CAF-03 CMA THEORY NOTES

CHAPTER 1 – INVENTORY VALUATION

1) Advantages & 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) Advantages & Disadvantages of AVCO

Advantages
 Smoothens out price fluctuations
 Easier to administer than FIFO and LIFO (Last in First Out)

Disadvantages
 Issue price is rarely what has been paid
 Prices tend to lag a little behind current market values when there is gradual inflation

CHAPTER 2 - INVENTORY MANAGEMENT

1) Definitions

(i) Stock out Costs:

These costs result from not having enough inventories in stock to meet customers' needs. These costs
include lost sales, customers’ ill will, and the costs of expediting orders for goods not in stock.

(ii) Lead Time:

The time period between placing an order till the receipt of the goods from suppliers is called lead time.

(iii) Reorder Point:

The point of time when an order is required to be placed or production to be initiated to replenish
depleted stocks is called reorder point. It is determined by multiplying the lead time and average usage.

(iv) Safety Stock:

To minimize stock outs on account of increased demand or delays in delivery etc., a buffer stock is often
maintained. Such a buffer stocks is called Safety stock.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
(v) Inventory control:
Inventory control can be defined as the system used in an organization to control its investment in
inventory/stocks. I.e. the overall objective of inventory control is to minimize, in total, the costs
associated with stock. This includes; the recording and monitoring of stock levels, forecasting future
demands and deciding
when and how many to order.

(vi) Maximum inventory level:

A company will set a maximum level for inventory. Inventory held above this would incur extra holding
cost without adding any benefit to the company.
The inventory level should never exceed a maximum level. If it does, something unusual has happened
to either the supply lead time or demand during the supply lead time. The company would investigate
this and take action perhaps adjusting purchasing behavior.

(vii) Minimum inventory level:

The inventory level could be dangerously low if it falls below a minimum warning level. When inventory
falls below this amount, management should check that a new supply will be delivered before all the
inventory is used up, so that there will be no stock-out.

2) The method of stock valuation which should be used in times of fluctuating prices:

Weighted Average stock valuation method should be used in times of fluctuating prices because this
method is rational, systematic and not subject to manipulation. It is representative of the prices that
prevailed during the entire period rather than the price at any particular point in time. It is because of
this smoothening effect that this method should be used for stock valuation in times of fluctuating
prices.

3) The practical Assumptions of EOQ

EOQ model is valid only as per the following assumptions:

 The holding cost per unit will be constant.
 The average inventory is equal to one half of the order quantity as the stock is consumed at a
constant rate throughout the period. (discussed in above sections)
 The cost per order is constant.
 There are no quantity discounts available.
 The demand for its inputs and outputs can be predicted with perfect certainty.

4) The practical limitations of EOQ

 It is assumed that annual demand of material is known and constant, which in fact not. The demand
will be based on sales which may vary.
 It is also assumed that per order cost and holding cost per unit shall not change. In practice, it is not
possible as some of these costs are not controllable. For example, increase in prices of petrol by
Government will enhance transportation cost.
 Another limitation of EOQ model is its assumption in connection to non-availability of discounts
which is not possible in practice.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
 In seasonal variation situation, the demand will be higher during season while it will be declined in
off season. Therefore, it will not justify the assumption that demand can be predicted with perfect
certainty.

5) Reasons of maintaining the safety stock:

(i) Protect against unforeseen variation in supply and/or demand.

(ii) Prevent disruption in manufacturing or deliveries.
(iii) Avoid stock-outs to keep customer service and satisfaction levels high.

6) Costs associated with holding of inventory:

(i) Cost of capital tied up

(ii) Insurance costs
(iii) Cost of warehousing
(iv) Obsolescence, deterioration and theft

7) situations in which EOQ model for determining optimum level of stocks becomes invalid:

The EOQ model becomes invalid in the following situations:

 The holding cost per unit is not constant.

 The stock is not consumed at a constant rate throughout the period due to which average inventory
is not equal to one half of the order quantity.
 The cost per order is not constant.
 There are quantity discounts available.

CHAPTER 3 - ACCOUNTING FOR OVERHEADS

1) Treatment of under-absorbed and over-absorbed factory overheads.

The under or over applied overhead may be:

treated as period cost by closing it to Cost of Goods Sold Account or directly to Income Statement.
apportioned between inventories and cost of goods sold.

2) Reasons for under-absorbed / over absorbed factory overheads

 The actual hours worked may be more or less than the estimated hours.
 The estimates may not be accurate.
 Actual overhead costs and actual activity levels are different from budgeted costs and activity levels.
 Changes in the methods of production.
 Abnormal changes in the component prices of factory overheads.
 Extraordinary expenses might have been incurred during the accounting period.
 Major changes might have taken place. For example, replacement of general purpose machine with
automatic high speed machines.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
3) Factors affecting the predetermined overhead rate:

In addition to the selection of bases, the following more factors are also considered:
1. Activity level selection
2. Inclusion or exclusion of fixed overheads
3. Single rate or several rates

4) Definitions

Normal Capacity
The company expects that there is no change in the demand and therefore, the same number of units
shall be produced. This is called Normal Capacity.

