
 Basic rule: Lower of cost and NRV

 Cost formulas
 First-in, first-out method of valuation (FIFO)
 Weighted average cost (AVCO) method
1.1 Basic rule: Lower of cost and NRV

The valuation of inventory can be extremely important for financial reporting,
because the valuations affect both the cost of sales (and profit) and also total
asset values in the statement of financial position.
Inventory must be measured in the financial statements at the lower of:
 cost, or
 net realisable value (NRV).
Net realisable value is the amount that can be obtained from disposing of the
inventory in the normal course of business, less any further costs that will be
incurred in getting it ready for sale or disposal.
 Net realisable value is usually higher than cost. Inventory is therefore
usually valued at cost.
 However, when inventory loses value, perhaps because it has been
damaged or is now obsolete, net realisable value will be lower than cost.
The cost and net realisable value should be compared for each separately-
identifiable item of inventory, or group of similar inventories, rather than for
inventory in total.
Example: Lower of cost and NRV

A business has four items of inventory. A count of the inventory has established
that the amounts of inventory currently held, at cost, are as follows:
₦ ₦ ₦
Cost Sales price Selling costs
Inventory item A1 8,000 7,800 500
Inventory item A2 14,000 18,000 200
Inventory item B1 16,000 17,000 200
Inventory item C1 6,000 7,500 150
The value of closing inventory in the financial statements:

Lower of: ₦
A1 8,000 or (7,800 – 500) 7,300
A2 14,000 or (18,000 – 200) 14,000
B1 16,000 or (17,800 – 500) 16,000
C1 6,000 or (7,000 – 200) 6,000
Inventory valuation 43,300

1.2 Cost formulas

With some inventory items, particularly large and expensive items, it might be
possible to recognise the actual cost of each item.
In practice, however, this is unusual because the task of identifying the actual
cost for all inventory items is impossible because of the large numbers of such
items.
A system is therefore needed for measuring the cost of inventory.
The historical cost of inventory is usually measured by one of the following
methods:
 First in, first out (FIFO)
 Weighted average cost (AVCO)
Illustration
On 1 January a company had an opening inventory of 100 units which cost ₦50
each.
During the month it made the following purchases:
5 April: 300 units at ₦60 each
14 July: 500 units at ₦70 each
22 October: 200 units at ₦80 each.
During the period it sold 800 units as follows:
9 May: 200 units
25 July: 200 units
23 November: 200 units
12 December: 200 units
This means that it has 300 units left (100 + 300 + 500 + 200) – (200 + 200 + 200
+ 200 + 200)) but what did they cost?
There are various techniques that have been developed to answer this question.
The easiest of these is called FIFO (first in first out). This approach assumes that
the first inventory sold is always the inventory that was bought on the earliest date.
This means closing inventory is always assumed to be the most recent purchased.
In the above example a FIFO valuation would assume that the 300 items left were
made up of the 200 bought on 22 October and 100 of those bought on 14 July
giving a cost of ₦23,000 {i.e. (200 @ 80) + (100 @ 70)}

1.3 First-in, first-out method of valuation (FIFO)

The FIFO and weighted average cost (AVCO) methods of inventory valuation are
used within perpetual inventory systems. They can also be used to establish a
cost for closing inventory with the period-end inventory system.
With the first-in, first-out method of inventory valuation, it is assumed that
inventory is consumed in the strict order in which it was purchased or
manufactured. The first items that are received into inventory are the first items
that go out.
To establish the cost of inventory using FIFO, it is necessary to keep a record of:
 the date that units of inventory are received into inventory, the number of
units received and their purchase price (or manufacturing cost)
 the date that units are issued from inventory and the number of units
issued.
With this information, it is possible to put a cost to the inventory that is issued
(sold or used) and to identify the cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units
that are used, it follows that the value of inventory at any time should be the cost
of the most recently-acquired units of inventory.
Example (as before)

each.
9 May: 200 units
25 July: 200 units
Inventory movement can be shown on a cost ledger card as follows.

Example: Inventory ledger card (FIFO)
Receipts Issues Balance

Date Qty @ ₦ Qty @ ₦ Qty @ ₦
1 Jan
b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 50/60 23,000
9 May 100 50 5,000 100 50 5,000
100 60 6,000 100 60 6,000
200 50/60 11,000 (200) 50/60 (11,000)
200 60 12,000
14 Jul 500 70 35,000 500 70 35,000
700 60/70 47,000
25 Jul 200 60 12,000 (200) 60 12,000
500 70 35,000
22 Oct 200 80 16,000 200 80 16,000
700 70/80 51,000
23 Nov 200 70 14,000 (200) 70 (14,000)
500 70/80 37,000
12 Dec 200 70 14,000 (200) 70 (14,000)
1,100 74,000 800 51,000 300 70/80 23,000
Note: 1,100 minus 800 equals 300
74,000 minus 51,000 equals 23,000

1.4 Weighted average cost (WAVCO) method

With the weighted average cost (WAVCO) method of inventory valuation it is
assumed that all units are issued at the current weighted average cost per unit.
The normal method of measuring average cost is the perpetual basis method.
With the perpetual basis WAVCO method, a new average cost is calculated
whenever more items are purchased and received into store. The weighted
average cost is calculated as follows:
Formula: Average cost

Cost of inventory currently in store + Cost of new items received
Number of units currently in store + Number of new units received
Example (as before)

each.
9 May: 200 units
25 July: 200 units
Inventory movement can be shown on a cost ledger card as follows:

Example: Inventory ledger card (weighted average method)
Receipts Issues Balance

Date Qty @ ₦ Qty @ ₦ Qty @ ₦
1 Jan
b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 57.5 23,000
9 May 200 57.5 11,500 (200) 57.5 (11,500)
200 57.5 11,500
14 Jul 500 70 35,000 500 70 35,000
700 66.43 46,500
25 Jul 200 66.43 13,286 (200) 66.43 (13,286)
500 66.43 33,214
22 Oct 200 80 16,000 200 80 16,000
700 70.31 49,214
23 Nov 200 70.31 14,062 (200) 70.31 (14,062)
500 70.31 35,152
12 Dec 200 70.31 14,062 (200) 70.31 (14,062)
1,100 74,000 800 52,910 300 70/80 21,090
Note: 1,100 minus 800 equals 300
74,000 minus 52,910 equals 21,090

2 COMPARISON OF METHODS
Section overview
 Choice of inventory valuation method

 Costing of issues from inventory and inflation
 Advantages and disadvantages of FIFO
 Advantages and disadvantages of AVCO
2.1 Choice of inventory valuation method

The value of inventory and the cost of materials issued and used in the period
are determined by a selected inventory valuation method, such as FIFO, LIFO,
weighted average cost or standard cost. (Note: LIFO – Last-in first-out, is outside
the scope of this syllabus).
The choice of valuation method – FIFO, weighted average cost, LIFO – therefore
affects the reported profit for each period.
LIFO is not allowed as a valuation method in financial reporting, but it may be
used in cost accounting systems, which are not governed by the rules of
accounting standards and external financial reporting.
2.2 Costing of issues from inventory and inflation

As a general rule, the different methods of inventory valuation will give
significantly different valuations for the cost of sales and the value of closing
inventory during a period of high inflation.
 With FIFO during a period of high inflation, the cost of sales will be lower
than the current replacement cost of materials used. The closing inventory
value should be close to current value since they will be the units bought
most recently (‘last’).
 With AVCO during a period of high inflation, the cost of sales will be higher
and the value of closing inventory lower than with FIFO valuation.
In the example used above to illustrate FIFO and AVCO, prices were rising and
the valuations of the cost of goods issued and closing inventory were as follows:
Example: FIFO vs AVCO when prices are rising

Valuation method Cost of goods issued Closing inventory
₦ ₦
FIFO 5,100 2,300
AVCO 5,290 2,110
The valuation of closing inventory is higher and the cost of goods issued is lower
using FIFO. This is typical during a period when prices are rising steadily.
The opposite is true when prices are falling. The valuation of closing inventory is
lower and the cost of goods issued is higher using FIFO.

2.3 Advantages and disadvantages of FIFO
Advantages
 Logical (probably represents physical reality)
 Easy to understand and explain to managers
 Gives a value near to replacement cost
Disadvantages
 Can be cumbersome to operate
 Managers may find it difficult to compare costs and make decisions when
they are charged with varying prices for the same materials
 In a period of high inflation, inventory issue prices will lag behind current
market value
2.4 Advantages and disadvantages of AVCO
Advantages
 Smoothes out price fluctuations
 Easier to administer than FIFO and LIFO
Disadvantages
 Issue price is rarely what has been paid
 Prices tend to lag a little behind current market values when there is
gradual inflation

3 CHAPTER REVIEW
Chapter review
 Measure inventory at the lower of cost and net realisable value
 Explain and apply FIFO
 Explain and apply AVCO


Foundation level
CHAPTER
5
Accounting for overheads
Contents
1 Manufacturing overheads
2 Introduction to absorption costing
3 Stages in absorption costing
4 Overhead apportionment
5 Apportionment of service department costs
6 Overhead absorption
7 Under-absorbed and over-absorbed overheads
8 Fixed and variable overheads
9 Chapter review

INTRODUCTION
Purpose
application of quantitative methods in financial management
Competencies
1(a) Classify costs for different purposes including identifying fixed and variable,
product and period, direct and indirect and costs by nature, function and
purpose
process costs
1(c) Identify and calculate unit costs and the effect of different costing methods on
reported financial results using marginal and absorption costing approaches
Exam context
This chapter explains overheads in more detail and shows how manufacturing overheads
can be included in production costs.

 Explain the meaning of overheads
 Identify manufacturing and non-manufacturing overheads
 Explain allocation and apportionment and apply the techniques to identify the total
overhead costs associated with different departments (including techniques of
secondary apportionment)
 Explain absorption
 Calculate departmental overhead absorption rates from data supplied
 Calculate the overhead costs absorbed by applying overhead absorption rate in an
appropriate manner
 Calculate and account for over and under absorption of overhead

Chapter 5: Accounting for overheads
1 MANUFACTURING OVERHEADS
Section overview
 Direct and indirect expenses

 Manufacturing, administration and selling costs
1.1 Direct and indirect expenses

Chapter 2 introduced and explained costing terminology.
The following table provides a classification which shows how the terms may be
combined in a way that is useful in providing costing information.
Part of
inventory Examples
value?
Direct costs (always
variable):
Direct materials Yes Raw materials and components
Direct labour Yes Factory labour
Direct expenses Yes Any incidental expense related
directly to production, for
example machine hire, sub-
contractor fees etc.
Indirect costs (overheads)
Variable production Yes Electricity to operate machinery
(manufacturing) Small consumables (small parts,
lubricants etc.)
Variable non-production No Finance costs
(manufacturing) Sales bonuses
Distribution costs (delivering
goods to customers)
Fixed production Depends on Factory rent
(manufacturing) the costing Supervisors’ salaries
system
Depreciation of production
machinery
Fixed non-production No Depreciation of non-production
(manufacturing) assets.
Salaries of non-production staff
Occupancy expenses for non-
production facilities (rent, light,
heat, property taxes,
maintenance, etc.)
Insurance.
Direct and indirect costs are treated differently.

Direct costs are charged directly to the cost of production. They are directly
identified with cost units, batches of production, a production process or a job or
a contract.
Overheads are indirect costs, and cannot be identified directly with specific cost
units, jobs or processes etc. They are therefore recorded as overhead costs, and
a distinction is made between production overheads (overheads occurring for
example in the factory where the product is produced), administration overheads
and sales and distribution (marketing) overheads.
Fixed production overhead costs can then be treated in either of two ways.
 Method 1 – Marginal costing. They might be treated as period costs, and
charged as an expense against the period in which they are incurred,
without any attempt to add a share of the fixed overhead costs to the cost
of units of production.
 Method 2 – Absorption costing. They might be shared out between cost
units or processes. Fixed production overhead costs might be charged to
cost units in addition to direct material, direct labour and variable overhead
so that the cost of goods sold (cost units) fairly reflects the actual cost of
production. When fixed production overheads are charged to cost units
they are said to be absorbed by them.
The next chapter explains marginal costing and the different methods on profit
measurement.
This chapter explains absorption costing in more detail but first talks more about
the different types of cost.
1.2 Manufacturing, administrative and selling costs
Manufacturing costs
Manufacturing costs are product costs. They are the costs of making cost units
and are included as part of the cost of inventory in accordance with financial
reporting rules (set out in IAS 2: Inventories).
IAS 2 says that “the cost of inventories shall comprise all costs of purchase, costs
of conversion and other costs incurred in bringing the inventories to their present
location and condition”.
Costs of conversion include costs directly related to the units of production, such
as direct labour. They also include a systematic allocation of fixed and variable
production overheads that are incurred in converting materials into finished
goods.
Fixed production overheads are indirect costs of production that remain relatively
constant regardless of the volume of production. They include depreciation and
maintenance of factory buildings and equipment, and the cost of factory
management and administration.
Variable production overheads are those indirect costs of production that vary
directly, or nearly directly, with the volume of production, such as indirect
materials and indirect labour.
Selling and administrative costs are overheads by definition (because they
cannot be direct costs). These costs are not “incurred in bringing the inventories
to their present location and condition”.

Selling costs
Selling overheads are expenses related to the process of selling inventory to
customers rather than the actual production of the inventory. Selling overhead
might be incurred before the production of the inventory in cases where sales
people obtain orders in advance of production but it is more commonly
associated with costs incurred after the inventory is complete.
Selling overheads include distribution costs where these relate to transferring
goods to customers.
Selling costs are period costs and are expensed in the period to which they
relate.
Some administration costs might be manufacturing costs, for example the factory
management might be said to have an administrative function. However, the term
administration generally relates to the functions necessary for the overall running
of the business.
These are costs like accountancy, human resources and purchasing.
Administration costs are period costs and are expensed in the period to which
they relate.
Overhead Classification
Factory machinery Manufacturing overhead
Factory insurance Manufacturing overhead
Salary of the Finance Director Administration overhead
Depreciation of the accounts clerk’s Administration overhead
computer
Petrol used in delivery vehicles Selling overhead
Cost of an advertising campaign Selling overhead

2 INTRODUCTION TO ABSORPTION COSTING
Section overview
 Introduction
 Absorption costing
 Commentary on absorption costing
2.1 Introduction
Manufacturing companies are concerned to understand what units have cost
them to produce or will cost them to produce in the future.
Absorption costing adds a share of fixed production overhead to direct material,
direct labour and variable overhead to obtain a ‘full cost’ or a ‘fully absorbed cost’
for cost units.
Consider the following.
Example: Unit cost

₦ (000)
Direct materials 50
Direct labour 20
Variable overhead 8
Marginal production cost 78
Fixed production overhead 24
Total absorption cost 102
This chapter explains the methods that are used to calculate the amount of fixed
production overhead costs to add to unit costs in order to obtain a full cost per
unit. It tries to explain how a company arrives at the figure for fixed production
overhead (₦24,000 above).
2.2 Absorption costing

Absorption costing measures cost of a product or a service as:
 its direct costs (direct materials, direct labour and sometimes direct
expenses and variable production overheads); plus
 a share of fixed production overhead costs
It is a system of costing in which a share of fixed overhead costs is added to
direct costs and variable production overheads, to obtain a full cost.
This might be:
 a full production cost, or
 a full cost of sale

Illustration:
₦ in ‘000 ₦ in ‘000
Sales 950
Cost of inventory at the beginning of the period 80
Production cost of items manufactured in the
period:
Direct materials 280
Direct labour 120
Direct expenses (if any) 0
Variable overhead 40
Fixed production overhead added to cost
(‘absorbed’) 200
640
720
Less: Cost of inventory at the end of the period (120)
Production cost of items sold (600)
Gross profit 350
Administration overhead 100
Selling and distribution overhead 200
(300)
Net operating profit 50
Inventory valuation is an important feature of absorption costing, because the

cost of production in any period depends partly on the valuation of opening and
closing inventory, including work-in-progress and finished goods inventory.
2.3 Commentary on absorption costing

Absorption costing is necessary to measure the cost of inventory for financial
reporting purposes. It can be argued that inventory should be valued in a similar
way in the cost accounting system. (However, inventory valuations may differ
between the cost accounts and the financial accounts).
There is also a view that in order to assess the profitability of products or
services, it is appropriate to charge products and services with a fair share of
overhead costs.
Unless products contribute sufficiently to covering indirect costs, its ‘profitability’
might be too low, and the business as a whole might not be profitable.
However, the technique is open to criticism as follows:
 The methods used to charge fixed production overhead costs to products
often rely on fairly arbitrary assumptions.
 Absorption costing does not provide cost information to help managers
make decisions (relevant costs). Marginal costing and relevant costs are
explained in later chapters.

Also, it has been argued by many that absorption costing is no longer relevant in
a modern manufacturing environment. It originated at a time when manufacturing
was labour intensive and total overhead costs were small compared with direct
costs.
Modern manufacturing environments are often not labour intensive and total
overhead costs are high.
Absorption costing might result in an incorrect view of what production actually
costs.
Further discussion of this although interesting is not in the scope of your syllabus.

3 STAGES IN ABSORPTION COSTING
Section overview
 Introduction
 Cost centres
 Allocation, apportionment and absorption (recovery)
 Overhead cost allocation
3.1 Introduction
Absorption costing requires a company to calculate a fixed overhead absorption
rate. This is then used to measure the fixed overhead that relates to each unit of
production.
Note that this is usually calculated in advance for a period rather than being
retrospective. For example, towards the end of 2014 a company would calculate
a fixed overhead absorption rate to be used in 2015 based on what it expected to
happen in 2015.
In order to carry out absorption costing a company must first identify the fixed
production overheads that it expects to incur in the future period.
The fixed production overheads are then attached to some kind of production
variable in order to load them into units of production. This is explained in much
more detail later but for now, what it means is that a company needs to find
something which varies with production (for example, the number of units or
number of hours worked) and divide the total fixed production overhead by that
figure in order to arrive at a fixed production overhead per unit.
Example: Basic absorption

A company has estimated that its fixed production overhead will be ₦1,000,000
next year.
It expects to produce 20,000 units next year.
Each unit is expected to use 2 hours of labour (i.e. the company expects to use
40,000 hours next year).
A company could calculate a fixed overhead absorption rate as follows:
Fixed production overheads/Number of units
= ₦1,000,000/20,000 of units = ₦50 per unit

or
Fixed production overheads/Number of hours
= ₦1,000,000/40,000 hours = ₦25 per hour

Each unit would take 2 hours and therefore would absorb ₦50 (2
hours @ ₦25 per hour).
This can seem a little strange as it is treated a fixed cost as if it is variable! Every
time a unit is made an amount of fixed cost is treated as being incurred. This

means that a system might absorb too much fixed production overhead (known
as over absorption) or too little fixed production overhead (known as under
absorption). This is covered later.
The above example is very simplistic. In practice, a company will produce more
than one type of item and the overheads will relate to more than one department.
Each item will have different direct costs and use the different department to
different degrees. This means that simply dividing the total fixed production
overhead by the total number of units or total hours to be worked may not arrive
at a fair allocation of fixed production overhead to different inventory lines.
A company must undertake a series of steps in order to arrive at meaningful
rates:
 Identify the fixed production overheads;
 Share the fixed production overheads to departments (cost centres, a term
which will be explained shortly) in the factory thus working out a fixed
production overhead for each department;
 Estimate fixed overhead absorption rate based on usage of the resources
in each department.
The rest of the chapter explains this in much more detail but first explains what
cost centres are.
3.2 Cost centres

Cost centres. A cost centre is a department or work group for which costs are
established, in order to measure the cost of output produced by the centre.
For example, in a factory a group of machines might be a cost centre. The costs
of operating the machines would be established, and a cost could then be
calculated for each unit of product manufactured by the machines.
Example:
A group of machines produces units of Product X. During one month, the costs of
operating the machines were ₦36,000.
There are 4 machines which were each operated for 150 hours in the month. The
machines produced 20,000 units of Product X.
The group of machines might be treated as a cost centre, and the costs of the
cost centre in the month were ₦36,000.
The cost per unit of Product X produced by the cost centre was ₦1.80 (36,000 /
20,000).
₦
The cost per machine hour could also be used = ₦60 ( 36,000/4 × 150).
In a system of absorption costing, each item of overhead cost is charged either:

 to a cost centre; or
 as a general expense.
The cost centres might be:
 a cost centre in the production function (production overhead);
 a cost centre in administration (administration overhead);

 a cost centre in sales and distribution (sales and distribution overhead)

The cost centres in the production function might be:
 a department engaged directly in production work (a production
department), or
 a department or service section engaged in support activities, such as
inventory management, production planning and control, quality control,
repairs and maintenance, and so on (service departments).
In a system of absorption costing, overheads are charged to products or services
on the basis of this structure of cost centres and general expenses.
3.3 Allocation, apportionment and absorption (recovery)

There are two main stages in absorption costing for charging overhead costs to
the cost of production and cost units:
Allocation and apportionment

These are means of charging fixed production overheads to cost centres.
 Allocation. Overheads are allocated to cost centres. If a cost centre is
responsible for the entire cost of an item of expenditure, the entire cost is
charged directly to the cost centre.
 Apportionment. Many overhead costs are costs that cannot be allocated
directly to one cost centre, because they are shared by two or more cost
centres. These costs are apportioned between the cost centres.
‘Apportionment’ means sharing on a fair basis.
Absorption
Absorption (also called overhead recovery). When overheads have been
allocated and apportioned to production cost centres, they are charged to the
cost of products manufactured in the cost centre. The method of charging
overheads to cost units is to establish a charging rate (an absorption rate or
recovery rate) and to apply this rate to all items of production.
Illustration: Allocation, apportionment and absorption

Overhead costs are recorded.
Initially they are allocated to a cost
Allocation
centre or recorded as a general
expense
Overhead costs are shared

Apportionment between the departments or
activities that benefit from them
Overheads are added to the cost of

Absorption
cost units, using a fair basis for
(Overhead recovery)
charging (absorption costing only)

3.4 Overhead cost allocation

Many items of indirect cost cannot be charged directly to a cost unit (a unit of
product or service), but they can be charged directly to a cost centre (for
example, a department or work group). Items of expense that can be identified
with a specific cost centre should be charged in full as a cost to the cost centre.
The process of charging costs directly to cost centres is called cost allocation.
Fixed production overheads may be allocated to:
 production departments or production centres: these are cost centres that
are directly engaged in manufacturing the products
 service departments or service centres: These are cost centres that provide
support to the production departments, but are not directly engaged in
production, such as engineering, repairs and maintenance, the production
stores and materials handling department (raw materials inventory),
production planning and control, and so on
Production overheads are the overhead costs of both the production departments
and the service departments.
Overhead costs that cannot be directly allocated to a cost centre must be shared
(apportioned) between two or more cost centres.
Examples: Allocation and apportionment

The salary of the manager of the production planning department can be allocated
directly as a cost of the production planning cost centre (a service department cost
centre within production).
The rental cost of equipment used by engineers in the maintenance department
can be allocated directly as a cost of the maintenance department (a service
department cost centre within production).
If the machining department has its own electricity power supply, electricity
charges for the machining department can be allocated directly to the department,
(a production department cost centre).
The salary of a supervisor in the finishing department can be allocated directly to
the finishing department (a production department cost centre).
The cost of security guards for the manufacturing site cannot be allocated to any
specific department or cost centre; therefore security guard services are likely to be
recorded as a general production overhead expense, and the cost is allocated to
‘security services’.

4 OVERHEAD APPORTIONMENT
Section overview
 The apportionment of shared costs between cost centres

 The basis of apportionment
4.1 The apportionment of shared costs between cost centres

Some costs cannot be allocated in full to a cost centre, because they are shared
by two or more cost centres. These are divided between the cost centres on a
fair basis. The process of dividing the shared costs is called apportionment.
Shared costs may be divided between administration cost centres and selling
and distribution cost centres, as well as production centres and service centres.
The apportionment of production overhead costs might be in two stages:
 sharing (or dividing) general costs between production centres and service
centres; and
 then sharing the costs of the service centres between the production
centres. This is called secondary apportionment.
After this has been done, all the production overhead costs have been allocated
or apportioned to the production centres. The total overhead costs of each
production centre should be:
(1) costs allocated directly to the production centre; plus
(2) shared costs apportioned to the production centre; plus
(3) a share of the costs of each service department, apportioned to the
production centre.
4.2 The basis of apportionment

Shared overhead costs should be apportioned on a fair basis between cost
centres. For each item of shared expense, a ‘fair’ basis for apportionment must
be selected.
Choosing the basis of apportionment for each cost is a matter of judgement, but
there is often an ‘obvious’ basis to choose. For example, the rental cost of a
building and the insurance costs for the building will be apportioned between the
cost centres that use the building. The basis of apportionment will probably be to
share the costs in relation to the floor space used by each cost centre.
In some cases, however, it might not be clear what the most suitable basis of
apportionment should be, and the choice is then simply a matter of judgement
and preference.
At the end of the apportionment process, all overhead costs should be allocated
or apportioned to a cost centre.

Example: apportionment of shared costs

A manufacturing company has two production departments, Machining and
Assembly, and two service departments, Repairs and Quality Control. The
following information is available about production overhead costs.
Quality
Total Machining Assembly Repairs control
₦ ₦ ₦ ₦ ₦
Indirect labour cost 15,500 5,000 5,000 3,500 2,000
Indirect materials 5,300 1,500 2,400 1,000 400
Factory rental 14,400
Power costs 4,800
Depreciation
(note 1) 14,000
Building insurance 1,800
Equipment
insurance 4,200
60,000
Note: Depreciation is a charge for the use of items of plant and equipment, such
as machinery.
Indirect labour and indirect material costs have been allocated directly to these
four cost centres. The other overhead costs are shared between the cost centres
and so cannot be allocated directly.
Other information
Quality
Cost of plant/
equipment (₦) 70,000 40,000 15,000 5,000 10,000
Floor area
(square metres) 1,800 500 900 100 300
Kilowatt hours
(000s) 800 600 100 50 50
Required
How should overheads be allocated and apportioned between the four cost
centres?

Answer
The indirect labour costs and indirect materials costs are allocated directly to the
cost centres. The basis of apportionment chosen for each of the other shared
costs will be as follows:
Basis of
Item of cost apportionment Rate of apportionment
Factory Floor area ₦14,400 ₦8 per square
rental / 1,800 = metre
Power costs Kilowatt hours ₦4,800 ₦6 per kilowatt
/ 800 = hour
Depreciation Cost of plant & ₦14,000 20% of cost
equipment /₦70,000 =
Building Floor area ₦1,800 ₦1 per square
insurance / 1,800 = metre
Equipment Cost of plant ₦4,200 6% of cost
insurance and equipment / 70,000 =
These apportionment rates are used to establish the amount of overheads to

apportion to each of the four departments.
Quality
₦ ₦ ₦ ₦ ₦
Indirect labour cost 15,500 5,000 5,000 3,500 2,000
Indirect materials 5,300 1,500 2,400 1,000 400
Factory rental 14,400 4,000 7,200 800 2,400
Power costs 4,800 3,600 600 300 300
Depreciation (note 1) 14,000 8,000 3,000 1,000 2,000
Building insurance 1,800 500 900 100 300
Equipment insurance 4,200 2,400 900 300 600
60,000 25,000 20,000 7,000 8,000
The workings for the machining department are shown below.
Apportionment basis Machining
₦
Indirect labour cost: -
allocated 5,000
Indirect materials: -
allocated 1,500
Factory rental ₦8 per square metre  500 4,000
Power costs ₦6 per kilowatt hour  600 3,600
Depreciation (note 1) 20% of cost  40,000 8,000
Building insurance ₦1 per square metre  500 500
Equipment insurance 6% of cost  40,000 2,400
Total overheads 25,000

5 APPORTIONMENT OF SERVICE DEPARTMENT COSTS
Section overview
 Secondary apportionment
 Secondary apportionment where one service department uses another service
department
 Secondary apportionment where service departments use each other: Reciprocal
method
 Reciprocal method: simultaneous equations technique
After production overheads have been allocated and apportioned to production

departments and service departments, the costs of the service departments must
then be apportioned to the production departments. When this has been done, all
production overhead costs would have been allocated or apportioned to the
production departments.
The purpose of doing this is to calculate an absorption rate for each production
department. Absorption rates are used to add overhead costs to the costs of
production (the cost of the cost units produced in the production department).
5.1 Secondary apportionment

The apportionment of fixed production overheads to service departments results
in a total fixed production overhead for each service department. The total for
each service department is then re-apportioned to the production department.
This process is called secondary apportionment.
The basis of reapportionment of the overhead from each service department is
some measure of how much its service is used by other departments.

Example:
A manufacturing company has two production departments, Department 1 and
Department 2. It also has two service departments, quality control and the repairs
department.
Allocated overhead costs and apportioned general overhead costs for each cost
centre are as follows:
Department 1: ₦100,000
Quality control ₦150,000
Repairs: ₦220,000
The repairs department does no work quality control: 75% of its time is spent on
repair work for Department 1 and 25% of its time is spent on repair work for
Department 2.
The quality control department does no work for repairs: 40% of its time is spent
on Department 1 and 60% of its time is spent on Department 2.
The secondary apportionment of overheads will be as follows:
Basis of Department Department Quality
apport. 1 2. control Repairs
₦ ₦ ₦ ₦
Initial
costs 100,000 200,000 150,000 220,000
Apportion
quality
control (40:60) 60,000 90,000 (150,000)
Apportion
repairs (75:25) 165,000 55,000 - (220,000)
325,000 345,000 nil nil

5.2 Secondary apportionment where one service department uses another

service department.
A service department might be used by production department and by another
service department. In this case the secondary apportionment must proceed in
two stages. The costs of the service department used by the other are
apportioned first and then the new total for the second service department is
apportioned.
Example:
A manufacturing company has two production departments, Department 1 and
Department 2. It also has two service departments, the factory canteen and the
repairs department.
Allocated overhead costs and apportioned general overhead costs for each cost
centre are as follows:
Canteen: ₦150,000
Repairs: ₦220,000
The repairs department does no work for the canteen: 75% of its time is spent on
repair work for Department 1 and 25% of its time is spent on repair work for
Department 2.
There are 10 employees in Department 1, 20 employees in Department 2 and 20
employees in the repairs department.
Canteen costs are to be apportioned based on the number of employees in each
department.
The apportionment of overheads will be as follows:
Basis of Department Department
apport. 1 2. Canteen Repairs
₦ ₦ ₦ ₦
Initial
costs 100,000 200,000 150,000 220,000
Apportion
canteen (10:20:20) 30,000 60,000 (150,000) 60,000
280,000
Apportion
repairs (75:25) 210,000 70,000 - (280,000)
340,000 330,000 nil nil

Practice question 1
A manufacturing company has two production departments, P1 and P2 and
two service departments, S1 and S2. The following information is available.
P1 P2 S1 S2
Allocated and
apportioned production ₦ ₦ ₦ ₦
overheads 200,000 250,000 195,000 180,000
Work done by service
department for other
departments
S1 40% 60% - -
S2 50% 25% 25% -
Apportion the overheads to the two production departments
5.3 Secondary apportionment where service departments use each other:

reciprocal method
A situation may arise where both service departments do work for the other
service department, as well as the production departments.
In this type of situation, the secondary apportionment is more complex. The
process is now called reciprocal apportionment and can be done in either of two
ways each of which gives the same result:
 repeated distribution method
 simultaneous equations method.
Repeated distribution method

Taking each service department in turn, the overheads of that department are
apportioned to all departments that use its service i.e. to the other service
department as well as to the production departments.
This leaves the first service department with no overheads. The overheads of the
second service department are then apportioned to all departments that use its
service i.e. to the first service department as well as to the production
departments.

Example:
A manufacturing company has two production departments, Machining and
Assembly, and two service departments, Repairs and Quality Control. The
following information is available.
Quality
Allocated/apport
ioned overhead ₦ ₦ ₦ ₦ ₦
costs 60,000 25,000 20,000 7,000 8,000
Work done by
the service
departments:
Repairs 100% 60% 10% - 30%
Quality Control 100% 30% 50% 20% -
The apportionment proceeds as follows.

Quality
₦ ₦ ₦ ₦ ₦
Allocated/
apportioned
overhead
costs 60,000 25,000 20,000 7,000 8,000
Repairs
(60:10:30) 4,200 700 (7,000) 2,100
0 10,100
Quality
Control
(30:50:20) 3,030 5,050 2,020 (10,100)
" 摧 d
Repairs
(60:10:30) 1,212 202 (2,020) 606
Quality
Control
(30:50:20) 182 303 121 (606)
Repeat again
Repairs
(60:10:30) 73 12 (121) 36
Quality
Control
(30:50:20) 11 18 7 (36)
Repeat again
Repairs
(60:10:30) 4 1 (7) 2
Quality
Control
(30:50:20) 1 1 0 (2)
60,000 33,713 26,287 0 0
Comment
The total overhead costs of ₦60,000 have been apportioned. (₦33,713 +
₦26,287 = ₦60,000).

5.4 Reciprocal method: simultaneous equations technique

This technique is an alternative to the repeated distribution technique, and should
produce exactly the same final apportionment of overhead costs between the
production departments.
The method is to create two equations for the apportionment of service
department overheads. These are simultaneous equations, which must then be
solved. The solutions to the simultaneous equations can then be used to
calculate the overhead apportionment to each production department.
Example:
The information is as follows:
Quality
Allocated/apportio ₦ ₦ ₦ ₦ ₦
ned overhead costs 60,000 25,000 20,000 7,000 8,000
Work done by the
service
departments:
Repairs 100% 60% 10% - 30%
Quality Control 100% 30% 50% 20% -
Step 1: formulate the simultaneous equations
The first step is to establish two simultaneous equations. There should be one
equation for each service department.
Each equation should state the total amount of overheads that will be
apportioned from the service departments. This total overhead is the original
overhead cost allocation/apportionment for the service department plus the
proportion of the costs of the other service department that will be apportioned to
it.
Using the example, the two equations are formulated as follows.
Let the total overheads apportioned from the Repairs department be X.
Let the total overheads apportioned from the Quality Control department be Y.
Then:
X = Original overheads of Repairs department + 20% of Quality Control costs.
Y = Original overheads of Quality Control department + 30% of Repair costs.
This gives us:
X = 7,000 + 0.20Y
Y = 8,000 + 0.30X

Example continued:
Step 2
The next step is to solve these simultaneous equations.
Re-arrange the two equations:
X - 0.2Y = 7,000 ………(1)
- 0.3 X + Y = 8,000 ………(2)
Solve to find values for X and Y.
In this example, the easiest method of solution is to multiply equation (1) by 5, so
that the coefficient for Y is -1. This matches the coefficient of + 1 in equation (2).
Add the two equations to obtain a value for X.
5X - Y = 35,000 ………(1)  5 = (3)
- 0.3 X + Y = 8,000 ….….. (2)
4.7 X = 43,000 ………(2) + (3)
X = 9,149 (= 43,000/4.7)
Now substitute this value for X in equation (2)
- 0.3 X + Y = 8,000
Y = 8,000 + 0.3 (9,149)
Y = 10,745
Step 3
Use the values for X and Y that you have calculated to establish the total costs to
apportion from the service department to each production department.
In this example:
 Of the total value of X, 60% is apportioned to Machining and 10% to
Assembly
 Of the total value of Y, 30% is apportioned to Machining and 50% to
Assembly.
Machining Assembly
₦ ₦
Allocated/apportioned overhead costs 25,000 20,000
Apportion costs of service departments:
Repairs (60% and 10% of X = 9,149) 5,489 915
Quality Control (30% and 50% of Y =10,745) 3,224 5,372
Final apportionment 33,713 26,287
This is the same as with the repeated distribution method.

Practice question 2
Nitrate Limited (NL), producing industrial chemicals, has three production
and two service departments.
The annual overheads are as follows:
Production departments: Naira in
‘000
A 56,000
B 50,000
C 38,000
Service departments:
X 16,500
Y 10,600
171,100
The service departments’ costs are apportioned as follows:

Service
Production departments departments
A B C X Y
Service department X 20% 40% 30% - 10%
Service department Y 40% 20% 20% 20%
Apportion costs of service departments using the simultaneous equation method

6 OVERHEAD ABSORPTION
Section overview
 Overhead absorption rate (recovery rate)

 Departmental absorption rates or a factory-wide absorption rate?
 The treatment of non-production overheads
6.1 Overhead absorption rate (recovery rate)

When all production overheads have been allocated or apportioned to the
production departments, a rate can be calculated for absorbing the overheads
into the cost of the cost units manufactured in each department. This is the
overhead absorption rate or overhead recovery rate.
The overhead absorption rate for a production department is calculated as
follows:
Formula: Overhead absorption rate

Total allocated and apportioned overheads
Volume of activity in the period
The volume of activity can be any of the following:
Activity basis Absorption rate

(volume of activity)
Units produced in the period, but Absorption rate per unit.
only if all units are identical Not practical where units are not
identical.
However, used in standard costing.
Direct labour hours worked in the Absorption rate per direct labour hour.
period Commonly-used method.
Direct labour cost in the period Overhead absorbed as a percentage of
direct labour cost.
Could be used when there are no
records for direct labour hours worked.
Machine hours operated in the Absorption rate per machine hour.
period Commonly-used method in machine-
intensive production departments.
Prime costs of production in the Overhead absorbed as a percentage of
period (direct materials plus direct prime cost.
labour costs) This is uncommon.
The basis of activity selected for an absorption rate should be one that charges
overhead costs to cost units on a fair basis. A rate per direct labour hour and a
rate per machine hour are the most common methods, although a rate per unit is
used in standard costing or where a single identical unit of product is
manufactured.

Example: absorption rate

The allocated and apportioned overhead costs of Production Department X are
₦24,000 during a period when the department produces the following units of
product:
Product A Product B Product C
Units produced (quantity) 3,000 4,000 1,000
Prime cost per unit ₦3 ₦4 ₦5
Direct labour hours per unit 0.1 0.2 0.4
Direct labour cost ₦3,500 ₦8,000 ₦4,500
Machine hours per unit 0.2 0.1 0.2
It has been decided that production overheads will be absorbed on a direct labour
hour basis.
The overhead absorption rate is calculated as follows.
Step 1: Calculate the total number of direct labour hours
Direct labour hours
Product A: (3,000 units × 0.1 hours) 300
Product B: (4,000 units × 0.2 hours) 800
Product C: (1,000 units × 0.4 hours) 400
Total direct labour hours 1,500
Step 2: Calculate an absorption rate per direct labour hour
Production overhead expenditure ₦24,000
Number of labour hours 1,500
Absorption rate per direct labour hour ₦16
Step 3: Use this absorption rate to charge overhead costs to products
Overheads absorbed by each product: ₦
Product A: (300 hours × ₦16) 4,800
Product B: (800 hours × ₦16) 12,800
Product C: (400 hours × ₦16) 6,400
Total 24,000
Product Product B Product C

A
₦ ₦ ₦
Prime cost per unit 3.00 4.00 5.00
Overhead at ₦16/direct labour
hour 1.60 3.20 6.40
Full production cost/unit 4.60 7.20 11.40
The choice of the basis for absorbing overheads can have a significant effect on
the overheads charged to each product or cost unit.

6.2 Departmental absorption rates or a factory-wide absorption rate?

An overhead absorption rate can be calculated for each production department
separately.
Alternatively, a single overhead absorption rate might be used for all the
production departments in the factory. Calculating a single factory-wide rate
involves less time and effort than calculating separate absorption rates for each
production department within the factory. However, it might be argued that a
single-factory wide absorption rate is less ‘exact’ or less ‘fair’ in sharing overhead
costs between products or cost units.
A factory wide rate is also called a blanket rate.
Example: absorption rate

A manufacturing company has two production departments. Each department is
involved in making two products, X and Y. Information about costs and production
volume in the year is shown below:
Production departments Products
Department Department Product Product
P1 P2 X Y
Overhead costs ₦60,000 ₦90,000
Direct labour hours/unit:
Product X 0.5 hours 2 hours
Product Y 3.5 hours 1.5 hours
Units produced 2,000 4,000
Required
Calculate the total production overhead cost/unit for Product X and Product Y
using:
(1) separate departmental overhead rates for departments P1 and P2
(2) a single absorption rate for the entire factory.

Answer
Separate departmental rates
Department P1 Department P2
Direct labour hours hours hours
Product X (2,000 × 0.5) 1,000 (2,000 × 2) 4,000
Product Y (4,000 × 3.5) 14,000 (4,000 × 1.5) 6,000
15,000 10,000
Overhead ₦60,000 ₦90,000

expenditure
Absorption rate/direct labour hour ₦4 ₦9
Production overhead cost/unit Product X Product Y

₦ ₦
Department P1 (at ₦4/hour) 2 14.00
Department P2 (at ₦9/hour) 18 13.50
Total production overhead cost/unit 20 27.50
Single departmental rate
₦60,000 + ₦90,000
= ₦6 per direct labour hour
15,000 + 10,000 hours
Production overhead costs

Product X: (0.5 hours + 2 hours) × ₦6 = ₦15 per unit of Product X.
Product Y: (3.5 hours + 1.5 hours) × ₦6 = ₦30 per unit of Product Y.
if you are given a question about overhead absorption rates, with two production
departments, you should normally assume that you are required to calculate
separate overhead absorption rates for each department.
6.3 The treatment of non-production overheads

In many costing systems, administration overheads and sales and distribution
overheads are not absorbed into product costs. Instead, they are treated in full as
an expense in the financial period to which they relate.
Non-production overhead costs are never added to the value of inventory. The
main reason for absorbing production overheads is normally to calculate a value
for inventory, for the purpose of measuring profit.
However, it is possible to add non-production overheads to the full production
cost of units produced, to obtain a full cost of sale. When this happens, the basis
for absorbing the overhead costs should be ‘fair’.
 Administration overheads might be added as a percentage of production
costs.
 Sales and distribution overheads might also be added as a percentage of
production costs. Alternatively, they might be added as a percentage of the
value of sales.

Example: Non-production overheads

A company has budgeted to make and sell 100,000 units of Product X and
50,000 units of Product Y. Product X will sell for ₦5 per unit and Product Y will
sell for ₦6 per unit.
The following costs have been budgeted.
₦
Full production cost, Product X 200,000
Full production cost, Product Y 100,000
Administration overheads 120,000
Sales and distribution overheads 200,000
Administration overheads will be absorbed into product costs as a percentage of
full production costs. Selling and distribution overheads will be absorbed as a
percentage of sales revenue.
Required
Calculate the cost of sales for each product and the budgeted profit for each
product.
Answer
Budgeted administration overheads = ₦120,000
Budgeted production costs (₦200,000 + ₦100,000) = ₦300,000.
Absorption rate for administration overheads = (120,000/300,000) × 100% =
40% of production cost.
₦
Budgeted sales revenue, Product X (100,000 × ₦5) 500,000
Budgeted sales revenue, Product Y: (50,000 × ₦6) 300,000
Total budgeted sales revenue 800,000
Budgeted sales and distribution costs 200,000

Absorption rate for sales and distribution overheads
= (200,000/800,000) × 100% = 25% of budgeted sales revenue.
Product X Product Y
₦ ₦ ₦ ₦
Sales 500,000 300,000
Production costs 200,000 100,000
(40% of production cost) 80,000 40,000
Sales and distribution costs
(25% of sales revenue) 125,000 75,000
Full cost of sale 405,000 215,000
Profit 95,000 85,000

7 UNDER-ABSORBED AND OVER-ABSORBED OVERHEADS
Section overview
 Predetermined overhead rate

 Calculating a predetermined overhead rate
 Under-absorption or over-absorption of overheads
 The reasons for under- or over-absorption: expenditure and volume variances
7.1 Predetermined overhead rate

There is a problem with calculating production overhead absorption rates using
actual overhead expenditure and actual activity levels (actual production volume).
Overhead rates are normally calculated for the entire financial year, and the
same absorption rate is used throughout the year. If overhead rates are based on
actual overhead expenditure and actual direct labour hours or machine hours, it
would be necessary to wait until the end of the financial year to calculate any
overhead absorption rates and product costs. This is unacceptable, because of
the delay in providing management information about costs and profitability.
The cost accountant needs to know what the overhead absorption rate is in order
to calculate product costs as soon as the products are manufactured. For this to
be possible, the absorption rate must be decided in advance, for the entire
financial year.
Predetermined absorption rates are therefore calculated and used. The
absorption rates are calculated in advance using estimates for cost and
production volume in the annual financial plan or budget.
7.2 Calculating a predetermined overhead rate

A predetermined overhead absorption rate is known by different names including
the fixed overhead absorption rate, the fixed overhead recovery rate or the fixed
overhead applied.
The predetermined overhead absorption rates are calculated from:
 budgeted (planned) overhead expenditure, and
 the budgeted volume or activity levels (for example, labour hours or
machine hours).
The method of calculating a predetermined overhead rate, either for separate
production departments or as a factory-wide rate, are the processes of allocation,
apportionment and absorption that have already been described. Budgeted data
is used, rather than data about actual costs and output.

7.3 Under-absorption or over-absorption of overheads

Actual overhead expenditure and actual production volume will almost certainly
be different from the planned expenditure and production volume. This means
that the production overheads absorbed into product costs will be higher or lower
than the actual production overhead expenditure.
The difference is calculated as follows:
Illustration: Under of over absorbed fixed overhead

₦
Amount absorbed:
Actual number of units Predetermined
 X
made (or hours used) absorption rate
Actual expenditure in the period (X)

Over/(under) absorbed X
Over absorption.
Every time a unit of production is made the accounting system posts fixed
production overhead into the item. This transfers expense out of the fixed
production overhead account as follows.
Illustration: Posting of fixed production overhead

Debit Credit
Finished goods X
Fixed production overhead X
If the amount of production overheads absorbed into product costs is more than
the actual production overhead expenditure, there is over-absorbed overhead.
Too much overhead cost has been charged to finished goods.
 This means that too much has been transferred out of the fixed production
overhead account.
 Finished goods are charged to cost of sales. The fact that fixed production
overhead has been over absorbed means that the expense in the
statement of comprehensive income is overstated.
These problems are corrected by the following journal:
Illustration: Accounting for over-absorption of fixed overhead

Debit Credit
Cost of sales X
The over-absorbed overhead is accounted for as an adjustment to the profit in

the period, and is added to profit in the cost accounting income statement.

Under-absorption
If the amount of production overheads absorbed into product costs is less than
the actual production overhead expenditure, there is under-absorbed overhead.
Not enough overhead cost has been charged to production costs, because actual
costs were higher. Under-absorbed overhead is accounted for as an adjustment
to the profit in the period, and is deducted from profit.
Illustration: Accounting for under-absorption of fixed overhead

Debit Credit
Cost of sales X
There is no adjustment to the value of closing inventory to allow for any over-
absorption or under-absorption of overhead in the cost accounting income
statement.
Example:
A company manufactures and sells a range of products in a single factory. Its
budgeted production overheads for Year 6 were ₦150,000, and budgeted direct
labour hours were 50,000 hours.
Actual results in Year 6 were as follows:
₦
Sales 630,000
Direct materials costs 130,000
Direct labour costs 160,000
Production overhead 140,000 (40,000 hours)
Administration overhead 70,000
Selling and distribution overhead 90,000
There was no opening or closing inventory at the beginning or end of Year 6.
The company uses an absorption costing system, and production overhead is
absorbed using a direct labour hour rate.
Required
(a) Calculate the production overhead absorption rate.
(b) Calculate the over or under absorption of fixed overhead.
(c) Calculate the full production cost.
(d) Show how the profit or loss for the year will be reported.

Answer
₦150,000
a. The predetermined absorption rate is /50,000 hours = ₦3 per direct labour
hour.
b Under absorption ₦
Overhead absorbed (40,000 hours @ ₦3 per hour) 120,000
Overhead incurred (actual cost) (140,000)
Under absorption (20,000)
c The full production cost: ₦

Direct materials costs 130,000
Direct labour costs 160,000
Production overhead absorbed (40,000 hours  ₦3) 120,000
Full production cost (= cost of sales in this example) 410,000
The profit for the year is reported as follows. Notice that under-absorbed overhead
is an adjustment that reduces the reported profit. Over-absorbed overhead would
be an adjustment that increases profit.
₦ ₦
d Sales 630,000
Full production cost of sales 410,000
Under-absorbed overhead 20,000
(430,000)
200,000
Administration overhead 70,000
Selling and distribution overhead 90,000
(160,000)
Profit for Year 6 40,000
7.4 The reasons for under- or over-absorption: expenditure and volume variances
Under or over absorption is caused by the actual fixed overhead and production
volume being different from those figures used to calculate the predetermined
rate.
There are two reasons for over-absorbed or under-absorbed overheads. These
can be measured as:
 an overhead expenditure variance, and
 an overhead volume variance.
The predetermined overhead absorption rate is based on budgeted overhead
expenditure and budgeted production volume. What was expected in the budget
might not actually happen. When there are differences between actual and
budgeted fixed overhead expenditure, and actual and budgeted activity volume,
an under- or over-absorption of overheads occurs.
An overhead variance is reported as either favourable (F) or adverse (A).
 When an overhead variance causes over-absorption of overhead, it is a
favourable variance. The over-absorption is an adjustment that increases
profit.

 When an overhead variance causes under-absorption of overhead, it is

an adverse variance. The under-absorption is an adjustment that reduces
profit.
Expenditure variance
Actual overhead expenditure might be different from the expected (budgeted)
expenditure. Therefore there will be some under-absorbed or over-absorbed
overheads because actual overhead expenditure differs from the budgeted
expenditure.
Illustration: Expenditure variance

₦
Expected overhead expenditure E
Actual overhead expenditure A
Expenditure variance (E – A) (favourable or adverse)
When actual fixed overhead expenditure exceeds the budget, there is an

‘adverse’ variance, and this will result in some under-absorption of fixed
overheads. When actual fixed overhead expenditure is less than budgeted, there
is a ‘favourable’ variance and this will result in over-absorption of fixed overhead.
The reasons for an expenditure variance might be either:
 excessive spending on overhead items, or
 under-estimating fixed overhead expenditure in the budget.
Volume variance
The second reason for under- or over-absorption of fixed overhead is the
difference between the actual and budgeted volume of activity (i.e. the volume of
activity on which the pre-determined overhead absorption rate was calculated).
Illustration: Volume variance

Units or
hours
Expected production volume E
Actual production volume A
(favourable or
Volume variance (units or hours) (E – A) adverse)
× Absorption rate per unit or hour

(₦) X
Volume variance (in ₦) X(E – A)

When actual activity volume exceeds the budget, there will be over-absorption of
fixed overheads, which is a ‘favourable’ variance. When actual activity volume is
less than budget, there will be under-absorption of fixed overhead, which is an
‘adverse’ variance.
When overheads are absorbed on the basis of direct labour hours or machine
hours, the actual hours worked might be higher or lower than budgeted. The
reasons for a favourable or an adverse volume variance might therefore be any
of the following.
 Working more hours than budgeted might be caused by working overtime,
or taking on additional direct labour employees.
 Working fewer hours than budgeted might be caused by staff shortages
(due to employees leaving or absence from work), hold-ups in production or
lack of customer orders.

Example:
In its annual financial plan for Year 1, a manufacturing company budgets that
production overhead expenditure will be ₦800,000 and that there will be
100,000 direct labour hours of work. It uses a single absorption rate, which is a
rate per direct labour hour.
Actual production overhead during Year 1 was ₦805,000 and 105,000 direct
labour hours were worked.
Answer
The total under- or over-absorbed overhead
The production overhead absorption rate for the year is ₦800,000/100,000 = ₦8
per direct labour hour. All cost units produced during the year are charged with
production overheads at the rate of ₦8 for each direct labour hour.
₦
Overheads absorbed (105,000 hours × ₦8) 840,000
(Overheads included in product costs)
Actual overhead expenditure 805,000
Over-absorbed overheads 35,000
This is added to profit when calculating the actual profit for Year 1.
Explaining the over-absorbed overhead
The over-absorbed overhead of ₦35,000 can be explained by a combination of an
expenditure variance and a volume variance.
₦
Budgeted overhead expenditure 800,000
Expenditure variance 5,000 Adverse
The expenditure variance is adverse because actual expenditure was more than
planned expenditure, and this has resulted in some under-absorption of
overhead.
Hours
Budgeted volume (direct labour hours) 100,000
Actual volume (direct labour hours) 105,000
Volume variance (direct labour hours) 5,000 Favourable
Absorption rate/direct labour hour ₦8

Volume variance in ₦ ₦40,000 Favourable
The volume variance is favourable because actual hours worked exceeded the
planned hours, and this has resulted in some over-absorption of overhead.
Summary ₦
Volume variance 40,000 Favourable
Total over-absorbed overhead 35,000 Favourable

8 FIXED AND VARIABLE OVERHEADS
Section overview
 Definition of fixed and variable overheads

 Absorption rates for fixed and variable production overheads
 Calculating under- or over-absorbed overhead with fixed and variable overheads
8.1 Definition of fixed and variable overheads

Most overhead is usually fixed, but some overhead might be a variable cost.
 Fixed overhead is overhead expenditure that should be a fixed amount in
total during a given period of time, and will not change if more or less
production work is done.
 Variable overhead is overhead that increases as more production work is
done or decreases as less production work is done. Total variable
overhead expenditure therefore depends on the volume of production.
Variable overhead is usually calculated as an amount for each direct labour
hour worked.
8.2 Absorption rates for fixed and variable production overheads

When an absorption costing system identifies fixed and variable overhead costs
separately, there will be separate absorption rates for fixed overheads and
variable overheads.
Example:
The budgeted production overhead expenditure for Year 1 is ₦2,400,000 of fixed
overheads plus variable overheads of ₦3 per direct labour hour. The budgeted
direct labour hours are 100,000 for the year.
₦
Budgeted fixed overhead 2,400,000
Budgeted variable overhead (100,000 × ₦3) 300,000
Total budgeted overhead expenditure 2,700,000
The overhead absorption rate per direct labour hour is calculated as a separate
rate for fixed and variable overheads:
₦
Fixed overhead absorption rate (₦2,400,000/100,000) 24
Variable overhead absorption rate 3
Total absorption rate per direct labour hour 27

Total overhead expenditure

The total fixed overhead expenditure is unaffected by changes in production
volume. However, total variable overhead expenditure increases or falls with
increases or falls in production volume.
Unit overhead cost and overhead absorption rate

The budgeted fixed overhead cost per unit or per direct labour hour decreases as
the planned production volume increases. The variable overhead absorption rate
and spending rate is the same, regardless of the volume of production.
Example:
Suppose that in the previous example, the budget is amended, and the new plan
is to work 120,000 direct labour hours, rather than 100,000 hours. The new
budget for overhead expenditure will be as follows:
₦
Budgeted fixed overhead 2,400,000
Budgeted variable overhead (120,000 × ₦3) 360,000
Total budgeted overhead expenditure 2,760,000
The overhead absorption rate per direct labour hour would be calculated as
follows, with the fixed overhead absorption rate lower due to the higher budgeted
direct labour hours, but the variable overhead absorption rate unchanged.
₦
Fixed overhead absorption rate (₦2,400,000/120,000) 20
Variable overhead absorption rate 3
Total absorption rate/direct labour hour 23
8.3 Calculating under- or over-absorbed overhead with fixed and variable

overheads
When there is some variable overhead, the method of calculating under- or over-
absorbed overhead is slightly different from the calculation when all overheads
are fixed. This is because variable overhead expenditure is expected to vary with
the actual volume of activity.
Example:
A company has budgeted fixed production overheads of ₦600,000 for Year 3,
and a variable overhead cost of ₦2 per direct labour hour.
The budgeted production volume is 60,000 direct labour hours of work.
Actual production in Year 3 was 62,000 direct labour hours, and actual overhead
expenditure (fixed and variable) was ₦790,000 in total.
Required
Calculate the under- or over-absorbed overhead in the year, and analyse this into
an expenditure and a volume variance.

Answer
Absorbed overheads ₦
Fixed overheads (62,000 hours × ₦10) 620,000
Variable overheads (62,000 hours × ₦2) 124,000
Total absorbed overheads 744,000
Under-absorbed overheads 46,000
Explaining the under-absorbed overhead

This under-absorbed overhead of ₦46,000 can be analysed into an expenditure
and a volume variance. There are two important points to note.
 The expected overhead expenditure is the budgeted fixed overhead
expenditure plus the expected variable overhead expenditure for the hours
actually worked.
 The volume variance affects fixed overheads only, not variable overheads.
Example: Summary
Expected overhead expenditure ₦

Expected fixed overheads (= Budgeted fixed 600,000
overhead)
Expected variable overheads (62,000 × ₦2) 124,000
Total expected overhead expenditure 724,000
Hours
Budgeted volume (direct labour hours) 60,000
Actual volume (direct labour hours) 62,000
Volume variance (direct labour hours) 2,000 Favourable
Fixed overhead absorption rate/hour ₦10
Volume variance in ₦ (fixed overhead only) ₦20,000 Favourable
Summary ₦
Volume variance 20,000 Favourable
Total under-absorbed overhead 46,000 Adverse

9 CHAPTER REVIEW
Chapter review
 Explain the meaning of overheads
 Identify manufacturing and non-manufacturing overheads
 Explain allocation and apportionment and apply the techniques to identify the
total overhead costs associated with different departments (including techniques
of secondary apportionment)
 Explain absorption
 Calculate departmental overhead absorption rates from data supplied
 Calculate the overhead costs absorbed by applying overhead absorption rate in
an appropriate manner
 Calculate and account for over and under absorption of overhead


Solutions 1
The service centre costs should be apportioned by apportioning the costs of S2 first. This
is because S2 does work for S1 as well as the production departments
Basis of P1 P2 S1 S2
apportion-
ment
₦ ₦ ₦ ₦
Initial costs 200,000 250,000 195,000 180,000
Apportion S2 (50:25:25) 90,000 45,000 45,000 (180,000)
240,000
Apportion S1 (40:60) 96,000 144,000 (240,000)
386,000 439,000 nil nil
Solution 2
Let X represent total overheads of department X
Let Y total overheads of department Y
Since X received 20% of Y’s services

Thus X = 16,500 + 0.2 Y
Likewise Y = 10,600 + 0.1X
Using substitution method of simultaneous equation
X = 16,500 + 0.2 (10,600 + 0.1X)
X = 16,500 + 2,120 + 0.02X
X – 0.02X = 18,620
0.98X = 18620
X = 19,000
Y = 10,600 + (0.1 × 19,000)
Y = 12,500
Overheads charged to production:
A B C
Allocated overheads 56,000 50,000 38,000
Share of X’s service (₦19,000 × % served) 3,800 7,600 5,700
Share of Y’s service (₦12,500 × % served) 5,000 2,500 2,500
64,800 60,100 46,200

Foundation level
CHAPTER
6
Marginal costing and
absorption costing
Contents
1 Marginal cost and marginal costing
2 Reporting profit with marginal costing
3 Reporting profit with absorption costing
4 Marginal costing and absorption costing compared
5 Advantages and disadvantages of absorption and
marginal costing
6 Chapter review

INTRODUCTION
Purpose
Competencies
Exam context
This chapter explains the distinction between marginal and absorption costing.
Marginal costing is useful for decision-making as it focuses only on those costs which
change with a decision.
Absorption costing is useful for inventory valuation for reporting purposes as it focuses on the
total cost of bringing an item of inventory to its present location and condition.

 Explain the concept of marginal costing
 Calculate the marginal cost of an item from given data
 Explain how marginal cost and the concept of contribution are important in decision-
making
 Describe absorption costing using examples
 Calculate the absorption cost of an item from given data
 Compare marginal costing and absorption costing
 Reconcile absorption costing and marginal costing profit figures

Chapter 6: Marginal costing and absorption costing
1 MARGINAL COST AND MARGINAL COSTING
Section overview
 Marginal cost
 Marginal costing and its uses
 Assumptions in marginal costing
 Contribution
1.1 Marginal cost

The marginal cost of an item is its variable cost.
 Marginal production cost = Direct materials + Direct labour + Direct
expenses + Variable production overhead.
 Marginal cost of sale for a product = Direct materials + Direct labour +
Direct expenses + Variable production overhead + Other variable overhead
(for example, variable selling and distribution overhead).
 Marginal cost of sale for a service = Direct materials + Direct labour +
Direct expenses + Variable overhead.
It is usually assumed that direct labour costs are variable (marginal) costs, but
often direct labour costs might be fixed costs, and so would not be included in
marginal cost.
Variable overhead costs might be difficult to identify. In practice, variable
overheads might be measured using a technique such as high/low analysis or
linear regression analysis, to separate total overhead costs into fixed costs and
variable cost per unit of activity.
 For variable production overheads, the unit of activity is often either direct
labour hours or machine hours, although another measure of activity might
be used.
 For variable selling and distribution costs, the unit of activity might be sales
volume or sales revenue.
 Administration overheads are usually considered to be fixed costs, and it is
very unusual to come across variable administration overheads.
1.2 Marginal costing and its uses

Marginal costing is a method of costing with marginal costs. It is an alternative to
absorption costing as a method of costing. In marginal costing, fixed production
overheads are not absorbed into product costs.
There are several reasons for using marginal costing:
 To measure profit (or loss), as an alternative to absorption costing
 To forecast what future profits will be
 To calculate what the minimum sales volume must be in order to make a
profit
It can also be used to provide management with information for decision making.

Its main uses, however, are for planning (for example, budgeting), forecasting
and decision-making.
1.3 Assumptions in marginal costing

For the purpose of marginal costing, the following assumptions are normally
made:
 Every additional unit of output or sale, or every additional unit of activity,
has the same variable cost as every other unit. In other words, the variable
cost per unit is a constant value.
 Fixed costs are costs that remain the same in total in each period,
regardless of how many units are produced and sold.
 Costs are either fixed or variable, or a mixture of fixed and variable costs.
Mixed costs can be separated into a variable cost per unit and a fixed cost
per period.
 The marginal cost of an item is therefore the extra cost that would be
incurred by making and selling one extra unit of the item. Therefore,
marginal costing is particularly important for decision-making as it focuses
on what changes as a result of a decision. This is explored in detail in later
chapters.
1.4 Contribution
Contribution is a key concept in marginal costing.
Contribution = Sales – Variable costs

Fixed costs are a constant total amount in each period. To make a profit, an
entity must first make enough contribution to cover its fixed costs. Contribution
therefore means: ‘contribution towards covering fixed costs and making a profit’.
Total contribution – Fixed costs = Profit

 When fixed costs have been covered, any additional contribution adds
directly to profit.
 If total contribution fails to cover fixed costs, there is a loss.

2 REPORTING PROFIT WITH MARGINAL COSTING
Section overview
 Total contribution minus fixed costs

 A marginal costing income statement with opening and closing inventory
 Calculation of marginal cost profit
2.1 Total contribution minus fixed costs

Profit is measured by comparing revenue to the cost of goods sold in the period
and then deducting other expenses.
The cost of goods sold is the total cost of all production costs in the period
adjusted for the inventory movement.
In a marginal cost system the opening and closing inventory is measured at its
marginal cost. The cost per unit only includes the variable costs of production
(direct materials + direct labour + direct expenses + variable production
overhead).
When measuring profits using marginal costing, it is usual to identify contribution,
and then to subtract fixed costs from the total contribution, in order to get to the
profit figure.
Illustration:
₦ ₦
Sales 360,000
Direct costs 105,000
Variable production costs 15,000
Variable sales and distribution costs 10,000
Total marginal costs (130,000)
Total contribution 230,000
Total fixed costs (150,000)
Profit 80,000

Total contribution and contribution per unit

In marginal costing, it is assumed that the variable cost per unit of product (or per
unit of service) is constant. If the selling price per unit is also constant, this
means that the contribution earned from selling each unit of product is the same.
Total contribution can therefore be calculated as: Units of sale  Contribution per
unit.
Example:
A company manufactures and sells two products, A and B.
Product A has a variable cost of ₦6 and sells for ₦10, and product B has a
variable cost of ₦8 and sells for ₦15.
During the period, 20,000 units of Product A and 30,000 units of Product B were
sold.
Fixed costs were ₦260,000. What was the profit or loss for the period?
Answer
Contribution per unit:
Product A: ₦10 – ₦6 = ₦4
Product B: ₦15 – ₦8 = ₦7
₦
Contribution from Product A: (20,000  ₦4) 80,000
Contribution from Product B: (30,000  ₦7) 210,000
Total contribution for the period 290,000
Fixed costs for the period (260,000)
Profit for the period 30,000
2.2 A marginal costing income statement with opening and closing inventory
The explanation of marginal costing has so far ignored opening and closing
inventory.
In absorption costing, the production cost of sales is calculated as ‘opening
inventory value + production costs incurred in the period – closing inventory
value’.
The same principle applies in marginal costing. The variable production cost of
sales is calculated as ‘opening inventory value + variable production costs
incurred in the period – closing inventory value’.
When marginal costing is used, inventory is valued at its marginal cost of
production (variable production cost), without any absorbed fixed production
overheads.

