DISTANCE LEARNING INSTITUTE

(UNIVERISTY OF LAGOS)

MODULES WRITTEN

ON
INTRODUCTION TO COST
ACCOUNTING
(ACC 220)

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 TABLE OF CONTENTS
PAGE
MODULE 1: INTRODUCTION TO COST ACCOUNTING
MODULE 2: ELEMENTS OF COST
MODULE 3: STORES AND STORES' ACCOUNTS
MODULE 4: LABOUR COSTING
MODULE 5: OVERHEAD COST
MODULE 6: INTRODUCTION TO COSTING METHOD
MODULE 7: PROCESS COSTING
MODULE 8: CONTRACT ACCOUNT
MODULE 9: COST BEHAVIOUR
MODULE 10: BREAKEVEN/CVP ANALYSIS
MODULE 11: MARGINAL AND ABSORPTION COSTING
MODULE 12: STANDARD COSTING 1
MODULE 13: STANDARD COSTING 2
MODULE 14: BUDGET AND BUDGETING TECHNIQUE 1
MODULE 15: BUDGET AND BUDGETING TECHNIQUE 2

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CHAPTER ONE
INTRODUCTION TO COST ACCOUNTING
1.0 OBJECTIVES:
At the end of this module you should be able to:
1. define cost and cost accounting;
2. state the history of cost accounting;
3. define cost accounting terminologies;
4. explain the uses of cost accounting data;
5. identify the three basis elements of cost accounting - material, labour and
overhead;
6. illustrate basic cost accounting procedures;
7. identify and group all known cost.

1.1 INTRODUCTION
WHAT IS COST ACCOUNTING?
The Institute of Cost and Management Accountants define Cost Accounting as
“The application of costing and cost accounting principles, methods and
techniques in the ascertainment of costs and the analysis of savings and/or
excesses as compared with previous experience or with standard. It includes the
presentation of information derived therefrom for the purpose of managerial
decision making."
In summary, cost accounting is "the techniques and processes of ascertaining
costs". It may be regarded as the systematic approach to the measurement,
recording and control of materials, labour and fixed assets. Essentially, it aims
at recording, classifying, analyzing and allocating or distributing expenditure

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for the determination of product, job, activity or service cost. Such costs
ascertained or determined could be: historical cost or predetermined or marginal
cost, which is the cost incurred during and after an operation. Predetermined
cost which is the cost ‘computed in advance of production on the basis of a
specification of all the factors affecting cost”.
Marginal cost is “the amount at any given volume of output by which aggregate
costs are charged if the volume of output is increased or decreased by one unit.”
The principal functions of cost accounting which is an expansion of the
definitions given above, are:
a. Establishment of cost centres.
b. Design of suitable systems for defining responsibilities and controlling
costs.
c. Predetermination of standards for standard costing and budgetary control.
d. Preparation of cost schedules to aid managers in making decision.
e. Proving information for estimating and the determination of prices.
f. Ascertaining the cost of jobs, processes and cost centres.
h. Analyzing costs and cost variances and reporting back to managers so
that action can be taken.
i. Stock-taking of work-in-progress and finished goods and valuation of
these
j. Preparation of periodical statements and profit and loss accounts.
The whole course will therefore be devoted to an introduction to these cost
principles which constitute the theoretical framework, costing methods like
stock valuation methods and costing techniques and standard costing.

1.1.1 HISTORICAL BACKGROUND TO COST ACCOUNTING

Cost Accounting (record keeping) can be traced back to 3600BC and real

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accounting to early Greek and Roman periods. The first double entry was
established in Italy at about 1340 A.D.
In the 16th century, Pacioli improved and popularized usefulness of accounting,
making available business information about assets and liabilities and other
results of annual operations. The rise in trade particularly in Italy, the growth of
partnership, joint ventures and agency relationship with its resultant
accountability relationship and the introduction of Arabic numerals led to the
spread and further development of accounting.
Hence the 17th century witnessed the development of periodic income
statements and impersonal accounts.
The industrial revolution in the United States and Britain led to the
development of cost accounting as a specialized area of accounting. This
occurred in the 19th and 20th centuries when mass production and specialization
became necessary. These developments gave rise to the problems of inventory
valuation, overhead allocation to products and other cost centres and how to
provide management information on production planning and control. Price
fixing became a problem while over expansion of business led to declining
profit margin. Some authorities however contend that the calculation of cost by
product can be traced back to the 14 and 15l centuries in early Florence and that
Antwerp Printers in the 16th century kept separate job cards and accounts and
some crude forms of perpetual inventory system.
Between 1890 and 1915, the mechanics for integrating cost records with the
general ledger accounts and certain theoretical basic structures of cost
accounting were formulated. Early writers like Emile Garcke (on factory
accounts) began to put together statements on principles of Cost Accounting.
With time, others like Fells began to see the need to differentiate between fixed
and variable costs, and the need to examine past records as a guide for planning.

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With development, emphasis started to shift to the comparison of actual costs
with predetermined costs. Attention was also focused on the need for the
frequent presentation of relevant and detailed cost information on each job done
or complete activity undertaken. But the application of the principles of
scientific management introduced by Fredrick W. Taylor influenced the rapid
development of costing. It certainly led to a shift in emphasis from cost
ascertainment to cost control and costing was developed. Early writers like John
Whitmore, for instance, popularized standard costing. Other developments on
costing methods and techniques followed thereafter. For instance budgetary
control system was widely applied in commercial undertakings during the post
World War II period while break even analysis became a subject for
consideration and as early as the beginning of this century. Later developments
in this field led to the formation of the Institute of Cost and Works Accountants
(Now Cost and Management Accountants) in 1919.

1.1.2 PURPOSES OF COST ACCOUNTING

The purposes of Cost Accounting can be enumerated as follows:
1. To indicate to the management any inefficiencies and the extent of
various forms of waste, whether of materials, time, expense or in the use
of machinery, equipment and tools. Analysis of the causes of
unsatisfactory results may indicate remedial action.
2. To provide data for periodical Profit and Loss Accounts and Balance
sheets at such intervals, e.g. weekly, monthly or quarterly as may be
desired during the financial year, not only for the whole business but also
by departments or individual products.
3. To show, where standard costs are prepared what the cost of production
should be, and with which the actual costs that are eventually recorded

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 may be compared.
4. To present comparative cost data for different periods and various
volumes of production output- and to provide guidance in the
development of the business.
5. To record the relative production results of each unit of plant and
machinery in use as a basis for examining its efficiency.
6. To explain in detail the sources of profit or loss revealed in total in the
Profit and Loss Account.
1.2 TERMINOLOGIES
The most important terminologies in Cost Accounting are defined and
explained below:
1. COST
This may be defined as: "the amount of expenditure (actual or notional)
incurred on, or attributable to, a specified thing or activity. In a simplified
manner, cost includes two components: quantity used multiplied by price.
Cost may be considered in relation to cost units which may be units of
production, a job or batch units of valuable service.
2) COST UNITS
A cost unit is a unit of quantity of product or service in relation to which
costs may be ascertained or expressed.
3) COST CENTRE
A cost centre is a production or service, location, function, activity or
item of equipment for which costs are accumulated.
4) DIRECT COST
Direct costs are those which are readily identifiable to a cost unit. Direct
labour, direct materials and direct expenses collectively form the prime
cost.

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5) INDIRECT COST
All costs that are not identifiable as direct are termed indirect. Indirect
labour, indirect material and indirect expenses are collectively known as
overheads.
6) CONVERSION COST
This is the term used to describe the cost of converting purchased
materials into finished or semi-finished products.
7) COST ALLOCATION
The process of assigning a w hole item of cost, or of revenue to a single
cost unit centre, account or time period is known as cost allocation.
8) COST APPORTIONMENT
It is the process of spreading revenues or cost over two or more cost
units, centres, accounts or time periods.
9) OVERHEAD ABSORPTION
This is the process of sharing out costs that cannot be directly related to
cost unit (overheads) among the entire cost unit produced in some
equitable manner.
10) TOTAL COST
Total cost is defined as the summation of prime cost (direct material,
direct labour and direct expense) and overheads (indirect material,
indirect labour and indirect expense).

1.3.0 THE USES OF COST ACCOUNTING

Cost accounting is used in many ways:
1. It provides information for use in the planning and control of routine jobs
and other major plans and policies: e.g. a management decision of

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 discount depends on information on the cost and benefit of such a policy.
2. It provides information for decision making situations, particularly those
that involve cost minimization. By providing cost information of
different alternatives like whether to buy or produce a part within the
factory and whether or not to mechanise, production costs are minimized
in order to ensure that profit is maximized.
3. Cost Accounting is very useful for costing products for stock valuations,
planning and control. The importance of this service lies in the fact that
decisions on stock valuation methods affect the net income.
4. It helps in the preparation of estimates which form a guide to policy
making decision and control purposes. In order to achieve the desired
return on investment, reasonable selling prices must be fixed with greater
level of certainty.
5. The comparison of actual cost with standard cost or estimated cost of
jobs, processes or activity, losses and wastes are identified during and
after an operation. When provided in an operation, corrective measures
can be taken to minimize further waste. At present, competition is tough;
leakages need to be checked in order to match performance with standard
and ensure a reasonable return on investment.
6. Through allocation and apportionment of costs, expenses are localized
and so effectively controlled.
7. When output falls below capacity, expenses, particularly overhead
expenses, may not be fully recovered. Costing shows the economies of
scale and so helps to check waste.

1.3.1 THE LIMITATION OF COST ACCOUNTING

The limitations of Cost Accounting arise from the insufficiency of its various

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techniques in solving peculiar problems or from the complexity" in particular
methods and techniques. One major limitation is the failure in practice to
conform to uniform procedure, for example, different costs can be calculated
for the same job. When costing is done with little consistency over a period, it
yields different values.
The allocation of overheads to cost centres or products, and the allocation
period of costs and joint product costs are most often not justifiable. The result
is that certain products or centres are over-charged and others under-charged
and the responsible managers partially rewarded or punished accordingly.
Cost Accounting does not recognise non-quantifiable cost like risk. This makes
cost accounting findings not as informative as management might require. The
breakdown of cost into fixed cost, and variable cost and sometimes semi-
variable cost is not always as accurate as management might think. Sometimes
it is difficult to determine the limit to which an analysis may be carried out.
Unnecessary and elaborate analysis may be wasteful while insufficient analysis
may be misleading.
Certain organizational, technical and financial difficulties may preclude the
possibility of the successful installation of a cost accounting system. It may be
expensive to install and operate. The costs of installation tend to be high and
those of operation even higher, for example, once installed, Parkinson's Law
operates-work tends to expand to fill the time available for its completion. The
system may become too complex and tend to encourage "red tape or pink tape.”
Not all cost accounting systems are practical or appropriate for a particular
business.

1.4 TRANSITION FROM FINANCIAL ACCOUNTING

Cost accounting is basically an extension of the principles which are followed

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in financial accounting though there are certain differences in the emphasis
between cost and financial accounting approaches.
Financial Accounting is mainly concerned with satisfying users like creditors,
government agencies, investors and owners and non-management staff. It is
aimed at recording, analysing, classifying, summarising, interpreting and
presenting post- operation results to interested parties, including top
management. Financial accounting is, therefore, concerned with the stewardship
function of accounting. It shows how managers are employing the resources
within the business. There is no detailed guidance on what should be done or
costs incurred by separate job or cost centres. Cost Accounting, on the other
hand, is concerned with providing management with accounting information
useful for management planning and other administrative tasks. It emphasizes
recording, classifying, summarising, interpreting and presenting in a significant
manner, the pre-and post-operation cost of factors of production and
distribution within a particular industry.
Financial accounting deals with personal and impersonal accounts, while cost
accounting is concerned with other aspects like cost control comparison and
utilization. The emphasis in Financial accounting is on total cost figures; the
emphasis in costing is on sub-total figures since they are useful for planning and
control during operations.
Cost Accounting is concerned with the composition of cost and the sources of
profit while financial accounting deals with the calculation of profit. The
transition from financial accounting to cost accounting means that more
detailed records have to be kept. Instead of simply recording expenditure to
show what is owed or owing, and what expenses have been incurred, a
comparison of two simple profit and loss accounts shows the first stage in the
transition.

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The application of costing in the preparation of profit and loss Account has
been simplified, because, in practice there would be stocks of finished goods
and work-in-progress. The second stage would be the collection of costs to each
product.

Comparison of Financial and Cost Accounting

A. Financial Accounting
Profit and Loss Account N N
Sales 60,500
Less returns 500
60, 000
Stock on hand at the end of the year 20, 000
80,000
Deduct Purchases and Costs of Purchases 20,000
Opening Stocks 10,000
Wages 10,000 40,000
Gross Profit 40,000
Deduct Selling, Administration& other costs 20,000
Net Profit 20,000

B. Cost Accounting
Profit and Loss Account N N
Sales less returns 60, 000
Stock of materials at 1st January 10, 000
Purchases 20,000
30,000
Less Closing Stock of materials 20, 000

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 10,000
Direct labour costs 10,000
Factory Overheads costs 5,000
Cost of goods sold 25,000
Selling and Administrative costs 15,000
Total Cost 40,000
Net Profit 20, 000

1.5 RELATIONSHIP BETWEEN COSTING AND OTHER

DISCIPLINES
Boundaries of disciplines tend to merge into others. This is the case between
Cost Accounting and disciplines like Industrial Engineering, Operations
Research, Economics and other areas of management.
Costing is concerned with cost measurement while Industrial engineering is
concerned with cost and efficiency. To be efficient, standard costing technique
is sometimes applied. Industrial engineer determines the standard and quantity
of material and labour to be used on a job while the cost accountant monetises
these estimates. Such relationships also exist in budgeting asset replacement
and in the evaluation of alternatives.
There is also a strong relationship between cost accounting and economics.
Economics is concerned with the study of social aspects of factors of
production and the efficient utilization of such scarce factors. Costing aids in
this regard since it points out the least cost methods and deals with the
application and results of economic laws.
Production planning and control - a device for regulating the routine and
procedure of manufacturing operations - rests on costing information for
effective functioning.

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Operations Research - an experimental and mathematical technique - helps the
cost accountant by providing management with useful information in its
planning and control functions. Cost minimization objective of operations
research is aided by the same objective of cost accounting.

1.5 SUMMARY
In this module you have learnt that:
1. Cost accounting is the techniques and processes of ascertaining cost,
2. The main purpose is to help managers make decisions by providing
relevant information.
3. Cost accounting provides - information for planning and control; cost
minimization, stock valuations, estimate preparation and comparison of
cost.
4. Limitations of cost accounting arise from the insufficiency of its various
techniques in peculiar problems or from the complexity in particular
problems or from the complexity in particular methods and techniques.
5. Cost accounting is an extension of the principles of financial accounting.
There are certain differences in the emphasis between, the two
approaches. Financial accounting renders stewardship function of
accounting i.e. satisfies internal and external users of accounting.
Cost accounting, on the other hand, provides management with
accounting information for decision making.

1.7 SELF ASSESSMENT QUESTIONS

1. Which of the following defines cost accounting
a) Technique and processes of ascertaining costs.
b) Technique and processes of ascertaining expenses

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 c) Technique and processes of ascertaining records
d) Technique and processes of ascertaining summary.
2. Cost can be applied in the following except.
a) Planning and control
b) Decision making
c) Stock valuation
d) Expenses
3. Cost accounting and financial accounting are related in the following areas
except
a) Operations research
b) Planning and control
c) Decision making
d) Attitude.

4. Total cost can be defined as

a) Summation of expenses
b) Summation of price cost
c) Summation of overhead cost
d) Summation of direct cost

5. Price cost is composed of

a) Direct material, direct labour, indirect overhead
b) Indirect factory overhead direct material direct sales
c) Price cost, indirect labour, indirect overhead
d) Direct material, direct labour, direct overhead

6. Direct cost is defined as costs that are…

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 a) Identifiable to a cost unit
b) Not identifiable to a cost unit
c) Process of assigning a whole cost item
d) Process of spreading revenues.

7. Cost allocation can be defined as

a. Process of spreading revenues
b. Process of assigning a whole item of cost
c. Cost of converting purchased materials
d. Cost identifiable to a unit.

8. Which of the following is not an overhead cost?

a) Individual labour
b) Indirect material
c) Indirect expenses
d) Direct expenses

9. Which of the following is concerned with cost and efficiency

a) Costing
b) Industrial engineering
c) Teaching
d) Accountancy

TRUE OR FALSE QUESTIONS

1. Cost allocation and appointment is one of the ways to localize and
control expenses. True ( ) False ( )
2. The estimates yielded by costing procedures are not useful for decision
making and control purposes. True ( ) False ( )

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3. Cost accounting is not as useful as financial accounting for costing
products for stock valuations, planning and control. True ( ) False ( )
4. The information provided by cost accounting is useful for decision
making situations such as cost minimization. True ( ) False ( )
5. Costing shows the economics of scale. True ( ) False ( )
6. The insufficiency of its various techniques in solving peculiar problems
is one of the limitations of cost accounting. True ( ) False ( )
7. Another limitation to cost accounting is the lack of conformity to uniform
procedures. True ( ) False ( )
8. Cost is defined as:
a. Quantity used multiplied by price
b. Unit of production
c. Unit price
d. Factory price

1.8 REFERENCES
1. C.A. Horn “How Victorian Industrial advances brought Cost
Accountancy to the fore”, Management Accounting, January 1974.
2. D.M.C. Jones “Evolution of accounting” July/August 1974.
3. A.H. Taylor, “Costing: A management approach” (ch. I) pan
Management Series 1975.
4. C.J. Walker, Principles of Cost Accounting, Macdonald and Evans.
Further Reading
1) Mustafa, A. (2011). Financial and management accounting, India: AITBS
Publishers.
2) Institute of Chartered Accountants of Nigeria (2009). Study Pack:
Costing and Qualitative Analysis Intermediate, Lagos: VI publishers.

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3) Institute of Chartered Accountants of Nigeria. (2009).Study Pack:
Managements Accounting PEL, Lagos: VI Publishers.
4) Institute of chartered Accountants of Nigeria. (2009). Study pack,
Strategic Financial Management PEII, Lagos: VI Publishers.
5) Jain, N.C. (2009). Dictionary of Accounting, (1st ed.) India: AITBS
Publishers.

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 CHAPTER TWO
ELEMENTS OF COST
2.1 OBJECTIVES:
At the end of this module you should be able to:
1. explain elements of cost material, labour and overheads
2. enumerate the components of manufacturing cost
3. Identify and group all known costs.

INTRODUCTION
The breakdown and classification of costs are based upon factors on which
expenditure is incurred. These factors are material, labour and overhead.

2. 1 MAJOR ELEMENTS OF COST

“Cost” is nothing more than an amount of expenditure, actual or notional. The
components of this expenditure, called the elements of cost can be analysed and
re-grouped into various headings. The diagram below adapted from the
"Terminology of Management and Financial Accountancy” in a publication of
the Institute of Cost and Management Accountants depicts such elements.
The major elements of cost are:
i) Purchase cost of materials including carriage inwards.
ii) Labour cost which is mainly wages
iii) Overhead and other incidental expenses.
Briefly they are regarded as material, labour and overhead. These elements of
cost can be grouped into direct and indirect expenses. Direct costs are expenses
that are directly attributable to products, jobs, services or other necessary
factors.
a) Direct Materials are all materials that are an integral part of the finished

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 goods and may be conveniently assigned to specific physical units.
Included are all materials acquired from stores or from the market for a
particular job, components whether semi-finished or finished but used as
an input for the job, cost of packing materials and carriage inwards. Other
costs like storage and repair costs are added to materials cost. Examples
of direct materials include planks used in building a table, steel sheet and
nails, etc.
b) Direct labour or direct wages include “remuneration for efforts and skills
applied directly to an identified product” or service or job. Such rewards
may be for skilled and/or unskilled workers as long as they can be traced
to the particular factor or final product. In certain exceptional instances,
the wages of foremen, inspectors and shop clerks are treated as direct
rather than indirect wages, for example, wages of an inspector at the site
of a particular contract.
c) Direct Expenses are “costs other than materials or wages which are
incurred for a specific product or saleable service", for example, the cost
of hiring and maintaining a special purpose machine used for a specified
job or contract, carriage inward, etc.
d) Indirect costs are those cost that are not traceable to a unit of output or a
segment of business operation. This means that the whole or part of
organization rather than the cost unit or cost centre benefits from the
services of such expenditure. Indirect costs include indirect material,
indirect labour or wages and indirect expenses. They constitute
manufacturing overheads.
e) Indirect materials are the cost of factory materials and supplies which
cannot be charged to any specific unit of product but can be apportioned
to, or absorbed by cost centres or cost units. The term "supplies" refers to

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 items required to keep plants in perfect working condition. They include
lubricants for plant and machinery and tool boxes.
f) Indirect labour or indirect wages are wages other than direct wages. They
represent the costs of auxiliary work done in connection with a
production process. In most firms indirect wages constitute a greater
percentage of factory labour which are apportioned. Classified as indirect
wages are the labour cost in service departments and the auxiliary labour
in production departments such, as the wages of a central quality control
inspector. Certain direct labour costs which cannot be assigned directly to
a unit of product are included in indirect or direct labour and it is
practically charged to indirect factory labour. Overtime premium incurred
on a particularly identified contract or job is charged to that unit of
product but overtime premium incurred as a result of general pressure of
work within the factory is charged to factory overhead account. Other
examples of indirect labour are the cost of idle time, vacation and
sickness pay and messengers.
g) Indirect expenses, that is, expenses other than direct expenses, include
other production costs which are difficult to classify under production
costs or under one category. They include royalty payments,
depreciation, rentals, and maintenance of fixed assets.

Overhead
The total cost of indirect material, wages and expenses constitute overhead
expenses. A detailed treatment of its problems and treatments in cost
accounting will be given prominent attention in later modules. It suffices at this
stage to know that overheads can be subdivided into fixed variable and semi-
variable elements.

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The elements can be regrouped and analysed into:
i) Production overhead
ii) Administrative overhead
iii) Selling and distribution overhead
Costs are also classified according to their nature. Thus, we have fixed variable
and semi-fixed or semi-variable costs.
Fixed cost
This is defined in the terminology of Cost Accounting as "A cost which tends to
be unaffected by variation in the volume of output". It depends on the length of
time, and not with the rate or volume of output. Examples are depreciation and
storage costs.
Variable cost
Variable cost which is also referred to as direct cost is costs that vary with the
volume or rate of output Examples include direct material and labour costs.
Semi-fixed and/or semi-variable costs
These are those costs that are partly fixed and partly variable. The fixed element
is constant and does not change with the level of activity, while the variable
element is the cost of hiring a delivery truck for a fixed cost per a given period
plus a variable cost based on mileage.

MANUFACTURING COSTS
Within a manufacturing organization, there is another classification of cost.
Earlier on, prime cost was defined as the total cost of direct material, direct
labour and direct expenses. In a tabular form, it is
Direct Material + Direct Labour + Direct Expenses = Prime Cost
Prime Cost + Factory Overheads = Manufacturing Cost.
Manufacturing Cost + Selling and Administration Overhead = Cost of sales

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Cost of Sales + Profit Margin = Selling Price or Sales Value OR
Cost of sales - Loss = selling Price or Sales Value
In addition to the foregoing classifications, there are other definitions, an
opportunity cost is the economic value of a benefit sacrificed in favour of an
alternative course of action.
Notional cost is "a hypothetical cost taken into account to represent a benefit
enjoyed by the undertaking in respect of which no actual - expenses is incurred"
e.g. rent charged in the accounts for own building.
Standard costs are scientifically predetermined costs. Product posts are costs
incurred in the production of units of a product.
Period cost is that cost associated with the length of time e.g. insurance and
advertising.
The difference between unit cost and total cost is on the fact that unit costs are
averages while total cost is a lump sum. Such units may not necessarily be
physical products but should be that of activity that is most closely related with
cost incurred. It could be number of persons, length or area, weight, value or
time. For example:
Total cost of a carton of milk N9.60
Number of tins (in this case units) = 96 tins
Cost per unit or per tin = 10k approx.
Actual cost is calculated on the basis of actual expenditure incurred under real
or actual conditions. Normal cost is the total expenditures incurred or that ought
to have been incurred under certain given normal conditions.

2.2 ORGANISATIONAL STRUCTURE AND COST ACCOUNTING

The ultimate goal of every business organization is to maximize profit via
greatest amount of productivity. Productivity is achieved through, among other

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things, efficiency, which can be measured by the quality of the product, its
price, amount of input compared with the final output or the input/output ratio,
delivery time and the cost of production.
One way of ensuring production efficiency is by a careful, planned organization
structure with its clear lines of authority and responsibility and its auxiliary cost
accounting department. Organisational structure varies amongst industries but it
is dependent upon the type of industry, the nature and size of the business, its
distribution system, resource availability, particularly capital and man power,
the location of the business and other non controllable factors like government
policies. However, a typical manufacturing enterprise has provision for the
positions of a chairman of the board of directors, a managing director who may
also be the chairman, the production manager or controller, the financial
director, the marketing executive and the personnel manager.
In addition, there are provisions for a foreman and other middle and lower level
management. The structure can be functional or line and staff or a combination
of both. The costing department invariably comes under the finance department.
The cooperation of all, particularly the functional heads, is needed to build a
total system where all departments including the costing department work as a
unit. For present purposes, it will be sufficient to describe the functions of the
various departments and perhaps officials connected with each department.

(a) Marketing/Sales Department

Marketing consists of those activities involved in getting goods-and services
from the producer to the consumer. With businesses fast becoming consumer
oriented, marketing has become a vital link between the business entity and the
public. The marketing department is charged with the responsibility of carrying
out the marketing plan. To achieve its objectives, the structure has provision for

24
the marketing director or marketing or sales managers. These executives study
and interpret consumer needs into final product, devise selling strategy and
advertising campaigns, control field salesmen, prepare a marketing plan and
revenues and sales estimate. In performing these duties, the marketing manager
works in conjunction with the production manager on the possible limiting
factors and types and quantities of products needed and also with the costing
department for the financial implications of their plans, and for other relevant
cost data.
The Personnel and the Administration departments are charged with the
responsibility for the recruitment, maintenance and discipline of employees, the
day to day routine functions of planning and organizing, the remuneration of
employees, and the provision of good working environment including the
maintenance of office furniture. In collaboration with the production manager
and cost accountant, the finance manager then looks into the financial aspect of
office equipment, production and wage rate fixing.
(b) Production Department
The Production department, headed by a production manager, is charged with
the responsibility for the operational aspects of the production of goods and
services. Production planning and control is the factory's nervous system and
therefore demands efficient management. To achieve this goal, the department
is broken down into sections which are:
1. Planning section.
2. Control section.
3. Purchasing section and
4. Service section.
The Planning and control sections take charge of the following:
(a) Making master production schedules

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(b) Receiving production orders and plan for men and materials needed to
meet such orders or schedules.
(c) Determining the tools and raw materials needed and where necessary
issue purchase requisitions.
(d) Controlling the stock of tools, parts and raw materials and finished
products.
(e) With the aid of the cost accountant, helping to make cost estimates for
new orders.
(f) Helping to expedite production by removing any bottle neck.
(g) Making provision for maximum utilization of production facilities.
In the performance of these duties, the storekeeper, the foreman, and other
managers need the services of a cost accountant. The foreman for instance,
needs a feed back in the form of performance report. The storekeeper maintains
proper records of receipts and issues and sends copies daily to the cost office.
Another area of the production department is the purchasing department headed
by the purchasing manager. The department is responsible for dealing with
replenishment, requisitions from the stores and other special requests. The
production department provides specifications for material needs while the
purchasing section, with knowledge of the most suitable market in terms of
price and specified quality, does the purchasing.
The service or auxiliary section is charged with the maintenance and repair of
physical facilities like tools, plants and equipment, at regular intervals, to avoid
any wastages, break-down, etc.
(c) The Finance Department
In most companies, the cost accounting section comes under the finance
department. In certain others, the cost accountant is responsible to the General
Manager. Wherever he/she may be, he/she must work in co-operation with

26
other functional heads.
Besides preparing cost returns and providing management information for
decision making, he presents daily, weekly or monthly performance reports
which are helpful for control purposes and guides against inefficiency and
waste. The preparation of reliable estimates depends on data provided by the
cost accountant. In conjunction with the finance department he controls the
wages, rate fixing and time-keeping offices and records particulars of
requisitions and prices of materials.
The nature of manufacturing process has some bearing on the type of costing
system employed. For cost accounting to be effectively utilized as a
management tool there has to be a sound organization structure. Clear outlines
of time as authority and responsibility must be based either on functions or on
areas of operation.
THE COST ACCOUNTING ORGANISATION
The Cost Accountant is a functional manager, that is, a manager who is
responsible for a specialized function (costing) throughout the organization. He
or his staff should not approach an employee on the shop floor or in any other
functional division; instead he should go through the appropriate departmental
manager. There are exceptions to this rule because if it is rigidly followed, it
can lead to frustration and red tapism. Certain routine matters such as a query
on a clock card may be dealt with by direct contact.