Expected Actual Capacity.

If the company expects that the demand will increase or decrease and estimates a level at 90% or 70%,
this is called Expected Actual Capacity.

Direct expenses
Expenses that are fully traceable to the product, service or department that is being costed.
Examples:
Raw Materials that are specifically used for the product in consideration,
Labor which is directly involved in converting the raw material
Other expenses that are specifically incurred for the product.

Indirect expenses (Production overheads)

Indirect expenses are those expenses that incur in the course of making a product, providing of service
or running department but which cannot be traced directly and fully to the product, service or
department.
Examples:
Labor which is not directly involved in the conversion of raw material but indirectly involved in
making of the product. Such as supervisor who is responsible to supervise the production
process is not directly involved and therefore treated as indirect cost,
Tools, spares and materials that are used in the machinery or equipment used in the production,
Factory rent if the factory premises are hired,
Depreciation of machinery and equipment.
Electricity and other utility expenses incurred for the production facilities

CHAPTER 4 – LABOUR COSTING

1) Types of labor cost:

a) Direct Labor Cost: Direct labor cost is any cost that is specifically incurred for or can be readily
charged to or recognized with any specific contract, job or work order. In cost accounting it is classified
as direct labor cost which becomes part of prime cost. For example: In a watch manufacturing factory, a
worker operating molding machine to produce a part of wrist watch.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
b) Indirect Labor Cost: Where the direct labor can be recognized with and charged to the job, the
indirect labor cannot be so charged and hence is treated as part of the factory overheads. For example:
Wages paid to supervisor of a factory or salary paid to driver of delivery van used for distribution of the
product.

2) Effective labor cost control

Effective labor cost control is achieved through different tools including;

 analyzing the targeted production,
 preparing labor budget and standardizing labor cost per unit,
 monitoring output, quality, wastage ratios, rework cost due to bad workmanship
 wage incentive systems

3) High Day Rate system

Advantages
 It is easier to calculate and understand.
 It assures the employee a consistently high wage.

Disadvantages
 Employees cannot go beyond the fixed hourly rate for the extra effort they put in. In the example
given above if the employee makes 280 units instead of 240 units in a 40 hours week, the cost per
unit would decrease even further but all the savings would go to the benefit of the employer and
none would go to the employee.
 The high wages might become the accepted wage level for normal working. Management might
need to keep checks on the productivity and efficiency levels of the employees.

4) Group Bonus Scheme

Advantages
 Group schemes reduce the clerical efforts to be put in for the calculations of individual incentive
schemes.
 They are easy to be administered.
 Group schemes improve the team cohesion.

Disadvantages
 Employees might demand for minimum targets for accepting the scheme.
 Employees doing the best and the worst might fall victim to team’s politics

5) Profit sharing scheme

Advantages
 The biggest advantage is that the organization will pay only what it can afford to pay out of the
actual profits earned.
 Such schemes can be offered to indirect labor as well.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
Disadvantages
 Employees may be putting in best of their efforts yet the organization might still incur losses on
account of issues beyond the control of the employees.
 It is a long term commitment that the organization is asking for. The employees have to wait for the
bonus until the year ends. The reward is not an immediate one

CHAPTER 9 – MARGINAL COSTING AND ABSORPTION COSTING

1) Advantages and disadvantages of absorption costing

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).
Assigning of Production overheads always include an element of discretion; and
It might led to sub-optimal decision-making as a product might be discontinued due to loss which
might be caused by fixed production over head.

2) Advantages and disadvantages of marginal costing

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 an accounting period.
 Marginal costing provides useful information for decision making.

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.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
CHAPTER 10 – STANDARD COSTING
1) Types of standard

Ideal standards.
These assume perfect operating conditions. No allowance is made for wastage, labour inefficiency or
machine breakdowns. The ideal standard cost is the cost that would be achievable if operating
conditions and operating performance were perfect. In practice, the ideal standard is not achieved.

Attainable standards.
These assume efficient but not perfect operating conditions. An allowance is made for waste and
inefficiency. However, the attainable standard is set at a higher level of efficiency than the current
performance standard, and some improvements will therefore be necessary in order to achieve the
standard level of performance

Current standards.
These are based on current working conditions and what the entity is capable of achieving at the
moment. Current standards do not provide any incentive to make significant improvements in
performance, and might be considered unsatisfactory when current operating performance is
considered inefficient.

Basic standards.
These are standards which remain unchanged over a long period of time. Variances are calculated by
comparing actual results with the basic standard, and if there is a gradual improvement in performance
over time, this will be apparent in an improving trend in reported variances.

CHAPTER 11 – VARIANCE ANALYSIS

1) Comments on the difference between overhead variances under marginal and absorption costing:

All variable and fixed overhead variances under marginal and absorption costing are same, except for
the fixed overhead volume (efficiency and capacity) variances which can be calculated only under
absorption costing.
In absorption costing, fixed overheads are allocated to the products and these are included in the
inventory valuations. Therefore, fixed overhead volume variances can be computed under absorption
costing only.
In marginal costing, only variable overheads are assigned to the product; fixed overheads are regarded
as period costs and written off as a lump sum to the profit and loss account.
Therefore, fixed overhead volume variances cannot be computed under marginal costing.