If an income statement is prepared using marginal costing, the opening and

closing inventory might be shown, as follows:
Illustration: Marginal costing income statement for the period

₦ ₦
Sales 440,000
Opening inventory at variable production cost 5,000
Variable production costs
Direct materials 60,000
Direct labour 30,000
Variable production overheads 15,000
110,000
Less: Closing inventory at variable production (8,000)
cost
Variable production cost of sales 102,000
Variable selling and distribution costs 18,000
Variable cost of sales 120,000
Contribution 320,000
Fixed costs:
Production fixed costs 120,000
Administration costs (usually 100% fixed costs) 70,000
Selling and distribution fixed costs 90,000
Total fixed costs 280,000
Profit 40,000
If the variable production cost per unit is constant (i.e. it was the same last year
and this year), there is no need to show the opening and closing inventory
valuations, and the income statement could be presented more simply as follows:
Illustration: Marginal costing income statement for the period

₦ ₦
Sales 440,000
Variable production cost of sales 102,000
Variable selling and distribution costs 18,000
Variable cost of sales 120,000
Contribution 320,000
Fixed costs:
Production fixed costs 120,000
Administration costs (usually 100% fixed costs) 70,000
Selling and distribution fixed costs 90,000
Total fixed costs 280,000
Profit 40,000

2.3 Calculation of marginal cost profit

The following example illustrates the calculation of marginal cost profit.
In the next section the same scenario will be used to show the difference
between marginal cost profit and total absorption profit.
Example:
Makurdi Manufacturing makes and sells a single product:
₦
Selling price per unit 150
Variable costs:
Direct material per unit 35
Direct labour per unit 25
Variable production overhead per unit 10
Marginal cost per unit (used in inventory valuation) 70
Budgeted fixed production overhead ₦110,000 per month
The following actual data relates to July and August:

July August
Fixed production costs ₦110,000 ₦110,000
Production 2,000 units 2,500 units
Sales 1,500 units 3,000units
There was no opening inventory in July.

This means that there is no closing inventory at the end of August as
production in the two months (2,000 + 2,500 units = 4,500 units) is the
same as the sales (1,500 + 3,000 units = 4,500 units)
The profit statements for each month are shown on the next page. Work through
these carefully one month at a time.

Example: Marginal cost profit statement
July August
Sales:
1,500 units  ₦150 225,000
3,000 units  ₦150 450,000
Opening inventory nil 35,000

Direct material: 2,000 units  ₦35 70,000
Direct labour: 2,000 units  ₦25 50,000
Variable overhead 2,000 units  ₦10 20,000

Closing inventory
500 units @ (70) (35,000)
Zero closing inventory nil
Cost of sale (105,000) (210,000)
Contribution 120,000 240,000
Fixed production costs (expensed) (110,000) (110,000)
Profit for the period 10,000 130,000

3 REPORTING PROFIT WITH ABSORPTION COSTING
Section overview
 Reporting profit with absorption costing

 Calculation of total absorption costing profit
3.1 Reporting profit with absorption costing

Absorption costing is the ‘traditional’ way of measuring profit in a manufacturing
company. Inventory is valued at the full cost of production, which consists of
direct materials and direct labour cost plus absorbed production overheads (fixed
and variable production overheads).
Fixed production overhead may be under- or over- absorbed because the
absorption rate is a predetermined rate. This was covered in chapter 6.
The full presentation of an absorption costing income statement might therefore
be as follows (illustrative figures included):
Illustration: Total absorption costing income statement for the period

₦ ₦
Sales 430,000
Opening inventory at full production cost 8,000
Production costs
Production overheads absorbed 100,000
198,000
Less: Closing inventory at full production cost (14,000)
Full production cost of sales (184,000)
246,000
(Under)/over-absorption
Production overheads absorbed 100,000
Production overheads incurred (95,000)
Over-absorbed overheads 5,000
251,000
Administration, selling and distribution costs (178,000)
Profit 73,000
3.2 Calculation of total absorption costing profit

The following example uses the same base scenario as that used to illustrate
marginal costing. This means that you can compare the difference between
absorption and marginal costing profits.

Example:
Makurdi Manufacturing makes and sells a single product:
₦
Selling price per unit 150
Variable costs:
Direct material per unit 35
Direct labour per unit 25
Variable production overhead per unit 10
70
Fixed overhead per unit (see below) 50
Total absorption cost per unit (used in inventory valuation) 120
Normal production 2,200 units per month

Budgeted fixed production overhead ₦110,000 per month
Fixed overhead absorption rate ₦110,000/2,200 units=
₦50 per unit
The following data relates to July and August:

July August
Fixed production costs ₦110,000 ₦110,000
Production 2,000 units 2,500 units
Sales 1,500 units 3,000units
There was no opening inventory in July.

This means that there is no closing inventory at the end of August as
production in the two months (2,000 + 2,500 units = 4,500 units) is the
same as the sales (1,500 + 3,000 units = 4,500 units)

Example: Total absorption cost profit statement
July August
Sales:
1,500 units  ₦150 225,000
3,000 units  ₦150 450,000
Opening inventory nil 60,000


Fixed production costs (absorbed)

2,000 units  ₦50 100,000
2,500 units  ₦50 125,000
Under (over) absorption

200 units @ ₦50 10,000
300 units @ ₦50 (15,000)
Closing inventory
500 units @ (70 + 50) (60,000)
Zero closing inventory nil
Cost of sale (190,000) (345,000)
Profit for the period 35,000 105,000

4 MARGINAL COSTING AND ABSORPTION COSTING COMPARED
Section overview
 The difference in profit between marginal costing and absorption costing

 Summary: comparing marginal and absorption costing profit
4.1 The difference in profit between marginal costing and absorption costing
The profit for an accounting period calculated with marginal costing is different
from the profit calculated with absorption costing.
The difference in profit is due entirely to the differences in inventory valuation.
The main difference between absorption costing and marginal costing is that in
absorption costing, inventory cost includes a share of fixed production overhead
costs.
 The opening inventory contains fixed production overhead that was
incurred last period. Opening inventory is written off against profit in the
current period. Therefore, part of the previous period’s costs are written off
in the current period income statement.
 The closing inventory contains fixed production overhead that was incurred
in this period. Therefore, this amount is not written off in the current period
income statement but carried forward to be written off in the next period
income statement.
The implication of this is as follows (assume costs per unit remain constant):
 When there is no change in the opening or closing inventory, exactly the
same profit will be reported using marginal costing and absorption costing.
 If inventory increases in the period (closing inventory is greater than
opening inventory),
 the increase is a credit to the income statement reducing the cost of
sales and increasing profit;
 the increase will be bigger under total absorption valuation than under
marginal costing valuation (because the absorption costing inventory
includes fixed production overhead); therefore
 the total absorption profit will be higher.
 If inventory decreases in the period (closing inventory is less than opening
inventory),
 the decrease is a debit to the income statement;
 the decrease will be bigger under total absorption valuation than
under marginal costing valuation (because the absorption costing
inventory includes fixed production overhead); therefore
 the total absorption profit will be lower.

The difference in the two profit figures is calculated as follows:
Formula: Profit difference under absorption costing (TAC = total absorption costing)
and marginal costing (MC)
Assuming cost per unit is constant across all periods under consideration.
Number of units increase or decrease  Fixed production overhead per unit
Returning to the previous example:
Example: Profit difference
Over the two

July August months
₦ ₦ ₦
Absorption costing profit 35,000 105,000 140,000
Marginal costing profit 10,000 130,000 140,000
Profit difference 25,000 (25,000) nil
This profit can be explained the different way the inventory movement is
costed under each system:
Units Units Units
Closing inventory nil nil
2,000 units made less 1,500
sold 500
Opening inventory nil 500 nil

500 (500) nil
Absorbed fixed production
overhead per unit (₦) 50 50 50
Profit difference (₦) 25,000 (25,000) nil

Note that the difference is entirely due to the movement in inventory value:
Example: Profit difference – due to inventory movement
Over the two

TAC inventory movement: July August months
₦ ₦ ₦
Closing inventory 60,000 nil nil
Opening inventory nil (60,000) nil
60,000 (60,000) nil
MC inventory movement
Closing inventory 35,000 nil nil
Opening inventory nil (35,000) nil
35,000 (35,000) nil
Profit difference 25,000 (25,000) nil
4.2 Summary: comparing marginal and absorption costing profit

An examination might test your ability to calculate the difference between the
reported profit using marginal costing and the reported profit using absorption
costing. To calculate the difference, you might need to make the following simple
calculations:
 Calculate the increase or decrease in inventory during the period, in units.
 Calculate the fixed production overhead cost per unit.
 The difference in profit is the increase or decrease in inventory quantity
multiplied by the fixed production overhead cost per unit.
 If there has been an increase in inventory, the absorption costing profit is
higher. If there has been a reduction in inventory, the absorption costing
profit is lower.
Ignore fixed selling overhead or fixed administration overhead. These are written
off in full as a period cost in both absorption costing and marginal costing, and
only fixed production overheads are included in inventory values.
Practice question 1
A company uses marginal costing. In the financial period that has just ended,
opening inventory was ₦8,000 and closing inventory was ₦15,000. The reported
profit for the year was ₦96,000.
If the company had used absorption costing, opening inventory would have been
₦15,000 and closing inventory would have been ₦34,000.
Required
What would have been the profit for the year if absorption costing had been
used?

Practice question 2
A company uses absorption costing. In the financial period that has just ended,
opening inventory was ₦76,000 and closing inventory was ₦49,000. The
reported profit for the year was ₦183,000.
If the company had used marginal costing, opening inventory would have been
₦40,000 and closing inventory would have been ₦28,000.
Required
What would have been the profit for the year if marginal costing had been used?
Practice question 3
The following information relates to a manufacturing company for a period.
Production 16,000 units Fixed production costs ₦80,000

Sales 14,000 units Fixed selling costs ₦28,000
Using absorption costing, the profit for this period would be ₦60,000
Required
What would have been the profit for the year if marginal costing had been used?
Practice question 4
1 Red Company is a manufacturing company that makes and sells a
single product. The following information relates to the company’s
manufacturing operations in the next financial year.
Opening and closing stock: Nil

Production: 18,000 units
Sales: 15,000 units
Fixed production overheads: ₦117,000
Fixed sales overheads: ₦72,000
Using absorption costing, the company has calculated that the
budgeted profit for the year will be ₦43,000.
Required
What would be the budgeted profit if marginal costing is used, instead
of absorption costing?

5 ADVANTAGES AND DISADVANTAGES OF ABSORPTION AND

MARGINAL COSTING
Section overview
 Advantages and disadvantages of absorption costing

 Advantages and disadvantages of marginal costing
The previous sections of this chapter have explained the differences between marginal
costing and absorption costing as methods of measuring profit in a period. Some
conclusions can be made from these differences.
 The amount of profit reported in the cost accounts for a financial period will
depend on the method of costing used.
 Since the reported profit differs according to the method of costing used, there
are presumably reasons why one method of costing might be used in preference
to the other. In other words, there must be some advantages (and
disadvantages) of using either method.
5.1 Advantages and disadvantages of absorption costing

Absorption costing has a number of advantages and disadvantages.
Advantages of absorption costing

 Inventory values include an element of fixed production overheads. This is
consistent with the requirement in financial accounting that (for the purpose
of financial reporting) inventory should include production overhead costs.
 Calculating under/over absorption of overheads may be useful in controlling
fixed overhead expenditure.
 By calculating the full cost of sale for a product and comparing it will the
selling price, it should be possible to identify which products are profitable
and which are being sold at a loss.
Disadvantages of absorption costing

 Absorption costing is a more complex costing system than marginal
costing.
 Absorption costing does not provide information that is useful for decision
making (like marginal costing does).

5.2 Advantages and disadvantages of marginal costing

Marginal costing has a number of advantages and disadvantages.
Advantages of marginal costing

 It is easy to account for fixed overheads using marginal costing. Instead of
being apportioned they are treated as period costs and written off in full as
an expense the income statement for the period when they occur.
 There is no under/over-absorption of overheads with marginal costing, and
therefore no adjustment necessary in the income statement at the end of n
accounting period.
 Marginal costing provides useful information for decision making.
 Contribution per unit is constant, unlike profit per unit which varies as the
volume of activity varies.
Disadvantages of marginal costing

 Marginal costing does not value inventory in accordance with the
requirements of financial reporting. (However, for the purpose of cost
accounting and providing management information, there is no reason why
inventory values should include fixed production overhead, other than
consistency with the financial accounts.)
 Marginal costing can be used to measure the contribution per unit of
product, or the total contribution earned by a product, but this is not
sufficient to decide whether the product is profitable enough. Total
contribution has to be big enough to cover fixed costs and make a profit.

6 CHAPTER REVIEW
Chapter review
 Explain the concept of marginal costing
 Calculate the marginal cost of an item from given data
 Explain how marginal cost and the concept of contribution are important in
decision making
 Describe absorption costing using examples
 Calculate the absorption cost of an item from given data
 Compare marginal costing and absorption costing
 Reconcile absorption costing and marginal costing profit figures


Solution 1
There was an increase in inventory. It was ₦7,000 using marginal costing (= ₦15,000 –
₦8,000). It would have been ₦19,000 using absorption costing.
₦
Increase in inventory, marginal costing 7,000
Increase in inventory, absorption costing 19,000
Difference (profit higher with absorption costing) 12,000
Profit with marginal costing 96,000
Profit with absorption costing 108,000
The profit is higher with absorption costing because there has been an increase in
inventory (production volume has been more than sales volume.)
Solution 2
There was a reduction in inventory. It was ₦27,000 using absorption costing
(= ₦76,000 – ₦49,000). It would have been ₦12,000 using marginal costing.
₦
Reduction in inventory, absorption costing 27,000
Reduction in inventory, marginal costing 12,000
Difference (profit higher with marginal costing) 15,000
Profit with absorption costing 183,000
Profit with marginal costing 198,000
Profit is higher with marginal costing because there has been a reduction in inventory
during the period.
Solution 3
Ignore the fixed selling overheads. These are irrelevant since they do not affect the
difference in profit between marginal and absorption costing.
There is an increase in inventory by 2,000 units, since production volume (16,000 units)
is higher than sales volume (14,000 units).
If absorption costing is used, the fixed production overhead cost per unit is ₦5 (=
₦80,000/16,000 units).
The difference between the absorption costing profit and marginal costing profit is
therefore ₦10,000 (= 2,000 units  ₦5).
Absorption costing profit is higher, because there has been an increase in inventory.
Marginal costing profit would therefore be ₦60,000 – ₦10,000 = ₦50,000.

Solution 4
Production overhead per unit, with absorption costing:
= ₦117,000/18,000 units
= ₦6.50 per unit.
The budgeted increase in inventory = 3,000 units (18,000 – 15,000).
Production overheads in the increase in inventory = 3,000 × ₦6.50 =
₦19,500.
With marginal costing, profit will be lower than with absorption costing,
because there is an increase in inventory levels.
Marginal costing profit = ₦43,000 - ₦19,500 = ₦23,500.


Foundation level
CHAPTER
7
Activity-based costing
Contents
1 Traditional costing systems
2 Activity-based costing (ABC)
3 Chapter overview

INTRODUCTION
Purpose
application of quantitative methods in financial management
Competencies
process costs
2(c) Select and justify the choice of the most appropriate methods of budgeting for
planning and controlling including motivational considerations, including
activity-based costing
Exam context
This chapter explains activity-based costing.

 Explain the difference between traditional volume based absorption methods and
 Apportion overheads using activity-based costing
 Estimate unit cost using activity-based costing

Chapter 7: Activity-based costing
1 TRADITIONAL COSTING SYSTEMS
Section overview
 Absorption costing
 Under- and over-absorption
 Criticisms of absorption costing
1.1 Absorption costing

Absorption costing is a form of costing in which the costs of products are
calculated by adding an amount for indirect production costs (production
overheads) to the direct costs of production.
This was covered in an earlier chapter but a brief revision is provided here for
your convenience.
 Production overheads are indirect costs. This means that the costs (unlike
direct costs) cannot be attributed directly to specific items (products) for
which a cost is calculated.
 A ‘fair’ share of overhead costs is added to the direct costs of the product,
using an absorption rate.
 A suitable absorption rate is selected. This is usually a rate per direct
labour hour, a rate per machine hour, a rate per amount of material or
possibly a rate per unit of product.
 Production overheads may be calculated for the factory as a whole;
alternatively, separate absorption rates may be calculated for each different
production department. (However, it is much more likely that a question
involving absorption costing will give a factory-wide absorption rate rather
than separate departmental absorption rates.)
 The overhead absorption rate (or rates) is determined in advance for the
financial year. It is calculated as follows:
Formula: Overhead absorption rate

Total allocated and apportioned overheads
Volume of activity in the period
Which is:
Budgeted production overhead expenditure for the period
Budgeted activity in the period
The ‘activity’ is the number of labour hours in the year, the number of machine
hours or the number of units produced, depending on the basis of absorption
(labour hour rate, machine hour rate or rate per unit) that is selected.

Practice question 1
A manufacturing company makes two products, X and Y. Budget
information about these products is as follows.
Product X Product Y
Direct cost per unit ₦10 ₦7
Direct labour time to make each unit
(minutes) 15 20
Budgeted production for the year (units) 8,000 9,000
The budgeted production overheads for the year are ₦120,000. The company
uses an absorption costing system and a direct labour hour absorption rate.
Required
a) Calculate the overhead absorption rate.
b) Calculate the budgeted cost per unit of X and unit of Y?
1.2 Under- and over-absorption

Overhead absorption rates are decided in advance (before the period under
review).
Actual overhead expenditure and actual production volume might differ from the
estimates used in the budget to work out the absorption rate.
As a consequence, the amount of overheads added to the cost of products
manufactured is likely to be different from actual overhead expenditure in the
period. The difference is under- or over-absorbed overheads.
Illustration: Under of over-absorbed fixed overhead

₦
Amount absorbed:
Actual number of units Predetermined
 X
made (or hours used) absorption rate
Actual expenditure in the period (X)

Over/(under) absorbed X
Overheads are under-absorbed when the amount of overheads absorbed into

production costs is less than the actual amount of overhead expenditure.
Overheads are over-absorbed when the amount of overheads absorbed into
production costs is more than the actual amount of overhead expenditure.
The amount of under- or over-absorbed overheads is written to profit or loss for
the year as an adjusting figure.
 If overhead is under-absorbed overhead the profit is adjusted down
(because production costs have been understated)
 If overhead is over-absorbed the profit is adjusted upwards.

1.3 Criticisms of absorption costing

Traditional absorption costing has many weaknesses, especially in a ‘modern’
manufacturing environment.
 Production overhead costs are often high relative to direct production costs.
Therefore, a system of adding overhead costs to product costs by using
time spent in production (direct labour hours or machine hours) is difficult to
justify.
 A full cost of production has only restricted value for many types of
management decision.
However, traditional absorption costing is still in use with some companies.
 It provides a rational method of charging overhead costs to production
costs, so that a full cost of production can be calculated for closing
inventories.
 It is also argued that absorption costing is useful for some pricing decisions.
(Pricing is covered in a later paper).
A number of alternative costing methods have been developed with a view to

replacing the traditional methods. One such method is activity-based costing.

2 ACTIVITY-BASED COSTING (ABC)
Section overview
 Introduction to activity-based costing

 Activities
 Cost drivers and cost pools
 When using ABC might be appropriate
 Advantages and disadvantages of ABC
2.1 Introduction to activity-based costing

Activity-based costing (ABC) is a form of absorption costing that takes a different
approach to the apportionment and absorption of production overhead costs.
Activity-based costing is based on the following ideas:
 In a modern manufacturing environment, a large proportion of total costs
are overhead costs, and direct labour costs are relatively small.
 It is appropriate to trace these costs as accurately as possible to the
products that create the cost because overhead costs are large.
 The traditional methods of absorbing production overhead costs on the
basis of direct labour hours or machine hours have no rational justification
as many production overhead costs are not directly related to the
production work that is carried out. For example:
 The costs of quality control and inspection depend on the quality
standards and inspection methods that are used: these do not
necessarily relate to the number of hours worked in production.
 The costs of processing and chasing customer orders through the
factory relate more to the volume of customer orders rather than the
hours worked on each job in production.
 Costs of managing the raw materials inventories (storage costs)
relate more to the volume of materials handled rather than hours
worked on the material in production.
 The costs of production relate more to the volume and complexity of
customer orders or the number of batch production runs, rather than
hours worked in production.

2.2 Activities
Activity-based costing (ABC) takes the view that many production overhead costs
can be associated with particular activities other than direct production work.
If such activities can be identified and costs linked to them overhead costs can
then be added to product costs by using a separate absorption rate for each
activity.
ABC costing of overheads and estimate of full production costs is therefore
based on activities, rather than hours worked in production.
Identifying activities
A problem with introducing activity-based costing is deciding which activities
create or ‘drive’ overhead costs.
There are many different activities within a manufacturing company, and it is not
always clear which activities should be used for costing.
Activities might include, for example:
 materials handling and storage;
 customer order processing and chasing;
 purchasing;
 quality control and inspection;
 production planning; and
 repairs and maintenance.
These activities are not necessarily confined to single functional departments
within production departments.
Although ABC is often concerned with production costs, it can also be applied to
activities outside production, such as sales and distribution. Sales and
distribution activities might include:
 selling activities;
 warehousing and despatch; and
 after-sales service.
In a system of activity-based costing, it is preferable to select a fairly small
number of activities. If a large number of activities are selected, the costing
system could become too complex and time-consuming to operate.
The activities are selected on the basis of management judgement and
experience, and their knowledge of the activities within manufacturing.

2.3 Cost drivers and cost pools
Cost drivers
For each activity, there should be a cost driver. A cost driver is the factor that
determines the cost of the activity. It is something that will cause the costs for an
activity to increase as more of the activity is performed.
Overhead costs are therefore caused by activities, and the costs of activities are
driven by factors other than production volume.
Each cost driver must be a factor that can be measured so that the number of
units of the cost driver that have occurred during each period can be established.
Possible examples include:
Activity Possible cost driver Information needed for

ABC
Customer order Number of customer Number of orders for
processing orders each product
Materials purchasing Number of purchase Number of orders for
orders materials for each
finished product
Quality control and Number of inspections Number of inspections
inspection of output of each
product
Production planning Number of production Number of runs or
runs or batches batches of each product
Repairs and Number of machines, or Number of machines or
maintenance machine hours operated machine hours worked
for each product
Selling Number of sales orders Number of orders for
each product
Warehousing and Number of deliveries Number of deliveries for
despatch made each product
Cost pools
A cost pool is simply the overhead expenditure allocated and apportioned to an
activity. Overhead costs are allocated (or allocated and apportioned) to each
activity, and for each activity there is a ‘cost pool’.
ABC absorbs overheads into the cost of products (or services) at a separate rate
for each cost pool (each activity).
The total production cost for each product or service is therefore direct production
costs plus absorbed overheads for each activity.
The cost absorbed under ABC might be very different to that absorbed using a
traditional, volume-based approach.

Example: ABC vs traditional, volume based absorption

A manufacturing company makes four products and incurs estimated material
handling costs of ₦250,000 per month. (This is the cost pool for material
handling cost).
The company produces 160,000 units per month and absorbs material handling
cost on the number of units. This gives a material handling cost of ₦1.5625
(₦250,000 ÷ 160,000 units)
The material handling cost is absorbed as follows:
Units Unit cost Cost absorbed
Product produced (₦) (₦)
W 60,000 ₦1.5625 93,750
X 33,000 ₦1.5625 51,563
Y 40,000 ₦1.5625 62,500
Z 27,000 ₦1.5625 42,187
160,000 ₦1.5625 250,000
The company has instigated a project to see if ABC costing would be appropriate.
The project has identified that a large part of the material handling costs are
incurred in receiving material orders and that the same effort goes into receiving
orders regardless of the size of the order. Order sizes differ substantially.
The company has identified the following number of orders in respect of material
for each type of product.
Number of
Product orders
W 15
X 22
Y 4
Z 9
50
An ABC cost per order (hence cost per unit) can be estimated as follows:
If the cost driver for order handling is the number of orders handled, the budgeted
order handling cost will be ₦5,000 per order (₦250,000/50).
Overhead costs will be charged to products as follows:
Number Cost per Apportioned Units
Product of orders order cost produced Unit cost
W 15 ₦5,000 75,000 60,000 1.25
X 22 ₦5,000 110,000 33,000 3.33
Y 4 ₦5,000 20,000 40,000 0.50
Z 9 ₦5,000 45,000 27,000 1.67
50 ₦5,000 250,000 160,000
The above example shows that the material handling overhead absorbed to each
type of product is very different under the two approaches.

For example, only 33,000 units of product X are made (out of a total of 160,000
units). However, product X requires 22 orders out of a total of 60 and it is the
number of orders that drive this cost.
The traditional approach recognised ₦51,563 as relating to product but ABC,
using the number of orders as the driver results in ₦110,000 being absorbed by
product X.
The above example shows the difference between traditional absorption and
ABC using a single cost. In reality there would be more than one activity used as
a basis for absorption leading to a series of absorption rates (per activity).
Also note that one of the absorption methods might be a volume-based method.
The point is that traditional absorption methods treat all costs as varying
according to a volume measure whereas ABC splits the total and treats each part
of the total cost according to what drives it.
Example: ABC
A company makes three products, X, Y and Z using the same direct labour
employees and the same machine for production.
Production details for the three products for a typical period are as follows:
Labour Machine Material Number of
hours per hours per cost per units
unit unit unit (₦) produced
Product X 0.25 0.75 100 1,500
Product Y 0.75 0.50 60 2,500
Product Z 0.50 1.50 120 14,000
Direct labour costs ₦160 per hour.
Total production overheads are ₦1,309,000 and further analysis shows that the
total production overheads can be divided as follows:
₦
Costs relating to machinery 196,350
Costs relating to inspection 458,150
Costs relating to set-ups 392,700
Costs relating to materials handling 261,800
Total production overhead 1,309,000
The following total activity volumes are associated with each product for the
period:
Number of
Number of Number movements Machine
inspections of set-ups of materials hours
Product X 360 80 40 1,125
Product Y 80 120 80 1,250
Product Z 960 500 280 21,000
1,400 700 400 23,375
Machine costs are absorbed on a machine hour basis.

Example (continued): ABC

The costs per unit for each product may be estimated as follows using ABC
principles.
Step 1: Cost per activity
Cost Overhead
allocated Activity per absorption
Activity (₦) Cost driver period rate
₦327.25 per
Inspection 458,150 Inspections 1,400 inspection
₦561 per set-
Set-ups 392,700 Set-ups 700 up
Materials ₦654.50 per
handling 261,800 Movements 400 movement
Machinery ₦8.40 per
operations 196,350 Machine hrs 23,375 machine hour
Total 1,309,000
Step 2: Allocate overheads to product types based on cost per activity and
cost drivers
X Y Z
₦ ₦ ₦
Set-ups
80 set ups  ₦561 44,880
120 set ups  ₦561 67,320
500 set ups  ₦561 280,500
Inspection
360 set ups  ₦327.25 117,810
80 set ups  ₦327.25 26,180
960 set ups  ₦327.25 314,160
Materials handling
40 movements  ₦654.50 26,180
80 movements  ₦654.50 52,360
280 movements  ₦654.50 183,260
Machinery operations
1,125 hours  ₦8.40 9,450
1,250 hours  ₦8.40 10,500
21,000 hours  ₦8.40 176,400
Overhead costs per product 198,320 156,360 954,320

Example (continued): ABC

Step 3: Calculate overhead per unit (if required)
X Y Z
Overhead costs per product
(from step 2) ₦198,320 ₦156,360 ₦954,320
Number of units 1,500 2,500 14,000
Overhead cost per unit ₦132.21 ₦62.54 ₦68.17
Step 4: Calculate total production cost per unit (if required)

Production cost per unit: ABC X Y Z
₦ ₦ ₦
Direct materials 100.00 60.00 120.00
Direct labour 40.00 120.00 80.00
Production overhead (from step3) 132.21 62.54 68.17
Full production cost per unit 272.21 242.50 268.17
Although ABC is a form of absorption costing, the effect of ABC could be to

allocate overheads in a completely different way between products. Product
costs and product profitability will therefore be very different with ABC compared
with traditional absorption costing.

Practice question 2
A company makes and sells two products, X and Y.
Data for production and sales each month are as follows:
Product X Product Y
Sales demand (units) 4,000 8,000
Direct material cost/unit (₦) 20 10
Direct labour hours/unit
(hours) 0.1 0.2
Direct labour cost/unit ₦2 ₦4
Production overheads are ₦500,000 each month.
An analysis of overhead costs suggests that there are four main activities that
cause overhead expenditure.
Total Total Product Product
Activity cost Cost driver number X Y
₦
Number of
Batch set-up 100,000 set-ups 20 10 10
Number of
Order handling 200,000 orders 40 24 16
Machine
Machining 120,000 hours 15,000 6,000 9,000
Number of
Quality control 80,000 checks 32 18 14
500,000
Required
Calculate the full production costs for Product X and Product Y, using:
(a) traditional absorption costing (absorbing production overhead on a direct
labour hour basis.
(b) activity-based costing.
2.4 When using ABC might be appropriate

Activity-based costing could be suitable as a method of costing in the following
circumstances:
 In a manufacturing environment, where absorption costing is required for
inventory valuations.
 Where a large proportion of production costs are overhead costs, and direct
labour costs are relatively small.
 Where products are complex.
 Where products are provided to customer specifications.
 Where order sizes differ substantially, and order handling and despatch
activity costs are significant.

2.5 Advantages and disadvantages of ABC
Advantages
 ABC provides useful information about the activities that drive overhead
costs. Traditional absorption costing and marginal costing do not do this.
 ABC therefore provides information that could be relevant to long-term cost
control and long-term product selection or product pricing.
 With ABC, overheads are charged to products on the basis of the activities
that are required to provide the product: Each product should therefore be
charged with a ‘fair share’ of overhead cost that represents the activities
that go into making and selling it.
 It might be argued that full product costs obtained with ABC are more
‘realistic’, although it can also be argued that full product cost information is
actually of little practical use or meaning for management.
 There is also an argument that in the long-run, all overhead costs are
variable (even though they are fixed in the short-term). Measuring costs
with ABC might therefore provide management with useful information for
controlling activities and long-term costs.
Disadvantages
 ABC systems are costly to design and use. The costs might not justify the
benefits.
 The analysis of costs in an ABC system may be based on unreliable data
and weak assumptions. In particular, ABC systems may be based on
inappropriate activities and cost pools, and incorrect assumptions about
cost drivers.
 ABC provides an analysis of historical costs. Decision-making by
management should be based on expectations of future cash flows.
 Within ABC systems, there is still a large amount of overhead cost
apportionment. General overhead costs such as rental costs, insurance
costs and heating and lighting costs may be apportioned between cost
pools. This reduces the causal link between the cost driver and the activity
cost.
 Many ABC systems are based on just a small number of cost pools and
cost drivers. More complex systems are difficult to justify, on grounds of
cost.
 Identifying the most suitable cost driver for a cost pool/activity is often
difficult. Many activities and cost pools have more than one cost driver.
 Traditional cost accounting systems may be more appropriate for the
purpose of inventory valuation and financial reporting.

3 CHAPTER REVIEW
Chapter review
 Explain the difference between traditional volume based absorption methods and
 Apportion overheads using activity-based costing
 Estimate unit cost using activity-based costing


Solution 1
a) Overhead absorption rate
Hours
Budgeted labour hours: Product X: 8,000  15/60 2,000
Budgeted labour hours: Product Y: 9,000  20/60 3,000
Total budgeted hours for the year 5,000
Budgeted production overheads ₦120,000

Absorption rate per direct labour hour ₦24
b) Budgeted cost per unit

Product Product
X Y
₦ per ₦ per
unit unit
Direct cost 10 7
Production overheads: ₦24  15/60 6 ₦24  20/60 8
Full production cost 16 15

Solution 2
a) Traditional absorption costing
The overhead absorption rate = ₦500,000/ (4,000 × 0.1) + (8,000 × 0.2) = ₦250
Product X Product Y
₦ ₦
Direct materials 20 10
Direct labour 2 4
Overhead (at ₦250 per hour) 25 50
Cost per unit 47 64
Number of units () 4,000 8,000
Total cost (₦) 188,000 + 512,000 = 700,000
b) Activity-based costing
Total cost Rate Product X Product Y
Activity (₦) Cost driver (₦) (₦) (₦)
Batch setup 100,000 No. of set-ups 5,000 50,000 50,000
Order handling 200,000 No. of orders 5,000 120,000 80,000
Machine
Machining 120,000 hours 8 48,000 72,000
Quality control 80,000 No. of checks 2,500 45,000 35,000
500,000 263,000 237,000
Unit cost under ABC Product X Product Y

₦ ₦
Direct materials 80,000 80,000
Direct labour 8,000 32,000
Overheads 263,000 237,000
Total cost 351,000 + 349,000 = ₦700,000
Number of units 4,000 8,000
Cost per unit (₦) 87.75 43.625
Tutorial note:
Using ABC in this situation, the cost per unit of Product X is much higher than with
traditional absorption costing and for Product Y the unit cost is much less.
The difference is caused by the fact that Product X uses only 20% of total direct labour
hours worked, but much larger proportions of set-up resources, order handling
resources, machining time and quality control resources. As a result, the overheads
charged to each product are substantially different.
This is an important feature of activity-based costing. The overheads charged to
products, and so the overhead cost per unit of product, can be significantly different
from the overhead cost per unit that would be obtained from traditional absorption
costing.


Foundation level
CHAPTER
8
Job, batch
and service costing
Contents
1 Job costing
2 Batch costing
3 Service costing
4 Chapter review

INTRODUCTION
Purpose
Competencies
process costs
Exam context
This chapter explains job, batch and service costing.

 Explain the nature of job costing
 Calculate job cost from given data
 Explain the nature of batch costing
 Calculate batch cost from given data
 Explain the nature of service costing
 Calculate cost of services rendered by a service organization

Chapter 8: Job, batch and service costing
1 JOB COSTING
Section overview
 The nature of job costing

 The cost of a job
 Cost records and accounts for job costing
Costing systems are used to record total costs. They are also used to record the costs
of individual cost units. The method used to measure the cost of units depends on the
production system and how the products are made.
1.1 The nature of job costing

Job costing is used when a business entity carries out tasks or jobs to meet
specific customer orders. Although each job might involve similar work, they are
all different and are carried out to the customer’s specific instructions or
requirements.
Examples of jobs include work done for customers by builders or electricians,
audit work done for clients by a firm of auditors, and repair work on motor
vehicles by a repair firm.
Job costing is similar to contract costing, in the sense that each job is usually
different and carried out to the customer’s specification or particular
requirements. However, jobs are short-term and the work is usually carried out in
a fairly short period of time. Contracts are usually long-term and might take
several months or even years to complete.
1.2 The cost of a job

A cost is calculated for each individual job, and this cost can be used to establish
the profit or loss from doing the job.
Job costing differs from most other types of costing system because each cost
unit is a job, and no two jobs are exactly the same. Each job is costed separately.
 The expected cost of a job has to be estimated so that a price for the job
can be quoted to a customer.
 A costing system should also calculate the actual cost of each job that has
been carried out.
A job costing system is usually based on absorption costing principles, and in
addition a cost is included for non-production overheads, as follows.

Illustration: Job cost

₦
Direct labour 300
Direct expenses 200
Prime cost 1,000
Production overhead absorbed 750
Production cost of the job 1,750
Non-production overheads 400
Total job cost 2,150
In many cases, job costs include not just direct materials costs and direct labour
costs, but also direct expenses, such as:
 the rental cost of equipment hired for the job
 the cost of work done for the job by sub-contractors
 the depreciation cost of equipment used exclusively on the job.
Production overheads might be absorbed on a direct labour hour basis, or on any
other suitable basis.
Non-production overheads might be added to the cost of the job:
 as a percentage of the prime cost of the job, or
 as a percentage of the production cost of the job.
Example:
The following cost information has been gathered about Job number 453.
The direct materials cost is ₦100, the direct labour cost is ₦60 and direct
expenses are ₦40. Direct labour costs ₦20 per hour. Production overheads are
charged at the rate of ₦30 per direct labour hour and non-production overheads
are charged at the rate of 40% of prime cost.
The job cost for Job 453 is calculated as follows:
Job cost: Job 453
₦
Direct labour (3 hours at ₦20) 60
Direct expenses 40
Prime cost 100
Production overhead (3 hours at ₦30) 90
Production cost of the job 190
Non-production overheads (40% of prime cost) 40
Total job cost 230

1.3 Cost records and accounts for job costing

In order to establish the cost of each individual job in a costing system, it is
necessary to have procedures for recording direct costs in such a way that they
can be allocated to specific jobs. Production overheads and non-production
overheads can be charged using overhead absorption rates within a system of
absorption costing.
Each job is given a unique identity number, or job number. The costs for
individual jobs are recorded as follows.
 The direct materials for a job are issued directly from stores to the job. The
materials requisition note should specify the job number and the costs of
the materials are charged to the job.
 The labour time spent on a job is recorded on time sheets or job sheets.
The time sheets for each individual employee identify the jobs he has
worked on and the time that he spent on each job. These can be converted
into a cost for the job at the employee’s hourly rate.
 A system is needed for recording direct expenses to specific jobs. Costs
might be obtained from purchase invoices from suppliers, and recorded in
the job cost record (the ‘job sheet’) for the job.
 Production overheads are charged to the job (absorbed, in an absorption
costing system) at the appropriate absorption rate, when the job has been
completed.
 Similarly, non-production overheads can be charged when the job has been
finished by charging them at the appropriate absorption rate.
Direct costs and overheads are recorded on a job sheet or job card for the job. At
one time, a job card used to be an actual card or sheet of paper, although job
costing systems are now likely to be computerised.
In a costing system, a job account is similar to a work-in-progress account,
except that it is for one job only. In a company that specialises in jobbing work,
the work-in-progress account is the total of all the individual job accounts.
Illustration: Job cost account

Job account: Job 12345
₦ ₦
Direct materials 1,800 Cost of sales 7,300
Direct wages 2,500
Direct expenses
Production overhead 3,000
7,300 7,300
When the job is finished, the total cost of the job is transferred to the cost of sales
account.

Example: Job costing

There is a comprehensive example on the following pages.
The information will be used to complete the following tasks:
1. Prepare a schedule to show the resources used in the month.
2 Prepare journal entries to account for the utilisation of resources and to
collect costs into the job accounts.
3 Prepare job cost accounts for each individual job in the costing ledger.
4 Prepare job cost cards showing the resources allocated to the jobs and
the allocation of administration and marketing expenses for the jobs
completed in the period. Also incorporate the revenue for the period and
show the profit or loss on those jobs completed.
5 Assuming that the company operates a system using a control account
in its general ledger for jobs, show the double entry (as T-accounts) to
account for job activity in the period.
(Note: The system suggested is similar to that for the receivables control
account backed up by the receivables ledger. In this case there is a WIP
control account backed up by the job costing ledger).

Example: Job Costing

The following information relates to job activity in the month of June.
Job 0503 Job 0402 Job 0607
Contract price ₦500,000 ₦980,000 ₦600,000
Commenced 3 May 2 April 7 June
Completed 25 June Not 19 June
completed
Opening WIP comprised: na

Direct materials (all ₦5,000 ₦10,000
material X)
Direct labour (all grade A) ₦10,000 ₦18,000
₦15,000 ₦28,000
Material issues from stores:

Material X 200 kgs 800 kgs 900 kgs
Material Y 400 kgs 600 kgs
Labour
Grade A 60 hours 120 hours 150 hours
Grade B 25 hours 100 hours 20 hours
Costs:
Material X ₦220 per kg
Material Y ₦500 per kg
Grade A ₦250 per hour
Grade B ₦400 per hour
Variable overhead recovery rate ₦300 per hour
Fixed production overhead is absorbed using direct labour hours

Budgeted fixed production overhead ₦160,000
Budgeted labour hours 500 hours
Actual fixed production overhead ₦161,000
expenditure in the period
The company needed to hire a special machine for job 0402 at a cost of
₦5,000 in the current month.
20 kgs of raw material were returned to stores on completion of job
0607.
For internal profit reporting purposes administration and marketing

expenses are added to cost of sales at 20% at the time of completion of
the job. Actual administration and marketing expense in the period was
₦130,000.

Example: Task 1 – Schedule of resources used in month
Material X Kgs Cost per kg ₦

Job 0503: 200 220 44,000
Job 0402 800 220 176,000
Job 0607 900 220 198,000
Less returns (20) 220 (4,400)
880 220 193,600
1,880 220 413,600
Material Y Kgs Cost per kg ₦

Job 0503: 400 500 200,000
Job 0402 600 500 300,000
1,000 500 500,000
Labour grade A Hours Cost per hour ₦

Job 0503: 60 250 15,000
Job 0402: 120 250 30,000
Job 0607: 150 250 37,500
330 250 82,500
Labour grade B Hours Cost per hour ₦

Job 0503: 25 400 10,000
Job 0402: 100 400 40,000
Job 0607: 20 400 8,000
145 400 58,000
Variable overhead Hours Cost per hour ₦

Job 0503: 60 + 25 = 85 300 25,500
Job 0402: 120 + 100 = 220 300 66,000
Job 0607: 150 + 20 = 170 300 51,000
475 300 142,500
Fixed overhead Hours Cost per hour ₦

Job 0503: 85 320 27,200
Job 0402: 220 320 70,400
Job 0607: 170 320 54,400
475 320 152,000

Example: Task 2 – Journal entries to record costs in the job accounts
Debit Credit
Issues of Material X
Job 0503 account 44,000
Material X inventory account 418,000
Returns of Material X
Material X inventory account 4,400
Issues of Material Y
Material Y inventory account 500,000
Grade A labour
Grade A labour account 82,500
Grade B labour
Grade B labour account 58,000
Variable overhead
Variable overhead account 142,500
Fixed overhead
Fixed production overhead account 152,000
Hire cost
Cash 5,000

Example: Task 3 – Job cost accounts
Job 0503
₦ ₦
Balance b/d 15,000
Issues from stores:
Material X 44,000
Material Y 200,000
Labour:
Grade A 15,000
Grade B 10,000
Variable overhead 25,500

Fixed overhead 27,200 Cost of sales 336,700
336,700 336,700
Job 0402
₦ ₦
Balance b/d 28,000
Issues from stores:
Material X 176,000
Material Y 300,000
Labour:
Grade A 30,000
Grade B 40,000

Fixed overhead 70,400
Machine hire 5,000 Balance c/d 715,400

715,400 715,400

Example: Task 3 – Job cost accounts (continued)
Job 0607
₦ ₦
Issues from stores: Returns to stores
Material X 198,000 Material X 4,400
Labour:
Grade A 37,500
Grade B 8,000

Fixed overhead 54,400 Cost of sales 344,500
348,900 348,900
Example: Task 4– Job cost cards

Job 0503 Job 0402 Job 0607
₦ ₦ ₦
Material X
In opening WIP 5,000 10,000 na
In period 44,000 176,000 193,600
49,000 186,000 193,600
Material Y (in period) 200,000 300,000
Grade A labour
In opening WIP 10,000 18,000 na
In period 15,000 30,000 37,500
25,000 48,000
Grade B labour 10,000 40,000 8,000
Variable overhead 25,500 66,000 51,000
Fixed overhead 27,200 70,400 54,400
Machine hire 5,000
Factory cost 336,700 715,400 344,500
Administration and marketing
@ 20% 67,340 68,900
Cost of sale 404,040 413,400
Contract price 500,000 600,000
Profit 95,960 186,600

The following journals were not asked for but they are included to help you to
understand the double entry in the general ledger.
Example: Task 5– Journal entries to record costs in the general ledger

Debit Credit
a Issues of Material X
WIP control account 418,000
Inventory control account 418,000
b Returns of Material X
c Issues of Material Y
d Grade A labour
Payroll control account 82,500
e Grade B labour
Payroll control account 58,000
f Variable overhead
Variable overhead account 142,500
g Fixed overhead
h Hire cost
Cash 5,000
i Transfer of costs on completed sales

Cost of sales account (336,700 for job 0503
681,200
and 344,500 for job 0607)

Example: Task 5 – WIP control account
WIP control
₦ ₦
Balance b/d 43,000
a) Inventory control 418,000 b) Inventory control 4,400
c) Inventory control 500,000
d) Payroll control 82,500
e) Payroll control 58,000
f) Var. overhead 142,500
g) Fixed overhead 152,000
h) Hire cost 5,000 i) Cost of sales 681,200
Balance c/d 715,400
1,401,000 1,401,000
Balance b/d 715,400
Cost of sales
₦ ₦
i) WIP control a/c 681,200
Fixed production overhead

₦ ₦
Balance b/d 161,000 g) WIP control a/c 152,000
(Actual spend)
We now need to recognise the following entries. Once again journals are
provided for your convenience.

Example: Task 5– Further journal entries
Debit Credit
Administration and marketing mark-up (20%
j
of cost of sales figure)
Cost of sales account (20% of 681,200) 136,240
Administration and marketing control a/c 136,240
Note that this is the same sum of the two
figures shown on the job cost card in task 4
(67,340 + 68,900)
Transfer of balance on cost of sales to the
k
income statement
Income statement 817,440
Cost of sales account 817,440
l Under recovery of fixed production overhead
Income statement (161,000 – 152,000) 9,000
Over recovery of administration and marketing
m
overhead
Administration and marketing control a/c 6,240
Income statement (136,240 – 130,000) 6,240
n Recognition of revenue on finished jobs
Receivables (500,000 + 600,000) 1,100,000
Income statement 1,100,000

Example: Task 5 – WIP control account
WIP control
₦ ₦
Balance b/d 715,400
Cost of sales
₦ ₦
i) WIP control a/c 681,200
j) Admin and
marketing 136,240 k) Income statement 817,440
Fixed production overhead

₦ ₦
Balance b/d (actual) 161,000 g) WIP control a/c 152,000
i) Income statement 9,000
161,000 161,000
Administration and marketing

₦ ₦
Balance b/d (actual) 130,000 j) Cost of sales 136,240
m) Income statement 6,240
136,240 136,240
Balance b/d
Income statement
₦ ₦
k) Cost of sales 817,440 j) Cost of sales
i) Fixed prod. O’hd 9,000 m) Admin and mkt. 6,240
n) Receivables 1,100,000
Profit 279,800
1,106,240 1,106,240
Balance b/d

2 BATCH COSTING
Section overview
 The nature of batch production

 The nature of batch costing
 Cost records and accounts for batch costing
2.1 The nature of batch production

As the name might suggest, batch costing is a system of costing for items that
are produced in batches rather than individually. A batch might also be called a
‘production run’.
Batch costing is used when production units are manufactured in batches or
production runs.
Batch production is used in manufacturing in the following circumstances:
 The capacity of a factory to make a product exceeds the sales demand for
the product. The factory is therefore not required to make the product
continuously. Instead it makes the product in occasional ‘production runs’
or batches.
 The factory makes several different products using the same equipment or
machinery. The machinery must therefore switch between making the
different products, which means that the products will not be manufactured
continuously. Instead the products are made in occasional ‘production runs’
or batches. For example, a company might manufacture a range of wooden
furniture items on the same machinery. It might manufacture a batch of 100
tables, followed by a batch of 400 chairs, followed by a batch of 200
bookshelves, and so on.
 In some industries, it might be impractical to manufacture items except by
making them several units at a time, in batches. An example is the
manufacture of bread rolls and other products in a bakery. Several bread
rolls are put into the baking oven on the same tray and they are made at
the same time, all in the same batch.
The products are therefore made in batches, several units at a time. The finished
units are transferred to finished goods inventory. The product is not
manufactured again until the finished goods inventory is sold and more units are
required. Another batch of the product is then manufactured.
2.2 The nature of batch costing

In batch costing, the total cost is established for each individual batch, where
each batch consists of a large number of similar units or items.
Unlike job costing, however, it is less common to include non-production
overhead costs within the total batch cost, although it is certainly possible to do
so.
To establish the cost per unit, the total batch cost is divided by the number of
units produced in the batch.
In all other respects, batch costing is very similar to job costing.

Illustration: Batch number 123
₦
Production overhead absorbed 75,000
Total production cost, batch 123 160,000
Number of units made in the batch 2,000

Production cost per unit ₦80
To prepare for the next batch production run, there might be set-up costs. If so,
set-up costs can be charged directly to the cost of the batch.
2.3 Cost records and accounts for batch costing

In job costing, it is necessary to record the direct costs of each job. In the same
way, in a system of batch costing there must be a system for charging costs
directly to individual batches or production runs.
 Each batch or production run should be given a unique identity code.
 When direct materials are issued from store, the materials requisition note
should specify the batch for which the materials will be used.
 Direct labour time spent on each production run or batch can be recorded
on time sheets within each production cost centre.

3 SERVICE COSTING
Section overview
 The nature of services and operations

 Service costing, product costing and job costing compared
 Cost units in service costing: composite cost units
 Calculating the cost per unit of service (or operation)
3.1 The nature of services and operations

It is usual to explain costing in terms of how to calculate and record the costs of
manufactured products. However, many business entities do not make and sell
products; they provide services.
Services are any activity carried out by a party to the benefit of another that is
essentially intangible and does not result in the ownership of anything.
Examples include hotel services, consultancy services, legal and accounting
services, providers of telephone services (telecommunications companies),
providers of television and radio channels, entertainment services, postal
services, medical services, and so on.
Characteristics of services
There are five major characteristics of services:
 Intangibility: They do not have a physical substance unlike goods. They
cannot be held or seen.
 Inseparability: Consumption and creation of a service cannot be
separated. Services are consumed as they are created. A service does not
exist until it is consumed by the person being served.
 Variability: Services face the problem of maintaining consistency in the
standard of output. Goods can usually be supplied to a standard
specification. This is more difficult to achieve for services.
 Perishability: Services cannot be stored.
 Lack of ownership: Services do not result in the transfer of property in
anything. The purchase of a service only confers on the customer a
temporary benefit.
Operations
Operations are activities. Like services, they do not result in a finished product to
sell to customers. Examples of operations include a customer service centre
taking telephone calls and e-mails from customers, and the staff canteen
providing meals to employees.
3.2 Service costing, product costing and job costing compared

Costs can be established for services, such as hotel accommodation, telephone
calls, auditing work, holidays and travel, and so on. The costs of a service are the
sum of direct materials, direct labour, direct expenses (if any) and a share of
operational overheads.

Costs can also be established for operations, in a similar way.

Service costing differs from costing in manufacturing industries in several ways.
 There is no production system; therefore there are no production
overheads.
 Direct materials costs are often a fairly small proportion of total costs (for
example, the direct materials costs to a telecommunications company of
providing telephone services are very small).
 In some service industries, direct labour costs are high (for example, in the
film-making industry, accountancy and investment banking).
 General overhead costs can be a very high proportion of total costs.
 Inventory is usually very small; therefore absorption costing is usually of
little or no value for management information purposes.
Not all entities that provide services will use service costing. The purpose of
service costing is to provide information to management about the costs of
different services that the entity provides, and the profitability of each of the
different services. Each service should be fairly standard. If they are not standard
services, it is more sensible to use job costing to calculate the cost of each ‘job’
of service. For example:
 Service costing might be used by a hospital to record or calculate the cost
of each of the different services provided by the hospital, such as the cost
of treating a patient for a particular condition.
 Job costing might be used by a professional firm such as a firm of
accountants or solicitors, where the cost of each job depends largely on the
amount of time spent on each job by the professional staff.
3.3 Cost units in service costing: composite cost units

One of the main problems with service costing is that it can be difficult to identify
a suitable cost unit for the service. It is often appropriate to use a composite cost
unit in service costing. This is a cost that is made up from two variables, such as
a cost per man per day (a cost per ‘man/day’). Here, the two variables are ‘men’
(the number of employees) and ‘days’.
Examples of composite cost units used in service costing are as follows:
 The cost per room per day. This is a useful unit cost in the hotel services
industry.
 The cost per passenger mile or the cost per passenger kilometre (= the
average cost of transporting a passenger for one mile or one kilometre).
This unit measure of cost is used by transport companies that provide bus
or train services.
 The cost per tonne mile delivered (= the average cost of transporting one
tonne of goods for one mile). This unit cost is commonly used for costing
freight services and delivery operations.
 The cost per patient/day (= the average cost of treating one patient for one
day) or the cost per hospital bed/day (= the cost of maintaining one hospital
bed in a hospital for one day). These costs are used by health service
providers.
 The cost per man day. This unit cost is widely used in professional
services, such as auditing, legal services and consultancy services.

Composite cost units can be used in addition to a ‘job costing’ type of service
costing system. For example, a firm of accountants might calculate the cost of
each job performed for a client. In addition, it might calculate the average cost
per man day for the professional services that it provides.
 The cost of each service ‘job’ enables management to monitor costs and
profits on individual jobs for a customer.
 The composite cost, which is an average cost for all ‘jobs’ allows
management to monitor the general level of costs.
3.4 Calculating the cost per unit of service (or operation)

The cost of a service unit (or composite cost unit) is calculated as follows.
Formula: Cost per unit of service

Total costs of the service
Number of units of service
Total costs are the costs of direct materials, direct labour and direct expenses,
plus a charge for overheads (unless marginal costing is used to cost the
services).
The total number of service units might be a bit more difficult to calculate. Here
are a few examples.
Example:
A hotel has 80 standard twin-bedded rooms. The hotel is fully-occupied for each
of the 350 days in each year that it is open. The total costs of running the hotel
each year are ₦3,360,000.
What would be a useful measure of the cost of providing the hotel services?
Answer
A useful unit cost is the cost per room/day. This is the average cost of
maintaining one room in the hotel for one day.
Room/days per year = 80 rooms × 350 days = 28,000
Cost per room/day = ₦3,360,000/28,000 = ₦120.

Example:
A train company operates a service between two cities, Southtown and
Northtown. The distance between the cities is 400 miles. During the previous
year, the company transported 200,000 passengers from Southtown to
Northtown and 175,000 passengers from Northtown to Southtown. The total
costs of operating the service were ₦60 million.
What would be a useful measure of the cost of providing the train service
between the two cities?
Answer
A useful unit cost is the cost per passenger/mile. This is the average cost of
transporting one passenger for one mile.
Passenger/miles per year = (200,000 × 400) + (175,000 × 400) = 150 million.
Cost per passenger/mile = ₦60,000,000/150,000,000 = ₦0.40.

4 CHAPTER REVIEW
Chapter review
 Explain the nature of job costing
 Calculate job cost from given data
 Explain the nature of batch costing
 Calculate batch cost from given data
 Explain the nature of service costing
 Calculate cost of services rendered by a service organization

Foundation level
CHAPTER
9
Process costing
Contents
1 Introduction to process costing
2 Normal loss
3 Abnormal loss
4 Abnormal gain
5 Process costing with closing work-in-progress
6 Opening work-in-progress: weighted average cost
method
7 Opening work-in-progress: FIFO method
8 Work-in-progress and losses
9 Process costing: joint products and by-products
10 Chapter review

Purpose
application of quantitative methods in financial management. Business information takes an
integrated approach by developing an awareness of information technology and systems
support.
Competencies
process costs
Exam context
This chapter explains process costing.

 Explain process costing
 Explain when process costing is appropriate
 Calculate the cost of output from a process including losses and opening and closing
WIP
 Distinguish between joint products and by-products
 Calculate the cost of joint products and by-products

Chapter 9: Process costing
1 INTRODUCTION TO PROCESS COSTING
Section overview
 Process costing
 Situations where process costing might be appropriate
 Process costing issues introduced
1.1 Process costing

Process costing provides a system of costing where any or all of these
characteristics occur.
 Output is continually produced from the manufacturing process and is
normally measured in total quantities, such as tonnes or litres produced, or
in very large quantities of small units (such as the number of cans or tins).
 In the production process, materials might be added in full at the start of a
process, or might be added gradually throughout the process. The
materials are processed to produce the final output. In a process costing
system, it is usual to distinguish between:
 direct materials and
 conversion costs, which are direct labour costs and production
overheads.
 There might be losses in the process, due to evaporation or chemical
reaction and the quantity of output might therefore be less than the quantity
of materials input. Process costing provides a system of costing that allows
for expected losses in the manufacturing process.
 When there is a continuous production process, it is difficult to measure the
quantity of work-in-process (incomplete production) at the end of a financial
period. Process costing provides a method of measuring and costing
incomplete WIP.
 In some processes, more than one product might be output from the same
process. When more than one product is output, they might be called joint
products or a by-product. Process costing offers methods of costing each of
the different products.
 In some process manufacturing systems, there is a series of sequential
processes. For example a manufacturing system might consist of three
consecutive processes: raw materials are input to Process 1, then the
output from Process 1 goes onto the next process (Process 2) and the
output from Process 2 then goes into a final process, Process 3. The output
from Process 3 is the final product.
Each process is different and all these characteristics do not occur in all
processes.

1.2 Situations where process costing might be appropriate

Process costing is used when output is produced in a continuous process
system, and it is difficult to separate individual units of output.
Examples of manufacturing where process costing is used are:
 chemicals manufacture;
 the manufacture of liquids; and
 the continuous manufacture of high volumes of low-cost food items such as
tins of peas or beans, or bottles of tomato ketchup.
In these types of production process, losses in process might occur and there are
often problems in measuring exactly the amount of unfinished work-in-process at
the end of a period.
The basic principle of costing is the same as for other types of costing. The cost
of a unit of output from a process is measured as the total cost of resources input
to the process divided by the total units produced.
1.3 Process costing issues introduced

Process costing can be quite tricky at first. It is often helpful to draw a process
account as this helps to focus one’s mind on the main issue which is that costs
are collected on the debit side of the account and they must be allocated to
whatever passes out of the account. This is more complex than it sounds.
We will proceed to give an overview of the issues before starting to look at the
detailed calculations.
Consider the following:
Example: Simple process account
Process
Units ₦ Units ₦
Materials 100 1,000
Conversion cost 500 Output 100 1,500
100 1,500 100 1,500
This is very straight forward. The total costs input to the process are ₦1,500. This
represents 100 units of raw material at a cost of ₦1,000 and the cost of work that
has been carried out on the raw materials. This cost ₦500 so the total costs input
are ₦1,500. 100 units are transferred out of the process and these must have
cost ₦1,500 or ₦15 per unit.
It might seem strange to labour this point but this is what process costing is
always trying to do. It collects costs of input and then allocates them to the output
from the process.

Now let’s add a complication.
Example: Process account – losses
Process
Units ₦ Units ₦
Materials 100 1,000 Output 90
Conversion cost 500 Loss 10
100 1,500 100 1,500
The input costs are still the same but now there are two lines on the credit side of
the account to which we could allocate cost, the good output and the loss.
A decision needs to be made. Should some of the cost relate to the loss or
should all of it relate to the good output? The answer to this question depends on
whether the loss is considered to be normal or abnormal. This will be explained
shortly.
Now let’s add another complication.
Example: Process account – closing WIP
Process
Units ₦ Units ₦
Conversion cost 500 Closing WIP 10
100 1,500 100 1,500
Again the input costs are still the same but now there are two types of output
from the process, the good output and the closing WIP.
We must decide how to allocate the input costs to the good output which is
complete and the closing WIP which is incomplete. How we do this is explained
later in the chapter.
Now let’s add yet another complication.
Example: Process account – opening WIP
Process
Units ₦ Units ₦
Opening WIP 10 100
Conversion cost 500 Closing WIP 15
110 1,600 110 1,600
The opening WIP is a cost that was input in the previous period. We still face the
same basic problem. The total costs on the debit side have to be allocated to

output. However, the existence of opening WIP means that we must have a
policy for dealing with it. Do we treat it just like any other costs and average all of
the input costs out or do we operate a FIFO system and simply allocate the cost
of opening WIP to the first units produced? This will be answered later.
The following proforma process account is provide as a reference.
Example: Proforma process account
Process
Units ₦ Units ₦
Opening WIP X X Good output X X
Direct material X X Normal loss X X-
Direct labour X
Direct expense X
Overheads X
Abnormal gain X X Abnormal loss X X
Good output X X
Closing WIP X X
X X X X
Note that it is not possible to have abnormal loss and gain on the same account
in the same period.
Whatever the complications the task that sits at the heart of process costing is
always to allocate the costs collected on the debit side of the account to the
possible outputs (good output, closing WIP and lost units) on the credit side.
In all questions you will need to:
 Identify the losses and output;
 Calculate the cost of good output, losses and WIP;
 Use the costs you have calculated to assign values to the good output,
losses and WIP;
 Complete the process account.

2 NORMAL LOSS
Section overview
 Normal loss
 Normal loss with no recovery value
 Normal loss with recovery value
 Normal loss with cost of disposal
2.1 Normal loss

A feature of process manufacturing is that there is often some loss or wastage in
production and output quantities are less than input quantities of materials.
Losses might be normal or abnormal.
Normal loss is the expected loss in processing.
Formula: Normal loss

Normal loss = Quantity of material input  Expected output
or
Quantity of material input = Normal loss + Expected output
or
Expected output = Quantity of material input  Normal loss
Normal loss is usually expressed as a percentage of the input units of materials.
Example: Normal loss

Normal loss of a process is 10%.
A company puts 5,000 litres into the process.
Normal loss is 10% of 5,000 = 500.
Expected output from the process would be 90% of 5,000 litres = 4,500 litres
Normal loss is unavoidable in the normal course of events. It is inherent in the

physical and chemical reactions that take place in a process.
Example:
A person buys a one litre tin of soup.
The soup must be heated but heating will cause evaporation.
When the soup is ready to eat there will be less than a litre left.
Normal loss is how much evaporation would normally be expected.