2.3 SUMMARY
In this module you have learnt that:
1. Costs can be analysed and grouped to suit particular purposes.
2. Direct material, labour and direct expenses are the elements of prime cost
while prime cost in addition to indirect costs constitutes total cost of

27
 goods sold.
3. The total cost of indirect material, wages and expenses make up
overheads, which can be regrouped into production, administration and
selling and distribution overheads. If analysed according to time factor,
there are fixed, semi-fixed and variable costs. Other types of cost include
actual, unit, average, notional and opportunity costs.
4. Overheads can be sub-divided into fixed variable and semi-variable
elements.
5. The elements can be re-grouped and analysed into:
- Production overhead
- Administrative overhead
- Selling and distribution overhead.
6. To ensure production efficiency, a carefully planned organisational
structure should be in place with a clear line of authority and
responsibility.

Problem for self study Questions:

1. Jara and Co. Ltd, a manufacturing enterprise incurred the following costs
during the month of June:

Direct Material Cost N500

Direct Labour Cost N650
Direct Expenses N150
The general foreman earned N75 while the plant maintenance engineer
earned N100. The cost of transporting materials to the store was N50.
Selling and distribution costs were N35 while administration cost for that
month was N200. Total number of units produced is 1,000.

28
 Calculate the prime costs, factory cost of sales and the unit cost?
2. 100 units of a product sell for N3,000 in the market. Enu and Co. decided
to manufacture them within their industrial complex. The cost of direct
materials, labour and overheads are N250, N600, and N1500 while the
foreman and other factory service heads earn N100 and N60 respectively.
It costs N160 to transport the final products to the market. Depreciation
of office furniture is calculated at N40 while other administration
expenses are in the neighbourhood of N350. Other selling costs are N75.
You are required to calculate the prime cost, factory cost, and cost of
sales, number of units, unit cost and opportunity cost of manufacturing.
3. Is the Cost Accountant likely to have a staff or line authority with the
organization described in this lecture?
Are the following direct or indirect cost?
Place a (ü) in the right box in front of each item.
Direct Indirect
Supervisors
Material handling clerks
Cost account clerk
Welfare officer
Gateman
Idle time
Overtime
General inspector
Lubricants
Nails, rivets
Freight in on direct materials
Fire insurance

29
 Property taxes on equipment?

The following example is a guide for solving this problem. Five columns are to
be used as choices for possible classification. On a separate sheet, do the same
for the following accounts, all of which are not necessarily for a single
company.
a. Salesmen's entertainment cost
b. Public accounting fee
c. Salary of factory stores clerk
d. Overtime premium
e. Idle time-Assembly
f. Rework-Machining
g. Salary-Engineering Department
h. Sandpaper purchases for a furniture manufacture
i. Clean up labour-machining
j. Factory Power
k. Heat of Factory
1. Freight out
m. Salesman's salary
n. Fire insurance (factory)
o. Fire insurance (office furniture)
p. Salary Production continued.

Write not more than 3 sentences on questions 4 and 5.

4. What is overhead? Name the types and examples of overhead.
5. What is the relationship between the marketing manager and the cost
account or between the production manager and the cost accountant?

30
6. In Zumratu manufacturing company's adjusted Trial Balance of
December 31, 2010, the following account balances have been obtained:
Raw materials January 1, 2010 75,000
Work in process “ “ 21,200
Finished goods “ “ 50,000
Purchases 198,000
Purchases returns 3,000
Indirect materials (90% for factory) 4,000
Direct Labour 125,000
Heat, Light and Power 35,000
Indirect Labour 40, 000
Insurance (75% of which is for factory) 8,000
Factory and Machine-Maintenance 8,000
Factory Supplies 6,000
Depreciation-Factory building 9,000
Depreciation-Office equipment 39,000
In addition raw materials costing Nl87,000 were used, the cost of goods
manufacture for the year was N40,000 and the cost of goods sold was
N4430,000.
Prepare:
(i) A statement of the cost of goods manufactured,
(ii) Suppose that 2,000 units were produced:
What is the (a) factory unit cost of production?
(b) The total unit cost?

31
Further Reading
1. Singh, S .P. (2009). Encyclopedia Dictionary of Corporate Strategy, India:
AITBS Publishers.
2. Pandey, I.M. (2003). Essentials of management Accounting, India: Vikas
Publishers.
3. Kaplan, R.S and Atkinson A.A. (2002). Advanced management accounting
(6thed) India: Practice Hall.
4. Banergee, B. (2005). Financial policy and management accounting (7th ed.),
India: Prentice Hall of India Private Limited.

32
 CHAPTER THREE
STORES AND STORES' ACCOUNTS
3.0 OBJECTIVES
At the end of this module, you should be able to:
1. explain the terms stores and stores accounting
2. state the procedure for purchasing material
3. identify the types of problems involved in purchasing and storage
4. make distinctions among record of material issued, return and transfer
to jobs and other cost unit and centres
5. explain how you would set up functional organisation structure with
purchasing stores and receiving store control.

3.1 INTRODUCTION
In most manufacturing companies, materials and spare parts constitute about
50% of the cost of production. To minimize production cost, material input,
amongst other things, has to be controlled. Purchasing, storing and pricing of
materials are effective ways of ensuring that the cost of material input is
minimized. A well organized purchasing department, a good storage facility
and an impartial pricing system are of importance to the realization of overall
production cost/objective.
3.2.1 MATERIALS: ORGANIZATION OF THE PURCHASING
DEPARTMENT
Functions of the Purchasing Department are:
(i) To purchase the right quantity and quality of materials, parts, and
machinery involves following instructions received from production
programme or from stores department or from the production control
section.

33
 (ii) To keep track and record of prices of all materials, their sources
particularly the dependable sources and the resale market for wastes
and by-products.
(iii) To obtain information and predict factors affecting sources of supply
and cost of materials.
(iv) To prepare and issue purchase orders, verify invoices in order to
secure agreement with purchase orders and materials receipt note.
(v) To receive and inspect ordered goods and keep record of other unfulfilled
orders.

3.2.2 ORGANISATIONAL STRUCTURE

Since most manufacturing companies buy quite a large quantity of one or more
assorted types of materials, they set up a functional organization structure with
purchasing, stores and receiving, and inventory control.
3.2.3 THE PURCHASING DIVISION
The purchasing division is headed by the purchasing manager who is usually a
specialist in his field. He keeps tract of prices, quality and new products. The
acquisition of material parts, supplies and containers, equipment and repair part
and the sale or the disposal of wastes and by-products fall within the compass
of his responsibilities. To be able to carry out these functions, he must have
knowledge of law of contract, buying and shipping regulations. The purchasing
manager normally keeps abreast of new materials in the market and advises the
production or engineering department. Sometimes he informs the production
manager where less costly materials can be used. To some extent, he is
concerned with certain strategic decisions like the make or buy decision
situation because he provides the figures for the cost of buying.

34
3.2.4 PURCHASING PROCEDURE
No one procedure is satisfactory in buying the various items of the raw
materials used in the manufacturing process. Some high value items like
machinery or repair spare parts are shipped just once on request from the
purchaser. Vendors bid separately and designs are considered before the
purchase order is approved by Top Management. Orders of a lower value are
shipped steadily as soon as the contract is signed. This class of items often
requires the procedure of going through the purchasing department. The third
category -the steady use items and supplies like nuts, lubricant and stationery
are easily purchased in the open market as soon as the purchase is authorized.
These are the many little sideway items necessary for operations in the plant
floor and the office.
Besides size of material used, transportation mode, availability of receiving
facilities, quality, cost and nature of the product and dependability of supply
influence the purchasing procedure used. There are five general steps in the
ordering of goods.
(i) A purchase requisition is raised by the plant manager or stores clerk or
the authorized section in need of the material,
(ii) A purchase order is then issued by the purchasing officer,
(iii) There is the follow up service to ensure timely delivery,
(iv) On receipt, a goods received note is raised by the stores officer.
(v) There is the issuing of acknowledgement slip and where necessary the
return slip for sub-standard items.

3.2.5 PURCHASE REQUISITION

A document requesting the purchasing section to purchase a specific quantity
that is a purchase requisition note is raised by any one of the following

35
authorised sections:
(i) Plant or Production
(ii) Stores Department
(iii) The administrative head or any departmental head as specified in the
organizational structure. Depending on the internal control system, the
requisition, (whose specimen is shown below) is made in duplicate,
triplicate or quadruplicate with a copy retained by the, initiating
department and others sent to the purchasing department, and if relevant,
to the production planning and control department.

PURCHASE REQUISITION NOTE

The required detail included in the purchase requisition varies from industry to
industry. In addition to the bare minimum specified in the figure 3.1aw below,
some companies require the reasons for the requisition, the date when the goods
will be required for use, the account to be charged or the stock balance at the
time of raising the order. It is very important that purchase requisitions be
approved only by authorized individuals.

3.2.6 PURCHASE ORDER

Upon receipt of the purchase requisition, the purchasing manager does either of
the following:
(i) If it is a repeat purchase, he goes through his records for the best, most
dependable and least cost supplies,
(ii) If a new purchase, of important high or lower value items, he obtains
quotations or invites tenders from suppliers.
In selecting the supply source, he takes cognizance of the purchase terms like
price or trade discount, the purchase price, dependability of supply,

36
transportation mode and other factors vis-a-vis quantity, quality, time, etc.
Next, the purchase order is raised (a typical format of which is shown below) by
the purchasing manager. It is an instruction to the vendor to supply the required
quality and quantity of material at agreed terms, price and date.

PURCHASE ORDER NOTE:

Note the content of the order like the purchase requisition, more than two
copies may be raised depending on the organization. Copies are sent to the
supplier, the receiving or stores department, the accounting department and a
copy is retained by the purchasing department.

37
 PURCHASE ORDER

ABC Ltd
31, Obafemi Awolowo Road
Ikeja
From:

TO: XYZ Ltd DELIVERY ADDRESS:

41, Tinubu St. 31, Obafemi Awolowo Road
Lagos Ikeja

Please supply the following in accordance with our

Standard Conditions of Purchase printed overleaf.

Quantity Description Price

Components to Drawing 85212

As quoted 5/10/-4 N150 each
Your ref 59529
Delivery: To schedule attached

For ABC Ltd

PURCHASING OFFICE

OUR ORDER NO. MUST BE QUOTED ON ALL COMMUNICATIONS

Fig 3.1

38
3.2.7 FOLLOW-UP
The lag between raising the purchase order and the receipt of the required
material may be described as a tense moment particularly where a material of
vital importance to the production processes has fallen below the minimum
stock level. Where the supply source is highly dependable, this stage may not
be necessary. The follow up service involves acknowledging acceptance of the
order either by mail or telephone contact and ensuring that conditions such as
price and delivery date are adhered to and where necessary the search for an
emergency source of supply.

3.2.8 RECEIPT OF MATERIAL

The receiving department normally sited at the gate or near the supply route like
railway sliding or wharf receives, records and inspects the goods to ensure that
the quantity, quality and other specifications stipulated agree with the purchase
order.
Usually, the suppliers send delivery note or bill of lading instructing the
purchasing company of the dispatch of the consignment. Armed with this, the
receiving clerk or inspector makes necessary arrangement for the discharge of
goods. The receiving clerk then prepares goods received notes or receiving
report copies sent to the purchasing, accounting and stores departments while
he retains a copy on his files.
Substandard goods are returned to the vendor with a note. For internal control
purposes, this may be raised by the clerk and approved by a responsible officer.
While the purchasing department utilizes the receipt of the vendor's invoice the
purchasing manager easily checks it against the purchase order and the goods
received note.

39
GOODS RECEIVED NOTE
The clerk issuing the purchase order and the goods received report stamps it,
approves the transaction by appending his signature and sends the original copy
to the accounting department for the settlement of the bill. The material control
procedure of re-calculating the total cost for correctness and guiding against
duplication of entries varies amongst businesses. Students who have gone
through the first financial accounting course should be able to journalise the
transactions at this stage.

3.3 STORES
Cost Accounting serves management by providing the information needed for
the task of providing for the physical control of investments in inventories. The
department charged with this responsibility is stores. A carefully organized
stores department is a guarantee against waste resulting from deterioration,
obsolesce, physical damage as a result of poor or too much material handling
and pilferage.

3.3.1 Organisation of stores Department

The stores department is usually headed by the storekeeper, who should be an
honest and dedicated staff with a vast knowledge of stores routine. Besides the
physical control of inventories, other functions of the stores department which
he heads include:
i. Orderly and tidy arrangement and quick identification of materials. Here
a good coding system is required.
ii. Issuing of purchase requisition and the receipt of ordered goods. This
involves ensuring that the maximum and minimum stock levels are
maintained.

40
iii. Ensuring that materials issued are properly authorized.
iv. Providing adequate insurance cover and reducing the risk of loss by fire.
v. Aiding management by providing information on stock turnover,
reconciled card and physical quantity balances and other control figures.

The organizational structure of the stores department varies amongst

businesses. It ranges from complete centralization to a decentralized structure
with either open or enclosed stock rooms. Centralisation of buying and storage
is advisable when practicable but it is difficult for a company with plants
scattered over the country to have one central buying office doing all the
purchasing services.

3.3.2 Centralisation
Centralisation has the advantage of possible bulk purchase which most often
means better prices via discounts. Central purchasing offers a company the
opportunity of making use of experts or specialized men by reducing the
frequency of purchase, reduced duplication of orders, clerical costs and other
ordering costs help to reduce the purchase cost.
It also helps to increase standardization in designs while equally giving
management tighter control over inventory policies. These ensure enough cost
savings to counter the disadvantages of sluggishness and tedious procedures in
centralization particularly where minor items are involved. However, central
authorities may not know local needs and may be too loose or too rigid in
applying its control mechanism. It is also possible that items purchased
separately from different markets may be cheaper and delivery failures reduced
in a community that experiences industrial unrest.
As a guide, some companies centralize major purchases involving big amounts

41
of money or requiring technical knowledge and then decentralize minor
purchases or place naira limits on local purchases. Sometimes policies and
procedures for local purchases are laid down by the central office which also
makes all disbursements directly to the vendor.
3.3.3 Centralised Versus Decentralised Storage
Some factories have a main store and a number of departmental sub-stores. This
arrangement has some advantages and disadvantages.

The advantages of main and departmental sub-stores are:

a. The cost of internal transport is minimized because material is
transported in bulk between the main and sub-stores
b. Materials are stored in the department using them.
c. Materials are quickly available for issue, reducing delay and the danger
that production will be brought to a standstill;
d. A more efficient use of direct labour can be maintained;
e. Losses of materials in the main store will necessarily stop production.
f. Sub-Stores provide facilities for the storage of finished production prior
to transfer to other departments, or the finished stock warehouse and
g. The issue of materials from sub-stores is an aid to good house keeping on
the shop floor.

The disadvantages of main and departmental sub-stores are:

a. Increase in staffing and therefore an increase in the indirect labour costs;
b. Supervision of storekeepers is more difficult;
c. Larger stocks may be carried entailing increased storage space and
additional working capital;
d. A physical stock-taking is more complex;

42
e. Increased clerical and stationery stocks, and
f. A greater risk of losses owing to obsolescence.
3.3.4 Location of Stores
The location of the stores department calls for careful planning. How and where
should the central or sub-stores be located?
Should it/they be located in a central position? Factors to be taken into
consideration include:
i. Cost of frequency and difficulty of handling.
ii. Nearness or accessibility to use departments, and the receiving
department;
iii. Bulkiness, perishability; quantity and quality of materials require
storage. Surely chemical properties like petroleum require extra
location planning attention.
iv. Safety consideration such as fire or flood hazards and theft.
In large multiproduct manufacturing companies, materials are sent directly from
the receiving department to the central stores from where they are issued to the
sub-stores located near departments serviced by the sub store.
Just as production processes require carefully planned layout, so does the stores
department if its objectives are to be realized. Where closed storage is
necessary, bins, racks and shelves are utilized. Particularly for items that are not
bulky and do not rust or evaporate. These containers are arranged in lines with
enough room for the passage for material handling equipments like trucks. In
general, the layout is determined by the nature, quality, quantity, physical size
and chemical composition of the material. Other factors include the
accessibility to use departments, convenience of the store-keeper particularly
where a good coding system is adopted, and there are sharp differences in
grading; regulations laid down by the Insurance Company and government

43
agencies.
3.3.5 Identification Systems
An identification system is almost mandatory in stores routine. Word
descriptions may be fine where few items are involved but sometimes they are
too cumbersome. Hence symbol designation is the vogue, every item dealt with
either in the factory floor or in the store room should be identified easily by its
code number or symbol. Coded numbers or number and letter system are used
to give numbers to similar items.
In the simple letter system, an alphabet or alphabets are used to denote 'a group
of material classification’. For example, a may represent nails while B
represents bolts.
In the Mnemonic system, like the alphabetical system, the objective is to hasten
quick memorization of item identities. The BL may represent large bolts while
BM represents medium size bolts and B8 represents little bolts of specified
measurement. The Numerical system assigns numbers to classified materials
and assigns a higher number in a sequence to each new type of material. The
following is a typical example where O represents bottles and other/numbers
represent types of bottle:
Code Number Description
011 Fanta Bottles
012 Cocacola Bottles
013 Crush Bottles
014 Seven-up Bottles
021 Stout Bottles
022 Maltex Bottles
031 Harp Beer Bottles
032 Star Beer Bottles

44
The decimal system and combination of letter and number are other systems
used.
Identification system saves time and cost and the pricing of identified or
classified materials in the cost accounting department is facilitated.
3.3.6 Issue of Materials:
Where materials are not sent directly user department but to stores, a definite
procedure is called for, before such items are issued from stores to the factory
floor. As a control device, materials are issued by the store keeper only on the
presentation of a duly signed material requisition form, a document which
authorizes and records the issue of materials for use. Alternatively, a bill of
materials listing all the materials required for a specific job is raised.

MATERIALS REQUISITION
ABC LTD.
Dated : January 19, 2010. No. 632
To: O.O. Oga

QUANTITY DESCRIPTION UNIT PRICE AMOUNT

Litres Diesel N105 N10, 500 00

Approved by: AA Issued by: BB

Received by: CC
Changed to Job/Dept: 20 Factory Overhead Expense
Figure 3.2

45
3.3.7 Material Requisition
You should note the minimum information included in the form. It is essential
that requisition should be duly authorized and signed by the foreman or user
department's manager and that the storekeeper duly endorses the issue. The
requisition is made in triplicate. A copy is retained by the needy department
while the other two copies are sent to the storekeeper. The storekeeper then
updates his records by entering the details on the Bin Cards and adjusting the
stock balances. A copy is later sent to the cost department where the pricing on
the agreed method are credited to the stores ledger account with a
corresponding debit entry to the cost ledger.
3.3.8 Material Transfer Form and; Material Return Note:
It sometimes happens that part or all the requisitioned materials, scrap,
defective or rejected products are transferred from one factory floor to another
or from one department back to stores for internal control purposes. These
movements must be authorized and recorded. Where transfers are involved, a
Material Transfer Form or Credit Requisition Note is completed by the
transferor department.
(i) Material Transfer Form
This is in duplicate with a copy sent to the cost clerk for necessary pricing
entries. In some companies, such inter-departmental transfers are prohibited,
excess materials are returned to stores before re-issue. Whichever procedure
that is adopted, it is essential that excess material is not allowed to waste on the
factory floor.
Sometimes they constitute hazards and impede movement. The cost department
credits and debits the transferor and transferee job cost centres respectively.
When materials are returned to stores, a Material Return form or stores debit
note is filled by the transferor department and sent to the stores department.

46
With it, the stores’ records are adjusted and the cost books brought up to date
by debiting the stores ledger accounts and crediting the relevant cost centre.
Similarly Returned Scrap form or Defective material Note may be applied
where appropriate.

(ii) Other Stores Routine

Bin Cards:
Attached to each bin or rack is a card which records essential data relating to
materials in it and its movements. The card is debited with each new item
received and credited with issue, a balance being struck after every entry. In
essence, it provides a perpetual inventory.
A typical bin card is shown below but there are variations with columns
showing of material ordered and expected delivery day or showing quantity
allocated to a specific job. Students should note the minimum information
contained in the card. Where the card is not attached to bin, it is necessary to
indicate the location of the bin on the card. This is helpful where the cards are
occasionally removed for stock taking purposes.
Mention will be made of the stores ledger in the next lesson but it suffices to
know at this stage that stores ledger is like the Bin Card but in ledger form with
both the quantity and monetary values of material.

47
 Fig 3.3

(iii) Stores Material Control Record

Like the Bin Card, it only records the quantity of materials but it is in a loose
leaf or card file form. It is prepared by the stores clerk or production department
as an alternative to the Bin Card.
(iv) Issue Analysis or Material Analysis Sheet
The Analysis sheet is a classified record of materials issued, returns and transfer
to jobs and other cost units and centres. Its objective is to ensure that all
material transactions are recorded and charged or credited as the case may be.
The serial number of issue, returns and transfers form is of vital importance
particularly in this regard since the omission of any transactions can be easily
detected in the material analysis sheet.

48
You should also remember that several other different forms are in use in
various business organizations. For instance, the stores Appropriation Record
may be utilized where Bin Cards do not show the maximum and minimum
stock levels, while punched card and materials requisition card are in use where
the accounting system is computerized.

The importance of a good purchasing procedure lies in the fact that material
items constitute over 50% of the total product cost and therefore the purchase of
sub-standard items and choice of unreliable supplies or a costly supply source
could be the beginning of reduced returns on investment.
Material control starts almost on receipt of ordered materials from Vendors.
The skill of an expert receiving officer is needed in making decision on the
location and type of storage desired. This helps to reduce handling and storage
costs and the efficient organization of the stores department routine. The store
keeper who must be honest at all times must ensure that only with duly
authorized notes should materials be issued or returned. Good stores and the use
of Bin card and other stores record are ways of reducing the onerous task of
store's control.

3.4 COST OF HOLDING MATERIAL STOCK:

The cost of holding stock are:
1. The purchase costs of stock/inventory.
They are costs of purchasing stock items. The unit of cost of the items may be
fixed with no quantity discount and it may vary with quantity discount. The
annual carrying cost increases as the quantity of stock increases.

49
2. Carrying or holding costs
They are the company's incurred costs on holding stock items such costs as:
a. Stock recording, stock taking, audit costs
b. Security and insurance of stock
c. Evaporation, pilferage, damages and breakages;
d. Storage which include rent, heating, lighting, etc.
e. Interest on capital invested in stock
f. Deterioration and obsolescence.

3. Ordering cost
They are costs incurred in placing and receiving the stock items into the
company store. These costs include:
a. The cost of communicating with the supplier
b. Transport and freight
c. Payment of the supplier
d. Loading and offloading
e. Clearing and forwarding charges
As the total annual ordering cost increases so also the number of orders per
annum increases.
4. Stock - out costs
When the stock is exhausted, and customer's demand cannot be met, there is a
stock - out. To prevent it, inventory policy of an organisation must consist of:
a. When to order, i.e. re -order level.
b. How much to order, that is, the economic order quantity

50
3.5 TERMINOLOGIES
Economic Order Quantity
It is the re - order quantity calculated to reduce relevant material cost each time
a replenishment order is made. Total relevant material cost consists of purchase
costs, ordering costs, carrying costs and stock out costs.
Demand:
The total quantity of materials required per week, month and per annum
Lead time:
The time interval between when an order for goods is placed and when the
goods are received.
Physical stock:
The stock items that can be physically observed and counted in the store.
Free stocks:
They are physical stock items plus orders placed less unfulfilled stock orders.
Buffer stock:
The stock allowance reserved to bridge the gap between order and receipt of
stock.
Maximum stock level:
The level of stock above which the stock may not be allowed to rise. The
following aspects are to be taken into consideration:
a. Rate of consumption of the material
b. Time to obtain new deliveries
c. Capital available
d. Risk of deterioration and evaporation
e. Availability of storage space
f. Storage cost
g. Price fluctuations

51
h. Risk of obsolescence
i. Economic order quantities
j. Seasonal market situation as to price and supplies
k. Government policies
1. Insurance issues

NOTE:
1. Maximum Level = Max. L
2. Minimum Level = Min. L
3. Re-order Level = RL
4. Re-order Quantity= RQ
Maximum stock level is calculated as follows:
Max. Level = RL + RQ - (Min. Usage x min. Lead time)

Minimum stock level:

The stock level which stocks should not be allowed to fall, there may be
shortage of supplies if the stocks go below this level and may result into
stoppage in production. In fixing the minimum stock level, the following are
put into consideration:
a. Rate of consumption of material»
b. Time to obtain delivery of the new material that is, lead time.
Minimum stock level is calculated as follows:
Min. L = RL – (Average usage x Average lead time)

Re-order Level:
This is the point at which a fresh order for materials is initiated. The point is
between maximum and minimum stock levels, iris higher than the minimum

52
stock and covers abnormal usage of materials and unexpected delay in delivery
of new supplies.
Re - order level is calculated as follows:
RL = Max Usage x Max LT = Max Usage x Max Lead time.