CHAPTER 12 – TRAGET COSTING

1) Definitions

Target cost:
Target cost is an estimate of a product cost which is determined by subtracting a desired profit margin
from a competitive selling / market price. This target cost may be less than the planned initial product

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
cost but it is expected to be achieved by the time the product reaches the maturity stage of the product
life cycle.

Cost gap:
Cost gap is the difference between the expected cost and the target cost. It can only be arising when
expected cost to produce one unit exceeds the target cost. It can be calculated as:
Cost gap = Expected cost – Target cost

2) Common methods of closing the target cost gap are:

 To re-design products to make use of common processes and components that are already used in
the manufacture of other products by the company.
 To discuss with key supplier’s methods of reducing materials costs. Target costing involves the entire
‘value chain’ from original suppliers of raw materials to the customer for the end-product, and
negotiations and collaborations with suppliers might be an appropriate method of finding important
reductions in cost.
 To eliminate non-value added activities or non-value added features of the product design.
Something is ‘non-value added’ if it fails to add anything in value for the customer. The cost of non-
value added product features or activities can therefore be saved without any loss of value for the
customer. Value analysis may be used to systematically examine all aspects of a product cost to
provide the product at the required quality at the lowest possible cost. This is the crux of target
costing.
 Using standardized components will reduce the cost but it might impact the innovation element for
the product
 To train staff in more efficient techniques and working methods. Improvements in efficiency will
reduce costs.

3) Advantages of Target Costing

There are several possible advantages from the use of target costing.
 It helps to improve the understanding within a company of product costs.
 It recognizes that the most effective way of reducing costs is to plan and control costs from the
product design stage onwards.
 It helps to create a focus on the final customer for the product or service, because the concept of
‘value’ is important: target costs should be achieved without loss of value for the customer.
 It is a multi-disciplinary approach, and considers the entire supply chain. It could therefore help to
promote co-operation, both between departments within a company and also between a company
and its suppliers and customers.
 Target costing can be used together with recognized methods for reducing costs, such as value
analysis, value engineering, just in time purchasing and production, Total Quality Management and
continuous improvement i.e. Kaizen costing.
 Target costing recognizes that process improvement and cost cutting is not a top down process but
rather one where workers who actually work on the product could come up with valuable
suggestions

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
CHAPTER 14 – RELEVANT COSTING
1) Definitions

Opportunity cost:
An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of
one course of action requires that an alternative course of action be given up.
Example
A company has an opportunity to obtain a contract for the production of Z which will require processing
on machine X which is already working at full capacity. The contract can only be fulfilled by reducing the
present output of machine X which will result in reduction of profit contribution by Rs. 200,000.
If the company accepts the contract, it will sacrifice a profit contribution of Rs. 200,000 from the lost
output of product Z. This loss of Rs. 200,000 represents an opportunity cost of accepting the contract.

Sunk cost
A sunk cost is a historical or past cost that the company has already incurred. These costs cannot be
changed/recovered in any case and are ignored while making a decision.
Example
A company mistakenly purchased a machine that does not completely suit its requirements. The price of
the machine already paid is a sunk cost and will not be considered while deciding whether to sell the
machine or use it.

Relevant cost:
The predicted future costs that would differ depending upon the alternative courses of action, are called
relevant costs.
Example
A company purchased a raw material few years ago for Rs. 100,000. A customer is prepared to purchase
it for Rs. 60,000. The material is not otherwise saleable but can be sold after further processing at a cost
of Rs. 30,000.
In this case, the additional conversion cost of Rs. 30,000 is relevant cost whereas the raw material cost
of Rs. 100,000 is irrelevant.

Incremental cost
An incremental cost is the additional cost that will occur if a particular decision is taken. Provided that
this additional cost is a cash flow.
Example:
To produce 1,000 units, a company incurred variable cost of Rs. 1.2 million. At a normal capacity of
2,000 units, fixed cost incurred was Rs. 0.6 million.
The incremental cost of making one extra unit would be Rs. 1,200 and it would not affect the fixed cost.

Avoidable and unavoidable costs

An avoidable cost could be saved (avoided), depending whether or not a particular decision is taken. An
unavoidable cost is a cost that will be incurred anyway.
Example:
A company is paying Rs. 0.5 million annually for a warehouse on a short term lease and incurring an
annual cost of Rs. 0.4 million on maintenance and security of the warehouse. One year of the lease is
remaining and the warehouse is no more required.

PREPARED BY FAHAD IRFAN

 CAF-03 CMA THEORY NOTES
The rental cost of the warehouse is unavoidable cost; therefore, it should be ignored while taking any
decision. However, by closing down the warehouse the company can avoid annual maintenance and
security costs of Rs. 0.4 million.

PREPARED BY FAHAD IRFAN