2.2 Normal loss with no recovery value
Example:
Returning to the soup example.
A person buys a one litre tin of soup for ₦500.
Normal evaporation during cooking is 10%.
When the soup is ready to eat there is 0.9 litres left.
The person has paid ₦500 for 0.9 litres and this is unavoidable.
The implication of this simple example is as follows. The normal loss is

something that is unavoidable in order to get the good output. The cost of the lost
units is part of the cost of obtaining the good output.
All of the cost should be assigned to the good output and none to the normal
loss.
If the normal loss has no scrap value it is given a nil value. This means that all of
the costs of input must be recognised as part of good output.
Formula: Cost of good output

Total process costs
Cost of good output per unit =
Expected units of output
Example: Normal loss – no scrap recovery value

The following information relates to a production process:
Input quantities 2,000 litres

Normal loss 10%
Therefore expected output 1,800 litres
Actual output 1,800 litres
Direct materials cost ₦3,600

Direct labour cost ₦300
Production overhead absorbed ₦600
The cost per unit produced can be calculated as follows: ₦

Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre ₦2.50

Process account in the cost ledger

The process cost account (shown below) is a work-in-progress account for the
process. The debit side of the account records direct materials and direct labour
costs, and production overheads absorbed. The credit side of the WIP account
records the cost of the finished output.
The account also includes memorandum columns for the quantities of direct
materials input and the quantities of output and loss. Normal loss is shown so
that the quantities columns add up to the same amount on the debit or credit
sides, but the normal loss has no cost.
Example: Process account with normal loss (no scrap recovery)

The following information relates to a production process X.
The process account can be completed as follows

Process X
Litres ₦ Litres ₦
Output (actual) at
Materials 2,000 3,600 ₦2.5 each 1,800 4,500
Direct labour 300
Prod. O’hd 600 Normal loss 200 
2,000 4,500 2,000 4,500
Note that it is always useful to draft a process account at the start of an answer
as it focusses the mind on what needs to be done.
2.3 Normal loss with recovery value

In some cases, losses in a process have a scrap value. The normal loss quantity
might not be physically lost but is changed in some way, so that it is not the same
as good output. For example, there might be some kind of chemical separation
with a substance scraped off the top of the liquid in the process and whatever is
scraped off might have a scrap value.
If normal loss has a scrap value the company is able to recover some of the input
costs to the process. The scrap value reduces the cost of the process.
To reflect this in the process account the normal loss is measured at its scrap
value and the calculation of the cost of good output becomes:
Cost of good Total process costs  Scrap value of the normal loss
=
output per unit Expected units of output

Example: Normal loss – with scrap recovery value

Normal loss 10%
Scrap value of normal loss (₦) 0.9 per litre
Direct materials cost (₦) 3,600

Direct labour cost (₦) 300
Production overhead absorbed (₦) 600

Direct labour 300
Less scrap value of normal loss (200 litres  0,9) (180)
4,320
The process account can be completed as follows:

Process X
Output (actual) at
Materials 2,000 3,600 ₦2.4 each 1,800 4,320
Direct labour 300
Prod. O’hd 600 Normal loss 200 180
2,000 4,500 2,000 4,500

2.4 Normal loss with cost of disposal

In other cases a company might have to pay to dispose of losses in a process.
The substance scraped off the top of the liquid in the process might be poisonous
and might have to be disposed of safely.
The cost of disposal represents an additional cost to the process.
To reflect this in the process account the normal loss is measured at zero but the
expected costs of disposal are debited to the process account.
Cost of good output Total process costs + Disposal costs of the normal loss
=
per unit Expected units of output
Example: Normal loss – no scrap disposal cost

Normal loss 10%
Disposal cost of normal loss ₦1 per litre

Direct labour 300
Disposal costs of normal loss (200 litres  ₦1) 200
4,700
The process account can be completed as follows:

Process X
Output (actual) at
Materials 2,000 3,600 ₦2.6111 each 1,800 4,700
Direct labour 300
Prod. O’hd 600
Disposal cost of
normal loss 200 Normal loss 200 
2,000 4,700 2,000 4,700

3 ABNORMAL LOSS
Section overview
 Introduction to abnormal loss

 Accounting for abnormal loss
 Abnormal loss with recovery value
3.1 Introduction to abnormal loss

Normal loss is the expected amount of loss in a process. Actual loss might be
more than the expected or normal loss. When actual loss exceeds normal loss,
there is abnormal loss. The excess of the total actual loss over the normal loss is
abnormal loss.
Formula: Abnormal loss

Abnormal loss = Actual loss – Expected (normal) loss
From earlier:
Quantity of material input = Normal loss + Expected output
But:
Expected output = Actual output + Abnormal loss
Therefore:
Quantity of material input = Normal loss + Actual output + Abnormal loss
Total loss = Normal loss + Abnormal loss.
Abnormal loss is not expected and should not happen. It therefore makes sense
to give it a cost. By giving a cost to abnormal loss, management information
about the loss can be provided, and management can be made aware of the
extent of any problem that might exist with excessive losses in process.
3.2 Accounting for abnormal loss

If it is assumed that all losses in process occur at the end of the process, units of
abnormal loss are costed in exactly the same way as units of finished output.
This might seem a little strange but the idea is to highlight the impact of the loss.
The cost per unit of abnormal loss is therefore the same as the cost of units of
good output. This is exactly the same as before.
=
The cost of units of abnormal loss is treated as an expense for the period, and
charged as an expense in the income statement for the period.

Example: Abnormal loss

Normal loss 10%
Therefore abnormal loss 100 litres

Direct labour 300
Costing:
Cost of finished output = 1,700 units  ₦2.50 = ₦4,250.
Cost of abnormal loss = 100 units  ₦2.50 = ₦250.

Process X
Output (actual) at
Materials 2,000 3,600 ₦2.5 each 1,700 4,250
Direct labour 300 Abnormal loss 100 250
Prod. O’hd 600
Normal loss 200 
2,000 4,500 2,000 4,500
Note that the abnormal loss is included in the credit side of the account, in the
same way that normal loss is shown on the credit side. However whereas normal
loss has no value/cost, abnormal loss has a cost.

The appropriate double entry in the cost ledger is:
Illustration: Abnormal loss double entry

Debit Credit
Abnormal loss account X
Process account X
Example: Abnormal loss account

Continuing from the example above.
Abnormal loss account
Process X account 100 250
At the end of the financial period, the balance on the abnormal loss account is
written off as a cost in the costing income statement.
3.3 Abnormal loss with recovery value

When loss has a scrap value, the scrap value of normal loss is deducted from
the process cost, as explained earlier.
Abnormal loss will also have a scrap value but this is treated differently to the
scrap value of normal loss.
 The cost of expected units of output is calculated in the usual way.
 The scrap value of normal loss is normal loss units  scrap value per unit
(as usual).
 In the process account the cost of abnormal loss is measured at the cost of
expected units (just as before).
 Periodically the units in the normal loss account are transferred to a scrap
account at scrap value.
 The balance on the abnormal loss account is an expense for the period
(measured at the cost of the units less the scrap value).
 This means that scrap value of abnormal loss is set off against the cost of
abnormal loss in the abnormal loss account, not the process account.
Illustration: Abnormal loss scrap value double entry

Debit Credit
Cash (money from the sale of scrapped units) X
Abnormal loss account X
The net cost of abnormal loss (cost of abnormal loss minus its scrap value) is
then transferred as a cost to the cost accounting income statement at the end of
the accounting period.

Example: Abnormal loss

Normal loss 10%
Therefore abnormal loss 100 litres
Scrap value of normal loss ₦0.9 per litre

Direct labour 300
Scrap value of normal loss (200  ₦0.90) (180)
Costing:
Cost of abnormal loss = 100 units  ₦2.40 = ₦240.
Normal loss = 200 units  ₦0.9 = ₦180

Process X
Materials 2,000 3,600 Output 1,700 4,080
Direct labour 300 Abnormal loss 100 240
Prod. O’hd 600 Normal loss 200 180
2,000 4,500 2,000 4,500

Example: Accounting for the losses

The double entry to account for the losses can be completed as follows
Abnormal loss account
Process X
account 100 240 Scrap account 100 90
Income statement 150
100 240 100 240
Scrap account
Process X
account (normal
loss) 200 180 Cash 300 270
Abnormal loss
account 100 90
300 270 300 270

4 ABNORMAL GAIN
Section overview
 Abnormal gain
 Accounting for abnormal gain: no scrap value for loss
 Abnormal gain where loss has a scrap value
4.1 Abnormal gain

Abnormal loss occurs when actual loss is more than the expected (normal) loss.
Abnormal gain occurs when the actual loss is less than normal loss. Abnormal
gain is the difference between the normal loss (expected loss) and the actual
loss.
Formula: Abnormal gain

Abnormal gain = Expected (normal) loss – Actual loss
From earlier:
Expected output = Actual output + Abnormal loss
Gain is opposite in sign so goes to the other side of the expression:
Expected output + Abnormal gain = Actual output
Actual loss = Normal loss – Abnormal gain
4.2 Accounting for abnormal gain: no scrap value for loss

The method of costing for abnormal gain is the same in principle as for abnormal
loss. If it is assumed that all losses occur at the end of the process, the cost per
unit of finished output and the value/cost of abnormal gain are calculated as the
cost per expected unit of output. (i.e. the cost of good output)
The cost per unit of abnormal loss is therefore the same as the cost of units of
good output. This is exactly the same as before.
=

The differences between costing for abnormal loss and costing for abnormal gain
are that:
 Abnormal gain is a benefit rather than a cost. Whereas abnormal loss is
written off as a cost at the end of the financial period, abnormal gain is an
adjustment that increases the profit for the period.
 Abnormal gain is recorded as a debit entry in the process account, because
it is a benefit.
 The other half of the double entry is recorded in an abnormal gain account.
At the end of the period, the balance on the abnormal gain account is then
transferred to the income statement as a benefit for the period, adding to
profit.
Example: Abnormal gain

Normal loss 10%
Therefore abnormal gain 50 litres

Conversion costs (direct labour + production overheads) 900
Costing:
Cost of abnormal gain = 50 units  ₦2.50 = ₦125.
Normal loss = zero (as there is no scrap value).

Process X
Conversion cost 900
Abnormal gain 50 125 Normal loss 200 nil
2,050 4,625 2,050 4,625

Accounting for abnormal gain: ledger entries

The abnormal gain is shown on the debit side of the account, and the total
number of units in the memorandum column for quantities (2,050) is larger than
the actual quantity of units input to the process (2,000).
The appropriate double entry in the cost ledger is:
Illustration: Abnormal gain double entry

Debit Credit
Process account X
Abnormal gain account X
Example: Abnormal gain account

Continuing from the example above.
Abnormal gain account
Process X account 50 125
The balance on this account is taken to the costing income statement at the end
of the period, and added to the reported profit.
4.3 Abnormal gain where loss has a scrap value

When loss has a scrap value, the value of abnormal gain is actually less than the
amount shown in the process account. The process has been more efficient and
produced more good output but there are less normal loss units so the scrap
recovery is less than expected.
Accounting for the scrap value of abnormal gain is similar to accounting for the
scrap value of abnormal loss.
 In the process account (WIP), abnormal gain is valued at the cost per
expected unit of output.
 The scrap value of normal loss is normal loss units  scrap value per unit
(as usual).
 The scrap value of abnormal gain is recorded as a debit entry in the
abnormal gain account (in a similar way to recoding the scrap value of
abnormal loss as a credit entry in the abnormal loss account).
 The scrap value of the abnormal gain is set-off against the value of the
abnormal gain in the abnormal gain account, not the process account.
 The balance on the abnormal gain account is the net value of abnormal
gain (value of abnormal gain minus the scrap value not earned from the
normal loss). This balance is transferred as a net benefit to the cost
accounting income statement at the end of the accounting period.

Example: Abnormal gain where loss has recovery value

Normal loss 10%
Therefore abnormal gain 50 litres
Scrap value of normal loss ₦0.9 per litre

Direct labour 300
Scrap value of normal loss (200  ₦0.90) (180)
Costing:
Cost of abnormal gain = 50 units  ₦2.40 = ₦120.
Normal loss = 200 units  ₦0.90 = ₦180.

Process X
Conversion cost 900
Abnormal gain 50 120 Normal loss 200 180
2,050 4,620 2,050 4,620

Example: Accounting for the abnormal gain and the normal loss
The double entry to account for the losses can be completed as follows
Abnormal gain account
Scrap account 50 45 Process X account 50 120
Income
statement 75
50 120 50 120
The balance on this account is ₦75. This is treated as an addition to profit in the
cost accounting income statement for the period.
Scrap account
Process X a/c Abnormal gain
(normal loss) 200 180 account 50 45
Cash 150 135
200 180 200 180
The company expected to be able to sell 200 litres of scrap product. The abnormal
gain means that they only have 150 litres to sell.

5 PROCESS COSTING WITH CLOSING WORK-IN-PROGRESS
Section overview
 Sharing out process costs between finished units and unfinished inventory
 Equivalent units
 A three-stage calculation
 Introduction to opening work-in-progress
5.1 Sharing out process costs between finished units and unfinished inventory
When manufacturing is a continuous process, there may be unfinished work-in-
progress (WIP) at the start and end of a period. This section looks at closing WIP.
In all the examples in this section it is assumed that there is no opening WIP.
Also note that the examples in this section assume that there are no losses.
This means that some units have been started and finished in the year and
others have been started but not finished.
It stands to reason that the cost or value of an unfinished unit is less than the
cost of a completed unit. The costs of the process must be shared between
finished output and unfinished work-in-process on a fair basis.
Previous sections have explained that costs are allocated to output by calculating
a cost per unit. This involves dividing a cost figure by the number of units of
expected output.
In order to do this when there is closing work-in-progress we use the concept of
equivalent units.
5.2 Equivalent units

An equivalent unit means ‘equal to one finished unit of output’. This is quite a
simple idea. A number of partially complete units is the equivalent of a number of
complete units depending on their degree of completion.
Illustration:
200 units that are 50% complete are equivalent to 100 (50%  200)
complete units
400 units that are 20% complete are equivalent to 80 (20%  400) complete
units
Costs are shared between finished units and inventory by calculating a cost per
equivalent unit.
Complication
In all of the previous examples a cost per unit was calculated by dividing the total
process costs (perhaps adjusting for expected normal loss or cost of disposal) by
the expected number of units.
The existence of work-in-progress complicates this because the work-in-progress
might be complete to different degrees in respect of different cost inputs. For

example a unit in the closing work-in-progress might be 80% complete with

respect to material but only 50% complete with respect to labour.
In this case the number of equivalent units of direct materials cost in a period will
therefore differ from the number of equivalent units of labour.
A cost per unit is calculated for each type of cost using the equivalent units for
that cost. The cost of output is then based on these individual costs.
Costs for finished output and closing inventory can be calculated from the
number of equivalent units and the cost per equivalent unit.
5.3 A three-stage calculation

We recommend a three-stage calculation:
 Prepare a statement of equivalent units to calculate the equivalent units for
each type of cost in the output from the process and for closing WIP
 Next, prepare a statement of cost per equivalent unit for each type of cost.
 Third, prepare a statement to calculate the cost of finished output and
closing WIP from the statement of equivalent units and statement of cost
per equivalent unit.
Example: Closing work-in-progress

Input quantities 4,000 units
Completed output 3,500 units
Closing WIP 500 units
All the direct materials are added to production at the beginning of the
process.
Closing inventory of 500 units is therefore 100% complete for materials but
is only 40% complete for conversion.
The costs incurred in the period were: ₦
Converison costs: 7,400

Answer
Statement of equivalent units
Equivalent units
Percentage Direct Conversion
Output Total units complete materials costs
₦ ₦
Finished output 3,500 100% 3,500 3,500
Closing WIP:
Materials 500 100% 500
Conversion 40% 200
4,000 4,000 3,700
Statement of cost per equivalent unit
Direct Conversion
materials costs
Total costs (₦) 24,000 7,400
Equivalent units ÷ 4,000 ÷ 3,700
Cost per equivalent unit (₦) 6 2
Statement of evaluation
₦
Cost of finished goods (3,500  (₦6 + ₦2)) 28,000
Cost of closing WIP
Materials (500 units  ₦6) 3,000
Conversion (200 units  ₦2) 400
Cost per equivalent unit 3,400
These costs would be recorded in the process account as follows.
Process (WIP) account
units ₦ units ₦
Direct materials 4,000 24,000 Finished goods 3,500 28,000
Conversion costs - 7,400 Closing WIP 500 3,400
4,000 31,400 4,000 31,400
5.4 Introduction to opening work-in-progress

Opening work-in-progress adds another level of complexity.
When there is opening work-in-progress there are two types of cost on the debit
side of the account. These are the costs that were incurred last period and
brought forward as work-in-progress and the costs that were incurred in the
current period. The issue is whether they should be treated together or
separately. This question is addressed in the accounting policy adopted for
opening work-in-progress.
 weighted average cost method treats all costs on the debit side of the
account in the same way.
 first-in, first-out (FIFO) method allocates the costs in opening WIP to the
finished goods and then spreads the remaining costs elsewhere.

6 OPENING WORK-IN-PROGRESS: WEIGHTED AVERAGE COST METHOD
Section overview
 The underlying principle

 The three-stage calculation
 Weighted average cost method: summary
6.1 The underlying principle

When the weighted average cost method is used, the assumption is that all units
produced during the period and all units of closing inventory should be valued at
the same cost per equivalent unit for materials and the same cost per equivalent
unit for conversion costs.
An average cost per equivalent unit is calculated for all units of output and
closing inventory. This includes the units that were partly-completed at the
beginning of the period (and which were therefore valued as closing WIP at the
end of the previous period).
The calculation of equivalent units is based on the number of units finished in the
period (it does not matter when they were started) and the number of units in
closing WIP.
6.2 The three-stage calculation

The costs are worked out in a similar way to the previous example (where there
was no opening WIP).
 Statement of equivalent units. Prepare a statement of equivalent units for
finished output and for closing WIP.
 Statement of cost per equivalent unit. Calculate the cost per equivalent
unit for direct materials and the cost per equivalent unit for conversion
costs. However, remember to include the cost of the opening WIP. The
materials cost of the opening WIP should be included in the total direct
materials cost, and the conversion costs in the opening WIP should be
added to the conversion costs for the current period.
You will normally have to calculate a separate cost per equivalent units for
materials and for conversion costs. This is because the equivalent units of
closing inventory will be different for materials and conversion costs.
 Statement of evaluation. Having calculated the equivalent units and a
cost per equivalent unit, prepare a statement of evaluation.

Example: Opening work-in-progress – Weighted average method

Opening inventory 3,000 units

Material cost in opening WIP (100% complete) ₦12,600
Conversion costs in opening WIP (30% complete) ₦970
During the month
Closing WIP (100% complete for direct materials and 60%
complete for conversion costs). 2,000 units
process.

Answer
Equivalent units
Finished output 8,000 100% 8,000 8,000
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 10,000 9,200
Direct Conversion
materials costs
Total costs ₦ ₦
Costs in opening WIP 12,600 970
Costs in the period 28,000 17,430
40,600 18,400
Cost per equivalent unit (₦) 4.06 2
₦
Cost of finished goods (8,000  (₦4.06 + ₦2)) 48,480
Cost of closing WIP
Materials (2,000 units  ₦4.06) 8,120
Conversion (1,200 units  ₦2) 2,400
units ₦ units ₦
Opening WIP 3,000 13,570
Conversion costs - 17,430 Closing WIP 2,000 10,520
10,000 59,000 10,000 59,000

6.3 Weighted average cost method: summary

The weighted average cost method for process costing with opening WIP can be
summarised as follows.
 All output and closing inventory is valued at the same cost per equivalent
unit
 Cost of opening inventory + Costs in the period = Total costs
 Units of closing inventory + Units of output in the period = Total equivalent
units
 Cost per equivalent unit = Total costs/Total equivalent units
Illustration: Summary of weighted average calculation of cost per unit

Direct Conversion
materials costs
Cost of opening inventory X X
Costs incurred in the period X X
Total costs Xm Xcc
Number of units output Y Y

Equivalent units of closing inventory Y Y
Total equivalent units Ym Ycc
Cost per equivalent unit (Xm/Ym) (Xcc/Ycc)

7 OPENING WORK-IN-PROGRESS: FIFO METHOD
Section overview
 FIFO method in process costing

 The three-stage calculation
 FIFO method: summary
7.1 FIFO method in process costing

The first-in, first-out (FIFO) method of process costing is based on the
assumption that the opening units of work-in-process at the beginning of the
month will be the first units completed. The cost of these units is their value at the
beginning of the period plus the cost to complete them in the current period.
It is necessary to calculate the number of equivalent units of work done in the
period. This consists of:
 The equivalent units of direct materials and conversion costs required to
complete the opening WIP. These are the first units completed in the
period.
 The equivalent units of finished output in the period that was started as well
as finished in the period. These have one equivalent unit of direct materials
and one equivalent unit of conversion costs. The total number of these
units is:
 the total finished output in the period
 minus the quantity of opening WIP (which are completed first)
 The equivalent units of closing WIP (calculated in the normal way).
7.2 The three-stage calculation

The three-stage calculation with the FIFO method is similar to the calculation
method previously described, with the exception that in the statement of
evaluation, the cost of finished output consists of:
 The finished cost of opening WIP which is the sum of:
 the costs in the opening WIP value at the start of the period; plus
 the costs in the current period to complete these units; plus
 the cost of finished output started as well as finished in the period.
Study the following example carefully.

Example: Opening work-in-progress – FIFO method


Material cost in opening WIP (100% complete – therefore
0% is needed in this period) ₦12,600
Conversion costs in opening WIP (30% complete –
therefore 70% is needed in this period) ₦970
₦13,570
During the month
process.

Answer
Equivalent units
Started last
period
Opening WIP 3,000
Materials 0% nil
Started and
finished in the
period 5,000 100% 5,000 5,000
Finished in
period 8,000 5,000 7,100
Closing WIP:
Materials 2,000 100% 2,000
10,000 7,000 8,300
Direct Conversion
materials costs
Total costs in current period ₦28,000 ₦17,430
Cost per equivalent unit ₦4 ₦2.1
₦
Cost of goods finished in the period (8,000 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100  ₦2.1) 4,410
17,980
Started and finished in this period (5,000  ₦4 + ₦2.1) 30,500
48,480
Cost of closing WIP
Materials (2,000 units  ₦4) 8,000
Conversion (1,200 units  ₦2.1) 2,520
units ₦ units ₦
Conversion costs - 17,430 Closing WIP 2,000 10,520
10,000 59,000 10,000 59,000

(Tutorial note: If you compare this example using FIFO with the previous
example using the weighted average cost method, you will see that the cost of
finished output and value of closing WIP is the same in each case. This is a
coincidence. Normally, the two methods provide different costs for finished output
and different closing WIP valuations.)
7.3 FIFO method: summary

The first-in, first-out method for process costing with opening WIP can be
summarised as follows.
 The cost of the opening units completed in the current period is calculated
separately from the cost of the units that are started and finished in the
current period.
 A cost per equivalent unit is calculated for the current period, as follows:
Illustration: Summary of weighted average calculation of cost per unit

Direct Conversion
materials costs
Costs incurred in the current period TCm TCc
Equivalent units of work in the current
period:
to complete opening WIP X Y
to start and finish units X Y
to make closing WIP X Y
Total equivalent units of work in this
period Xm Ycc
Cost per equivalent unit in the current
period TCm / Xm TCc / Ycc
 These costs are used to apportion the process costs in the current period
between:
 the cost of completing the opening WIP
 the cost of units started and finished in the current period
 the value of closing inventory.
 Having calculated costs for the current period, the valuation of output from
the process is calculated as follows:

Illustration: Summary of evaluation of outputs under the FIFO method

₦
Cost of Items started in the previous period and finished in
this period
Opening WIP X
Cost of finishing the opening WIP
To complete material X
To complete other costs X
X
Cost of items started and finished in this period X
Cost of items finished in the period X
Cost of items started in this period
Material X
Other costs X
X
Total process costs X

8 WORK-IN-PROGRESS AND LOSSES
Section overview
 Introduction
 Opening WIP and losses (Weighted average)
 Opening WIP and losses (FIFO)
8.1 Introduction
Questions might combine WIP and losses.
Earlier in the chapter, we explained that normal loss is measured at zero or its
scrap value if it has one. This recognised that the scrap recovery reduces the
overall cost of the process.
When a question requires the calculation of cost per unit by components of cost
the question arises as to what cost the expected scrap recovery should be set off
against. After all the value of the scrapped unit would lay partly in its material cost
but also partly in its conversion costs. The usual approach is to employ a
convention that ignores the complication, and offset the expected scrap recovery
against the material cost only.
We saw that abnormal loss is measured in the same way as good production.
The number of abnormal loss units are included in the expected good output
used in the cost per unit calculation.
The same principles are followed when a question requires the calculation of cost
per unit by component through the calculation of equivalent units. The number of
equivalent units taken to build the abnormal loss must be included in the total
number of equivalent units.

Example: Closing work-in-progress and losses

Normal loss (all units having a scrap recovery of ₦1 per
unit) 10% of input
Closing WIP 500 units
process.
Inspection of the units occurs when they are 50% complete. (Note that this
must relate to conversion as they are 100% complete for material).
is 60% complete for conversion.
It is useful to construct an extra working with these questions to show the

physical number of units.
Example: Closing work-in-progress and losses – Preliminary working:

Units
Opening WIP 0
Input 4,000
Total possible units 4,000
Normal loss (10% of input) (400)
Expected good output 3,600
Actual good output (3,000)
Closing WIP (500)
Abnormal loss 100

Example: Closing work-in-progress and losses

Equivalent units
Finished output 3,000 100% 3,000 3,000
Closing WIP:
Conversion 60% 300
Abnormal loss
Conversion 50% 50
3,600 3,600 3,350
Direct Conversion
materials costs
Total costs ₦24,000 ₦7,400
Expected scrap recovery of normal loss
(10%  4,000 units  ₦1) ₦(400)
₦23,600 ₦7,400
Cost per equivalent unit ₦6.56 ₦2.21
Note that the costs per unit above have been rounded to two decimal
places. However, the calculations below are based on unrounded figures
(23,600/3,600 and 7,400/3,350)
₦
Cost of finished goods (3,000  (₦6.56 + ₦2.21)) 26,294
Cost of closing WIP
Materials (500 units  ₦6.56) 3,278
Conversion (300 units  ₦2.21) 662
Cost of closing abnormal loss
Materials (100 units  ₦6.56) 656
Cost per equivalent unit 766
units ₦ units ₦
Normal loss 400 400
Conversion costs - 7,400 Abnormal loss 100 766
Closing WIP 500 3,940
4,000 31,400 3,600 31,400

8.2 Opening WIP and losses (Weighted average)
Example: Opening work-in-progress and losses – Weighted average method


Material cost in opening WIP (100% complete) ₦12,600
Conversion costs in opening WIP (30% complete) ₦970
During the month
Input quantities (units) 7,000
Normal loss (all units having a scrap recovery of ₦1) 5% of input
Completed output (units) 7,500
complete for conversion costs) (units) 2,000
process.
Example: Opening work-in-progress and losses – Weighted average method –

Preliminary working:
Units
Opening WIP 3,000
Input 7,000
Actual good output (7,500)
Closing WIP (2,000)
Abnormal loss 150

Example: Opening work-in-progress and losses – Weighted average method

Equivalent units
Finished output 7,500 100% 7,500 7,500
Closing WIP:
Materials 2,000 100% 2,000
Abnormal loss
Conversion 50% 75
9,650 9,650 8,775
Direct Conversion
materials costs
Total costs ₦ ₦
Costs in opening WIP 12,600 970
Costs in the period 28,000 17,430
(5%  7,000 units  ₦1) (350)
40,250 18,400
Cost per equivalent unit 4.17 2.10
(40,250/9,650 and 18,400/8,775)
₦
Cost of finished goods (7,500  (₦4.17 + ₦2.1)) 47,009
Cost of closing WIP
Materials (2,000 units  ₦4.17) 8,342
Conversion (1,200 units  ₦2.1 2,516
10,858
Abnormal loss
Conversion (75 units  ₦2.1 157
783
units ₦ units ₦
Opening WIP 3,000 13,570 Finished goods 7,500 47,009
Direct materials 7,000 28,000 Normal loss 350 350
Conversion costs - 17,430 Abnormal loss 150 783
Closing WIP 2,000 10,858
10,000 59,000 10,000 59,000

8.3 Opening WIP and losses (FIFO)
Example: Opening work-in-progress and losses – FIFO method


Material cost in opening WIP (100% complete – therefore
0% is needed in this period) ₦12,600
Conversion costs in opening WIP (30% complete –
therefore 70% is needed in this period) ₦970
₦13,570
During the month
Normal loss (all units having a scrap recovery of ₦1) 5% of input
process.
Example: Opening work-in-progress and losses – FIFO method – Preliminary

working:
Units
Opening WIP 3,000
Input 7,000
Actual good output:
Started in the previous period but finished in this period (3,000)
Started and finished in this period (4,500)
Output in this period (7,500)
Closing WIP (2,000)
Abnormal loss 150


Equivalent units
Started last
period
Opening WIP 3,000
Materials 0% nil
Started and
finished in the
period 4,500 100% 4,500 4,500
Finished in
period 7,500 4,500 6,600
Closing WIP:
Materials 2,000 100% 2,000
Abnormal loss
Conversion 50% 75
9,650 6,650 7,875

Direct Conversion
materials costs
₦ ₦
Total costs in current period 28,000 17,430
(5%  3,500 units  ₦1) (350)
27,650 17,430
Cost per equivalent unit ₦4.16 ₦2.21


(27,650/6,650 and 17,430/7,875)
₦
Cost of goods finished in the period (8,000 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100  ₦2.21) 4,648
18,218
Started and finished in this period (4,500  (₦4.16 + ₦2.21)) 28,671
46,889
Cost of closing WIP
Materials (2,000 units  ₦4.16) 8,316
Conversion (1,200 units  ₦2.21) 2,655
10,971
Cost of abnormal loss

790
units ₦ units ₦
Conversion costs - 17,430 Normal loss 350 350
Abnormal loss 150 790
Closing WIP 2,000 10,971
10,000 59,000 10,000 59,000

9 PROCESS COSTING: JOINT PRODUCTS AND BY-PRODUCTS
Section overview
 Definition of joint products

 Apportioning common processing costs between joint products
 By-products
9.1 Definition of joint products

In some process manufacturing systems, two or more different products are
produced.
Definition: Joint products

Joint products are two or more products generated simultaneously, by a single
manufacturing process using common input, and being substantially equal in
value.
Until the joint products are produced in the manufacturing process, they cannot
be distinguished from each other. The same input materials and processing
operation produces all the joint products together.
Each joint product has a substantial sale value relative to each other joint
product.
Example: Joint products

The refining of crude oil produces a series of products fuel oil, gasoline, and
kerosene.
Domestic animals are grown for food and their hides are turned into leather.
9.2 Apportioning common processing costs between joint products

The costs of the common process that produces the joint products are common
costs. In order to calculate a cost for each joint product, these common costs
must be shared (apportioned) between the joint products. The common costs of
the process must be apportioned between the joint products on a fair basis, in
much the same way that overhead costs are apportioned between cost centres.

One of the following three methods of apportionment is normally used:

 Units basis: Common costs are apportioned on the basis of the total
number of units produced. The cost per unit is the same for all the joint
products. (This is also described as the physical quantities basis).
 Sales value at the split-off point basis: Common costs are apportioned
on the basis of the sales value of the joint products produced, at the point
where they are separated in the process (the ‘split-off point’).
 Net realisable value (sales value less further processing costs basis):
Common costs are apportioned on the basis of their eventual sales value
after they have gone through further processing to get them ready for sale.
Example: Joint products

Two joint products JP1 and JP2, are produced from a common process.
During March, 8,000 units of materials were input to the process. Total costs of
processing (direct materials and conversion costs) were ₦135,880.
Output was 5,000 units of JP1 and 3,000 units of JP2.
JP1 has a sales value of ₦40 per unit when it is output from the process and can
be sold for ₦120 per unit after further processing costs of ₦25 per unit.
Joint costs can be apportioned in one of the following ways.
Answer: Units basis

Output Units
JP1 5,000
JP2 3,000
8,000
Costs: ₦
JP1:  ₦135,880.
5,000 units/8,000 units 84,925
JP2: 3,000 units/8,000 units  ₦135,880. 50,955
135,880
units ₦ units ₦
Direct materials 8,000 135,880 JP1 5,000 84,925
JP2 3,000 50,955
8,000 135,880 8,000 135,880

Answer: Sales value at point of split-off

Sales value ₦
JP1 (5,000 units  ₦40) 200,000
JP2 (3,000 units  ₦55) 165,000
365,000
Costs: ₦
₦200,000
JP1: / ₦365,000  ₦135,880. 74,455
₦165,000
JP2: / ₦365,000  ₦135,880. 61,425
135,880
units ₦ units ₦
JP2 3,000 61,425
8,000 135,880 8,000 135,880
Answer: Net realisable value at the point of split-off

NRV value ₦
JP1 (5,000 units  ₦120  ₦25) 475,000
JP2 (3,000 units  ₦80  ₦15) 195,000
670,000
Costs: ₦
₦475,000
JP1: /₦670,000  ₦135,880. 96,333
₦195,000
JP2: /₦670,000  ₦135,880. 39,547
135,880
Process account
units ₦ units ₦
JP2 3,000 39,547
8,000 135,880 8,000 135,880

9.3 By-products
When two or more different products are produced, any product that does not
have a substantial sales value is called a by-product.
Definition: By-products
By-products are outputs from a joint process that are relatively minor in quantity
and/or value.
A by-product has a small value relative to the joint products but it may have some
value.
The proceeds of sale of the by-product can be treated in a number of ways and
the method chosen has an implication for how the by-product is measured in the
joint process account.
Possible methods include:
Measurement of by-product in joint

Treatment of proceeds of sale
process account
As revenue (adding it to the revenue No cost is allocated to the by product.
from sales of other products).
As other income No cost is allocated to the by product.
As a deduction from joint process By-product is measured at scrap
costs (this is the most commonly used value (the accounting treatment is
method). very similar to that used for normal
loss).
Since a by-product does not have any substantial value, there is no sense in
charging it with a share of the common processing costs.
Instead, the sales value of the by-product is usually deducted from the common
processing costs (just as for normal loss). If there are joint products, the common
processing costs are apportioned after deducting the sales value of the by-
product from the total costs of the process.
Example: By-product and joint products

Two joint products JP1 and JP2, are produced from a common process.
During March, 9,000 units of materials were input to the process. Total costs of
Output was 5,000 units of JP1 and 3,000 units of JP2 and 1,000 units of by-
product BP3.
BP3 has a sales value of ₦1.58 per unit
The company’s policy is to treat the proceeds of sale of a by-product as a
reduction of joint process costs
Apportion the process costs between the joint products on the basis of net
realisable sales value at the split-off point.


Common process costs ₦
Total process costs 135,880
Deduct: Sales value of by-product (1,000  ₦1.58) (1,580)
134,300

NRV value ₦
JP1 (5,000 units  ₦120  ₦25) 475,000
JP2 (3,000 units  ₦80  ₦15) 195,000
670,000
Costs: ₦
₦475,000
JP1: /₦670,000  ₦134,300. 95,213
₦195,000
JP2: /₦670,000  ₦134,300. 39,087
134,300
Process account
units ₦ units ₦
JP2 3,000 39,087
By product 1,000 1,580
8,000 135,880 8,000 135,880
Example: By-product and joint products

Two joint products XX and YY, are produced from a common process.
During July, 11,000 units of materials were input to the process. Total costs of
Output was 6,000 units of XX and 4,000 units of YY and 1,000 units of by-product
Q.
XX has a sales value of ₦24 per unit when it is output from the process.
YY has a sales value of ₦12 per unit when it is output from the process.
Q has a sales value of ₦1 per unit
The company’s policy is to apportion joint costs based on sales value at the point
of split-off.
80% of the output of both XX and YY was sold by the month end.
The proceeds of sale of the by-product could be treated in one of the following
ways.

Answer: Sales value at point of split-off deducting proceeds of sale of the by-
product from the joint process cost (as before)
Sales value ₦
XX (6,000 units  ₦24) 144,000
YY (4,000 units  ₦12) 48,000
192,000
1 By-product deducted from costs

Costs: ₦
₦144,000
XX: / ₦192,000  (₦100,000  ₦1,000) 74,250
₦48,000
YY: / ₦192,000  (₦100,000  ₦1,000). 24,750
99,000
units ₦ units ₦
Direct materials 11,000 100,000 XX 6,000 74,250
YY 4,000 24,750
Q 1,000 1,000
11,000 100,000 11,000 100,000
The income statement would show the following:

₦
Revenue:
Sales of XX (80%  6,000 units  ₦24) 115,200
Sales of YY (80%  4,000 units  ₦12) 38,400
153,600
Cost of sales:
Production costs 99,000
Less: Closing inventory (20%  99,000) (19,800)
(79,200)
Profit 74,400

Answer: Sales value at point of split-off treating proceeds of sale of the by-product
as other income
Sales value ₦
XX (6,000 units  ₦24) 144,000
YY (4,000 units  ₦12) 48,000
192,000
1 By-product deducted from costs

Costs: ₦
₦144,000
XX: / ₦192,000  ₦100,000 75,000
₦48,000
YY: / ₦192,000  ₦100,000 25,000
100,000
units ₦ units ₦
Direct materials 11,000 100,000 XX 6,000 75,000
YY 4,000 25,000
Q 1,000 nil
11,000 100,000 8,000 100,000
The income statement would show the following:

₦
Revenue:
Sales of XX (80%  6,000 units  ₦24) 115,200
Sales of YY (80%  4,000 units  ₦12) 38,400
153,600
Cost of sales:
Production costs 100,000
Less: Closing inventory (20%  100,000) (20,000)
(80,000)
Gross profit 73,600
Other income 1,000
Profit 74,600
The profit in the above example is higher than the profit in the previous example
by ₦200.
This is because the whole sales proceeds from the sale of the by-product has
been recognised as other income.
When the sales proceeds from the sale of the by-product are deducted from the
joint process cost part of that deduction is carried forward to the next period in
the valuation of closing inventory. The deduction in joint process costs was
₦1,000 and 80% of the inventory to which it relates has been sold leaving 20%
(₦200) to be carried forward to the next period.

10 CHAPTER REVIEW
Chapter review
 Explain process costing
 Explain when process costing is appropriate
 Calculate the cost of output from a process including losses and opening and
closing WIP
 Distinguish between joint products and by-products
 Calculate the cost of joint products and by-products


Foundation level
CHAPTER
10
Forecasting
Contents
1 Trend lines
2 Seasonal variations
3 Chapter review

INTRODUCTION
Purpose
Competencies
2(a) Compile forecasts for management information purposes
Exam context
This chapter explains forecasting techniques used in business. The bulk of the chapter
covers time series analysis which is also covered in Paper A: Quantitative Techniques in
Business. The material is largely a repeat from the relevant chapter in that text. However,
this chapter also explains how a trend line might be derived using least squares linear
regression analysis and illustrates the different results produced by each from the same set
of data.

 Construct a time series
 Identify and draw the trend line
 Derive the line of best fit using centred moving averages or least squares linear
regression analysis
 Use the additive model to make forecasts
 Use the proportional model to make forecasts

Chapter 10: Forecasting
1 TREND LINES
Section overview
 The nature of a time series

 Analysing a time series
 Moving averages
 Centred moving averages
 Line of best fit (high-low method)
 Line of best fit (least squares linear regression analysis)
 Lines of best fit compared
1.1 The nature of a time series

A time series is a record of data over a period of time for example, sales revenue
per month or revenue per quarter. The time series is a convenient way of
representing historical information but more importantly, it might be used to make
predictions about the future. This is done by continuing the series forward in time.
In order to do this the time series must be analysed into its component parts.
Components of a time series

A change in value of an observed variable in a time series might be due to a
combination of factors. These are described as the components of the time
series. There are two models of a time series which differ in how these
components are linked together.
Formula: Time series models

Additive model:
TS = T + S + C + R
Proportional (multiplicative model)

TS = T  S  C  R
Where:
T = Trend – the overall direction of change in the data.
S = Seasonal variation – differences between the actual data observed
for a time period and the amount predicted by the trend for that period.
C = Cyclical variation – Longer term variations which might cause
changes over longer periods.
R = Random fluctuations
Note that the term “seasonal variation” has a specific meaning in time series
analysis. It relates to the variation in each period covered in the analysis.
Therefore it could mean a daily, weekly, quarterly or annual variation depending
on the analysis.

Questions requiring analysis of a time series will require the identification of a

trend and seasonal variations.
 Random fluctuations cannot be predicted. The usual assumption made is
that they are negligible and can be ignored in any analysis.
 Also, there is usually insufficient data to identify cyclical variations.
The plot of a time series as a graph is called a historigram.
The diagram below shows a trend line with seasonal variations above and below
the trend line. The general trend in this diagram is up and the trend can be shown
as a straight line. However the actual value in each time period is above or below
the trend, because of the seasonal variations.
Illustration: Historigram of a time series
1.2 Analysing a time series

There are two aspects to analysing a time series from historical data:
 estimating the trend line; and
 calculating the amount of the seasonal variations (monthly variations or
daily variations).
The time series can then be used to make estimates for a future time period, by
calculating a trend line value and then either adding or subtracting the
appropriate seasonal variation for that time period.
Two methods of calculating a trend line are:
 Moving averages.
 Linear regression analysis
Linear regression analysis is a technique that produces a line of best fit for
observed data. This is covered in the next chapter. Note that both might be used
together. Moving averages might be used to identify the underlying trend and

then linear regression might be used to identify a line of best fit for the moving
averages identified.
Methods of calculating seasonal variations are explained later.
1.3 Moving averages

Moving averages can be used to estimate a trend line, particularly when there
are seasonal variations in the data.
The technique involves smoothing out fluctuations in the underlying observed
data by calculating averages for small groups of observations from that data. The
size of the small group is related to the type of data. If the data is quarterly then a
group of 4 would be used or if the data was monthly a group of 12 would be
used.
Moving averages are calculated as follows:
Step 1: Decide the length of the cycle. The cycle is a number of days or weeks,
or seasons or years.
 The cycle might be seven days when historical data is collected daily for
each day of the week or perhaps six days if the business is closed for one
day per week.
 The cycle will be one year when data is collected monthly for each month of
the year or quarterly for each season.
Step 2: Use the historical data to calculate a series of moving averages. A
moving average is the average of all the historical data in one cycle.
For example, suppose that historical data is available for daily sales over a period
Day 1 – Day 21, and there are seven days of selling each week.
 A moving average can be calculated for Day 1 – Day 7. This represents an
amount for the middle day in the data i.e. day 4.
 Another moving average can be calculated for Day 2 – Day 8. . This
represents an amount for the middle day in the data i.e. day 5.
This process continues until all of the data has been included. Note that as this is
an averaging process, it results in a figure related to the mid-point of the overall
period for which the average has been calculated.
Note that it is easier to number each day, month or quarter in a cycle starting
from 1 rather than retain actual day names, dates etc.
Step 3: If there is an even number of items of data in the moving average
calculation then the average will correspond to a point between the middle two
time periods. A second average is calculated for each pair of values in the
moving average column. This is done to centre the observation and align it with a
time period.
For example:
 A moving average for Quarter 1 – Quarter 4 gives a value which represents
the mid-point of the range. This is Quarter 2.5.
 A moving average for Quarter 2 – Quarter 5 gives a value which represents
the mid-point of the range. This is Quarter 3.5.
 Quarters 2.5 and 3.5 do not exist so the values are averaged to give a
value which is taken to represent Quarter 3.

Step 4: Use the moving averages (and their associated time periods) to calculate
a trend line.
The following example illustrates the calculation of moving average in detail to
ensure that you understand what it means before moving on to produce a
complete trend.
Example: Calculating moving averages

A company operates for five days each week. Sales data for the most recent
three weeks are as follows:
Sales Monday Tuesday Wednesday Thursday Friday
units units units units units
Week 1 78 83 89 85 85
Week 2 88 93 99 95 95
Week 3 98 103 109 105 105
Moving averages are calculated as follows:
Day Sales
1 78
2 83
3 89 = 420 ÷ 5 days = 84 per day
4 85
5 85
84 represents the sales on the middle day
of the period (day 3)
Day Sales
2 83
3 89
4 85 = 430 ÷ 5 days = 86 per day
5 85
6 88
86 represents the sales on the middle day
of the period (day 4)
The example is continued to complete the trend on the next page.

Example: Constructing a trend line with moving averages

A company operates for five days each week. Sales data for the most recent
three weeks are as follows:
Sales Monday Tuesday Wednesday Thursday Friday
units units units units units
Week 1 78 83 89 85 85
Week 2 88 93 99 95 95
Week 3 98 103 109 105 105
For convenience, it is assumed that Week 1 consists of Days 1 – 5, Week 2

consists of Days 6 – 10, and Week 3 consists of Days 11 – 15.
This sales data can be used to estimate a trend line. A weekly cycle in this
example is 5 days. Moving averages are calculated for five day periods, as
follows:
Moving average (trend
found by dividing the 5
Day Sales 5 day total day total by 5)
Day 1 78
Day 2 83
Day 3 89 420 84
Day 4 85 430 86
Day 5 85 440 88
Day 6 88 450 90
Day 7 93 460 92
Day 8 99 470 94
Day 9 95 480 96
Day 10 95 490 98
Day 11 98 500 100
Day 12 103 510 102
Day 13 109 520 104
Day 14 105 530
Day 15 105 540
Note that this process always results in a loss of values for points in time at the
start and at the end of the range.

Line of best fit

The trend is an indication of the general movement in a set of data. In order to
make predictions, the trend must be expressed as a straight line.
In the above example, the trend increases by 2 each day. This means that each
moving average actually lies on a straight line. An equation can be found for this
trend line by taking the first sales figure as a starting point and then adjusting it
by the number of days multiplied by 2 per day to give the following formula:
Daily sales = 78 + 2x.
This trend line can be used to forecast a trend value for any day in the future. For
example, the forecast for sales on day 50 is:
Daily sales = 78 + 50x = 178
This of course assumes that sales will continue to grow at 2 per day on average.
This trend line can also be used to calculate the ‘seasonal variations’ (in this
example the daily variations in sales above or below the trend).
In turn, these can be used to adjust the forecast value of the trend line to take
account of whether day 50 is a Monday, Tuesday, Wednesday, Thursday or
Friday.
This is explained later.

1.4 Centred moving averages

When there is an even number of seasons in a cycle, the moving averages will
not correspond to an actual season. When this happens it is necessary to take
moving averages of the moving averages in order to arrive at a value which
corresponds to an actual season of the year.
Example: Constructing a trend line with centred moving averages

The following quarterly sales figures have been recorded for a company.
Sales Quarter 1 Quarter 2 Quarter 3 Quarter 4
₦000 ₦000 ₦000 ₦000
Year 1 20 24 27 31
Year 2 35 39 44 47
Year 3 49 56 60 64
In the following analysis the quarters are numbered from 1 to 12 for ease
of reference. (Thus year 1: Q1 is numbered Q1 and year 3: Q4 is numbered
Q12).
Moving average values for each quarter are calculated as follows:
4 quarter Moving average (trend found by
Quarter Sales total dividing the 4 quarter total by 4)
₦000 ₦000 ₦000
1 20
2 24
102 25.5
3 27
117 29.25
4 31
132 33.00
5 35
149 37.25
6 39
165 41.25
7 44
179 44.75
8 47
196 49.00
9 49
212 53.00
10 56
229 57.25
11 60
12 64

Each of the moving average figures above line up opposite a point between two
quarters (seasons). For example, the average for quarters 1 to 4 sits between
quarter 2 and quarter 3 at quarter 2.5.
Analysing seasonal variation requires the figures in the trend to be lie opposite an
actual season (quarter). This is achieved by carrying out a second averaging for
each adjacent pair of numbers. The resultant numbers are called centred moving
averages
Example: Constructing a trend line with centred moving averages (continued)
Centred
Moving Centre total (of 2 moving
Quarter Sales average moving averages) average (÷2)
₦000 ₦000 ₦000 ₦000
1 20
2 24
25.5
3 27 25.5 + 29.25 = 54.75 27.38
29.25
4 31 29.25 + 33.00 = 62.25 31.13
33.00
5 35 33.00 + 37.25 = 70.25 35.13
37.25
6 39 37.25 + 41.25 = 78.50 39.25
41.25
7 44 41.25 + 44.75 = 86.00 43.00
44.75
8 47 44.75 + 49.00 = 93.75 46.88
49.00
9 49 49.00 + 53.00 = 102 51.00
53.00
10 56 53.00 + 57.25 = 110.25 55.13
57.25
11 60
12 64
The moving averages in the right hand column correspond with an actual season
(quarter). These moving averages are used to estimate the trend line and the
seasonal variations.

1.5 Line of best fit (high-low method)

As explained earlier, the trend is an indication of the general movement in a set
of data but in order for it to be used to make predictions it must be expressed as
a straight line.
The first moving average value can be used as a starting point in the equation of
a straight line. One way of identifying the slope is to subtract the lowest moving
average from the highest and divide the figure by the number of periods between
those two figures.
Example: Line of best fit
From the previous example

Moving
average
₦000
Quarter 10 55.13
Quarter 3 (27.38)
27.75
Number of periods between Q10 and Q3 ÷7
3.96
The equation of the line of best fit is:

y (Sales) = 27.38 + 3.96x
Care must be taken in using this equation. Remember the starting point for the
equation id Q3 so any value must be calculated in reference to Q3.
Example: Line of best fit
From the previous example estimate the trend sales figure for Q4 in year 4.
This corresponds to Q16 in the example which is 13 quarters after the starting
point.
y (Sales) = 27.38 + 3.96x
y (Sales in Q4 of year 4) = 27.38 + 3.96 (13) = 78.86

1.6 Line of best fit (least squares linear regression analysis)

This technique has already been explained in the context of cost estimation but it
can also be used to construct a trend line for forecasting purposes. The time
periods must be numbered sequentially (starting at zero or one) to provide values
of x.
Example: Constructing a trend line using least squares linear regression

The following quarterly sales figures have been recorded for a company.
Sales Quarter 1 Quarter 2 Quarter 3 Quarter 4
₦000 ₦000 ₦000 ₦000
Year 1 20 24 27 31
Year 2 35 39 44 47
Year 3 49 56 60 64
Required: Construct the equation of a line of best fit for this data.
Working:
x y x2 xy
₦000 ₦000
1 20 1 20
2 24 4 48
3 27 9 81
4 31 16 124
5 35 25 175
6 39 36 234
7 44 49 308
8 47 64 376
9 49 81 441
10 56 100 560
11 60 121 660
12 64 144 768
78 496 650 3,795
= x = y = x2 = xy
n ∑ xy − ∑ x ∑ y 12(3,795) − (78)(496)
b= =
n ∑ x − (∑ x) 12(650) − (78 )
45,540 − 38,688 6,852
= = = 3.99
7,800 − 6,084 1,716
∑y b∑x 496 3.99(78)
a= − a= −
n n 12 12
a = 41.33 − 25.94 = 15.39
Line of best fit: = +
= 15.39 + 3.99

1.7 Lines of best fit compared

Care must be taken when comparing the sales values predicted by each
approach.
The centred moving averages approach results in the loss of data from each end
of the original data range. The first data point on the straight line is now at Q3 of
year 1. This becomes the value where x = zero.
There is no loss of data when using least squares linear regression. The a value
found is where the straight line cuts the y axis, i.e. where x = zero. This is one
quarter behind the first observation.
This is a little difficult to visualise at first. Study the following example carefully to
make sure that you can see where the values come from.
Example: Comparison of trend lines

The previous examples result in the following lines of best fit under each method.
These have been extrapolated forward to provide forecast data for the next four
quarters.
Line of best fit
Least squares Centred moving
method average method
x y = 15.39 + 3.99x x1 y = 27.38 + 3.96x
Q1, Year 1 1 19.37
Q2, Year 1 2 23.36
Q3, Year 1 3 27.36 0 27.38
Q4, Year 1 4 31.35 1 31.34
Q1, Year 2 5 35.34 2 35.30
Q2, Year 2 6 39.34 3 39.26
Q3, Year 2 7 43.33 4 43.22
Q4, Year 2 8 47.32 5 47.18
Q1, Year 3 9 51.32 6 51.14
Q2, Year 3 10 55.31 7 55.10
Q3, Year 3 11 59.30 8 59.06
Q4, Year 3 12 63.29 9 63.02
Forecasts:
Q1, Year 4 13 67.29 10 66.98
Q2, Year 4 14 71.28 11 70.94
Q3, Year 4 15 75.27 12 74.90
Q4, Year 4 16 79.27 13 78.86
x1 = centred values of x
Either of these lines can provide a basis for further analysis to find the seasonal
variations. This chapter continues by using the trend data found by the centred
moving average method.

2 SEASONAL VARIATIONS
Section overview
 Introduction
 The additive model
 The proportional model
2.1 Introduction
The trend line on its own is not sufficient to make forecasts for the future. We
also need estimates of the size of the ‘seasonal’ variation for each of the different
seasons.
Consider the two examples above:
 In the first example we need an estimate of the amount of the expected
daily variation in sales, for each day of the week.
 In the second example we need to calculate the variation above or below
the trend line for each season or quarter of the year.
A ‘seasonal variation’ can be measured from historical data as the difference
between the actual historical value for the time period, and the corresponding
trend value.
The seasonal variation is then used to adjust a forecast trend value.
There are two models used to estimate seasonal variation:
 The additive model
 The proportional model
2.2 The additive model

This model assumes that seasonal variations above and below the trend line in
each cycle adds up to zero. Seasonal variations below the trend line have a
negative value and variations above the trend line have a positive value.
The seasonal variation for each season (or daily variation for each day) is
estimated as follows, when the additive assumption is used:
 Calculate the difference between the moving average value and the actual
historical figure for each time period.
 Group these seasonal variations into the different seasons of the year
(days of the week; months or quarters of the year).
 Calculate the average of these seasonal variations for each season (or day;
month; quarter).
 if the total seasonal variations for the cycle do not add up to zero the
difference is spread evenly across each season (or day; month; quarter).
 This adjusted figure is the seasonal variation.

Example: Additive model

Using the previous example for quarterly sales, actual sales and the
corresponding moving average value were as follows:
Variation
Actual sales in (Actual – Moving
Quarter Trend the quarter average)
₦000 ₦000 ₦000
Year 1: Q3 27.375 27 0.375
Year 1: Q4 31.125 31 0.125
Year 2: Q1 35.125 35 0.125
Year 2: Q2 39.250 39 0.250
Year 2: Q3 43.000 44 1.000
Year 2: Q4 46.875 47 0.125
Year 3: Q1 51.000 49 2.000
Year 3: Q2 55.125 56 0.875
The seasonal variation (daily variation) is now calculated as the average

seasonal variation for each day, as follows:
Variation Q1 Q2 Q3 Q4 Total
₦000 ₦000 ₦000 ₦000 ₦000
Year 1 0.375 0.125
Year 2 0.125 0.250 1.000 0.125
Year 3 2.000 0.875
Average 1.063 0.313 0.313 0.0 0.437
Adjustment: 0.10925 0.10925 0.10925 0.10925 0.437
Seasonal
adjustment 0.95375 0.42225 0.42225 0.10925 0
The seasonal variations can then be used, with the estimated trend line, to make
forecasts for the future.
Example: Forecast sales

The forecast for the trend value of sales in Q4 in year 4 is 78.86.
The estimated sales in this quarter are:
₦000
Trend value 78.86
Quarter 4 adjustment (rounded) 0.11
Sales forecast 78.97

2.3 The proportional model

This model expresses the actual value in each season as a proportion of the
trend line value.
When a proportional model is used to calculate seasonal variations, rather than
the additive model, the seasonal variations for each time period are calculated by
dividing the actual data by corresponding moving average or trend line value.
The sum of the proportions for each time period must add up to 1. This means
that the total of the proportions quarterly data must sum to 4. If this is not the
case the difference is spread evenly over each quarter
Example: Proportional model

Using the previous example for quarterly sales, actual sales and the
corresponding moving average value were as follows:
Seasonal
variation: actual
sales as a
Actual sales in proportion of the
Quarter Trend the quarter moving average
₦000 ₦000 ₦000
Year 1: Q3 27.375 27 0.986
Year 1: Q4 31.125 31 0.996
Year 2: Q1 35.125 35 0.996
Year 2: Q2 39.250 39 0.994
Year 2: Q3 43.000 44 1.023
Year 2: Q4 46.875 47 1.003
Year 3: Q1 51.000 49 0.961
Year 3: Q2 55.125 56 1.016
The seasonal variation (daily variation) is now calculated as the average

seasonal variation for each day, as follows:
Variation Q1 Q2 Q3 Q4 Total
₦000 ₦000 ₦000 ₦000 ₦000
Year 1 0.986 0.996
Year 2 0.996 0.994 1.023 1.003
Year 3 0.961 1.016
Average 0.978 1.004 1.004 0.999 3.985
0.00375 0.00375 0.00375 0.00375 0.015
0.98175 1.00775 1.00775 1.00275 4.000

Example: Forecast sales
The forecast for the trend value of sales in Q4 in year 4 is 78.86.
The estimated sales in this quarter are:

₦000
Trend value 78.86
Quarter 4 adjustment (rounded) 1.003
Sales forecast 79.01

3 CHAPTER REVIEW
Chapter review
 Construct a time series
 Identify and draw the trend line
 Derive the line of best fit using centred moving averages or least squares linear
regression analysis
 Use the additive model to make forecasts
 Use the proportional model to make forecasts

Foundation level
CHAPTER
11
Budgeting
Contents
1 The budgeting process
2 Preparing functional budgets
3 Budgetary systems
4 Behavioural aspects of budgeting
5 Chapter review

INTRODUCTION
Purpose
Competencies
2(b) Compile budgets and extracts from budgets using information provided
2(c) Select and justify the choice of the most appropriate methods of budgeting for
planning and controlling including motivational considerations, including:
i) Bottom-up and top-down approaches
ii) Marginal and absorption approaches (see also chapter 6)
iii) Activity-based costing (see also chapter 7)
iv) Zero-based and incremental approaches
v) Budget implementation and monitoring
Exam context
This chapter explains the process of budgeting and various budgeting approaches. It also
explains the role of budgeting in influencing the behaviour of workers.

 Explain the purposes of budgeting
 Construct functional budgets from information provided
 Describe the main features of, and explain the differences between bottom-up and top-
down budgeting
 Explain activity-based budgeting
 Describe the main features of, and explain the differences between zero-based and
incremental budgeting

Chapter 11: Budgeting
1 THE BUDGETING PROCESS
Section overview
 Introduction to budgeting
 Preparing the budget
 Principal budget factor
 Stages in the budget process
1.1 Introduction to budgeting
Planning framework
A business entity should plan over the long term, medium-term and short-term.
 Long-term planning, or strategic planning, focuses on how to achieve the
entity’s long-term objectives.
 Medium-term or tactical planning focuses on the next year or two.
 Short-term or operational planning focuses on day-to-day and week-to-
week plans.
Budgets are medium-term plans for the business, expressed in financial terms. A
typical budget is prepared annually, and the overall budget is divided into control
periods for the purpose of control reporting.
The nature of budgets

A budget is a formal plan, expressed mainly in financial terms and covering all
the activities of the entity. It is for a specific period of time, typically one year.
When budgets are prepared annually, they are for the next financial year.
The total budget period (one year) may be sub-divided into shorter control
periods of one month or one quarter (three months).
Purposes of budgeting
Budgets have several purposes:
 To convert long-term plans (strategic plans) into more detailed shorter term
(annual) plans.
 To ensure that planning is linked to the long-term objectives and strategies
of the organisation.
 To co-ordinate the actions of all the different parts of the organisation, so
that they all work towards the same goals. (This is known as ‘goal
congruence’). One of the benefits of budgeting is that it covers all activities,
so the plan should try to ensure that all the different activities are properly
co-ordinated and working towards the same objective.
 To communicate the company’s plans to the individuals (managers and
other employees) who have to put the plans into action.
 To motivate managers and employees, by setting targets for achievement,
and possibly motivating them with the incentive of bonuses or other
rewards if the targets are met.

 To provide guidelines for authorising expenditure. Expenditure might not be

permitted unless it has been planned in the budget or unless it is within the
budgeted expenditure limits for the department.
 To identify areas of responsibility for implementing the plans. For each part
of the budget, an individual manager should be made responsible for
achieving the budget targets for performance.
 To provide a benchmark against which actual performance can be
measured.
 To control costs. Costs can be controlled by comparing budgets with actual
results and investigating any differences (or variances) between the two.
This is known as budgetary control.
1.2 Preparing the budget

Preparing the annual budget is a major activity for many entities. In many
medium-sized and large companies, there is a well-defined process for budget
preparation, because a large number of individuals have to co-ordinate their
efforts to prepare the budget plans. The budgeting process may take several
months, from beginning to eventual approval by the board of directors.
The budget process might be supervised and controlled by a special committee
(the budget committee). This consists of senior managers from all the main
areas of the business. The committee co-ordinates the various functional budgets
submitted to it for review, and gives instructions for changes to be made when
the draft budgets are unsatisfactory or the functional budgets are not consistent
with each other.
Although the budget committee manages the budget process, the functional
budgets are usually prepared by the managers with responsibility for the
particular aspect of operations covered by that functional budget.
Budget manual
There should be a budget manual or budget handbook to guide everyone
involved in the budgeting process, This should set out:
 The key objectives of the budget
 The planning procedures and the timetables to follow when preparing the
budget
 Instructions about the budget details that must be included in the functional
budgets
 Responsibilities for preparing the functional budgets (sales budget,
production budget, materials budgets, labour usage budget and overhead
expenditure budgets)
 Details of the budget approval process. The budget must be approved by
the budget committee and then by the board of directors.
The master budget

The ‘master budget’ is the final approved budget. It is usually presented in the
form of financial statements - a budgeted income statement and a budgeted
balance sheet for the end of the financial year.

However the master budget is the result of a large number of detailed plans,
many of them prepared at a departmental or functional level. To prepare the
master budget, it is therefore necessary to prepare functional budgets first.
Functional budgets
A functional budget is a budget for a particular aspect of the entity’s operations.
The functional budgets that are prepared vary with the type of business and
industry. In a manufacturing company, functional budgets should include:
 A sales budget
 A production budget
 A budget for production resources and resource costs (such as a materials
cost budget and a labour cost budget)
 A materials purchasing budget
 Expenditure budgets for every overhead cost centre and general overhead
costs.
1.3 Principal budget factor

The budgeting process begins with the preparation of functional budgets, which
must be co-ordinated and consistent with each other. To make sure that
functional budgets are co-ordinated and consistent, the first functional budget
that should be prepared is the budget for the principal budget factor.
The principal budget factor (also called the key budget factor) is the factor in the
budget that will set a limit to the volume and scale of operations.
Sales demand (sales volume) as the principal budget factor

Normally, the principal budget factor is the expected sales demand. When this
happens, the expected sales demand should set a limit on the volume of
production (or volume of services). A company might have the capacity to
increase its production and output, but producing larger quantities has no
purpose unless the extra quantities can be sold.
A company will therefore prepare a budget on the basis of the sales volumes that
it hopes or expects to achieve. When sales demand is the principal budget factor,
the sales budget is the first functional budget that should be prepared.
A principal budget factor other than sales volume

Sometimes, there is a different limitation on budgeted activity. There might be a
shortage of a key resource, such as machine time or the availability of skilled
labour. When there is a shortage of a resource that will set a limit on budgeted
production volume or budgeted activity, the first functional budget to prepare
should be the budget for that resource.
In government, the principal budget factor for each government department is
often an expenditure limit for the department. The department must then prepare
a budget for the year that keeps the activities and spending plans of the
department within the total expenditure limit for the department as a whole.