The re - order quantity:

The quantity which is usually ordered each time new supplies of materials are
required. These factors are taken into consideration:
a. Cost of storage i.e. interest on tied up capital invested in stored
materials, deterioration and obsolescence.
b. Cost of purchasing materials e.g. purchase order cost, raw material
inspection cost, transport cost, etc.
c. Insurance costs against fire and explosion.
Re - order quantity is calculated as follows:
RQ = Max. L - RL + (Min Usage x Min Lead time.)
Assuming that there is a steady demand, the larger the quantity ordered at a
time the longer it will remain in store and the higher the carrying cost because
half of the quantity ordered may have to be carried. On the other hand, larger
stock of materials will allow for longer production runs. As there are opposing
costs, the cost of stock held must be balanced against the diminishing unit cost
of ordering so that the total cost may be minimised. Here comes the issue of the
economic order quantity for the raw material at which cost are minimised.
The Economic Order Quantity (EOQ)
It is the optimum ordering quantity of an item of stock which will balance and
minimize cost between carrying cost and ordering cost.
Assumptions of EOQ
They are:

53
 1. Purchase price per unit is constant. Quantity discount is not allowed
2. Demand per annum and utilisation rate is constant
3. Lead time is constant
4. All units of stock ordered are delivered at the same time
5. Ordering cost is constant

Determination of EOQ
There are three methods involved:
1. Tabular method
2. Algebraic method
3. Graphical method

Algebraic method EOQ is determined by this formulae

EOQ = 2DO
C
Where D = Annual demand
O = Cost per order
C = Carrying cost or holding cost.

Example 1:
Assume the following data:
Annual demand for material 24, 000 units
Cost of material per unit N10
Cost of ordering per order N4
Cost of storage is 48%

54
Required: Determine the Economic Order Quantity.
EOQ = 2 x 24,000 x N4
N10 x .48

= 192,000
4.80

= 200 units

Example 2:
Alphonsus Ltd has the following date pertaining to materials being ordered:
Working days per annum 250
Average use per day 250 units
Maximum use per day 300 units
Lead time 5 days
Cost of placing order N18
Carrying cost per unit per annum Nl
Calculate:
1. economic order quantity
2. safety stock
3. reorder point

Solution
EOQ = 2 x 62500 x N18 = 2250000
1 = 1500 units.

55
2. Maximum use per day 300 units
Average use per day 250 units
Safety stock 50 units
Total safety stock = 50 units x 5 days lead time = 250 units

3. Average use per day 250 x 5days lead time = 1250 units
Safety stock = 250 units
Re - order point = 1500 units

Working Note:
Annual Demand = 250 x 250 = 62,500 units.

3.6 MATERIAL RECEIPT, ISSUE AND PRICING

Goods receipt:
Quantity of materials received must be recorded on goods received notes. Stock
record must be updated and purchase invoices are forwarded to accounts
department for payment.

Stock taking:
Stock taking should be either by continuous stock taking by an independent
storekeeper or perpetual stock taking to know the quantity of stock without
physical stock count.

3.7 STOCK PRICING SYSTEM

There are eight methods of stock pricing but only two will be considered here.
They are:

56
 1. First in - first out (FIFO)
2. Last in, first out (LIFO).
3. Base stock
4. Simple average
5. Weighted average
6. Periodic simple average
7. Periodic weighted average
8. Standard price

3.7.1 FIFO: FIRST - IN - FIRST - OUT

This method is easy to operate. It ensures that materials are issued at actual cost
and in strict chronological order.

ADVANTAGES
1. It is realistic. Materials are issued in order of receipt.
2. No profit or loss arises on valuation
3. The system is accepted by Inland Revenue Department.

DISADVANTAGES
1. The price of material issued may vary from batch to batch hence cost
comparison between jobs becomes difficult.
2. The material issuing price may not reflect current economic value

3.7.2 LIFO: LAST-IN-FIRST-OUT

This method is a reverse order to FIFO. The last materials receipts are the first
issue and are issued at actual cost.

57
ADVANTAGES
1. No profit or loss on stock valuation.
2. The charge to production is close to current price levels.

DISADVANTAGES
1. It is tedious to calculate and the comparison of job cost is difficult and
unfair.
2. The oldest method in the store does not represent the current price.
3. It is not recommended by SAS 4

3.7.3 WEIGHTED AVERAGE

In this method, on receipt of materials, issued prices are calculated rather than
issue of materials. When materials are received the total cost stock is divided by
the total quantity stock. It is based on actual cost.

ADVANTAGES
1. It is easy to administer
2. It encourages cost comparison between jobs
3. The method is based on actual cost hence there is no unrealised stock
profits and losses
4. Under fluctuating stock prices, it gives satisfactory results than FIFO,
LIFO, etc.
5. It is approved by Inland Revenue
6. It is of greater accuracy

DISADVANTAGES
1. It is complex to use.

58
 2. The price of issuing may run into four decimal places.

3.7.4 STANDARD PRICE

Standard price as related to stock issue is a predetermined price used for each
material in store. It takes into consideration these factors:
a. Quantity of materials purchased which will affect the quantity discount.
b. A rise in prices owing to expected increase in wages.
c. A rise or fall in prices owing to market conditions
d. Expenses on material freight and warehousing.

ADVANTAGES
1. It is simple to operate because all issued materials are based on actual
price.
2. Efficiency of material purchased can be ascertained if the actual price
exceeds standard or vice - versa.
3. It makes for standard price being set for each material for comparison to
know when profit or loss is made,

DISADVANTAGES
1. As standard price is not an actual price, profit or loss may arise on
comparison of standard with actual price.
2. It is difficult to establish realistic stock standard price because of price
fluctuations.
Example 3:
Governor Limited is an importer and seller of XYZ Tyres. Data for 6months
ended June 30,2009 are as follows:

59
 Date Receipts Purchase Issues (Units) Selling
(Units) Price (N) Prices@4)
January 10 3,000 8.00
February 5 2,000 9.00
March 6 1,600 10.00
April 12 2,000 12.00
May 20 1,800 9.60
June 20 3,000 14.00

Stock 1/1/2009 was 1,000 units at the rate of N7.00 per unit.
Required:
From the information given above and using First-in-First-out and Last-in-
First-Out methods for pricing issues,
a. Show the stores ledger records including the closing stock balance
and valuation.
b. Prepare trading account using First- in -First -Out.
c. Highlight the advantages and disadvantages of Last-in-First-out

60
 Solution:

GOVERNOR LIMITED
Date Particulars Receipts Issue Balance
UNITS PRICE AMOUNT UNIT PRICE AMOUNT UNIT PRICE AMOUNT
N N N N N N
.Jan. 1 Opening
2009 Stock 1000 7.00 7.000

Jan. 10 Purchases 3.000 8.00 24.000 4000 1000 x 7 31,000

2009 3000 x 8
Feb. 5 Purchases 2.000 9.00 18,000 6000 1000 x 7 49,000
3000 x 8
2000 x 9
Mar. 6 Sales 1,600 1000 x 11,800 4400 2400 x 8 37,200
600
7 x8 2000 x 9 .
April Sales 2,000 2000 x 16,000 2400 400 x 8 21,200
12 8 2000 x 9
May Purchases 1,800 9.60 17,280 4200 400 x 8 38,480
2000 x 9
20
1800 x
June Sales 3,000 400 x 8 26,960 9.6
1200 1200 x 11,520
20 2000 x 9.6
600x
9
9.6
1

61
 LIFO
Date Particula Receipts Issue Balance
rs UNIT PRIC AMOUN UNIT PRICE AMOUN UNIT PRICE AMOUN
N N N N N N
S E T T T
.Jan. 1 Opening
2009 Stock 1000 7.00 7.000

Jan. 10 Purchases 3.000 8.00 24.000 4000 1000 x 7 31,000

2009 3000 x 8
Feb. 5 Purchases 2.000 9.00 18,000 6000 1000 x 7 49,000
3000 x 8
2000 x 9
Mar. 6 Sales 1,600 9 14,400 4400 1000 x 7 34,600
2400 x 8
2000 x 9 .
April Sales 2,000 1600 x 8 16,400 2400 400 x 8 18,200
12 400 x 9 2000 x 9
May Purchases 1,800 9.60 17,280 4200 1000 x 7 38,480
1400 x 8
20
1800 x
June Sales 3,000 1200 x 8 26,960 9.6 x 7 8,600
1200 1000
20 1800 x 200 x 8
9.6

62
B) USING FIFO METHOD

TRADING ACCOUNT FOR THE SIX MONTHS ENDED, 30TH JUNE.

N N
Turnover/Sales 82,000
Opening stock 7, 000
Add purchases 59,280
Cost of goods available
For sale: 66,280
Less closing stock (11,520)
Less cost of Sales (54,000)
Gross profit 27,240

C) Advantages of LIFO
1. Issues represent current economic prices.
2. No profit/ loss resulted

Disadvantages of LIFO
1. It is not recognised by tax authority.
2. It is cumbersome to apply.

3.8 SUMMARY
In this module you have learnt that:
1. Stores and Stores accounting involves classification and recording of
materials purchased, issued returned and transferred to jobs and
other cost units and centres.
2. The purchasing division is headed by the purchasing manager who

63
 keeps track of prices, quality and new products. He is responsible for
the acquisition of material parts, supplies and containers, equipment
and repair parts and the sale of the disposal of wastes and by-
products.
3. There are five general steps in the purchasing of goods.
4. The receiving department receives, records and inspects the goods to
ensure that the quantity and quality and other specifications
stipulated agree with the purchase order. The functions of the stores
department headed by the storekeeper who should be honest and
dedicated with a vast knowledge of stores routine.
5. Centralised and decentralized storage are stores with a main store
and a number of departmental sub-stores respectively. They have
advantages and disadvantages.
6. Materials are not sent directly from the vendor to the user
department but to stores where the materials are issued to the user
department.
7. There are costs of holding stock such as carrying ordering, stock out
costs.
8. There are eight methods of pricing stock e.g. FIFO, LIFO, etc.
EXERCISES:
1. The invoice is entered in the original book of entry-the Purchase Journal.
Which accounts are opened and how are the transactions up to the
settlement of the bill recorded? Answer in five sentences
2. Do you consider that the store-keeper should see and pass invoices for
material received? Briefly explain in two or three sentences.
3. Write one advantage and one disadvantage of centralized storage or
decentralized storage

64
4. Oladuni Ltd has the following information:
Units required per annum N15,000
Cost of placing an order N 200
Unit carrying cost per annum N 300
There is an assumption that 75 units will be required throughout the year.
What is the economic order quantity?
5. Mr. Cane sells cane baskets; the Demand for the cane baskets during
Christmas period is at a constant figure of 2000 packages. The producer's
cost is N20 per package of 12. Mr. Cane's cost is N10 per package. He
requires a three day lead time from the date of order to date of delivery.
The ordering cost is Nl.20 per order and the carrying cost is 10% per
annum.
Calculate:
a. The economic order quality.
b. The number of orders needed per annum.
c. The total cost of buying and carrying cane baskets per annum

The information below is for questions 6-8.

The following data is available in respect of material XYZ.
Re - order quantity = 7, 200 units
Re - order period = 3-5 weeks
Maximum consumption = 1, 800 units per week.
Normal consumption = 1,200 units per week
Minimum consumption = 600 units per week
6. What is the re - order level?
a. 9,000 units b. 15,000 units c. 3,000 units d. 10,000 units e.6,000 units
7. What is the minimum stock level?

65
 a. 4, 200 units b. 2,100 units c. 4, 000 units d. 9, 000 units
e. 6, 000 units
8. The maximum + stock level is
a. 14, 400 units b. 14, 000 units c. 12, 600 units
d. 10,000 units e. 7, 000 units
9a. Give specimen ratings of defective materials and stores requisition forms
and
b. Describe fully their movements and treatments through the factory floor
and cost department.
10. The stores department is usually headed by------- ( choose best answer
from alternative a- d).
a. Storekeeper b. Purchasing officer c. Internal auditor
d. Manager e. Accounting officer
11. The term centralized storage means:
a. Main storage b. dephi storage c. Storage
d. diverse storage e. Accounting officer
12. The purchasing division is headed by the
a Shoe keeper b. Auditor c .requisition order purchase d
.ordering officer e. planning officer
13. Purchase order is an order form for ---------------------
a. Store requisitions b.
14. Purchase requisition is defined as
a. b. c. d. e.
15. Centralization is the advantage of _____________________ purchase
a. Single b. Bulk c. Unit d. Materials

16. Identify the functions of purchasing department

66
17. “Stock control” is
a. Carrying and holding stock
b. Inventory
c. Stock Issues
d. Physical Stock
18. “Store keeping” is
a. Control of Inventories
b .Stock taking
c organization of stock
d Material issue

Further Reading
1. Drury, c. (1992). Management and cost Accounting (3rd.ed.), London:
Chapman and Hall.
2. Omolehinwa,A. (2001). Work out Management Accounting (Notes and
worked examples), (1st ed.) Lagos: st John consultants LTD.
3. Anumaka, N.M. (2000). Managerial accounting and Control, Lagos: Matic
Educational Books.
4. Lucey, I. (2002). Costing (6th.ed), London: Thompson.

67
 CHAPTER FOUR

LABOUR COSTING
4.0 OBJECTIVES.
At the end of this module you should be able to:
1. explain labour cost and what it involves;
2. record labour time and output;
3. calculate time clocks and other methods of remuneration;
4. Distinguish one from the other defective work, lost time and sundry
employees’ records.

4.1 INTRODUCTION
Labour is one of the elements of cost. It is a factor which requires a very careful
thought for it represents a large part of total cost of production. It is a factor
which can be easily influenced and it is fairly easy to measure. Management has
devoted much time to the study of labour costs than any other cost of
production because reduction in labour costs is one of the chief objectives of the
Production Manager.
The purposes of labour costs are:
1. to serve as the basis for control of direct labour.
2. ascertain product cost by allocating direct labour costs to jobs, processes,
etc.
3. absorb overhead where required by using direct labour as a basis.
4. Determine indirect costs in order to control the efficiency of departments
or cost centres.
The control of labour costs does not consist solely in the reduction of labour
expenses but also in the verification of efficiency of labour operation which are:

68
 a. adequate level of remuneration
b. ascertainment of product quality with the predetermined standards.
c. ensuring that the level/volume of production is in line with set
standards.
In an organization, before labour cost is incurred, a great deal of work has to be
done, e.g. recording of times of attendance at work, evaluation of work done,
laying down systems of remuneration, compiling and applying rates of pay to
time spent and work produced, preparation of payroll, etc.
The departments which are responsible for the planning and control of labour in
an organization are:
1. Personnel Department
The personnel department is delegated with the engagement of labour in
response to authorised request for employees Deceived from departmental
managers. Hiring of labour is subject to existence of vacancies within the
organization. The personnel department is also responsible for the training,
transfer, welfare, retirement and keeping of records on each worker/employee.
2. Time - Keeping Department
The time keeping department supplies information through the clock cards,
labour time, and tickets to the accounting department for the computation of
their wages.
3. Production Department
The cost accountant provides the production manager relevant labour cost
information as it affects the workers in his/her department.

4. Engineering and Work Study Department

a. prepare plans and specification for production of each job.
b. study methods of work;

69
 c. set production standard;
d. set different rates as they affect the worker;
e. put in place safety and efficient working conditions.
5. Wages Department
Wages department keeps records of job specifications, classification and wage
rates of each worker, putting into consideration the gross and net amount of
earnings.
6. Cost Accounting Department
It costs jobs, processes, and products as supplied by the wages department. The
department also sends relevant information to management for control measures
and decision making.
7. Recording of Time and Output
Timekeeping is the detailed recording of attendance or time spent on a given
job or the amount of work done. It is used for the preparation of payrolls,
distribution of labour costs and other cost records.

Method of Recording Time

The method of recording tine is based on the nature of the work and the system
of wage payment. It is divided into:
a. Attendance time/Time spent in the factory: It is the basis upon which the
wages of a worker is obtained. The form being used may be a time sheet
or a clock card.
b. Job time/Time spent on job or process: Job time is obtained from time
sheets, piecework tickets or job cards.
REMUNERATION:
It comprises of:
1) Wage rate - The wage which any worker receives depends on:

70
 a. The supply of his class of labour.
b. The demand for it
The rate depends on:
a. The nature of the work whether difficult, dangerous, unpleasant,
etc.
b. The standard of education, the amplitude, intelligence, the amount
of training, the length of experience, etc., of the worker.
2) Wage rate is the oldest system of remuneration. It is the hour, the day, the
week or the month worked without regard to output. In some firms the
time-rate varies with the production of the whole work/factory or the
selling price of the product or cost of living index. Overtime operates in
respect of work done outside normal hours of work.

Methods of Remuneration
1. Day rate also known as time rate
2. Piece rate
3. Premium bonus
1. Day/Time rate: Workers are paid on the basis of hours engaged. It is the
hour, the day, the week or month regardless of output. It is appropriate
a. Where labour is indirect e.g. night guards, cleaners, etc.
b. Where accuracy is emphasized than speed.
c. Where production unit is small and supervision of foremen is near.
d. Where work involves high degree of skill and use of expensive
equipment.
Overtime pay in respect of work done outside office hours is usually in
operation from Monday to Friday. The rate of overtime payment is at the
discretion of the employers.

71
Advantages:
a. Simplest to operate and easiest to understand.
b. It is applicable to different skills and grades of workers.
Disadvantages:
a. It offers no incentive to increase in output
b. Workers on completion of an assignment tend not to ask for further work
or instruction.
c. Workers have the tendency to spend longer time on a job in order to earn
overtime pay.
d. Efficient and inefficient workers are paid the same rate per hour.

Example 4.1
Hourly rate N5
Hours worked 8
Day rate pay = N5 x 8 = N40
2. Piece rate: Workers are paid at the rate of pay per unit of output
regardless of the time taken. Their weekly/monthly earnings depend on
the number of units produced/or finished at a fixed rate.

Advantages:
1. Output of each employee can be identified.
2. It is easy to operate and it gives workers incentive to do their best;
3. The clerical and supervision costs are low.
4. Production tends to increase while fixed overhead expenditure per unit is
reduced.

72
Disadvantages:
1. When remunerations are tied to worker's output, the quality of output
may be in jeopardy in order to produce greater quantity.
2. When there are stoppages in production owing to machine breakdowns,
shortage of raw materials etc. workers may earn less wages.
Piece rate with guaranteed day rate.
If earning from piece work is less than normal day rate, day rate will be paid.
This is meant to compensate workers for delays, breakdowns of machines,
shortages of materials etc. This is applicable when the piece rate system or
guaranteed day rate system is used. The worker receives the higher of the two
rates (day rate or piece rate).
Piece rate with guaranteed week rate.
This is applicable when the worker receives the higher of
a. the pay given by the total output for the week multiplied by piece rate;
b. the guaranteed week rate.
Guaranteed week rate is preferred in order to guard against workers who may
abuse the guaranteed day rate by wording very hard on some days in a week to
earn the higher pay and putting less effort in other days to earn the same higher
pay.
Example 4.2
Standard production per hour = l00units
Hourly rate of pay = N5.00
Units produced = 400
The piece rate per unit of output = N5 = 0.05
100
Piece rate earnings = N.05 x 400 = N20

73
Premium Bonus Scheme
Premium Bonus Scheme relates earnings to the time worked and the output
produced with the operation of Day/Time rates. An extra effort of workers is
not rewarded. The value of increased output is entirely to the employer where
piece rates are applicable. The value of increased output is partly to the
employee and partially to the employer if the cost of his fixed overhead per unit
is reduced.
In this scheme, the bonus arising from time saved in relation to standard set is
shared between the employer and the employee. The employer's labour cost is
reduced as production increases. Here, the employer's interests are more
effectively protected than in the piece rate system where measurement of work
is difficult and there 'is a danger of fixing higher rates. A premium bonus
scheme is a compromise between the day work and piece work systems because
it relates earnings to the time worked and the output achieved. It is made up of:

a. Day rate amount on the hours worked.

b. A bonus amount on the time saved in producing an output.
Premium bonus schemes are named after their originators. They are:
a. Halsey scheme
b. Halsey - Weir Scheme
c. Rowan Scheme
a. Halsey scheme

a. Halsey Scheme
F.A Halsey, an American Engineer, introduced this scheme in 1891. The
earning is based on day/rate if they fail to complete the job in the time allowed.
If the job is completed under the time allowed, a bonus based on the percentage

74
of time saved is paid. It is usually 50%
Forniular: ½ x time saved x hourly rate.
b. Halsey - Weir Scheme
It was introduced by G and J. Weir Limited in Glasgow about 1900. It is
different from Halsey Scheme in the sense that only one third of the time saved
is added as a bonus.
Formular:
Bonus Pay = 1/3 x time saved x hourly rate
c. The Rowan Bonus Scheme
This was introduced in 1901 by David Rowan and Company Limited in
Glasgow. The bonus is based on the time saved as a fraction of time allowed. It
is designed to ensure that the bonus pay is smaller than the day rate pay.

Formular:
Bonus Pay = Time Taken x Time saved x Hourly rate
Time allowed
Example 4.4
A company's remuneration scheme is made up of the following:
Hourly rate N5
Units of production per hour 80
Actual hours taken 8
Units produced 800

Required Exercise:
Calculate remunerations under
a. Day/ rate scheme
b. Halsey Bonus Scheme

75
c. Halsey - Weir Bonus scheme
d. Rowan Bonus scheme

SOLUTION
Halsey Bonus Scheme
a. Day rate pay = N5 x 8hrs = N40
b. Bonus pay = ½ time saved x hourly rate
Time allowed = 800 = 10 hrs
80

Actual time taken = 8hrs

Time saved 2hrs
Halsey bonus Pay ½ x 2x 5 = N5.00
Day rate pay = N40.00
Total = N45.00

c. Halsey - Weir Bonus Scheme

Bonus pay 1/3 x time saved x hourly rate
= 1 /3 x 2 x 5 3.33
Day rate pay N5 x 8 40.00
43.33
Rowan Bonus Scheme
Bonus pay = Time taken x Time saved x hourly rate
Time allowed
Bonus pay = 8 x 2 x N5 = 80 = N8
10 10

76
Day rate pay N5 x 8 = N40
= N48

Piece work
Differential Piecework
Here a flat rate per unit is paid. If at higher production level, this system is used
to increase rate of pay at various levels of' production e.g.
At 100 units per day/20k per unit
At 101 - 150 units per day 22k per unit
At 151- 200 units per day 25k per unit
This is applicable too in all bonuses:
A worker who is transferred to an ordinary day work where he earns day rate
earns a bonus instead of an incentive scheme.

Disadvantages of piecework
1. Establishment of piecework rate involves hydration and expensive
negotiations with the employees.
2. Quality of the output may be sacrificed for quantity of output;
3. Errors in rate fixing and total wage calculation may lead to loss on the
part of employers and employees
4. Recording piecework is more complex than recording day rate work
5. There is need to set up control system to monitor employees' abuse of the
system.

Group Bonus Scheme

As we calculate hours on individual basis so we can calculate bonus on the
basis of group basis when:

77
a. The group is small and each member of the group can influence one
another.
b. A worker on an assembly line cannot increase his output without the
cooperation of other members of the group on the assembly line.
A group of employees working together as a team can share out a bonus on the
basis of the results of the team effort. It is meant to create a collective interest in
the work for efficiency and better result/Examples of group bonus scheme are:
a. Group bonus scheme for a group of operators.
b. Priestman's production bonus where all factory employees are paid
a bonus percentage increase on their wages according to their
percentage increase in output.
Example:
A company's standard production is 20 units per day. It is agreed that 20%
increase in production will attract a bonus of N50. The bonus is to be shared
among the 20 members of the group. In a day 25 units were produced which
represent an increase of 25%.

Solution:
Total pay = 25 x N50 - N62.50
20

Payment for each member of the group = N62.50 ÷ 20

= N3.125 bonus
Or Bonus 5 x N50 =12.50
20
=50.00
62.50

78
Priestman’s production bonus:
This method brings about the idea of extending the scope to include the whole
factory. Here a standard is set for a factory to achieve a number of units of
production in a week. The actual output is compared with the standard. If actual
output exceeds standard, the employees are paid a bonus in proportion to the
increase in production.

Example:
A factory produces a face-cap with 200 employees. The standard set for a week
is 100,000 units. The actual output in a week is 120,000 units. The employees
are entitled to basic wages and bonus as follows:
Standard output 100,000 units
Actual output 120,000units
Increase 20% 20,000units
All the employees will receive a bonus of 20% of their wages.
Advantages of Group Scheme
1. There is a team spirit and a greater cooperation among them
2. Administration is simple because there is less of record keeping of time
and rate.
3. Rates can easily be negotiated
4. Working arrangement among the group is possible.
Disadvantages
1. Hardworking members receive the same bonus as less hardworking
members.
2. There is a tendency for some workers to abuse the scheme through
absenteeism.

79
CONDITIONS OF INCENTIVE SCHEMES
Conditions to be satisfied by any incentive scheme to operate successfully are:
1. It must have well defined objectives which are attainable by employees
2. The rules and conditions of the scheme should be easy to understand and
operate.
3. It must be acceptable by all concerned including union organization
officials.
4. The bonus should be paid promptly.
5. Allowances should be made for shortages of raw materials, and machine
breakdowns to control reduction in employees' productivity.

Advantages of incentive schemes are:

1. Increased production resulting in increased wages.
2. Rewards given for extra effort of employees improve their morale.
3. Hardworking and efficient workers are attracted by the incentive
schemes.
Disadvantages of incentive schemes are:
1. Some incentive schemes are complex and expensive to operate.
2. There are problems m establishing performance rates and wages with
frequent agitation for increase from workers.
TREATMENT OF OVERTIME PREMIUM
Overtime premium is an additional pay over/above the normal pay which a
worker must earn if he is to work for a given period after the regular hours.
Overtime rate is 150% normal rate and 200% on public holidays, Overtime may
arise on account of time demand for production to either general or
specific/particular production. If it is general i.e. production does not arise
because of a particular production, the overtime should be treated as overhead

80
cost of production to be shared by all the jobs. On the other hand, if the
overtime is for a particular job, it should be regarded as a direct cost and
because of the job, there would have been no overtime but for the particular job.

Example 4.5:
Ojo spent 6hrs after regular hours of work and overtime pay is one and half i.e.
150% for N3 normal hourly rate. What is the total pay for six hrs overtime?
Solution:
Basic or Day rate Pay 6 x 3 = NI8
Overtime Premium ½ x 6 x 3 = 9
Total overtime pay = N27
Or
Total overtime payment = 1.50 x 6 x 3 x N27

Example 4.6:
There are jobs A, B C, D to work on. A & B were completed at normal hours, B
& C to be completed using overtime. Hourly rate for Soji is N3 for 4hrs. Soji is
to work on any of the jobs on the same hours with overtime of 150% of regular
hourly rate.
How much labour cost has to be charged to jobs B & D?
Solution:
Overtime Premium for Soji:
In 4hrs he earns N6 overtime
Basic pay = N12.
Overtime Premium = N6
He worked on 2 jobs in 4hrs.
Basic pay on each job = N12 ÷ 2 = N6

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The overtime occurred because of job C &D
Overtime premium of N6 is divided by 2 = N3
It is divided between C & D.
Labour cost of Job B = N3 x 2 = N6
Labour cost of job D = N6 + N3 = N9.