1.4 Stages in the budget process

The budgeting process for a manufacturing company is probably more complex
than for many other types of organisation, and manufacturing company budgets
are more likely to be the subject of an examination question than budgets for
companies in other industries. This chapter therefore describes the budgeting
process for a manufacturing company.
The stages in setting the budget might be as follows:
 Stage 1: Identify the principal budget factor (or key budget factor). The
principal budget factor is often sales volume.
 Stage 2: Prepare the functional budget or plan for the principal budget
factor. Usually, this means that the first functional budget to prepare is the
sales budget.
 All the other functional budgets should be prepared within the limitation of
the principal budget factor. For example, even if the company has the
capacity to produce more output, it should not produce more than it can sell
(unless it formally decides to increase the size of the finished goods
inventory, in which case the production volume will be higher than the sales
volume).
 Stage 3: Prepare the other functional budgets, in logical sequence where
necessary. When the sales budget has been prepared, a manufacturing
organisation can then prepare budgets for inventories (= plans to increase
or reduce the size of its inventories), a production budget, labour usage
budgets and materials usage and purchasing budgets. Expenditure
budgets should also be prepared for overhead costs (production
overheads, administration overheads and sales and distribution
overheads). Overhead costs budgets are usually prepared for each cost
centre individually.
 Stage 4: Submit the functional budgets to the budget committee for review
and approval. The functional budgets are co-ordinated by the budget
committee, which must make sure that they are both realistic and
consistent with each other.
 Stage 5: Prepare the ‘master budget’. This is the budget statement that
summarises the plans for the budget period. The master budget might be
presented in the form of:
 a budgeted income statement for the next financial year
 a budgeted balance sheet as at the end of the next financial year
 a cash budget or cash flow forecast for the next financial year.
 It should be possible to prepare the master budget statements from the
functional budgets.
 Stage 6: The master budget and the supporting functional budgets should
be submitted to the board of directors for approval. The board approves
and authorises the budget.
 Stage 7: The detailed budgets are communicated to the managers
responsible for their implementation.
 Stage 8: Control process. After the budget has been approved, actual
performance should be monitored by comparing it with the budget. Actual
results for the period should be recorded and reported to management.
These results should be compared with the budget, and significant

differences should be investigated. The reasons for the differences

(‘variances’) should be established, and where appropriate control
measures should be taken. Comparing actual results with the budget
therefore provides a system of control. The managers responsible for
activities where actual results differ significantly from the budget will be held
responsible and accountable.
The planning process (budgeting) should therefore lead on to a management
monitoring and control process (budgetary control).
The next section describes the approach that can normally be used to prepare
functional budgets for a manufacturing organisation. In practice, budgets are
usually prepared with a computer model, such as a spreadsheet. However, you
need to understand the logic of budget preparation.

2 PREPARING FUNCTIONAL BUDGETS
Section overview
 The sales budget

 Cost budgets
 The production budget
 The materials usage budget
 The materials purchases budget
 The labour usage budget
 Budgeted profit and loss account
2.1 The sales budget

The sales budget is the plan for the volume and value of sales in the budget
period. It is prepared for each product individually, in units of sale and sales
revenue, and for sales revenue in total.
It is calculated for each product simply by multiplying the volume of sales in units
by the budgeted sales price per unit.
Example: Sales budget

Enugu Plastics Ltd makes and sells two products, Product P and Product Q.
The sales price and expected sales volume for each product next year are as
follows:
Product P Product Q
Sales price per unit ₦400 ₦500
Budgeted sales volume 2,000 units 3,000 units
A sales budget can be prepared as follows:
Budgeted
Budgeted Budgeted sales
Product sales quantity sales price revenue
units ₦ ₦
P 2,000 400 800,000
Q 3,000 500 1,500,000
Total 2,300,000
A sales budget might be prepared by making adjustments to actual sales in the

current financial year.

Example: Sales budget

A company is preparing its sales budget for the year. In the current financial year
it expects that total sales will be ₦2.6 million. Next year, it hopes to raise its
selling prices by 3% and to increase sales volume by 5%.
The sales budget for next year is therefore: ₦2.6 million  1.03  1.05 = ₦2.8
million (to the nearest ₦100,000).
2.2 Cost budgets

When sales are a key factor, the cost budgets all flow from the number to be sold
and must be prepared in the following order:
Production budget
This is the number of units to be produced in the period. This number starts with
the number of units to be sold which is then adjusted for inventory movement.
(For example, if 100 items are to be sold, in the absence of other information, the
company would need to make 100 items. However, if 20 items can be taken from
inventory, the company would only need to make 80 items).
Materials usage budge

This can only be constructed after the number of units to be made is known.
Materials purchases budget

This can only be constructed after the amount of raw material to be used is
known.
Labour usage budget

This can only be constructed after the number of units to be made is known.
You can see from the above that the labour usage budget can be prepared
before the materials usage budget if you prefer.
The various functional budgets can be combined to produce a profit or loss

account for the period.
The process will be explained with a series of examples building the functional
budgets and budgeted profit or loss account of Enugu Plastics limited.

2.3 The production budget

The production budget is calculated initially in units of output, although a budget
for production costs can be prepared when production quantities have been
decided.
The production budget for each product in units is the sales budget in units
adjusted for any planned changes in finished goods inventories.
The production budget in units is prepared for each product, as follows:
Illustration: Production budget

Units
Sales budget in units X
Plus: Budgeted closing inventory X
Minus: Opening inventory (X)
Production budget X
Example: Production budget

Enugu Plastics Ltd makes and sells two products, Product P and Product Q. Its
sales budget for next year is to sell 2,000 units of Product P and 3,000 units of
Product Q.
The following opening and closing inventories are budgeted:
Opening Closing
Finished goods: Units Units
P 200 300
Q 150 100
A production budget can be prepared as follows:

Product P Product Q
units units
Sales budget 2,000 3,000
Plus: Budgeted closing inventory 300 100
2,300 3,100
Minus: Opening inventory (200) (150)
Production budget 2,100 2,000

Practice question 1
A company makes and sells two products, Product P and Product Q. Its sales
budget for next year is to sell 40,000 units of Product P and 27,000 units of
Product Q.
It has been decided that inventory of Product P should be reduced to 2,000
units by the end of the budget period, and inventory of Product Q should be
increased to 1,500 units.
It expects opening inventory of finished goods to be 4,000 units of Product P
and 500 units of Product Q.
Prepare a production budget.
2.4 The materials usage budget

After the production budget has been prepared, budgets can be prepared for the
resources required to achieve the production targets.
Production resources budgets will include a materials usage budget, a direct
labour usage budget and possibly a machine hours budget.
Separate budgets can be prepared for each production centre, and these can be
added together to create the total production budget. For example, if a
manufacturing process consists of a machining department, a finishing
department and an assembly department, production budgets will be prepared
for each department separately, and these will then be combined to produce a
total production department budget.
The materials usage budget is a budget for the quantities of materials that will be
used. It is a statement of the quantities of direct materials required for production,
and their cost.
The usage budget is prepared for each item of material separately, and a total
cost of the materials used should also be shown.

Example: Materials usage budget

The company has determined that it will make 2,100 units of Product P and
2,950 units of Product Q next year.
The products are expected to use raw materials as follows:
Product P Product Q
Direct materials Usage (kgs) Usage (kgs)
Material A (₦40 per kg) 2 0.5
Material B (₦50 per kg) 0.5 3
Material C (₦70 per kg) 1 -
A material usage budget can be prepared as follows:

A (kgs) B (kgs) C (kgs)
Usage to make 2,100 units of P
2,100 units  2 kgs 4,200
2,100 units  0.5 kgs 1,050
2,100 units  1 kgs 2,100
Usage to make 2,950 units of Q

2,950 units  0.5 kgs 1,475
2,950 units  3 kgs 8,850
Usage in kgs 5,675 9,900 2,100
Cost per kg ₦40 ₦50 ₦70
Usage in naira 227,000 495,000 147,000
Total cost ₦869,000
Practice question 2
A company makes and sells two products, Product S and Product T. Its
production budget for next year is to make 40,000 units of Product S and
10,000 units of Product T.
The materials required to make one unit of each product, and their cost, are
as follows:
Cost per
Product S Product T kilo
kilos kilos ₦
Material M1 2.0 3.0 400
Material M 2 2.5 1.5 600
Prepare a materials usage budget.

2.5 The materials purchases budget

The budgeted cost of materials for use in production is not the same as the
quantity and cost of materials that will be purchased. Material purchases and
material usage will be different if there are plans to increase or reduce raw
materials inventories.
The materials purchases budget is the budget for the purchase cost of materials
that will be purchased in the budget period. The materials purchases budget
might be prepared for all materials, direct and indirect, or for direct materials only.
The purchases budget differs from the materials usage budget by the amount of
the planned increase or decrease in inventory levels of materials in the budget
period.
The purchase quantities are calculated first. Purchase quantities are calculated
as follows, for each item of material:
Illustration: Materials purchases budget

kgs
Material usage X
Plus budgeted closing inventory X
Minus opening inventory (X)
Purchases budget X
The purchase quantities for each item of material are converted into a purchases
cost at the budgeted purchase price for the item of material.
The total material purchases budget (in ₦) is the sum of the purchases budget for
each of the individual items of material.

Example: Materials purchases budget

The company expects to use raw materials in the coming year as follows:
Direct materials Usage (kgs)
Material A 5,675
Material B 9,900
Material C 2,100 -

Opening Closing
Materials: Cost per kg (₦) kgs kgs
A 40 500 600
B 50 550 400
C 70 100 250
A material purchases budget can be prepared as follows:

A (kgs) B (kgs) C (kgs)
Usage 5,675 9,900 2,100
Clsoing inventory 600 400 250
6,275 10,300 2,350
Opening inventory (500) (550) (100)
Purchases (kgs) 5,775 9,750 2,250
Cost per kg (₦) 40 50 70
Purchases (₦) 231,000 487,500 157,500
Total cost ₦876,000

Practice question 3
A company makes and sells two products, Product X and Product Y. Its
production budget for next year is to make 20,000 units of Product X and
15,000 units of Product Y.
The materials required to make one unit of each product, and their costs are
as follows:
Cost per
Product X Product Y litre
litres litres ₦
Material M3 0.5 1.5 3
Material M4 1.0 2.0 4
The company expects to have opening inventory of 3,000 litres of Material M3
and 2,000 litres of Material M4. It plans to have closing inventory of 3,500 litres
of Material M3 and 1,200 litres of Material M4
Required
Prepare the materials usage and purchases budget for the year.
Practice question 4
A company produces Products A and B and the budgeted production in the
coming year is 5,000 units of A and 10,000 units of B.
Products A and B require the following quantities of raw materials to produce one
unit.
Product A Product B
per unit per unit
Raw material X 5 kg 4 kg
Raw material Y 7 kg 3 kg
Raw material X costs ₦10 per kg and raw material Y costs ₦20 per kg.
Data relating to opening and closing inventory is as follows:
Raw material
X Y
Closing inventory 10,000 8,000
Opening inventory 8,000 4,000
Required
Prepare the materials usage and purchases budget for the year.

2.6 The labour usage budget
Direct labour usage budget

The direct labour usage budget is prepared in a similar way to the materials
usage budget. It is a statement of the quantities of direct labour required for
production, and its cost.
The budget is prepared for different grades of labour separately, but the total
labour cost should also be shown.
The expected hours of work to make the budgeted production quantities of each
product should be calculated separately for each grade of labour and then for all
the products in total. The total budget in hours for each grade of labour is
converted into a cost at the standard/budgeted rate per hour for the grade of
labour.
Example: Labour usage budget

The company has determined that it will make 2,100 units of Product P and
2,950 units of Product Q next year.
The products are expected to require labour as follows:
Usage Usage
Direct labour (hrs) (hrs)
Grade X (₦100 per hr.) 0.25 0.5
Grade Y (₦80 per hr.) 0.25 0.75
A labour usage budget can be prepared as follows:

Grade X (hrs) Grade Y (hrs)
Usage to make 2,100 units of P
2,100 units  0.25 hrs 525
2,100 units  0.25 hrs 525
Usage to make 2,950 units of Q

2,950 units  0.5 hrs 1,475
2,950 units  0.75 hrs 2,212.5
Usage in kgs 2,000 2,737.5
Cost per kg (₦) 100 80
Usage in naira 200,000 219,000
Total cost(₦) 419,000

Practice question 5
A company makes and sells two products, Product S and Product T. Its
sales budget is to sell 40,000 units of Product S and 10,000 units of
Product T.
The expected opening inventories of finished goods are 500 units of
Product S and 1,000 units of Product T, and the plan is to double finished
goods inventories by the end of the budget period.
The direct labour hours required to make one unit of each product, and
their cost, are as follows:
Product S Product T Cost per hour
hours hours ₦
Grade G1 labour 0.2 0.6 20
Grade G2 labour 0.3 0.8 16
Prepare the direct labour usage budget.
Indirect labour costs

Budgets must also be prepared for indirect labour employees. It is usual to
include indirect labour costs within the budget for the overhead cost centre or
department where the employees work.

2.7 Budgeted profit and loss account

The functional budgets can be combined to produce a budgeted profit and loss
account for the period.
Full details from the Enugu Plastics examples are given below for your
convenience.
Example: Preparing a functional budget

Enugu Plastics Ltd makes and sells two products, Product P and Product Q. Its
sales budget for next year is to sell 2,000 units of Product P at a sales price of
₦400 per unit and 3,000 units of Product Q at a sales price of ₦500 per unit.
The following cost information is expected to apply in the next year:
Product P Product Q
Usage Usage
Direct materials (kgs) Cost (₦) (kgs) Cost (₦)
Material A (₦40 per kg) 2 80 0.5 20
Material B (₦50 per kg) 0.5 25 3 150
Material C (₦70 per kg) 1 70 - -
175 170
Usage Usage
Direct labour (hrs) (hrs)
Grade X (₦100 per hr.) 0.25 25 0.5 50
Grade Y (₦80 per hr.) 0.25 20 0.75 60
45 110
Unit cost 220 280

Opening Closing
Finished goods: Cost (₦) Units Total (₦) Units Total (₦)
P 220 200 44,000 300 66,000
Q 280 150 42,000 100 28,000
86,000 94,000
Materials: Cost kgs kgs
A 40 500 20,000 600 24,000
B 50 550 27,500 400 20,000
C 70 100 7,000 250 17,500
54,500 61,500
Total inventory 140,500 155,500

Example: Preparing a functional budget

The following additional information has been derived from the above during the
budget process:
Product Sales price (₦) Units ₦
Sales budget P 400 2,000 800,000
Q 500 3,000 1,500,000
2,300,000
Purchases 876,000
Labour usage 419,000
The above figures can be used to produce a budgeted profit or loss account
for the year as follows:
₦ ₦
Sales budget 2,300,000
Cost of sales:
Purchases 876,000
Labour usage 419,000
1,435,500
Closing inventory (155,500)
(1,280,000)
Budgeted gross profit 1,020,000
The budgeted gross profit can be checked as follows:

(Units  (Sales price – Unit cost) ₦
Profit from selling P (2,000 units  (400  220)) 360,000
Profit from selling Q (3,000 units  (500  280)) 660,000
1,020,000

3 BUDGETARY SYSTEMS
Section overview
 Top-down and bottom-up budgeting

 Incremental budgeting and zero-based budgeting (ZBB)
 Activity-based budgeting
A budgetary system is a system for preparing budgets (and producing control reports
for the purpose of budgetary control). There are several budgetary systems, and
entities will choose a system that is appropriate for their needs and circumstances.
3.1 Top-down budgeting and bottom-up budgeting
Top-down budgeting
In a system of top-down budgeting, the budget targets for the year are set at
senior management level, perhaps by the board of directors or by the budget
committee. Top-level decisions might be made, for example, about the amount of
budgeted profit that will be achieved, the growth in sales, reductions in production
costs and other functional department costs, and so on.
Divisions and departments are then required to prepare a budget for their own
operations that is consistent with the budget imposed on them from above.
For example, the board of directors might state that in the budget for the next
financial year, sales revenue will grow by 5% and profits by 8%. The sales
director would then be required to prepare a more detailed sales budget in which
the end result is a 5% growth in annual sales revenue. A production budget and
other functional budgets will then be prepared that is consistent with the sales
budget. The target for 8% growth in profits cannot be checked until all the
functional budgets have been prepared in draft form. If the initial draft budgets fail
to achieve 8% growth in profits, some re-drafting of the budgets will be required.
This process is called top-down budgeting because it starts at the top with senior
management and works its way down to the most detailed level of budgeting
within the management hierarchy. This might be departmental level or possibly
an even smaller unit level, such as budgets for each work section within each
department. A system of top-down budgeting would normally be associated with
an entity where management control is highly centralised.
Bottom-up budgeting
In a system of bottom-up budgeting, budgeting starts at the lowest level in the
management hierarchy where budgets are prepared. This may be at work section
level or departmental level. The draft lower-level budgets are then submitted to
the next level of management in the hierarchy, which combines them into a co-
ordinated budget, for example a departmental budget. Departmental budgets
might then be submitted up to the next level of management, which might be at
divisional level, where they will be combined and co-ordinated into a divisional
budget. Eventually, budgets for each division will be submitted up to the budget
committee or board of directors.
The budget committee or board of directors will consider the draft budgets they
receive, and ask for changes to be made if the overall master budget is

unsatisfactory. Re-drafting of budgets will then go on until the master budget is

eventually approved.
In a system of bottom-up budgeting, lower levels of management are likely to
have more input to budget decision-making than in a top-down budgeting system,
and it is associated with budgeting in entities where management authority is
largely decentralised.
3.2 Incremental budgeting and zero-based budgeting (ZBB)

Incremental budgeting and zero-based budgeting are two different approaches to
estimating budgeted expenditure. The difference between them is most obvious
in budgeting for administrative activities (and other overhead activities) and
overhead costs.
Incremental budgeting
With incremental budgeting, the budgeted expenditure for the next financial
period is estimated by taking expenditure in the current period as a starting point.
An incremental amount is then added for:
 inflation in costs next year, and
 possibly, the cost of additional activities that will be carried out next year.
In its simplest form, incremental budgets for a financial period are prepared by
taking the expenditure in the current year, and adding a percentage to allow for
inflation next year.
This approach to budgeting is very common in practice because of its relative
simplicity. For example in order to prepare a labour cost budget, it might be
sufficient for the manager to make assumptions about (1) changes in staffing
levels and (2) the general level of pay rises, and apply these assumptions to the
actual labour costs for the current year that is just ending. If labour costs in the
current year are ₦2.4 million, and if it is assumed that the work force will increase
by 2% next year and that wages and salaries will increase by an average of 4%,
a labour cost budget can be prepared simply as: ₦2.4 million  102%  104% =
₦2.546 million.
A serious weakness of incremental budgeting, however, is that there is no
incentive to eliminate wasteful or unnecessary spending from the budget. For
example suppose that next year’s budget is based on this year’s actual spending
plus an allowance for inflation. If there has been wasteful spending in the current
year, next year’s budget will include an allowance for the wasteful spending, plus
inflation.
Incremental budgeting can also encourage more waste (sometimes called
‘budget slack’), because managers will try to spend up to their budget limit, so
that in the next financial year their budgeted spending allowance will not be
reduced.
Zero-based budgeting (ZBB)

Zero-based budgeting (ZBB) has a completely different approach to budgeting. It
aims to eliminate all wasteful spending (‘budget slack’) and only to budget for
activities that are worth carrying out and that the organisation can afford.
Planning starts from ‘zero’ and all spending must be justified.

It can be particularly useful in budgeting for activities that are prone to wasteful
spending and budget slack, such as activities in a bureaucracy. ZBB might be
usefully applied, for example, to the budgets of government departments.
The approach used in ZBB is as follows:
 The minimum level of operations in a department or budget centre is
identified. These are the essential things that the department will have to
do. A budget is prepared for this minimum essential level.
 All other activities are optional additional activities that need to be justified,
in terms of the benefits obtained in return for the costs. Each additional
activity is called a decision package.
A decision package is a program of activities that will achieve a specific purpose
during the budget period. Each decision package must have a clearly-stated
purpose that contributes to the goals and objectives of the entity.
There are two types of decision package:
 Decision packages for a minimum level of operation. For example,
there may be a minimum acceptable level of training for a group of
employees. There may be several alternative decision packages for
providing the training – internal courses, external courses, or computer-
based training programmes. An expenditure estimate should be prepared
for each alternative basic decision package.
 Incremental decision packages. These are programmes for conducting a
more extensive operation than the minimum acceptable level. For example,
there may be incremental decision packages for providing some employees
with more training than the essential minimum, or for having more
extensive supervision, or more extensive quality control checks. For
incremental decision packages, an estimate should be made of the cost of
the incremental operation, and the expected benefits. Incremental decision
packages are optional activities: the entity need not include them in the
budget.
For each decision package, a budget decision must be made about whether to
include it in the budget and the following should be considered:
 Purpose of the activity (decision package)
 The likely results and benefits from the activity
 The resources required for the activity, and their cost
 Alternative ways of achieving the same purpose, but perhaps at a lower
cost
 A comparison of the costs and benefits of the activity.
A zero-based budget is then prepared as follows:
 A decision must be taken to provide for a minimum level of operation. This
means deciding for each basic operation:
 Whether or not to perform the operation at all – do the benefits justify
the costs?
 If the operation is performed at a basic level, which of the alternative
basic decision packages should be selected?
 Having decided on a basic level of operations, a basic expenditure budget
can be prepared.

 The next step is to consider each incremental decision package, and

decide whether this additional operation, or additional level of operations, is
justified. An incremental decision package is justified if the expected
benefits exceed the estimated costs.
 A budget can then be prepared consisting of all the selected basic decision
packages and incremental decision packages.
 If the total expenditure budget is too high, when all these decision
packages are included, some incremental decision packages should be
eliminated from the budget. One method of doing this is to rank the
incremental decision packages in an order of priority (typically in order of
net expected benefits, which are the expected benefits minus the estimated
incremental costs). The decision packages at the bottom of the priority list
can then be eliminated from the budget, until total budgeted expenditure
comes within the maximum permitted spending limit.
Extensive use of value judgements by managers will be needed to rank decision
packages in a priority order. This is because the expected benefits from
incremental activities or incremental programmes are often based on guesswork
and opinion, or on forecasts that might be difficult to justify.
The advantages of zero-based budgeting

There are some obvious benefits from zero-based budgeting
 All activities are reviewed and evaluated and no activity is included in the
budget unless it appears to be worthwhile.
 Inefficiency in using resources and inefficiency in spending should be
identified and eliminated.
 A ZBB approach helps managers to question the reason for doing things
rather than simply accepting the current position.
 When total expenditure has to be reduced, ZBB provides a priority list for
activities and expenditures.
 ZBB encourages greater involvement by managers and might motivate
them to eliminate wasteful spending.
The disadvantages of zero-based budgeting

However, there are also some severe disadvantages to ZBB:
 ZBB is a very time-consuming process, particularly if undertaken every
year.
 It is also costly, because it takes more time.
 Planners need to understand the principles of relevant costing and
decision-making, in order to compare properly the incremental costs and
incremental benefits of activities (decision packages).
 Managers might see ZBB as a threat and an attempt by senior
management to cut back their expenditure allowances in the next budget
year.
 When incremental decision packages are ranked in priority order, there
may be disputes between managers of different decision units (budget cost
centres), as each tries to protect his own spending levels and argue that
budget cuts should fall on other cost centres.

In view of the large amount of management time that is required to prepare a

zero-based budget, an entity may decide to produce a zero-based budget
periodically, say every three years, and to prepare incremental budgets in the
intervening years.
In order to maintain the support of budget cost centre managers for a system of
ZBB, it is also necessary to make sure that any system of performance-based
rewards (such as annual bonuses for keeping spending within budget limits) is
not affected by the use of ZBB. If managers feel that their rewards will be
threatened – for example because it will be difficult to keep spending within the
ZBB limits – they are unlikely to give their support to the ZBB system.
ZBB and performance monitoring

A successful system of ZBB requires methods for monitoring actual performance
and comparing actual performance with the budget.
 Each decision package must therefore have one or more measurable
performance objectives. The package must specify the objective or
objectives, and the activities or operations that will be required to achieve
those objectives.
 Actual performance should be measured and compared with the objectives.
Management must be informed whether or not the performance objectives
are achieved.
3.3 Activity-based budgeting

Activity-based budgeting applies the principles of activity-based costing to the
preparation of budgets.
 Activities drive costs. By identifying cost drivers, it might be assumed that
costs that are directly attributable to an activity can be more accurately
forecast and monitored.
 In service cost centres and non-production departments many costs are
likely to be caused by activities outside of the control of the department. By
identifying cost drivers, activity levels are more visible. For example,
maintenance requirements may be a function of the age of the machinery
and level of usage. The maintenance manager will require estimates from
the production manager to enable a budget to be produced.
 With activity-based budgeting, it might also be possible to identify activities
that do not add value, and their associated costs. These activities can then
be eliminated from the budget.

Example:
A manufacturing company has identified that a large part of its overhead costs
are incurred in handling customer orders, and that the same effort goes into
handling a small order as the effort required to deal with a large order. Order
sizes differ substantially. The company makes four products.
A system of activity-based budgeting is used, and each activity is treated as a cost
centre for the purpose of budgeting. For the order-handling activity, budgeted
directly-attributable expenditure is ₦2,500,000 for the year.
Budgets for sales volumes and sales orders are as follows:
Number of Total number of
Product orders units ordered
W 150 60,000
X 220 33,000
Y 40 40,000
Z 90 27,000
500 160,000
It is assumed that the cost driver for order handling is the number of orders
handled.
The budgeted order handling cost will be ₦2,500,000/50 = ₦50,000 per order.
Overhead costs will be charged to products in the budget as follows:
Number of Budgeted
Product orders cost
₦
W 150 750,000
X 220 1,100,000
Y 40 200,000
Z 90 450,000
500 2,500,000

4 BEHAVIOURAL ASPECTS OF BUDGETING
Section overview
 Introduction
 Misunderstanding and worries about cost-cutting
 Opposition to unfair targets set by senior management
 Sub-optimisation
 Budget slack (budget bias)
 Participation in budget setting
4.1 Introduction
The effectiveness of budgeting and budgetary control depends largely on the behaviour
and attitudes of managers and (possibly) other employees.
 Budgets provide performance targets for individual managers. If managers are
rewarded for achieving or exceeding their target, budgets could provide them
with an incentive and motivation to perform well.
 It has also been suggested that budgets can motivate individuals if they are able
to participate in the planning process. Individuals who feel a part of the planning
and decision-making process are more likely to identify with the plans that are
eventually decided. By identifying with the targets, they might have a powerful
motivation to succeed in achieving them.
When budgeting helps to create motivation in individuals, the human aspect of
budgeting is positive and good for the organisation.
Unfortunately, in practice human behaviour in the budgeting process often has a
negative effect. There are several possible reasons why behavioural factors can be
harmful:
 Misunderstanding and worries about cost-cutting
 Opposition to unfair targets set by senior management
 Sub-optimisation
 Budget slack or budget bias
4.2 Misunderstanding and worries about cost-cutting

Budgeting is often considered by the managers affected to be an excuse for
cutting back on expenditure and finding ways to reduce costs. Individuals often
resent having to reduce their spending, and so have a hostile attitude to the
entire budgeting process. This fear and hostility can exist even when senior
management do not have a cost-cutting strategy.

4.3 Opposition to unfair targets set by senior management

When senior managers use the budgeting process to set unrealistic and unfair
targets for the year, their subordinates may unite in opposition to what the senior
managers are trying to achieve. Senior managers should communicate and
consult with the individuals affected by target-setting, and try to win their
agreement to the targets they are trying to set. Targets need to be reasonable.
A distinction can be made between:
 aspirational budgets, which are budgets based on performance levels
and targets that senior managers would like to achieve, and
 exceptional budgets, which are budgets based on performance levels and
targets that senior managers would realistically expect to achieve.
Aspirational budgets might be considered unfair, especially if the individuals
affected have not been consulted. Exceptional budgets, based on current
performance levels, do not provide for any improvements in performance.
Ideally perhaps, budgets might be set with realistic targets that provide for some
improvements in performance.
4.4 Sub-optimisation
There may be a risk that the planning targets for individual managers are not in
the best interests of the organisation as a whole. For example, a production
manager might try to budget for production targets that fully utilise production
capacity. However, working at full capacity is not in the best interests of the
company as a whole if sales demand is lower. It would result in a build-up of
unwanted finished goods inventories. The planning process must be co-ordinated
in order to avoid sub-optimal planning. In practice, however, effective co-
ordination is not always achieved.
4.5 Budget slack (budget bias)

Budget slack has been defined as ‘the intentional overestimation of expenses
and/or underestimation of revenue in the budgeting process’ (CIMA Official
Terminology). Managers who prepare budgets may try to overestimate costs so
that it will be much easier to keep actual spending within the budget limit.
Similarly, managers may try to underestimate revenue in their budget so that it
will be easier for them to achieve their budget revenue targets. As a result of
slack, budget targets are lower than they should be.
When managers are rewarded for achieving their budget targets, the motivation
to include some slack in the budget is even stronger.
An additional problem with budget slack is that when a manager has slack in his
spending budget, he may try to make sure that actual spending is up to the
budget limit. There are two reasons for this:
 If there is significant under-spending, the manager responsible might be
required to explain why.
 Actual spending needs to be close to the budget limit in order to keep the
budget slack in the budget for the next year.
The problem of budget slack is particularly associated with spending on
‘overhead’ activities and incremental budgeting. One of the advantages of
zero-based budgeting is that it should eliminate a large amount of slack from
budgets.

In some cases, budget bias operates the other way. Some managers might
prepare budgets that are too optimistic. For example, a sales manager might
budget for sales in the next financial year that are unrealistic and unachievable,
simply to win the approval of senior management.
4.6 Participation in budget setting

Rewards for performance are intended to motivate individuals to achieve the
targets that have been set.
Another view is that individuals can be motivated to improve their performance
and to set challenging budgets through their commitment to the work that they
do. If individuals enjoy their work and feel committed to performing as well as
possible, challenging budget targets can be agreed and better levels of actual
performance should be achieved.
Personal motivation to improve performance, it may be argued, can be achieved
if individuals are allowed to:
 Participate meaningfully in the budget-setting or target-setting process
 Be directly involved in negotiating performance targets for the budget
period.
Advantages and disadvantages of participation

The advantages of participative budgeting are as follows:
 Stronger motivation to achieve budget targets, because individuals are
involved in setting or negotiating the targets.
 There should be much better communication of goals and budget targets to
the individuals involved, and a better understanding of the target-setting
process.
 Involvement by junior managers in budgeting provides excellent experience
for personal development
 Better planning decisions – participation might lead to better planning
decisions, because ‘local’ managers often have a much better detailed
knowledge of operations and local conditions than senior managers.
However, there are significant disadvantages with participation.
 It might be difficult for junior managers to understand the overall objectives
of the organisation that budgets should be designed to meet.
 The quality of planning with participation depends on the skills, knowledge
and experience of the individuals involved. Participation is not necessarily
beneficial in all circumstances, particularly when individuals lack
experience.
 There might be a danger that budget targets will be set at a level that is not
ambitious. Participation on its own is not necessarily a sufficient incentive to
raise standards and targets for achievement. Individuals might try to argue
that performance targets should be set at current levels of achievement.
 Senior managers might pretend to be encouraging participation, but in
practice they might disregard all the proposals and ideas of their
subordinates. To be effective, participation must be ‘real’.

 It is generally considered that participation is a good thing, but it needs to

be strictly managed by senior management to make sure optimum
decisions are taken that are in line with the company’s goals.
Imposed budgets
The opposite of a participative budget is an imposed budget, where senior
management dictates what the budget targets should be. Imposed budgets have
certain advantages:
 Less time consuming. Line managers do not have to spend time on
budgeting and so are not distracted from the task of running the business.
 Senior managers may have a greater appreciation of the constraints faced
by the business, such as restrictions on cash and other resources, and
shareholder expectations of profits and dividends.
 It may be easier to co-ordinate departmental budgets if they are prepared
together by senior management.
However the disadvantages of imposed budgets are that:
 Targets may be set at a challenging level and so are unachievable. If
unachievable targets are imposed, this will lead to de-motivation.
 Opportunities for exploiting the specialist knowledge of more junior
managers may be lost if they are excluded from the budget-setting process.

5 CHAPTER REVIEW
Chapter review
 Explain the purposes of budgeting
 Construct functional budgets from information provided
 Describe the main features of, and explain the differences between bottom-up
and top-down budgeting
 Explain activity-based budgeting
 Describe the main features of, and explain the differences between zero-based
and incremental budgeting


Solution 1
Product P Product Q
units units
Budgeted closing inventory 2,000 1,500
Opening inventory (4,000) (500)
Solution 2
A materials usage budget can be prepared as follows:
Material M1 Material M2 Total
kilos kilos
To make 40,000 S 80,000 100,000
To make 10,000 T 30,000 15,000
Total quantities 110,000 115,000
Price per kilo (₦) 400 600
Total cost (₦) 44,000,000 69,000,000 113,000,000
Solution 3
Material M3 Material M4 Total
litres litres
To make 20,000 X 10,000 20,000
To make 15,000 Y 22,500 30,000
Material usage quantities 32,500 50,000
Opening inventory (3,000) (2,000)
33,000 49,200
Price per litre (₦) 3 4
Total cost (₦) 99,000 196,800 295,800

Solution 4
Materials usage budget Raw material Raw material
X (kgs) Y (kgs) Total (kgs)
To make 5,000 A 25,000 35,000 60,000
To make 10,000 B 40,000 30,000 70,000
Total quantities 65,000 65,000 130,000
Total cost (₦) 650,000 1,300,000 1,950,000
Materials purchases budget Raw material Raw material

X (kgs) Y (kgs) Total (kgs)
Materials usage budget 65,000 65,0000
73,000 69,000
Opening inventory (10,000) (8,000)
Budgeted materials
purchases 63,000 61,000
(₦) 630,000 1,220,000 1,850,000
Solution 5
A direct labour usage budget can be prepared as follows, after a production budget has
been established.
Product S Product T
units units
Plus: Budgeted closing inventory 1,000 2,000
Minus: Opening inventory (500) (1,000)
Grade G1 Grade G2 Total

hours hours
To make 40,500 S 8,100 12,150
To make 11,000 T 6,600 8,800
Total labour hours 14,700 20,950
Rate of pay per hour (₦) 20 16
Total direct labour cost (₦) 294,000 335,200 629,200

Foundation level
CHAPTER
12
Cash budgeting and working capital
Contents
1 Working capital
2 Cash budgets and cash flow forecasts
3 Cash operating cycle
4 Chapter review

INTRODUCTION
Purpose
Competencies
2(d) Compile and identify and explain the business consequences of a cash
budget identifying flows, balances and limits
2(e) Calculate and explain the working capital and cash cycles of a business
Exam context
This chapter explains what working capital is. It then moves on to explain how cash budgets
and cash flow forecasts are prepared before explaining the working capital and cash cycles
of a business.

 Construct a cash budget from information provided
 Construct the components of a cash operating cycle from information provided
 Construct a cash operating cycle from information provided

Chapter 12: Cash budgeting and working capital
1 WORKING CAPITAL
Section overview
 The nature and elements of working capital

 The objectives of working capital management
1.1 The nature and elements of working capital

Working capital is the capital (finance) that an entity needs to support its
everyday operations.
Working capital is defined as the net current assets (or net current operating
assets) of a business.
The total investment in working capital is calculated as:
Illustration: Working capital

Current assets: ₦
Inventory X
Trade receivables X
Short-term investments X
Cash X
X
Minus current liabilities:
Bank overdraft X
Trade payables X
Other current liabilities X
(X)
Working capital X
To operate a business, an entity must invest in inventories and it must sell its
goods or services on credit. Holding inventories and selling on credit costs
money.
Some of the finance required for operations is provided by taking credit from
suppliers. This means that the suppliers to an entity are helping to support the
business operations of that entity. Some short-term operating finance might also
be obtained by having a bank overdraft.
Cash and short-term investments are also elements of working capital. Some
cash might be held for operational use, to pay liabilities. Surplus cash in excess
of operational requirements might be invested short-term to earn some interest.

1.2 The objectives of working capital management

The management of working capital is an aspect of financial management, and is
concerned with:
 Ensuring that the investment in working capital is not excessive; and
 Ensuring that enough working capital is available to support operating
activities.
Cash management is a key element of working capital management.

The objective of good cash management is to hold sufficient cash to meet
liabilities as they fall due, whilst making sure that not too much cash is held.
Money held as cash is not being invested in the wealth-creating assets of the
organisation, thereby making the company less profitable than it might otherwise
be.
Cash budgets and cash flow forecasts are key cash management tools.

2 CASH BUDGETS AND CASH FLOW FORECASTS
Section overview
 Cash budgets
 Format of a cash budget
 Receipts from credit sales
 Payments to suppliers
2.1 Cash budgets

A cash budget is a detailed plan of cash receipts and cash payments during a
planning period. The planning period is sub-divided into shorter periods, and the
cash receipts and payments are forecast/planned for each of the sub-divisions of
time.
The cash budget might be prepared on a monthly basis, or possibly a quarterly
basis as part of the annual master budget but many businesses also prepare
cash flow forecasts for shorter periods, for example the next week, or weekly
cash flows for the next month.
The main uses of a cash budget are as follows:
 To forecast how much cash receipts and payments are expected to be over
the planning period.
 To learn whether there will be a shortage of cash at any time during the
period, or possibly a cash surplus.
 If there is a forecast shortage of cash, to consider measures in advance for
dealing with the problem - for example by planning to defer some
purchases of non-current assets, or approaching the bank for a larger bank
overdraft facility.
 To monitor actual cash flows during the planning period, by comparing
actual cash flows with the budget.
Cash flow forecasts

Cash flow forecasts, like cash budgets, are used to predict future cash
requirements, or future cash surpluses. However, unlike cash budgets they are
prepared throughout the financial year, and are not a part of a formal budget
plan.
The main objectives of cash flow forecasting, like the purposes of a cash budget,
are to:
 Make sure that the entity is still expected to have sufficient cash to meet its
payment commitments as they fall due.
 Identify periods when there will be a shortfall in cash resources, so that
financing can be arranged.
 Identify whether there will be a surplus of cash, so that the surplus can be
invested
 Assess whether operating activities are generating the cash that is
expected from them.

The main focus of cash flow forecasting is likely to be operating cash flows,
although some investing and financing cash flows might also be significant.
There is no real difference in the preparation of a cash flow budget and a cash
flow forecast in terms of exam questions.
2.2 Format of a cash budget

A cash budget is a budget of cash receipts and cash payments during each
control period of the budget. Cash budgets might be prepared on a month-by-
month basis. However, cash budgets might be prepared on a week-by-week
basis, or even a day-by-day basis if required for short-term planning.
A cash budget can be prepared by producing a table for the cash receipts and
cash payments, containing each item of cash receipt and each item of cash
payment. The cash receipts and then the cash payments should be listed in rows
of the table, and each column of the table represents a time period, such as one
month.
A typical format for a monthly cash budget is shown below.
Example: Cash flow budget
January February March

Cash receipts ₦ ₦ ₦
Cash sales 5,000 6,000 5,000
Cash from credit sales 72,000 64,000 64,000
Other cash receipts 4,000 2,000 2,000
Total cash receipts 81,000 72,000 71,000
Cash payments
Cash purchases 6,000 6,600 6,200
Payments for credit purchases 8,400 9,000 9,900
Rental payments - 30,000 -
Wages and salaries 23,000 23,000 23,000
Dividend payments - - 40,000
Other payments 3,000 73,000 13,000
Total cash payments (40,400) (141,600) (92,100)
Receipts minus payments (net
cash flow) 40,600 (69,600) (21,100)
Cash balance at the beginning
of the month 45,000 85,600 16,000
Cash balance at the end of the
month 85,600 16,000 (5,100)
The cash budget should show all cash items of receipt or payment, including:
 Cash from issuing shares;
 Interest or dividends received from investments;
 Interest payments, but only in the months that interest is actually paid;

 Taxation payments but only in the months that tax is actually paid; and
 Dividend payments.
Receipts and payments must be recorded in the month when they are expected
to occur. Non-cash expenditures, such as depreciation of non-current assets,
must not be included.
2.3 Receipts from credit sales

One of the more difficult calculations in a cash budget is the cash receipts from
trade receivables. When sales are on credit, payments will not be received until a
later month.
A question will provide you with a collection pattern for cash on credit sales. This
collection pattern must be applied to the monthly sales figures to identify which
month the cash is collected.
There might also be information about bad debts which are dealt with easily by
reducing the cash to be received. A question might also require you to estimate
sales figures for a number of periods before being able to calculate the cash
receipts.
Example: Receipts from credit sales

A company is in the process of preparing a cash budget for January to March
2015.
The company has actual sales in October and November 2014 of ₦100,000.
December sales are expected to remain at this level but a new advertising
initiative to be launched on 1 January 2015 are expected to lead to a month on
month increase in sales of ₦10,000 per month for the first 6 months of next year.
10% of sales are for cash, 40% is collected in the next month and the balance
(net of bad depts. of 1%) is collected in the following month. This means that 49%
of the cash (being the remaining 50% less 1% bad debt) is collected in the second
month.
A table of workings for cash receipts can now be prepared, as follows (with all
figures in ₦000):
Cash receipts:
Sales Nov Dec Jan Feb Mar
Nov 100 10 40 49
Dec 100 10 40 49
Jan 110 11 44 53.9
Feb 120 12 48
Mar 130 13
 100 105 114.9

Note that it is necessary to find the sales figures for each month before the
cash flows can be found.

Practice question 1
Product P (units) Product Q (units)

November 1,500 2,000
December 2,000 3,000
January 1,000 2,000
February 2,000 3,000
March 3,000 4,000
Product P is sold for ₦20 per unit, and Product Q for ₦30.
All sales are on credit. 20% of total sales are paid for in the month of sale, and
40% in the following month.
The rest, excluding bad debts, are paid at the end of the second month.
Bad debts are 2% of total sales and are written off at the end of the second
month following sale.
Calculate the cash receipts expected in January, February and March.
2.4 Payments to suppliers

Payments to suppliers can be calculated in a similar way to cash receipts from
credit sales. This can be a little tricky.
The starting point for calculating payments in each month is the purchases in
each month. When calculating this figure you might need to take cost structures
and inventory policies into account.
Having established total purchases, you can then work out when the payments
will be made. Remember that bad debts are irrelevant as all goods sold must be
paid for whether or not the cash is received from their subsequent sale.
Example: Payments for credit purchases

A company is in the process of preparing a cash budget for January to
March 2015.
The company has actual sales in October and November 2014 of ₦100,000.
December sales are expected to remain at this level but a new advertising
initiative to be launched on 1 January 2015 are expected to lead to a month on
month increase in sales of ₦10,000 per month for the first 6 months of next
year.
Cost of sales is budgeted to be 60% of the sales figure in each month.
It is the company’s policy to have enough closing inventory at each month end to
cover 10% of the next month’s sales.
(This means that if sales in month 2 are expected to be 100 the closing
inventory at the end of month 1 will be 6 being 10%  100  60%).
Half of all purchases in each month are paid for in that month and the remaining
balance is paid in the next month.
The cash payments made in January, February and March can be calculated as
follows:

Example (continued): Payments for credit purchases

The first step is to calculate the purchases figures for each month by constructing
a cost of sale working.
This will be done in stages to allow you to understand the process.
Cost of sales in each month is 60% of the sales figure for that month.
Nov Dec Jan Feb Mar
Sales 100.0 100.0 110.0 120.0 130.0
Opening inventory
Purchases
Closing inventory
Cost of sales 60.0 60.0 66.0 72.0 78.0
The closing inventory at the end of each month is 10% of the next month’s sales
multiplied by 60% (to reduce selling price to cost). A short cut way of calculating
this is to simply take 10% of the following month’s cost of sales figure.
Nov Dec Jan Feb Mar
Sales 100.0 100.0 110.0 120.0 130.0
Opening inventory
Purchases
Closing inventory (6.0) (6.6) (7.2) (7.8) (8.4)
Cost of sales 60.0 60.0 66.0 72.0 78.0
The closing inventory at the end of each month becomes the opening inventory
for the next month. These figures can be entered and the purchases figures are
found as balancing figures.
Nov Dec Jan Feb Mar
Sales 100.0 100.0 110.0 120.0 130.0
Opening inventory 6.0 6.0 6.6 7.2 7.8
Purchases 60.0 60.6 66.6 72.6 78.6
Closing inventory (6.0) (6.6) (7.2) (7.8) (8.4)
Cost of sales 60.0 60.0 66.0 72.0 78.0
A table of workings for cash payments can now be prepared, as follows (with all
figures in ₦000):
Cash payments
Purchases Dec Jan Feb Mar
Dec 60.6 30.3 30.3
Jan 66.6 33.3 33.3
Feb 72.6 36.3 36.3
Mar 78.6 39.3
63.3 69.6 75.6

3 CASH OPERATING CYCLE
Section overview
 The nature of the cash operating cycle

 Constructing a cash operating cycle
 Changes to the operating cycle and its components
3.1 The nature of the cash operating cycle

An important way of assessing the adequacy of working capital and the efficiency
of working capital management is to calculate the length of the cash operating
cycle (also called the working capital cycle).
This cycle is the average length of time between paying suppliers for goods and
services received and receiving cash from customers for sales of finished goods
or services.
There are three main elements in the cash operating cycle:
 The average length of time that inventory is held before it is used or sold;
 The average credit period taken from suppliers; and
 The average length of credit period taken by (or given to) credit customers.
The operating cycle is measured as follows:
Illustration: Cash operating cycle

Days/weeks/
months
Average inventory holding period X
Average trade receivables collection period X
X
Average period of credit taken from suppliers (X)
Operating cycle X
The working capital cycle measures the time taken from the payment made to
suppliers of raw materials to the payments received from customers.
In a manufacturing company this will include the time that:
 Raw materials are held in inventory before they are used in production
 The product takes in the production process
 Finished goods are held in inventory before being purchased by a
customer.

3.2 Constructing a cash operating cycle
Calculating the inventory holding period

The average inventory holding period is normally calculated as follows:
Formula: Average inventory holding period

Average inventory
Average inventory holding period = ×365 days
Annual cost of sales
Calculating the average receivables collection period

The average period for collection of receivables can be calculated as follows:
Formula: Average receivables collection period

Average trade receivables
Average receivables collection period = × 365 days
Annual sales
Calculating the average payables period

The average period of credit taken from suppliers before payment of trade
payables can be calculated as follows:
Formula: Average payables period

Average trade payables
Average payables period = × 365 days
Annual purchases
If possible, average inventory/receivables/payables balances should be used to

calculate the ratios because the year-end balances might not be representative
of the average balances in the period. Average balances are usually calculated
as the average of the balances at the beginning and end of the period.
The year-end balances are used when opening balances are not given and
average balances cannot be calculated.

Example: Constructing a cash operating cycle

The following figures have been extracted from a company’s accounts:
Statement of profit or loss ₦
Sales 1,200,000
Cost of sales:
Purchases 1,000,000
1,250,000
Closing inventory (250,000)
Cost of sales (1,000,000)
Gross profit 200,000
Statement of financial position

Trade receivables 400,000
Trade payables 166,667
Average inventory holding period:

Average inventory
Average inventory holding period = × 365 days
Annual cost of sales
250,000
Average inventory holding period = × 365 days 91 days
1,000,000
Average receivables collection period:

Average trade receivables
Average receivables collection period = × 365 days
Annual sales
400,000
Average receivables collection period = × 365 days 122 days
1,200,000
Average payables period:

Average trade payables
Average payables period = × 365 days
Annual purchases
166,667
Average payables period = × 365 days 61 days
1,000,000
Cash operating cycle: Days

Average inventory holding period 91
Average trade receivables collection period 122
Average period of credit taken from suppliers (61)
152

Comments on the example

Each of these periods calculated give insight into the working capital held in
relation to the activity level of the business.
 The company in the above example had inventory of ₦250,000 and cost of
sales ₦1,000,000. In other words, it has enough inventory to supply three
months cost of sales. This implies an average inventory holding period of 3
months (or the 91 days shown above).
 The company’s sales in the year were ₦1,200,000 of which it has yet to
collect ₦400,000. This implies that it is taking about 4 months (or the 122
days shown above) to collect receivables (as sales are ₦100,000 per
month).
 The company’s purchases in the year were ₦1,000,000 of which it has yet
to pay ₦166,667. This implies that it is taking about 2 months (or the 61
days shown above) to pay its trade creditors (as purchases are ₦83,333
per month).
A company can introduce policies which have the effect of changing these
balances and hence the periods calculated from them.
 The company could decide to hold less inventory. It would do this by using
inventory and not replacing it. This would result in the inventory balance
falling and that in turn would result in a reduction in the average inventory
holding period.
 The company could decide to hold chase payment of its receivables. This
would result in the receivables balance falling and that in turn would result
in a reduction in the average collection period.
 The company could decide to delay payment of creditors. This would result
in the trade payables balance rising and that in turn would result in an
increase in the average payables period.
Taken together each of these would cause a fall in the length of the cash
operating cycle.
The cash operating cycle and its components are key tools in monitoring a
company’s working capital. Changes in each of these might indicate the need for
the company to take remedial action.
 When normal credit terms offered to customers are 30 days (i.e. the
customer is required to pay within 30 days of the invoice date), the average
collection period should be about 30 days.
 If it exceeds 30 days, this would indicate that some customers are taking
longer to pay than they should, and this might indicate inefficient collection
procedures for receivables.

3.3 Changes to the operating cycle and its components

Changes to the operating cycle and its components usually have a direct impact
on the company’s cash balance.
Changes to the inventories, receivables and payables balances impact cash
balances through the operation of double entry in the accounting system.
Example: Cash impact of reducing inventory levels

The company decides to change its policy to hold 1 month’s of inventory instead
of the current 3 months.
It does this by using inventory and not replacing it for a period of two months.
Consequences of this:
1 Inventory would fall to ₦83,333
(1/3 of 250,000 or 1 month  1,000,000/12 months)
2 The Inventory holding period would fall to 30 days (83,333/1,000,000)
3 Cash would increase by ₦166,667
(2/3 of 250,000 or 2 month  1,000,000/12 months)
This is because, whilst in the past inventory sold in each month has been
replaced and paid for, there would be a period of two months where no
such payment would be made. Therefore all other things being equal the
cash balances would rise to a new level due to the absence of the
outflow.
In summary
Change in the length of the cash operating cycle, has implications for cash flow
as well as working capital investment.
 A longer cash operating cycle (with no change in sales or the cost of sales),
increases the total investment in working capital.
 An increase in the inventory holding period means more inventory is held,
and an increase in the average collection period means an increase in
trade receivables. Both of these would increase the length of the cycle and
indicate higher levels of working capital.
 A reduction in the average payables period means fewer trade payables,
which also increases working capital.
An increase in working capital reduces operational cash flows in the period.
The reverse is also true. A shorter cash operating cycle results in less working
capital investment and an increase in operating cash flows in the period.

4 CHAPTER REVIEW
Chapter review
 Construct a cash budget from information provided
 Construct the components of a cash operating cycle from information provided
 Construct a cash operating cycle from information provided

Solution 1
The total sales in each month must be calculated.
Sales of product P Sales of product Q Total
sales
units SP(₦) ₦ units SP(₦) ₦ ₦
Nov 1,500 20 30,000 2,000 30 60,000 90,000
Dec 2,000 20 40,000 3,000 30 90,000 130,000
Jan 1,000 20 20,000 2,000 30 60,000 80,000
Feb 2,000 20 40,000 3,000 30 90,000 130,000
Mar 3,000 20 60,000 4,000 30 120,000 180,000
A table of workings for cash receipts can now be prepared, as follows (with all figures in
₦000):
Cash receipts:
Sales Nov Dec Jan Feb Mar
Nov 90 18 36 32.2
Dec 130 26 52 49.4
Jan 80 16 32 30.4
Feb 130 26 52
Mar 180 36
102.2 107.4 118.4


Foundation level
CHAPTER
13
Cost-volume-profit (CVP) analysis
Contents
1 The nature of CVP analysis
2 Break-even analysis
3 Break-even charts and profit-volume charts
4 Chapter review

INTRODUCTION
Purpose
Competencies
2(f) Calculate, explain and comment upon the contribution, break-even point and
margin of safety for a product or service.
Exam context
This chapter explains how to estimate the break-even point in terms of the number of units
sold and in terms of the revenue earned. It also explains how to calculate the margin of
safety and how to calculate the number of units that must be sold or revenue earned to
achieve a target profit.
By the end of this chapter you will be able to calculate the:

 Number of units that must be sold to achieve break-even
 Revenue that must be earned to achieve break-even
 Margin of safety associated with a given level of production in terms of the number of
units sold or revenue
 Number of units that must be sold to achieve a target profit
 Revenue that must be earned to achieve a target profit

Chapter 13: Cost-volume-profit (CVP) analysis
1 THE NATURE OF CVP ANALYSIS
Section overview
 Introduction to CVP analysis

 Assumptions in CVP analysis
 Contribution
1.1 Introduction to CVP analysis

CVP analysis stands for cost-volume-profit analysis’. It is used to show how
costs and profits change with changes in the volume of activity. CVP analysis is
an application of marginal costing concepts.
This chapter explains CVP analysis and some of its applications.
1.2 Assumptions in CVP analysis

Costs are either fixed or variable. The variable cost per unit is the same at all
levels of activity (output and sales). Total fixed costs are a constant amount in
each period.
Fixed costs are normally assumed to remain unchanged at all levels of output.
The contribution per unit is constant for each unit sold (of the same product).
The sales price per unit is constant for every unit of product sold; therefore the
contribution to sales ratio is also a constant value at all levels of sales.
If sales price per unit, variable cost per unit and fixed costs are not affected by
volume of activity, sales and profits are maximised by maximising total
contribution.
1.3 Contribution
Contribution is a key concept. Contribution is measured as sales revenue less
variable costs.
Profit is measured as contribution minus fixed costs.
Illustration:
₦
Sales (Units sold × sales price per unit) X
Variable costs (Units sold × variable cost price per unit) (X)
Contribution X
Fixed costs (X)
Profit X
Total contribution = Contribution per unit  Number of units sold.
Many problems solved using CVP analysis use either contribution per unit (CPU)
or the CS (Contribution/Sales) ratio.

Contribution per unit

It is assumed that contribution per unit (sales price minus variable cost) is a
constant amount over all sales volumes.
Example:
A company makes and sells a single product. The product has a variable
production cost of ₦8 per unit and a variable selling cost of ₦1per unit.
Total fixed costs (production, administration and sales and distribution fixed
costs) are expected to be ₦500,000.
The selling price of the product is ₦16.
The profit at sales volumes of 70,000, 80,000 and 90,000 units can be
calculated as follows
70,000 units 80,000 units 90,000 units

₦ ₦ ₦
Sales revenue (₦16/unit) 1,120,000 1,280,000 1,440,000
Variable cost (₦9/unit) (630,000) (720,000) (810,000)
Contribution (₦7/unit) 490,000 560,000 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000
Notes
A loss is incurred at 70,000 units of sales because total contribution is not large
enough to cover fixed costs. Profit increases as sales volume increases, and the
increase in profit is due to the increase in total contribution as sales volume
increases.
Somewhere between 70,000 and 80,000 there is a number of units, which if sold
would result in neither a profit nor a loss. This is known as the break-even
position.

The contribution line could have been completed without calculating the sales
and variable costs by simply multiplying the quantity sold by the CPU.
Example:
Facts as before but calculating total contribution as the number of units 
contribution per unit.
₦
Sales price per unit 16
Variable production cost per unit (8)
Variable selling cost per unit (1)
Contribution per unit 7

₦ ₦ ₦
70,000  ₦7 per unit 490,000
80,000  ₦7 per unit 560,000
90,000  ₦7 per unit 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000
CS (Contribution/Sales) ratio
The sales revenue in each case could be calculated by dividing the total
contribution for a given level of activity by the CS ratio.
Formula: CS ratio (contribution to sales ratio)

Selling price per unit
Example: C/S ratio

Contribution to sales ratio:
Contribution per unit/Selling price per unit = 7/16 = 0.4375

₦ ₦ ₦
Contribution (₦7/unit) 490,000 560,000 630,000
CS ratio ÷0.4375 ÷0.4375 ÷0.4375
Sales revenue 1,120,000 1,280,000 1,440,000
Notes
This may seem a little pointless here as the sales figures were obtained more
easily in the first place by multiplying the numbers of units sold by the selling
price per unit.
However, we have taken this opportunity to demonstrate this relationship.

2 BREAK-EVEN ANALYSIS
Section overview
 Break-even analysis
 Calculating the break-even point
 Margin of safety
 Target profit
2.1 Break-even analysis

CVP analysis can be used to calculate a break-even point for sales.
Break-even point is the volume of sales required in a period (such as the
financial year) to ‘break even’ and make neither a profit nor a loss. At the break-
even point, profit is 0.
Management might want to know what the break-even point is in order to:
 identify the minimum volume of sales that must be achieved in order to
avoid a loss, or
 assess the amount of risk in the budget, by comparing the budgeted
volume of sales with the break-even volume.
2.2 Calculating the break-even point

The break-even point can be calculated using simple CVP analysis.
At the break-even point, the profit is zero. If the profit is zero, total contribution
is exactly equal to total fixed costs.
We therefore need to establish the volume of sales at which fixed costs and total
contribution are the same amount.
Two methods of calculating the break-even point

There are a number of methods of calculating the break-even point when the
total fixed costs for the period are known:
Method 1: Break-even point expressed as a number of units.
The first method is to calculate the break-even point using the contribution per
unit. This method can be used where a company makes and sells just one
product.
Formula: Break-even point expressed as a number of units

Total fixed costs
Break-even point in sales units =
Total fixed costs are the same as the total contribution required to break even,
and the break-even point can therefore be calculated by dividing the total
contribution required (total fixed costs) by the contribution per unit.
Remember to include any variable selling and distribution costs in the calculation
of the variable cost per unit and contribution per unit.

Once the break-even point is calculated as a number of units it is easy to express

it in terms of revenue by multiplying the number of units by the selling price per
item.
Example: Break-even point as number of units

A company makes a single product that has a variable cost of sales of ₦12 and a
selling price of ₦20 per unit. Budgeted fixed costs are ₦600,000.
What volume of sales is required to break even?
Method 1
Total fixed costs
Break-even point in sales units =
Contribution per unit = ₦20 – ₦12 = ₦8.

Therefore break-even point:
₦
In units: 600,000/₦8 per unit = 75,000 units of sales.
In sales revenue: 75,000 units × ₦20 per unit = ₦1,500,000 of sales.
Method 2: Break-even point expressed in sales revenue

The second method calculates the break-even point in sales revenue.
Formula: Break-even point expressed in sales revenue

Fixed costs
Break-even point in revenue =
Contribution to sales ratio
Once the break-even point is calculated as an amount of revenue it is easy to

express it as a number of units by dividing the revenue by the selling price per
item.
Example: Break-even point as revenue

A company makes a single product that has a variable cost of sales of ₦12 and a
selling price of ₦20 per unit. Budgeted fixed costs are ₦600,000.
What volume of sales is required to break even?
Method 2
Total fixed costs
Break-even point in revenue =
C/S ratio
C/S ratio = ₦8/₦20 = 40%

Therefore break-even point:
₦
In sales revenue = 600,000/0.40 = ₦1,500,000 in sales revenue.
In units = ₦1,500,000 ÷ ₦20 (sales price per unit) = 75,000 units.

2.3 Margin of safety

The margin of safety is the difference between:
 the budgeted sales (in units or ₦) and
 the break-even amount of sales (in units or ₦).
It is usually expressed as a percentage of the budgeted sales. However, it may
also be measured as:
 a quantity of units (= the difference between the budgeted sales volume in
units and the break-even sales volume), or
 an amount of sales revenue (= the difference between the budgeted sales
revenue and the total sales revenue required to break even).
It is called the margin of safety because it is the maximum amount by which
actual sales can be lower than budgeted sales without incurring a loss for the
period. A high margin of safety therefore indicates a low risk of making a loss.
Example:
A company budgets to sell 25,000 units of its product. This has a selling price of
₦16 and a variable cost of ₦4. Fixed costs for the period are expected to be
₦240,000.
The break-even point = ₦240,000/(₦16 – 4) = 20,000 units.
The budgeted sales are 25,000 units.
Margin of safety = Budgeted sales – break-even sales
= 25,000 – 20,000 = 5,000 units
The margin of safety is often expressed as a percentage of budgeted sales.
Formula: Margin of safety ratio

Margin of safety (units)
Margin of safety ratio =
Budgeted sales (units)
Margin of safety (revenue)

Margin of safety ratio =
Budgeted revenue
Example: Margin of safety ratio

Returning to the previous example where the margin of safety was 5,000 units
and budgeted sales were 25,000 units.
Margin of safety ratio 5,000 units/25,000 units =20% of budgeted sales

This means that sales volume could be up to 20% below budget, and the
company should still expect to make a profit.

2.4 Target profit

Management might want to know what the volume of sales must be in order to
achieve a target profit. CVP analysis can be used to calculate the volume of
sales required.
The volume of sales required must be sufficient to earn a total contribution that
covers the fixed costs and makes the target amount of profit. In other words, the
contribution needed to earn the target profit is the target profit plus the fixed
costs.
The sales volume that is necessary to achieve this is calculated by dividing the
target profit plus fixed costs by the contribution per unit in the usual way.
Formula: Volume target expressed in units

Total fixed costs + target profit
Volume target (units) =
Once the volume target is calculated as a number of units, it is easy to express it

in terms of revenue by multiplying the number of units by the selling price per
item.
Similarly the sales revenue that would achieve the target profit is calculated by
dividing the target profit plus fixed costs by the C/S ratio.
Formula: Volume target expressed in sales revenue

Total fixed costs + target profit
Volume target in revenue =
Contribution to sales ratio
Once the volume target is calculated as an amount of revenue it is easy to

express it as a number of units by dividing the revenue by the selling price per
item.

Example:
A company makes and sells a product that has a variable cost of ₦5 per unit and
sells for ₦9 per unit.
Budgeted fixed costs are ₦600,000 for the year, and the company wishes to
make a profit of at least ₦100,000.
The sales volume required to achieve the target profit can be found as follows:
The total contribution must cover fixed costs and make the target profit.
₦
Fixed costs 600,000
Target profit 100,000
Total contribution required 700,000

Sales volume required to make a profit of ₦100,000:
₦700,000
/₦4 per unit = 175,000 units.
Therefore the sales revenue required to achieve target profit
175,000 units × ₦9 = ₦1,575,000
Alternatively:
C/S ratio = 4/9
Sales revenue required to make a profit of ₦100,000
= ₦700,000  (4/9) = ₦1,575,000.
Therefore the number of units required to achieve target profit
₦1,575,000 ÷ ₦9 = 175,000 units

1 A company makes a single product that it sells at ₦80 per unit. The
total fixed costs are ₦360,000 for the period and the
contribution/sales ratio is 60%. Budgeted production and sales for the
period is 8,000 units.
Required
Calculate the margin of safety for the period, as a percentage of the
budgeted sales.
2 A company makes and sells a single product. The following data
relates to the current year’s budget.
Sales and production (units): 8,000
Variable cost per unit: ₦20
Fixed cost per unit: ₦25
Contribution/sales ratio: 60%
The selling price next year will be 6% higher than the price in the
current year budget and the variable cost per unit will be 5% higher
than in the current year budget. Budgeted fixed costs next year will be
10% higher than budgeted fixed costs in the current year.
Required
(a) For the current year, calculate:
(i) the budgeted contribution per unit
(ii) the budgeted total profit
(b) For next year, calculate the number of units that will have to be
sold in order to achieve a total profit that is equal to the
budgeted profit in the current year.
3 (a) Entity D makes a single product which it sells for ₦10 per unit.
Fixed costs are ₦48,000 each month and the product has a
contribution/sales ratio of 40%.
Required
If budgeted sales for the month are ₦140,000, what is the
margin of safety in units?
(b) Entity E has monthly sales of ₦128,000, but at this level of sales,
its monthly profit is only ₦2,000 and its margin of safety is
6.25%.
Required
Calculate:
(i) the monthly fixed costs
(ii) the level of monthly sales needed to increase the monthly
profit to ₦5,000.

3 BREAK-EVEN CHARTS AND PROFIT-VOLUME CHARTS
Section overview
 Break-even charts
 Profit-volume charts
3.1 Break-even chart

A break-even chart is a chart or graph showing, for all volumes of output and
sales:
 Total costs, analysed between variable costs and fixed costs
 sales
 Profit (= the difference between total sales and total costs)
 The break-even point (where total costs = total sales revenue, and profit =
0).
The concept of a break-even chart is similar to a cost behaviour chart, but with
sales revenue shown as well.
If the chart also indicates the budgeted volume of sales, the margin of safety can
be shown as the difference between the budgeted volume and the break-even
volume of sales.
Two examples of break-even charts are shown below. The only difference
between them is the way in which variable costs and fixed costs are shown.
 In the first diagram, variable costs are shown on top of fixed costs. Fixed
costs are represented by the horizontal line of dashes. Fixed costs are the
same amount at all volumes of sales. Variable costs are shown on top of
fixed costs, rising in a straight line from zero sales. Total costs are shown
as the sum of fixed costs and variable costs.
 In the second diagram (a more unusual presentation), fixed costs are
shown on top of variable costs. An advantage of this method of
presentation is that total contribution is shown. This is the difference
between the total sales line and the total variable costs line.
 Total costs are exactly the same in both diagrams.
Because the sales price per unit is constant, the total sales revenue line rises in a
straight line from the origin of the graph (i.e. from x = 0, y = 0).

First break-even chart: variable costs on top of fixed costs
Illustration:
$
Sales
Break-even PROFIT
point Total costs
Variable
costs
Fixed LOSS Margin of

costs safety
Break-even Budgeted Sales volume

point sales
Second break-even chart: fixed costs on top of variable costs
Illustration:
$
Sales
Break-even PROFIT
point Total costs
Contribution
Fixed LOSS
costs Margin of
Variable safety
costs
Break-even Budgeted Sales volume
point sales
Points to note
You should be able to identify the following points on these charts.
 The break-even point is shown on both charts as the volume of sales at
which total revenue equals total costs.
 In the second chart, total contribution at the break-even point is shown as
exactly equal to fixed costs.
 If budgeted sales are shown on the chart, the margin of safety can also be
shown, as the difference between budgeted sales and the break-even
point.

3.2 Profit/volume chart (P/V chart)

A profit volume chart (or P/V chart) is an alternative to a break-even chart for
presenting CVP information. It is a chart that shows the profit or loss at all levels
of output and sales.
An example is shown below.
Illustration:
$
profit
Margin of
safety Profit
Budgeted Sales
sales
Fixed
costs Break-even
point
$
loss
At zero sales, there is a loss equal to the total amount of fixed costs. The loss
becomes smaller as sales volume increases, due to the higher contribution as
sales volume increases. Break-even point is then reached and profits are made
at sales volumes above the break-even point.
A line could also be drawn on the graph to show fixed costs. This line should be
drawn parallel to the x axis, starting at the loss (= total fixed costs) at zero sales.
By drawing this line for fixed costs, total contribution would be shown as the
difference between the line showing the profit (or loss) and the line for the fixed
costs.

Practice question 2
You are a management accountant for a business that develops
specialist computers. You are consulted to investigate the viability of
marketing a new type of hand-held computer.
With the help of the manager of research and development, the
production manager, the buyer and the sales manager, you have made
the following estimates of annual sales and profitability:
Sales Profit/(loss)
units ₦
12,000 (30,000)
15,000 150,000
18,000 330,000
The selling price will be ₦150.
Required
(a) Prepare a traditional break-even chart using the information
given above.
(b) Calculate the margin of safety if annual sales are expected to be
15,000 units.

4 CHAPTER REVIEW
Chapter review
Before moving on to the next chapter check that you now know how to calculate the:
 Number of units that must be sold to achieve break-even
 Revenue that must be earned to achieve break-even
 Margin of safety associated with a given level of production in terms of the
number of units sold or revenue
 Number of units that must be sold to achieve a target profit
 Revenue that must be earned to achieve a target profit

Solutions 1
1 Contribution per unit = 60% × ₦80 = ₦48
Fixed costs = ₦360,000
Break-even point = ₦360,000/₦48 per unit = 7,500 units
Budgeted sales = 8,000 units
Margin of safety = (8,000 – 7,500) units = 500 units
As a percentage of budgeted sales, the margin of safety is (500/8,000)
× 100% = 6.25%.
2 (a) Contribution/sales ratio = 60%

Therefore variable costs/sales ratio = 40%.
Variable cost per unit = ₦20
Therefore sales price per unit = ₦20/0.40 = ₦50.
₦
Budgeted contribution (8,000 × ₦30) 240,000
Budgeted fixed costs (8,000 × ₦25) 200,000
Budgeted profit, current year 40,000
(b) Sales price next year = ₦50 × 1.06 = ₦53 per unit
Variable cost per unit next year = ₦20 × 1.05 = ₦21
Therefore contribution per unit next year = ₦53 – ₦21 = ₦32
₦
Target profit next year 40,000
Fixed costs next year (200,000 × 1.10) 220,000
Target contribution for same profit as in the current year 260,000
Therefore target sales next year = ₦260,000/₦32 per unit = 8,125
units.

Solutions (continued) 1
3 (a) Break-even point = ₦48,000/0.40 = ₦120,000 (sales revenue).
Margin of safety (in sales revenue) = ₦140,000 – ₦120,000 =
₦20,000.
Selling price per unit = ₦10.
Margin of safety (in units) = ₦20,000/₦10 = 2,000 units.
(b) (i) The margin of safety is 6.25%. Therefore the break-even
volume of sales = 93.75% of budgeted sales = 0.9375 ×
₦128,000 = ₦120,000
Budget Break-even
₦ ₦
Sales 128,000 120,000
Profit 2,000 0
Total costs 126,000 120,000
This gives us the information to calculate fixed and variable
costs, using high/low analysis.
₦ ₦ Cost
Revenue
High: Total cost at 128,000 = 126,000
Low: Total cost at 120,000 = 120,000
Difference: Variable cost of 8,000 = 6,000
Therefore variable costs = ₦6,000/₦8,000 = 0.75 or 75% of
sales revenue.
Substitute in high or low equation Cost
₦
Total cost at ₦128,000 revenue 126,000
Variable cost at ₦128,000 revenue (× 0.75) 96,000

Solution (continued) 1
Alternative approach
3 (ii) At sales of ₦128,000, profit is ₦2,000.
The contribution/sales ratio = 100% – 75% = 25% or 0.25.
To increase profit by ₦3,000 to ₦5,000 each month, the
increase in sales must be:
(Increase in profit and contribution) ÷ C/S ratio
= ₦3,000/0.25 = ₦12,000.
Sales must increase from ₦128,000 (by ₦12,000) to
₦140,000 each month.
Alternative approach to the answer

₦
Target profit 5,000
Fixed costs 30,000
Target contribution 35,000
C/S ratio 0.25

Therefore sales required (₦35,000/0.25) ₦140,000

Solutions 2
(a)
Workings
Sales
Sales (at ₦150) Profit
units ₦ ₦
18,000 2,700,000 330,000
12,000 1,800,000 (30,000)
Difference 6,000 900,000 360,000
An increase in sales from 12,000 units to 18,000 units results in an
increase of ₦900,000 in revenue and ₦360,000 in contribution and
profit.
From this, we can calculate that the contribution is ₦60 per unit
(₦360,000/6,000) and the C/S ratio is 0.40 (₦360,000/₦900,000).
Variable costs are therefore 0.6 or 60% of sales.
To draw a break-even chart, we need to know the fixed costs.
Substitute in high or low equation
When sales are 18,000 units: ₦
Sales (at ₦150 each) 2,700,000
Variable cost (sales  60%) 1,620,000
Contribution (sales  40%) 1,080,000
Profit 330,000
When sales are 18,000 units: ₦

Fixed costs 750,000
Variable cost (see above) 1,620,000
Total costs 2,370,000

(b) Break-even point = Fixed costs ÷ C/S ratio
= ₦750,000/0.40 = ₦1,875,000
Break-even point in units = ₦1,875,000/₦150 per unit = 12,500
units.
If budgeted sales are 15,000 units, the margin of safety is 2,500 un
This is 1/6 or 16.7% of the budgeted sales volume.


Foundation level
CHAPTER
14
Decision-making techniques
Contents
1 Costs for decision-making
2 Limiting factor decisions
3 Chapter review

INTRODUCTION
Purpose
Competencies
2(g) Calculate, explain and comment upon the best allocation of scarce resources
to a product or service based on contribution per unit of limiting factor
Exam context
This chapter explains the concept of limiting factors, how to identify them and how to
formulate an optimum production plan when there is a single limiting factor.
Problems involving more than one limiting factors are solved using linear programming. This
is examined in Paper A: Quantitative Techniques in Business and not in this paper.
By the end of this chapter, you will be able to:

 Explain the issue of limiting factors
 Identify limiting factors
 Carry out limiting factor analysis to formulate an optimal production plan (i.e. the
production plan that maximises contribution and hence profit)

Chapter 14: Decision-making techniques
1 COSTS FOR DECISION-MAKING
Section overview
 Management information for making decisions

 Using marginal costing for decision-making
1.1 Management information for making decisions

One of the functions of management is to make decisions about how to run the
business. Decisions involve making a choice about what should be done,
between different possible options. To help them make good-quality decisions,
managers need reliable and relevant information.
Both financial and non-financial information is needed to make decisions. This
chapter (and the chapters that follow) concentrate mainly on financial information
for decision-making, but it is useful to remember that factors of a non-financial
nature will often influence the choices that managers make.
Since it is often assumed that the aim of a business should be to maximise
profits, financial information to assist managers with decision-making will consist
mainly of information about revenues and costs.
Information for decision-making is different from information about historical
costs. This is because decisions are concerned with the future, not what has
happened in the past.
The following principles of relevant costs and revenues should be applied to all
decision-making by management.
 Information about costs and revenues should be about future costs and
future revenues.
 Decisions should be concerned with cash and cash flow. Only those costs
and revenues that represent cash flow are relevant to decision-making.
Non-cash items of cost or revenue, such as depreciation or absorbed fixed
overheads, are not relevant for decision-making. The conventions of
financial accounting and financial reporting, such as the accruals concept,
are irrelevant for business decisions.
 It is assumed for the purpose of providing cost information for decision-
making that the aim or objective is to maximise profit.
 Historical costs are irrelevant for decision-making, because they are not
future costs. Costs that have been incurred in the past are ‘sunk costs’:
they have already happened, and any decision taken now cannot affect
what has already happened in the past.
A useful definition of relevant costs and revenues is as follows:
Definition
Relevant costs and revenues are future cash flows that would arise as a direct
consequence of a decision being taken.

1.2 Using marginal costing for decision-making

It is often assumed that marginal costs are relevant costs for the purpose of
decision-making.
 The marginal cost of a product is the extra cost that would be incurred by
making and selling one extra unit of the product.
 Similarly, the marginal cost of an extra hour of direct labour work is the
additional cost that would be incurred if a direct labour employee worked
one extra hour. When direct labour is a variable cost, paid by the hour, the
marginal cost is the variable cost of the direct labour wages plus any
variable overhead cost related to direct labour hours.
This chapter focuses on decision-making when there are limiting factors that
restrict operational capabilities. Decision-making techniques for limiting factor
situations are based on the following assumptions:
 The objective is to maximise profit and this is achieved by maximising
contribution;
 Marginal costs (variable costs) are the only relevant costs to consider in the
model: and
 Fixed costs will be the same whatever decision is taken; therefore fixed
costs are not relevant to the decision.

2 LIMITING FACTOR DECISIONS
Section overview
 Limiting factor: the issue

 Identifying limiting factors
 Maximising profit when there is a single limiting factor
2.1 Limiting factor: the issue

It is often assumed in budgeting that a company can produce as many units of its
products (or services) as is necessary to meet the available sales demand. Sales
demand is therefore normally the factor that sets a limit on the volume of
production and sales in each period.
Sometimes, however, there could be a shortage of a key production resource,
such as an item of direct materials, or skilled labour, or machine capacity. In
these circumstances, the factor setting a limit to the volume of sales and profit in
a particular period is the availability of the scarce resource, because sales are
restricted by the amount that the company can produce.
If the company makes just one product and a production resource is in limited
supply, profit is maximised by making as many units of the product as possible
with the limited resources available.
However, when a company makes and sells more than one different product with
the same scarce resource, a budgeting problem is to decide how many of each
different product to make and sell in order to maximise profits.
2.2 Identifying limiting factors

A question might tell you that there is a restricted supply of a resource without
telling you which one it is.
In this case you must identify the limiting factor by calculating the budgeted
availability of each resource and the amount of the resource that is needed to
meet the available sales demand.

Example: Identifying a limiting factor

A company manufactures and sells two products, Product X and Product Y which
are both manufactured using two different machines.
The time taken to make each product together with the maximum machine time
availability and contribution per unit and demands are as follows:
Hours
Product X Y available
Machine type 1 10 minutes 6 minutes per 3,000 hours
per unit unit
(6 per hour) (10 per hour)
Machine type 2 5 minutes per 12 minutes 4,200 hours
unit per unit
Sales demand in units 12,000 15,000
Which machine is the limiting factor is identified by calculating the time

needed to meet the total demands for both goods and comparing that to
the machine time available:
Machine type 1 Machine type 2
(hours) (hours)
12,000 ÷ 6 per hour 2,000
12,000 ÷ 12 per hour 1,000
Making 15,000 units of Y would use:

15,000 ÷ 10 per hour 1,500
15,000 ÷ 5 per hour 3,000
Total hours needed to meet
maximum demand 3,500 4,000
Total hours available 3,000 4,200
Therefore, machine 1 time is the limiting factor

2.3 Maximising profit when there is a single limiting factor

When there is just one limiting factor (other than sales demand), total profit will
be maximised in a period by maximising the total contribution earned with the
available scarce resources.
The approach is to select products for manufacture and sale according to the
contribution per unit of scarce resource in that product.
Step 1: Calculate the contribution per unit of each type of good produced.
Step 2: Identify the scarce resource.
Step 3: Calculate the amount of scarce resource used by each type of good
produced.
Step 4: Divide the contribution earned by each good by the scarce resource used
by that good to give the contribution per unit of scarce resource for that good.
Step 5: Rank the goods in order of the contribution per unit of scarce resource.
Step 6: Construct a production plan based on this ranking. The planned output
and sales are decided by working down through the priority list until all the units
of the limiting factor (scarce resource) have been used.
Example: Limiting factor analysis

A company manufactures and sells two products, Product X and Product Y which
are both manufactured using two different machines.
The time taken to make each product together with the maximum machine time
availability and contribution per unit and demands are as follows:
Hours
Product X Y available
Machine type 1 10 minutes 6 minutes per 3,000 hours
per unit unit
Machine type 2 5 minutes per 12 minutes 4,200 hours
unit per unit
Contribution per unit ₦7 ₦5
Sales demand in units 12,000 15,000
Given that machine 1 is a limiting factor the optimal production plan

(that which maximises annual contribution and hence profit) can be
found as follows:
Step 1: Calculate the contribution per unit of goods produced (given)
Step 2: Identify scarce resource (given as machine 1 in this case)
Step 3: Calculate the amount of scarce resource used to make each type
of product (given in this case)

Example (continued): Limiting factor analysis
Step 4: Contribution per unit of scarce resource (machine time)

Product X Y
Contribution per unit ₦7 ₦5
Machine type 1 time per unit 10 minutes 6 minutes
Contribution per hour (Machine type 1) ₦42 ₦50
Step 5: Ranking 2nd 1st
The products should be made and sold in the order Y and then X, up to
the total sales demand for each product and until the available machine
1 time is used completely.
Step 6: Construct a production plan to maximise contribution

Machine 1 Contribution Total
Product Sales units hours used per unit contribution
₦ ₦
Y (1st) 15,000 1,500 5 75,000
(maximum)
X (2nd ) 9,000 1,500 7 63,000
(balance)
3,000 138,000
Note: The plan is constructed as follows:

Y is ranked first so the company needs to make as many of these as
possible. The most it can sell is 15,000 units which would take 1,500
hours (10 per hour) to make. The company has 3,000 hours available so
all of these can be made.
The company now has 1,500 hours left. X is ranked second and the most
of X that can be sold is 12,000 units. This would use 2,000 hours (6 per
hour). This means that only 9,000 units of X can be made (found as
1,500 units at 6 per hour or 12,000 units  1,500 hours/2,000 hours).

Practice question 1
1 A company makes four products, A, B, C and D, using the same direct
labour work force on all the products.
The company has no inventory of finished goods.
Direct labour is paid ₦12 per hour.
To meet the sales demand in full would require 12,000 hours of direct
labour time.
Only 6,000 direct labour hours are available during the year.
Budgeted data for the company is as follows:
Product A B C D
Annual sales demand
(units) 4,000 5,000 8,000 4,000
₦ ₦ ₦ ₦
Direct materials cost 3.0 6.0 5.0 6.0
Direct labour cost 6.0 12.0 3.0 9.0
Variable overhead 2.0 4.0 1.0 3.0
Fixed overhead 3.0 6.0 2.0 4.0
Full cost 14.0 28.0 11.0 22.0
Sales price 15.5 29.0 11.5 27.0
Profit per unit 1.5 1.0 0.5 5.0
Calculate the optimal production plan

Practice question 2
1 A company makes four products, W, X, Y and Z, using the same single
item of direct material in the manufacture of all the products.
Budgeted data for the company is as follows:
Product W X Y Z
Annual sales demand 4,000 4,000 6,000 3,000
(units)
₦ ₦ ₦ ₦
Fixed overhead 8.0 12.0 6.00 10.00
Full cost 18.0 23.5 17.75 22.25
Sales price 50.0 31.5 59.75 54.25
Profit per unit 32.0 8.0 42.00 32.00
Due to restricted supply, only ₦78,000 of direct materials will be

available during the year.
Required
Identify the quantities of production and sales of each product that
would maximise annual profit.
Tutorial note
This question does not tell you the amount of material but it does give you its
value. The analysis can proceed in the usual way using contribution per value of
material rather than contribution per amount of material.

3 CHAPTER REVIEW
Chapter review
 Explain the issue of limiting factors
 Identify limiting factors
 Carry out limiting factor analysis to formulate an optimal production plan (i.e. the
production plan that maximises contribution and hence profit)


Solution 1
Step 1: Calculate the contribution per unit of goods produced
Product A B C D
Sales price 15.5 29.0 11.5 27.0
Variable cost per unit (11.0) (22.0) (9.0) (18.0)
Contribution per unit 4.5 7.0 2.5 9.0
Step 2: Identify scarce resource (given as labour in this case)

Step 3: Labour hours per unit
(total labour cost/labour cost per hour) 6/12 12/12 3/12 9/12
0.5 1 0.25 0.75

Step 4: Contribution per hour
(contribution per unit/ labour hours per unit 4.5/0.5 7/1 2.5/0.25 9/0.75
Contribution per hour (₦) 9 7 10 12
Step 5: Ranking 3rd 4th 2nd 1st

The products should be made and sold in the order D, C, A and then B, up to
the total sales demand for each product and until all the available direct
labour hours (limiting factor resources) are used up
Step 6: Construct a production plan to maximise contribution

Direct labour Contribution Total
Product Sales units hours used per unit contribution
₦ ₦
D (1st) 4,000 3,000 9.0 36,000
(maximum)
C (2nd) 8,000 2,000 2.5 20,000
(maximum)
A (3rd) 2,000 1,000 4.5 9,000
(balance)
6,000 65,000

Note: The plan is constructed as follows:
D is ranked first so the company needs to make as many of these as
possible. The most in can sell is 4,000 units which would take 3,000 hours
(0.75 hours per unit) to make. The company has 6,000 hours available so all
of these can be made.
The company now has 3,000 hours left. C is ranked second and the most of C
that can be sold is 8,000 units. This would use 2,000 hours (0.25 hours per
unit).
The company now has 1,000 hours left. A is ranked third and the most of
these that can be sold is 4,000 units. However, this would use 2,000 hours
(0.5 hours per unit) so only half of these can be made.
Solution 2
W X Y Z
₦ ₦ ₦ ₦
Sales price/unit 50.0 31.5 59.75 54.25
Variable cost/unit 10.0 11.5 11.75 12.25
Contribution per unit 40.0 20.0 48.00 42.00
Direct materials per unit (₦) 5 4 8 6
₦contribution per ₦1 direct 8.0 5.0 6.0 7.0

material
Priority for making and selling 1st 4th 3rd 2nd
Profit-maximising budget
Sales Direct Contribution Total
Product units materials per unit contribution
₦ ₦ ₦
W (1st) 4,000 20,000 40 160,000
Z (2nd) 3,000 18,000 42 126,000
Y (3rd) - balance 5,000 40,000 48 240,000
78,000 526,000


Foundation level
CHAPTER
15
Introduction to information
technology and information systems
Contents
1 Introduction to information technology
2 Software and operating systems
3 Introduction to information systems
4 Information systems in business
5 Chapter review

Purpose
Business information takes an integrated approach by developing an awareness of
information technology and systems support.
Competencies
3(a) Explain and distinguish the nature of data, information and knowledge
3(b) Identify and explain the main information technologies that support modern
information systems
3(c) Identify and explain the main information systems used by entities including
business process systems, transactions processing systems, management
information systems, decision-support systems and executive information
systems
3(h) Information Technology Architecture - explain, describe or discuss how IT
architecture relates to the entity’s business model:
i. General systems concepts
iii Hardware components
iv Software
Exam context
The modern business environment requires a reasonable level of computer literacy amongst
its professionals. The work of accountants and auditors will invariably involve interaction with
some kind of information system typically supported by information technology.
Accountants will be involved in entering, maintaining and adjusting information within an
information system. Auditors will need to assess whether the information system is capable
of producing true and fair financial statements and whether they have been extracted
accurately.
This is the first chapter on information systems and technology. The chapter introduces you
to a number of fundamentals such as general systems concepts, hardware and software.
The chapter concludes with a section on information systems in business.
 Understand general systems concepts
 Describe different types of computer hardware including input devices, output devices
and storage devices
 Explain the different types of software that are used in business including system
software, programming tools, language translators and application software
 Define the terms data, information, knowledge and wisdom
 Understand and distinguish between information technology and information systems
 Explain the different levels and roles of information found within a business’s
information system
 Describe the common information systems found in modern business including TPS,
MIS, DSS, EIS, expert systems, financial reporting systems, order processing and
inventory control systems, personnel systems, integrated IT systems and Enterprise
Resource Planning (ERP).

Chapter 15: Introduction to information technology and information systems
1 INTRODUCTION TO INFORMATION TECHNOLOGY
Section overview
 General systems concepts

 Computer hardware
 Input devices
 Output devices
 Storage devices
1.1 General systems concepts
Definition: A system
A system is a group of related elements or activities that are organised for a
specific purpose or to achieve a common objective.
A system converts (processes) inputs into outputs to achieve that goal.
Elements of a system
The elements of a system include:
 Goals
 Inputs
 Processes
 Outputs
 The environment
 Boundary (this limits the system from its environment)
Open and closed systems
Closed systems - the environment has no effect on the system and the system
has no effect on the environment. Examples in the real world are rare and
business examples even rarer; one useful example is that of a scientific
experiment.
Open systems - do interact therefore the environment will affect the system and
the system will affect the environment. All businesses, social and information
systems are examples of open systems.
System adaptation
Open systems will adapt to their environment with varying degrees of extremity.
Examples include:
 Deterministic systems
 Use predetermined rules
 Therefore have predicted operations
 Giving predictable outputs
 Examples include machines and computer programs
 These systems will follow a standard and often have a rule book.

 Probabilistic systems
 Assign a probability to future events
 Their behaviour is less easy to predict
 Most businesses are examples of probabilistic systems
 When a business sales forecasts it will try to predict sales based on
past evidence.
 In effect the business tries to change before the event has occurred.
 Self-organising or cybernetic systems
 Most complex type of system
 Continually changing
 Adapts to the environment
 Trade union negotiations is an example
 These types of systems are the least likely to be computerised
 Rely heavily on interaction from people
Control systems
Control is important in any information system. The two main types of control are
open and closed loop control.
 Closed loop control has inbuilt control very much like a thermostat in a
heating system, they are not responsive to changes in the environment. A
business example which has inbuilt control is a stock or a credit control
system where the system automatically checks responses.
Closed loop control is most suitable for the type of system that is stable.
Systems which exist in a relatively dynamic environment are not suitable for
this type of control.
 Open loop control systems do not have inbuilt control as control comes
from outside the system - no thermostat as you have in the closed loop
control.
A business example would be the whole organisation. Open control
systems are responsive to the environment and they often involve
interaction from users.
The elements of a control system include:
 Input, process, output
 Sensor - measures the output from the system and determines a new value
 Comparator - compares the new value with that of the standard
 Standard - the predetermined limit set within the system
 Effector - effects of the feedback into the system can be positive or
negative.
This is shown in the diagram below:

Elements of a control system:
System
processes
Feedback and feed-forward control
Definition: Feedback control

Feedback control involves a sensor taking a measurement and an adjustment is
then made to the system in response to the result of the measurement.
For example, when you feel cold your body will sense the drop in temperature
causing you to react by adding an extra layer of clothing to warm up.
Similarly a heating system will switch on when it senses that the current
temperature has dropped below the desired level. It will then switch off again
when the required temperature is reached.
A stores manager may discover that a particular component is out of stock only
when a production manager requests five units of the component. This discovery
would lead to a new order being placed for components from the supplier.
Definition: Feed-forward control

Whilst feedback control reacts to something that has already happened, feed-
forward control makes control adjustments based on attempting to achieve a
particular outcome (that hasn’t yet happened).
For example a treasury department might prepare a cashflow forecast for the
next three months and identify that the organisation will run out of funds unless it
borrows more money from the bank.
A second example might involve a fisherman who studies the weather forecast
then plans his fishing route so as to avoid areas of predicted bad weather.
Finally, we saw an example above of feedback control with inventory
management when the stores manager reacted to the discovery of an ‘out of
stock’ item by placing an order with the supplier. The stores manager might
however employ feed-forward control. This would involve establishing predicted
demand for units based on forecast production and sales. The stores manager
would then place orders in advance based on the anticipated demand in order to
avoid stock-outs.

Computer systems
Definition: Computer systems

A computer system comprises of four key components:
Input Central processing unit (CPU) Output
Storage
Input devices facilitate the introduction of data and information into the system.
Examples might include a keyboard, scanner, mouse or barcode reader.
Output devices facilitate the extraction of processed information from the system.
Examples would include a printer, speaker or screen (visual display unit).
The central processing unit is the ‘brain’ of the computer system that takes the
inputs, processes them and then outputs the results.
Finally, some type of storage facility is useful to enable data to be saved for
future use.
1.2 Computer hardware

Computer hardware is the physical part of the computer system plus all the
peripheral equipment connected to a CPU for input, output and storage of data.
Examples of peripherals include printers and stand-alone disc drives.
The computer systems used in IT systems range from the very large
supercomputers to the very small hand-held computer systems. In many
organizations, different computers are connected to each other to form a
network.
The different types of computer systems that you might encounter as an
accountant would typically include:
Computer type Description

Supercomputers Used only in the very largest systems – e.g.
national defence and aerospace.
Mainframe The most powerful computers typically found in

multi-nationals and other large businesses – e.g.
an airline or oil company. Not as powerful as a
supercomputer, but still incredibly powerful.

Computer type Description
Mini-computers Less powerful than mainframe computers

although not portable like smaller models below
Desk-top personal A computer placed at the user’s desk with its own
computers (PCs) processing capabilities and usually a keyboard,
mouse and screen: PCs can operate as stand-
alone computers, or they may be linked as
terminals to a network where the PC functions as
an input/output device but the processing is
executed by another device on the network.
Portable laptops and Similar concept to PCs but much smaller and
notebooks computers portable.
Handheld computers Given the speed of technological advancement in

today’s fast-moving world there is an increasing
number of ever evolving variations on the above
forms. For example, hand-held computers (or
PDAs: personal data assistants) and even many
smart-phones (mobile phones with large touch-
sensitive input screens) have much of the
functionality found on PCs.
The globalisation of the business environment has resulted in much more

widespread use of portable laptop computers. Portable laptops can typically be
connected to the organisation’s computer network or to the Internet from remote
locations via a data connection such as Wi-Fi or a phone line. This means, for
example, that a manager can access his e-mails or the organisation’s Intranet
system (a system that looks and feels like the internet but is only available to
employees) from anywhere in the world.
1.3 Input devices

As you saw in section 1.1 above computer systems have four key components –
input, CPU, storage and output. In this section we take a brief look at some of the
many input devices commonly used in computer systems.
Keyboards
Keyboards are the most common input device and are part of virtually all
computer systems. Keyboards can be stand-alone and connected to the
computer with a cable or through a wireless connection, or they might be
integrated into the computer itself, such as with a laptop or notebook.
The basic layout of a keyboard is consistent within a particular geographical
location (based on the local language character set). Variations commonly exist
to reflect things like space saving, video-game enhancements or ergonomic
designs.
Touch-sensitive screens and touch pads
A recent trend has been towards integrating the keyboard into touch-sensitive
screens and touch pads. Both these devices involve the user touching an area of

a screen, for example a picture of a keyboard, to simulate the pressing of a

physical key such as on a regular keyboard.
Touch pads are connected to the computer via a cable or wireless connection
whereas a touch screen would be built-in to the display unit.
Examples of touch-sensitive screens include automated payment booths used to
buy train or bus tickets and bank ATM machines.
Magnetic ink character recognition (MICR)
Magnetic ink character recognition (MICR) requires the input media to be formed
of specially formatted characters printed in magnetic ink. These characters are
then read automatically using a specialised reading device called MICR reader.
The most common example of MICR is in the banking industry with the use of
cheques and deposit slips.
Optical mark reading (OMR)
Optical mark reading (OMR) is similar to MICR in that it is an automated input
method. OMR involves marking a pre-printed form with a pen or typed line (or
cross) in an appropriate box. The card is then read by an OMR device which
senses the mark in each box.
Uses can include national lottery entry forms, ballot voting slips and objective test
examination answer sheets.
Scanners and optical character recognition (OCR)
Scanners read text or illustrations printed on paper and translate the information
into a format the computer can use. The resolution (number of pixels recorded for
each image – pixels are minute areas of illumination on a display screen which
taken together form the image) can normally be adjusted to reflect how sharp the
users need their image on the computer. The greater the resolution the larger the
file size of the scanned image.
Some scanners incorporate optical character recognition (OCR) software which
translates the image into text. For this to work accurately the input document
must be high quality print.
Mice, trackballs and similar devices
Mice and trackball devices are hand-operated devices with internal sensors pick
up the motion and convert it into electronic signals which instruct the cursor
(pointer) on screen to move.
The ball mouse is now largely replaced by the optical mouse which incorporates
a small light-emitting diode that bounces light off the surface when the mouse
moves across. Optical mice are more comfortable to use and typically more
responsive to movement.
Mice typically have two or three buttons which can be pressed (clicked) to send
messages to the computer. They also frequently have a wheel which can be
used to scroll within images or documents that cover multiple screens.
Trackballs are similar to mice in that they control the cursor on the screen.
However, whilst mice move the cursor through movement across a surface,
trackballs move the cursor by rotating the ball rather than moving the device
across a surface.
Touch sensitive pads and joysticks that similarly control the cursor are also now
commonly found in the centre of the keyboard. Most current laptops and
notebooks incorporate a pad or joystick.

Voice date entry (VDE)

Many computers can now accept voice input via a microphone and voice data
entry (VDE) software.
One particularly useful application is found in language translation programs that
support simultaneous translation. Another example might be in a smartphone
where you can enter commands aurally rather than by typing, for example with
an instruction such as “Call Office”.
Barcodes and QR (quick response) codes, EPOS
Barcodes are the groups of black and white marks with variable spacing and
thickness found on product labels such as those at the supermarket. Each code
is unique and can be read automatically by an electronic barcode reader. This
keeps inventory movement up to date and also converts into a customer invoice
instantly.
QR codes are matrix, or two-dimensional, barcodes. Originally popular in the
automotive industry they have seen a recent rise in popularity elsewhere given
their fast readability and greater storage capacity than standard barcodes.
EPOS stands for electronic point of sale which is normally integrated with
barcode readers. EPOS allows credit and debit cards to be read for instant
payment for goods.
A recent development of EPOS has seen the growth of technology that supports
mobile phones being used in a similar way to credit and debit cards. A phone
signal rather than the magnetic strip on a credit card is used to identify the
purchaser.
Digital cameras
Digital cameras can be found in the form of stand-alone units or they may be
integrated into other technology such as smartphones and tablet computers.
Digital cameras capture images and videos in digital form and allow easy transfer
to a computer where they can be manipulated by software.
Digital cameras are used in many situations whether it is for the development of
marketing material, recording of crime scenes by the police, or by an auditor on a
year-end inventory count.
Benefits and limitations
The following table presents some of the benefits and limitations of each of the
input methods described above.
Input method Benefits Limitations

Keyboards Common, simple and Labour-intensive and slow.
cheap Prone to error in keying-in.
Touch-sensitive Saves space. Integrated Can be difficult to grasp

screens and touch graphicual user interfaces the techniques for
pads are very user-friendly and accurate data entry.
intuitive. Labour intensive and slow.
Expensive.

Input method Benefits Limitations

Magnetic ink Speed and accuracy MICR documents are
character expensive to produce.
recognition (MICR)
Optical mark Speed and accuracy OMR documents can be

reading (OMR) expensive to produce.
Also a risk of ‘spoilt’
documents (marks made
outside the allotted
boxes).
Scanners and Excellent for inputting Can be slow to scan

optical character graphics and text quickly multiple images. File sizes
recognition (OCR) might be large for very
high quality scans. OCR
can be somewhat
inaccurate if input image is
of low quality.
Mice and trackball Easy to use and very Slow and can be prone to
devices common. Cheap and error.
simple.
Voice data entry Convenient and simple. Can be inaccurate and

(VDE) affected by external
interference (noise)
Barcodes and Very common. Accurate. Damaged barcodes are

EPOS Quick. impossible to read.
Incompatibility issues if
different types of barcodes
are received by the
organization.
Digital cameras Versatile, quick, accurate. Higher quality means

Widevariety of high quality larger file size which can
image editing software become expensive and
now available. difficult to manage.
1.4 Output devices

Output devices
An output device is the part of a computer system that receives the processed
data from the computer and presents it in some way.
Output devices are distinct from input devices which are the parts of the
computer that provide data and instructions. However, technology has advanced
to the stage where some devices are a combination of both input and output such
as a touch-sensitive screen.
Output devices come in a number of forms:

Output
Description
device
Monitor A monitor is a bit like a television screen – it provides visual
(display) output from the computer for text and graphics. Note though that
monitors only offer temporary output as the image is lost when
power is removed.
Monitors can be external, such as those found attached to PCs,
or can be integrated into the computer such as with laptops and
notebooks. An external monitor can be upgraded or changed
whereas a built-in monitor offers much less flexibility.
The old-fashioned large and bulky cathode-ray tube monitors
(CRT) have been largely replaced by much less bulky flat-
screen technology including LCD and LED displays.
The screen’s resolution is the number of pixels (dots) used to
build a picture. Fewer pixels provide lower resolution or image
quality. More pixels means higher resolution and image quality.
Printers A printer is a device that prints output to a page (on paper).

Printing can be in colour or ‘black and white’ depending on the
printer type.
A number of different types of printers exist
Speakers Speakers are attached to computers for the output of sound.

and The sound output is produced by a sound card. Speakers range
headsets from simple, single-speaker output devices offering low-quality
audio to surround-sound multi-channel units sending different
output to multiple speakers in different locations.
Headsets are a combination of speakers and microphones and
are commonly used by gamers. They are also growing in
popularity as an increasingly cost-effective method of
communicating with friends and family over the internet using
software such as Skype.
Storage Output may be made to some kind of storage device such as a

devices DVD or CD-ROM, flash memory (USB flash disk or key), blu-ray
drive or external hard disk drive.
Projector A projector can be thought of as a variation of monitor in that it

translates the digital output into a visual display directed onto a
screen. Think of some of the lectures you attended and how
common it is for a computer to be connected to a projector to
output the presentation slides.
1.5 Storage devices

Storage devices
You have already seen how the CPU is the brain of the computer taking inputs
from various devices such as keyboards, mice and scanners then outputting to
devices such as speakers, printers and monitors. However, computers need
somewhere to store all the data such as music, videos, pictures, documents,
spreadsheets, presentations, emails and so on.

The different types of storage devices found within a computer system include
the following:
Storage type Description

Primary Internal temporary store directly accessible by the CPU that
storage allows it to process data.
(internal
Volatile by nature as it is erased when power is turned off.
memory)
Much smaller than secondary or tertiary storage but much
quicker to access (as it has no mechanical parts).
Examples include RAM and ROM (see 1.2 above) plus the
CPU’s cache memory (temporary store of instructions
repeatedly required to run programs – typically up to 2MB
(megabytes) in size).
Secondary Secondary storage differs from primary storage in that it is not

storage directly accessible by the CPU.
(external
Secondary storage is used for data not currently being
memory)
processed but which may need to be accessed at a later stage,
for example the operating system, documents, music files and
emails.
Non-volatile as data remains intact even when powered off.
Located further from the CPU than primary storage (and not
directly accessible by the CPU). Therefore takes longer to
access. However, is much larger than primary storage.
A computer’s largest secondary storage location is typically its
hard disk drive (also called hard drive), the capacity of which
would typically fall between 40GB (gigabytes) to 2 TB
(terabytes). Other examples include:
 Flash memory (USB flash drives or keys)
 Floppy disks
 CD
 DVD
 Blu-ray drive
 Magnetic tape
 Cloud drive
Tertiary Tertiary storage is not as commonly recognisable as primary or
storage secondary storage by most computer consumers as they may
never encounter it.
Tertiary storage typically involves a robotic mechanism that
mounts (inserts) and dismounts removable mass storage
media into a storage device.
Often used for archiving rarely accessed information as it is
much slower than secondary storage.
Primarily useful for extremely large data stores accessed
without human operators.

Storage type Description

Offline Offline storage describes any type of data storage that is not
storage under the control of a processing unit. The medium is typically
recorded on a secondary or tertiary storage device which is
physically removed or disconnected. Off-line storage therefore
needs human intervention to re-connect for subsequent
access.
With offline storage being physically separate from the
computer it can be used to increase general information
security. For example keeping a copy of all your important files
offline in a separate building.

2 SOFTWARE AND OPERATING SYSTEMS
Section overview
 Introduction
 System software
 Programming tools and language translators
 Application software
2.1 Introduction
Definition: Computer software

Computer software comprises a set of machine-readable instructions that directs
a computer’s processor to perform specific operations. Computer software can
be divided into the following types:
system software
programming tools and language translators
application software
2.2 System software

There are three categories of system software:
 Operating system software
 Utility software
 Communications software
Operating system software
Definition: Operating system software

An operating system (OS) is the software that controls the operation of the
computer. Examples of operating systems include DOS (short for disk operating
system), Windows and Linux.
Key features of OS include:

 The OS controls all operations within the computer itself
 The OS controls the operation of all other software, such as the application
software
 The OS controls the operation of all the other hardware connected to the
computer
 The OS provides systems security. For example, it enables work to be
saved and provides password protection
 The OS also provides the graphical user interface (GUI) between the user
and the computer
DOS dominated the IBM PC compatible market between 1981 and 2000 but is
now all but invisible to most PC users due to the development of Microsoft

Windows (often simply called ‘Windows’) into its own stand-alone operating
system.
Earlier versions of Windows needed to run on machines whose operating system
was DOS. However, now Windows no longer requiring DOS (ever since the
launch of Windows 95 in 1995) the majority of users have stopped using DOS
directly.
Linux is a computer operating system assembled under the model of free and
open source software development and distribution. Open-source software
(OSS) is computer software with its source code made available and licensed
with an open-source license in which the copyright holder provides the rights to
study, change and distribute the software for free to anyone and for any purpose.
Originally developed as a free operating system for PCs Linux now appears in
many more computer hardware platforms such as:
 Mainframe and supercomputers – an estimated 90% of today’s 500 fastest
supercomputers run some variant of Linux
 Mobile phones and tablet computers including the Android and EOS
systems
 Network routers
 Televisions and video game consoles
Utility software
Definition: Utility software

Utility software performs a variety of general functions on the computer, such as
copying files, sorting data on files and checking for viruses.
Utilities are either:

 Provided with the operating system by its developer (e.g. a file copying
utility); or
 Purchased in the form of utility packages (e.g. Norton Utilities anti-virus
software)
Utility programs provide many of the background operations essential for the
efficient operation of any computer system such as continuous protection against
viruses.
Communications software
Definition: Communications software

Communications software controls the transmission of data within a computer
network making it possible to send and receive data over media such as
telephone lines and fibre optic cables
2.3 Programming tools and language translators

Programming tools are software that assists programmers with writing programs.
Software is written in a programming language, such as ‘Java’, which is used in
the development of Internet applications. Programs written in a particular
programming language have to be ‘translated’ into a binary coded form that the

computer can understand. The translation of coded programs is done by

translation software.
2.4 Application software

Application software enables computer users to do their jobs. Application
software can be classified into two broad types:
 Off-the-shelf software or software packages. This is software that can be
purchased (or may in some cases be free such as Google docs) from a
supplier and installed on the computer. Examples include accounting
software packages, word processing packages (e.g. Microsoft Word),
spreadsheet packages (e.g. Microsoft Excel), presentation packages (e.g.
Microsoft PowerPoint) and database packages (e.g. Microsoft Access)
 Bespoke software or tailored software. These are programs that are
written for a specific purpose, to meet the user’s specific processing
requirements. Bespoke software is commonly used by larger organisations
to fulfil their special purpose needs which cannot be completed by off-the-
shelf software.

3 INTRODUCTION TO INFORMATION SYSTEMS
Section overview
 Data, information, knowledge and wisdom

 Information technology vs. information systems
 Levels and roles of information in business
3.1 Data, information, knowledge and wisdom

Data and information – revision
You have already learnt about the difference between data and information in
chapter 1:
Definition: Data and information

Data consists of unprocessed facts and statistics.
Data is collected and processed to produce information.
Data has no meaning until it has been processed into information.
Information has a meaning and a purpose. It is produced from ‘data’. It is
processed data that has relevance to a particular useful purpose.
You also learnt that information is only useful to managers if it possesses certain
qualities or attributes:
 Understandable.
 Purpose and relevance.
 Reliable.
 Sufficiently complete.
 Timeliness.
 Comparability.
 Communicated to the right person.
 Its value must exceed its cost (Information must be cost effective).
Knowledge and wisdom
Knowledge allows us to interpret meaningful information in order to determine
what actions to take.
Definition: Knowledge
Knowledge reflects the application of information to a decision. For example
whether to continue to advertise and sell a product; or whether to discontinue
product A and replace with product B
Wisdom reflects a higher level of understanding and involves using knowledge

for the greater good. Wisdom is therefore deeper and more uniquely human.
Wisdom requires a sense of good and bad, right and wrong, and of course ethics.

The DIK hierarchy and evolution

The DIK hierarchy demonstrates the cyclical relationship of data, information,
knowledge and wisdom. Understanding the DIK hierarchy provides context for
the evolution of information systems and associated information technology.
Wisdom
Knowledge
Information
Data
Information systems have evolved as follows:

 Data processing is relatively straightforward so the early days focused on
processing data. E.g. Payroll and book-keeping systems.
 Data processing then evolved into producing information systems to
connect and process data for decision making. E.g. Management
information systems and decision support systems (see later).
 The more recent evolutionary trend has seen the development of
knowledge management systems, for example customer relationship
management and expert systems (see later).
Information literacy
Definition: Information literacy

Information literacy is the ability to know when information is needed and then be
able to locate, evaluate and effectively use that information.
The internet has had a huge impact on information literacy. For example, pre-
internet, if you wanted to buy a camera you might have looked at a couple of
magazines for reviews and asked your friends for advice. Today you can access
multiple camera reviews online, get a good estimate of the value of your current
equipment, and see prices of new cameras from dozens of retailers, all without
leaving your home.
However, you need to know what you are doing. Effective business people need
to have the ability to efficiently and effectively determine what information is
needed, then assess, evaluate, use, and manage that information in an ethical
manner.
Information literacy is increasingly considered “the” critical skill for the future.
Whilst benefitting us in the business place, information literacy will also benefit us

personally as well as professionally - for example, the ability to invest wisely in

savings and pensions.
3.2 Information technology vs. information systems
Definition: Information technology

Information technology describes the application of computers and
telecommunications equipment to store, retrieve, transmit and manipulate data.
The term is typically associated with computers and computer networks. However,
the full definition includes other information distribution technology such as
television, telephone and radio.
Definition: Information system

Information systems describe complementary networks of software and hardware
that people and organizations use to collect, filter, process, create and distribute
data and information.
Within organisations, information systems support operations, management and
decision making.
The term ‘information system’ is broader than ‘information technology’ as it
incorporates the way in which people interact with the technology in support of
business processes, as well as the information and communication technology
(hardware and software) itself.
In summary:
 System – a set of interacting components that operate together to
accomplish a purpose
 Business system – a collection of people, machines and methods
organised to accomplish a set of specific functions
 Information system – all systems and procedures involved in the collection,
storage, production and distribution of information – i.e. an organized
combination of hardware, software, infrastructure, data and people that is
used to accomplish a specified organizational or personal objective
 Information technology – the equipment used to capture, store, transmit
and present information
 Information management – planning, the environment, control and
technology

3.3 Levels and roles of information in business

Levels of information
Information systems are seen in virtually every corner of a business whether in
finance, operations, human resources or marketing.
Information systems assist employees across all levels of the business as
follows:
Strategic
Tactical
Operational
 Strategic information relates to long-term decision making e.g. over a 3-5

year time horizon. Strategic information is useful to senior management
and Directors for establishing the overall goal of the business. It therefore
incorporates both internal information as well as external information about
competitors, the market and the general business environment.
 Tactical information assists managers in making short-term tactical
decisions such as:
 Establishing a fee to quote on a particular order
 Whether to offer discounts on a particular product to help lower
excess inventory
 Whether to switch suppliers
 Operational information relates to the day to day activities of an
organisation. Examples might include:
 Daily sales reports
 Daily production reports
 Latest inventory levels
 Details of customer complaints

Roles of information systems

Irrespective of the level of information (strategic, tactical or operational),
information is generally used in one of five ways.
Use Description
Planning Help establish appropriate resources, time scales
and forecast alternative outcomes
Controlling To ensure processes are implemented as planned
Recording Information systems are used to record
transactions transactions throughout a business e.g. sales,
purchases, errors, returns, customer complaints
and quality control inspections, deposits and cash
movements
Performance Compare actual versus planned (budgeted) activity
measurement to identify variances from planned activity and take
corrective action as necessary
Decision making Information systems are used to help managers
make all kinds of decisions such as volume (e.g.
purchases and production), price, whether to make
a component internally or buy it from a supplier,
whether to switch suppliers, when to replace assets
and how to organize affairs to minimise a tax
charge.

4 INFORMATION SYSTEMS IN BUSINESS
Section overview
 Transaction processing systems

 Management information systems
 Decision support systems
 Executive information systems
 Expert systems
 Financial reporting systems
 Order processing and inventory control systems
 Personnel systems
 Integrated IT systems
 Enterprise Resource Planning (ERP)
4.1 Transaction processing systems
Definition: Transaction processing system (TPS)

A TPS executes, records and processes routine transactions.
Finance and accounting TPS

The major functions would typically include:
 Budgeting
 The nominal ledger
 Invoicing
 Management accounting
The system might be split into a number of modules including:
 Nominal ledger
 Accounts payable
 Accounts receivable
 Budgeting
 Treasury management
Human resources TPS
The major functions would typically include:
 Personnel records
 Benefits
 Salaries
 Labour relations
 Training

The system might be split into a number of modules including:

 Payroll
 Employee records
 Employee benefits
 Career path systems (appraisal)
4.2 Management information systems
Definition: Management information system (MIS)

A management information system digests inputted data (distinct pieces of
information such as facts, numbers and words) and processes it into useful
information.
A management information system is characterized as follows:

 It support structured decisions
 It reports on existing operations
 An MIS has little analytical capability and is relatively inflexible
 MIS has an internal focus
 Used to generate regular reports and typically would allow online access to
a wide range of users.
 Will incorporate both current and historical information
4.3 Decision support systems
Definition: Decision support system (DSS)

A decision support system is a set of related computer programs and data required
to assist with the analysis and decision-making within an organization.
DSS were initially developed to overcome the rigid nature of management
information systems.
The characteristics of decision support systems include:

 DSS assists managers at the tactical level when they are required to make
intelligent guesses
 A DSS uses formula and equations to enable mathematical modelling
 DSS are real-time systems enabling managers to solve problems through
queries and modelling
 User inputs queries for the model through a user interface
 Contains a natural language interpreter for querying the system
 The user interface is integrated with data management and modelling
software from the key components
 Spreadsheet packages can become the tool for the development of a
decision support system.

4.4 Executive information systems
Definition: Executive information system (EIS)

An executive information system is a type of management information system that
facilitates and supports senior executives in their decision-making.
An EIS incorporates both internal and external data and tends to be more forward
looking rather than historical-based.
EIS typically emphasize graphical displays and simple user interfaces with a ‘high-
level’ executive summary styled dash-board. Executives can then drill-down into
various components of the dashboard to extract more detailed information if
required.
Other characteristics of EIS include:

 Helps senior managers to make unstructured decisions with many
contributing factors such as price fixing
 Tends to be very expensive and real-time
 Often restricted for use by a small number of senior managers within the
business
4.5 Expert systems
Definition: Expert system

An expert system is a computer program that simulates the judgement and
behaviour of a human or an organization that has expert knowledge and
experience in a particular field.
Expert systems contain a database of accumulated experience and scenarios as
well as a set of rules for applying the knowledge to each particular situation
described by the program.
Examples include legal diagnostics, medical diagnostics, processing a loan
application and on a social level, programs that play chess!
Expert systems are most effective when the following preconditions exist:
 The problem is reasonably well-defined
 The expert can define some rules
 The problem cannot be solved through conventional transaction processing
systems
 The expert can be released to focus on more difficult problems
 The investment is cost-justified
The advantages gained from using an expert system include:
 Allows non-experts to make expert decisions
 Fast, accurate and consistent advice
 Ability to change input details to explore alternative solutions
 Reduction in staff costs - less experts required
 Improved allocation of human resources experts concentrate on the more
complex issues

 Can become a competitive advantage

 Availability potentially 24 hours 365 days per year
 Multi-access can deal with many problems at one time.
However, some disadvantages may exist, such as:
 High initial capital expenditure
 Technical support required
 System does not automatically learn, it has to be constantly updated by
experts
 User as a non-expert may give inaccurate advice without recognising
 Down time - systems failures effect all users
 Reliance - probable reduction in basic skills
 Possible user resistance for higher level experts.
4.6 Financial reporting systems
Definition: Financial accounting and reporting

Financial accounting and reporting involves:
 Maintaining a system of accounting records for business transactions and
other items of a financial nature; and
 Reporting the financial position and the financial performance of an entity
in a set of ‘financial statements’.
Many businesses operate a system of recording their business transactions in

accounting records. This system is called a book-keeping system or ledger
accounting system and forms the foundation of the financial reporting system.
All large businesses (and many small ones) have a book-keeping system for
recording the financial details of their business transactions on a regular basis.
The information that is recorded in the book-keeping system (ledger records) of
an entity are also analysed and summarised periodically, typically each year, and
the summarised information is presented in financial statements.
Financial statements provide information about the financial position and
performance of the entity.
Financial reporting systems must be reliable, accurate and complete. Access to
data entry should be strictly controlled to authorised personnel only.
Unlike management information systems where there are no formal rules about
the presentation of data extracted from the system, financial reporting systems
must be capable of extracting and summarizing data that will satisfy strict
external reporting requirements.
This means:
 The system must be able to support an audit trail for transactions and
manual updates (called journals)
 The system must capture all transactions from the transaction processing
system

 Transactions must be categorized correctly so that they will ultimatey be

extracted and summarised in the correct way within the external financial
statements.
4.7 Order processing and inventory control systems
Definition: Order processing

The order processing system should be capable of recording all orders accurately
and in a timely fashion. For some business such as airlines and hotels the
information needs to be updated immediately, whereas for other businesses an
end of day update may be sufficient.
The system will typically be linked to the inventory control system so that the sales
person can establish whether the organisation is capable of fulfilling the order
received.
Definition: Inventory control system
The objective of the inventory control system is to ensure that the business
maintains an appropriate amount of inventory at all times. The control system
should be able to indicate accurate levels of inventory for all the lines maintained
by a business and trigger the ordering of replacement inventory when inventory
levels fall to a certain level.
When the business is involved in manufacturing the inventory control system

must ensure that there are enough items in place to allow production to continue
smoothly.
Order processing and inventory control systems typically share the following
characteristics:
 The system can accurately report the current inventory level at any time
 A rule should be associated with each item that will trigger a reorder such
as minimum inventory level
 The age of the inventory can be tracked. This will assist sales managers in
identifying ageing stock and employing tactics to reduce it. This is
particularly important with perishable inventory (e.g. food and drink) that
could have hygiene as well as commercial considerations to consider.
 The system should be able to highlight shortages
 The system should be able to show individual and total costs of items
 The system should maintain supplier details
 Delivery dates both inwards and outwards must be maintained to enable
the warehouse manager to manage goods inwards and despatch
 The location of the inventory should be recorded to ensure that it can be
found easily and efficiently

4.8 Personnel systems
Definition: Personnel system

The personnel system exists to support the human resources management
function in performing its duties of maintaining an appropriate workforce. This
involves
 Recruitment
 Selection; and
 Staff development and appraisal.
Furthermore, the system contains a significant amount of sensitive and
confidential information meaning there must be strict control around maintaining
data security and access to the system.
The system will typically incorporate a number of components including:

 Recruitment
 Highlighting internal job vacancies that are available to existing staff
 Running external recruitment campaigns and tracking their cost
effectiveness
 Redundancy
 Planning and executing voluntary redundancy programs
 Planning and executing compulsory redundancies making sure the
company follows all the legal requirements
 Personnel management and control
 Maintaining contract of employment details such as salary, holiday
entitlement and duties
 Family and medical contact details
 Employment history
 Training records
 Training plan
 Qualifications and skills
 Amount of holiday accrued and taken
 Sick leave accrued and taken plus authorised absences such as
bereavements
 Unauthorized absence
 Time off in lieu
 Disciplinary record
 Bonus and pay history
 Other rewards and commendations
 Annual appraisal
 Goals and objectives

 Formal checks such as references

 Personnel management reporting – management will benefit from seeing
graph trends and summary reports to help with making decisions on
headcount. These might include:
 Benefits report
 Headcount (employee numbers) report
 Pay details and total wage expense
 Gender and diversity mix information
 Age profiling
 Tenure profiling
 Absence analysis
4.9 Integrated IT systems
Definition: Integrated IT systems

An integrated IT system describes the scenario where all modules of the system
are linked and function together as a system in a coordinated fashion.
Integrated finance system

An integrated finance system would link a number of underlying modules such as
 Accounts payable control
 Accounts receivable control
 Accruals and prepayments
 Bank and cash
 Inventory
 Purchases
 Sales
So for example a new sales order would be simultaneously reflected in the
accounts receivable, sales and inventory modules.
Advantages of integrated systems
 Offers a more complete view
 Enables better informed decisions
 Should ultimately lead to a more efficient operation
 Which would lead to greater customer satisfaction and hence profitability
Disadvantages of integrated systems
 Greater risk that if one module fails the whole system could fail
 More complex and therefore prone to error
 More expensive than standalone systems
 May require a greater level of support as the system is likely to need to be
bespoke (tailored) specifically to the organisation

4.10 Enterprise Resource Planning (ERP)
Definition: Enterprise Resource Planning

Enterprise Resource Planning (ERP) is a cross-functional system driven by an
integrated suite of software modules supporting the basic internal processes of a
business.
The system incorporates a real-time view of core business processes such as:
 Order processing
 Inventory management
 Productions
Business resources
ERP systems track business resources such as:
 Cash
 Raw materials
 Production capacity
 Personnel
Commitments
ERP systems also track the status of commitments such as:
 Purchase orders
 Employee costs
 Customer orders
Tracking is permanently updated irrespective of the department that entered the
information – hence the term ‘enterprise’.

5 CHAPTER REVIEW
Chapter review
Before moving on to the next chapter check that you can:

 Understand general systems concepts
 Describe different types of computer hardware including input devices, output
devices and storage devices
 Explain the different types of software that are used in business including system
software, programming tools, language translators and application software
 Define the terms data, information, knowledge and wisdom
 Understand and distinguish between information technology and information
systems
 Explain the different levels and roles of information found within a business’s
information system
 Describe the common information systems found in modern business including
TPS, MIS, DSS, EIS, expert systems, financial reporting systems, order
processing and inventory control systems, personnel systems, integrated IT
systems and Enterprise Resource Planning (ERP)

Foundation level
CHAPTER
16
Networks and communications
Contents
1 Networks, architecture and protocols
2 The internet and website hosting
3 Email
4 Video conferencing
5 Chapter review

Purpose
Competencies
3(b) Identify and explain the main information technologies that support modern
information systems
3(h) Information Technology Architecture - Explain, describe or discuss how IT
v Protocols, standards and enabling technologies
Exam context
In this second chapter on information systems and technology you will focus on networks
and communications. This chapter is reasonably technical and will introduce you to the main
acronyms and topics related to networks, architectures and protocols. The chapter also
includes practical sections on email and video conferencing in the business environment.
By the end of this chapter students will be able to:
 Explain the fundamentals of computer networks and system architectures
 Define the terms LAN and WAN
 Briefly describe the basics of protocols including the OSI reference model, WAP, packet
switching, URL, HTTP, HTML, XML and XBRL,
 Describe different types of web hosting services and the underlying building blocks of the
internet needed to support web hosting
 Give further context to web hosting by explaining key considerations when selecting a
web host
 State the main features of email
 Explain the benefits and limitations of email
 Describe when to use different channels of communication
 Advise the basics of email etiquette
 Describe the main features of video conferencing including the benefits and limitations

Chapter 16: Networks and communications
1 NETWORKS, ARCHITECTURE AND PROTOCOLS
Section overview
 Networks
 System architectures
 LAN – Local area network
 WAN – Wide area network
 Introduction to protocols, standards and enabling technologies
 Seven-layer OSI reference model
 Wireless application protocol (WAP)
 Packet switching
 Uniform resource locator (URL)
 Hypertext transfer protocol (HTTP) and Hypertext mark-up language (HTML)
 Extensible Mark-up Language (XML)
 Extensible business reporting language (XBRL)
1.1 Networks
Definition: Computer network

A computer network is a telecommunications infrastructure that allows computers
to exchange data (or ‘talk’) with each other.
The physical connection that exists between networked computers can use either
physical media such as fibre optic or copper wire cables, or wireless media.
The best-known computer network is the internet.
Computer networks support a vast range of uses including:

 The world wide web (internet)
 Sharing software applications such as databases and Worksheets
 Email
 Sharing devices such as printers, fax machines and scanners
 Online booking systems
 Instant messaging
 Internet-based communication such as Skype
1.2 System architectures
Definition: System architecture

The term system architecture refers to the way in which the components of a
computer system such as printers, PCs and storage devices are linked together
and how they interact.
A centralised architecture involves all processing being performed on a single
central computer.

Decentralised architectures spread the processing power throughout the

organisation at several different locations. This is typical of the modern workplace
given the significant processing power of modern PCs.
Typical network configurations include star networks, ring networks, bus
networks and tree networks.
Definition: Client-server computing

Client-server computing describes one level of interaction found between
computers in systems architecture.
A server is a machine that is dedicated to providing a particular function or
service requested by a client within a network system.
Servers can range in power from ‘top-end’ super servers, capable of driving
thousands of network users, to ‘low-end’ servers which are typically a powerful
personal computer (PC). Different types of servers might include file servers,
network servers, print servers, e-mail servers and fax servers.
File servers are used to manage the data files that are accessible to users of the
network. All the shared data files for the system are held on a file server, or are
accessible through a file server.
Network servers are used to route messages from terminals and other equipment
in the network to other parts of the network. In other words, network servers
manage and control the routing of messages within computer networks.
1.3 LAN – Local area network

A LAN is a computer network covering a small geographic area such as a home,
office, group of buildings or school. A LAN’s distinguishing features include:
 Due to its localised nature, the data transfer speeds are high
 Typically owned, controlled and managed by one person or a single
organization
 Low cost maintenance
 Relatively low data transmission errors
 One LAN can be connected to another LAN over any distance via
telephone lines and radio waves
1.4 WAN – Wide area network

A WAN is a computer network that covers a broad area i.e. a network that
communicates across regional, metropolitan or national boundaries over a long
distance. A WAN’s distinguishing features include:
 Data transfer speeds are much lower than with LANs due to the greater
distance that information must travel.
 WANs exist under collective or distributed ownership and management
covering long distances.
 Setup costs are typically higher due to the need to connect to remote
areas. Furthermore, maintaining a WAN is more difficult (and expensive)
than maintaining a LAN due to its wider coverage.

 In contrast to LANs, the data transmission error rate tends to be

significantly higher.
1.5 Introduction to protocols, standards and enabling technologies
Definition: Protocol
In computing, a protocol is a convention or standard that controls or enables the
connection, communication, and data transfer between computing endpoints.
In its simplest form, a protocol can be defined as the rules governing
communications over a network.
Protocols may be implemented by hardware, software, or a combination of the
two.
At the lowest level, a protocol defines the behaviour of a hardware connection.
Typical properties
While protocols can vary greatly in purpose and sophistication, most specify one
or more of the following properties:
 Detection of the underlying physical connection (wired or wireless), or
the existence of the other endpoints;
 How to start and end a message;
 How to format a message;
 What to do with corrupted or improperly formatted messages (error
correction);
 How to detect unexpected loss of the connection, and what to do next; and
 Termination of the session and or connection.
Importance of protocols
The protocols in human communication are separate rules about appearance,
speaking, listening and understanding. All these rules, also called protocols of
conversation, represent different layers of communication. They work together to
help people successfully communicate.
The need for protocols also applies to network devices. Computers have no way
of learning protocols, so network engineers have written rules for communication
that must be strictly followed for successful computer-to-computer
communication. These rules apply to different layers of sophistication such as
which physical connections to use, how computers listen, how to interrupt, how to
say good-bye, and in short how to communicate, what language to use and many
others. These rules, or protocols, that work together to ensure successful
communication are grouped into what is known as a protocol suite.
Common protocols
Common protocols used for today's data communications include:
Protocol Description
IP Internet protocol
UDP User datagram protocol
TCP Transmission control protocol

Protocol Description
HTTP Hypertext transfer protocol
FTP File transfer protocol
SOAP Simple object access protocol
IMAP Internet message access protocol
SMTP Simple mail transfer protocol
POP3 Post office protocol 3
We will now take a look at each one in a little more detail.

Internet protocol (IP)
The Internet Protocol (IP) is a protocol used for communicating data across a
packet-switched internetwork using the Internet Protocol Suite, also referred to as
TCP/IP. IP is the primary protocol in the Internet Layer of the Internet Protocol
Suite and has the task of delivering distinguished protocol datagrams (packets)
from the source host to the destination host solely based on their addresses. For
this purpose the Internet Protocol defines addressing methods and structures for
datagram encapsulation.
IP works by exchanging pieces of information called packets. A packet is a
sequence of bytes and consists of a header followed by a body. The header
describes the packet's destination and, optionally, the routers to use for
forwarding-generally in the right direction-until it arrives at its final destination.
The body contains the data which IP is transmitting.
User datagram protocol (UDP)
The User Datagram Protocol (UDP) is one of the core members of the Internet
Protocol Suite, the set of network protocols used for the Internet. With UDP,
computer applications can send messages, in this case referred to as datagrams,
to other computers on an Internet Protocol (IP) network without requiring prior
communications to set up special transmission channels or data paths. UDP is
sometimes called the Universal Datagram Protocol.
Transmission control protocol (TCP)
The Transmission Control Protocol (TCP) is one of the core protocols of the
Internet Protocol Suite. TCP is so central that the entire suite is often referred to
as "TCP/IP".
Whereas IP handles lower-level transmissions from computer to computer as a
message makes its way across the Internet, TCP operates at a higher level,
concerned only with the two end systems, for example a Web browser and a
Web server.
In particular, TCP provides reliable, ordered delivery of a stream of bytes from
one program on one computer to another program on another computer.
Besides the Web, other common applications of TCP include e-mail and file
transfer.
Among its management tasks, TCP controls message size, the rate at which
messages are exchanged, and network traffic congestion.
TCP is used extensively by many of the Internet's most popular application
protocols and resulting applications, including the World Wide Web, E-mail, File
Transfer Protocol, Secure Shell, and some streaming media applications.