TREATMENT OF IDLE TIME

Idle time occurs when direct workers stop work owing to organization forces
like faulty machine, power failure, machine break-down, or shortage of raw
material. Idle time card is required for recording idle time, its duration, causes,
and sources. It could be recorded on the clock card. Sources of idle time are
recorded for market use for decision making to know whether idle time is
controllable or uncontrollable. Daily lunch break in idle time is uncontrollable.
Waiting for material i.e. stock out is controllable. Whatever may be responsible
for idle time, workers should be paid the day rate for the time. Idle time is not
part of direct labour cost because it is not used for production.
Uncontrollable idle time is manufacturing overhead in the form of indirect cost.
Controllable idle time is manufacturing time e.g. stock out is charged directly
against profit and Loss account.

Example 4.7:
If a worker earns N5 per hour for 40hrs with an idle time of 5hrs, the labour
cost is:
Direct labour cost (35 x 5) = 175
Idle time (5 x N5) = 25
200

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Controllable and uncontrollable idle time depends on each case or
circumstances. It should be regarded as controllable unless it is otherwise
stated. Power failure owing to non payment of electricity is controllable and
should be charged against Profit a Loss account. On the whole, idle time should
be regarded as uncontrollable and charged against production overhead as an
indirect labour cost.

TREATMENT OF FRINGE BENEFITS

Fringe benefits are costs to employers for benefits that are enjoyed by workers
e.g. paid holidays, medical expenses. Fringe benefits must be taken into
consideration if not, the labour rate used to charge jobs will be understated.

Example 4.8:
There are time workers in an establishment earning the following annual
salaries:N5500, N47500, N8000, N9000, N10000. These are for working days
weekly and eight working hours. Each worker is entitled to an annual leave of a
month (20 days). There are 10 public holidays (falling within normal working
days), each worker is entitled to 5 days casual leave annually. The total fringe
benefits amounts to 10% of salary. Compute the average labour cost per hour of
work?

Solution:
Total salary (N5500, N7500, N8000, N9000, N10000) 40,000
Add 10% as fringe' benefit 4,000
Total direct labour 44,000
For each worker
Days in a year 365

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Less:
Saturdays and Sundays (52 x 2) 104
Annual leave 20
Public leave 10
Sick/casual leave 5
139 139
226
There are 8 working hours daily and for 5 workers, the total working hours in a
yr for 5 workers is 226 x 8 x 5 = 9040
Labour cost per hour 44,000
9040
= N4.90

Labour Related Deductions

To arrive at Net Pay i.e. take home pay, certain deductions are made from the
gross pay, e.g. tax, contribution to National Provident Fund, union dues,
repayment of loans or any other loans.

SUMMARY:
At the end of this module you have learnt that;
1. Labour is one of the elements of cost. It represents a large part of local
cost of production. It is a factor which can be easily influenced and
measured.
2. The departments responsible for the planning and control of labour in an
organisation are personnel, time - keeping, production, engineering and
work study, wages and cost accounting departments.
3. Time and output are recorded for the preparation of payrolls. The method

84
 of recording time is based on attendance time and the job time.
4. Remuneration methods are day/time rate wages, piece rate and premium
bonus.
5. Halsey, Halsey - Weir and Rewan Schemes are methods of incentive
Schemes.
6. Advantages of incentive schemes are increased production and increased
wages, rewards for extra effort leading to improved workers morale.
7. Its disadvantages are complexity of the scheme and problems of
establishing performance rules/wages.
8. Workers get paid for overtime, idle time, fringe benefits and they are all
accounted for accordingly.

EXERCISE:
Use this information to answer questions 1-5.
Time rate Nl.00
Hours worked: 20
Units Produced 36
1. Calculate the wages using time rate
a. N20.00
b. N32.60
c. N22.00
d. N36.00
e. N35.00
2. Calculate the wages using Rowan Scheme.
a. N23.33
b. N20.00
c. N25.32

85
 d. N28.00
e. N30.00
3. Calculate the wages using Halsey Scheme
a. N20.00
b. N28.00
c. N22.00
d. N14.44
e. N18.65
4. Calculate the wages using Halsey - Weir Scheme
a. N12.66
b. N10.00
c. N21.33
d. N14.00
e. N20.00
5. Calculate the wages using piece rate
a. N20.00
b. N10.00
c. N18.00
d. N36.00
e. N 30.00
6a. Discuss the principles on which a financial incentive system in respect of
output should be based.
b. Give the advantages to be derived from such properly planned and
applied system.
7. Compare and contrast the Halsey Premium Bonus (50 - 50) and the
Rowan Premium - Bonus systems of payment.
Outline the differences in

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 a. Formulae
b. Purpose and effect
c. State the advantages and disadvantages.
8. Calculate the earnings and labour cost per piece under each system if the
time allowed is 10hours, time taken 8 hours, rate N80 per hour.

Further Reading
1. Horngren,C.T, Datar, S and foster G. (2006). Cost Accounting: A
managerial emphasis (12th ed), lanai: Pearson prentice Haee.
2. Lucey, T. (1989). Costing (3rd ed.) London: Book power.
3. Omolehiuwa, E.O. (2000). Coping with cost Accounting (2nd ed.) Lagos:
Pumak Nigeria Limited.
4. Lucey, I. (2002). Costing (6th.ed), London: Thompson.

87
 CHAPTER FIVE
OVERHEAD COST
5.0 OBJECTIVES
At the end of this module you should be able to:
1. define overhead costs;
2. determine overhead costs;
3. define cost centre, cost unit, production centre, service centre and other
terminologies.
4. Explain the process of allocating overhead costs to cost centres.
5. State the process of apportioning common items of costs to cost centres.
6. Charge service costs to production department.
7. Itemise methods of absorbing overhead costs.
8. Explain the treatment of over and under absorbed costs.

5.1 INTRODUCTION
The manufacturing cost element of a finished product consists of direct
material, direct labour and overhead. All manufacturing costs which are not
traceable to finished products are indirect costs. The total of indirect costs is
overhead cost. It is also known as factory overhead, on-cost etc. Being indirect
costs, they cannot be allocated but can be apportioned to or absorbed by cost
centres to the products on the condition that is appropriate to the cost of works
done or performed. The accountant must obtain adequate information
concerning total manufacturing overhead cost. This information can be obtained
from:
1. Clock card where clock-in and clock-out system of time recording is used
to time workers in order to know:

88
 a. Time of arrival and departure from work in order to control
payment for idle time.
b. How much to pay workers for equipment maintenance, etc.
2. Indirect materials requisition book.
3. Invoices.
4. Bills for electricity consumption, receipt for rent, fuel usage, rates and
other indirect material used for production.
5. Vouchers for indirect wages.
6. Journal entries.
Overhead costs may be time or activity based and grouped into:
1. Production overhead e.g. factory rent, power, depreciation of machinery,
lighting and heating, insurance, wages of indirect workers, screws, rents,
and repairs of rented buildings.
2. Administrative overhead e.g. general office expenses, stationery,
telephone, postage, office rent, managing director's fees, etc.
3. Selling overhead e.g. selling cost, warehouse rent, depot expenses,
warehouse labour etc.
4. Distribution overhead, carriage and freight, delivery vehicle costs,
packing charges, etc.
5. a. Research and developments: laboratory technicians, depreciation of
equipment for research, patent fees, journals, research association
subscription, etc.
b. In marginal costing, it may be grouped into fixed cost overhead,
(semi-fixed cost overhead) and variable overhead.
TERMINOLOGIES
Costs Centre: It is an accounting area, location, or item of equipment where
costs are ascertained before they are apportioned to units within the cost centre

89
for the purpose of cost control.
Production Centre: It is a cost centre involved in the production of a product.
Service Centre: It renders services for the production activities e.g. purchases
section, maintenance section, power section, etc.
Cost Unit: It is a unit of output or service to which cost is ascribed. There may
be different cost units in an establishment for costing various products and
services e.g. unit of production; litre of fuel, tables, chairs, a job, and a contract.
Unit of Service: Examples are machine hours, consulting hours. Cost unit
chosen must be relevant to the activities of the company.
Common cost: It occurs when items of costs are used by more than one centre
e.g. electricity bills, depreciation of factory building or premises, rent,
insurance, rate, etc.
Allocation of Overhead: It is the charging of the manufacturing overhead cost
to centres that solely incurred the cost.
Apportioning of Overhead : It is the charging of common items of cost to
more than one cost centre.
One-step Apportioning: It is the means by which the overhead cost incurred in
the service cost centre are apportioned straight to the production centre.
Sequential Apportioning: It is the apportioning of service centre cost in a
special order whereby the most widely used service costs are distributed first.
Cross Apportioning: It is a method of charging a portion of service costs to
each service centre using the service.
Capacity level: It is the amount of production a company has space and
facilities to produce. Such a level is called the normal capacity.
Theoretical Capacity: It is the level where production takes place without
interruption to attain 100% capacity. Avoid unnecessary delays like repairs of
machine, raw material delivery, and stoppages of any kind in the production

90
activity.
Expected Capacity: It is the usage of an expected capacity to meet customer's
demand.
Normal Capacity: The level of capacity put in place to meet customers'
Practical capacity: The minimum level of production whereby adjustment is
made to demand for a long period of time, taking into consideration seasonal
and other unavoidable conditions.
Relevant Range: It is the production level in which fixed costs are fixed. If
production increases above the normal capacity, a new plant is to be built
resulting in increase in fixed cost.
Service Centre Costs
Service centre costs are indirect costs. (It is a cost centre whose costs are
indirect costs). It is not involved in the conversion of raw materials to finished
products. It renders services for the production activities e.g. purchases
department/section, maintenance section, receiving and shipping, etc. It incurs
costs which are allocated to e.g. store-man's wages, share of rates, electricity,
heating, etc. The service centre costs are shared to production departments by
secondary apportionment so as to reflect the use of each service. This is done to
show that all service department costs are reflected in the unit cost of each
production. Before apportionment to production department, cost of each
service department must be established.
Use these criteria in charging service centre costs.
1. Types of services available,
2. Types of services provided,
3. Types of benefits received.

91
5.3.1 The basis of apportionment of service costs to production cost
centres are as follows:
APPORTIONMENT OF SERVICE COSTS
Service Department Departmental costs of production cost centres
Electricity generation Use of meter, use of advance payment.
Stores Numbers of materials issued, number of times
requisition are made. Weight of materials issued.
Maintenance Maintenance labour hours and wages.
Personnel Number of employees in each department and Wages
per department.

In charging service centre costs to appropriate centre, we must realize that

service centre is not servicing production centre only but also serves other
service centres like maintenance, repairs, power, electricity, gas, meter
operatives and inspection of plant and equipment facility to avoid breakdown
and stoppages of production. Apportionment must therefore be done in a special
order in which the most universally and widely used services are distributed
first.

92
5.4 BASIS OF APPORTIONMENT OF OVERHEAD COSTS
S/N Overhead Costs Basis of apportionment
1. Rates, rent, heating, cleaning, Measurement of floor area
lighting, depreciation of building
2. Heating, lighting, depreciation. Volume of space occupied
3. Insurance, depreciation Book value, plant value, equipment
premises.
4. Personnel office, canteen, Number of workers
administration
5. Weight of materials Store keeping, materials handling.
6. Heat Number of radiators.
7. Power Horse power ratings.
8. Store keeping Store requisition.

5.5 PROCEDURES IN OVERHEAD APPORTIONMENT

1. Identify and share the overhead traceable to each cost centre.
2. Share the accumulated overhead costs of service centre to the production
centre.
3. Divide the total accumulated overhead cost in each production centre by
the production centre operating volume to arrive at an overhead rate.
4. Using the overhead rate mentioned above, share the total production
overhead costs among all the jobs/products.
5.5.2 OVERHEAD ABSORPTION
Overhead absorption is the charging of overhead cost to cost unit of production
above the prime cost to arrive at factory overheads. Overhead is a part of cost of
production. It is more involving to establish than direct costs. Because they

93
cannot be identified with a cost unit, overheads are spread over the cost units
using overhead absorption or overhead recovery method as follows:
1. Determine the total overhead cost for each production department and
share the overhead costs among the units in the department in the cost
centre.
2. Divide the total overhead cost of production by the operating volume of
the department if all units produced are similar but they are hardly the
different.
3. Since they are hardly the same, different types of units produced need
different types of overhead absorption methods. Overhead absorption
rates are based on direct material cost, direct labour cost, machine hours,
kilograms of direct materials consumed, percentage of prime cost, etc. It
is necessary to select the appropriate methods that will measure and
adequately distribute manufacturing overhead incurred considering over
or under absorption of overhead.

5.6 OVERHEAD ABSORPTION METHODS

1. Percentage of materials costs: It is used when the product is produced
with the same material and the usage is the same. Use this method by
dividing budgeted overhead cost by budgeted material cost and multiply
by 100.
2. Machine hours: It is used when
a. The manufacturing process is machinery intensive i.e. it is solely
used for production.
b. Overhead is made up of depreciation of equipment, maintenance,
etc.

94
To apply this method, divide the total production overhead cost by machine
hours.
= Production overhead cost
Machine hours used
3. Direct Labour Hours: This method is appropriate where manual labour
is mainly used in the manufacturing process. Use the method by dividing
the total department overhead cost by the total direct labour hours.
Budgeted overhead
Budgeted labour hours
4. Percentage of Direct Labour: Here the total overhead is to be expressed
as a percentage of labour cost. To use this method, divide Budgeted
factory overhead by Budgeted direct Labour hours and multiply by 100.
For example: Express N900 factory overhead as a percentage of 3000
direct labour hours.
Budgeted overhead x 100%
Labour hours

= N900 x 100
3000
= 30%
5. Percentage, of Prime Cost: This method is appropriate when all the
products produced are made up of direct materials and direct labour. To
apply this method, divide Budgeted overhead by budgeted prime cost and
multiply by 100.
Budgeted overhead
Budgeted Prime cost

95
Example 5.1
Manpower manufacturing company has the following data for two production
departments, Department A and Department B.
Department Department
A B
N N
Material used 12,000 1,000
Direct labour cost 6,000 3,000
Factory overhead 3,600 2,400
Director labour hours 24,000 10,000
Machine hours 20,000 4,000

Job B20 has the following overhead costs

Departments
A B
N N
Material used 240 20
Direct labour cost 130 50
Direct labour hours 530 140
Machine hours 510 50
You are required to:
1. Absorb factory overhead to job B 20 using the following methods of
overhead absorption
a. Percentage of direct material used
b. Percentage of direct labour cost
c. Percentage of prime cost.
d. Direct labour hours

96
 e. Machine hours.
2. Show the total overhead costs absorbed by Job B20 using two most
appropriate methods.
SOLUTION:
Department Department
A B
N N
1a. Percentage of direct labour cost 3600 x 100 2400 x 100
12,000 1,000

= 30% = 240%
b. Percentage of direct labour cost 3600 x 100 2400 x100
6,000 3,000

= 60% = 80%

c. Percentage of prime cost 3600 x 100 2400 x 100

1,800 4,000

= 20% = 60%

d. Direct labour hours 3600 2400

24,000 10,000

= N.15DLH = N.24DLH

97
e. Machine hours 3,600 2,400
20,000 4,000

N18 per N60 per

Machine Machine

2. The overhead costs absorbed using two most appropriate methods

Departments
A B
a. Direct labour cost = N.15 x 530 N.24 x 140
N79.50 N33.60
Total N113.10

Department Department
A B
b. Machine hours = N.18 x 510 N.60 x 50
= N91.80 N30.00
Total N121.80

The two jobs passed through two departments hence the figures are added
together.

5.7 PREDETERMINED/BUDGETED OVERHEAD RATE

It is a common practice to use budgeted/predetermined rate to recover overhead
cost instead of using actual overhead cost. There is always a delay in getting
information on actual usage of overhead cost. The overhead costs fluctuate

98
from time to time depending on the type of job being done. As a result, there is
a tendency for approximation of figures.

5.7.1 ACTUAL AND ABSORBED OVERHEAD COST

In absorption overhead cost, the amount absorbed will never agree with the
actual incurred. There will be over and under absorbed overhead. This means
that:
a. The actual overhead cost is different from the predetermined/budgeted
overhead. This leads to expenditure variance in standard costing.
b. The actual volume of products is different from the budgeted /
predetermined overhead. This also leads to volume variance in standard
costing. A volume variance measures the over and under absorbed
overheads.
There is over absorbed overhead cost when:
a. The actual overhead cost is less than the budgeted/predetermined
overhead cost.
b. The number of output or hours worked exceed the budgeted /
predetermined output or hours worked.
c. There is a credit balance in the overhead account.
d. There is an overstatement of production cost.
There is an under-absorbed overhead cost when:
a. The actual overhead cost is more than the budgeted/predetermined cost
b. The number of output or hours worked are more than the predetermined /
budgeted output or hours worked.
c. There is a debit balance in overhead account.
d. There is an understatement of production cost.

99
5.8 ACCOUNTING ENTRIES: The accounting entries are:
a. Debit production overhead control account.
b. Debit work-in-progress account with the total overhead absorbed into
production and credit production overhead account.
c. Over and under absorbed overhead is transferred to profit and loss
account against cost of goods sold.
d. If the over and under absorbed overhead cost is immaterial, write it off to
cost of goods sold.

Example 5.2
Kogunrege Ltd, a manufacturing company, incurred actual overhead cost of
N75,000, depreciation N10,000, maintenance N1,000. The absorbed production
overhead cost is N73,000. Cash payment N64,000.
What is the under absorbed figure?

Solution:
PRODUCTION OVERHEAD ACCOUNT
N N
Cash 64,000 Work-in-progress 73,000
Production overhead: (absorbed overhead)
Depreciation 10,000 Cost of goods sold:
Maintenance 1,000 Under absorbed overhead 2,000
75,000 75,000

100
 WORK-IN-PROGRESS ACCOUNT
N
Production overhead 73,000
Example 5.3
Olawale Ltd, a manufacturing company, has a predetermined overhead rate on
direct labour hours.
The following data apply:
Product A and other jobs were undertaken for a month. The data for the jobs are
as follows:
Product Other Budgeted at
A Jobs Normal
Capacity
Direct hours 60 10,000 N100,000
Direct labour Cost N400 N60,000 N250,000
Direct material Cost N800 N150,000 N1,800,000
Budgeted factory overhead for the year was N1,000,000.00. The actual
overhead for the month was N106,000.
You are required to compute the cost of product A and find the over/under
absorbed factory overhead for the month.
SOLUTION:
1. Pre-determined Overhead rate
= Budgeted overhead for the year
Budgeted direct labour hours
= N1,000,000
100,000

= N10.00 per direct labour hour

101
 N N
Cost of Product A:
Direct Materials 800.00
Direct Labour 400.00
1,800.00
Actual Overhead for the month 106,000.00
Less Overhead absorbed for the month 100,000.00
Under-absorbed overhead for the month 6,000.00
SUMMARY:
In this module you have learnt that:
1. Overhead is the total of indirect costs. It may be time or activity based.
2. Overhead may be analysed into production, administrative, selling and
distribution overheads.
3. To establish overheads you define a number of cost centres, gather the
indirect cost together and allocate or apportion cost to the cost centres.
4. Overhead absorption methods are percentage of material cost, machine
hours, direct labour hours, percentage of direct labour and percentage of
prime cost.
5. The over-absorbed overhead occurs when the actual overhead cost is less
than the budgeted or predetermined overhead cost.
6. There is an under-absorbed overhead cost when the actual overhead cost
is more than the budgeted/predetermined overhead cost.

5.7 EXERCISES
1. Oniseirin Ltd has two departments - Assembly and Packing departments.
The assembly department has budgeted factory overhead of ^840,000 and
1 4,000 predetermined direct labour hours. The packing department has a

102
 factory overhead rate of N64 per direct labour hour. Another product in
the packing department requires 30 hours.
a. How much overhead rate will be allocated to the assembly department?
b. How much of the packing department overhead cost will be .allocated to
the product in the packing department?
2a. Oye Ltd makes three styles of women's dresses: Casual, Work, Dress.
The company has budgeted the following overhead expenses for this
period.
N
Factory depreciation 20,000
Indirect labour 420,000
Factory electricity 45,000
Indirect materials 35,000
Administrative expenses 85,000
Selling expenses 170,000

Factory overhead is allocated to the three products on the basis of direct labour
hours. The products had the following production budget volume and direct
labour hours per unit.
Budgeted Direct
Production Labour
Volume Hours per unit
N N
Casual 225,000 0.1
Work 100,000 0.2
Dress 75,000 0.3
Required:

103
1. Determine the single factory overhead rate.
2a. Use the factory overhead rave to determine the amount of total and per
unit overhead allocated to each of three products under generally
accepted accounting principles (GAPP).
2b. i) Name overhead absorption methods.
ii) Explain allocation and apportionment of overhead
Choose correct answers from a-d for each of the following questions:
3. For the product costs to be available on a timely basis it is usual to apply
overhead by using.
a) step method b) predetermined overhead rate
c) job cost sheet d) job order costing
4. All indirect manufacturing costs incurred in the factory are:___________
a) direct materials and direct labour b) opportunity cost
c) Overhead cost d) sunk cost
5. The sum of direct labour and factory overhead is
called_______________
a) cost of idle time b) process cost c) operation cost
d) Conversion cost
Further Reading
1. Kaplan, R.S and Atkinson A.A. (2002). Advanced management accounting
(6thed) India: Practice Hall.
2. Banergee, B. (2005). Financial policy and management accounting (7th ed.),
India: Prentice Hall of India Private Limited.
3. Drury, c. (1992). Management and cost Accounting (3rd.ed.), London:
Chapman and Hall.
4. Omolehinwa,A. (2001). Work out Management Accounting (Notes and
worked examples), (1st ed.) Lagos: st John consultants LTD.

104
 CHAPTER 6
INTRODUCTION TO COSTING METHODS
1.0 OBJECTIVES
At the end of this module you should be able to:
1. define and explain Costing Methods and techniques.
2. state the two categories of costing methods.
3. explain the two major costing techniques of absorption and marginal
costing.
4. define and understand job and batch costing.

6.1 INTRODUCTION
Each firm should have a costing method which has unique features.
Costing methods refer to the system of cost finding and ascertainment. They are
devised to suit the methods by which goods are manufactured or services are
provided. It follows therefore that each firm will have a working method
which has unique features:
a) Where work is undertaken to customer's specification, the job
costing method is adopted
b) Where it is continuous operation, then process costing is used.

Therefore, it must be clearly understood that whatever costing method is

employed we must be guided by the basic costing principle to facilitate the
recording and collection of costs allocation, apportionment and absorption into
products and services.

Categories of costing methods:

Costing methods are divided into two broad categories, namely, order costing

105
and process costing
Costing method

Specific order costing (or job costing) Unit costing (or Average costing)

Job Contract Batch Batch Service or Process or

Costing Costing Costing costing Operative Operation
Costing Costing
Fig 1: Illustration of Costing Method

i. Specific Order Costing

Definition: Specific job costing is the allocation of time, material and
expenses to an individual project or job, specifically job costing is
normally software based for budgeting forecasting, collecting and
reporting on the expenditure and revenue associated with specific
projects or jobs.
ii. Continuous Operation/process costing (sometimes called Unit/Average
costing)
Definition:
"The costing method applicable where goods or services result from a
sequence of continuous or repetitive operations or processes; Costs are
arranged over the Units produced during the period, being initially

106
 charged to the Operation or process." This is where expenses cannot be
linked directly with the cost object and are, therefore, charged to the
department or process. The total costs are then averaged over the total
units produced. Examples are Batch costing service or operating costing,
and Process or Operation costing.
The diagram below is an illustration:
Costing methods

Specific Order Costing Unit Costing

Batch Service
Fig 2: Illustration of Costing Methods

6.2 COSTING TECHNIQUES

Costing techniques refer to the way of presenting the cost information. There
are two major costing techniques, namely: absorption and Marginal costing.
Absorption costing is the practice of charging all manufacturing costs, both
fixed and variable, to cost units, while marginal costing is the practice of
charging only variable manufacturing cost to cost units.

107
This can be represented diagrammatically as follows:
Costing Technique

Absorption costing Marginal costing

Historical Standard Historical Standard

Absorption Absorption Marginal Marginal
Costing costing Costing costing
Fig. 3. Illustration of costing techniques.

6.2.1 Job Costing:

Definition:
"A form of specific order costing in which cost is attributed to individual jobs".
It is always in line with customers’ specification e.g. printing, construction,
furniture, general engineering. Job costing is applicable in the following ways:
i. The specific request of a customer is received.
ii. The precise details of customer's, requirement agreed with technical
personnel.
iii. Costing department prepares the cost estimate according to the quotation
submitted to the customer.
iv. A deposit payment made by a customer signifies acceptance of a
quotation.
v. A distinct job number is then assigned and a job card is opened for proper
cost accumulation,
vi. The job may be more or less than one accounting period. Where it is
more than one period, then some accounting issues will arise making
contract accounting rules to be applied.

108
Examples of Organizations using job costing:
The following are few examples of companies using job costing:
i. Hair dressing.
ii. Fashion design.
iii. Accounting firms.
iv. Plumbing.
v. Building, contracting, machine tool manufacturing.
vi. Foundries, printing, general engineering.

6.2.2 Objectives of Job Costing:

a. To determine the profit or loss on individual job. This serves as check on
the accuracy of the estimates on which prices have been quoted.
b. To value work-in-progress for balance sheet purposes.

6.2.3 Recording/Accounting Entries:

The following entries are relevant in job costing:
i. Materials Used:
DR. Job Ledger Control A/c (or WIP ledger control)
CR. Material Stock Ledger Control Account.
ii. Labour:
DR. Job Ledger Control A/c (or WIP ledger control)
CR. Payroll A/c.
iii. Direct Expenses:
DR. Job Ledger Control A/c
CR. Expenses Ledger A/c.
iv. Overhead:
Apportion using appropriate basis.

109
 Costing methods: Job and batch costing
JOB COST CARD Job No.
Customer Customer’s Order No. Start
Date
Job Description Delivery
Estimate Ref. Invoice No. Date
Quoted Invoice Dispatch
Price Price Note No.
Material Labour Overheads
Date Req. Qty Price Cost Date Lab Cost Hrs Rate Bonus Cost M/c OAR Cost
No. N N Anal Ctre N N Hrs. N N
Ref.

Total C/F Total C/F Total C/F

Expenses Job Cost Summary Actual Estimate
Date Ref. Description Cost Direct Material
Direct Expenses B/F
= Prime Cost
Factory Overheads B/F
= Factory Cost
Selling & Admin. Overheads
% on Factory Cost
= Total Cost
Invoice Price

Total C/F Job Profit/Loss

Comments

Job Cost Card Completed by………………………………………………

Figure 6.4: Typical job cost card

110
c. Batches of dissimilar products: At times batches of dissimilar products
are brought together for a common operation to be performed on them so
as to save set-up time on the machine. To apportion common cost of this,
joint operation becomes a problem. Note that common costs should be
apportioned on fair basis.

6.3 Illustration 3(a)

Unilag Press Ltd was asked to quote for supplying 5,000 and 10,000 answer
booklets. The establishment normally expects a profit of 10% of sales.
Costs were reckoned to be: N
Paper and other materials:
(per 1,000 copies) 60.000
Wages (per 1,000 copies) 40.000
Layout cost l,000.000
Fixed Overhead 400.000
Variable Overhead 12% of wages.