However, because TCP is optimized for accurate delivery rather than timely
delivery, TCP sometimes incurs relatively long delays (in the order of seconds)
while waiting for out-of-order messages or retransmissions of lost messages, and
it is not particularly suitable for real-time applications such as Voice over IP.
Hypertext transfer protocol (HTTP)
Hypertext Transfer Protocol (HTTP) is an application-level protocol for distributed,
collaborative, hypermedia information systems. Its use for retrieving inter-linked
resources led to the establishment of the World Wide Web.
HTTP is a request/response standard of a client and a server. A client is the end-
user; the server is the web site. The client making a HTTP request-using a web
browser or other end-user tool is referred to as the user agent. The responding
server which stores or creates resources such as HTML files and images is
called the origin server. In between the user agent and origin server may be
several intermediaries, such as proxies and gateways.
HTTP is not constrained to using TCP/IP and its supporting layers, although this
is its most popular application on the Internet. Indeed HTTP can be "implemented
on top of any other protocol on the Internet, or on other networks.
File transfer protocol (FTP)
File Transfer Protocol (FTP) is a network protocol used to exchange and
manipulate files over a TCP computer network, such as the internet. An FTP
client may connect to an FTP server to have access to and manipulate files on
that server as if the files are directly on the local storage medium.
The uses of FTP include the following:
 To promote sharing of files (computer programs and/or data);
 To encourage indirect or implicit use of remote computers;
 To shield a user from variations in file storage systems among different
hosts; and
 To transfer data reliably, and efficiently.
Simple object access protocol (SOAP)
SOAP is a protocol specification for exchanging structured information in the
implementation of Web Services in computer networks.
As a layman's example of how SOAP procedures can be used, a SOAP message
could be sent to a web service enabled web site (for example, a house price
database) with the parameters needed for a search. The site would then return
an XML-formatted document with the resulting data (prices, location, features,
etc.). Because the data is returned in a standardised format, it could then be
integrated directly into a third-party site.
Internet message access protocol (IMAP)
The IMAP is one of the two most prevalent Internet standard protocols for e-mail
retrieval, the other being POP3. Virtually all modern e-mail clients and servers
support both protocols as a means of transferring e-mail messages from a server,
such as those used by Gmail, to a client, such as Mozilla Thunderbird, Apple Mail
and Microsoft Outlook. Once configured, the client's use of such protocols
remains transparent to the user.
IMAP supports both connected (online) and disconnected (offline) modes of
operation. E-mail clients using IMAP generally leave messages on the server
until the user explicitly deletes them.

E-mail messages are usually sent to an e-mail server that stores received
messages in the recipient's e-mail mailbox. The user retrieves messages with
either a web browser or an e-mail client that uses one of a number of e-mail
retrieval protocols.
Some clients and servers preferentially use vendor-specific, proprietary protocols,
but most support the Internet standard protocols, SMTP for sending e-mail and
POP3 and IMAP4 for retrieving e-mail, allowing interoperability with other servers
and clients.
SMTP can also be used for retrieving email; it is more suitable for permanent
Internet connection than, say, a dialup connection, and is supported by most e-
mail client software. For example, Microsoft's Outlook client uses a proprietary
protocol to communicate with an Exchange server as does IBM's Notes client
when communicating with a Domino server, but all of these products also support
POP3, IMAP4, and outgoing SMTP.
Simple mail transfer protocol (SMTP)
Simple Mail Transfer Protocol (SMTP) is an Internet standard for electronic mail
(e-mail) transmission across Internet Protocol (IP) networks. While electronic mail
server software uses SMTP to send and receive mail messages, user-level client
mail applications typically only use SMTP for sending messages to a mail server
for relaying. For receiving messages, client applications usually use either the
Post Office Protocol (POP) or the Internet Message Access Protocol (IMAP) to
access their mail box accounts on a mail server.
SMTP is a relatively simple, text-based protocol, in which one or more recipients
of a message are specified (and in most cases verified to exist) along with the
message text and possibly other encoded objects. The message is then
transferred to a remote server using a series of queries and responses between
the client and server.
Post office protocol (POP)
In computing, the Post Office Protocol version 3 (POP3) is an application- layer
Internet standard protocol used by local e-mail clients to retrieve e-mail from a
remote server over a TCP/IP connection. POP3 and IMAP4 (Internet Message
Access Protocol) are the two most prevalent Internet standard protocols for e-
mail retrieval. Virtually all modern e-mail clients and servers support both.
1.6 Seven-layer OSI reference model

The Open Systems Interconnection Reference Model (OSI Reference Model or
OSI Model) is an abstract description for layered communications and computer
network protocol design. It was developed as part of the Open Systems
Interconnection (OSI) initiative.
In its most basic form, OSI divides network architecture into seven layers which,
from top to bottom, are the Application, Presentation, Session, Transport,
Network, Data-Link, and Physical Layers. Therefore it is often referred to as the
OSI Seven Layer Model.
A layer is a collection of similar functions that provide services to the layer above
it and receives service from the layer below it. For example, a layer that provides
error-free communications across a network provides the path needed by
applications above it, while it calls the next lower layer to send and receive
packets that make up the contents of the path.

OSI was developed by the International Organisation for Standardization (ISO) in

an effort to develop standard communications architecture that satisfies all
demands across heterogeneous communications platforms and devices.
The layers
Group Data unit Layer Function

Host Data 7. Application Network process to application
layers 6. Presentation Data representation and encryption
5. Session Inter-host communication
Segment 4. Transport End-to-end connections and reliability
Media Packet 3. Network Path determination and logical
layers addressing
Frame 2. Data link Physical addressing
Bit 1. Physical Media, signal and binary transmission
1.7 Wireless application protocol (WAP)

Wireless Application Protocol (commonly referred to as WAP) is an open
international standard for application layer network communications in a wireless
communication environment. Its main use is to enable access to the Internet
(HTTP) from a mobile phone or PDA.
A WAP browser provides all of the basic services of a computer based web
browser but simplified to operate within the restrictions of a mobile phone, such
as its smaller view screen. WAP sites are websites written in, or dynamically
converted to, WML (Wireless Mark-up Language) and accessed via the WAP
browser.
Before the introduction of WAP, service providers had extremely limited
opportunities to offer interactive data services. Interactive data applications are
required to support now commonplace activities such as:
 Email by mobile phone;
 Tracking of stock market prices;
 Sports results;
 News headlines;
 Music downloads;
1.8 Packet switching

Packet switching is a network communications method that groups all transmitted
data, irrespective of content, type, or structure into suitably-sized blocks, called
packets. The network over which packets are transmitted is a shared network
which routes each packet independently from all others and allocates
transmission resources as needed.
The principal goals of packet switching are to optimize utilisation of available link
capacity and to increase the robustness of communication. When traversing
network adapters, switches and other network nodes, packets are buffered and
queued, resulting in variable delay and throughput, depending on the traffic load
in the network.

Packet switching in networks

Packet switching is used to optimise the use of the channel capacity available in
digital telecommunication networks such as computer networks, to minimise the
transmission latency (i.e. the time it takes for data to pass across the network),
and to increase robustness of communication.
The most well-known use of packet switching is the Internet and local area
networks. The Internet uses the Internet protocol suite over a variety of Link
Layer protocols. For example, Ethernet and frame relay are very common. Newer
mobile phone technologies (e.g., GPRS, I-mode) also use packet switching.
1.9 Uniform resource locator (URL)

To be able to see a particular web page, you have to be able to find it among the
many millions of others spread around the Internet. This is done using a Uniform
Resource Locator. As the name suggests, a URL is a standard way of describing
the location of a particular resource (like the position of a web page). So a URL is
an address. Here is an example of an address:
http://www.icanig.org/ng/login.html
The first time you see a URL, it looks very confusing, but in fact it is built up very
logically. It contains the abbreviation http followed by the name of the computer
containing the web page, and then the name and location of the page.
http://
This is the name of the protocol used to send the information between the server
and your computer. A protocol is a set of rules specifying how communication
between computers should take place. Ordinary web pages are sent using
Hypertext Transport Protocol, so most URLs start with the abbreviation http. The
name of the protocol is always followed by a colon and two slashes (//). As nearly
all addresses start with http://, it is often left out when an address is given. It is
unnecessary to include it when you type an address in most browsers.
www.icanig.org
This is the address of a web server. Most computers that have permanent access
to the Internet, like the web servers, have an address consisting of a number of
words, separated by full stops (called dots). In this case, the address of the
computer is www.icanig.org.
/ng/
This is the position of the web page's folder (directory) on the server. Names of
folders are separated by slashes. In this case, the web page is contained in a
folder called ng. There is a difference between large and small letters.
login.html
This is the file name of the web page. The .html extension shows that it is just an
ordinary web page. Most web pages have either a .html or .htm. extension. This
stands for HyperText Mark-up Language and shows that the file is in that format.
There is a difference between large and small letters, so login.html is NOT the
same file as Login.HTML.
Computer addresses
Computers with a direct connection to the Internet have an address consisting of
two or more words or abbreviations, separated by dots. In the URL shown above,
the computer’s address looks like this:

 www.ican.org
The last part of an address is often a country code, showing in which country the
computer is. For example:
 uk = Great Britain
 de = Germany
 cn = China
 jp = Japan
Instead of a country code, the USA uses a number of three letter extensions
showing what type of organisation each computer belongs to. For example:
 com = Commercial companies
 edu = Educational institutions, like universities
 gov = The American government
 mil = The American military
 org = Non-profit organisations
 net = Organisations engaged in the maintenance of the Internet.
Nowadays these addresses can actually be anywhere in the world, even though
the majority of them are American. There is also the extension .int specifying an
international organisation.
1.10 Hypertext transfer protocol (HTTP) and Hypertext Mark-up Language (HTML)
Hypertext Mark-up Language (HTML) is the predominant mark-up language for
web pages. It provides a means to describe the structure of text-based
information in a document by denoting certain text as links, headings,
paragraphs, lists, etc., and to supplement that text with interactive forms,
embedded images, and other objects.
HTML is written in the form of "tags" that are surrounded by angle brackets.
HTML can also describe, to some degree, the appearance and semantics of a
document, and can include embedded scripting language code (such as
JavaScript) that can affect the behaviour of Web browsers and other HTML
processors.
1.11 Extensible Mark-up Language (XML)

XML is a general-purpose specification for creating custom mark-up languages. It
is classified as an extensible language, because it allows the user to define the
mark-up elements. XML's purpose is to aid information systems in sharing
structured data, especially via the Internet, to encode documents, and to serialize
data.
XML's set of tools helps developers in creating web pages but its usefulness
goes well beyond that. XML, in combination with other standards, makes it
possible to define the content of a document separately from its formatting,
making it easy to reuse that content in other applications or for other presentation
environments.
Most importantly, XML provides a basic syntax that can be used to share
information between different kinds of computers, different applications, and
different organisations without needing to pass through many layers of
conversion.

1.12 Extensible business reporting language (XBRL)

XBRL is a language for the electronic communication of business and financial
data which is revolutionising business reporting around the world. It provides
major benefits in the preparation, analysis and communication of business
information. It offers cost savings, greater efficiency and improved accuracy and
reliability to all those involved in supplying or using financial data.
XBRL stands for eXtensible Business Reporting Language. It is one of a family of
"XML" languages which is becoming a standard means of communicating
information between businesses and on the internet.
XBRL is being developed by an international non-profit consortium of
approximately 450 major companies, organisations and government agencies. It
is an open standard, free of licence fees. It is already being put to practical use in
a number of countries (e.g. the UK) and implementations of XBRL are growing
rapidly around the world.
Instead of treating financial information as a block of text - as in a standard
internet page or a printed document - XBRL provides an identifying tag for each
individual item of data. This is computer readable. For example, company net
profit has its own unique tag.
The introduction of XBRL tags enables automated processing of business
information by computer software, cutting out laborious and costly processes of
manual re-entry and comparison. Computers can treat XBRL data "intelligently":
they can recognise the information in a XBRL document, select it, analyse it,
store it, exchange it with other computers and present it automatically in a variety
of ways for users. XBRL greatly increases the speed of handling of financial data,
reduces the chance of error and permits automatic checking of information.
Companies can use XBRL to save costs and streamline their processes for
collecting and reporting financial information. Consumers of financial data,
including investors, analysts, financial institutions and regulators, can receive,
find, compare and analyse data much more rapidly and efficiently if it is in XBRL
format.
XBRL can handle data in different languages and accounting standards. It can
flexibly be adapted to meet different requirements and uses. Data can be
transformed into XBRL by suitable mapping tools or it can be generated in XBRL
by appropriate software.

2 THE INTERNET AND WEBSITE HOSTING
Section overview
 Introduction to the internet

 How website hosting works
 Website hosting services
 Key considerations when selecting a Web host
 Types of Web hosting
2.1 Introduction to the internet

Many students will have used the internet at some stage of their lives. You may
have used it to research a client, check the news, purchase goods or read about
your favourite sports team.
We start this section by formally defining the following terms:
 The internet
 World Wide Web
 Server
Definition: The Internet

Many people use the terms Internet and World Wide Web (or in short, the Web)
interchangeably. However, they are two very different (yet interconnected) things.
The Internet is the underlying global system of interconnected computer networks
consisting of millions of private, public, academic, business and government
networks. These networks are linked by an array of electronic, wireless and
optical networking technologies.
The Internet supports different applications such as email (e.g. Microsoft
Outlook), communications (e.g. Skype) and the World Wide Web (see below) by
transporting information across the network.
Think of the Internet as being the roads and motorways in a transport system.
Applications like email, Skype and the World Wide Web are the vehicles and
people that use those roads.
Definition: World Wide Web (or in short, the Web)

The World Wide Web is an example of an application that uses the Internet. The
World Wide Web is a global collection of documents, images and other resources
stored in millions of databases (sitting on computers) around the world. These
documents, images and resources are interrelated by hyperlinks and referenced
(indexed) through unique identifiers.
Identifiers are similar to street addresses that uniquely identify properties around
the world.

Web browser software is used to access the World Wide Web and locate and view
documents, images and resources. Examples of web browsers include Internet
Explorer, Mozilla Firefox, Opera, Apple’s Safari and Google Chrome.
A programming language called HTML (hypertext mark-up language) is used to
create web pages.
Definition: Server
A server is a physical computer dedicated to run (host) one or more services to
serve the needs of users and other computers on a network. Examples include
print servers and Web servers.
In a typical office environment employees might use a desktop PC (or laptop
computer) connected to servers via their company’s network. When an employee
sends a document to print for example their PC actually sends the document to
the print server which receives similar print requests from many other PCs on the
network. The print server prioritises all the print requests then communicates
with the printer on behalf of all the PCs on the network (i.e. serving them) in a
logical and organised fashion.
Similarly, when using web browser software such as Internet Explorer or Firefox a
user’s desktop PC actually communicates with a Web server rather than directly
with the Web. It’s the Web server that then physically manages access to the
World Wide Web on the Internet via for example modems, Wi-Fi of fibre optic
cables.
2.2 How website hosting works

There are a number of other definitions you need to understand in order to
provide an appropriate context for understanding website hosting. These include:
 Internet hosting
 Internet protocol (IP) address
 Internet service provider (ISP)
 Website hosting
Definition: Internet hosting

Internet hosting is a generic term that describes a computer or computers that
support an Internet based service. For example:
- Email host. Whilst many of us might have a Hotmail or Gmail account the
actual account (a bit like a post box) physically resides on one of Microsoft’s
or Google’s computers somewhere in the world. It’s this physical computer
that performs the role of email host by hosting our email account for us.
- Game host (or game server). In a multiplayer video game the physical
computer where the game software resides is the host that hosts the game.
- File host (cloud storage). File hosting, also called cloud or online storage,
involves a remote computer housing (hosting) user files. For example, rather
than saving a Microsoft Excel file to your local hard drive you in fact store it to
the hard drive of a computer perhaps even in a different country by sending
the file contents across the Internet.
- Website host. See below

Definition: Internet Protocol (IP) address

An IP address is a code that uniquely identifies a particular computer on the
Internet. Every computer requires a unique IP address to connect to the Internet
and consists of four sets of numbers from 0 to 255.
- e.g. “125.148.224.63”
IP addresses enable computers to locate other computers and Internet hosts on
the Internet.
Internet hosts typically log the IP addresses of computers that access their
services, thus providing an audit trail useful to developers, governments and of
course the security services.
Definition: Internet Service Provider (ISP)

An Internet service provider (ISP) is an organization that provides physical access
to the Internet. This access might be provided in the form of a plugged-in cable
(e.g. copper or fibre-optic), a Wi-Fi signal or a mobile telephone signal.
Practical examples of ISPs in action include:
- Paying a monthly fee to your home phone provider enabling you to connect
your home PC to the internet via your telephone line
- Whilst in a coffee shop or airport lounge you might be able to access the
internet by connecting your laptop to a Wi-Fi signal provided by an ISP
Definition: Website hosting

A Website host stores all the pages of a website making them available to
computers connected to the Internet.
A website is identified by its domain name, such as sony.com, which is linked to
an IP address pointing to a specific physical computer.
Given the capacity of modern computers it is common for many website hosts
(i.e. the physical computers) to host multiple websites on the same host
computer. It may help to think of just how many different files you have stored on
your laptop or PC then apply this concept to a website host computer.
Conversely websites that attract extremely high amounts of traffic, such as
Microsoft.com or apple.com, will use several computers to host one site.
The Web host can of course be physically located anywhere in the world.
Web hosts run Web hosting software such as Apache, OS X Server and Windows
Server.
Example: Gola Inc.

Let’s use a simple company called Gola Inc. as an example to bring together
the above definitions:
 Gola Inc. is based in Islamabad and pays a third party internet host (Chutani
Inc. – located in Lahore) a monthly fee to host their corporate website. The
corporate website has a domain name called Gola.com.

 Chutani Inc. is the website host.

 Gola Inc. employees use Gmail accounts (provided by Google) for their
email. Employees login to their accounts on the internet. Gola Inc. pays
Vodafone a monthly fee to provide access to the internet via phone lines
 Vodafone is the internet service provider that provides physical access to
the internet for Gola Inc. employees
Each employee’s physical machine will be allocated an IP address by
Vodafone to identify them when accessing their Gmail account on the
internet
Google is the internet hosting company that provides the mail hosting
service. Google’s mail servers might well be physically located in the USA
rather than in Pakistan.
 Employees of Gola Inc. frequently need to perform client research using the
World Wide Web (for example using search engines such as
www.Google.com or www.Bing.com).
 Their laptops communicate with Gola Inc.’s Web server which then provides
access to the World Wide Web.
 Both the World Wide Web and Gmail applications described above use the
Internet to communicate information across the world.
2.3 Website hosting services

As noted in the definitions above, in order to publish a website online the author
needs a Web host which stores all the pages that make up the website. The Web
host then makes the website available to computers across the globe via the
Internet and can be found through a domain name such as Microsoft.com.
When someone enters a domain name in their Web browser’s address field (e.g.
by typing in www.microsoft.com) their Web server will locate the IP address of the
website whose domain name they have entered. The Web server then loads
(takes a copy of) the website pages from the domain name’s Web host into the
Web browser.
When a company wants to publish their website they will need to locate and sign
up (pay for) a Web hosting service. Locating one should not be a problem given
there are literally thousands of Web hosting services across the world. However,
there are a number of factors that need to be considered when choosing a Web
host that we will explore in more detail below.
Web hosting fees will also typically vary depending on:
 How much disk space your site will use (a bit like renting an office – the
bigger the office rented the higher the cost – the bigger the website, the
higher the cost)
 The bandwidth a site will use

Definition: Bandwidth
Bandwidth describes the maximum data transfer rate of a network or Internet
connection and measures how much data can be sent over a specific connection
in a given amount of time.
To help visualise the concept of bandwidth compare a narrow one lane road to a
large five-lane super-highway. On average, much more traffic should be able to
flow at any one time down the five-lane super-highway than the narrow one lane
road.
2.4 Key considerations when selecting a Web host

The following table describes key considerations that must be factored in when
selecting a Web host:
Consideration Comments
Up-time ‘Down-time’ describes the period when a website is
percentage unavailable due to a problem with the Web server. This is a
bit like a shop being closed – no-one can enter to view the
goods, make purchases or communicate with the owner. The
inverse is called ‘up-time’.
Up-time is often measured in “nines”. Five nines means the
Website is available 99.999% of the time which equates to
being ‘down’ for just over five minutes per year. Three nines
(99.9% availability) equates to being ‘down’ for nearly nine
hours per year!
Storage space Many straightforward basic sites consume less than a couple
of hundred megabytes of disk space. This would even
accommodate product catalogs and a handfull of
downloadable documents such as user or technical manuals.
However, if extensive audio, video and image libraries are
required then significantly more space will be needed. It is not
unusual for Web hosts to offer in excess of 650 gigabytes in
their basic package.
Ecommerce Ecommerce describes the suite of tools required to take

orders and payment for selling products online. Common
examples include Paypal and eBay.
Smaller (cheaper) Web hosts don’t tend to offer either the
quality or quantity of tools required to support a professional
and robust Ecommerce environment. So a company must
decide whether it wants to invest in shopping cart software,
Ecommerce tools, database builders and secure servers to
support online business.

Consideration Comments
Number of Many companies might start off with a single domain name
domains that identifies their website. However, multiple domain names
either pointing to the same website (to enhance the success
from user searches or even mis-spelt searches) or indeed
representing different parts of a more diversified business
may well become relevant. Obviously the more domain
names supported the higher the cost.
Consider for example the number of domain names
associated with the Google search engine, a few examples
being:
 Google.com (US version)
 Google.com.pk (Pakistan version)
 Google.co.in (Indian version)
 Google.co.uk (UK version)
 Google.com.hk (Hong Kong version)
 Etc.
Technical The standard of technical support offered by a company’s

support Web host is one of the most important factors for an
organisation to consider. For example, the Internet is a
24/7/365 shop for businesses so will technical suport be
available similarly throughout the year offering real-time
solutions.
Web hosts typically offer a range of services in increasing
cost from email support to messenger (chat) and phone.
Companies with less experience of running their website will
generally benefit from investing in phone support.
Bandwidth As defined above, bandwidth is a measure of the amount of

data that can be transferred from a website to clients when
they access it.
Similar to storage space above, this wouldn’t typically be a
concern for most businesses unless selling downloadable
video or high resolution images.
Number of A final consideration relates to how scalable the Web host is

Emails, FTP and whether it could match an organisation’s growth. For
accounts and example, blogs require their own databases and as more staff
databases and products are added it will become necessary to support
more email addresses and domain names.
Of course another test to perform when choosing a Web host having narrowed
down the options based on the above technical and strategic considerations is to
perform a Google search on user reviews of the shortlisted hosts. User reviews
are becoming invaluable tools in making purchasing decisions.

2.5 Types of Web hosting

So far we have explored the different forms of internet hosting services typically
used by organisations (e.g. Web hosting, Email hosting, file hosting). We have
also considered the key variables that are relevant when building a Web hosting
strategy based on a straightforward standard Web hosting scenario.
The section concludes with a brief look at some alternative types of Web hosting
available in today’s increasingly diverse market.
Type of Web
Description
hosting
Free Free Web hosting is exactly that – zero cost to the user. The
Web host covers their costs (and profit) through selling
advertising that is added automatically to Web pages through
pop-ups, frames and scripts.
As you would expect though, given the zero cost to users the
quality of service (space, bandwidth or software) is typically
lower than that of paid-for Web hosts.
Standard Standard Web hosting is a broad term covering the most

common form of paid Web hosting. A standard fee would
secure a specific amount of server space on a Web hosting
system that provides high-speed servers and quality
software. The Web host would typically use a shared system
granting each user say 10GB space on a 200GB server.
Variations on the package could typically include:
- Bandwidth charges – there may be an upper ceiling
beyond which extra charges are levied
- Administrative access – can vary between a Web-based
console and telnet access.
- Operating system – varies between Windows and Linux
The market for Standard Web hosting is highly competitive
which is reflected in the pricing which can be as low as a few
dollars per month.
Dedicated Dedicated Web hosting describes when the client pays for
their own dedicated server machine for its Web site’s
exclusive use.
Dedicated Web hosting is useful when a business needs
greater control over their Web site. The site owner will
normally be granted something called root access which
allows them access to the server to make changes and
control the site.
One other key benefit of paying the premium for Dedicated
Web hosting (apart from the extra space) is the increased
security this provides. There is a risk with shared servers (as
is the norm with free and standard services) that if one
website is attacked or hacked then other websites on the
same shared server are typically vulnerable too.

Type of Web
Description
hosting
Colocation With free, standard and dedicated Web hosting, it’s the Web
host themselves who owns the server hardware (the physical
computer).
Colocation is similar to dedicated hosting in that a Website
resides on a dedicated server. However, with colocation it’s
the website owner who owns the server, not the Web host.
The colocation fee therefore covers renting the physical

space in the host’s facility plus their high-speed Internet
connection.
Colocation is offered in two forms – managed and
unmanaged. With a managed service the Web host provides
an IT department to manage the server (useful where a
customer does not have their own IT department). With the
unmanaged service the customer themselves handles all the
administration and management of the server covering things
like software updates, the Web server and the site itself.
Colocation is beneficial to companies who require something
unusual in their Web software configuration and also
enhanced security.
Ecommerce Ecommerce is required when a business sells goods on the

Web. Ecommerce Web hosting describes when an SSL
(secure socket layer) has been added to one of the above
types of Web hosting to protect customers when paying for
goods.
Many Ecommerce Web hosts will lease their SSL certificates
to Websites for an additional fee and typically include
features like shopping carts.
Reseller Reseller Web hosting is when a company wants to become a

Web hosting business themselves. A reseller purchases Web
hosting facilities off another Web host, then sells them on to
other clients acting as their Web host – i.e. operating as a
wholesaler.
Clustered Companies with extremely popular sites will replicate the

same content onto multiple servers in order to provide better
access to Website visitors. This is called Clustered Web
hosting.
File and image File and image hosting is technically not Web hosting in that
customers’ Websites are not hosted by the file and image
host. What file and image hosting does provide is essentially
online storage.

Type of Web
Description
hosting
Weblog Weblog hosting is when a company hosts Weblogs and blogs
rather than Web sites specifically. Weblog functionality is
typically more limited than the standard Web hosting
described above and hence conversely less expensive.
Customers are however limited to building a Web site with the
blog software which for most organisations will be too
commercially limiting.

3 EMAIL
Section overview
 Main features of email

 Benefits and limitations of email
 When to use different channels of communication
 Email etiquette
3.1 Main features of email

How it works
Email (also referred to as e-mail or electronic mail) involves the transmission of
messages (called emails, or email messages) over an electronic network such as
the Internet or an intranet. An intranet is similar to the Internet except that it is
internal to a company.
Email systems are therefore essentially electronic versions of a traditional postal
system. They operate as follows:
 Instead of using a pen and paper to write a letter the sender uses an
electronic device such as a computer, tablet or smartphone to compose the
message.
 The addressee is identified by an email address which is a specific unique
identifier. Typical forms might be name@gmail.com or name@hotmail.com
 Emails are ‘sent’ by clicking a ‘sent’ button on the email software. Email
servers transmit email messages from sender to recipient across a network
such as the Internet. This involves copying the message from the sender’s
device (e.g. computer) to an email server that the recipient can access.
Think of this as letters having been delivered to your local post office to
await collection
 The recipient’s device (e.g. a computer) can ‘fetch’ new email from their
mail server (like collecting mail from the post office). The device
communicates with the local email server and makes a copy of the email
onto the recipient’s device.
 Alternatively, the recipient is able to access their email directly on the email
server by using a Web browser such as Internet Explorer, Chrome or
Safari. In this case the local device does not take a copy of the email – the
user views the ‘live’ copy on the email server.
Synchronising email
As described above emails are computer files stored on an email server. We
have also described how they can be downloaded (copied) onto devices such as
laptops, smartphones and tablets. In fact, this relationship is not mutually
exclusive as the same emails can be downloaded onto multiple devices. For
example a user can view the same email account from their smartphone as well
as their laptop computer.
Care must be taken to ensure users are working with the most up-to-date version
of the mail server copy of their email account. Most email applications either
automatically refresh the local contents of the mailbox or alternatively have a

simple “refresh email” or “send/receive” button that can be used to refresh the
mailbox.
Sending emails
Sending an email typically involves:
 Click on the New button to open a new blank email
 Enter a valid email address
 Enter a subject
 Write your message in the main body of the email
 Spell-check for typing errors
 Click Send
4. Send
1. Enter a valid
email address
2. Enter a
subject
3. Write your
message
Receiving, replying and forwarding emails

Emails are delivered to your inbox. Any unread emails are either highlighted or
appear in bold.
To open and read an email click somewhere on the email, for example the
subject line.
Once an email is open you will see a number of further options such as:
 Close – this will save your email for future reference.
 Reply - to reply to the sender. The subject line is retained but prefixed with
the letters “Re:” to show this is a reply to a previous message.
 Reply all - to reply to everyone that received the email. Again the subject
line will be prefixed with the letters “Re:”.
 Forward – very similar to reply except that the recipient address is left blank
for you to send the message on to a new recipient. The subject line will be
prefixed with the letters “Fwd.:”.
 Delete
Note that some systems also include ‘spam filters’ which quarantine what appear
to be unwanted spam emails. You should check the quarantine periodically as
spam filters can make mistakes and segregate legitimate emails.

Attachments
A basic email comprises a message made up of text. However, when sending
emails you can add attachments such as photos, documents (e.g. Word files,
Excel files, pdf documents), videos and photos.
To send an attachment with your email:
 Compose the basic email as described above
 Click the attach button (or equivalent, such as attach file)
 This will typically open a Windows Explorer dialog box. Locate the file you
wish to attach then click attach/ok.
 Click send
Using folders
Most email systems support the use of folders to help you manage and file your
emails. The concept is similar to Windows Explorer which allows you to move,
delete and arrange your computer files in a logical fashion.
The email system will normally include some standard folders such as:
 Inbox
 Sent
 Junk
 Deleted
 Drafts
 You can then add personalised folders such as:
 Client matters
 Suppliers
 IT issues
 Corporate communications
 Urgent
 Personal items
3.2 Benefits and limitations of email

Benefits of email
Benefits of using emails include:
 An audit trail of messages is automatically retained (and can be for long
periods). This can be invaluable in disputes or simply to check the details of
an email conversation or client order.
 The sending and receiving of emails is virtually instantaneous anywhere in
the world. This enables managers to communicate with colleagues and
companies to communicate with clients or suppliers incredibly quickly.
 Recipients can access emails anywhere and anytime at their convenience.
 Traditional and expensive mailshots to multiple recipients can be replaced
by significantly quicker and cheaper multi-recipient email communications
achieving much greater penetration. For example when a large global

organisation needs to communicate a corporate message to 100,000

employees it can do so in a matter of minutes..
 Easy to use and organize daily correspondence.
 Low cost.
 Good for the environment – doesn’t use paper (unless the email is printed
out).
Limitations of email
Common limitations of email include:
 Can be an inefficient way of reaching a decision where a telephone call or
meeting might better facilitate the immediate exchange of views and
reaching a consensus.
 Can be seen as an insensitive way of sharing bad-news and personal
messages when a ‘human touch’ would be more appropriate.
 Poorly constructed messages might be misinterpreted by the recipient.
 An absence of non-verbal communication such as body language can also
lead to misinterpretation of an email.
 Electronic signatures may not be legally binding in some jurisdictions.
 Email overload! Given how easy it is to include multiple recipients on emails
there can be a tendency to include non-relevant recipients in emails. This
generates work for each non-relevant recipient to open the message, digest
the contents, conclude that it is not relevant to them, then either delete or
file the message.
 Spam! A variation on the previous point – this is where companies typically
advertising their products repeatedly send unwanted advertisement emails
that flood a user’s inbox.
 Emails may carry viruses which spread rapidly!).
3.3 When to use different channels of communication

When to use different channels of communication
To give some context to the previous section on benefits and limitations of email
the below table provides a comparison on the suitability of a number of common
channels of communication.
Channel Situations when most effective

Email - Retention of record of information is important.
- Information has to be conveyed quickly.
- Facilitate recipient to respond at a convenient time.
- Identical information has to be communicated to many
persons.

Channel Situations when most effective

Face-to-face - Interactive communication requiring prompt exchange of
conversation viewpoints.
- Exchange of persuasive, bad-news and personal
messages.
- Where non-verbal communication is important.
Letter - Authentic signatures of the sender are important.

- Formal communication with customers, external
organizations and officials.
Memo - Explanation of policies and procedures to employees.

- Dissemination of important information within an
organization.
Phone call - Conveying or obtaining quick information is important.

- Non-verbal cues are not important.
- Face to-face meetings are not convenient.
Video - Group interactions and consensus are important and

conference members are in different locations.
- Saves time and money.
3.4 Email etiquette

We have already seen how email is quick, efficient and inexpensive. However,
email can be susceptible to misinterpretation and isn’t always the most
appropriate channel of communication.
The guidance below provides some practical yet crucial advice for using emails in
the workplace:
 Think before you send
 Once sent an email can’t be unsent and becomes a permanent
written record with your name attached to it.
 Never send an email when upset or angry. You could draft an email
but then hold off sending it for at least a few hours. Ask yourself how
you would interpret the message if you were to receive the message
you’ve just written.
 If emailing multiple recipients ensure the communication is
appropriate to all.
 Hold off entering the recipient’s email address until you’ve finished
composing an email. This will ensure you don’t send an incomplete or
un-reviewed message prematurely.
 Email is unsecure and never private
 Emails can be forwarded or sent to the wrong recipients by mistake or
worse, hacked.

 Consider a personal meeting or phone call instead for communicating

particularly sensitive information.
 Be careful when forwarding or replying to all
 Review the content to make sure there’s nothing confidential that
should not be forwarded.
 Careful not to reply to all when you only mean to reply to the sender
 Take care with sarcasm and humour
 Body language and tone of voice are lost over email. Even emotion is
much more diluted than during face to face communication. Therefore
something that may appear funny through alternative channels of
communication can appear offensive in an email causing
misunderstandings and hurt feelings.
 Note too that crude jokes and insulting language is rarely welcome by
any recipient, however well you may know them.
 Use clear and standard grammar and punctuation
 Business emails sent from your corporate email address are
essentially letters without the ink and paper. Therefore observe the
usual rules of clarity, grammar and style as if you were writing a letter.
 Careful when capitalising words – it’s the equivalent of SHOUTING
and can offend if misused
 Avoid opening suspicious emails or attachments
 Suspicious emails or attachments may well contain at best, irritating
links to time-wasting Websites, and at worst viruses.
 If you are unfamiliar with the source of an unsolicited email and there
is a lack of business rationale to having received it there may well be
cause to be concerned and suspicious.
 Avoid sending overly large attachments unless absolutely necessary
 Remember that the recipient of your email may not enjoy the latest
high-speed internet connection. Therefore be considerate when
attaching large files as it may severely slow the performance of
recipients’ computer and indeed take many minutes (or even hours)
to download a single email.
 Furthermore, many email servers have firewalls (security devices)
that limit the maximum size of individual emails and the size of users’
inboxes.
 One tactic is to warn the recipient you plan to send a large
attachment beforehand.
 Keep it simple – avoid using overly intricate colours and fonts
 Using overly intricate colours and fonts tends to clutter an email and
detract from the core message.

4 VIDEO CONFERENCING
Section overview
 Features of video conferencing

 Benefits and limitations of video conferencing
4.1 Features of video conferencing

What is video conferencing?
Video conferencing is a system used by people in different physical locations to
hold a meeting (called a virtual meeting). Simple videophone calls are aimed at
enhancing a phone call between two individuals with video imaging. However, full
video conferencing aims to serve multiple locations with greater flexibility and
functionality.
For example, the sales team of an international company which has operations in
London, Hong Kong and Karachi wants to hold a meeting to discuss sales
strategy.
One option is for the delegates from say London and Hong Kong to board a
plane and meet the rest of the team in Karachi. However, this would be
expensive as it would require flights, accommodation and other expenses to be
incurred.
An alternative option is to set up a video conference. This might involve the
teams in the three locations sitting in meeting rooms that have a camera,
microphone and speakers providing a live link directly to the meeting room in the
other location.
Why is video conferencing becoming so popular in commercial organisations?
 A number of factors have contributed to the rapid increase in demand for
video conferencing in businesses over recent years including:
 Improved lower-cost technology with greater bandwidth
 Wider variety of video conferencing tools available associated with
increasingly more powerful PCs
 Environmentally friendly IT initiatives such as reduced air travel
 High travel costs combined with austerity related cost saving initiatives
 Such is the success of video conferencing some companies even use video
conferencing for intra-business as well as inter-business communications.
Types of video conferencing
At its simplest, video conferencing will provide the transmission of static images
and text between two locations. However, at its most sophisticated, video
conferencing provides the transmission of video images (full-motion) and high-
quality audio between multiple locations.
Another variable is the number of people (or connections) that can be supported
in each meeting. Commercial video conferencing companies offer a range of
options supporting different number of log-ins, quality and speed of transmission.
Some will even allow you to record a meeting.

Equipment
Participants only require minimal equipment including:
 Video input: camera or webcam
 Video output: computer monitor, projector or television
 Audio input: Microphone
 Audio output: loudspeakers or headphones
 Data transfer: Internet or other communications connection (preferably high
speed) such as a digital telephone network or LAN (local area network).
 Computer with video conferencing software including video and audio
compression and decompression
 Video conferencing systems broadly fall into two categories:
 Dedicated systems: All the necessary components are packaged into a
single piece of equipment – typically a console with high quality remote
controlled video camera.
 Desktop systems: These are add-ons to regular PCs which transform them
into videoconferencing devices.
4.2 Benefits and limitations of video conferencing

Benefits
Benefits of video conferencing can be summarised as follows:
 Next best option when face-to-face meeting are not possible: Cost-effective
solution where a live conversation is needed and non-verbal (i.e. visual)
information is an important component of the conversation but a face-to-
face meeting is not possible
 Reduced travel costs
 Increased productivity across dispersed workforces and teams – video
conferencing helps ensure delegates capture the up to 80 per cent of
communication consisting of non-verbal visual cues
 Short-notice meetings: Enables individuals in distant locations to participate
in meetings at short notice.
 No need to leave the desk: Technology such as VoIP can be used in
conjunction with desktop video conferencing to enable low-cost face-to-face
business meetings without leaving the desk.
 Telecommuting: Greatly assists the facilitation of telecommuting (home
working) enabling businesses to embrace diversity of workforce and flexible
working. This helps improve work-life balance, particularly with the
reduction in lengthy commutes.
 Hiring and retention: Improved hiring and retention of top talent by
extending the geographical scope of the early recruitment phase.
 Competitive advantage: Sustained competitive advantage from:
 improved sharing of knowledge
 faster and more informed decisions that reduce time to market for
new products and services
 improved relationships with suppliers and customers

 good public relations through promoting video conferencing as proof

of environmental initiatives
Limitations
Limitations of video conferencing can include:
 Eye contact: Camera positioning and interaction are highly important yet
frequently overlooked. Video conferencing can often give the incorrect
impression that the remote participant is avoiding eye contact when in fact
they are not.
 Appearance consciousness: This describes the psychological problem
where delegates change their behaviour or feel uncomfortable because
they are on camera. The problem may well be exacerbated if the session is
recorded. There has been some research performed that suggests that
communication is in fact impaired by the addition of camera.
 Technology: The video conference experience is entirely reliant on stable
technology and communications links with large bandwidth. Unexpected
variations in signal quality or technology issues can destroy the video
conference unexpectedly.
 Limited non-commercial take-up: Mass adoption and use of video
conferencing in non-commercial environments remains relatively low due to
the perceived complexity of systems, lack of common technology
standards, highly variable bandwidth and quality of service in different
countries and relative expense of commercial systems.
 Anxiety: The stress and anxiety present in some participants due to
appearing on camera can have a negative impact on their health and social
wellbeing.

5 CHAPTER REVIEW
Chapter review
Check that you now know how to:

 Explain the fundamentals of computer networks and system architectures
 Define the terms LAN and WAN
 Briefly describe the basics of protocols including the OSI reference model, WAP,
packet switching, URL, HTTP, HTML, XML and XBRL,
 Describe different types of web hosting services and the underlying building
blocks of the internet needed to support web hosting
 Give further context to web hosting by explaining key considerations when
selecting a web host
 State the main features of email
 Explain the benefits and limitations of email
 Describe when to use different channels of communication
 Advise the basics of email etiquette
 Describe the main features of video conferencing
 Explain the benefits and limitations of video conferencing


Foundation level
CHAPTER
17
Data management
Contents
1 Data processing methods
2 Principles of Database Management Systems (DBMS)
3 Physical and logical database design
4 Data warehousing
5 Data mining
6 Chapter review

Purpose
Competencies
3(f) Identify and explain the data processing methods that aid in generation of
Management information such as:
i. Batch processing
ii. Online processing
iii. Real-time processing
iv. Distributed processing
v. Multi-tasking - multi-processing
3(h) Information Technology Architecture - Explain, describe or discuss how IT
ii. Transaction processing in business systems
v. Protocols, standards and enabling technologies
vi. Data organization and access methods
Exam context
Information systems are the source of the financial statements on which an auditor
expresses an opinion. Information systems also provide information for day-to-day running of
an organisation as well as for medium and long-term strategic planning.
Given the importance and relevance of information systems to both the external auditor and
management it is important for students to understand how data and information is
processed, stored and organized.
 Explain and differentiate between the different methods of data processing methods
including transaction, batch, online, real-time, distributed, multi-tasking and multi-
processing.
 Discuss the principles of database management systems
 Define data integrity, independence and integration
 Describe physical and logical database design including relational databases
 Explain the concept and mechanics of data warehousing including data marts, staging,
cleansing and on-line analytic processing (OLAP)
 Summarise the concept of data mining and explain how it is applied in business

Chapter 17: Data management
1 DATA PROCESSING METHODS
Section overview
 Transaction processing
 Batch processing
 Online processing
 Real time processing
 Distributed processing
 Multi-programming, multi-tasking and multi-processing
1.1 Transaction processing

In this section we look at the various elements of transaction processing systems
including:
 Data entry (capture) and transmission
 Data processing methods
 Master file updates
 Storage and back-ups
 Accounting, control, management and reporting
 Query
 Errors
Data entry (capture)
Definition: Data entry

Data entry describes any of the techniques used to initially record data into a
system.
Some examples of raw data that might be entered into a system include:
 Sales information
 Purchase information
 New employee details
 Updates to existing employee details
Data could be entered manually by a person keying the information in. Some
systems are more advanced and support technology-based data entry such as
optical character recognition or magnetic ink character recognition.
Data transmission
Data transmission is the physical transfer of data over a point-to-point or point-to-
multi-points communication channel. Examples of such channels are copper
wires, optical fibres, wireless communication channels, and storage media. The
data is often represented as an electro-magnetic signal, such an electrical
voltage signal, a radio wave or microwave signal or an infra-red signal.
Data transmitted may be:

 A digital bit stream originating from a data source, for example a computer
or a keyboard; or
 An analogue signal such as a phone call or a video signal, converted or
digitised into a bit-stream for example using pulse-code modulation (PCM)
or more advanced source coding (data compression) schemes. This source
coding and decoding is carried out by coded equipment.
Data processing methods
During data entry, some application software provides file/data look-ups on some
key fields or data item. This is usually a pop-up menu that displays, either
automatically or by tapping a key, of a list of options a user must select from. This
serves to control and maintain a uniform data for that particular data item which
eventually support query of data for ad hoc information request.
Example of this is where a data entry in a transaction processing demands
capturing customers' state of origin, it might be necessary for a list of states
available to pop-up so that data entry operator can look it up and make a
selection instead of having to type it every time. This helps to reduce entry time
and promote data consistency.
In entering or capturing data, some data items are compared logically with a
predefined data value as a control to ensure an entry fall within a predefined
range. If the entered value falls below or above the range, an error message may
be displayed to alert the data entry operator so as to make the necessary
correction.
Master file updates
Master file update is the process of changing the contents of a master file with
new transaction entries. This update is usually done at a predefined frequency
depending on the type of transactions involved or could be determined by the
frequency of information request that depends on the master file. The frequency
of master file update is usually part of the operational procedure in any
transaction processing system.
Usually, there are several types of files involved in a typical data processing
system. There is the transaction file which stores day-to-day transaction entries
like daily sales entries. Secondly, there could be intermediate files and then
thirdly the master files. The intermediate and master files must be updated with
the summarised data from the transaction file at a predefined interval for
information consistency.
Storage
As you saw in the previous chapter, computers store data in a number of storage
media such as:
 Magnetic tape
 Hard disk
 Optical disc (or compact disk – CD)
 Solid state storage (e.g. USB flash drive)
 Remote backup service

Backup
Definition: Backup
A backup refers to making copies of data so that these additional copies may be
used to restore the original after a data loss event. These additional copies are
typically called "backups."
Backups are useful primarily for two purposes:
 To restore a state following a disaster (called disaster recovery).
 To restore small numbers of files after they have been accidentally deleted
or corrupted.
Backups are typically the last line of defence against data loss, and consequently
the least granular and the least convenient to use.
Since a backup system contains at least one copy of all data worth saving, the
data storage requirements are considerable. Organising this storage space and
managing the backup process is a complicated undertaking which must be
planned as an integral part of an information control or security management
process.
A number of backup procedures exist, including:
 Snapshot backup: A snapshot is an instantaneous function of some
storage systems that presents a copy of the file system as if it was frozen in
a specific point in time, often by a copy-or-write mechanism. An effective
way to back up live data is to temporarily freeze it (e.g. close all files), take
a snapshot, and then resume live operations. At this point the snapshot can
be backed up through normal methods.
 Open file backup: Many backup software packages feature the ability to
handle open files in backup operations. Some simply check for openness
and try again later.
 Cold database backup: During a cold backup, a database is closed or
locked and not available to users. The data files do not change during the
backup process so the database is in a consistent state when it is returned
to normal operation.
 Hot database backup: Some database management systems offer a
means to generate a backup image of the database while it is online and
usable ("hot"). This usually includes a consistent image of the data files
plus a log of changes made while the procedure is running. Upon a restore,
the changes in the log files are reapplied to bring the database in sync.
Accounting, control, management and reporting
To minimise errors, disaster, computer crime and breaches of security, special
policies and procedures must be incorporated into the design, implementation
and continual usage of information system. The combination of manual and
automated measures that safeguard information system and ensure performance
according to management standards is termed controls.
Controls consist of all the methods, policies and organisational procedures that
ensure the safety of the organisation's assets, the accuracy and reliability of its
accounting records and operational adherence to management standards.
Organisations are so critically dependent on information systems that
vulnerabilities and control issues must be identified as early as possible. The
control of an information system must be an integral part of its design. Users and

builders of systems must pay close attention to control throughout the system's
life span.
Computer systems are controlled by a combination of general controls and
application controls:
 General controls are those that control the design, security, and use of
computer programs and the security of data files in general throughout the
organisation. On the whole, general controls apply to all computerised
applications and consist of a combination of system software and manual
procedures that create an overall control environment
 Application controls are application specific – for example pre-checking the
creditworthiness of customers in the sales system.
Query
A query is a database management system feature that supports the extraction
of information from a database through a structured language called Structured
Query Language, or SQL. This language contains commands that permit end
users and programming specialists to extract data from the database to satisfy
information requests and develop applications.
Example: SQL
SELECT fname, lname, empID,DOB
FROM employees WHERE empID = 35284
Errors
In capturing data, error detection and correction has great practical importance in
maintaining data (information) integrity across storage media.
Definition: Error detection

Error detection is the ability to recognise the presence of errors caused by noise
or other impairments during transmission from the transmitter to the receiver.
Definition; Error correction

Error correction is the additional ability to reconstruct the original, error-free data.
There are two basic ways to design the channel code and protocol for an error
correcting system:
 Automatic repeat-request (ARQ) - the transmitter sends the data and also
an error detection code, which the receiver uses to check for errors, and
requests retransmission of erroneous data.
 Forward error correction (FEC) - the transmitter encodes the data with an
error-correcting code (ECC) and sends the coded message. The receiver
never sends any messages back to the transmitter. The receiver decodes
what it receives as the "most likely" data. The codes are designed so that it
would take an "unreasonable" amount of distortions to trick the receiver into
misinterpreting the data.
It is possible to combine the two, so that minor errors are corrected without
retransmission, and major errors are detected and a retransmission requested.
The combination is called hybrid automatic repeat-request.

Error detection
Several mechanisms exist to achieve error detection, and generally they are
quite simple. All error detection codes (which include all error-detection and
correction codes) transmit more bits than were in the original data.
Most codes are "systematic": the transmitter sends a fixed number of original
data bits, followed by fixed number of check bits (usually referred to as
redundancy) which are derived from the data bits by some deterministic
algorithm. The receiver applies the same algorithm to the received data bits and
compares its output to the received check bits; if the values do not match, an
error has occurred at some point during the transmission.
The main error detection algorithms include:
 Repetition schemes: Given a stream of data that is to be sent, the data is
broken up into blocks of bits, and in sending, each block is sent some
predetermined number of times. However, this scheme is not very efficient,
and can be susceptible to problems if the error occurs in exactly the same
place for each block.
 Parity schemes: A parity bit is an error detection mechanism that is limited
in that it can only detect an odd number of errors. The stream of data is
broken up into blocks of bits, and the number of 1 bits is counted. Then, a
"parity bit" is set (or cleared) if the number of one bits is odd (or even).
 Checksum: A checksum of a message is an arithmetic sum of message
code words of a certain word length, for example byte values, and their
carry value. The sum is negated by means of ones-complement, (1's) and
stored or transferred as an extra code word extending the message.
On the receiver side, a new checksum may be calculated from the
extended message. If the new checksum is not 0, an error has been
detected.
 Cyclic redundancy checks: More complex error detection (and correction)
methods make use of the properties of finite fields and polynomials over
such fields. The cyclic redundancy check considers a block of data as the
coefficients to a polynomial and then divides by a fixed, predetermined
polynomial. The coefficients of the result of the division is taken as the
redundant data bits, the CRC.
Other error detection algorithms include:
 Hamming distance based checks
 Horizontal and vertical redundancy check
 Polarity schemes
Error correction
 Automatic repeat request (ARQ): (ARQ) is an error control method for
data transmission which makes use of error detection codes,
acknowledgment (and/or negative acknowledgement) messages and
timeouts to achieve reliable data transmission. An acknowledgment is a
message sent by the receiver to the transmitter to indicate that it has
correctly received a data frame.
If the transmitter does not receive the acknowledgment within a specified
period of time it retransmits the frame until it is either correctly received or
the error persists beyond a predetermined number of retransmissions.

 An error-correcting code (ECC) or forward error correction (FEC) code

is a code in which each data signal conforms to specific rules of
construction such that departures from that construction in the received
signal can be automatically detected and corrected. Error-correcting codes
are used in computer data storage, for example in dynamic RAM, and in
data transmission.
The basic strategy is for the transmitter to apply one or more error detecting
codes; then the receiver uses the same codes to narrow down exactly
where in the message the error (if any) is located.
Other error correcting methods include:
 Repetition schemes
 Parity schemes
 Cyclic redundancy checks
 Hamming distance based checks
1.2 Batch processing
Definition: Batch processing

Batch processing is the collection of a group of similar transactions over a period
of time, and their processing at a single time as a whole.
This type of processing has been associated with mainframe centralised type
systems. The method has been reduced in importance with the development of
more advanced types of processing. It still remains an important form of
processing as many systems used now, are based on batch processed systems.
 Advantages
 Relatively easy to develop
 Less processing power is required as it deals with similar updates
 Checks in place as part of the systems run
 Less hardware required, therefore cheaper.
 Disadvantages
 Often delays between when a transaction is made and when the
master file is updated and the output generated.
 Management information is often incomplete due to out of date data.
 Often master files are kept off line therefore access may not always
be available.
1.3 Online processing
Definition: Online processing

Online processing refers to equipment that operates under the control of the
central computer but typically from a different location through some kind of
terminal.

Examples of online processing include:

 An ATM machine for a bank – the ATM is linked to the bank’s central
computer system and updates the user’s account immediately
 Flight booking system at a travel agency
If a service is no longer online (available) it is described as being offline. When a
system is offline its services are no longer available.
You may have experienced something similar when browsing the internet. For
example when you have a Wi-Fi connection your web-browser is considered to
be ‘online’ and will update. However, if there is no Wi-Fi signal and hence no
connection the browser is considered to be ‘offline’. In this case you will not be
able to download any new information to the computer.
1.4 Real time processing
Definition: Real time processing

Real time processing is the processing of individual transactions as they occur
without the need for batching them together.
This type of processing allows the user to update the master files immediately.
 Advantages
 Information is more up to date therefore providing better management
information.
 Increased ability for data to be online.
 Disadvantages
 Increase in expense as the system becomes more complex to run
and to develop.
 Increased hardware capacity which increases costs.
1.5 Distributed processing
Definition: Distributed processing

Distributed processing is the use of more than one processor to perform the
processing of an individual task. It also refers to any of a variety of computer
systems that use more than one computer, or processor, to run an application.
A distributed processing network is one where:
(a) There are two or more geographically separated networks
(b) These are linked by communication devices such as routers, modems.
(c) The network of computers serves a single organisation.
Distributed processing includes parallel processing, in which a single computer

uses more than one CPU to execute programs. More often, however, distributed
processing refers to local-area networks (LANs) designed so that a single
program can run simultaneously at various sites.
Most distributed processing systems contain sophisticated software that detects
idle CPUs on the network and parcels out programs to utilise them.

Another form of distributed processing involves distributed databases, databases

in which the data is stored across two or more computer systems especially over
a network. The database system keeps track of where the data is so that the
distributed nature of the database is not apparent to users.
A distributed database is a set of databases stored on multiple computers that
typically appears to applications as a single database. Consequently, an
application can simultaneously access and modify the data in several databases
in a network.
Advantages of distributed processing networks
 There is a greater flexibility as additional computers can be added to the
networks as needed.
 The organisation is not reliant on a single computer, which might break
down.
Disadvantages of distributed processing networks
 With several computers at dispersed sites, lack of standardisation of
equipment, software and data storage may occur
 Retaining control may be more difficult.
1.6 Multi-programming, multi-tasking and multi-processing

Multi-programming
Early computers ran one process at a time. While the process waited for
servicing by another device, especially peripheral devices, the CPU was idle. In
an Input/Output intensive process, where large data is being transmitted to and
from these Input/Output devices, the CPU could be idle most of the time.
Advancements in operating systems led to computers that load several
independent processes into memory and switch the CPU from one job to another
when the first becomes blocked while waiting for servicing by another device.
This is what is being referred to as multiprogramming. It reduces the idle time of
the CPU and helps to optimise the CPU capabilities by efficiently using the CPU
time.
Programs in a multi-programmed environment appear to run at the same time.
Processes running in a multi-programmed environment are called concurrent
processes. In actuality, the CPU processes one instruction at a time, but can
execute instructions from any active process.
Multitasking
In computing, multitasking is a method by which multiple tasks, also known as
processes, share common processing resources such as a CPU. In the case of a
computer with a single CPU, only one task is said to be running at any point in
time, meaning that the CPU is actively executing instructions for that task.
Multitasking solves the problem by scheduling which task may be the one
running at any given time, and when another waiting task gets a turn. The act of
reassigning a CPU from one task to another one is called a context switch. When
context switches occur frequently enough the illusion of parallelism is achieved.
On computers with more than one CPU (called multiprocessor machines),
multitasking allows many more tasks to be run than there are CPUs.

Example: multitasking
A sales representative could write a letter to prospective clients with a word
processing program while simultaneously using a database program to search for
all sales contacts in a particular city of geographic area.
Instead of terminating the session with the word processing program, returning to
the operating system, and then initiating a session with the database program,
multitasking allows the sales representative to display both programs on the
computer screen and work with them at the same time.
Operating systems may adopt one of many different scheduling strategies, which
generally fall into the following categories:
 In multiprogramming systems, the running task keeps running until it
performs an operation that requires waiting for an external event (e.g.
reading from a tape) or until the computer's scheduler forcibly swaps the
running task out of the CPU. Multiprogramming systems are designed to
maximise CPU usage.
 In time-sharing systems, the running task is required to relinquish the CPU,
either voluntarily or by an external event such as a hardware interrupt. Time
sharing systems are designed to allow several programs to execute
apparently simultaneously.
 In real-time systems, some waiting tasks are guaranteed to be given the
CPU when an external event occurs. Real time systems are designed to
control mechanical devices such as industrial robots, which require timely
processing.
The term time-sharing is no longer commonly used, having been replaced by
simply multitasking.
Multi-processing
Multi-processing is the use of two or more central processing units (CPUs) within
a single computer system. The term also refers to the ability of a system to
support more than one processor and/or the ability to allocate tasks between
them.
There are many variations on this basic theme, and the definition of
multiprocessing can vary with context, mostly as a function of how CPUs are
defined (e.g. multiple chips in one package, multiple packages in one system
unit, etc.).
Summary
Multiprocessing sometimes refers to the execution of multiple concurrent
software processes in a system as opposed to a single process at any one
instant. However, the terms multitasking or multiprogramming are more
appropriate to describe this concept, which is implemented mostly in software,
whereas multiprocessing is more appropriate to describe the use of multiple
CPUs. A system can be both multiprocessing and multiprogramming, only one of
the two, or neither of the two.

2 PRINCIPLES OF DATABASE MANAGEMENT SYSTEMS (DBMS)
Section overview
 Files and databases

 Definitions of a database
 Database management systems (DBMS)
 Integrity of data
 Independence of data
 Integration of data
 Advantages and disadvantages of database systems
2.1 Files and databases

In a ‘traditional’ transaction processing system, separate systems were
developed for major processing applications. For example, a sales order system
would be developed to process sales orders, a sales ledger system would be
developed to prepare invoices and record receipts from customers, a separate
inventory control system would be developed to manage inventory and record
inventory levels, and so on.
Each separate system had its own master files and master file records. For
example, a payroll system would have its own master file for employees on the
payroll, and the separate human relations personnel records system would have
its own master file with employee details. If a new employee joined the company,
a separate record for the employee would have to be added to each master file in
each system, as two separate processes.
Similarly, a sales order system would have master files containing customer
records, and the sales ledger system would have a separate master file
containing records for credit customers. There would be extensive duplication of
data on the two master files, but each would be operated and updated
independently.
The main weaknesses of traditional transaction processing systems
Traditional transaction processing systems, each with their separate master files,
had some obvious weaknesses.
 The master files of different systems often contained the same or similar
data. However, each master file had to be updated separately. This is
inefficient, because it involves a duplication of work.
 When the master files of two different systems ought to contain duplicate
data, there is a probability that there will be some differences. There are
several reasons why master file data might differ between two systems,
even when they should be exactly the same. E.g.
 There might be input errors in one system but not the other.
 There might be differences in the address or contact details of
customers or suppliers between two different systems.
 One system might be updated more quickly than the other.

 Separate transaction processing systems cannot ‘talk’ to each other (unless

special arrangements exist for electronic data interchange or EDI). This
means that output from one system cannot be fed automatically into
another system for further processing.
 It is difficult to obtain information that is held in different computer systems,
on separate master files. Information would be much easier to access if it
were all held in the same files.
Databases were designed to overcome these problems.
2.2 Definitions of a database

There are many different definitions of a database. Most definitions assume that
a database is computerized, but the term can also be applied to paper-based
files. Several definitions are listed here.
Definition: Database
 A database is ‘a collection of information that has been systematically
organised for easy access and analysis’ or ‘a collection of data that is
organised so that its contents can easily be accessed, managed and
updated’.
 A database is ‘a collection of data organised so that various programs…
can access the information.’
 A database is ‘a collection of… data stored in one or more computerised
files in a manner that can be accessed by users or computer programs via
a database management system’ or ‘a collection of electronic records
having a standardised format using specific software for computer
access.’
There are several points to note about these definitions.

 A database improves access to data, and provides a common set of data
files for all users of the system.
 The data in a database can be accessed for use by many different users
and programs. A database can be used by application programs, as well as
for extracting information.
 The data in a database has to be organised and in a standard format.
 A computerised database is accessed and controlled by special software, a
database management system.
 A database may be held on the same computer file, but a database may
also be distributed between several computers in a network.
2.3 Database management systems (DBMS)

A database management system (DBMS) is the software that manages a
database, dealing with all aspects of access to data, file maintenance and data
security. An organisation may employ a database administrator, with
responsibility for administering and managing the database and the DBMS.
The facilities provided by a DBMS include:
 The ability to add new records, and amend or delete existing data on the
database

 The ability to retrieve data for processing or information to help with

decision-making
 The ability to update the database without requiring modifications to any
applications programs
 The ability to present data on the database in different combinations and in
different forms
 The ability to control access to parts of the database, though the use of
passwords.
A database management system provides for the:
 Integrity
 Independence and
 Integration of data.
2.4 Integrity of data

The ‘integrity’ of data refers to the way in which the data is kept, and:
 The security of the data against unauthorised access
 Making sure that there is an effective system for restricting access to some
parts of the database to authorised individuals
 Making sure that the data is accurate and up-to-date (for example by
means of extensive data validation checks in the software on insertions and
amendments to data)
 Procedures for updating the data or maintenance of the data (insertions,
amendments, deletions)
 Restricting the authority to insert, amend or delete data to approved
individuals.
The database administrator is responsible for making sure that data is accurate,
and for monitoring access rights to the system and the database.
2.5 Independence of data

A key feature of database systems is that the data on the database is
independent of the applications programs that use the data.
 A change to the data in the database does not mean that there must be
amendments to the application programs that use the data.
 Similarly if a change is made to an applications program that uses a
database, there is no requirement to amend the database.
The independence of data in a database from the applications programs is
achieved by using ‘schemas’. An application program makes a request to the
DBMS (in a ‘sub-schema’) for data that it needs. The DBMS maps this data
requirement on to a physical data record, which the application program then
uses.

2.6 Integration of data

A key objective of database systems is data integration. The aim of data
integration is that data should be stored and maintained in a single file location
within the organisation.
 If six different IT applications need the same or similar data, they should all
use the same data record. Each IT application system should not have its
own, separate data files.
 When data is held in a single location, for use by all IT applications, there is
no risk that the data used by each application may be different (due to
discrepancies between the data files of the different systems).
 Integration also avoids the duplication of data on different system files. (It
avoids ‘data redundancy’). Data has to be entered into the system once,
and once only. In contrast, if six systems each have their own data files,
holding the same or similar data items, new data would have to be entered
six times, once into each of the separate systems.
Data in a database is referred to as ‘shared data’ or ‘corporate data’.
2.7 Advantages and disadvantages of database systems

The advantages and disadvantages of database systems are set out in the
following table.
Advantages Disadvantages
 Independence of data: the data  Integrity of data. It is extremely
is available for all users in the important that the data in a
organisation, and is available for database should be reliable, and so
different uses. Data is not just for sufficiently accurate. Ensuring the
individual departments or integrity of the data may be a
applications. difficult task.
 Integration of data: data only  The initial development costs for a
needs to be input once. There is database may be high. However,
no duplication of data in different standard software is available for
systems. Because it is only input creating simple databases.
once, there is consistency of  For both hierarchical and network
data and information throughout databases (explained later), access
the organisation. paths through the files must be
 A database is available for new specified in advance. They are
uses and applications. The much less flexible than relational
database is therefore a valuable databases.
resource for the organisation.
 A relational database (explained
later) can be very flexible,
allowing data to be accessed
and extracted in many different
ways and forms.

3 PHYSICAL AND LOGICAL DATABASE DESIGN
Section overview
 Organising data in a database

 Physical design
 Logical design
 Relationship database model
3.1 Organising data in a database

There are two ways in which data must be organised in a database:
 Data must be physically organised, and held in locations in the physical file
space
 Data must also be logically organised, to that it can be accessed by
software.
The physical organisation of a database and its logical organisation are separate
matters.
3.2 Physical design

The physical design of data is the way in which data is physically held in the
storage media for the database and, where this data is ‘physically’ located.
The physical design of data in a database is a separate matter from the logical
design of data. This enables the data in a database to be independent of the
application systems that use it.
3.3 Logical design

The logical design of data is concerned with the relationships between items in
the database, from the point of view of the user of the database. The designer of
the database defines these relationships in a way that the user is able to
understand, and that meets the user’s requirements.
The logical design of a database is based on one of three models:
 A hierarchical database model
 A network database model
 A relational database model.
The modern trend is towards relational databases given their ability to handle
large data volumes and complex relationships. Relational databases are
discussed in more detail below.
3.4 Relationship database model

A relationship database logical structure is used to construct more complex
databases, and can provide for a large number of many-to-many relationships.
The logical structure of data within a relational database is based on two-
dimensional tables, each with columns and rows.

 Each table contains records or entities. For example, there may be

different tables for customers, products, suppliers, sales invoices, and so
on.
 Each row of the table contains the attributes for an entity. For example, in a
table for suppliers, each row contains the attributes for a particular supplier.
 Each column of the table is an attribute. An attribute is a characteristic or
feature. For example, the attributes of a supplier may include supplier code,
name, address, telephone number, e-mail address and product code.
 Each entity (each row in the table) can be identified uniquely, usually by a
key code. For example, in a suppliers table, each supplier will be identified
uniquely by a supplier identification code number. (Sometimes, it may need
two or more attributes to identify an entity uniquely.)
 Data in one table can ‘point’ to data in another table, provided that there are
common attributes that exist in both tables. For example, a product code
may be an attribute in a suppliers table. This means that the product code
in the suppliers table would be able to point to a products table, provided
that the products table contains product code as an attribute.
 When data in different tables is linked, a user of the database is able to
access data from two or more tables with a single enquiry. Databases can
be used to extract information using enquiry ‘tools’ such as Structured
Query Language (SQL). As a result, the user can use a database to create
unique ‘data sets’ (records) for an application program, in a form that meets
the data requirements of the application program.

Illustration: relational database

In this simple illustration there are three tables:
 customer invoices
 customers
 inventory items.
Attributes in the invoices table point to the customer table and the inventory
table. This enables an application program to create a data set (record) for an
invoice, with invoice number and date, customer code, name and address, and
the product purchased, number of units purchased and the price per unit.
Relational database structure:

4 DATA WAREHOUSING
Section overview
 Definition of a data warehouse

 Features of a data warehouse
 Data marts
 Constructing a data warehouse: data staging and data cleansing
 Using a data warehouse
 On-line analytic processing (OLAP)
4.1 Definition of a data warehouse
Definition: data warehouse

A data warehouse is a large database, containing operational data from different
IT systems including legacy systems. Some of the data may therefore be five or
ten years old, or even older.
A data warehouse also has reporting and query tools, so that the data can be
analysed and information presented in report format.
A useful definition of a data warehouse is therefore: ‘Any centralised data
repository which can be queried for business benefit.’
A more extensive definition is given by The OR Society: ‘A data warehouse is a
central data repository containing stable, accurate, consistent, clearly-understood
data that are needed for management information and decision-making across
the whole organisation.’ (www.orsoc.org.uk)
4.2 Features of a data warehouse

The data in a data warehouse is normally extracted from several different IT
systems. These systems are likely to use different data structures and coding
systems. To create a data warehouse, all the data needs to be put into a
consistent framework. For example, one IT system might use the codes F and M
to indicate ‘female’ and ‘male’ whereas another system might use the codes ‘0’
and ‘1’ to mean the same thing. For a data warehouse, the same coding must be
used for all entries on the system, which means having to alter the codes in at
least one of the IT systems for input to the data warehouse.
Most data warehouses include a copy of data in the organisation’s operational IT
systems such as its purchasing, inventory control and sales systems. It is usual
to take copies of data from operational systems at regular intervals for transfer to
the data warehouse. In this way a historical record of operational data can be
built up over time in the data warehouse.
Note that the data warehouse contains a copy of operational data: this data is not
then used for operational purposes, only for data analysis.
A data warehouse may also contain external data, or additional data copied from
spreadsheets or other databases.

The key features of a data warehouse can be stated as follows:

 A data warehouse can be used to extract archived operational data and
integrate data throughout the organisation by removing inconsistencies
between data formats in different systems.
 Holding data from legacy systems makes it possible to analyse
operational data for the past five or ten years, or even longer. This can be
useful for trend analysis and forecasting.
 The data in a data warehouse is non-volatile. This means that once it has
been entered into the data warehouse, it is not updated or altered. It is
simply accessed for analysis.
 The organisation of data in a data warehouse is usually subject-oriented.
This means that the data is usually organised by subject rather than by
application or function. For example, the data warehouse of an insurance
company might organise its data by customer, premiums and claims. In
contrast, its operational IT systems might organise data by types of policy
(life policy, motor policy, and so on).
Data warehouses are usually constructed using relational databases.
4.3 Data marts
Definition: data mart

A data mart is a database of similar information that is used to store data for a
specific purpose, such as performance measurement or sales analysis.
A data mart is normally used by just one department or a small number of users
in the organisation. It is therefore designed and constructed to meet their specific
needs, producing reports and analyses for those users.
The content of a data mart is likely to be either:
 A part or sub-set of the data that would be held in a data warehouse, or
 The same data that would be held in a data warehouse, but in less detail.
A data mart is easier and quicker to build than a complete data warehouse for the
entire organisation. A company may therefore prefer to build several data marts
instead of a single data warehouse.
Alternatively, a central data warehouse can be used to provide the data for
several data marts. The users of each data mart can then adapt the data from the
data warehouse to their own specific requirements.
4.4 Constructing a data warehouse: data staging and data cleansing

The most difficult and time-consuming tasks in creating a data warehouse are:
 Extracting the data from different source IT systems
 Converting them into a consistent format for input to the data warehouse
and
 Checking the quality of the data.
These processes are referred to collectively as ‘data staging’.

A part of this process is data cleansing. Data cleansing involves removing some
details from the operational data records, such as low-level detail in transaction
records. Removing unnecessary and unwanted details:
 reduces the final size of the data warehouse, and also
 speeds up query times for users of the data warehouse.
Illustration: data warehouse
4.5 Using a data warehouse

Data warehouses can be used in a variety of ways for obtaining information.
 A data warehouse allows a large number of people within an organisation
to obtain regular reports, for example performance reports and other
management reports.
 On-line analytic processing (OLAP) can be used to carry out multi-
dimensional analysis of the data. This can provide extensive quantitative
analysis of data.
 Statistical analysis can be carried out on the data. The quality of the
statistical information can be high, because the user has access to a very
large volume and wide range of data on file.
 Data mining. Specialist software can be used to search the data on file for
useful hidden patterns and relationships that no one previously knew
existed.
4.6 On-line analytic processing (OLAP)

The term on-line analytic processing (OLAP) is used to distinguish between the
reporting requirements of reporting and analysis systems from the requirements
of transaction processing systems.
OLAP does not require a data warehouse, but it works best with data held in a
relational database, where every item of data is held in one place.
Software tools that are used for OLAP portray data as if it is held in a multi-
dimensional array, known as a cube. It is probably easiest to think of a multi-
dimensional array as having three dimensions, but in practice it can have more
than three.

Illustration: on-line analytic processing (OLAP)

A three-dimensional array can be shown as a cube, with each side of the cube
representing an item of data, such as year, sales region and product. Each cell in
the cube can be uniquely identified by specifying its value for each dimension, for
example 20X6, North Region, Product A sales.
OLAP: Multi-dimensional analysis
Each dimension can be organised into a hierarchy. For example, the dimension
of years can be analysed into months, and sales for each region can be analysed
further into sales for each area within each region. This allows the user to ‘drill
down’ to a lower level to obtain more detailed information.
OLAP makes it fairly easy to explore data in a data warehouse, and identify fairly
simple patterns and trends, such as:
 Which product has the fastest rate of annual sales growth in South Region?
 What was the biggest selling product last month in each region, and for the
company as a whole?
OLAP can be used to extract from a database or data warehouse:
 Standard ‘static’ reports: these have a fixed layout and fixed content
 Parameter reports: these have a fixed layout but the user can specify which
data to include (the parameters), usually through a series of screen
prompts, such as ‘Which year?’ ‘Which region?’ and so on.
Interactive reports: the user can start with a generic report, but then alter its
structure, layout and content. The user can be more selective and flexible
in the choice of data for analysis and how it is analysed.
More sophisticated users of a data warehouse (or database) can also make ‘ad
hoc’ or ‘one-off’ enquiries. However, the ability to make ad hoc enquiries depends
on the amount of data available on file and the capabilities of the software
reporting tools that are available.

5 DATA MINING
Section overview
 Definition of data mining

 Using data mining
 Results from data mining
 Applications of data mining
With the development of data warehouses, large volumes of data are made
accessible, but many of the methods for analysing all the data are fairly limited in
their scope. In most cases, the data user knows what information he or she
wants to obtain.
Data mining originated with the recognition that if the available data is analysed
in an appropriate manner, it should be possible to discover information that is
unexpected and not looked for. Suitable data analysis could unearth hidden
relationships that management had not previously been aware of.
Finding hidden relationships can help managers to make better decisions.
5.1 Definition of data mining

The term ‘data mining’ is very descriptive. Data mining involves digging down into
a database (data warehouse) looking for gold nuggets of valuable information.
Most of the search results on finding nothing, but occasionally a very valuable
and unexpected item of data is found. It is possible to ‘strike gold’ in unexpected
places.
Definition: data mining

Two definitions of data mining are as follows:
 Data mining is ‘the non-trivial extraction of implicit, previously unknown
and potentially useful information from data. This encompasses a
number of different technical approaches, such as clustering, data
summarisation, learning classification rules, finding dependency
networks, analysing changes and detecting anomalies.’ (Frawley,
Piatetsky-Shapiro and Matheus)
 Data mining is ‘a variety of techniques to identify nuggets of information
or decision-making knowledge in bodies of data, and extracting these in
such a way that they can be put to use in areas such as decision support,
prediction, forecasting and estimation. The data is often voluminous, but
as it stands of low value as no direct use can be made of it. It is the
hidden information in the data that is useful.’ (Clementine User Guide – a
data mining toolkit)
Data mining is therefore concerned with the analysis of data using software
techniques for finding patterns, regularities and similarities in sets of data.

5.2 Using data mining

Data mining can be applied to the data in a data warehouse, or to the data in a
smaller database (provided that the data is reconfigured into a common format
and cleansed).
There are two types of data mining ‘model’:
 A verification model
 A discovery model.
Verification model
A verification model takes a hypothesis from the data user and tests the validity
of the hypothesis against the data. The analysis of the data shows the extent to
which the hypothesis is correct (or incorrect).
Example: verification model

The marketing department of a company might be planning a direct mailing
campaign, but there is a limited budget for the campaign and the marketing
team want to target customers for a mail shot. They want to send out brochures
to customers who they think are most likely to respond. The marketing team
might therefore hypothesise about the characteristics of the customers they
expect to be most responsive to the mailing campaign.
A data mining analysis of previous customer purchases will show whether the
hypothesis is correct. The assumptions can be changed, and new hypotheses
checked, until a satisfactory mailing list is compiled.
The main problem with a verification model is that no new information is created
or discovered. The model simply provides information that confirms a hypothesis
or proves it wrong.
Discovery model
A discovery model is used to discover automatically information that is hidden in
the data, by looking for trends, patterns and regularities without any input or
interference from the data user. This is the type of model most usually associated
with data mining.
5.3 Results from data mining

The results that may be obtained from data mining can be grouped into five
categories or types:
 Associations
 Sequences
 Classification
 Clustering
 Forecasting.
Associations
An association is something that happens that can be linked statistically
(‘correlated’) to another event. Useful associations may be found in retailing,
where the purchase of one product may be closely linked to the purchase of
another item.

Example: Wal-Mart
A well-known example is the association that US stores group Wal-Mart
discovered between sales of beer and sales of baby nappies (diapers). This
surprising link was apparently caused by fathers stopping in at a store on the way
home from work, and buying both products. Wal-Mart experimented with putting
beer and nappies close together in their stores, with the result that sales of both
products went up.
Sequences
Sequences are events that are linked over time, so that when one event
happens, another (different) event is likely to occur at a time in the future. For
example, a link might be detected between a rise or fall in sales of running shoes
with a rise or fall, some months later, in sales of foot plasters and bandages.
Classification
Classification involves using data mining to identify a particular group
(classification) that displays the same sort of behaviour. Having identified a
classification, it might then be possible to predict how the individuals within that
group might behave in the future, perhaps in response to a targeted marketing
campaign.
Example: data mining - classification

It might be identified that individuals, both men and women, in their 30s, with an
income above a certain amount each year and who own a particular type of car
are likely to buy certain types of luxury goods on credit.
A retailer may predict how this classification of potential customers might
respond to the marketing of a luxury goods item (say a satellite navigation
system or a flat screen TV) linked to the offer of a discount if the item is bought
with the retailer’s own credit card.
A marketing campaign aimed at this classification of customers might invite
applications for the retailer’s credit card, with an introductory offer of low-price
navigation systems or flat screen TVs.
Clustering
Clustering is similar to classification, except that with clustering, there is no
attempt to establish identifiable classifications. Instead, clustering identifies
groups within the data warehouse that share the same characteristics. When a
cluster pattern has been identified, it might then be possible to establish a
classification.
Example: clustering
For example, if there is a data warehouse containing details about customers, the
characteristics investigated by data mining may include combinations of age, sex,
education, home address (post code), type of job, proximity to town centres or
major roads, the newspaper or magazines that they read, and so on.
By identifying clusters, it may be possible to identify behaviour patterns or trends
that can be exploited.
For example, data mining may discover that in a particular region of the country,
the average weekly consumption of car fuel (petrol) by female drivers between
the ages of 40 and 55 is 25% higher than the national average for car drivers as
a whole. This item of information might provide ideas for the marketing car-
related or driving-related products to women in that particular area.

Forecasting
Data mining can also be used to discover trends in historical data that had not
previously been identified. These trends may then be used to prepare forecasts
for the future.
Example: trends and forecasting

Data mining may show that the annual pattern of sales demand for lawn mowers
is changing, with a greater proportion of electric-powered mowers being sold, and
with the annual peak in sales happening a day or two earlier in each successive
year.
Identifying this trend would help manufacturers and retailers of lawn mowers to
switch more production and stock-holding to electric-powered motors, and to
have the products available in-store one or two days earlier than in the previous
year.
Identifying a trend of this sort may also help with decisions about the timing and
content of advertising and other marketing campaigns.
5.4 Applications of data mining

Some of the many possible uses of data mining are listed below.
Illustration: Data mining 1

Data mining can be used to:
 identify buying patterns from customers
 finding associations and similarities among the demographic patterns of
customers
 predicting a response to a mailing campaign.
Illustration: Data mining 2

 identify ‘loyal’ customers
 predict which customers are most likely to switch their credit card provider
 predict credit card spending by group of customer
 detect patterns of fraudulent credit card use
 predict which customers will renew their insurance policies.
Illustration: Health care and medicine

 identify behaviour patterns of individuals most at risk of certain illnesses or
infections
 identify the most successful therapies for different illnesses.
It is important to remember, however, that the value of data mining depends on
the quality of the data warehouse or database that is analysed. Patterns cannot
be identified if the data is missing from the database. For example, a
geographical analysis of customer behaviour patterns cannot be undertaken
unless the database includes postcodes.

6 CHAPTER REVIEW
Chapter review

 Explain and differentiate between the different methods of data processing
methods including transaction, batch, online, real-time, distributed, multi-tasking
and multi-processing.
 Discuss the principles of database management systems
 Define data integrity, independence and integration
 Describe physical and logical database design including relational databases
 Explain the concept and mechanics of data warehousing including data marts,
staging, cleansing and on-line analytic processing (OLAP)
 Summarise the concept of data mining and explain how it is applied in business


Foundation level
CHAPTER
18
Information systems - security
Contents
1 Information system security
2 Using core windows security features
3 Chapter review

Purpose
Competencies
3(d) Identify and explain the main risks to the reliability of data and information and
how these may be managed and controlled operationally and through
management of systems and technology including development of new
systems
3(i) Identify and explain the main risks to the reliability of data and information and
how these may be managed and controlled operationally and through
management of systems and technology including development of new
systems covering but not limited to:
i. Privacy Issues
ii. Secrecy issues
iii. Data transfer practices
iv. Use of USB and other removable devices
v. Virus and worms
vi. Access to social networking sites using company time and resources
3(k) Explain the impact of social media on organisations.
Exam context
Information system security is an important topic from both the auditor’s and client’s
perspectives. The auditor themselves stores their work in an information system which must
be kept confidential and secure in order to promote client trust and safeguard their work.
The auditor also needs to understand the client’s information system relevant to the audit in
order to conclude whether that information system is capable of producing a fairly presented
set of financial statements.
This chapter explains the various information systems threats that exist and also describes
the common safeguards available in countering those risks.
 Explain the threats to information systems faced by organisations in the modern business
environment
 Describe the options available to manage information system security risks
 Summarise techniques for protecting against physical disaster, fraud and theft, hacking,
computer viruses and other attacks
 Discuss internet and email user policies and WebTrust
 Explain the impact that social networking sites have on the workplace and summarise the
risks they pose
 Use core Windows security features such as screen-savers, computer locking,
passwords and log-on/off

Chapter 18: Information systems - security
1 INFORMATION SYSTEM SECURITY
Section overview
 Threats to system security

 The management of security risks
 Protection against physical disaster
 Protection against fraud and theft
 Protection against hacking
 Computer viruses and other attacks
 Internet and email user policies
 Use of USB sticks and other removable devices
 WebTrust
 Social networking sites in the workplace
1.1 Threats to system security

Privacy and secrecy
Definition: Privacy
Privacy is the ability of an individual or group to seclude themselves or
information about themselves and thereby reveal themselves selectively.
Definition: Secrecy
Secrecy involves norms about the control of information, whether limiting access
to it, destroying it, or prohibiting or shaping its creation.
Secrecy norms are embedded in role relationships and involve obligations and
rights to withhold information, whether reciprocal or singular.
The boundaries and content of what is considered private may differ between
different cultures and individuals, but they share basic common themes. Privacy
is sometimes related to anonymity, the wish to remain unnoticed or unidentified in
the public realm. When something is private to a person, it usually means there is
something within them that is considered inherently special or personally
sensitive.
Privacy and secrecy in business
The above description can be applied in business. Businesses have the right to
protect their assets (both tangible and intangible), processes, information and
trade secrets. They have the right to use them in a legal way in order to generate
profit from their enterprise.
One of the key assets within organisations is the information system and
associated contents. Information system security is therefore critical and the key
objectives are:
 Confidentiality - requires that the information in a computer system be
accessible for reading by authorised parties only. This type of access

includes printing, displaying, and other forms of disclosure, including simply

revealing the existence of an object.
 Integrity: requires that computer assets can be modified by authorised
parties only. Modification includes writing, changing, changing status,
deleting and creating.
 Availability: requires that computer system resources are available to
authorised parties as and when they are needed.
Security
Information system security incorporates the protection of computer systems and
the data that they store or access. Given the widespread use of computers, their
security is a critical priority in the modern world. Businesses must take computer
security seriously in order to enhance the confidence of stakeholders in order to
support critical business processes and protect business information.
Information systems need to be kept secure from errors, breakdown,
unauthorised access and corruption. Maintaining system security, even for small
home computers linked to the Internet, is a permanent problem and the risks
must be managed continually.
Some of the major risks are as follows:
 Human error. Individuals make mistakes. They may key incorrect data into
a system. In some cases, they may wipe out records, or even an entire file,
by mistake. Human error is also a common cause of lapses in system
security – leaving computer terminals unattended is just one example.
 Technical error. Technical errors in the computer hardware, the software
or the communications links can result in the loss or corruption of data.
 Natural disasters. Some computer systems may be exposed to risks of
natural disasters, such as damage from hurricanes, floods or earthquakes.
 Sabotage/criminal damage. Systems are also exposed to risk from
criminal damage, or simply theft. Risks from terrorist attack are well-
publicised. Losses from theft and malicious damage are much more
common.
 Deliberate corruption. All computer systems are exposed to risk from
viruses. Hackers may also gain entry to a system and deliberately alter or
delete software or data.
 The loss of key personnel with specialist knowledge about a system (for
example, the risk that a senior systems analyst will leave his job in the
middle of developing a complex new system)
 The exposure of system data to unauthorised users (for example
hackers) and industrial espionage.
Other risks include:
 Recorded keystrokes and stolen passwords
 Spam (unwanted) and phishing (attempts to illicit confidential information)
emails
 Harvesting and selling email addresses and passwords
 Accessing restricted, personal or client information
 Illegally distributing music, movies and software

 Infection of other systems

 Hiding programs that launch attacks on other computers
 Generating large volumes of data transfers, slowing down the entire system
The business impact of the above security violations could be severe and
include:
 Risk to security and integrity of personal or confidential information e.g.
identity theft, data corruption or destruction, unavailability of critical
information in an emergency
 Loss of valuable business information
 Loss of employee and public trust, embarrassment, adverse publicity,
media coverage and news reports
 Costly reporting requirements in the case of a compromise of certain types
of personal, financial and health information
 Internal disciplinary action(s) up to and including termination of
employment, as well as possible penalties, prosecution and the potential for
sanctions / lawsuits
1.2 The management of security risks

An organisation must take measures to eliminate or reduce information security
risks. A risk management process should be established which will involve:
 Identifying risks to system security
 Evaluating and prioritising the risks
 Developing controls to avoid the risk or control the risk within acceptable
limits
 Implementing the controls and monitoring their effectiveness.
An entity may use a risk register to keep a record of the risks it has identified and
the control measures that have been taken.
Risks to the system must be identified. The identified risks might be classified
into similar types of risk, such as human risks, technical risks, natural disaster
risks, unauthorised access risk, and so on).
Evaluation and prioritisation. Each risk should be measured or quantified.
Typically, each risk should be assessed according to:
 The probability that an adverse event or incident will occur risks, and
 The severity or size of the loss when an adverse event does occur.
The risks can then be assessed and prioritised, with a view to deciding how
serious they are, and what measures might be appropriate to deal with them.
Developing controls. Measures for managing the risk should be decided, for
each risk where some control action is considered necessary. Risk control
measures should be designed to:
 Avoid the risk entirely, or
 Reduce the probability that it will occur, or
 Reduce its impact if it does occur.
There are various methods of managing a risk:

 Risk avoidance. This means avoiding any chance that the risk might
occur. For example, the risk of illegal hacking into the system from the
Internet can be avoided if the system is not connected to the Internet. Risk
avoidance measures, however, are often fairly extreme, and involve
ceasing to carry on an activity. It is often therefore necessary to use
different risk control measures to reduce the risk rather than avoid it
entirely.
 Risk transfer. Risks can be transferred, so that someone else bears the
risk of any loss that may occur. For example, the risk of providing
inadequate physical security for a computer system can be transferred by
outsourcing the task of providing security to an external security services
firm. Risk transfer is also obtained through insurance: insurance should be
obtainable against risks from natural disasters, sabotage or criminal
damage and theft of hardware.
 Risk reduction: controls. Risks can be reduced by taking suitable control
measures. For example, the risk of losing important data is reduced by
backing up the files for a computer system every day and storing the back-
up copy off-site or in a secure fire-proof (and theft-proof) safe.
 Risk acceptance. This means doing nothing to avoid or reduce the risk.
This approach is recommended only for insignificant risks. Measures to
reduce risks should only be applied if the benefits from the control measure
exceed the cost of applying the control.
 Implement controls and monitor their effectiveness. Controls should be
reviewed regularly, to confirm that they are adequate. However, a breach of
security should prompt an immediate investigation into why the controls
failed. Weaknesses in the controls should be identified, and improved
controls devised and applied.
This risk management process should be a continual cycle, and repeated
continuously at regular intervals of time.
Physical and logical access controls
When designing a risk management system to deal with computer risk, it may be
useful to think of the controls in the systems as consisting of two levels or layers
of control:
 Physical controls and
 Logical controls.
The physical controls are the physical measures to protect the computer systems
such as:
 Putting locks on doors to computer rooms and keeping the rooms locked
when there are no authorised staff in the room.
 Putting bars on windows, and shatterproof glass in computer room
windows, to deter a break-in.
Logical controls are controls within the software such as passwords, encryption
software, and software firewalls. These are explained later.
1.3 Protection against physical disaster

Computer systems are vulnerable to physical disasters, such as fire and flooding.
Risk control measures might include:

 Locating hardware in places that are not at risk from flooding and away
from locations that are in low-lying areas
 Physical protection for cables (to provide protection against fire and floods)
 Back-up power generators, in the event of a loss of power supply
 Using shatter-proof glass for windows where the computer is located
 Installing smoke detectors, fire alarms and fire doors
 Regular fire drills, so that staff know what measures to take to protect data
and files in the event of a fire
 Obtaining insurance cover against losses in the event of a fire or flooding.
Note that in some organisations, risk measures have also been taken to counter
the risk to computer systems from terrorist attack, and ensure that the computer
system will continue to operate even if there is a damaging attack. For example,
two companies might agree to allow the other to use its mainframe systems to
operate key computer systems, in the event that one of them suffers the
destruction of its system in a terrorist attack.
1.4 Protection against fraud and theft

Computer systems are often at risk from fraud or theft. There are two approaches
to managing this risk:
 Risk prevention: designing controls for the system that reduce the likelihood
of the risk occurring, and
 Risk detection: identifying fraud or theft if and when it occurs.
The risk is greatest for systems that process financial data, such as accounting
systems and banking systems.
The risks come from:
 Unauthorised users of the system, including individuals who gain
unauthorised access to computer terminals in a secure area of a building
 Fraud by employees with access to a computer system.
Measures that can provide protection against fraud and theft include the
following:
 Internal controls. A large number of internal control measures should be
included within a system. For example, segregating duties or requiring
formal authorisation to amend the files win a system. There should also be
controls over physical access to the computer system, particularly
mainframes and servers (for example, by employing security guards and
CCTV, and locking rooms containing valuable equipment).
 Internal audit. Investigations by the internal auditors might be planned to
look for fraud and errors. The work of auditors and investigators is assisted
by the existence of an audit trail in the system.
 There should be controls to check system design. This might avoid the
risk that a dishonest systems analyst will include a fraudulent element in
the system design.
 There should be care in the recruitment, selection and training of staff
who use or operate computer systems.

 Digital certificates/signatures. These are now provided by e-commerce

organisations, to ensure the identity of the correct person entering a system
over the Internet.
Other measures to provide protection against fraud and theft, and also against
the more general risk of unauthorised access to data, include passwords and
encryption.
1.5 Protection against hacking
Definition: Computer hacking

Computer hacking is the accessing of a computer system without authorisation.
Various measures might help to protect against system hacking, or to detect

when a hacker has gained unauthorised access. However, the fight against
hacking is never-ending, and computer users must be alert at all times.
Controls to prevent or detect hacking include:
 Physical security measures to prevent unauthorised access to computer
terminals
 The use of passwords
 The encryption of data
 Audit trails, so that transactions can be traced through the system when
hacking is suspected
 Network logs, whereby network servers record attempts to gain access to
the system
 Firewalls.
We now take a look at some of these in more detail.
Passwords
A computer password is defined as ‘a sequence of characters that must be
presented to a computer system before it will allow access to the systems or
parts of a system’ (British Computer Society definition).
Typically, a computer user is given a prompt on the computer screen to enter his
password. Access to the computer system is only permitted if the user enters the
correct password.
Passwords can also be placed on individual computer files, as well as systems
and programs.
To gain access to a system, it may be necessary to input both a user name and a
password for the user name. For example, a manager wanting to access his e-
mails from a remote location may need to input both a user name and the
password for the user name.
However, password systems are not always as secure as they ought to be,
mainly due to human error. Problems of password systems include the following:
 Users might give their passwords to other individuals who are not
authorised to access the system.
 Users are often predictable in their choice of passwords, so that a hacker
might be able to guess, by trial and error, a password to gain entry to a
system or program or file. (Typically, users often select a password they

can remember, such as the name of their father or mother, or the month of
their birth).
 Passwords are often written down so that the user will not forget it. Copied
passwords might be seen, and used, by an unauthorised person.
 Passwords should be changed regularly, but often-poor password control
management means that passwords go unchanged for a long time.
Password controls
A system of password controls should operate more successfully if certain control
measures are taken.
 Passwords should be changed regularly frequently, and employees should
be continually reminded to change passwords.
 Users should be required to use passwords that are not easy to guess: for
example, an organisation might require its employees to use passwords
that are at least 8 digits and include a mixture of letters and numbers.
 A security culture should be developed within the organisation, so that the
user’s staff are aware of the security risks and take suitable precautions.
Encryption
Encryption involves the coding of data into a form that is not understandable to
the casual reader. Data can be encrypted (converted into a coded language)
using an encryption key in the software.
A hacker into a system holding data in encrypted form would not be able to read
the data, and would not be able to convert it back into a readable form (‘decrypt
the data’) without a special decryption key.
Encryption is more commonly used to protect data that is being communicated
across a network. It provides a protection against the risk that a hacker might
intercept and read the message. Encryption involves converting data into a
coded form for transmission with an encryption key in the software, and de-
coding at the other end with another key. Anyone hacking into the data
transmission will be unable to make sense of any data that is encrypted.
A widely-used example of encryption is for sending an individual’s bank details
via the Internet. An individual buying goods or services from a supplier’s web site
may be required to submit credit card details. The on-line shopping system
should provide for the encryption of the sender’s details (using a ‘public key’ in
the software for the encryption of the message) and the decryption of the
message at the seller’s end (using a ‘private key’ for the decryption).
Firewalls
Firewalls are either software or a hardware device (between the user’s computer
and modem). Computer users might have both.
The purpose of a firewall is to detect and prevent any attempt to gain
unauthorised entry through the Internet into a user’s computer or Intranet system.
A firewall:
 Will block suspicious messages from the Internet, and prevent them from
entering the user’s computer, and
 May provide an on-screen report to the user whenever it has blocked a
message, so that the user is aware of the existence of the messages.

In spite of the preventive measures that are taken, there is a very high risk that
computers attached to the Internet will suffer from unauthorised access. An
organisation would be well advised to carry out regular tests on its computers, to
search for items that have been introduced without authority and illegally, and to
get rid of them.
Firewalls can be purchased from suppliers. Some software is provided with in-
built firewall software. Some firewall software can be downloaded free of charge
from the Internet. There is no excuse for a computer user with Internet access
not to have a firewall.
Firewalls are necessary for computers with Internet access because:
 They are continually exposed to corrupt messages and unauthorised
access for as long as they are connected to the Internet (which may be 24
hours a day) and
 The volume of ‘suspicious’ messages circulating the Internet is immense.
Logging of user-data
Many firms and systems have the ability to log information about users. On the
one hand whilst this can help firms monitor their staff’s work and adherence to
internet and email policies it can sometimes be argued that it causes resentment,
suspicion and a general lack of trust.
However, in today’s increasingly litigious society firms are increasingly duty
bound to ensure they are doing everything possible to monitor and control their
staff through maintaining a tight audit trail (a record of past activity). This could be
referred to in a legal defence (e.g. disputing the terms of a client order) or might
be useful in diagnostics (e.g. a flight recorder).
Illustration: logging of user-data

Logs are typically either event-oriented or keystroke recorders. Examples of
important information that could be recorded in a typical office environment
whilst a user is logged-in include:
Internet sites visited
Log-in and log-out times (to calculate hours worked)
Emails sent and received
Idle time
Which files and programs have been accessed
Key strokes
Conversations made using VoIP
Number of log-in attempts and entries of an incorrect password
Details of documents faxed and sent to a printer

Example: Windows Administrator logs

Windows Administrator accounts have the ability to maintain the following logs:
Application (program) events
Security-related events
Setup events
System events
Forwarded events (events forwarded from other computers)
Safeguarding data – other controls and best practice

Other controls commonly applied for safeguarding data from hacking include:
 Digital signatures
 Digital watermarks
 Digital certificates
 Biometrics control (fingerprint, face, voice or eye recognition)
 Make sure the computer's operating system and applications are protected
with all necessary security patches and updates
 Make sure the computer is protected with up-to-date antivirus and anti-
spyware software
 Users should avoid clicking on unknown or unsolicited links or attachments,
and downloading unknown files or programs onto their computer
 Avoid sending information via standard, unencrypted Wi-Fi (which is
especially easy for hackers to intercept). Encrypted Wi-Fi scrambles the
signal making it useless to hackers unless they have the codes to decrypt
it.
 Using "https" in the URL before entering any sensitive information or a
password. (The "s" stands for "secure".)
 Avoid standard, unencrypted e-mail and unencrypted Instant Messaging
(IM)
 Backup data frequently. Keep one backup copy off-site (i.e. at a separate
physical location)
 Perform frequent systems maintenance to ensure performance does not
erode
 Update hardware to keep pace with the speed of change of the software it
supports
 Take out adequate insurance cover for systems and software
 Invest in an uninterruptable power supply
 Document systems and keep the documentation up-to-date for system
amendments

Safeguarding stored data

In addition to adopting the above security procedures the following techniques
are also often used by firms to assist in further safeguarding of stored data:
 Maintain version-control of files so that you are always working on the latest
version of a document. This is particularly important with documents that
require editorial input from multiple users.
 Employ a DBMS (database management system) to control access to
shared files to avoid editing conflicts
 Routinely checking the accuracy of standing data
1.6 Computer viruses and other attacks

Viruses are computer software that is designed to deliberately corrupt computer
systems. Viruses can be introduced into a system via a file containing the virus. A
virus may be contained:
 In a file attachment to an e-mail or
 On a backing storage device such as a CD.
Other methods of corrupting systems have also been developed such as:
Term Description
Trojan horses A Trojan horse is a type of virus that disguises itself often
hidden within other software or files. Whilst the user thinks
that the system is carrying out one program, the Trojan
horse secretly carries on another.
Worms This is corrupt data that replicates itself within the system,
moving from one file or program to another.
Trap doors A trap door is an entry point to a system that bypasses
normal controls to prevent unauthorised entry.
Logic bombs This is a virus that is designed to start ‘working’ (corrupting
the files or data processing) when a certain event occurs.
Time bombs This is a virus that is designed to start ‘working’ (corrupting
the files or data processing) on a certain date.
Denial of service Rendering the system unusable by legitimate users – for
example by overloading a website with millions of
computer-generated queries
Viruses vary in their virulence (the amount of damage they may cause to
software or data). The most virulent viruses are capable of destroying systems
and computers (by damaging its operating system).
Viruses are written with malicious intent, but they may be transmitted unwittingly.
Since a virus does not always begin to corrupt software or data immediately,
there is time for a computer user to transmit the virus to another computer user,
without knowing.
New viruses are being written continually. Some software producers specialise in
providing anti-virus software, which is updated regularly (perhaps every two
weeks) to include software for dealing with the most recently-discovered viruses.

Anti-virus software is able to:

 Detect known viruses in a file
 Report the virus to the computer user
 Isolate the virus so that it is not able to corrupt software or data in the
computer.
Measures for dealing with viruses
There are a number measures that might be taken to guard against computer
viruses. These include the following:
 The computer user should buy and install anti-virus software. Since new
viruses are written daily, the anti-virus software must be updated regularly.
Providers of anti-virus software allow customers to download updated
versions of their software regularly.
 The computer user might restrict the use of floppy disks and re-writable
CDs, because these are sources of viruses. The computer user may even
install computer terminals that do not have a CD drive or floppy disk drive,
to eliminate the risk of a virus being introduced on a disk.
 Firewall software and hardware should be used to prevent unauthorised
access from the Internet. This will reduce the risk from e-mails with file
attachments containing viruses.
 Staff should be encouraged to delete suspicious e-mails without opening
any attachments.
 There should be procedures, communicated to all staff, for reporting
suspicions of any virus as soon as they appear.
When a virus is detected in the computer system, it may be necessary to shut the
system down until the virus has been eliminated.
1.7 Internet and email user policies

The Internet is a particularly risky area for firms and individuals. As we saw above
organisations employ increasingly sophisticated security measures such as
firewalls, encryption and virus protection. Many businesses also require their staff
to comply with internet and email usage policies.
Internet usage policy
The contents of an internet usage policy might include:
 Limiting internet use to business purposes
 Notification of the ability to track internet usage
 Prohibiting access to sites that are offensive to gender, sexuality, religion,
nationality or politics
 Ensuring that downloads only occur from a safe and reputable website
 Prohibiting downloading executable (program) files as well as pirated
music, movies or software
 Prohibiting providing the users’ business email address to limit the
likelihood of SPAM and PHISHING
 Consequences of violation

Email usage policy

Many businesses adopt an email usage policy which is driven by both
commercial and security reasons. Typical policy content might include:
 Prohibiting the use of personal email accounts for business matters
 Check email regularly
 Organize emails efficiently
 Use of professional standards and courtesy in messages
 Prohibit email use for unlawful purposes (copyright infringement, obscenity,
slander, fraud, computer tampering, etc.)
 Prohibiting email use outside your firm’s policies
 Prohibiting sending large attachments
 Prohibiting opening email attachments from unknown sources (as they may
contain malicious software)
 Prohibiting accessing email accounts of other individuals
 Prohibiting sharing email account passwords
 Prohibiting excessive personal use of your firm’s email
 Notification that the firm will monitor email
 Reporting of misuse
 Disciplinary action for any breach of policy
1.8 Use of USB sticks and other removable devices

A USB memory stick (a ‘flash stick’) is a data storage device that is inserted into
the USB port of a device (e.g. a PC or laptop). Once inserted into the USB Port,
the flash stick acts like an external hard drive and data can be read from and
written onto it just like any kind of storage device.
Flash sticks are a popular device for data storage and transportation. They are
extremely easy to use with manufacturers continually expanding their capacity up
to 32GB, 64GB and beyond.
Although memory sticks are highly reliable and work well even in extreme
conditions, care must be taken to protect memory sticks. Measures include:
 Use an encryption-secured memory stick, or encrypt confidential data
saved to a memory stick
 Use a password-protected memory stick
 Always remove a USB Memory Stick with a devices’ safe eject’ facility to
ensure information is not corrupted
 Maintaining physical security – for example keep them locked in a safe
when not in use
 Do not expose memory sticks to extreme heat
 Keep memory sticks dry
Examples of other equally useful removable devices similarly vulnerable to theft,
heat, moisture and other compromise include:
 Portable hard disk drives

 Cameras and video recorders

 Personal music players
 GPS enabled gadgets
 Hand-held bar-code readers
These gadgets all have their place in a business environment and care should be
taken over safeguarding both the gadgets themselves and information they
contain.
1.9 WebTrust
Definition: WebTrust
WebTrust is a seal of assurance attached to a Website to assure users of its
integrity and safety.
WebTrust is a seal of best practices, and a new service jointly developed by the
Canadian Institute of Chartered Accountants (CICA) and the American Institute of
Certified Public Accountants (AICPA).
WebTrust enables consumers and businesses to purchase goods and services
over the Internet with the confidence that vendors' web sites have historically met
specific high standards for privacy, security, business practices, transaction
integrity and more.
Three principles are used to evaluate a site:

 Business and information privacy practices
 Transaction integrity
 Information protection
The WebTrust seal provides assurance of an unqualified report with respect to
the above three objectives for a particular website.
1.10 Social networking sites in the workplace
Definition: Social networking

Social networking is the use of dedicated websites and applications to interact
with other users and to find people with similar interests to one’s own.
A social network website requires users to create a public profile which is then
used to establish links with other profiles.
Examples of social networking sites include MySpace, Bebo, LinkedIn, Twitter,
Weibo, Google+, Raptr and Facebook.
Used effectively, social networking sites enable organizations to vastly improve

communication and productivity by disseminating information amongst different
stakeholder groups in an efficient manner. Stakeholder groups include current
employees, suppliers, customers, potential customers and other interested
parties.
Some of the benefits and risks of social networking sites for organisations are as
follows:

Benefits
 Modern and quick way for employees to discuss ideas, post news, ask
questions and share links
 Can target a wide audience which improves recruitment potential
 Social networks allow organisations to target select groups or individuals
fostering more of a friendship rather than corporate relationship. This
personal touch is highly appreciated and also gives business access to that
customer’s own network of contacts too.
 Vastly expanded market research resource. Can be accessed by
employees for market research about other organisations and products and
also used to enhance one’s own marketing campaigns by delivering
communications and directing interested people to specific sites
 Promotes open communication, leading to enhanced information discovery
and delivery
 Offers an opportunity to widen business contacts
 Helps improve business reputation and client base with minimal spend on
advertising
 Social networking is here to stay and the future of business is a networked
future. Employers who embrace that reality and effectively integrate social
networking into their strategy will prosper in the long-term.
Risks
 Provides an extra channel for hackers to attack and launch spam or viruses
 Can result in negative comments from disgruntled employees about the
company.
 Potential legal consequences if employees use sites to view objectionable,
illicit or offensive material
 Increased risk of employees succumbing to online scams resulting in
identity or data theft
 Lost productivity if employees are using the sites for personal use rather
than work-related activity. (However, there is a counter-argument that
employees who waste time on social networking sites are the same
employees who would waste time irrespective of the existence of social
networking sites or not. Thus to ban social networking sites would just
mean those employees find another excuse to waste time and reduce
productivity).
 Employees may send negative messages, status up
Social media policies

Whilst employers have the right to ban non work-related computer activity such a
total ban on all social networking sites may not yield the desired results.
Employees will seek ways around such a ban (e.g. by using their smart-phone
instead of a works computer to access a site) and may arguably view their
employer as stuck in the past and not moving with the times.
A number of studies have shown employees with access to social networking
sites to be more productive than employees without such access. It is therefore
key for policies to focus on the positives of work productivity and output. For

example employees may reward themselves on the completion of each task with
a visit to their favourite social networking site.
Many employers therefore issue a social media policy which will typically address
the following:
 Define the term ‘social networking’ to establish a scope for the policy
 Establish the purpose of the policy
 Communicate the benefits of social networking and establishing a policy
 Consider legal redress of not abiding by the law
 Provide guidance to employees regarding their use of social networking
outside of company time (and property) where it could be associated with
the company, customers or employees. Many employers will prohibit the
posting of company information on social networking sites without specific
authorisation
 Outline disciplinary measures for breach of policy
 Provide examples of policy breach
 Facilitate employee education with respect to social networking and the
policy
 Make reference to the need for confidentiality of employer trade secrets
and confidential or private information.
Employers can use the communication of a social media policy as an opportunity
to remind staff of general internet use risks and safeguards. For example, social
media sites promote the sharing of personal information and encourage people to
be more open than they perhaps otherwise might have been. However,
employees may need reminding about the risks of clicking a suspicious link or
visiting an unusual website.
Focus on productivity
Nowadays employees are more likely to perform work-related activities away
from the work place. For example, an employee might check their email at
breakfast time (at home) after catching up on the overnight social networking
activities. They may review a report whilst watching their children at a football
match or take a work-related phone call whilst on holiday.
Subsequently, access to personal social media during working hours can be
seen as a trade-off with work-activities being performed outside of working hours.
The key remains a holistic focus on productivity.
Note that similar arguments were raised when both telephones and email were
introduced to the work environment, without which no business would survive
today!

2 USING CORE WINDOWS SECURITY FEATURES
Section overview
 Logging on and off

 Locking the computer in Microsoft Windows
 Using the Windows screen-saver
 Changing your Windows password
2.1 Logging-on and -off

When a user logs-off from Windows all the programs they were using are closed
but the computer is not turned off. This makes the computer available for another
user to log-in to without needing to re-start the computer.
If another user subsequently switches off the computer the first user’s information
(files, emails etc.) will already have been automatically saved by Windows during
log-off.
To log-off:
 Click the Start button on the desktop taskbar
 Select Log off from the Shut down menu
Alternatively you can use ‘Fast user switching’. This is similar to a full log-off in
that it makes the computer available for another user to log-in to. However, with
fast user switching Windows does not automatically save files that are open
before logging the first user off. Therefore you should save any open files before
switching users as any unsaved data will be lost if a subsequent user switched
off the computer.
To use fast user switching:
 Select Switch User from the Shut down menu
Alternatively:
 Press CTRL+ALT+DELETE and then click the user that you want to switch
to
1. Click Start 3. Switch user

or Log off
2. Open the
Shut-down
menu
2.2 Locking the computer in Microsoft Windows

A locked computer prevents unauthorised access to the desktop without using a
correct password.

To lock the computer either:

 Press CTRL + ALT + Delete
 Select Lock this computer
Or:
 Select Lock from the Shut down menu
1. Click Start
3. Lock
2. Open the
Shut-down
menu
To unlock the computer simply type in the password and hit the RETURN key.
Note that Windows passwords are case-sensitive so check that Caps Lock is not
activated when entering your password.
2.3 Using the Windows screen-saver

Screen savers were originally used to save older, monochromatic monitors from
damage, but now they're mainly a way to personalize your computer or enhance
its security by offering password protection.
To set-up the screen-saver:
 Right-click on the desktop and select Personalize
 Click Screen-saver to open the screen-saver dialog box
 Amend settings including any or all of the following:
 Select screen saver type from the drop-down menu. Note some
screen savers have customizable settings you can amend from the
Settings button
 Change the period of inactivity required to start the screen saver
 Require the user to re-log-in to resume their desktop session by
ticking “On resume, display logon screen”
 Click OK

Click to open
screen saver
dialog box
Amend
settings as
applicable
then click OK

2.4 Changing your Windows password

You can help keep your computer secure by changing your Windows password
regularly and using a strong password (mixture of alpha-numeric including both
upper and lower-case).
The two common methods for changing your password are:
Method 1
 Press CTRL+ALT+DELETE
 Select Change a password
 In the prompts provided:
 Type the old password
 Type the new password
 Confirm the new password
 Press Enter
Method 2
 Press Start on the taskbar and select Control Panel
 Click User Accounts and Family Safety
 Select Change your Windows password under User Accounts
 Click Change your password
 Enter your current password, new password, confirm your new password,
then click Change password
If you forget your password it can be reset by one of the following methods:
 Log-in under an administrator account and re-set the password for the
relevant user account
 Use a password reset disk for the account (or the password reset
information stored on a USB flash drive). A password reset disk should be
created when you first set-up your computer – see the manufacturer’s
instructions for your machine.
Note that data such as unsaved files may be lost if the administrator account has
to be used to reset the password.

3 CHAPTER REVIEW
Chapter review
 Explain the threats to information systems faced by organisations in the modern
business environment
 Describe the options available to manage information system security risks
 Summarise techniques for protecting against physical disaster, fraud and theft,
hacking, computer viruses and other attacks
 Discuss internet and email user policies and WebTrust
 Explain the impact that social networking sites have on the workplace and
summarise the risks they pose
 Use core Windows security features such as screen-savers, computer locking,
passwords and log-on/off

Foundation level
CHAPTER
19
Information systems -
management and strategy
Contents
1 Aligning IT and business strategy
2 Accounting for IT/IS costs
3 Career paths for accountants in an IT environment
4 IT management in organisations
5 Chapter review

Purpose
Competencies
3(e) Explain, describe or discuss the importance of aligning IT strategy with
business strategy
3(g) Professionals Accountants and career Path in IT environment
3(j) Explain, describe or discuss how IT is managed within an organisation, with a
focus on:
i. Accounting systems
ii. Performance monitoring, and
Exam context
In the previous four chapters you were introduced to the main technologies that support
modern information systems. We now change focus and look at IS/IT from a strategic and
managerial perspective over the next two chapters.
 Understand the strategic importance of IT and information
 Explain the nature and ownership of IS/IT strategy
 Describe how the costs of the IT/IS systems can be accounted for
 Summarise typical career paths for accountants in an IT environment
 Describe typical structures of the IT department in organisations
 Explain the concepts of centralisation, outsourcing and facilities management in the
context of IT/IS systems

Chapter 19: Information systems - management and strategy
1 ALIGNING IT AND BUSINESS STRATEGY
Section overview
 Business strategy and supporting strategies

 The nature of IS/IT strategy
 The strategic importance of IT
 The strategic importance of information
 The ownership of IS/IT strategy
1.1 Business strategy and supporting strategies

Business strategy
Every organisation should have an overall objective and should develop business
strategies to achieve this objective. In a commercial environment, the objective of
businesses is often assumed to be to increase the wealth of their owners, the
shareholders.
Business strategies are often aimed at growing the business, so the aim of a
business strategy might therefore be to:
 Increase annual profits
 Increase annual sales
 Increase the entity’s share of the market.
Example: Objectives
Objectives or targets can be set for each business objective. For example, there
may be objectives to increase annual sales by 10% and annual profits by 15%
within the next three years, and to increase the entity’s share of the market from
15% to 18% in that period.
Supporting strategies
Having established business objectives, an entity should develop strategies for
achieving those objectives. There should be strategies for all the key areas and
operations, and there will usually be supporting strategies (and strategic
objectives) for:
 Financing the business
 Product innovation and market development
 Marketing
 Human resources
 Information systems and information technology.
1.2 The nature of IS/IT strategy

Computer systems and information systems are used to support business
operations, and for many organisations, they are strategically important. The
purpose of IS/IT strategy should be to develop information systems and
information technology in ways that will help the entity to achieve its overall
business objectives.

Recall the definitions of information systems and technology from earlier:
Definition: information system

This is a system within an organisation that captures and processes data from
inside or outside the organisation, and makes the information available to users.
An IS is usually associated with a computer system, but an IS does not have to be
computer-based.
Definition: information technology

This is the equipment and software that is used to provide an information system.
IT refers to computer hardware and software, and communications networks.
The elements or aspects of an IS/IT strategy will usually include the following:
 A strategy for IT staffing, including (where appropriate) a strategy on
outsourcing
 A strategy for the purchase and use of computer equipment
 A software strategy: for example, a small company might adopt a strategy
of using Microsoft software products throughout the organisation
 A strategy on developing new IS/IT systems ‘in-house’ or purchasing them
from an external software supplier
 Where the entity has an in-house IT department, a strategy (or policy) on
whether the department should operate as a cost centre or as a profit
centre.
How does IS/IT strategy help an entity to achieve its business objectives?
An IS/IT strategy can help an entity to achieve its business objectives in several
ways:
 Improvements in IS and IT systems can improve operational efficiency and
reduce operating costs per unit of output (units of product or units of
service) for the operations that use the systems. Lower costs result in
higher profits.
 Using IS/IT systems can improve the quality of service provision. For
example, a company might be able to provide an improved ‘shopping’
service for customers, by allowing them to buy its products on-line.
Providing a better service should result in higher sales and higher profits.
 A company might be able to improve its marketing and sales strategies by
using IS/IT systems. For example, a company might be able to target
customers more effectively using a customer database.
 IS/IT systems can be used to support innovation, such as the design of new
products and services. Business entities need to innovate in order to
compete (and survive) in their markets.

1.3 The strategic importance of IT

Some of the reasons why information systems and information technology are of
strategic importance are as follows:
 There is a high cost for developing and operating IT systems. This means
that IT systems are of financial significance.
 IT systems are an essential part of operations in many organisations.
Computer systems might direct and control operations (for example, in
transport and shipping companies); they are an essential part of product
design in other companies (for example, electronic equipment and
engineering projects) and they are also used to process transactions (for
example, in retail organisations).
 IT systems can give an organisation a competitive advantage over rivals.
For example, major publishers of scientific and technical ‘books’ and
journals are making their products available in electronic form and
accessible on-line. Smaller publishers do not have the IT systems to
compete in this area, and produce most of their output in paper form only.
 Businesses can improve their strategic relationships by creating IT links
between their computer systems, or allowing each other access to their
intranet systems.
The pace of development in IT is rapid. Strategic managers must keep
themselves up-to-date with these changes, and consider how these changes
might be significant – as a threat to the business objectives of the entity or as an
opportunity for achieving its business objectives more successfully.
Corporate business strategy and IT strategy will be affected constantly by
changes in the IT environment. Consequently IT strategies must be reviewed
regularly.
1.4 The strategic importance of information

In an advanced economy, most business entities rely on information and
communication systems, and computer technology. Managers need information
to make high-quality decisions. A general principle is that managers will make
better decisions if they are provided with better information.
Well-designed information systems can be used to:
 Capture data from many different sources
 Store large quantities of data, which can be retrieved easily and quickly
when it is needed
 Process data in many different ways to provide valuable information
 Communicate information to managers and other individuals who need it
 Improve communications within an organisation and world-wide.
Changes in information technology create both opportunities and threats, and
business entities need to develop an IS/IT strategy to support their business
strategy. The need for high-quality information must be recognised by senior
management, and business strategy should drive the demand for new and better
information systems.

1.5 The ownership of IS/IT strategy

The manager
The manager (or managers) with ‘ownership’ of IS/IT strategy is the person
responsible for ensuring that:
 IS/IT strategy is developed and continually reviewed and updated,
 IS/IT strategy is implemented successfully, and
 The strategic objectives for IS/IT are achieved.
In some companies, the board of directors might take ownership of IS/IT strategy.
In larger companies with an IT department, the responsibility may be given to:
 An IT director or manager, who is accountable to the board for the success
or failure of the strategy, or
 An IT steering committee.
Getting it wrong
If there is a mismatch between IS/IT strategy and the organisation’s overall
business strategy then the organisation will be less effective in achieving its
business objectives.
Example: getting it wrong

An airline is dependent on safety critical real-time systems. This will require
significant ongoing investment in IS/IT.
If the airline were to suffer failures in its IS/IT due to a cost-saving rather than
safety critical strategy it may:
 at best only lose profit through lost bookings;
 at worst suffer a catastrophic flight failure and subsequent bankruptcy.
Compare the airline to a small charity organisation that is aiming to minimise
costs whilst delivering aid work.
If the charity were to invest heavily in the latest high tech IS/IT with lots of extra
features and capacity that it will never use, then the aid work will suffer as funds
are spent on unnecessary and high-cost IS/IT rather than the provision of aid (e.g.
vaccines, food, water or schooling).

2 ACCOUNTING FOR IT/IS COSTS
Section overview
 The accounting challenge for IT and IS

 IT system development costs
 IT operating costs
 Charging for IT costs
 The IT department as a non-rechargeable cost centre
 The IT department as a cost centre, with costs re-charged
 IT department as a profit centre
 IT department as a stand-alone subsidiary company
 Shared infrastructure costs
2.1 The accounting challenge for IT and IS

A significant accounting challenge for IT and IS systems is the control of costs. In
many organisations, a large number of employees have access to IT facilities
such as a desk-top computer or a portable computer, or a terminal for a large IT
system (with keyboard, screen and mouse).
Employees often expect to use IT facilities and there is a common assumption
that IT facilities should be made available because they improve efficiency, save
time and reduce costs.
This assumption that IT improves efficiency and reduces costs may be correct,
but isn’t necessarily so. In practice, a significant amount of expenditure on IT
could be wasted on activities that do not provide benefits to justify the costs.
A task for management is therefore to consider the most appropriate method of
accounting for IT costs and to provide a system in which IT costs can be
monitored and controlled.
2.2 IT system development costs

When a new computer system is developed and implemented, various costs will
be incurred. Some of these costs may be treated as capital expenditure, and
some as operating costs that are charged immediately as an expense in the
income statement.
Example: Capital costs

 Hardware costs (computers and other IT equipment)
 Software costs, when software is purchased ‘off the shelf’
 Cost of other new equipment (equipment other than IT equipment)
 Wiring and network installation costs

Example: Operating costs

 Costs of systems development staff (systems analysts and programmers
and other IT staff) when the system is developed ‘in-house’
 Staff training costs: cost to train the users of the system
 Costs of staff of the user of the system, for staff who are assigned to the
system development work
 Hiring of temporary staff (if required)
 Sundry costs incurred in development and testing
2.3 IT operating costs

An entity using IT systems will incur the following regular operating costs for
systems in operation.
 Staff costs associated with operating the IT systems
 Costs of consumable items, such as replacement parts for equipment
(printer cartridges, portable storage disks, new keyboards and screens, and
so on), and paper costs (for printing)
 Cost of fees payable to external IT companies for out-sourced IT work
 Data transmission costs (line rental or transmission charges).
 Power costs
 Costs of maintaining a back-up system in the event of breakdown
 Rental/lease costs, when equipment is rented or leased
There will also be regular capital expenditure on the replacement of computer
equipment. In the accounting system, there will be an annual depreciation charge
for all capital items.
There may also be an allocation or apportionment of general overhead costs to
the IT department.
2.4 Charging for IT costs

Many organisations use a cost and management accounting system to record
costs, and to manage and control costs.
 When a department incurs IT costs directly, the costs will be charged
directly to the department.
 When costs are incurred by an IT department, which provides IT services to
other departments, the costs will be charged initially to the IT department,
and then re-charged to the user departments (or ‘customer departments’)
that receive the IT services.
2.5 The IT department as a non-rechargeable cost centre

One way of accounting for the costs of an IT department is to treat the
department as a cost centre. This means that all the costs incurred by the IT
department will be charged initially to the department. In this way, total
expenditure by the IT department can be identified. The IT department manager
is responsible for cost control.

The IT department provides support services to other departments within the

organisation. IT costs are therefore overhead costs.
When the IT department is a non-rechargeable cost centre, its costs are not re-
charged to the customer departments that use its services. Instead, the IT costs
are treated as a part of general overhead costs.
As general overheads, they are either:
 Absorbed into production costs as a part of general production overhead
costs, or
 More commonly, written off as a part of general administration costs each
year.
The usage of IT department services by the customer departments is not
recorded, and customer departments are not charged for IT costs (i.e. for their
use of the IT department’s services).
Advantage
The advantage of treating the IT department as a non-rechargeable cost centre is
simplicity. There is no requirement to record the usage of IT department services
by the customer department, and there is no requirement for a system for
allocating IT costs to each customer department.
Disadvantage
The disadvantage of treating the IT department as a non-rechargeable cost
centre is that there is no information for analysing how IT services have been
used.
Customer departments are not charged for the IT services they use. There is a
lack of end-user awareness of how much IT cost they are incurring. This means
that the customer departments have no incentive to control their use of IT
services, and they may use these services inefficiently. For example, a customer
department may use costly IT services that do not provide any significant
economic benefits. As a consequence, the costs of the IT department could be
excessive.
2.6 The IT department as a cost centre, with costs re-charged

Another method of accounting for the IT costs of an IT department is to treat the
IT department as a cost centre, and to re-charge its costs to its customer
departments.
 All the costs incurred by the IT department will be charged initially to the
department. The IT department manager remains responsible for control
over expenditures on operational cost items.
 The costs of the IT department are then re-charged to the customer
departments that use its services. There are two ways of re-charging costs:
 sharing (apportioning) the costs on a ‘fair’ basis, such as the number
of employees in each user department, or the number of computer
terminals in each user department, or the computer time used by
each customer department
 keeping a record of the services provided to customer each
department (staff time, computer time, computer equipment and
materials, and so on. Each customer department is then charged at
cost for the services provided.

Advantage
The customer departments (user departments) are charged with the cost of the IT
services they use, and so will be more conscious of the need to manage and
control IT costs, and avoid the wasteful use of IT services.
Disadvantages
There are several disadvantages in re-charging IT costs to user departments.
 The customer departments may try to control their own costs by reducing
the amount of IT services they use, with the result that the services of the
IT department are under-used.
 A second problem is that user departments can try to control the amount of
IT services they use, but they cannot control the spending of the IT
department. IT spending is the responsibility of the IT department manager,
and if spending is excessive and inefficient, the cost is passed on to the
customer departments.
 It may be difficult to choose a basis of charging that is fair to all the user
departments, unless the costing system is quite sophisticated.
2.7 IT department as a profit centre

Another method of accounting for the IT department is to treat the department as
a profit centre. The IT department is expected to ‘sell’ its services to customers,
and to make a profit on the services it provides.
 It will charge each user department for the services that it provides. For
example, user departments will have to charge for the services of systems
analysts and programmers, and for a help desk service. Users will also
have to charge for the time they make use of the IT department computers.
The charge for the services provided should usually be at close to the
market rate or market price.
 The IT department may also try to sell its services to external organisations,
charging a market rate.
Advantages
The benefits of charging IT department costs to user departments are as follows:
 There should be better control over IT costs, because user departments will
be more careful about using IT services, for which they will be charged a
market rate. The IT department will still want to control its spending,
because the department will be required to ‘make a profit’ (or at least break
even) and cost control may be as important as earning revenue.
 The efficiency of the IT department may be measured more effectively if it
is set a profit target.
 The quality of IT services to user departments should improve, because
user departments are likely to demand a better quality of service when they
are being charged for it.
 There may be improved job satisfaction for IT department staff, since they
are able to ‘see’ the financial results of their efforts, and might even be
given bonuses for good financial performance.
 If the performance of the IT department is measured on the basis of
profitability, the IT management will try to achieve greater efficiencies and
provide more IT services, in order to meet or exceed its profit targets. This

incentive will be even stronger if IT managers are rewarded for meeting or

exceeding the profit target.
The efficiency and effectiveness of the IT department may therefore improve.
Disadvantages
There are also disadvantages in treating the IT department as a profit centre.
 There is a risk that if the IT department becomes a profit centre, it may
focus too much attention on selling to external customers, instead of
providing a high-quality service to customer departments within its own
organisation.
 A charge based on cost plus a profit margin might not be a realistic
commercial price or market price, and user departments might resent
having to pay an excessively high rate. If the IT charges are not realistic
commercial rates, the profit recorded by the IT department will not have
much meaning.
 There could be arguments between user departments and the IT
department for over-charging and unfair pricing. This will result in
inefficiency within the business.
 User departments might be persuaded to make less use of IT services, and
this could have an adverse effect on their performance.
2.8 IT department as a stand-alone subsidiary company

The IT department might be established as a separate subsidiary company within
the group, with its own assets and liabilities. (It will then be an investment centre,
rather than a profit centre, within the group.) It will be allowed to charge market
prices for IT services to user departments, and might also be allowed to offer its
services to external customers.
However, user departments might also be allowed to buy IT services from
external suppliers, if they are dissatisfied with the IT department’s prices or
quality of service.
Advantages
The advantages of a stand-alone IT subsidiary are similar to the advantages of
treating the IT department as a profit centre. There are some additional
advantages.
 The IT department is given the incentive to perform as a business, and to
achieve a good rate of return on investment.
 The IT department may achieve higher levels of efficiency and
effectiveness because it has to compete with external suppliers of IT
services.
Disadvantages
There are also disadvantages.
 The IT department might not have the relevant business expertise to
operate as an efficient ‘stand-alone’ business, in competition with external
IT companies.
 The IT department may be too small to operate effectively as a stand-alone
company.

 The IT department might try to focus its resources on services with a high
profit margin, and forget that its main purpose is to provide a good IT
service to user departments within the organisation.
 External customers might be given priority service, ahead of internal user
departments.
2.9 Shared infrastructure costs

Another aspect of accounting for IT system costs is sharing the ‘infrastructure’
costs of large systems between the user departments. For example, a company
might have a large Intranet system that is used by all departments. The costs of
the system need to be charged between each department, so that they receive a
fair share of the total costs.
Similarly, if several departments use the same database system, the costs of the
system should be shared on a fair basis between its users.
A basis for sharing infrastructure costs cannot be fair unless it is based on actual
usage, or estimates of actual usage, of the system by each department. A
suitable basis for sharing the costs might therefore be:
 The number of terminals or workstations connected to the system in each
department. Each department receives a share of the system costs in
proportion to the number of terminals that it uses. This would be fair if it is
reasonable to assume that the use of the system is about the same for
each terminal.
 If it is possible to monitor network traffic, as the number of messages
transmitted or the number of units of data transferred over the system
network, the system costs could be apportioned on the basis of message or
data transmission.