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Draft a cost computation, showing minimum selling prices that might be quoted
per 1,000 copies for each of the supplies.
Solution:
1,000 copies 5,000 copies 10,000 copies
N N N
Set up cost:
Layout cost 1,000 1,000 1,000
Material:
Paper 60 300 600
Labour:
Wages 40 200 400
Overhead:
Fixed Overhead 400 400 400
Variable Overhead 4.8 24 4.8
Total cost: 1,504.8 1,924 2,408
Profit Margin: 150.8 192.4 240.8
Selling/Invoice Price: 1,655.28 2,116.40 2,645.6

If cost per unit is desired, it will be obtained by simply averaging the total cost
per batch over the Units that made up the batch size:
At 1000 copies, total cost was N1,655.28/1000 i.e. N1.66. At 5000 copies, total
cost was N2,116,40; copies per copy therefore is N2116.40/5000 = 0.42. At
10,000 copies, total cost was N2,645.6 the unit cost is N2645.6/10000 = 0.27
thus proving a notion that unit cost decreases as the batch size increases. Selling
price per copy will also be calculated in the same way, using 10% mark-up.

112
6.3.1 BATCH COSTING:
Illustration 3(b)
XYZ Ltd has the following budgeted overheads for the year, on the basis of
normal activity levels:
Department Budgeted Overhead Overhead Absorption
(N) Base
Dept. 1 Blanking 36,000 1500 hours
Dept. 2 Machining 86,000 2500 hours
Dept. 3 Welding 40,000 1800 labour hours
Dept. 4 Assembly 30,000 1000 labour hours.

Selling and Administrative overheads are 20% of factory cost.

An order for 250 assemblies type A made as Batch 601, incurred the following
cost:
Material N6,214.
Labour: 128 hours Dept. 1 Blanking shops at N10.50 per hour
452 hours Dept. Machining shops at N11.00 per hour.
90 hours dept. 3 Welding shops at N10.50 per hour
175 hours Dept. 4 Assembly shops at N9.60 per hour.
N1000 was paid for the hire of special X-ray equipment for testing the welds;
the time booking in the machine (Dept. 2) shops was N1,286 machine hours.

Calculate the total cost of the batch, the unit cost and the profit per assembly if
the selling price was N1300 per assembly.

113
Solution:
WORKING NOTE
The First step is to calculate the overhead absorption rates for the production
departments.
Dept. l Blanking = N36.000 = N24 per labour hour
1500

Dept.2 Machining = N86.000 = N34.4 per Machine hour

2500

Dept. 3 Welding = N40,000 = N22.22 per labour hour

1800

Dept. 4 Assembly = N30,000 = N30.00 per labour hour

1000

XYZ Ltd.
TOTAL COST - BATCH 601 N
Direct Material 6,214:00
Direct Expenses: 1,050:00

Direct Labour: N N
Dept. 1 128 x N10.50 per hour = 1,344
Dept. 2 452 x N11.00 per hour = 4,972
Dept. 3 90 x N10.50 per hour = 945
Dept. 4 175 x N009.60 per hour = 1,680 8,941:00
Prime Cost 16,205:00

114
Production Overheads Absorption: N N
Dept. 1 128 x N24.00 per hour = 3,072
Dept. 2 643 x N34.40 per hour = 22,119.2
Dept. 3 90 x N22.22 per hour = 1,999.80
Dept 4 175 x N30.00 per hour = 5,250.00 32.441:00
Prime Cost N48646:00
Selling and Administrative
Overheads (20% of factory cost) 9,729:20
Total cost N58.375:20

Total cost per Unit = N58.375.20 N233.50

250

= Total cost /Quantities per Batch

Profit per Unit = Selling Price - Total cost Unit
= N300.00 - N233.50
= N66.50
SUMMARY:
In this module you have learnt that:
1. Costing method refers to the system of cost finding and ascertainment.
They are devised to suit the method by which goods are manufactured or
services are provided.
2. Costing methods are divided into two broad categories of order costing
and unit costing.
3. Costing techniques refer to the way of presenting the cost information.
There are two major costing techniques - absorption and marginal

115
 costing.
4. Job costing is a form of specific order costing in which costs are
attributed to individual jobs.
5. Batch costing is a special type of job costing or modification of job
costing. It is used when production involves the manufacture of a single
product in lots of more than one as in printing when a batch of thousand
copies of a book may be produced.

EXERCISE:
Choose from alternatives (a=d) the most suitable answer to complete the
following statements:
1. Costing method is____________________________________
a. method of differentiating goods for valuation
b. method which is designed to suit the way goods are processed or
manufactured
c. method by which goods are distinguished from each other.
d. method of production
2. Specific order costing and continuous operation costing are the same ( )
a. True
b. Uncertain
c. false
d. all of the above.
3. The main purpose of job costing is _______________________
a. to establish the profit or loss on each job.
b. to ensure adequate system of cost is followed
c. to maintain good accounting record
d. none of the above

116
4. A job cost card is used for:
a. recording work in progress
b. recording continuous/process costing
c. recording all costs incurred on a particular job
d. recording various costs in the production
5. Costing methods can be classified into:
a. five categories
b. two categories
c. four categories
d. three categories
6. Job costing is used in
a. repairs shop
b. buying and selling
c. paint manufacturing
d. ship building
7. In a manufacturing outfit, short runs are more expensive than long runs.
Produce a report to management illustrating this fact with appropriate
figures and indicate the nature of the industry and the size of the
business.
8. What is job costing?
9. For a job costing system to operate efficiently, what factors need to be
addressed?
10. How does batch costing differ from job costing?
11. The two major costing techniques are_____________ and ___________
12. Costing methods are divided into_______ categories, namely____ _____
13. Batch No. X40 incurred the following costs:

117
 Dept A 420 labour hours at N7
B 686 labour hours at N6
Direct Materials N6560
Factory Overheads are absorbed on labour hours and the rates are N6 per hour
for Dept A and N10 per hour for Dept B.
The firm uses a cost plus system for .selling prices and expects a 25% gross
profit (Sales Value minus Factory Cost).
Administrative overheads are absorbed as 10% of selling price.
Assuming that 2,000 units were produced in Batch No. X40
a. Calculate the selling price per unit
b. The total amount of administrative overheads recovered by Batch No.
X40
c. The notional net profit per unit.

Further Reading

1. Kaplan, R.S and Atkinson A.A. (2002). Advanced management accounting

(6thed) India: Practice Hall.
2. Banergee, B. (2005). Financial policy and management accounting (7th ed.),
India: Prentice Hall of India Private Limited.
3. Drury, c. (1992). Management and cost Accounting (3rd.ed.), London:
Chapman and Hall.
4. Omolehinwa,A. (2001). Work out Management Accounting (Notes and
worked examples), (1st ed.) Lagos: st John consultants LTD.

118
 CHAPTER 7

PROCESS COSTING
7.0 OBJECTIVES:
At the end of this module you should be able to:
1. define process costing
2. state the various companies using process costing method of production.
3. list 3 of the terminologies associated with process costing.
4. explain the characteristics of process costing
5. solve problems on process costing.

7.1 Introduction
It is a method used in a situation where production follows a series of sequential
processes. The method is used to ascertain the cost of product at each stage/
level of production, manufacture or process. This method is applied in
industries where continuous mass production is possible.
Process costing is used by firms which have a continuous flow of identical
products where it is not possible to distinguish one unit from another in
particular; the following may be mentioned as a few examples:
Ø Food products
Ø Canning
Ø Milk dairy
Ø Biscuit works
Ø Oil refining
Ø Paper mills.
Ø Soap making
Ø Box making

119
7.2 Terminologies:
By Products
By products are incidental products resulting from the processing of
another product.
Joint Products:
“Represent two or more products separated in the course of the same processing
operations, usually requiring further processing; each product being in such
proportion that no single product can be designated as a major product”.
In a process where two or more products are inevitably produced and each one
earns approximately the same profit as another, the products would be
considered joint products.

Scrap:
“The incidental residue from certain types of manufacture, usually of small
amount and low value, recoverable without further processing”.
Products which are found to be defective or raw materials which prove to be not
up to standard may be sued in other departments of the firm or sold at a much
lower price than the cost. It is essential to keep the quantity of scrap produced
to a minimum and, if possible, make it more profitable by further processing.

WASTE:
“That portion of a basic raw material lost in processing, having no recovery
value”.
Anything which has no value is considered to be waste. An example of waste is
a tank of soup into which broken glass has fallen, with the result that the soup is
unfit for consumption and must be destroyed.

120
11.1 Characteristics of process costing:
The following are the main characteristics of process costing:
(i) Process cost centres are set up for each operational stage and the
accumulation of the material cost, wages and overhead by these process
cost centres.
(ii) The average costs of all production in each process are determined.
(iii) The cost unit chosen is relevant to the organization.
(iv) the output of one process becomes the raw material of a subsequent
process.
(v) Wastage due to scrap on evaporation is unavoidable as it is kept to the
barest minimum.
(vi) The cost is separated where one product is split up into two or more
different products or where by- products arise in the course of production
of the main product.
(vii) The main product or by-product may require further processing before
reaching a marketable state.

7.4 BASIS OF PROCESS COSTING

The production system is broken down into stages known as processes. Material
passes through the various processes gathering cost as it progresses. A unit of
production is complete after passing through all the stages/processes. By this
very fact, the finished product of a stage/process acts as the raw material of the
next stage/process.
Furthermore, additional fresh materials may or may not be added at the
immediate stages of production. At the end of the final year of the company
there is the likelihood of the presence of work in progress which is to be valued
using the concept of the equivalent units or using average price or cost method

121
or FIFO method.
Standard costs in Process costing
In industries where process costing is applicable, standard costs can be used
with great advantage. Standard costs are pre-determined or forecast estimates of
cost to manufacture a single unit, or a number of units of a product, during a
specific immediate future period.
Standard costing in connection with process costs gives the management an
excellent measure of the efficiency of production.

ILLUSTRATION 7.1
A product passes through three distinct processes: I, II, III to completion.
During the period December, 2008, 100kg of Tamo a detergent was produced.
The following information is obtained:
Process I Process II Process III
N N N
Material cost 8,000 3,000 1,000
Labour cost 4,000 5,000 3,000
Direct Overhead expenses

Indirect Overhead expenses for the period were ^6,000 apportioned to the
processes on the basis of wages.

Required:
Calculate the cost of output to be transferred to finished goods stock and the
cost per kg.

122
 SUGGESTED SOLUTION
Process I
Unit Total Unit Total
Kg N Kg N
Material 100 8,000 100 15,000
Labour cost 4,000
Transferred
Indirect Overhead 2,000
To
100 15,000
Process II

Process II
Unit Kg Total Unit Total
N Kg N
Process 1 100 15,000 100 26,100
Material 3,000
Labour cost 5,000
Transferred
Indirect Overhead 600
To
2,500
100 26,100 Process III 100 26,100

Process III
Unit Total Unit Total
Kg N Kg N
Process 1 100 26,100 100 32,200
Material 1,000
Labour cost 3,000
Indirect Overhead 600
1,500 Finished
100 32,200 good 100 32,200

123
Working note:
(a) Indirect expenses were apportioned as follows:
Process I = 4,000 x 6,000 = 2,000
12,000

Process II = 5,000 x 6,000 = 2,500

12,000

Process III = 3,000 x 6,000 = 1,500

12,000
The cost per Kg:
= N32,200
100

= N322/kg

Process losses
In many forms of production system, the quantity, weight or volume of the
process output is always less than the quality, weight or volume of the inputs.
This may be attributed to various reasons such as:
a) Evaporation, residue, ash or sward.
b) Unavoidable handling, breakage and spoilage losses.
c) Withdrawal for testing and inspection. In view of this, records must be
kept of losses occurring and the resulting cost implications.
Process losses can be normal or abnormal. It is normal losses when it is within
the provision made and in line with normal practice otherwise if they are above
expectation, they are known as abnormal process losses.

124
Normal Process losses
These are unavoidable losses arising from the nature of the production process
and it is therefore fair and equitable that the cost of such losses be absorbed by
production. However, any value realized from the sale of imperfect article is
credited to the process account thereby reducing the total cost.

Illustration 7.2
ABC Ltd a food manufacturing process have a normal wastage of 5% which
can be sold as animal feedstuff at N10 per tonne in a given period. The
following data were recorded:
Input materials are 160 tonnes at N46 per tonnes labour and overheads N5,792.
Losses were at the normal level. Compute the cost per tonne.
Solution
Input: Tonnes N
Materials 160 7,360
Labour and Overheads - 5,792
160 13,152
Less Normal loss 5% 8 80
Good production 152 N13,072

Cost per tonne of good production = 13,072 = N86

152

Abnormal process losses

Abnormal losses are those losses above the level that is deemed to be the
normal loss rate for the process. Abnormal losses arise owing to any of the
following factors:

125
 • Plant breakdown
• Industrial accidents
• Inefficient working or unexpected defects in materials.
The cost of abnormal losses are determined on the same level as good
production thereby carrying a share of the cost of normal losses.

Abnormal Process gain:

Abnormal process gains arise as a result of unexpectedly favourable conditions
which make actual losses to be lesser than normal loss provision.
Abnormal gain = Actual loss - Normal loss. Here actual loss is lower than the
Normal loss.
Lastly, Abnormal gains are determined on the same basis as good production
thereby carrying a share of the cost of normal losses.

Illustration 7.3:
Assume the same data as in illustration 7.2 except that actual production was
148 tonnes. Complete the abnormal loss and show the relevant accounts.

Solution:
Tonnes N Tonnes N
Material 160 7,360 Good production 148 12,728
Labour & Normal losses 8 80
Overhead 5,792 Abnormal losses 4 344
160 13,152 160 13,152

126
 Abnormal losses Account
Unit Amount Unit Amount
Process A/c 4 344 Scraps & Oils 4 40
P & L a/c 304
4 344 4 344
Scrap sales A/C

Process A/C 80
Abnormal losses 40

Abnormal loss = Actual loss - Normal loss

= 12 - 8
= 4 tonnes

Illustration 7.4
Example 1: Using the data in illustration 7.3 and assuming that the actual
production was 155 tonnes. Calculate the abnormal gain and show the relevant
accounts.

Solution:
Abnormal gain = Actual loss - Normal loss.
=5-8
= 3 tonnes.

127
 Process A/c
Tonnes Amount Tonnes Amount
N N
Material 160 7,360 Good production 155 13,330
Labour & Normal losses 8 80
Overhead 5,792
Abnormal gain 3 258
163 13,410 163 13,410

Abnormal Gains A/C

Scrap sales A/c 30 Process A/c 258

P & L a/c 228

258 258

Abnormal Gains A/C

Process A/c 80 Abnormal gains 30

SUMMARY
In this module you have learnt that:
1. Process costing is a method used when production follows a series of
sequential processes to ascertain the cost of product at each stage of
production.
2. In process costing, by-product, joint product, scrap and wastage
frequently occur in the course of production.
3. Characteristics of process costing include setting up cost centres for each

128
 operational stage and accumulation of material cost, wages and
overheads; determination of average cost of all production in each
process, the relevance of the cost unit chosen to the organization, the
output of one process becomes the input of another.
4. Production system is broken down into stages known as processes,
material passing through the various processes, gathering cost to
determine cost of unit of production.
5. Standard costing in combination with process cost gives the management
an efficient measure of production.
EXERCISES
1. Which of this will likely use process costing?
a. architectural firm
b. building construction
c. paint manufacturing
d. Ship building
e. light industry
2. The sum of direct labour and factory overhead per unit is called the:
a. processing cost per unit
b. conversion cost per unit
c. combined cost per unit
d. prime cost per unit
e. production cost per unit
3. The basic approach to cost accounting and accumulation is
a. standard costing
b. process costing
c. contract costing
d. product costing

129
 e. weighted average costing
4. Mention the characteristics of process costing systems?
5. What is the distinction between “input material” and “material
introduced”
6. ABC Limited has two processes 1 and 2.
Process 1: There were no opening stocks and no process losses and there
were transfer of 18,000 units to process 2. The unfinished units were
complete as to material and 50% complete as to Labour and overhead.
The cost of process 1 were Direct Material N72,000, Direct Labour
N64,000 and overheads N16, 000.
Process 2 completed 15,200 units and there were 1,200 scrapped which
was considered normal. The balance was unfinished and deemed to be
25% complete in labour and overheads. The cost of process 2 were:
Labour N57,000 and Overheads N28,000.
Required:
You are to prepare process accounts for each process.
7. Write short notes on "Abnormal" gains in process costing.
8. Distinguish between Job and Process costing?.
9. Write a brief note on the abnormal losses and abnormal gains for the use
of management.
Further Reading
1. Banergee, B. (2005). Financial policy and management accounting (7th ed.),
India: Prentice Hall of India Private Limited.
2. Drury, c. (1992). Management and cost Accounting (3rd.ed.), London:
Chapman and Hall.
3. Omolehinwa,A. (2001). Work out Management Accounting (Notes and
worked examples), (1st ed.) Lagos: St John consultants LTD.

130
 CHAPTERS 8
CONTRACT ACCOUNT
8.1 OBJECTIVES:
At the end of this module you should be able to:
1. define a contract account.
2. explain the similarities between contract and job costing.
3. list the attributes of contract costing
4. identify the characteristics of contract costing.
5. explain the treatment of direct cost such as Material, Labour, and
Expenses.
6. identify overheads and the various methods of apportioning the cost to
contract account.
7. state various methods of calculating profit to be recognized and taken to
profit and loss account in the relevant financial year.
8. identify loss, and fully charge it to relevant financial year without
apportionment.

8.2 INTRODUCTION
Contract costing has many similarities to job costing, principles are applied and
separate cost account is kept for each contract or job undertaken. The following
professionals make use of this type of cost accounting technique: Builders,
Civil-engineering contactors, Construction and Mechanical- engineers.
It is applied to work with the following attributes:
(i) It is undertaken to customer's specification.
(ii) It is relatively for a long duration.
(iii) It is site based, sometimes overseas.
(iv) Mostly it is of a contractual nature.

131
8.3 CHARACTERISTICS OF CONTRACT COSTING
The following characteristics are common to contract costing:
(i) Higher proportion of direct costs - Direct material, direct labour and
direct expenses.
(ii) Low proportion of indirect cost - the only item involved is a charge for
Head Office expenses.
(iii) Problem of cost control, owing to the magnitude of the contract. There
are problems of cost control with regard to material usage and losses,
pilferage etc.
(iv) For excess materials recorded, contract account would be credited
with the cost of the materials not used if transferred to another
contract or returned to stores.

8.4 PROCEDURES
8.4.1 The cost of Direct Materials
Materials are received from the stores, or sometimes purchased outside or
manufactured for a particular job or contract. All are debited to the contract
account. Material returned to the store is accompanied by a material returned
note and the contract account is to be credited. All materials on site at the end of
each accounting period are valued and carried forward as a charge against the
next accounting period.
8.4.2 The cost of direct labour
Generally speaking, the method employed on contracts is by means of an hourly
rate with a bonus addition if work is completed on time.
The cost of labour incurred is debited to contract account either it is fully paid
or accrued for the period.

132
8.4.3 The cost of Direct Expenses
The cost of direct expenses incurred are also debited to the contract account.
Examples are special drawings /designs etc.
8.4.4 The Cost of Overhead
The indirect expense may easily be allocated to the contract involved, but where
this cannot be done it is apportioned on the following basis e.g. direct labour
rate, machine hour rate etc.
8.4.5 Cost of Plant
The book value of plant and tools sent to the site is debited to the Contract
account and plant account is credited. Later when the plant is returned to the
yard the value is credited to the contract account and debited to Plant account
thus revealing the depreciation or the value of plant used.

8.5 Certification of work done

As the work progresses, the architect or surveyor appointed by the contractee
issues certificate to the effect that so much money is now due to the contractor
based on the work done and in line with the terms of the agreement.
The contract normally stipulates that retention of between 10% - 20% is held
back for a period between 6 - 12months after the contract is completed for the
purpose of any problem which has to be remedied before releasing of retention
money
8.6 Profit on uncompleted contract
The objective of contract costing is to show the profit and loss on each
completed contract. However, when a contract is still in progress at the end of
every financial year, it is necessary to estimate the profit to be taken into the
account, in order to avoid excessive fluctuations in company results from year
to year.

133
Furthermore, it is necessary to provide a realistic figure of the value of work in
progress for balance sheet purposes.
The following possibilities exist for estimating the profit on incomplete
contracts, although one should be guided by prudential concepts:
(i) If the contract is at early stage, say less than 30% complete, no profit
should be taken or recognized in the current financial year.
(ii) When substantial cost has been incurred say when a contract is between
30% - 80% complete, profit taken or recognized in the current
financial year is computed thus:
Notional Profit x 2 x cash received
3 work certified
(iii) When the contract is nearing successful completion, profit taken
/recognized in the current financial year is computed thus:
Notional Profit X World certified
Contract price
ILLUSTRATION 1
ABC Construction Co. Ltd has undertaken the construction of a road. The value
of the contract is N500,000 subject to a retention of 20% until one year after the
certified completion of the contract, and final approval of the council's surveyor
The contractor has given the contract number 102 for reference and the
following are the details as shown in the books:

134
 N
• Labour on site 162,000
• Materials sent to site, less returns 168,000
• Materials from store and workshop 32,480
• Plant upkeep Account - hire and use of plant 4,840
• Direct expense 9,200
• General overhead apportioned to this contract 14,840
• Material on hand December 31 2,520
• Wages accrued December 31 3,120
• Direct expenses accrued 640
• Work not yet certified at cost 6,600
• Amount certified by the council's surveyor 440,000
• Cash received on account 352,000
Prepare the contract accounts to show the position at December 31, retaining an
adequate provision against possible losses before final acceptance of the
contract.
Solution:
Contract account No 102
N N
Direct material 168,000 Materials on hand c/d 2,520
Other material 32,480 Cost of contract to date c/d 386,000
Wages 162,000 Work done not yet certified 6,600
Direct expenses 9,200
Plant unkeep a/c 4,840
General overheads 14,840
Wages accrued c/d 3,120
Direct expenses accrued c/d 640
395,120 395,120

135
Cost to date b/d 386,000 Wages b/d 3,100
Materials on site b/d 2,520 direct expenses b/d 640
Workdone not yet certified 6,600

Contract No 102- Certificate A/c

Certificates N440,000

Contract No 102- Retention A/c

Certificate A/c N88,000

Contract No 102 Profit suspense A/c

Transfer to P&L a/c 28.800 profit to be taken c/d 28.800
Balance c/d 28,800

Calculation of profit to be taken

54,000 x 2 x 352,000 = 28,7999.98 ≈ 28,800
3 440,000

BALANCE SHEET (EXTRACT)

N N
Work in progress including profit 421,400
Less cash (on account) received 352.000 69,400
Materials on site 2,520
Liabilities
Accrued charges:
Wages 3120
Expenses 640 3760

136
ILLUSTRATION 2
The ABC construction Co: is engaged on two contracts during the year. The
following information relates to these contracts, which were commenced on
January 1 and July 1 respectively:
Contract
A B
N N
Contract price 600,000 800,000
Direct materials issued 110,000 80,000
Materials returned to store 1,000 2,000
Direct labour payments 96,000 64,000
Accrued wages December 31 4,000 5,000
Plant installed at cost 60,000 90,000
Establishment charges 50,000 30,000
Direct expenses 30,000 20,000
Direct expenses accrued December 31 2,000 1,000
Work certified by architect 320,000 160,000
Cost of work not yet certified 20,000 30,000
Value of plant December 31 40,000 80,000
Materials on site December 31 11,000 8,000
Cash received from contractee 300,000 120,000
Show the accounts for these contracts and for the contractees, and also extract
from the company's balance sheet as at December 31.

137
SOLUTION 2:
ABC CONSTRUCTION CO.
CONTACT A
N N N
Direct material 110,000 Materials on site c/d 11,000
Less returns 1,000 109,000 Cost c/d 300,000

Direct wages 96,000

Accrued c/d 4,000 100,000

Establishment charges 50,000

Direct expenses 30,000

Accrued c/d 2,000 32,000

Plant depreciation 20,000

311,000 311,000
Cost b/d 300,000 Value of work certified 320,000
Profit: 20,0000
P & L a/c 25,000
Bal c/d 15,000 40,000
340,000 340,000
Balance b/d 11,000 Balance b/d
Wages 4,000
Work not yet certified 20,000 31,000 Expenses 2,000
Profit & Loss 15,000 21,000

138
Note: calculation of profit. The proportion which it is normally considered
prudent to include in the profit and loss account for the year is:
2 x notional profit x cash received
3 value of work certified

2 x 40,000 x 300,000
3 320,000

= N 25,000

139
 ABC CONSTRUCTION CO.
CONTACT B
N N N
Direct material 80,000 Materials on site c/d 8,000
Less returns 2,000 78,000 Cost c/d 200,000
Direct wages 64,000
Accrued c/d 5,000 69,000
Establishment 30,000
charges
Direct expenses 20,000
Accrued c/d 1,000 21,000
Plant depreciation 10,000 208,000
208,000
Cost b/d 200,000 Value of work 160,000
certified
Cost of work not yet
certified c/d 30,000
Loss on contract 10,000
200,000 200,000
Balance c/d Balance b/d
Stores 8,000 Wages 5,000
Work not yet 6,000 Expenses 1,000
certified
Certified 30,000 38,000

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 CONTRACTEE A/C
N N
Value of work 160,000 Cash 120,000
certificate
Balance c/d 40,000
160,000 160,000
Balance b/d 40,000

Note: The loss is written off to P & L a/c, not apportioned as in the case of
profits. It is not apportioned to profit for prudency reason.

BALANCE SHEET (EXTRACT)

N N N N
Profit & Loss a/c Plant at cost 150,000
Profit A 25,000 Less depreciation 30,000 120,000
Loss A (10,000) 15,000 Materials 19,000
Sundry creditors: Work in progress 95,000
Wages accrued 9,000
Expenses accrued 3,000 12,000

Work in progress
This can be calculated as follows:
N
A: Cost of work not yet certified 20,000
Contractee's balance 20,000
40,000

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Less Profit provision 15,000 25,000
B: Cost of work not yet certified 30,000
Contractee's balance 40,000
70,000
Less Profit provision Nil 70,000
95,000

8.7 SUMMARY
In this module you have learnt that:
1. Contract costing has similarities to job costing.
2. Among the characteristics of contract costing are:
• Higher proportion of direct cost
• Problem of cost control
• Excess materials
3. Direct materials are received from store, directly purchased from
outside or manufactured in the works are all debited to the contract
account.
4. Other costs such as direct labour, direct expenses and overheads are
recognized and debited to contract account.
5. Plant purchased or moved from company to site are recognized and
debited to contract account. When the plant is transferred from the site
to another site or back to the company the plant is valued and the cost
credited to the contract account to note the depreciation or usage.
6. The various methods of calculating profit on uncompleted contracts
are:
a) If the contract is at early stage of less than 30% complete, no
profit should be taken or recognized.
142
 b) When the substantial work has been done i.e. between 30% -
80% complete.
Notional Profit x 2/3 x Cash received
Work certified
c) When the contract is nearing successful completion
Notional Profit x work certified
Contract price

8.8 SELF ASSESSMENT QUESTIONS:

1. In contract costing, loss is recognized in____ the relevant financial
year.
2. What do you understand by the term “Architect certificate”?
3. Mention balance sheet entries that may arise in connection with
uncompleted contract
4. XYZ Limited undertook three contracts in one year, one on January 1,
one on Juland one on October 1, on December 31, when the
company’s accounts were prepared, the position was as follows:
Contract No: 101 102 103
N N N
Contract price 300,000 202,500 75,000
Expenditure:
Materials 54,000 43,500 5,000
Wages 82,500 84,300 3,500
General expenses 3,000 2,100 250
Plants installed 15,000 12,000 3,000
Materials on site 3,000 3,000 500

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Wages accrued 2,550 2,700 400
General expenses accrued 450 300 50
Work certified 150,000 12,000 9,000
Cash received on work certified 112,500 90,000 6750
Work completed but not certified 4,500 6,000 550

The plant was installed on the commencing date of the contract and
depreciation is calculated at 10% per annum.
Prepare the respective account in the Contracts Ledger and give suitable
entries in the Company's Balance Sheet as at December 31. A columnar
layer may be adopted and calculations approximated to the nearest N.