3 CAREER PATHS FOR ACCOUNTANTS IN AN IT ENVIRONMENT
Section overview
 Introduction
 Working in public practice
 Working in industry
 Working in the public sector
3.1 Introduction
The growth of information technology (IT) and information systems (IS) within
business has been rapid and widespread over recent years. Most organisations
nowadays incorporate IT/IS into their business model as a core component. IT/IS
will therefore almost certainly impact an accountant’s life in some capacity.
Accountants take on a wide variety of roles such within predominantly one of
three sectors:
 Public practice
 Industry
 The public sector (government)
3.2 Working in public practice

Accountants will invariably encounter IT/IS when working in a firm of
accountants. Some of the most common occurrences include:
 Auditors
 Modern audit firms invariably maintain computerised audit files. This
approach offers a number of advantages including enhanced
accuracy, efficiency and the ability to access and review files
remotely.
 Auditors are required to form an understanding of their clients’
information system relevant to the audit. This requires good basic
knowledge of IT/IS.
 Auditors may employ CAATs (computer assisted audit techniques) to
help with certain audit procedures.
 IT/IS audit: IT/IS audit is a specialist form of audit that provides assurance
on a clients’ IT/IS. This requires specialist skills.
 Time and billing systems: Similar to solicitors, accountants frequently
negotiate fees based on hours worked. This basis requires a robust
information system that can be used to record what hours have been
worked, by whom, on which client. The system then uses that data to
generate client invoices.
 Forensic auditing: Forensic auditing is a specialist branch of auditing
devoted primarily to ‘special investigations’, often employed when a fraud is
suspected. Specialist IT/IS skills may be required in order to help uncover
hidden audit trails adopted to camouflage fraudulent activity.
 Due diligence and corporate finance advisory: One of the increasingly
popular assurance services offered by firms of accountants is due diligence

and corporate finance advisory of a take-over target. The accountant needs

robust knowledge of IT/IS in order to analyse and advise fully in a corporate
action.
The above roles describe IT/IS interaction in fee-earning roles within public
practice accountancy firms. Exposure may also occur with IT/IS in public practice
away from front-line roles, such as:
 Being involved in developing, implementing or consulting on the systems to
support the above;
 Working as a management or financial accountant in a public practice
preparing monthly management and yearly annual accounts for the practice
as a business;
3.3 Working in industry

The term ‘working in industry’ is generally used to describe accountants working
outside of public practice in commercial (or charitable) profit-based organisations.
Employers in this sector range from large multi-nationals such as Microsoft,
Starbucks, Vodafone and Mercedes to small businesses of just a few employees.
Traditional accountant-based roles in medium and large organisations might
include:
Role Responsibilities
Treasurer Ensuring the business has sufficient funds for ongoing
operations, investing excess funds, managing foreign
currency exposure
Credit controller Managing trade receivables and chasing payments
Payables controller Managing trade payables and ensuring suppliers are
paid
Management Preparing regular management accounts for
accountant management
Payroll accountant Running and accounting for both salaried and hourly-
paid payroll
Project accountant Seconded to advise on the accountancy issues for
specific
Tax accountant Accounting for various taxes including sales tax and
corporation tax
Financial controller A junior management position typically responsible for
overseeing the above roles for one particular business
sector or subsidiary
Group accountant Employed by head office of a group company
responsible for consolidating group accounts including
both management and financial accounts
Finance director Board level responsibility for the whole of the finance
department
The above list is by no mean exhaustive. Furthermore the larger the organisation
the greater the likelihood that there will be multiple employees involved in a
number of the above roles. E.g. there may be a team of three in the treasury
group and a pool of five project accountants.

The following illustration shows how an accountant’s career may develop from a
foundation in public practice followed by a career mainly in industry.
Illustration: Accountant career path in an IT environment

Martin trained as an auditor with a medium sized firm of accountants that
employed electronic audit files. During his audit training Martin was seconded to
the corporate finance team where he was involved in performing due diligence on
a range of clients. This work required excellent presentation and Spreadsheet
skills for analytical purposes.
After qualifying as a chartered accountant Martin worked for three years as an
audit manager with a greater responsibility for budgeting, forecasting, credit
control and management accounting.
Martin then left public practice to take a position as a financial controller of a
small listed company with a turnover of ₦20m. As a financial controller Martin
had much greater involvement with the management information and payroll
systems as well as the decision support system.
After 5 years working as the financial controller Martin was promoted to finance
director. In his new role Martin was much more involved in board strategy
discussions with a key responsibility for the financial strategy for the firm.
Following his promotion Martin’s emphasis moved away from the operational and
tactical systems towards the main strategic executive information system.
3.4 Working in the public sector

The largest employer in most countries is usually the public sector (national and
local government). It follows therefore that there are a huge number of roles
available to accountants.
Many of the roles are similar to those described in the previous section for
accountants working in industry. Let’s take a hospital as an example.
Example: A hospital
A public hospital is like a mini business:
 The clients/customers are the patients. Revenue will be a combination of
private payments from patients and subsidy grants received from the
government. In some countries (e.g. the UK) the government may even
subsidise 100% of most treatments (funded through social security
payments from the country’s population).
 Expenditure needs managing on items such as:
 Real estate (the hospital building)
 Vehicles (e.g. ambulances)
 Doctors, nurses, administrators (payroll)
 Equipment (e.g. beds, sheets and blankets, medicine)
A large public hospital may employ hundreds, if not thousands of people.
Therefore, similar to a regular business in industry, there will be demand for
accountancy skills in management accounting, payroll systems, executive
information systems, expenses and purchases systems and so on. Each hospital
(or group of hospitals) may therefore employ a team of accountants just like a
normal profit making company.

Beyond the specific ‘mini-businesses’ operated by the government for the

provision of public services such as schools, hospitals, roads and defence
(police, army, navy and air force) governments also employ large teams of
accountants to administer the tax regime. These accountants will ensure the
various taxes are collected such as:
 Personal income tax
 Sales tax
 Corporation tax
 Inheritance (death) tax
 Import taxes, customs and duties
Similarly, significant IT/IS systems are required by the government to support this
part of their operation.

4 IT MANAGEMENT IN ORGANISATIONS
Section overview
 IT department structure
 Centralisation of IT
 Decentralisation of IT
 Advantages and disadvantages of centralisation of IT
 Outsourcing IT
 Facilities management
 Advantages and disadvantages of outsourcing
4.1 IT department structure

The ‘traditional’ structure of an IT department is shown in the organisation chart
below. This is an organisation chart for a large company or not-for-profit
organisation with a large ‘in-house’ IT department.
Senior IT management
An IT department should have a person at board level who is responsible for IT
and accountable to the rest of the board for IS/IT strategy and performance. The
individual at board level may have other responsibilities, in addition to IT. The
director should therefore have a senior manager with full-time responsibility for
IS/IT. In the chart above, this senior manager is called the Information Systems
Manager.

Steering committee
An organisation may include a steering committee for IS/IT. This is a committee
of senior managers from other ‘user’ departments in the organisation, together
with one or more senior IT managers. The chairman of the steering committee
may be the IT director.
The purpose of a steering committee is to consider the entity’s IS/IT strategy, and
to approve proposed new developments, such as the development of a new IT
system. The role of the steering committee might therefore be to:
 Decide how to allocate scarce IT resources between competing IT projects
 Approve the IT spending budget, for submission to the board of directors
 Approve individual new spending projects, such as a major purchase of
new computer equipment, or the design and development of a new IS/IT
project
 Monitor the development of IS/IT projects, and whether the system is being
delivered on time, on budget and to its design specifications.
However, there are disadvantages to having a steering committee. The main
problem is that management by committee can be slow and inefficient. It can
take time for committee members to reach agreement, and decisions may be
based on a compromise solution instead of what is actually the best thing to do.
For these reasons, an entity with a large IT department might not have a steering
committee for IT.
Systems development
Some organisations develop their own computer systems ‘in-house’. (An
alternative to in-house system development is to purchase systems from external
software suppliers or consultancy firms.)
When there is a systems development section in the IT department, its function
will be to design, develop and test new IT systems, and to help the computer
system user with system implementation. The systems development team will
normally also be responsible for updating and maintaining the system (for
example, correcting faults that are discovered after the system has been
implemented).
The systems development staff may consist of:
 Systems analysts – these are specialist systems designers. They carry
out investigations into the feasibility of developing new systems, and also
design new systems. They are also responsible for the testing of new
systems, and for their ‘hand-over’ to the users of the system on successful
completion of the tests.
 Programmers – these are specialists who design and write the programs
(software).
 Business analysts – these are individuals from the user departments who
are assigned to a system development project, to work with the systems
analysts. Their job is to make sure that the system is being designed in the
best way to meet the user’s requirements. They will also write the user
instruction manual/procedures manual, for use by the system users when
the system is implemented and becomes operational.
 Data analysts – these design the logical file structures for any database for
a new system.

Operations staff
Operations staff are responsible for running the computer systems, and are
located in computer centre(s) where the centralised systems are operated. Their
operating tasks include operating the computer equipment, making back-up
copies of files and storing them safely, correcting faults and dealing with any
breakdown in the equipment.
They may have some other tasks, such as printing output from the system and
distributing it to the computer system users.
Help desk/information centre
An IT department might include a support service or help desk. This is a small
section of IT experts who provide assistance and support to computer users
within the organisation. For example, they will:
 Give help and advice to users who are having difficulty using the system
software
 Be a point of contact for reporting software faults in the system
 Help users when they have problems with their computer equipment
 Help users who report problems such as a suspected virus or worm in the
system
 Handle user requests for the supply of additional computer equipment.
A help desk is often used when IT systems are decentralised, but local users of
the system are not IT experts, and so may need specialist help from time to time
when they run into difficulties.
4.2 Centralisation of IT
When IT is centralised, all IT operations are the responsibility of a central IT unit
at head office, reporting to an IT director. Traditionally the IT department was
centralised because major computer systems needed large ‘mainframe’
computers and specialist operators. It was therefore efficient and cost-effective to
operate IT systems centrally.
If an entity developed its own new IT systems in-house, it also made sense to
centralise the system development work, because all the available expert
systems development staff could be located in the same place, and used more
efficiently.
4.3 Decentralisation of IT
Developments in computer technology and communications technology have
transformed information processing capabilities, and made IT much cheaper.
 Data can be processed ‘locally’ on desk-top computers, instead of
processed on a central mainframe computer.
 Local departments can operate their own local computer networks, without
the need for a link to a central mainframe computer at head office.
These developments in ‘local’ data processing raise the questions:
 Should the IT department be centralised or should it be decentralised?
 Who should make decisions about how to develop and use IS/IT systems?
Should decisions be taken by local managers, or centrally by management
at head office?

 Should the operation of computer systems be controlled centrally, or should

responsibility be delegated to local managers?
 Should IT specialists be located in different places, closer to the end-users
who process the data?
When IT functions are decentralised, the implications might be that:
 Local departments operate their own computer systems, and there may be
no integration between the local systems. (This would mean, for example,
that one department might be unable to send information from its computer
system to the system of another department, because their systems are
incompatible.)
 Local managers buy the computer equipment of their own choice, for use
by their own staff locally.
 Local managers make their own decisions about introducing new systems,
either by in-house system development or by purchasing a system from an
external supplier.
 Local departments have their own separate information files.
 Local departments employ their own IT specialist staff.
In practice, IT is usually partly centralised and partly decentralised. The extent to
which IT is centralised or decentralised may depend on circumstances. This is
because there are advantages (and disadvantages) in centralisation, and
advantages (and disadvantages) in decentralisation. In some cases,
centralisation might be the best solution, whereas in other cases a decentralised
arrangement might be more effective or efficient.
4.4 Advantages and disadvantages of centralisation of IT

Advantages of centralisation
There should be economies of scale, with fewer staff required. In addition, a
central department can benefit from larger computers, more hardware and
possibly more sophisticated software.
 Scarce IT skills are available to the entire organisation.
 Processing operations can be standardised throughout the organisation.
This should result in better control over information.
 There will be central control over purchasing of hardware and software: all
users of IT within the organisation will use compatible equipment. It may
also be possible to use the greater ‘buying power’ of a central purchaser to
buy computer equipment at lower prices (with larger bulk purchase
discounts).
 A central IT department might lead to better strategic planning of IT
systems.
 Security is likely to be greater when data files are held and controlled
centrally.
There may be a benefit for legal reasons in holding some kinds of data centrally
in a single database. Some countries have legislation to protect private
individuals from the misuse of personal data about them that may be held on a
computer system (or any other information system). In the UK, for example, the
Data Protection Act and the Computer Misuse Act provide such protection. In
order to comply more easily with the data protection law, and ensure that all

personal data is kept safe and secure, and is used only for proper reasons, it
might be more practical and convenient to hold all the data in a centralised file.
When all data is held centrally in the same file or database, it might be easier to
access the data for analysis and research. For example, if there is a centralised
file about customers, instead of separate regional files, it may be easier to carry
out market research into customer buying habits and buying preferences on a
national basis.
Disadvantages of centralisation of IT
There are some disadvantages with decentralisation of IT.
 Local users of IT systems have little or no control/influence over systems
development.
 There could be management problems, with local computer users and a
central IT department failing to co-operate efficiently.
 Centralised IT systems management may become bureaucratic and
inefficient.
 IT staff at head office may fail to understand the ‘technical’ operating details
of local systems and or properly understand the business context in which
the local system operates.
 Changes to a system might take longer to introduce because a centralised
management could be slow to respond to the changing needs of local
users.
 It may be inappropriate to apply a single centralised IT solution to all
departments or local regions. It might be better to allow local departments
or regions to develop their own systems to suit their particular
circumstances.
To a large extent, the advantages of decentralisation are also the disadvantages
of centralisation. Similarly the disadvantages of decentralisation are also the
advantages of centralisation.
Advantages of decentralisation
The advantages of decentralisation of IT can be summarised as follows:
 Decentralisation of authority may result in more efficient management.
Local managers are responsible for their use of IT and their IT expenditure,
and are able to budget and control their IT spending.
 Local managers may be more aware of local IS/IT needs than managers at
head office.
Disadvantages of decentralisation
 The disadvantages of decentralisation of IT can be summarised as follows:
 When local regions or different departments use their own computer
equipment, computer software and computer systems, the IT systems of
the entity are fragmented, and it is difficult (if not impossible) to get the
different systems to communicate with each other.
 Decentralisation can result in a duplication of resources and efforts. This
would result in unnecessary costs.
 Local managers cannot buy as efficiently as centralised IT purchasing staff
should be able to, because they cannot obtain similar bulk purchasing
discounts.

 Data security may be much more difficult to control.

 If IT skills are scarce, local departments may be unable to recruit sufficient
numbers of staff with the required skills.
 It is important to recognise, however, that the choice is not between
centralisation of IT or decentralisation. An entity can decide how much
centralisation and how much decentralisation of IT there should be. There
should be a suitable balance between centralisation and decentralisation,
depending on the circumstances.
4.5 Outsourcing IT
Definition: outsourcing
Outsourcing occurs when a third party computer service organisation runs a part
or the whole of an organisation’s computer systems on the third party’s own
premises. In other words, outsourcing involves an entity paying an external
organisation to do some aspects of its IT work.
Any aspect of IT activity can be outsourced to an external service provider:

 Systems development and programming. An entity may outsource
systems development work. This is very common, for example, in the
government services. A government department may pay an external IT
company to design, develop and test a major computer system. This work
would include writing all the software for the new system
 Systems operations. An entity may outsource the operations for one or
more IT systems. For example, it is common for small and medium-sized
companies to outsource their monthly payroll work to an external IT
company.
 Systems support services/help desk facilities. When an entity
purchases specialised software from an external software company, it
might also use the software supplier for outsourcing help desk facilities and
system support facilities for the system. The external firm will provide help
desk services, such as dealing with calls for assistance by users who are
having difficulty operating the system. It will also investigate problems
where the system does not seem to be operating as planned, and may also
write amendments to the software.
When IT work is outsourced, the customer usually pays a fixed fee for a given
period of time, or a fixed annual fee for an agreed contract period. The fee will be
payment for an agreed level of service. In addition, there may be an additional
fee for extra work, based on a rate per hour or a rate per man-day.
The service agreement with an outsource organisation will specify levels of
service that the outsource organisation is expected to meet. Management of the
client organisation will need to monitor the service levels, to ensure that the
external IT company is meeting its obligations under the service level agreement.

4.6 Facilities management
Definition: facilities management

Facilities management describes an arrangement where an external IT company
provides a customer with all its IT services, not just some of them. In addition, the
external IT service company runs the whole or part of the customer’s computer
systems on the customer’s own premises, using the customer’s own computer
equipment.
4.7 Advantages and disadvantages of outsourcing

Advantages
There are several advantages of outsourcing IT work.
 Lower costs. It is often cheaper to pay an external organisation to perform
an IT service (such as payroll) than to employ in-house staff with an in-
house computer system.
 Specialist expertise. The IT service organisation (outsource organisation)
is more likely to have a greater number of specialist and experienced IT
staff, who the computer user might have difficulty in recruiting as full-time
employees.
 Outsourcing takes away a management problem and enables the
organisation to concentrate on its core business activities.
 For systems design and development, an external IT organisation might be
able to deliver a new system more quickly and more efficiently than an in-
house IT department.
Legacy systems
Definition: legacy systems

A legacy system is a computer system that:
 has been established for a long time, and has been operating successfully
for many years
 was developed using programming languages that are now no longer used
to write system software.
 The system is a ‘legacy’ from an earlier generation of computer systems.
Since the computer system is operating successfully, there is no reason to

replace it with a more modern system. However, until the system is eventually
replaced, it will need occasional maintenance (to correct faults that occur from
time to time) and updating.
It can be difficult to find IT staff who are willing to work on out-of-date legacy
systems, because individuals prefer to work with modern technology and
software languages and ‘tools’.
Some IT firms therefore offer a legacy systems service, whereby they will provide
a maintenance and updating service to customer organisations for their legacy
systems. For the customer, this type of arrangement gives it the IT support it
needs for its legacy system, that would be more expensive to obtain by hiring in-
house staff to do the work – if indeed in-house staff could be recruited who would
be willing to do the work.

Disadvantages
There are some disadvantages with outsourcing IT work.
 When IT work is outsourced, there is a risk of losing control over IT
processing and systems development.
 There might be hidden costs that are not apparent until after the contract
with the outsource firm has been signed. The customer may expect to pay
a fixed fee, but find that it is paying more for additional services, at a high
cost per hour or man-day.
 An outsourcing agreement might be a long-term contract lasting several
years. This may lead to problems if the working relationship between the
client organisation and the external IT organisation deteriorates. (A
deterioration in the working relationship might occur when client and
service provider begin to blame each other for operational weaknesses and
mistakes, or argue about the amount of fees that should be paid for work
that has not been done properly.)
 The external service provider might become financially unstable and go out
of business.
 There might be risks to security of data files held on the premises of an
external IT company. IT security is more difficult to manage and control.
 There could be practical difficulties when an outsourcing service agreement
comes to an end, and a company wants to bring the IT work back in-house,
or wants to change to a different external service provider. The existing
service provider might be unhelpful, because its services are no longer
required and its contract is being terminated.

5 CHAPTER REVIEW
Chapter review

 Understand the strategic importance of IT and information
 Explain the nature and ownership of IS/IT strategy
 Describe how the costs of the IT/IS systems can be accounted for
 Summarise typical career paths for accountants in an IT environment
 Describe typical structures of the IT department in organisations
 Explain the concepts of centralisation, outsourcing and facilities management in
the context of IT/IS systems


Foundation level
CHAPTER
20
Information systems -
change management
Contents
1 Implementation issues
2 Implementation methods
3 Post-implementation issues
4 System maintenance and change control
5 Chapter review

Purpose
Competencies
3(j) Explain, describe or discuss how IT is managed within an organisation, with a
focus on:
iii. Change management and procedures for updating hardware and
software
Exam context
This chapter is the second of two chapters focusing on IS/IT from a strategic and
management perspective.
Given the dynamic nature of information technology and information systems and also the
seemingly continuous rapid technological advancements in the modern business place it is
perhaps inevitable that you will encounter some form of new system implementation at some
stage during your career.
In its simplest form this may involve replacing an old laptop computer with a new model. At
the other extreme this may involve a multi-national organisation replacing its full information
system across the globe.
 Summarise the key implementation considerations such as user resistance, training,
file conversion/creation and system documentation
 Differentiate between the various system implementation methods including parallel
running, direct changeover, pilot testing and phased changeover
 Briefly explain the various post-implementation considerations including collecting
metrics for measuring success of the implementation
 Summarise the different types of system maintenance
 Explain the concepts of change control and user groups

Chapter 20: Information systems - change management
1 IMPLEMENTATION ISSUES
Section overview
 Introduction
 Late implementation (‘project over-run’)
 User resistance to the new system
 Training
 File conversion and file creation
 System documentation
1.1 Introduction
There are several issues that may have to be considered when a new system is
implemented. These include possible problems of late implementation and user
resistance to the system; deciding how much training should be given to staff of
the system user, and what form the training should take; planning the file
conversion or file creation for the new system; and deciding on the most
appropriate method of system implementation.
1.2 Late implementation (‘project over-run’)

When a large new computer system is being developed, implementation is a
major operational problem, and it must be planned carefully and in detail. There
should be a planned implementation data, so that the systems designers and
computer user can have everything ready on time for putting the system into
operational use.
However, the risk is high of late completion of the system development,
particularly if the system is complex, or the computer user changes the system
specifications during the development phase.
The project sponsor or computer user should be kept informed (by the project
manager) when there is a delay in completing the project. The sponsor or
computer user can then decide whether the delay is acceptable, from a business
or operational perspective, or whether alternative measures need to be taken
until the new system can be implemented.
1.3 User resistance to the new system

User resistance is a common problem with the implementation of a large new
computer system. Resistance from the staff of the computer user may be caused
by:
 dislike of change and unfamiliar new procedures (‘the unknown’)
 a fear about losing their jobs
 a fear that the skills they have built up in the past with the old system will
become worthless
 dislike of having changes forced on them by management.
When there is user resistance, the staff of the computer user might refuse to
operate the new system properly, and deliberately try to make the system seem
inadequate. The benefits of the new system could easily be lost.

A task for management is therefore to overcome this resistance and persuade

staff to accept it and try to make it work successfully.
 This may have been achieved by involving the user’s staff throughout the
development of the new system. This could mean asking user staff for their
opinions about aspects of the new system design, or asking for their
suggestions about how the design can be improved. For example, staff
should be encouraged to comment on the system during acceptance
testing.
 Top management must also be actively involved in giving their full support
to the new system and the driving the development project forward. The
Project Sponsor might be a senior manager.
 Training and development is also vital to make the user’s staff familiar with
the new system.
 There should also be regular communication by senior management and
the system development team with all users. Communication should begin
before the project commences, and should continue during the
development of the new system and post-implementation. Employees like
to be told what is happening, and will be less fearful if they are kept well
informed.
1.4 Training
User staff should be trained in how to use the system, and training should be
timed to coincide with acceptance testing and implementation.
A training plan should be prepared. The issues to consider are as follows:
 The new skills required by the new system, and so the amount of training
required, and the nature of the new skills.
 The number of user staff who will need training, and the time scale within
which they must be trained.
 The various methods of training available, and the preferred choice of
training method (or combination of training methods).
 Whether the training should be on the user’s own premises or in a remote
location.
 The costs (and relative effectiveness) of the different training options.
 Deciding on a process for monitoring the effectiveness of the training, so
that additional training can be provided if the initial training is ineffective.
Training methods
The method or methods selected for training staff may vary according to the
number of individuals who need training, and whether or not the software is
bespoke or an application package.
 Classroom training ‘in-house’. A computer user may arrange its own
classroom training for staff. This form of training may be appropriate for a
new bespoke system, where large numbers of staff will work with the
system.
 External classroom training. A supplier of an application package may
provide training for employees of its customers. This training may be delivered
at the premises of either the software supplier or the customer (the computer
user).

 Computer-based training. Computer-based training may be available for

an application package.
 Instruction manuals. The user may expect its staff to learn the new
system by reading instruction manuals about the new system and how it
operates. Instruction manuals may be available in a printed form or in
electronic form (or both).
 Desk training/ work-based training. Users may be expected to learn how
to use a new system ‘on the job’. Work-based training (desk training) can
be effective provided that the system is user-friendly and provided that
there are other staff available to give advice and assistance who are
already familiar with the system.
Advantages and disadvantages of training methods
Each method of training has advantages and disadvantages.
Advantages Disadvantages
In-house classroom training

It should be possible to train large Large numbers of staff will be away
numbers in a short time. from their day-to-day work at the same
time.
Probably the quickest and most It may be administratively difficult to
effective training method for a provide enough hardware facilities for
bespoke system, where only in- an effective training programme.
house staff have knowledge of the
system.
External training courses

An external trainer will normally take Training all staff could take a long time.
relatively small numbers on a
course. This means that only a few
members of staff will be away from
their day-to-day work at any time.
Staff will have a chance to meet The content of an external training
users of the software who work in course is likely to be standardised, and
other organisations, and learn from is not customised to the particular
their ideas and experiences. needs of a customer.
Computer-based training (CBT)

The training can be delivered at a Individuals often have difficulty in
time to suit the individual getting motivated by CBT.
Probably by far the cheapest training There is no tutor to answer questions
option. when the trainee does not understand
something in the learning material.
CBT for the software may not be
available.

1.5 File conversion and file creation

File conversion and file creation have been explained in an earlier chapter. When
a new computer system is designed and implemented, up-to-date data files must
be available for the new system. Since the data files do not exist in the required
form and format before the new system is developed, it is necessary to create
new files and populate them with up-to-date and accurate data.
There are two ways of producing data files for the new system.
 To produce the files ‘from scratch’ (file creation). This involves transferring
data from existing manual system files to the new computer system file
formats
 Where the new system is replacing an old computer system, to convert the
files for the old system into files that are compatible with the new system
(file conversion).
In many cases, there is a combination of file conversion and file creation. Data on
the files of the old system may be converted to files for the new system, but the
new system may need additional data, or may need the data in an amended
form. In such cases, some data can be converted, but new data has to be
created and added to the files.
File creation and file conversion are important activities in system
implementation, because the computer user needs to have accurate data files
from the beginning. If the files are not accurate from day one of the new system,
they will never be accurate.
File creation
Transferring data from existing (‘old’) system files to computer files for the new
system can be a time-consuming process. It may involve employing staff to key in
the data to the new system to create the files. Input using keyboard, mouse and
screen is not only time-consuming: there will be a high risk of input errors. The
conversion process should include checks and safeguards to minimise the errors.
 There should be an audit of the existing manual file records, to ensure that
they are accurate and contain all up-to-date relevant data.
 The records for input to the new system files should be put into a format for
copying them by keyboard and mouse. This could involve copying data
from the existing manual files on to specially designed data input forms or
documents. Where necessary, additional items of data should be added to
these forms.
 The data input forms should be batched, so that a check can be made on
the batch totals, to ensure that no entries are lost or omitted. (For example,
the computer program can check that the number of records input in a
batch equals the batch control total number of records for the batch).
 The computer program should include data validation checks, to identify as
many input errors as possible. Many input errors will occur due to keying-in
errors by staff (human error).
 The input of data to the new files might be done in two stages. ‘Fixed data’
might be input first, and ‘variable’ transaction data might be entered at a
later date, closer to the system implementation date. Fixed data is data that
is expected to remain unchanged on the file for a fairly long period of time.
For example, in a payroll system, fixed data will include for each employee,
the employee number, employee name, department, home address, and
employment grade or level of wage or salary. Variable data would include

total pay for the tax year to date and total deductions from pay (for tax and
other deductions) for the year to date.
The advantage of inputting variable data later is that once variable data has been
input to the new computer files, it must be kept up-to-date. Keeping fixed data up-
to-date is much easier, because changes are less frequent.
A cut-off date must be established for when new transaction data will cease to be
input to the old system, and will be input directly to the new system instead.
Copies of the data input to the new computer system files should be printed out
and checked for accuracy, by comparing them with the data on the current
manual system files.
File conversion
When the new computer system is replacing an old computer system, the
process of creating new system files should be easier. A special program can be
written (a bespoke program) to convert the records on the old system files and
produce new system files automatically.
The transfer from an existing computer system to the new computer system file
formats will involve:
 Validation checks and
 Control totals may also be used in the specially-written conversion
software, to ensure the accuracy of the data transfer.
Planning file conversion and data creation
File conversion and data creation require careful planning.
 As a general rule, file conversion should be preferred to file creation, for
large data files. Although there is the expense of writing a file conversion
program, the process should be quicker than creating data files, and there
will be fewer errors.
 The system designers need to identify how much data can be converted
from the old system, and how much data will have to be created.
 A specification for a data conversion program can then be prepared.
 An estimate should be made of the amount of time it will take to convert
/create the files for the new system. Where necessary, plans should be
made to hire staff to carry out the data creation tasks.
 The file conversion/creation process should be scheduled so that the files
are available for implementing the new system.

Example:
Suppose that a university is developing a new student registration system to
replace an older system. Both the old and the new systems have a student file.
The contents of the old system file and the contents of the new system file are as
follows:
Old system New system
Field/attribute Characters Field/attribute Characters
Family name Maximum 15 Family name Maximum 20
Other names Maximum 20 Other names Maximum 25
Date of birth 6 digits Date of birth 6 digits
Address Maximum 50
House number/name Maximum 20
and street
Town Maximum 20
Postal code Maximum 7
Student number 5 digits Student number 6 digits
Course number 3 digits Course number 3 digits
Tutor Maximum 15
Much of the data for the student file in new system can be converted.
 The family name of the student and the other names can be converted
directly. The new system file allows more characters for each
field/attribute, but this does not matter, and will not affect conversion.
However, on conversion, no student will have a family name exceeding 15
characters or other names exceeding 20 characters in length.
 The date of birth and the course number can also be converted directly.
 The five-digit student number in the old system can be converted to a six-
digit number for the new system, probably using a code conversion table
in the conversion program.
Some of the data will have to be created for the new system file.
 The ‘Tutor’ field is new, and will have to be added to the new system file
records.
 The address in the old system is a single field of up to 50 characters. For
the new system, the address is divided into two lines plus a postal code.
The system designers will need to assess whether the single field for the
address can be converted automatically into three fields for the new
system. If conversion is not possible, the three address fields will have to
be keyed in by hand for the new system files.
1.6 System documentation

When a new system is implemented there should be a complete set of
documentation for the system including user instruction manuals and operating
instructions. However, documentation should be available relating to the system
design and testing.
Documentation should be prepared in accordance with IT standards and quality
assurance procedures.

Feasibility study report

The initial document for a new computer system is the feasibility study report.
This should be produced to a high standard so that:
 It can provide a starting point for designing the new system, and
 It can be used as a reference point for system review, when the actual
costs and benefits of the new system are assessed, and compared with the
expected costs and benefits.
Requirements specification
This document specifies the user’s requirements for the new system. The
requirements should be specified in detail. (In the Spiral method of system
development, the user’s requirements may be amended with each new prototype
of the system.)
It is an important document, because it:
 Provides detailed guidance for the system designers about what the system
is expected to produce for the user
 Provides a reference point during testing to check whether the new system
is meeting all the requirements
 Provides a reference point for resolving any disputes between IT staff and
the computer user about the actual performance of the system after it has
been implemented.
System (design) specification
This document, prepared by the systems analysts, contains the detailed systems
design and program specifications.
 It is a documentary record of the system that the analysts have designed.
 It is used by programmers as a starting point for programmers, for writing
individual programs for the system.
 It is used for system maintenance. If a program has to be changed, to
remove errors or to update the system, the system specification is used as
a starting point for designing and making the changes.
 It is a reference document for dealing with technical problems or queries.
The systems specification will actually consist of several documents, including:
 An overall system design (including diagrams and charts)
 Program specifications, for each program
 User manuals
 The systems performance requirements (see below)
 Test data. A copy of the test data used for program tests and system tests
is retained in the system specification documentation. This may be referred
to when errors are discovered in the system after implementation, or might
be used again for re-testing if the programs are updated or amended.
 Test results. The expected results from processing the test data should
also be kept on record, together with the results from the actual tests.
These will also be referred to when errors are discovered in the system
after implementation, or might be used again for re-testing if the programs
are updated or amended.

System performance specifications

The systems performance specifications state the levels of performance that are
expected from the system, and the standards to which the new system should be
operated.
They are not specifications for the processing and output of the data in the
system. These specifications relate to IT aspects of operating the system.
Items that will normally be included in the systems performance specifications
are:
 Performance objectives, such as processing response times (how quickly
the system should respond to input by a user), and the amount of computer
downtime.
 Volumes of data and transactions that the system should handle from the
beginning of operations, plus the expected growth in volume over time
 The methods that should be used for creating archives of historical data (for
example, creating file archives on CD or DVD)
 Methods of creating back-up copies of files, and the frequency with which
back-up copies should be created
 Recovery procedures for the use of back-up files
 The requirements for creating and maintaining network logs
 Specifications for providing an audit trail for data and transactions
 Specifications for the interface of the system with other systems of the
computer user
 Specifications for file creation or file conversion
 Specifications for data protection and data security
 Specifications for physical security for the system
 Specifications for the training of staff
 Specifications of the documentation required
 Specification of the implementation method/changeover method.

2 IMPLEMENTATION METHODS
Section overview
 Introduction
 Parallel running
 Direct changeover
 Pilot test
 Phased changeover
 Comparison of parallel running and direct changeover
2.1 Introduction
When a new computer system is implemented, there must be a strategy for
moving from the old system to the new system, with minimum disruption or
operational difficulties. Strategies for implementing a new system are sometimes
called ‘changeover strategies’. There are four possible changeover strategies:
 Parallel running
 Direct changeover
 Pilot test
 Phased changeover
2.2 Parallel running

With parallel running, the new system is introduced in full, but the old system is
also kept in operation. The two systems are therefore operational at the same
time, operating ‘in parallel’.
The output from the new system is checked against the output from the old
system. When the new system appears to be working correctly and effectively,
the old system is shut down and the period of parallel running comes to an end.
In theory, parallel running is the least risky changeover strategy, because the old
system is not shut down until the new system is shown to be working properly.
However, parallel running is expensive, because two systems are running at the
same time. It also requires a lot of staff, some to operate the old system and
some to operate the new system.
In many cases, parallel running is also impracticable. For example, a retail store
cannot introduce a new point-of-sale computer system (EPOS system) and run it
in parallel with the old one – customers would refuse to tolerate having their
purchases checked out twice, once by the old system and once by the new
system.
2.3 Direct changeover

With direct changeover, the old system is shut down immediately, and the new
system is introduced in full to take its place. This is suitable when management
has great faith in the new system and is confident that nothing serious can go
wrong with it. Alternatively, it might be appropriate when the new system is not
critical, so that if it fails to work properly, the risk to operations is not high.

The problem with direct changeover, however, is the risk that the new system
might not work properly. If it doesn’t, the user cannot resolve the problem initially
by returning to the old system for a while, until the problems have been resolved,
because the old system no longer exists.
2.4 Pilot testing

Pilot testing might be appropriate when the new system will be implemented in
several different parts of the organisation, such as in several geographical
regions or areas, or in several different departments.
A pilot test can be conducted in one area or one department first. In the test area,
the old system is replaced directly with the new system, and the new system is
monitored closely for a test period. Typically, senior management of the
computer user and system development staff will visit the test area regularly, and
monitor operations.
An advantage of pilot testing is that if there are problems with the new system,
they will be restricted to a small part of the organisation. If IT staff monitor the test
closely, it is also more likely that the problems will be identified early and
corrected quickly.
2.5 Phased changeover

In a phased changeover, the new system is introduced gradually, in phases.
There are two ways of doing this.
 When the system is being introduced into a large number of different areas
or departments, it might be introduced gradually, into just a few areas or
departments at a time. For example, if there are 20 regional branches in a
business, two branches at a time might be changed over to the new
system. This method of conversion is popular for geographically dispersed
network systems.
 When the system contains several different parts or elements, the different
parts might be introduced one at a time. For example, when a new
accounting system is introduced, the receivables and nominal ledger
modules might be introduced first, followed by the payables module, then
the inventory control module, then the payroll module and so on.
The purpose of a phased changeover is to enable problems with each location or
with each new module to be dealt with one at a time, instead of having to deal
with all the problems arising with the new system all at the same time.
2.6 Comparison of parallel running and direct changeover

The computer user has to choose a method of implementation for a new system.
The choice will depend on circumstances. Parallel running and direct changeover
are compared in the following table. Pilot tests and phased changeovers are
restricted forms of direct changeover.

Parallel running Direct changeover

Advantages Advantages
Less risky. If the new system fails, The quickest method of implementing a
the old system is still in operation. new system.
File changeover is also safer. The Less expensive than parallel running.
new system files can be compared Only one system is in operation at any
directly with the old system files. time.
Requires less staff time than parallel
running, because only one system is in
operation at any time.
The risk can be reduced by having a
pilot test or phased changeover.
In some cases, direct changeover (or a
pilot test) is the only practicable option.
Main disadvantages Main disadvantages
Needs more staff resources and is Possibly a high risk. What will happen if
more expensive than direct the new system fails?
changeover.
Parallel running may not be
practicable. This is often the case
when external users have access to
the system, or when customers are
affected by the system (for example,
a point of sale system is a
supermarket or store).

3 POST-IMPLEMENTATION ISSUES
Section overview
 Measuring the success of a new system: metrics

 System efficiency
 System effectiveness
 Other metrics
 Collecting metrics
 Post-implementation review and end-project review
 The time-cost-quality triangle
 User support: information centres/help desks
3.1 Measuring the success of a new system: metrics

When a new system has been implemented, management should monitor its
performance. For control purposes, management should try to establish whether
the system is a success or a disappointment.
To assess the success or failure of a system, there must be measures (‘metrics’)
for measuring performance and comparing performance against a target or
objective. Metrics are quantitative measures of something.
Metrics for measuring the success of a system may include measures of:
 System efficiency. Did the original feasibility study expect the system to
provide efficiency improvements? If so, what was the efficiency target? Has
this target been achieved by the new system?
 System effectiveness. Did the original feasibility study expect the system
to carry out a task or function? Was there a target for what it should
achieve? If so, what was this target for achievement? Has this target been
achieved or exceeded by the new system?
 Usability. How easy to use is the new system? How intuitive is the
interface?
 System performance. This can be measured in response times for users
of the system, volumes of transactions processed and the average down
time for the system per month.
 Quality. Does the system deliver effectiveness in an efficient manner?
 Cost. Did the original feasibility study include estimates of how much the
system should cost to operate? How do actual operating costs compare
with the original plan?
 Time. What was the original planned implementation date for the new
system? Was this achieved?

3.2 System efficiency

Tests of system efficiency are to check whether the system:
 Makes efficient use of operational resources
 Is cost-efficient
 Carries out a particular task or operation more efficiently than the old
system.
The post-implementation review will also consider the efficiency of the system
development, as well as the system in operation.
Some tests of efficiency are as follows:
 Has the new system achieved the expected cost savings in operation?
 Has the new system achieved the required improvements in processing
speed and response times?
 Have other expected productivity gains (such as reductions in staff
numbers) been achieved?
 Does the computer user find the new system easier to operate?
 Does the new system operate with more reliability (less down-time) than
the old system?
Examples of metrics for testing efficiency are:
 The number of transactions (for example, customer orders) processed per
day
 The response time for database queries by users
 The time taken to print a standard report.
3.3 System effectiveness

Tests of effectiveness are to check whether the system achieves its operational
requirements, for which it was designed and developed. Some ways of testing
effectiveness are as follows:
 Does the new system meet the user’s requirements in terms of data
processing and data filing?
 Has the new system improved the quality of information for the user?
 Has the system succeeded in boosting sales revenue by the amount
expected in the feasibility study?
 Does the new system interface effectively with other computer systems of the
user?
 Is the new system able to respond effectively to changes in the business
environment? Is the system flexible and adaptable?
 Has the new system improved the satisfaction of the user and the user’s
customers?
Examples of metrics for testing effectiveness are:
 The volume and growth rate for the number of transactions processed
 The number of users per day
 The volume of data stored on a database

 The percentage of customer orders delivered by the agreed delivery date

 The percentage of business functions defined in the requirements
specification which have been successfully implemented
3.4 Other metrics

Metrics for usability
Metrics for testing the usability of a system might be:
 A measure of how many people are using the system each day or each
week, compared with the original expectation. The metric can be measured
by logging each connection or call to the system over a period of time.
 A ‘usability score’, based on a questionnaire survey. For example, users
may be asked to complete a questionnaire in which they rate the usability
of the system on a scale of 1 to 10. An average score can then be
calculated. The survey can be repeated from time to time, and changes in
the usability score can be monitored.
Metrics for system quality
Metrics for testing the quality of a system might be:
 The average time between failures of the system (for an average of 20
days between crashes)
 The total time spent on corrective maintenance of an application
3.5 Collecting metrics

Metrics may be gathered manually or by computer. For example, calls to a
helpdesk might be logged manually on paper records by the helpdesk staff, but it
is more likely that calls would be logged and counted by a computerised call-
management system.
Software monitors
Software monitors are items of software in a system that monitor the activity in
the system, as a way of collecting information for metrics. For example, a
software monitor could be used to measure the number of hits per hour on a web
site page, or the number of input data errors per 1,000 transactions.
3.6 Post-implementation review and end-of-project review

The purpose of post-implementation review and an end-of-project review is to
consider whether objectives have been met, efficiently and effectively, or whether
mistakes were made from which lessons can be learned for the future.
Post-implementation review
A post-implementation review is a meeting of management, system users and
system developers that is held sometime after the system has been
implemented.
The purpose of the post-implementation review is to assess the success of the
system, and to discuss what went well and what went badly in the development
of the system. Management will want to establish whether the system has
achieved its business objectives.

End-of-project review
An end-of-project review is a meeting of the project team and IT management at
the end of the project, just before the project is officially terminated. The purpose
of the meeting is to consider whether the project was a success and whether the
system development was satisfactory.
The matters considered by an end-of-project review should include:
 Assessing the terms of reference in the project initiation document, and
deciding whether these have been met successfully.
 Productivity of the project team. The review should consider whether the
project team did its work efficiently, or whether more resources were used
than expected. The meeting should also review the budget for the project,
and whether actual costs were kept within the budget.
 Performance. The review should also consider the effectiveness of the
performance of the project team. In particular, it should look at whether the
project was completed before the target date. The reasons for any delays,
such as the need to correct errors found in testing, or continual changes in
the user’s requirements, should be identified.
 Quality. The review should assess the quality of the systems development
work, and its conformity to IT standards and quality assurance procedures.
Metrics for review assessments
Post-implementation reviews and end-of-project reviews are likely to include
metrics about system performance and system development.
 The metrics used to assess the success of system development in the
post-implementation review should be agreed at an early stage of the
project and specified in the Project Initiation Document. The post-
implementation review will then use these metrics to evaluate the
implemented system.
 For an end-project review, a metric used to review performance might be
the average percentage overrun in time for various project tasks. Statistics
might be gathered for individual stages of the system development, such as
analysis, design, programming, testing and implementation. The end-of-
project review can then identify significant problems in the conduct of any of
these stages and recommend what actions should be taken to avoid similar
problems in future projects.
3.7 The time-cost-quality triangle

Projects are affected by the conflicting requirements of time, cost and quality.
 Time. The computer user will want the project to be ready for
implementation by a target date. In order to achieve an early target date, it
may be necessary to incur additional costs (by obtaining more resources to
complete the work more quickly) or to accept some reduction in project
quality (for example, by reducing the amount of testing on the system).
 Cost. The computer user or project sponsor will want the project to be
completed within the budget spending limit. However, to reduce spending,
it may be necessary to tolerate some delay in completing the project or to
accept some reduction in quality. For example, the computer user may
have to accept an application software solution because it is cheaper, when
a bespoke solution would be much better, but more expensive.

 Quality. The project team and the computer user will want the system to
achieve targets for quality. However, in order to achieve those targets, it
may be necessary to accept some delay in completing the project, or some
over-spend above the budget limit.
When a project is planned and initiated, management should have a clear idea of
where they want to position the project in the time-cost-quality triangle. If a quick
completion is required (for example, because a competitor has already
introduced a successful new system) it may be decided to incur higher costs or
accept a lower quality of system.
Most critical
Example of a project
factor
Time A new system to compete with systems of competitors
Cost Low-budget system
Quality A new system where health and safety issues are critical,
such as a system for recording patients’ medical records in
a health system.
The review of a system and the review of the project development should also
recognise the conflicting needs of time, cost and quality.
3.8 User support: information centres/help desks

Another post-implementation issue is providing support for the computer user,
whenever the user is having difficulty with operating the system.
Maintenance and user support from a software supplier
When software is purchased from an outside supplier (both standard packages
and bespoke software provided by a software house), the computer user might
enter into a user support agreement. The software supplier will then undertake to
provide a level of support and maintenance, in return for an agreed fee.
A contract with a software supplier may provide, for an agreed period of time (say
each year, with the agreement renewable at the end of each year):
 a help desk service (see below)
 an undertaking to correct any errors discovered in the system
 an offer to supply a new version of the system (a system upgrade),
whenever a new version is produced, at a discounted price.
Information centres/help desks
User support can be provided by an in-house or external help desk. An
information centre or help desk is a small team of IT experts who provide support
to a computer user. This end-user technical support may be provided by an
internal IT department or by a third party organisation (outsourced).
A user is having difficulty with the system, or needing something for the system
(such as new hardware items), can contact the information centre and ask for
assistance.
Assistance is usually provided by e-mail and telephone. However, in some
circumstances, an individual from the information centre might make a site visit to
the user to deal with the problem directly.

The main services provided by an information centre include:

 providing technical ‘help desk’ support; for example
 Helping the user with system recovery where the system has crashed
 Answering queries about the system and operating the system when
the user gets into difficulty.
 Procurement (purchasing) advice to end-user departments
 Providing advice and recommendations to the user’s management about
the performance of the system, such as the need for
 maintenance
 better security measures (such as better quality anti-virus software,
improved quality firewall software and better password systems)
 additional software licences, where additional users have been added
to the system.

4 SYSTEM MAINTENANCE AND CHANGE CONTROL
Section overview
 The need for system maintenance

 Types of system maintenance
 Planning system maintenance
 Change control
 User groups
4.1 The need for system maintenance

System maintenance is a continuing requirement for a system after its
implementation. If errors are discovered in the system, these must be corrected.
If the user’s requirements change, possibly due to a change in the business
environment (for example, a change in the law or a change in computer
technology), the system should be altered to meet the new requirements.
The costs of system maintenance after implementation can be much higher than
the costs of the original system development. There are several reasons for this.
 Increased dependence on computer systems for core operations. For
many organisations, key operations depend on a computer system that is
reliable and functions properly. Keeping the system well maintained is
therefore essential. For example, the banking system would collapse if the
computer systems of the banks were not of excellent quality.
 The increased complexity of computer systems. As systems get more
complex, the probability of errors in the system increases, and the
probability that the system requirements will continually change is also
higher.
 The speed of technological change in computer systems and
communications systems. Old systems might have to be adapted to the
requirements of new technology.
 Distributed processing and networks. Many entities have
geographically-dispersed business units, each requiring a constant high
quality of operation and so a high standard of maintenance provision.
 A constantly changing business environment. The requirements of the
computer user will change continually as the business environment
changes.
 Increasing security threats to computer systems. There are severe
threats to computer systems from unauthorised ‘hackers’ and computer
users need to be on a constant alert for unauthorised access to their
systems. Security measures have to be improved continually, although the
sophistication of computer hackers also continues to increase.
4.2 Types of system maintenance

System maintenance often refers to maintenance of the software, but can also
refer to the maintenance of faulty hardware, or upgrading of hardware systems
as the technology changes.
Three types of system maintenance are commonly identified:

 Corrective maintenance (including preventive maintenance)

 Adaptive maintenance
 Perfective maintenance
Corrective maintenance
Corrective maintenance is the correction of errors in the system software and
repairing hardware faults. The need for corrective maintenance arises because
of:
 Poor quality systems design
 Errors in the programs
 Transactions with features that were not anticipated when the system was
designed, such that the system cannot process the transaction correctly
 Human errors in handling hardware, and hardware failures
 Deliberate corruption of the system, for example by computer viruses.
The computer user should expect the amount of corrective maintenance to be
within an acceptable limit.
If the level of corrective maintenance is within the expected limit, then it may be
useful to initiate a preventative maintenance plan. Preventive maintenance is
intended to reduce the probability of errors that need correction. A program of
preventive maintenance would involve periodic system audits to identify software
maintenance requirements. All subsequent changes to the system made to the
system must be documented in order to provide a maintenance audit trail.
Regular servicing of hardware might also successfully prevent hardware faults in
system operations.
Adaptive maintenance
This is maintenance to adapt the system to new requirements. These arise
because of changes in the system’s environment. The need for adaptive
maintenance might arise because of:
 Changes in the user’s needs
 Changes in legislation
 Changes in IT technology
 A need to adapt the system to handle larger volumes of data
 Changes arising because of a change in the computer user’s organisation
structure.
If a system is kept in operation for a long time, the user’s requirements will
inevitably change over time. If the system is not adapted as change becomes
necessary, it will become less efficient and less effective.
Perfective maintenance
Perfective maintenance is carried out on a system to make it more efficient and
more effective (to make it more ‘perfect’). Opportunities to perfect a system might
arise as a result of:
 New capabilities of standard software (such as improvements in operating
systems)
 New opportunities arising from new technology

 The user’s experience in using the system, so that the user identifies ways
in which the system could be made better
 A post-implementation review into the system’s efficiency and
effectiveness.
4.3 Planning system maintenance

The maintenance of a computer system should not be a haphazard operation. It
should be a planned activity. This will ensure that the quality of the performance
of the system is maintained within acceptable business standards. Planned
maintenance activity can be referred to as a maintenance life cycle because the
process is repeated continually.
The following diagram illustrates a formal procedure that might be used:

4.4 Change control

Change control refers to the requirement for controlling changes to a system,
whenever corrective, adaptive or perfective maintenance changes are made.
Changes should be properly planned, documented and controlled. All changes
should be designed using standard procedures and properly tested.
Procedures for change planning and control should include:
 A formal document for requesting a change to the system
 A procedure for analysing/assessing the impact of the change
 A process for agreeing and authorising the change: a change should be
authorised by a manager with the authority to approve a corrective change
or an adaptive change to the system
 A procedure for analysing the change requirements, and drafting a design
for the change
 A procedure for allocating the programming work to an appropriate
programmer
 A procedure for testing the new version of the software
 A procedure for identifying each new version of software, and releasing it
into operational use
 A procedure for documenting the system design and programming changes
 A procedure for updating the user’s documentation for the system
(operating instructions and help facilities in the software).
Regression testing and post-implementation changes
Regression testing was described earlier, in the context of making amendments
to a system during the testing stages of system development. Regression testing
should also be used for testing post-implementation changes to the software.
Regression tests are automated tests on software that has not been re-written, to
test that there is no knock-on effect from changes that have been made to
another part of the system software.)
4.5 User groups

A user group is a group of users who all use the same computer system. They
can form a self-help group.
If one user has difficulty with an aspect of the system, help can be sought from
another user who might have had a similar experience in the past.
Users can also share their experiences, and exchange information about
operating the system.
For off-the-shelf application packages, a user group might consist of different
organisations. The software provider might help to establish the user group, and
put users in contact with each other.
For bespoke software, there might be different users of the system within the
organisation. These might form a user group.
If the user group is successful, its members will improve their understanding of
the system they are using, and will find ways of dealing with operational problems
that they encounter – without having to incur the cost of a maintenance support
contract with the software supplier.

5 CHAPTER REVIEW
Chapter review
Before completing your work on this study text check that you can:
 Summarise the key implementation considerations such as user resistance,
training, file conversion/creation and system documentation
 Differentiate between the various system implementation methods including
parallel running, direct changeover, pilot testing and phased changeover
 Briefly explain the various post-implementation considerations including collecting
metrics for measuring success of the implementation
 Summarise the different types of system maintenance
 Explain the concepts of change control and user groups

Foundation level
I
Index
Average payables period 287

a
Abnormal gain 193
b
Abnormal loss and loss with a scrap
value 190 Backup 395
Abnormal loss 188 Bandwidth 375
Absorption costing 80, 124, 139 Barcodes and EPOS 337
advantages and disadvantages 131 Basis of apportionment 87
definition 80 Batch costing 170
Absorption rate 98, 139 Batch processing 398
Absorption for 85 Batch production 170
abnormal gain 193 Bottom-up budgeting 264
abnormal loss 188 Break-even
normal loss 184 analysis 298
Activity-based budgeting 268 chart 304
Activity-based costing (ABC) 142 point 298
advantages 150 Budget 247
disadvantages 150 committee 248
Adaptive maintenance 487 manual 248
Additive model 240 period 247
Administration costs 21 process 250
Allocation 85 slack (budget bias) 271
Application software 344 slack 265
Apportioning common processing Budgetary
costs 218 control 248
Apportionment 85, 87 systems 264
Aspirational budgets 271 By-products 221
Automatic repeat-request (ARQ) 396
Average collection period 287

Data entry 393

c Data mart
Data mining
410
413
Data warehouse 409
Career paths for accountants in an IT Data 4
environment 453
Database management systems
Cash budgets 281 (DBMS) 403
Cash flow forecasts 281 Database 403
Cash operating cycle 286 Decentralisation of IT 459
Centralisation of IT 459 Decision package 266
Change control 486 Decision support systems 351
Client-server computing 362 Decision-making: marginal costing 318
Closed systems 331 Denial of service 430
Cloud storage 372 Desk-top personal computers (PCs) 335
Clustering 415 Digital cameras 337
Collection of receivables 287 DIK hierarchy 346
Communications software 343 Direct changeover 477
Composite cost units 173 Direct expenses 35
Computer Direct labour usage budget 260
hardware 334 Direct labour 34
network 361 Direct materials 33
software 342 Discovery model 414
systems 334 Distributed processing 399
Contribution per unit 120, 295 Domain name 373
Contribution 118
Contribution/Sales ratio 295, 297
Control systems
Control
332
7 e
Conversion costs 179
Corrective maintenance 487 Email etiquette 384
Cost accounting 8 Email usage policy 432
Cost and management accounting 9 Email 380
Cost behaviour graphs 28 Encryption 427
Cost behaviour 26 End-of-project review 483
Cost centre 84 Enterprise resource planning (ERP) 357
Cost drivers 144 Equivalent units - FIFO method 205
Cost estimation 45 Equivalent units - weighted average
Cost formulas for inventory 66 cost method 201
Cost pools 144 Equivalent units 198
Cost-volume-profit analysis 295 Error
CVP analysis 295 correction 396
detection 396
Executive information systems 352
D Expectational budgets
Expenditure variance
271
107
Expert systems 352
Data and information 345 Extensible business reporting
Data cleansing 411 language (XBRL) 370

Index
Extensible Markup Language (XML) 369 Information system 347

types 348
role 349
f Information technology
Information
347
4
Input devices 335
Facilities management 463 Integrated IT systems 356
Feasibility study report 475 Integration of data 405
FIFO method of process costing 205 Integrity of data 404
File conversion 472 Internet hosting 372
File creation 472 Internet message access protocol
File servers 362 (IMAP) 365
Finance costs 22 Internet Protocol (IP) 364
Financial accounting 9 address 373
Financial reporting systems 353 Internet Service Provider (ISP) 373
Firewall 427 Internet usage policy 431
First-in, first-out method (FIFO) 67 Internet 371
Fixed costs 26 Introduction to information systems 345
Fixed overhead 110 Inventory turnover period 287
absorption costing 110 IS
Forward error correction (FEC) 396 costs 447
Fraud and theft 425 strategy 443
Full cost 37 IT costs 447
Functional budgets 249, 252 IT management in organisations 457
Functional costs 23 IT strategy 443
h j
Hacking 426 Job account 159
Help desk 484 Job card 159
High/low analysis 45 Job costing 157
HTML 372 Job sheet 159
Hypertext mark-up language (HTML) 369 Joint products 218
Hypertext transfer protocol (HTTP) 365, 369
k
i
Keyboards 335
Implementation methods 477 Knowledge 345
Incremental budgeting 265
Independence of data 404
Indirect costs
Information - attributes
36, 78
5
l
Information literacy 346
Information system security 421 Labour costs 20

Labour usage budget 260 Network servers 362

Legacy systems 463 Networks 361
Linear regression analysis 57 Non-production costs 21
Local area network (LAN) 362 absorption costing 101
Locking the computer 436 Normal loss 183
Logging of user-data 428 Notebooks 335
Logging-on and -off 436
Logic bombs 430
o
m Off-line storage 341
One-off decision making 7
Magnetic ink character recognition On-line analytic processing (OLAP) 411
(MICR) 336 Online processing 398
Mainframe 334 Open systems 331
Management accounting 8 Operating system software 333, 342
Management information systems 351 Optical mark reading (OMR) 336
Manufacturing costs 21 Order processing and inventory
Margin of safety 300 control systems 354
Marginal cost 27, 117 Output devices 338
Marginal costing Outsourcing IT 462
advantages and disadvantages 132 Over-absorption 104
assumptions 118 Overhead absorption 98
reporting profit 119 rate 98
uses 117 Overhead apportionment 87
Marginal costing and absorption Overhead cost allocation 86
costing 127 Overhead costs 144
Marginal costing for decision-making 318 Overhead recovery rate 98
Marginal costing 78 Overheads 36, 78
Marketing costs 21
Master budget 248
Material costs
20
257
p
Materials usage budget 255
Mice, trackballs and similar devices 336 Packet switching 367
Mini-computers 335 Parallel running 477
Monitor (display) 339 Participation in budget setting 272
Moving averages 231 Passwords 426
Multi-processing 400 Perfective maintenance 487
Multi-programming 400 Period costs 37, 38
Multi-tasking 400 Personnel systems 355
Phased changeover 478
Physical disaster 424
n Pilot testing
Planning
478
6
Portable laptops 335
Net realisable value (NRV) 65 Post office protocol (POP) 366

Index
Post-implementation Scanners and optical character

issues 480 recognition (OCR) 336
review 482 Scarce resources 321
Predetermined overhead rate 103 Seasonal variations 240
Primary storage (internal memory) 340 Secondary storage (external
Prime cost 35 memory) 340
Principal budget factor 249 Secrecy 421
Printers 339 Security risks 423
Privacy 421 Selling and distribution costs 21
Process costing 179 Semi-variable cost 28
abnormal gain 193 Server 372
joint products and by-products 218 Service
Product costs 38 centres 87
Production and non-production costs 23 costing 173
Production budget 254 department costs -
apportionment 90
Production costs 21
departments 86
Profit/volume chart (P/V chart) 306
Set-up costs 171
Programming tools and language
translators 343 Shared infrastructure costs 452
Projector 339 Simple mail transfer protocol (SMTP) 366
Proportional model 242 Simple object access protocol
(SOAP) 365
Protocol 363
Single limiting factor 321
Social networking 433
r Software and operating systems

Speakers and headsets
342
339
Spreadsheet 251
Real time processing 399 Statement of cost per equivalent unit 199
Reciprocal method: simultaneous Statement of equivalent units 199
equations technique 95 Steering committee 458
Recovery rate 98 Stepped cost 30
Recovery 85 Storage devices 339
Regression analysis 57 Supercomputers 334
formulae 58 Synchronising email 380
Relevant costs 317 System/s 331
Requirements specification 475 analysts 458
architecture 361
(design) specification 475
s documentation
effectiveness
474
481
efficiency 481
Safeguarding data 429 maintenance 486
Safeguarding stored data 430 performance specifications 476
Sales budget 252 software 342
Sales value at the split-off point basis 219
Sales value less further processing
costs basis 219

Variable overhead 110

t absorption costing
costs
110
117
Verification model 414
Target profit and CVP analysis 301 Videoconferencing 386
Tertiary storage 340 Virus 430
Time bombs 430 Voice date entry (VTE) 337
Time-cost-quality triangle 483 Volume variance 107
Top-down budgeting 264
Total contribution 119
Touch-sensitive screens and touch
pads 335 w
Transaction processing systems 350
Transaction processing 393 WAVCO 69
Trap doors 430 Website hosting 371, 372, 373
Trojan horses 430 WebTrust 433
Weighted average cost (WAVCO)
method 69
u Weighted average cost method
Weighted average cost
201
66
Wide area network (WAN) 362
Under- and over-absorption 140 Windows password 439
Under-absorption 105 Windows screen-saver 437
Uniform resource locator (URL) 368 Wireless application protocol (WAP) 367
USB sticks and other removable Working capital cycle 286
devices 432
Working capital 279
User datagram protocol (UDP) 364
Working in industry 454
User groups 489
Working in public practice 453
User resistance 469
Working in the public sector 455
Utility software 343
World Wide Web (www) 371
Worms 430
v
z
Valuation of inventory 65
Variable cost 27
Zero-based budgeting (ZBB) 265

ICAN
Institute of Chartered
Accountants of Nigeria

MIS

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MIS

Uploaded by

Copyright:

Available Formats

Management

© Emile Woolf International, September 2014

© Emile Woolf International ii The Institute of Chartered Accountants of Nigeria

© Emile Woolf International iii The Institute of Chartered Accountants of Nigeria

© Emile Woolf International iv The Institute of Chartered Accountants of Nigeria

Accountants play a vital role in management and management decision-making. Business

Content and competencies - Overview

© Emile Woolf International v The Institute of Chartered Accountants of Nigeria

Contents and competencies Chapter

© Emile Woolf International vi The Institute of Chartered Accountants of Nigeria

Contents and competencies Chapter

3 Information technology and systems

© Emile Woolf International vii The Institute of Chartered Accountants of Nigeria

Contents and competencies Chapter

3 Information technology and systems (continued)

© Emile Woolf International viii The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 1 The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 2 The Institute of Chartered Accountants of Nigeria

1 ACCOUNTING FOR MANAGEMENT

 Introduction to accounting information

1.1 Introduction to accounting information

The main purposes of accounting are to:

© Emile Woolf International 3 The Institute of Chartered Accountants of Nigeria

1.2 Data and information

Illustration: Data and information

© Emile Woolf International 4 The Institute of Chartered Accountants of Nigeria

Data is analysed and processed to produce management information, often in

1.3 Qualities of good information

© Emile Woolf International 5 The Institute of Chartered Accountants of Nigeria

1.4 Purpose of management information

© Emile Woolf International 6 The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 7 The Institute of Chartered Accountants of Nigeria

2 COST AND MANAGEMENT ACCOUNTING VERSUS FINANCIAL

 Purpose and role of cost accounting, management accounting and financial

© Emile Woolf International 8 The Institute of Chartered Accountants of Nigeria

The information is often provided to a wider range of stakeholders (those with an

2.2 Comparison of financial accounting and cost and management accounting

Cost and management accounting

© Emile Woolf International 9 The Institute of Chartered Accountants of Nigeria

Financial accounting system Cost accounting system

© Emile Woolf International 10 The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 11 The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 12 The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 13 The Institute of Chartered Accountants of Nigeria

By the end of this chapter you will be able to:

© Emile Woolf International 14 The Institute of Chartered Accountants of Nigeria

1.1 Types of organisation

Type of production Examples Costing system

© Emile Woolf International 15 The Institute of Chartered Accountants of Nigeria

The need to know about costs

© Emile Woolf International 16 The Institute of Chartered Accountants of Nigeria

Definitions: Cost object

Examples of cost objects include:

Definitions: Cost unit

Definitions: Unit cost

Cost objects and cost units should be selected so as to provide management

Industry/activity Cost object Cost unit

© Emile Woolf International 17 The Institute of Chartered Accountants of Nigeria

Examples: Cost objects and cost units

Examples: Cost objects and cost units

1.2 Cost classification: Introduction

© Emile Woolf International 18 The Institute of Chartered Accountants of Nigeria

Illustration: Cost classification

© Emile Woolf International 19 The Institute of Chartered Accountants of Nigeria