7. At their year end ABC Developments has three contracts in progress

and their details are as follows:
Contract ABC DEF XYZ
Contract price 300,000 550,000 370,000
Costs to date 70,000 288,000 308,000
Estimated costs to
completion 176,000 192,000 14,000
Value of work certified 84,000 330,000 344,000
Progress payments
received 68,000 280,500 292,400
Costs of work certified 56,000 276,000 300,000
What interim profits, if any should be taken on the three contracts (no profits
have been taken so far)
8. What are the balance sheet entries for the three contracts below?

144
 Contract 101 102 103
N N N
Contract price 300,000 550,000 370,000
Costs to date 70,000 288,000 308,000
Estimated costs to completion 176,000 192,000 14,000
Value of work certified 80,000 330,000 344,000
Progress payment received 68,000 280,500 292,400
Cost of work certified 56,000 276,000 300,000
Calculated turnover - 187,000 292,400
Calculated cost of sales - 156,400 254,468
Calculated profit - 30,600 37,932

9. Contract costing has many similarities to_________costing.

10. Itemise three characteristics of contract costing?
11. Explain the procedures involved in the preparation of Contract
account.

Further Reading
1. Jain, N.C. (2009). Dictionary of Accounting, (1st ed.) India: AITBS
Publishers.
2. Singh, S .P. (2009). Encyclopedia Dictionary of Corporate Strategy,
India: AITBS Publishers.
3. Pandey, I.M. (2003). Essentials of management Accounting, India:
Vikas Publishers.

4. Kaplan, R.S and Atkinson A.A. (2002). Advanced management

accounting (6thed) India: Practice Hall.

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 CHAPTER 9
COST BEHAVIOUR
9.0 OBJECTIVES
At the end of this module you should be able to:
1. understand cost behaviour involving cost-volume-profit analysis
(breakeven) in the short term.
2. explain classification of cost.
3. State the basic techniques used to determine linear cost functions.
4. list significance of normal range concept.
5. explain variable, fixed and mixed cost behaviours.
6. state other cost behaviour patterns.
7. explain the difference between independent and dependent variables.
8. List the accounting classifications of fixed and variable costs.

9.1 Introduction
Managers are often faced with making decisions concerning cost, sales,
volume and profit. The proper combination of these factors will earn
desired profit Management must therefore evaluate the effect of these factors
on the profit by analyzing the relationship among the factors.

Cost-volume-profit otherwise known as breakeven is a management

accounting technique used to determine how cost and profit are affected by
changes in the level of production in the short term. This cost behaviour is
only suitable for a short term. It is unreliable for a long-time situation.
A management accountant must be able to evaluate cost of each item incurred
or expended in order to determine the cost function, that is, the relationship
among cost-volume-profit. Total manufacturing cost depends on the number

146
of units produced. Therefore, cost is the dependent variable while the units
produced are the independent variables. It is very important to differentiate
between fixed and variable costs in this topic because it is the basis of
breakeven analysis.
In this module, therefore, we are going to look at the importance of cost
behaviour to the management accountant and study the accounting
classifications of fixed and variable costs.

9.2 Classification of cost

The three manufacturing cost elements of any finished product are:
(a) Material
(b) Labour
(c) Expenses
To analyse cost, each type of expenditure must be classified into one of the
two groups:
(a) Direct costs
(b) Indirect costs

9.2.1 Direct cost:

Direct costs otherwise known as prime costs are directly traceable to specific
units of production. They are direct material, labour and expenses. Direct
materials are the raw materials that are integral parts, solely used and
traceable to the finished products, for example, the output of one process as
an input of subsequent processes:
• Packing material, such as tins for packing beverages, cigarettes, etc,
plastic used for plastic products.
• The crude oil used for fuel.

147
 • All materials and component parts traceable to and solely used for a
particular job, product, process, project and contract, e.g. gum, glue,
bricks, planks, nails, etc.

9.2.2 Direct Labour:

The wages paid to employees whose time and effort can be traced to producing
products are classified as direct labour. Furthermore, when the employee
performs tasks that can be identified with the conversion of direct materials
into finished products it is also direct labour, e.g. cost of machine operators,
assemblers of products, etc.

9.2.3 Direct Expenses:

Expenditure incurred on a specific cost of products other than direct material
or labour such as:
• Expenses related to a particular job, project, etc.
• Cost of special design, drawings.
• Hire of special tools, equipment, etc. for a particular production of goods
• Maintenance cost of equipment
• Carriage inwards.

Prime Costs:
It is the summation of Direct Material, Direct Labour and Direct Expenses.
Indirect Costs:
Indirect costs are not directly traceable to specific units of production. The
total indirect cost is termed overhead. Overhead costs are:
- Production overhead

148
 - Administrative overhead
- Selling overhead.

Examples of indirect costs are:

- Production facility expenses such as plant depreciation, rate, rent,
electricity, power, plant, supervisor's wages or salaries. It comprises all
manufacturing costs less the sum of direct materials, labour and
expenses.
The sum of direct and indirect costs is TOTAL COST

THE TOTAL COSTS ANALYSIS

The sum of direct and indirect costs is TOTAL COST

TOTAL COST ANAYSIS

TOTAL COST

Prime Cost Factory Overhead

Expenses

Direct Direct Direct Indirect Indirect Indirect

Material Labour Expenses Material Labour Expenses

Conversion Cost: It is the sum total of direct labour cost and manufacturing overhead.

149
Cost Behaviour:

The three basic costs function - fixed, variable and mixed can be graphed
as shown below:

Cost Cost Cost

Level of activity Level of activity Level of activity

Figure 9.1
Fixed Cost Variable Cost Mixed Cost
y = a y = bx y = a + bx
b = o a=o

Variable Cost Behaviour:

Variable costs (activity based) vary in total amount proportionately with the
level of activity/production. They are costs of material, labour and expenses.
Not all variable costs are direct costs. There are certain manufacturing
overheads like power, indirect labour and materials, factory wages, machine
repairs which will be variable costs. The total production costs vary directly
with the volume of production. The cost per unit remaining the same; for
example if the cost of production is increased by 5%, the material cost will
increase by 5%. The variable costs behave exactly as linear functions (straight
line) with constant slopes over all levels of activity known as straight line
as shown below:

150
 N N N

Cost Cost Cost

Units Units Units

Level of activity
Figure 9.2
Fig. 1: Example of Linear Variable Cost
This pattern represents costs, which vary in direct proportion to the level of
activity. It is unlikely to have perfect linear variable cost over all activity as
shown above in figure 1. The cost may be linear only over the normal range of
activity levels, normal or relevant range of activity within which a firm expects
to operate. Normal
Activity
range

Level of activity

Fig. 9.3: Normal Activity Range

Note that:
a. The slope of the line represented by 'b' is the variable cost per
unit of activity.
b. The activity level in unit is represented by ‘x.

151
A variable cost with a linear relationship is expressed as:
Y = bx.
Where Y is the expected cost.

Variable Cost Patterns - Curvilinear:

Curvilinear or non-linear variable cost function occurs where costs do not
vary in direct proportion to activity changes as shown below:
Convex Concave

Level of activity
Fig. 9.4: Curvilinear Variable Costs
Convex occurs where each extra unit of output causes a less than
proportionate increase in cost, i.e. there is economies of scale.
Concave occurs where each extra unit of output causes a more than
proportionate increase in cost, i.e. there is diminishing returns.
Many variable costs may show curvilinear characteristics. If in some
manufacturing processes the amount of waste material remains constant so
that when there is an increase in output the unit cost of material reduces and
there is an economy of scale. On the other hand where increasing differential
piece rate of labour is paid so as to increase output, there is diminishing
return and some form of concave curvilinear function will result.

152
9.4.2 Fixed Cost Behaviour
Fixed cost (time based) is constant in total amount over a relevant range of
activity. It changes in proportion to the length of time involved e.g. on
annual rent of a premise for N50, 000 may suddenly be increased to N80,000
per annum.
Fixed cost also known as capacity cost will be the same regardless of the
amount of production. It can also change owing to increase in the volume of
activities or factors outside it. For example, manufacturing overhead items
such as depreciation, rate, rent, salaries and wages of factory supervisors are
fixed costs that can change, not as a result of change in the level of activity.
Fixed costs known as discretionary fixed costs of advertising, research, and
development, employees learning programme can be reduced or
discontinued by management. Added capacity may be necessary to satisfy
demand for a firm's product or services. As a result, fixed costs such as
depreciation and managerial salaries will increase.
Total fixed cost therefore, would remain uncharged no matter the level of
activity. Fixed cost per unit, however would be decreasing as activity level
increases as shown in the graphs below:

Cost Cost

TFC

Level of activity units Level of activity

Fig. 9.5: Fixed Cost function

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9.4.3 Mixed Costs: (Time-Based and Activity-Based) behaviour
Cost VC

FC

Level of activity units

It is semi-variable cost which contains fixed and variable cost components.

This cost changes with activity but not in direct proportion to it. A mixed cost
increases or decreases linearly in a straight line with changes in activity, and a
positive amount at zero level of activity. The fixed portion of a mixed cost
shows the minimum cost of obtaining a service while the variable part is the
result of a change in activity.
Examples of mixed cost are maintenance, utilities, sales, salaries, employees’
insurance, rentals, supervision, storekeeping, office machine rental, power and
telephone charges.
For example maintenance can be analyzed into time-based maintenance of
weekly, monthly, annually and activity-based maintenance of 3 kilometres
series and when there are breakdowns.
To predict the behaviour of a semi-variable cost, it is necessary to divide the
cost into fixed and variable costs.

9.5 COST ESTIMATION TECHNIQUE:

The cost estimation techniques are the methods available for separating

154
mixed cost into variable and fixed costs. They are:
1. Account classification method
2. Scattered graph ;

3. High and Low method.

1. ACCOUNTS CLASSIFICATION METHOD:
It is otherwise known as account analysis method used in separating
mixed cost into variable and fixed cost. In this method each element of
cost incurred is separated into variable and fixed cost by an experienced
manager based on his knowledge of such costs
2. SCATTERED GRAPH:
To separate fixed cost from variable cost in semi-variable (mixed cost) this
statistical analysis must be followed:
(a) Prepare a graph both starting at zero level of activity (horizontal
line) cost (vertical line)
(b) Take the figure from a number of past periods and for each period, plot
the activity and cost as a single point.
(c) Draw the 'line of best fit' through the points and extend this to the cost
axis. This is the total cost line.
(d) The point where the total cost line cuts the cost axis gives the fixed cost
component of the semi-variable cost.
(e) The variable cost component at any level of activity is given by the
difference between the fixed cost and the total cost line.
Example 9.1:
To develop a cost function that best reflects the cost behaviour pattern of
mixed cost, we have this example; Oladapo Manufacturing Company
has the following monthly maintenance costs and machine hours during
the past six months, (a) Show the variable and fixed costs, (b) Calculate the

155
 variable cost rate.

Month Maintenance Costs Machine Hours

January 27500 2900
February 28600 3600
March 31600 4380
April 33300 4752
May 35000 5986
June 41700 8600

Maintenance
cost 55
thousands 50

45
40
35
30
25
20
15
10
5
0
1 2 3 4 5 6 7 8 9 10

Machine Hour (Thousands)

Fig. 9.6: Scattered Diagram - Maintenance Costs

156
The line of best fit is applied by drawing a straight line through the
relationship of the dependent and independent variables. The line of best fit
is on N35,000 and 6000 machine hours. Total maintenance costs of
N35,000.00 are estimated for N6,000.00 machine hours. Therefore, the
variable cost is N15,000.00, i.e. N35,000.00 - N20,000.00 fixed costs.
The variable cost rate is N15,000.00 = N.50
6,000
= N2.50 per machine hour
The estimate cost function = N20,000 + N2.50 per machine hour.

The high-low method can be applied to the maintenance cost data as follows:

3 The High and Low Method:

The high and low method can be used to determine the slope of any linear
function. It can be applied to the maintenance cost data thus:

Variable cost rate N14,200 = 2.484 per hour

5700

Fixed cost N41,00 - (2.484 x 8,640) = N20,298

The results of using either the line of best fit or the high and low method are the
same.
The weakness of these two cost estimation approaches can be avoided by
applying linear regression analysis in statistics.

157
OTHER COST BEHAVIOUR PATTERNS
There are other cost behaviour patterns as regards electricity bill, rental
of machine, material purchased at a discount, on bulk purchases, etc.

Total Variable Cost: It moves with the level of activities. It increases or

decreases in sympathy with the increase and decrease in the level of activities.
N
Cost
6 Total Figure 9.7
4 Variable
2 Cost
0 Activities
1 2 3

Variable cost per activity is constant no matter the level of activity. For
instance N5 per unit will remain N5 per unit at 40,000 or 25,000 units. It can
be graphed as follows:

N
Cost
6
4 Variable
2
0 Activities
1 2 3

Figure 9.8

158
Semi-Variable or Mixed Cost
Some costs cannot be totally fixed. They are partially fixed or partially
variable costs or mixed costs. For example maintenance costs in a firm will
vary with the level of activity. While some maintenance costs will still be
incurred without using the machines for production. The maintenance cost
therefore has components of variable and fixed costs which is mixed cost. It
is necessary to separate variable cost from fixed costs using statistical
analysis.
Graphical illustration of Mixed Cost end Semi-variable cost.

Mixed Cost
N
Cost
N VC
Maintenance
Cost FC
Level of Activity
Level of Activity
Figure 9.9

Total Fixed Cost: It remains constant whether there is increase or decrease

in the level of activity within the relevant range. Relevant range is of great
importance in defining total fixed cost because no cost is fixed. For
example, machine being used for production has its maximum capacity. If
there is a need to produce above capacity there is need to acquire/purchase
an additional machine. In this case the capacity of the machine will be the
relevant range in relation to fixed cost.

159
 N
Cost

Total fixed cost

Activities

Figure 9.10
Fixed cost per activity will reduce as activity increases.
N
Cost

Fixed Cost per activity

Activities
Figure 9.11
Fixed Costs like administrative cost, rent, depreciation, salaries will be
fixed cost if computation is based on straight line, reducing balance
method. They will be variable cost if computation core is based on
output in units, men hours and machine hour's methods i.e. (time and
activity based).

160
Step-fixed Cost: This type of fixed cost is fixed within a relevant range.
It will increase above the range by a lump-sum and remain at that level
until another lump-sum increase. Examples are rent, salaries,
depreciation, etc.

N
Cost Step fixed cost

Activities
N
Cost

Quantity
Figure 9.12
This graph shows that the total purchase cost of material for storage may change as
increase in demand for a limited supply pushes up the unit cost.
N
Cost

Quantity
Figure 9.13
The graph shows purchase costs if material is affected by bulk purchase

161
discounts on every unit purchased provided that total demand exceeds
quantity required for discounts.
N
Cost

Quantity
Figure 9.14
The graph shows the effect of materials purchased at a discount per unit on
quantities in excess of level of supply e.g. a unit cost of N5 per unit for the first
1000 units at N4.50 per unit for the next 1000 units, N4.25 per unit for
subsequent amount of purchase.
N
Cost

Level of activity
Figure 9.15

This graph shows the cost behaviour pattern as regards electricity bill where
fixed period change plus a variable charge after a certain number of kilowatts
are consumed.
N
Cost Figure 9.16

Level of activity

This cost pattern applies to a rental of a machine where the charge is variable

162
per unit produced up to a maximum fixed rental.

9.6 SUMMARY
In this module you have learnt that:
(a) The three manufacturing elements of cost of any finished product are
material, labour and expenses which are further classified into direct
and indirect costs/overheads.
(b) Cost behaviour is the measure of how a cost will respond to changes in
the level of production. The most important ones are variable costs,
fixed costs and mixed costs. Mixed costs consist of fixed and variable
costs.
(c) All cost functions are assumed to be linear so that the rate of change is
constant and easy to forecast. It is not likely to have a perfect linear
variable cost over all level of activities. The cost may be linear only
over the normal range of activity levels. We have non-linear or
curvilinear cost where costs do not vary in direct proportions to
changes in production.
(d) Fixed costs are separated from variable costs using statistical
analysis, scatter diagrams and high and low method.

9.7 Exercises
1. In one sentence, identify the major characteristics of each of the
following:
a. Variable cost
b. Fixed cost
c. Mixed cost
2. In not more than five sentences, explain what is meant by the normal

163
 range concept. How does the concept contribute to the linearity of cost
functions?
3. In two sentences, distinguish between a discretionary fixed cost and a
committed fixed cost. Give an example of each.
4. Bosade Ltd has these data for the highest and lowest levels of
production.

Total cost Total units produced

Highest levels 500,000 45,000
Lowest levels 250,000 10,000
Required:
a. Determine the difference between the total cost and total units
produced at the highest and lowest levels of production.
b. Use the high-low method of mixed cost to show the variable and fixed
cost per unit.
c. Using the answers from (a) and (b) above estimate the total cost for
60,000 units of production.
5. What are the essential cost classifications for cost prediction purposes?
6. Regarding cost behavior, give one major reason why the management
accountant must constantly know cost classification and its
assumptions.
7. What is stepped cost? (Answer in one sentence)
8. Describe High-Low technique in just two sentences.
9. Why is it that all variable costs may not vary with the level of
activity?
10. Selling and Administrative expenses are: (choose one answer)
a. product expenses

164
 b. direct expenses
c. period expenses
d. manufacturing expenses
e economic expenses
11. Cost Allocation is:
a. a cost accounting coding system
b. the transfer of cost to cost centres
c. the charging of discrete, identifiable items to cost units or cost
centres
d. the division of costs among two or more costs centre in
proportion to their estimated benefits
12. What term is used to describe a cost which has both variable and fixed
cost?
a. Variable cost
b. Sunk cost
c. Mixed cost
d. Fixed cost
e. Product cost
13. If Bosede Ltd has 750,000 units of production at N120,000 (the high
point of production) and N76,250 at 40,000 unit of production (the
low point of production), the variable cost per unit using the high-low
method of cost estimation is:
a. N1.00
b. N0.80
c. N1.25
d. N1.45
e. N1.62

165
14. Which of the following will be classified as fixed cost in cost -
volume - profit analysis
a. Direct materials
b. Direct labour
c. Direct expenses
d. Real estate taxes
e. Supplies

15. The following are the Maintenance Costs incurred in a Machine Shop
per six months corresponding machine hours:
Months Machine Hours Maintenance Costs
January 2,000 600
February 2,200 640
March 1,700 540
April 2,400 680
May 1,800 560
June 1,900 580
Total 12,000 3,600

Analyse the Maintenance Cost which is semi-variable into fixed and variable
element.

Further Reading
1. Banergee, B. (2005). Financial policy and management accounting (7th
ed.), India: Prentice Hall of India Private Limited.
2. Drury, c. (1992). Management and cost Accounting (3rd.ed.), London:
Chapman and Hall.

166
3. Omolehinwa,A. (2001). Work out Management Accounting (Notes and
worked examples), (1st ed.) Lagos: st John consultants LTD.
4. Anumaka, N.M. (2000). Managerial accounting and Control, Lagos:
Matic Educational Books.

167
 CHAPTER 10
10.0 OBJECTIVES:
At the end of this module you should be able to
1 explain the terms breakeven point and breakeven analysis.
2. list and explain the assumptions of breakeven analysis
3. state the various breakeven equations
4 draw Breakeven chart
10.1 INTRODUCTION
Breakeven analysis is sometimes called cost-volume-profit relationship. It is
based on the company's profit function. It is the sales level at which sales
revenue and total costs are equal with no loss or profit sustained. Profit is
earned above breakeven point while loss is earned below it. The sales
revenue, the volume and fixed costs, i.e. breakeven point, provides
information on the impact of cost behaviour at different sales levels and the
minimum sales level to be achieved in order to continue in business. It
provides for targeted profit and evaluates the margin of safety concerning
the expected sales level.
It uses variable costing techniques to ascertain contribution per unit whereby
the total contribution from all sales during a trading period is compared with
the fixed cost of that period. Any excess or deficiency of contribution over
fixed costs represents profit or loss respectively for that period. It also shows
the level of activity at which there are neither profits nor loss.
Breakeven point (BEP) can be calculated mathematically or graphically. To
calculate BEP mathematically, the number of units needed to be sold to
breakeven will be the total fixed costs divided by the contribution per unit.
This is because the contribution, required to breakeven must be an amount
which equals the amount of fixed costs.

168
Cost-profit -volume analysis answers these questions:
1. What is the firm's breakeven point in units and naira terms?
2. What will be the effect on sales volume and profit if there is an
increase in the costs of advertisement, promotion and other
distributive and selling expenses?
3. If selling price is increased or decreased what will be the effect on
volume of sales?
4. If a variable cost such as labour or material is replaced with a fixed
cost such as machine, or equipment depreciation, what will be the
effect on profit?
5. How much additional sales volume is required to make up for increase
in direct materials cost?
6. What sales volume is necessary to earn a targeted profit?
7. What amount of sales is required to earn a profit after tax at a
specified tax rate?

10.2 Assumption of Cost- volume- Profit Analysis:

1. The unit sales price remains constant
2. All costs are recognized as variable or fixed costs.
3. The fixed cost will remain constant and variable costs vary
proportionately with activity.
4. The variable costs vary proportionally with volume.
5. Efficiency will not change.
6. The only factor affecting costs and revenues is volume
7. The analysis relates to one project only particularly in graphical
method.

169
8. Stocks are valued at marginal costs only.
These assumptions are over-simplified for most practical situations. It is
used as a guide for decision-making.

10.3 Format of Breakeven Analysis

Per Unit Total
N N N N
Selling Price x Sales x
Less Variable/Marginal cost: Less Variable/Marginal Cost
D/Material x D/Material x
D/Labour x D/Labour x
D/Expenses x D/Expenses x
Prime Cost x Prime Cost x
Variable O/H x Variable O/H x
Variable Cost (x) (x)
Contribution per unit x Contribution x
Less fixed cost (x)
Profit before tax x
Tax (x)
Profit after tax x
Breakeven analysis can be undertaken by graphical means or by simple
formular which are listed below.

170
Various formulae of Breakeven Analysis:
(a) Break-even points (units) = Fixed cost
Contribution/Unit

where, contribution per unit = Total contribution

Total units

(b) Break even point (Naira) = Fixed cost x Selling price

Contribution / Unit

Or Fixed cost
CMR

Where, CMR = SP – VC = Contribution = C/S

SP SP

Contribution margin Ratio

The term contribution represents the difference between sales value and variable
cost of sales .
Contribution= SV – VC
For the difference between sales and the relevant cost of sales or the summation of
fixed cost with profit.
Contribution = FC + π
The process of expressing contribution as a percentage or a proportion of sales
value is described as c/s ratio or contribution margin ratio (CMR).
In practice, the specific approach to be adopted in identifying the contribution
margin ratio (CMR) depends on the information provided where total sales (TS),
total costs (TC), selling price per unit (SP), Cost per unit (VC). The various
definition of CMR are:

171
 C
i. /S ratio = CMR = Contribution per unit = SP - VC
Selling price per unit SP

ii. CMR = Total sales – Total variable cost = TS – TC = FC + π

Total sales TS TS

iii. CMR, in units where the original data are to be altered.

CMR = RSP – RVC
RSP

iv. CMR in total where the original data are to be altered

CMR = C/S = RTs – RTVc
RTs

ILLUSTRATION 1
Assume you were given the data below:
N
Revenue 250,000
Cost of Goods sold 100,000
No of units 5,000
Required:
Calculate
i. Contribution per unit
ii. Sales per unit
iii. Variable cost per unit
C
iv. /S ratio or CMR
Solution:
i. Sales per units (SP) = Total sales = TS = 250,000
No of units Units 5,000

= N50

172
ii. Cost per unit (VC) = Total cost = TVC = 100,000
No of units Units 5,000

= N20

iii. Contribution per unit = SP – VC = 50 – 20 = N30

Alternative method
Contribution per unit = TS – TVC = N250,000 – 100,000
No of units 5,000

= N150,000
N5,000

= N30.00

CMR = SP – VC = 50 – 20 = 30 = 3
SP 50 50 5

OR TS - TVC = 250,000 – 100,000 = 150,000 = 3

TS 250,000 250,000 5

ILLUSTRATION II
Assuming you were given the data below:
N
Direct material 125,000
Direct Labour 75,000
Variable overhead 25,000
Fixed overhead cost 100,000

173
Sales 425,000
Units sold 5,000 units
Calculate
i. Total variable cost
ii. Variable cost per unit
iii. Selling price
iv. Contribution per unit
C
v. /S ratio or contribution margin ratio
Solution:
i. Total variable cost
Direct material 125,000
Direct labour 75,000
Variable overhead 25,000
225,000
ii. Variable cost per until
Total variable cost = 225,000 = N45.00
No of units 5,000

iii. Selling price = Sales = 425,000 = N85.00

Units sold 5,000

iv. Contribution per unit = SP – VC = 85 – 45 = N40

= SP – VC = 85 -45 = 40 = 8
SP 85 85 17

Alternatively
TS – TVC = 425,000 – 225,000 = 200,000 = N40
No of units 5,000 5,000

174
CMR or C/S = TS – TVC = 200,000 = 8
TS 425,000 17

APPLICATION OF BREAK EVEN ANAYSIS

a. Break even points (units)
Break even points in units is derived by dividing total fixed cost for the
period by contribution per unit.
Total fixed cost = TFC
Contribution per unit CM/U

ILLUSTRATION 111
Given the following data
Direct material 250,000
Direct labour 75,000
Variable overhead 25,000
Fixed production overhead 300,000
Fixed selling overhead 600,000
No of units 10,000
Sales 1,000,000
Calculate the Breakeven point in units.

Solution
Breakeven point = Fixed cost = N500,000
Contribution per unit N60

= 10,000 units

175
Working Notes
i. Total variable cost
Direct Material 275,000
Direct Labour 75,000
Variable Overhead 50,000
400,000
Variable cost per unit 400,000 = N40.00
10,000
ii. Selling price = Total sales x 1,000,000 = N100
No of units 10,000

iii. Contribution per unit = SP – VC = 100 – 40 = 60

b. Breakeven point (Naira):

This is the point where total sales is equal to total costs. This is derived by
dividing Total fixed cost by C/S ratio or contribution margin ratio.
Total Fixed Costs = TFC = TFC = TFC x S
C
Contribution Margin Ratio = CMR = /S Contribution per unit

Or
Total Fixed Costs = TFC = TFC = TFC
C
Contribution Margin Ratio CMR = SP - VC = /S
SP
Where,
CMR = SP – VC = Contribution = C
SP SP S

ii. TFC = TFC ÷C/S = TFC x S/C = TFC x S

C
/S C

176
ILLUSTRATION IV
With reference to the data given in illustration I
Calculate the breakeven points in naira.

Solution
Breakeven point in Naira = TFC x S = 600,000 x 100
Cont. per unit 60

N1,000,000
Level of sales to result in target profit before tax in units

Fixed costs + Targeted profit before tax

Contribution per unit

FC + T.PBT
CM/U

This is used to calculate the turnover in units

ILLUSTRATION V
Assume you are given the data below:
Gross profit 950,000
Total expenses 250,000
Direct material 550,000
Direct labour 150,000
Variable overhead 100,000
Total units 10,000

177
 Sales 1,200,000
Fixed cost 1,300,000
Solution
FC + T.PBT = N1,300,000 +N 700,000 = 25,000
CM/U N80

Working Notes
i. PBT = GP – Total Expenses = 950,000 – 250,000 = 700,000
ii. Total variable cost = 550,000 + 150,000 + 100,000 = 800,000
iii. Variable cost per unit = 800,000 = N80
10,000

ILLUSTRATION VI
Given the following data
Profit before tax 350,000
Fixed cost 650,000
Total variable cost 400,000
Revenue 600,000
Total units 5,000 units

Solution
FC + PBT = 650,000 + 350,000 = N1,000,000 = 25,000 units
CM/U 40,000 N40

Working Notes:
i. Contribution = Sales – Variable cost
= 600,000 - 400,000 = 200,000

178
ii. Contribution per unit = Contribution = 200,000 = N40
Total units 50,000

e. Level of sales to result in target profit before tax in Naira value

Fixed cost + targeted profit before tax x Selling Price
Contribution per unit
This is used to calculate the sales or turnover required to achieve a pre-determined
amount of profit before tax.
TFC + PBT x SP = Turnover in units x Selling price
CM/U

ILLUSTRATION V11
With reference to the dates in question d(iii)
Calculate the sales value in Naira

Solution
Turnover in naira = Turnover in units x s…………………………… (i)
Recall the answer in question d(ii), 25,000 units
Therefore,
Turnover in Naira = 25,000 x 120 = N3,000,000.00

Working Note:
SP = 600,000 = N120
5,000

Alternatively,
= TFC + PBT x S
CMR

179
 = 650,000 + 350,000 x 120
40

= 3,000,000.00

F. Level of sales in target profit after tax in units.

Contribution per unit = TFC + Target profit after tax
1 – tax rate

Contribution per unit = TFC + PAT = TFC+ PBT

I–t

Take note
The target Profit After Tax (PAT) is grossed up or converted to Profit Before Tax
(PBT)
PBT = PAT
I–t
Where,
t = tax rate

ILLUSTRATION VIII
Assume you were given the data below:
Profit after tax = 490,000
Total fixed cost = 1,300,000
Contribution per unit = 50.00
Calculate the total units required to produce and sell in order to achieve the pre-

180
determined amount of PAT. (tax rate = 30%).

Solution:
TFC + PBT = 1,300,000 + 700,000
CM/U 50

= N2,000,000
N50

= 40,000 units

Working Note
PBT = PAT = 490,000 = 490,000 = N700,000
1–t 1 – 0.3 0.7

Level of sales in target profit after tax in sales

.
Fixed cost + Target profit after tax
1 – tax rate X sales
Contribution per unit

FC + PAT
I–t x S = FC + PBT x S
CM/U CM/U

181
Alternatively,
Fixed cost + Target Profit after tax
1 – tax ratio
Contribution margin ratio

FC + PAT
I–t = FC + PBT
CMR CMR

Where, CMR = SP – VC = Contribution = C/S

SP Selling Price
or
PBT = PAT
I–t
FC + PBT = FC + PBT
C/S C/S

ILLUSTRATION IX
Colour Ltd makes a single product, White, with a sales price of N20.00 and a
marginal cost of N12.00, fixed costs are N120,000 per annum.
Calculate
a. Number of Units to break-even
b. Sales at break-even point
c. C/S ratio
d. The number of Units to be sold in order to achieve a profit before tax of
N40,000
e. The sales to be made in order to achieve a profit before tax of N40, 000.
f. Because of increasing cost, the marginal cost is expected to rise to N13.00
and fixed cost to N140,000 per annum. If the selling price cannot be
increased, what will be the number of units required to maintain a profit of

182
 N40,000 per annum before tax.
g. If the taxation rate is 40%, how many units will need to be sold to make a
profit after tax of N40,000?

SOLUTION 1X
Contribution / Unit = Selling Price - Marginal Cost
= N20.00 - N12.00
= N8.00
(a) Break-even point (Units) = Fixed cost
Contribution / Unit

= N120,000
N8.00

= 5,000 Units

(b) Break-even point (Sales) fixed cost x Selling Price

Contribution / Unit

N120,000 x 20 = N300,00
N8.00

(c) C/s ratio = Contribution / Unit x 100

Selling Price

= N8.00 x 100
N20.00

= 40%

(d) Number of Units for Fixed cost + Target profit before tax

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 N40,000 target profit = contribution / Unit
before tax
= N120,000 + N40,000
N8.00

= N160.000
N8.00

= N20,000 Units

(e) Sales for target profit FC + Target PBT = FC + PBT

of N40,000 before tax = C/S or CMR C/S

N120,000 + 40,000 = (120,000 + 40,000 x 1

8/20

160,000 = N160,000 x 20
0.4 8

= N400,000 = 3,200,000 = 400,000

8
(f) Note that the fixed cost, marginal cost and contribution have changed.
Contribution = Selling Price – Marginal cost
= N20 – N13.00
= N7.00

(g) No. of Units for target profit after tax is computed as follows:

Fixed cost + Profit before tax = FC + PBT

Contribution / Unit CM/U

184
 = N20,000 + N66,667 = N86,667
N8.00 N8

= 23,333 Units

Working Notes:
PBT = PAT
I–t

= 40,000
1 – 0.4

= 40,000
0.6

= N66,667
10.4 Breakeven Equation
Profit is a function of:
a. Sales
b. Variable costs
c. Fixed costs
10.5 Breakeven analysis
Breakeven analysis is a method of decision-making based on cost behaviour and
variable costing ideas.
Breakeven (CVP) analysis using variable costing technique can ascertain the
contribution per unit. The total contribution from all sales for a period is compared
with the fixed cost of the same period. The excess or deficiency of contribution
over fixed cost is the profit or loss respectively for the period. It highlights the
level of activity at which there is profit or loss. It can be calculated mathematically
thus:

185
Example 10.1:
A company reports as follows:
N
Sales (N10 per unit) 10,000
Variable cost 6,000
Fixed cost 1,500
Calculate:
a. variable cost per unit
b. contribution per unit
c. contribution per 1000
d. BEP in units and Naira terms.

SOLUTION:
a. Variable cost per unit = Total variable cost
Total units
= N6,000 = N6.00
1,000

Working Note
Total units = Total Sales = 10,000 = 1,000 units
SP 10

b. Contribution per unit (CM/U) = SP – VC = 10 – 6 = N4

c. Contribution for 10,000 units = CM/U x Units
= N4 x 10,000 units
= N40,000 =
d. BEP in units = FC = N1500 = 375 units
CM/U 4

186
 BEP in Naira terms = FC x SP
CM/U

= 1500 x N10 = N3750

4
OR
BEP in Naira = BEP in units x SP
= 375 x 10
= 3750

Example 10.2
Solution:
BEP = Fixed cost
C/S or CMR

= 10,000
0.8

= N12, 500
Working Note
SP = 1.00
VC = 0.2
CMR = SP - VC = 1 - 0.2 = 0.8 = 0.8
SP 1 1

187
 OR
C/S ratio = Contribution = 1 – 0.2 = 4/5
SP 1

Graphical Approach:
Breakeven chart can be defined as a cost graphic analysis.

30,000
Sales

20,000
Profit

12,500
Total cost
Variable costs
10,000 Fixed cost
Margin of
Safety Budgeted costs

10,000 12,500 20,000 30,000 units

Breakeven Charts
The breakeven point is determined by graph using breakeven chart which indicates
profit or loss at different levels of sales volume within a limited/relevant range, N
shows on the horizontal axis the sales/output in units and in monetary value while
on the vertical axis sales revenue and costs are shown. It makes use of three lines:
(a) The sales line starts at the origin, i.e., zero sales line (volume/revenue) and
ends at the point of expected sales.
(b) The fixed costs line, which is above, and parallel to the horizontal axis at a

188
 point on the x vertical axis, denotes the total fixed costs.
(c) The total costs line starts at the point where the fixed costs line meets the
vertical axis at zero level of output and ends at the point of sales in units on
the horizontal axis and, on the vertical axis, the sum of total variable costs
plus the total fixed cost.
The breakeven point is where the sales line meets the total cost line. By projecting
the lines horizontally and vertically, the breakeven point in sales units and sales in
naira value can be easily read.

Example 10.3
A company makes a single product with a total annual output of 120,000. The
fixed overhead amount is N40, 000 and the variable costs are N.50 per unit. The
sales price is N1.00.
Construct a breakeven chart showing the current breakeven point and profit earned.
Solution:
Calculation of profit N
Sales (120,000 units) 120,000
Variable cost N.50 per unit 60,000
Contribution 60,000
Less fixed cost 40,000
Profit 20,000

189
Breakeven Chart:
Solution

N
c
120 Profit

100 d
Breakeven point b
80 V.C Total cost
60 a
Loss Margin of safety
40 e

20 Fixed cost

0 f
20 40 60 80 100 120 Units in
thousand

Fig. 10.2 Traditional Breakeven chart

The chart shows:
a. The vertical axis, which represents costs and revenue. The horizontal axis
represents the level of activity- production and sales.
b. The fixed costs (N40,000) on a straight line is parallel to the horizontal axis.
c. The variable costs above the fixed costs are added to give total costs. The
fixed costs are constant at levels of output.
The costs lines are straight. The two most important points plotted and
joined up are total costs at zero output and sales. At zero output, costs are
equal to fixed costs. - N40, 000. There are no variable costs.
At the output of 120,000 units, costs are N100, 000
Fixed costs 40,000
Variable costs for 120,000 units
120,000 x N50 60.000
Total costs N100,000

190
The sales lines are made up by plotting and joining two points at:
a. Zero sales revenue is nil.
b. At the output and sales of 120,000 units, revenue is N120, 000.
The breakeven point is where total costs are equal to total revenue. In the
breakeven chart above, it can be seen that revenue is N80, 000 and costs are N80,
000 (breakeven). It can be proved mathematically as:
Contribution = fixed costs = N40,000
Contribution per unit N5
= 80,000 units

Contribution Breakeven Chart:

Contribution chart shows the impact on profit of changes in turnover. On this chart,
it is possible to draw the variable costs line first instead of the fixed costs line as
shown below using the same example:

120
c

100

80 Breakeven point b
Contribution
Total Cost
60

40 a e

Variable
20 S.R Margin of safety

0 f
20 40 60 80
20 100 120

Fig. 10.3 Contribution Breakeven Chart

191
The area C.O.E. represents the contribution earned. The area D.A.O.F. represents
total costs. In this chart, the reversal of fixed costs and variable costs makes it
possible to draw contribution to provide additional information.

Note that:
When contribution margin is stated as a naira value, the breakeven point is
calculated as sales unit. To find contribution, subtract all variable costs from sales.
Contribution = S- V
Contribution must be equal to fixed cost to find breakeven point. To find the
number of units to be sold at breakeven point, divide fixed cost by unit
contribution margin.
FC
Unit contribution

The use of contribution margin measured as a percentage of sales will result in a

breakeven point in naira value or terms.
To find contribution margin ratio, divide unit contribution by unit sales.
Use this formulae = Unit contribution = S–V = C
Unit sales S S

Formulae for breakeven sales in naira value = FC

Unit contribution
10.4 Taxation in CVP
Compute contribution before taxation
You already know that:
Contribution = fixed cost + profit
This profit is before taxation.

192
Example 10.4
Mogbabe Limited earns profit after tax of N25,000 with a tax rate of 20%. What is
the profit before tax?
Working:
This question gives profit after tax, therefore calculate profit before tax. To do so:
Let profit befoRr tax Nx
Tax rate = 20% of profit before tax.
It means that the profit after tax = 80% of profit before tax
That is 80% x Nx = N25,000
.8x = N25,000
x = N25,000 = N31,250.00
.8

Profit before tax = profit after tax

1 - tax rate

= N25.000
1-20

= N25,000
.8

= N31, 250

Cost-volume-profit relationships can be used to find combination of sales revenue

and costs that will produce desired profits. It is also important for budgetary
processes; hence management can use various alternative strategies regarding the
future financial performance of a company to show the impact on profit of:

193
1. Changes in fixed costs
2. Changes in variable costs
3. Changes in selling price
4. Changes in sales volume.
The following example evaluates potential changes:

Example 10.5
Manpower Ltd deals in farming implements.
Following data are given:
N
Fixed cost 400,000
Selling price per unit 70.00
Variable cost per unit 20.00

Required:
1. a. Calculate the breakeven in units of sales and in naira value
b. If Manpower Ltd pays N1,000 more to each of 10 foremen
c. If the cost of direct materials is increased by N2 per unit
d. If selling price increased to N72 per machine.
What is the sales volume necessary to earn
a. Profit of N200,000.00
b. Earn a profit before tax of N50,000
c. Earn a profit after tax of N50,000.00 at a tax rate of 20%.

Solution
The breakeven, the contribution must be equal to fixed cost.
The number of units to be sold at BEP .

194
 = Fixed cost
Contribution per unit

= FC
CM/U

= 400,000 = 8000 units

50

Breakeven points in Naira terms

Number of units at BEP x SP
= 8,000 units x N70
= N560,000.00
Alternative method
= FC
CMR

= 400,000
50/70
= 400,000 x 70
50

= N560,000

Working Notes
1. Contribution Margin Ratio = SP – VC
= 70 – 20
= N50.00

195
2. Contribution margin ratio = SP - VC
SP
CMR or C/S ratio = 70 – 20 = 50/70
70

(b) N1,000 each is paid to 10 foremen = N1,000 x 10 = N10, 000.

This is regarded as fixed cost.
New fixed cost = N400,000 + N10,000
Breakeven point = N410,000
50
= 8200 units

(c) Increase in the cost of material by N2 per unit is a reduction in contribution

margin.
The new contribution = N50 - N2 = N48
Breakeven point = N400,000
48
= 25,000 = 8333units
3

(d) There is an increase in selling price from N70 to N72.

New contribution margin = N72 - N20 = N52
New breakeven point = 400,000
52
= 7692 units

1. (a) To earn a profit of N200,000 contribution required

= FC + Profit = N400,000 + N200,000 = N600,000

196
 No. of unit to be sold = 600,000
50
12,000 units.

(b) To earn a profit before tax of N50,000

Fixed Cost + targeted profit
Contribution per units

= N400,000 + N50,000
50
= N450,000
50
= 9000 units.

(c) To earn a profit after tax of N50,000 at a tax rate of 20%

= FC + PAT
I–t
CM/U

= 400,000 + 50,000
1 – 0.2
50

= 400,000 + 62,500
50

= 462,500
50

= 9250 units

197
10.5 Margin of Safety
Margin of safety is used to determine the amount by which sales can
decrease before a loss is recorded. It is otherwise known as operating
leverage ratio. It is the excess of sales over the breakeven sale, i.e. sales -
breakeven.
Margin of safety can be expressed as a naira amount or a percentage of sales.
P = profit
S = sales at breakeven point
F = fixed costs.

Formulae: P
S–V
S

P
= C ratio
S

= P
Contribution ratio

Example 10.6
Ibukun Ltd supplies the following business information.
Sales N1,000,000
Breakeven sales N 700,000
Profit N 300,000
Determine the margin of safety.

198
Solution
Margin of safety in naira value = N1,000,000 - N700,000 = N300,000
1,000,000 – 700,000
1,000,000

Margin of safety as a percentage of sales = N300, 000 = 3 = 30%

Nl, 000,000 10
Margin of safety = 30%

Example 10.7
MM Ltd makes and sells a product with variable cost of N60 and sells for N80.
Fixed costs are N140,000, budgeted sales are 8,000 units. Calculate the breakeven
point and the margin of safety.

Solution:
(a) Breakeven point fixed cost = N140, 000
Contribution per units N80 - N60

= N140, 000
20
Breakeven = N7, 000

(b) Margin of safety = 8,000 - 7,000 units = 1,000 units

May be expressed as 1,000 units x 100%
8000

= 12.5%

199
The margin of safety indicates that actual sales can fall below budget, i.e. there is a
variance between actual and budgeted sales unit by 1,000 units or 12.5% before the
breakeven point and no profit is made.

10.6 Angle of incidence

This is the angle at which the sales line cuts the total costs line. If the angle is
large, it is an indication that profits are being made at a high rate. Taken in
conjunction with the margin of safety, it can be seen that a large angle of incidence
with a high margin of safety indicates an extremely favourable position, and even
the existence of monopoly conditions.
On the other hand, if the angle of incidence is small, it indicates that, while profits
are made, they are achieved under less favourable conditions:

Example 10.8
Colour Ltd. Makes and sells a single product. The variable cost is N6.00 per unit,
and the variable cost of selling is N2.00 per unit. Fixed cost total N12, 000 and the
unit sales price is N12.00. The company budgets to make and sell 3, 600 units in
the next years.
Required; a break-even chart, and a p/v graph, each showing the expected amount
of output and sales required to break even and the safety margin in the budget.

SOLUTION
Selling price N12
Variable cost N6.00
Variable selling cost N2.00
Marginal/Variable cost (8)
Contribution /Unit 4

200
Example 10.9
Colour Ltd currently makes and sells 7,000 of their product each year. Fixed costs
are N36,000 per annum, the variable cost of the sales is N16.00 per unit and sales
revenue N22 per unit. By changing the organisation’s production level, it is
thought that variable cost could be reduced by N0.40 per unit, although fixed costs
would rise as consequence by N2, 600.
a) how would the change affect:
i) Budget profit, and
ii) The breakeven point and margin of safety, assuming that there would
be no alterations in the sales price or budgeted sales demand for the
product?
b) At what level of sales volume would the change-over be profitable?

SOLUTION
a) Current System Proposed System:
Contribution (7000 x N6.00) 42,000 contribution (7000x6.400) 44,800
Fixed Costs (36,000) Fixed Cost 38,600
6,000 6,200

Breakeven point = N36, 000 Breakeven point = N38, 600

N6 6.40
6000units 6.031.25units

Margin of Safety = 1000 x 100 Margin of Safety = 968.75 x 100

7000 7000
14.29% 13.84%

b. At 6500 Unit: Proposed

201
 N N
Contribution 6,500 x N6 39,000 Contribution 6500 x N6.40 41,600
Less Fixed Cost 36,000 Less Fixed Unit 38,600
Profit 3,000 Profit 3,000
At 6501 Units
Contribution 6501 x 6 39,006 Contribution 6501 x N6.4 41,606.4
Fixed Cost 36,000 38,600
3,006 3,600.4

At 6501 Units/ N104,016 files

10.7 Uses of Breakeven Analysis

i. In its simplest form, it is based on the assumption of a linear total cost
function, i.e. of constant unit variable cost and constant total fixed. It is an
application of marginal costing principles. Therefore, it is an important tool
in short term planning.
ii. The technique if used carefully within the limitation of its assumptions may
be helpful in the following ways:
a. Budget planning. The volume of sales required to make profit (i.e. break
even-point) and the safety margin for profits in the budget can be measured.
b. Pricing and sales Volume decisions
c. In sales mix decisions; i.e. in what proportion should each product be sold?
d. Special Order acceptance
e. Decisions affecting the cost structure and production capacity of the
company.

10.8 Limitation of Cost Volume Profit Analysis

1. The assumption of constraint variable costs per unit is unattainable because

202
 of quantity and cash discount.
2. The method ignores other marked situations which may be constant to
production and sales.
3. The method assumes no labour turnover whereas there might be labour
rotation and changing of jobs.
4. There are many factors affecting production and sales which cannot be
mathematically expressed.
5. The angle of incidence is where the sales line cuts the total costs line. A
large angle indicates that profits are being made at a high rate. In
conjunction with the margin of safety, a large angle of incidence with a high
margin of safety indicates a favourable position and monopoly condition. If
angle of incidence is small it indicates that profits are being made under less
favourable conditions.
6. Breakeven analyses are used for budget planning, pricing and sales volume
decisions and special order acceptance.
7. Cost-Volume Profit analysis are limited by assumption of constant variable
cost per unit which is unattainable, the method ignores other
market situations and assumes no labour turnover.

10.9 Summary
In this module you have learnt that:
1. Breakeven, sometimes called cost-volume profit, is based on the company's
profit function. It is the sales level at which sales revenue and total costs are
equal with no profit made or loss sustained.
2. Breakeven/cost volume profit gives a firm breakeven point in units and naira
value using specified formulae.
3. Breakeven provides effect on sales volume and profit if there are changes in
selling price, fixed costs, variable costs, selling and distribution costs.

203
4. Breakeven assumes that unit sales price remain constant. Costs are variable
and fixed, variable costs vary with volume of production Efficiency will not
change, and volume is the only factor affecting costs and revenue.
Breakeven relates to one project only particularly graphical approach. Stocks
are valued at variable costs only.

10.10 Exercises
1. If sales are N300,000 and sales at the breakeven point is N250,000, what is
the margin of safety?
2. Morountodun Ltd trading in wireless telephones, records the following
business transactions:
Sales N200,000
Breakeven sales N150,000
Determine the operating leverage ratio?
5. Rolling plant sells its only product at a price of N240 per unit. Variable costs
are N180 per unit and total fixed costs are N270, 000, annual sales are 6000
units.
You are required to calculate the company's profit under these situations;
a. variable expenses increase by 10% ;
b. sales volume decrease by 10%;
c. fixed costs increase by 10%;
d. sales price increase by 10%;
e. sales price 10% variable;
f. variable expenses increase by 10%, and
g. fixed cost decrease by 10%.
6. Monde distributed a new product. The product sells for N40 per unit with a
contribution margin rate of 20 percent. The company's fixed costs is
N400,000.

204
Require:
a. What is the variable cost per unit?
b. How many units must the firm sold to breakeven?
c. What is the breakeven point in naira terms?
d. If the firm wants to earn a profit before tax of N8,000, how many units must
be sold?
e. If the firm wants to earn a profit before tax income of 10% sales, how
many units must be sold?
7. Oyeyemi Limited has two businesses named Abusi and Ere. The two
businesses have the following data:
Abusi Ere
Sales per unit 20 20
Variable cost per unit 4 12
Fixed cost per annum 100,000 50,000
You are required to:
a. Determine the breakeven in naira and units for each business.
b. What is the profit for each business if sales in units increase by
10% above the breakeven point?
c. If selling price per unit is N8 which of the two businesses will fare
better?
d. Compute the profit for each business if sales are increased by 20%
above the breakeven point.
e. If sales drop to 5,000 units which business will do better?
8. (a) What is the breakeven analysis? In what area of business is it
useful?
(b) Olamide store sells a product for N50.00. The variable cost associated
with the product is N35.00 per unit and the fixed cost is N200,000?
(i) How many units must be sold to breakeven?

205
 (ii) What profit will result if sales are increased by 5, 000
units?
9. Which of the following changes would have the effect of increasing the
breakeven point of a firm?
a. a decrease in fixed cost
b. a decrease in variable cost
c. a decrease in unit selling price
d. a decrease per unit with a decrease in activity level
e. none of the above

10. In cost-volume-profit analysis variable costs are costs that:

a. increase pre unit with an increase in the activity level
b. decrease per unit with decrease in the activity level
c. remain the same in total at different activity levels
d. remain the same per unit at different activity levels
e. none of the above
11. If sales are N300, 000 and sales at the break-even point are N250,000. What
is the margin of safety?.
a. 17%
b. 25%
c. 85%
d. 92%
e. 100%
12. The basic breakeven and cost volume Profit models are subject to some
limiting assumptions. Explain these assumptions.
13. The following information is given by Oladunni Ltd
Sales (in units) N20

206
Variable (in units) 6
Total fixed costs N100,000
Calculate the following:
a. Contribution margin ratio
b. Contribution per unit
c. Break-even sales in Naira
d. Break-even sales in units
e. Sales (in units) required to obtain a net profit of N8,000
f. Sales (in units) to have a net profit of 15% of sales

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 CHAPTER 11

MARGINAL AND ABSORPTION COSTING

11.0 OBJECTIVES
At the end of this module you should be able to:
1. define marginal and absorption costing
2. state the advantages of marginal and absorption costing
3. State the disadvantages of marginal and absorption costing
4. Enumerate the reasons for the use of marginal and total/full absorption
5. Identify examples of decisions where marginal costing can be used
6. Identify areas of application of marginal costing

11.1 Introduction
Absorption costing also known as Total/Costing is the basis of all financial
accounting statements. It is the process by which all overheads are absorbed into
production. The absorption approach does not distinguish between fixed and
variable costs. Total overhead contains fixed costs, which do not change with the
level of activity, e.g. rent and variable costs which vary with the level of activity,
e.g. raw material usage. It also contains the valuation of stock' and work-in-
progress (WIP)

Marginal costing is a process of charging variable costs to cost units and the fixed
costs to the relevant period. It includes direct material; direct labour, direct
expenses and the variable part of overheads. Contribution is the difference
between sales and variable cost/marginal cost. Fixed cost is subtracted from the
contribution to arrive at net profit. In marginal costing, fixed costs are not

208
absorbed into costs of production; they are treated as period costs and written off
to profit and loss account

In finding the cost of goods produced or sold, two methods of costing are applied:
(a) Variable or marginal costing
(b) Absorption costing
The difference between these two methods is in the application of fixed costs and the
valuation of stock.
The term contribution mentioned above is the difference between sales and
marginal cost thus:
Marginal cost = variable cost = Direct Material:
+Direct Labour
+Direct Expenses
+Variable Overheads

Contribution = Sales - Marginal Cost

Other names of marginal costing are contribution approach and direct costing.
These are treated as product cost.

11.2 Uses of Marginal and Absorption Costing. Marginal Costing:

(1) It provides information to management for planning and decision making in
the short term involving changes in volume or activity and related cost charges.
(2) It is used to cancel the deficiency of absorption costing
(3) Used in the calculation of cost and the valuation of stocks.

Absorption costing
It is used in the calculation of cost and the valuation of stocks. It is used for
external reporting purposes because Generally Accepted Accounting

209
Principles(GAAP) require fixed and variable manufacturing overhead costs to
be absorbed as product costs:
1. All costs manufacturing, selling and administration are analyzed to know
which are fixed or variable. A mixed cost is separated into fixed and
variable costs.
2. Variable and manufacturing costs as illustrated above are treated as
product costs. The work-in-progress, finished goods and cost of goods
sold are valued as costs that vary proportionately with volume.
3. All fixed manufacturing costs including selling and administrative costs
are treated as period costs and charged to profit and loss account of the
period. The variable selling and administrative expenses are separated
from the fixed selling and administrative expenses for preparation of profit
and loss account. The variable selling and administrative expenses are
deducted from sales to determine the contribution margin. The fixed
selling, administrative expenses and the fixed manufacturing overheads
costs are subtracted from the contribution margin to determine the net
profit for the period.
Marginal cost treats fixed cost as a period cost, therefore fixed costs are not
included in the closing stock for the period. Fixed costs are treated as period costs
because it is incurred periodic ally and not on the production of particular goods.
For example, fixed costs like rent will still be incurred whether production takes
place or not.
Administrative and selling costs are not included in the closing stock.
Variable overhead cost is not an indirect cost but it is part of marginal cost
because in production of goods, variable overheads cost will be incurred.
Absorption costing includes fixed costs as a period cost of goods sold and part of
closing stock. It has variable cost and fixed cost as production cost for the reason that
both costs are necessary for production to recover all cost with profit. Absorption

210
costing does not charge all fixed cost on increases in production.

All administrative and selling expenses whether fixed or variable costs are
charged against profit and loss account. Closing stock is arrived at by multiplying the
number of units in closing stock by the unit cost of production. Administrative and
selling expenses are not included in the closing stock.
In absorption costing, fixed cost is incurred in stock valuation. Therefore
absorption costing transfers some of this period fixed cost into next period to be
charged against the revenue from the stock carried forward assuming it is sold.
Marginal costing writes off all fixed

When there is increased stock in any period, absorption costing will show higher
profit than marginal costing. On the other hand in a period of decreasing stocks,
marginal costing will show higher profits. This difference is due to the treatment of
fixed costs in the valuation of stock.

11.4 The Difference Between Marginal And Absorption Costing

The major difference between the two approaches of costing is the timing of
deduction of the fixed manufacturing costs.
The marginal costing approach charges fixed cost to profit and loss account as they
are incurred.

Absorption costing charges the fixed manufacturing cost to the products produced
during the period and is deducted from profit and loss account when the products are
sold.
When sales and production volumes are equal, stock will not increase or decrease.
Therefore, the same amount of fixed manufacturing costs will be charged to the profit
and loss account in both approaches. The net profit of marginal costing will be equal

211
to the net profit of absorption costing.
If sales and production volumes are different, the net profit of marginal costing will
be different from the net profit or absorption costing.
When production exceeds sales, (i.e. increased stock) part of the fixed
manufacturing cost in absorption costing will form part of stock of future period.
Therefore net profit in absorption costing will be greater than marginal costing net
profit.
When sales exceed production, i.e. decrease in stock or no stock marginal costing net
profit will be higher than that of absorption costing.

FORMAT 1
Format of Marginal Costing Technique
N N
Sales xx
Less Variable cost of goods sold:
Opening Stock xx
Add Production Cost xx
Less Closing Stock (xx)
xx
Add other variable cost xx xx
Total Contribution xx
Less Period Cost:
Fixed production overhead xx
Fixed Selling and distribution cost xx
Administration Cost xx (xx)
Net Profit xx
1. Fixed production overheads are treated as a period cost to be written off in
total for the year. It is excluded from stock valuation.

212
2. Opening stock, production and Closing stock are valued using variable cost
of production.

FORMAT 2
Format of Absorption Costing Technique
N N
Sales xx
Less cost of goods sold:
Opening Stock xx
Add Production Cost xx
Less Closing Stock xx
xx
Add /less under/over absorbed cost
Fixed production overhead xx (xx) xx
Gross Profit xx
Less Expenses
Selling and distribution (variable and fixed) xx
Administration Cost xx xx
Net Profit xx

Opening stock production and closing stock are valued using full cost of
production i.e. both variable and fixed production cost.

Example 11.1:
20,000 units of a product were produced and sold by Onirin Ltd. Costs and
sales were as follows:

213
 N
Sales 200,000
Production cost
Variable costs 70,000
Fixed costs 30,000
Administrative and Selling overheads 50,000
Required; Present the above statement using both the marginal approach and
absorption approach

SOLUTION
Marginal Approach Absorption Approach
Sales N200,000 Sales 200,000
Less marginal cost (70,000) Less Production cost of sales 100,000
Contribution 130,000 Gross Profit 100,000
Less fixed cost Less Admin + Selling
Production (30,000) Overhead 50,000
100,000
Administrative
Selling 50,000
Net profit 50,000 50,000
The above example illustrates the characteristics of marginal and absorption
costing approaches.

214
Finding the cost and profit per unit

Absorption Approach
N
Selling price per unit 10.00
Less total cost per unit 150,000 (7.50)
20,000
Profit per unit 2.50

Marginal approach

Selling price per unit 10.00

Less marginal cost per unit 70,000 (3.50)
Contribution per unit 20,000
6.50

The closing stock using the two approaches:

Marginal costing N70, 000
20,000

= N3.5 per unit

Absorption costing N100,000

20,000

N5 per unit.

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11.5 Treatment of Stock in Marginal and absorption Costing

Example 11.2
Following example 11.2 let us accept that out of 20,000 units produced 16,000 were
sold, 4,000 units were carried as stock to the next period.
N N
Marginal Costing Approach
Sales - (16,000 x N 10) 160,000
Cost of goods available per sale 70,000
Less closing stock 4,000 x 3.5 14.000 (56,000)
Contribution 104,000
Less fixed costs:
Production 30,000
Administrative and Selling cost 50,000 (80,000)
Profit 24,000
Absorption Costing:
N N
Sales 16,000 X N10 160,000
Total cost of goods available for sale 100,000
Less Closing stock 4,000 x N5 20,000 (80,000)
Gross profit 80,000
Less administrative and selling overheads (50,000)

Net profit 30,000

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 11.6.1 ADVANTAGES OF ABSORPTION COSTING METHOD
i) All costs of production find their way into the costs per unit of
production hence no valid production costs can be overlooked.
ii) Valuation of closing stock is generally acceptable.
iii) Absorption costing is used for Income Tax purposes and external
financial statements.

11.6.2 DISADVANTAGES OF ABSORPTION COSTING METHOD,

i) The cost figures attributed to each unit of production are dependent on the
level of costs incurred as well as the volume of production. All increase in
volume can cause an apparent reduction in cost per unit even in cases
where the underlying cost structure is unaltered.
ii) Fixed overheads are difficult if not impossible to accurately attribute to
each unit, hence they by genuinely being dependent on the various allocation
methods used.

11.7 Advantages of Marginal Costing

1. It furnishes data regarding costs, volume revenue and profit to
management.
2. It presents cost data to highlight the relationship between sales and
variable production cost which move in line with sales.
3. It presents how changes in production volume affect costs and income.

Disadvantages of Marginal Costing

1. Marginal costing is not a generally accepted method of inventory
costing for external reporting purposes.
2. In marginal costing where statistical techniques are used to separate

217
 costs into variable and fixed components, the results may lead to errors.
3. In marginal costing, no fixed factory overhead cost is included in
work-in or finished goods inventories. There, the inventory figures
do not reflect the total cost of production and key do not present
a realistic inventory/stock cost valuation on the balance sheet.

ILLUSTRATION 1
In the year 200X, Colour limited produced and sold 20,000 units of white.
Relevant costs and revenue are as follows:
N
Sales - 2,000,000
Production Costs:
Variable 700,000
Fixed 300,000
Administrative + Selling Overheads
Fixed 500,000
You are required to prepare operating statements based on both Absorption and
Marginal Costing.

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SOLUTION 1:
COLOUR LTD.
OPERATING STATEMENT FOR THE YEAR ENDED 200X
Absorption Costing Approach Marginal Costing Approach
N N
Sales 2,000,000 Sales 2,000,000
Less Prod. Cost of Sale 1,000,000 Less Marginal Cost 700,000
Gross Profit 1,000,000 Contribution 1,300,000
Less Fixed cost:
Less Admin. Selling Production 300,000
O/Heads 500,000 Distribution 500,000 800,000)
Net Profit 500,000 Net Profit 500,000

ILLUSTRATION II
In the year 200x, Colour Ltd produced and sold 20,000 and 18,000 units of white
respectively. Cost structure was as contained in Illustration 1. You are required to
produce operating statements based on marginal costing and absorption costing
principles.

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SOLUTION II
COLOUR LTD.
OPERATING STATEMENT FOR THE YEAR ENDED 200XAbsorption Costing
Approach Marginal Costing Approach
N N
Sales (18,000 x N100) 1,800,000 Sales(18,000 units x N100) 1,800,000
Less Prod. Cost of Sale 1,000,000 Less Cost of Sales 700,000
Less Closing Stock (100,000) (900,000) Less Closing of Stock(700,000) (630,000)
Gross Profit 1,000,000 900,000 Contribution 1,170,000
Less Fixed cost:
Less Admin + Selling Production 300,000
Overheads (500,000) Admin Selling &
Distribution 500,000 (800,000)
Net Profit 400,000 Net Profit 370,000

Working Note:
i. The Closing Stock Valuation using absorption costing method.
Total Cost = Nl. 000.000 N50 per unit
Total Unit Produced 20,000 units = Average production cost
including fixed costs.

ii. The closing stock valuation using marginal costing approach

Total Variable cost = N700,000 N35 per unit
Total unit produced 20,000 = variable cost only.

11.8 ARGUMENTS FOR THE USE OF MARGINAL COSTING

Arguments for the use of marginal costing in routine costing are as follows:

220
 (a) Simple to operate
(b) No apportionment, on arbitrary basis, of fixed costs to products
or departments. Many fixed costs are indivisible by their nature.
(c) Where sales are constant but production fluctuates ,marginal costing
shows a constant net profit whereas absorption costing shows different
amounts of profit.
(d) Under-or over-absorption of overheads is avoided. The usual reason
for under/over-absorption is the inclusion of fixed costs into
overhead absorption rates and the level of activity being different to the
planned.
(e) Fixed costs are incurred on a time basis e.g. salaries, rent, rates etc and
do not relate to activity. Therefore, it is logical to write them off in the
period they are incurred and this is done using marginal costing.
(f) Accounts prepared using marginal costing approach is the same as the
actual cash flow position.

11.9 ARGUMENTS FOR THE USE OF TOTAL/FULL ABSORPTION OF

ROUTINE COSTING
(a) Production cannot be achieved without incurring fixed costs which thus
form an inescapable part of the cost of production so it should be included
in stock valuations. Marginal costing may give the impression that fixed
costs are somehow divorced from production.
(b) Where production is constant but sales fluctuate, net profit fluctuations
are less in the core of absorption costing than with marginal costing.
(c) Where stock building is a necessary part of operations e.g. timber
seasoning etc, the inclusion of fixed costs in stock valuation is necessary
and desirable.

221
 (d) The calculation of marginal cost to arrive at contribution margin may
lead to the firm setting prices which are below total cost. Absorption
cost makes this less likely. On the other hand it may not experience the
problem because of the automatic inclusion of fixed charges.
(e) S A S 4 (stock and work in progress) recommends the use of absorption
costing for financial accounts because costs and revenues must be
matched in the period when the revenue occurs and when the costs are
incurred.

11.10 EXAMPLES OF DECISIONS WHERE MARGINAL COSTING

CAN BE USED
Many situations in which marginal costing can provide useful information
for decision making are given below:
(a) Acceptance of a special order
(b) Dropping a product
(c) Choice of product where a limiting factor exists.
(d) Make or buy.

11.10.1 ACCEPTANCE OF A SPECIAL ORDER

We mean the acceptance or rejection of an order which utilizes spare capacity
but which is only available if a lower than normal price is quoted.

ILLUSTRATION III
For many years, demand for the product of Colour Ltd a company based in
Lagos has fallen steadily. This resulted in considerable excess capacity. The
standard cost card for the product of the company, the 'White' is based on an
output of 20,000 units per annum: though facilities exist for the manufacture of

222
 100,000 units per annum. The standard unit cost appears as follows:

Variable cost: N
Direct Material 20
Direct Wages 10
Prime Cost 30
Variable Overhead 10
Variable Cost 40
Fixed Overheads 24
Total Production cost 64
Selling Prices 60
Loss per Unit (4)

A market exists for the product in the Eastern states of Nigeria at a selling price of
N47.00 each and it is estimated that 80,000 units per annum could be sold at this
price.
The additional cost of selling and distribution would be N2.00 per set. The sale of sets
in the East would not affect sales in Lagos. Would it be profitable to sell sets at this
price? Give reasons for your answer.

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SOLUTION III
COLOUR LTD.
OPERATING STATEMENT FOR THE YEAR ENDED 200X
Sales in Lagos only Sales in Lagos & the East
N N
Sales 1,200,000 4,960,000
Direct Materials 400,000 2,000,000
Direct Wages 200.000 1.000.000
Prime Cost 600,000 3,000,000
Variable Overhead 200,000 1,000,000
Selling Distribution - (800.000) 160,000 (4,160,600)
Contribution 400,000 800,000
Less Fixed Overhead (480.000) (480.000)
Profit/(Loss) (80.000) 320,000

Decision: It will be profitable to accept the special order at N47.00 per set in the Eastern
States.
Working Note:
Lagos only Lagos & East
N N
Sales in 20,000 x N 60 1 ,200,000 1 ,200,000
80,000 units x N 47 - 3,760,000
1,200.000 4.960.000
There are several other factors which would need to be considered before a final decision is
taken; viz.
i) Is it absolutely certain that fixed costs will not alter?
ii) Is the special sale (in the East) the most profitable way of using the Spare capacity?
iii) Will the acceptance to sell in the East at a lower price lead other customers to
demand lower prices as well?

224
11.10.2 DELETING A PRODUCT OR SEGMENT
If a company has a range of products and one of it is not making profit is, it
may consider deleting the item. Analysis of the cost of different products on
marginal costing principles shows that:
(a) Products, which appear to show the largest net profit, do not necessarily make
the largest contribution to total profit.
(b) It may be profitable to sell articles, which appear by other costing methods, to
show a loss.
(c) It may be advantageous in time of depression, or where there is surplus
capacity to sell goods below total cost.

ILLUSTRATION IV
Colour Ltd. manufactures four products White, Blue, Red and Yellow. The costs,
profits and sales of which are as follows:

225
 PRODUCT
White Blue Red Yellow Total
N N N N N
Direct material 30,000 40,000 50,000 20,000 140,000
Direct wages 10,000 30,000 40,000 20,000 100,000
Variable overhead 16,000 40,000 40,000 20,000 116,000
Fixed overhead 16,000 80,000 90,000 20,000 206,000
Net profit/(Loss) 8,000 50,000 (20,000) 40,000 78,000
Sales 80,000 240,000 200,000 120,000 640,000
% of profit to sales 10% 20.83% (10%) 33.33%

Management is thinking that the business would be better to cease production of

product red and make White, Blue and Yellow. You are to advise management on
this line of action or the proposal as the consultant to the company.

SOLUTION IV
If products Red were discontinued and no change took place either in the sales of
other products or in the level of fixed costs, the total profit and loss account
would appear as follows:

White Blue Red Yellow Total

N N N N N
Sales 80,000 240,000 200,000 120,000 640,000
Direct material 30,000 40,000 50,000 20,000 140,000
Direct wages 10,000 30,000 40,000 20,000 100,000

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 Variable overhead 16,000 40,000 40,000 20,000 116,000
(56,000) (110,000) (130,000) (60,000) (356,000)
Contribution 24,000 130,000 70,000 60,000 284,000
Fixed Cost (206,000)
Net Profit 78,000

Sales (N640,000 - N200, 000) N440, 000

Less Variable Cost:
Direct Material (N140,000 - N50,000) N90,000
Direct Wages (N100,000 - N40,000) N60,000
Prime Cost N150,000
Variable overhead (N116,000 - N40,000) 76,000 (226,000)
Contribution 214,000

Conclusively, product Red should not be discontinued based on the following

facts:
(i) It contributes N70,000 towards the overall recovery of the company’s fixed
cost and realized profit.
(ii) It’s deletion will reduce overall profit to N8,000 (N78,000 – N70,000)
(iii) The contribution of yellow though lower than that of Red, it should not be
deleted. Efforts should be geared towards improvement in sales.

Fixed Cost (206,000)

Net Profit 8,000

The reduction in net profit from N78, 000 to N8,000 will be seen to be equal to the

227
contribution of product Red N70,000.
Note: the deletion of a product or segment with negative contribution will increase profit
by the same amount while a product or segment with positive contribution will reduce
profit by the same amount
Contribution of the various product are as follows:

Product Contribution P/V Ratio (C/S)

White 24,000 24,000 x 100 = 30%
N80, 000
Blue N130,000 130,000 x 100 = 54.17%
240,000
Red N70,000 70,000 x 100 = 35%
200,000
Yellow N60, 000 60,000 x 100 = 50%
120,000
It will be seen from these figures that the 'Loss Making' product Red actually
contributes to total profit a greater amount per N1 of sales than product White,
which on a total cost basis shows a 10% profit. Similarly, product Blue which
makes 20.83% overall profit contributes a greater amount than Product Yellow;
although the latter shows a much higher profit on the total cost basis.

11.10.3 CHOICE OF A PRODUCT WHERE A LIMITING FACTOR

EXISTS
This is where a firm has a choice between various types of products which it
could manufacture and where there is a single, binding constraint.

228
A limiting factor is described as a resource out of the various factors of production
which limits the continuous expansion of the productive capacity of an organization
beyond certain level as a result of the fact that such factor is limited in supply.
Examples of key limiting factor may include material, labour, processing time
capacity etc

Where a common limiting factor restrict sales of all products maximum profitability
is achieved by comparing the contribution of each product per unit of limiting
factor and choosing that which provides the greatest return.

ILLUSTRATION V
Colour Ltd. Manufactures three products; White, Blue and Red. Each
product/passes through the same production operations spending ne same
proportion of total processing time. The company's operations are restricted
solely by its productive capacity. Already market is available at current prices
for unlimited quantities of any one or more of the products.
The cost of producing each of the various products is as follows:

229
 White Blue Red
N N N
Variable costs:
Direct material 8 20 50
Direct wages 12 10 30
Variable O/H (N1 / hr) 10 20 30
30 50 110

White Blue Red

N N N
Fixed costs:
Fixed Overhead (N1/hr) 10 20 30
Profit 40 70 140
Cost 20 30 80
Selling price 60 100 220

Assuming the production working hours are limited to 30,000 hours, determine
which product pays the company to concentrate on.

230
Solution V
White Blue Yellow
N N N N N N
Selling Price 60 100 220
Direct material 8 20 50
Direct wages 12 10 30
Variable O/H 10 (30) 20 (50) 30 (110)
Contribution/hr 30 50 110

Contribution/hr N30 N50 N110

10 20 30
N3/hr N2.5/hr N3.67/hr

Remarking 3rd 2nd 1st

Optimal product mix under a key limiting factor

Optimal product mix that will maximize profit on organization is possible by applying the
following steps:
(i) Identify the key limiting factors away the known factors of production. This will be
achieved by comparing the total resources required with total resource available.
(ii) Identify the key factor per unit for each of the product line
(iii) Calculate the product per unit, savings per unit or relevant cost per unit for each of the
product line.
(iv) Divide contribution per unit or savings per unit by the key limiting factor required also
per unit
(v) Rank the result obtained in (iv) above in a descending order
(vi) Identify the maximum unit demanded by each of the product line
(vii) Consider the issue of priority allocation among the various product lines and comply if
it is specifically provided

231
(viii) Prepare an allocation table for the purpose of allocating the available key
limiting factor based on the format below

Ranking Products Demand Key factor Commitment Balance

per unit allocated
1
2
3

(ix) Allocate the key factor among the various competing product line based on the
order of ranking established in (v) above
(x) Identify the optimal product mix factor from the allocation table in (viii) above

ILLUSTRATION VI
Ibori Limited is considering 3 products White, Blue and Yellow. The information
regarding these products are as given in V. The unites demanded for White, Blue and
Yellow are 700, 900, and 300 respectively

Required:
What product mix will maximize the annual contribution, assuming the labour is
stricted to 30,000 hrs.
White Blue Yellow
N N N N N N
SP 60 100 220

232
Direct material 8 20 50
Direct wages 12 10 30
Variable O/H 10 30 20 50 30 (110)
30 50 110

Contribution per key factor

White Blue Yellow
Contribution 30 50 110
H/u 10 20 30
Contribution/hr 3/hr 2.5/hr 3.67/hr
Ranking 2nd 3rd 1st

Allocation table for 30,000hrs

Ranking Products Demand Key factor Commitment Balance
per unit allocated
1 Yellow 700 30 21,000 900
2 White 900 10 9,000 -
3 Blue 300 20 -

Optimal mix
Yellow 700 units
White 900 units

11.10.4 MAKE OR BUY DECISION

In many cases, a business may be in a position either to manufacture
particular components or to buy them outside, and the cost accountant is asked to

233
advise which course of action should be followed.

It will be appreciated that where total cost of manufacture is compared with

outside suppliers price, the cost includes some absorption of the fixed expenditure,
which will be incurred whether the goods are manufactured or not. Where
however, a business is already operating at full capacity, the manufacture of the
articles would restrict saleable output, and it is then necessary to take into
consideration the fixed costs and also the profit on the saleable output which will
be lost by applying the facilities else where.

I LLUSTRATION VI
Colour Ltd is considering whether to manufacture or purchase white
components, which can be obtained from an outside source for N700 per 1000.
The marginal and total cost of the components, are respectively N480 and N800
per 1000.

The manufacture of these components would involve work on a machine which is

currently operating at full capacity, and figures have been produced to show that for
each thousand of component white manufactured, the sales of a finished product
Blue will be restricted by 250. The marginal cost and selling price of product Blue
are N1000 and N 1600 per 1000 respectively. Is it more profitable to purchase or
manufacture the white components?

SOLUTION VI
To solve this problem, we have to compare the net marginal cost of manufacture
with outside price thus:

234
 N
Marginal Cost per 1000 White 480
Add: Loss contribution on Blue (250 x N0.60) 150
630
Outside price 700
Overall Profit N700- N630 = N70

The Overall profit will be N70 per 1000 if the components white are manufactured
rather than bought form outside.

Working Note:
Contribution of Blue product per unit is calculated as follows:

N
Selling price per 1000 units 1,600
Marginal Cost per 1000 Units 1,000
Contribution per 1000 Units 600
Contribution per Unit = 600 = N0.60
1,000

1.11 Summary
In this module you have learnt that:
1. Absorption costing is the basis of all financial accounting statement and
the process of absorption of all overheads.
2. Marginal costing is the process of charging variable costs to cost units
and fixed costs to the relevant period.
3. Marginal costing is used for planning and decision making. It is also

235
 used for the calculation of cost and valuation of stock.
4. Production costs, manufacturing selling and administrative costs are
analyzed into fixed and variable costs, i.e. A mixed cost is separated into
fixed and variable costs;
5. Marginal and absorption 'costing is different in the timing of deduction of
the fixed manufacturing costs and in the valuation of stock.
6. How to solve problems on marginal and absorption costing approaches.

11.12 Exercises
1. Alagbara Ltd manufactured 4,000 units of a product and had these data for the
year 2006.
Direct material per unit 15
Direct labour per unit 10
Variable manufacturing overhead per unit 3
Selling price per unit 50
Fixed selling and administrative expenses 15,000
Fixed manufacturing overhead 48,000

There was no beginning stock in 2005 and 3,800 units were sold during the year.

Required
(a) Calculate the marginal cost per unit
(b) Calculate the absorption cost per unit.
(c) Calculate the net profit using marginal approach
(d) Calculate the net profit using absorption approach.

3. The following records are from Ore-Oluwa Ltd:

236
 N
Sales per unit 20
Variable manufacturing cost per unit 8
Variable selling and administrative cost per unit 2
Fixed costs:
Manufacturing 80,000
Selling and administrative 60,000
Number of unit produced 80,000
Number of unit sold 60,000
You are required to:
(a) Calculate the net profit for the period using marginal and absorption
costing.
(b) Give the value of closing stocks for marginal and absorption costing.
(c) Give the difference in net profit between marginal costing and absorption
costing.
4. Which of the following would not be deducted in determining the
contribution margin under variable costing?
a. Sales commissions
b. Direct labour
c. Sales office depreciation
d. Variable factory overhead
e. Variable fixed overhead
5. Merry Mary Ltd has the following data for the month of March
Sales (in units) 200
Sales price (in units) N40
Variable manufacturing cost (in unit) N10
Fixed cost N600

237
 Variable selling and Administrative cost (in units) N8
Fixed selling and administrative cost (in units) N220
Using the absorption costing and marginal (direct) method, prepare an
income statement for the month of March.

6. Tinuola manufacturing Ltd has the following data for the year ended 31st
Dec. 2010
N
Production cost
Direct materials 33,600
Direct labour 504,000
Factory overhead
Variable 180,000
Fixed 360,000
Sales commission 88,000
Fixed sales salaries 92,000
Fixed general and administrative 124,000
Units of production 150,000 units
Units of sales (at N36) 60,000 units
Complete the amount in income before tax and closing inventory under:
a. Marginal (direct) costing
b. Absorption costing

7. The manufacturing margin under variable costing is determined by

deducting
a. Equipment commission

238
 b. Selling commissions
c. Direct materials
d. Plant manager's salary
e. Indirect materials

8. Which of the following elements of cost is included in the cost of goods

manufactured under absorption costing but not under variable costing?
a. Direct labour
b. Fixed factory overhead
c. Variable factory overhead
d. Direct materials
e. All of the above
9. When units produced are in excess of units sold, the income from
operations under absorption costing will be--------the income from production
under variable costing.
a. Equal to
b. Less than
c. Greater than
d. Either greater or less than
e. None of the above.

239
 CHAPTER 12
STANDARD COSTING
12.0 Objectives
At the end of this course you should be able to:
1. Define Standard cost and standard costing
2. Calculate variance analysis, involving material, labour and overhead
3. State types of Standard in cost Accounting
4. Differentiate between standard and Budget
5. Understand the Objectives of Standard Costing
6. Mention the advantages of Standard Costing
7. Explain disadvantages of Standard Costing
8. Explain how to set Standards and Problems Involved
9. State the Behavioural Aspects of Standards
10. Solve problems on variances (Material, Labour and overhead).

12.1 INTRODUCTION
This module introduces standard costing and defines the main types of
standard, the relationship between standard and budget. Standard Revision
and the all important behavioural aspect of standard costing are discussed.
Finally, the problem in setting standard,its advantages and disadvantages,
and the calculation of variances coupled with variance analysis are given.
Standard costs are pre-determined or forecast estimates of cost to manufacture
a single unit, or a number of units of a product, during a specific immediate
future period.

240
 Standard costs are usually planned cost of the product under current and
anticipated conditions. They are used as a measure with which the actual cost,
as ascertained, may be compared.

Standard costing is a technique which establishes predetermined estimates of

the costs of products and services and then compare these predetermined costs
with actual costs as they are incurred.

The difference between standard cost and the actual cost is known as a
variance and the process by which the total difference between actual cost
and standard cost are analysed is known as Variance analysis.

Variance can be Adverse or Favourable, Variances are "adverse" where

actual cost is greater than standard while variances are "favourable" where
actual cost is less than standard. Alternatively, these variances may be
known as minus (Adverse) or plus (Favourable) variances.
Standard costing is a useful tool, which can be used in a variety-of costing
situations, batch and mass production, process manufacture, transport etc.Its
major application in practice is in organizations involved in mass production
and/or respective assembling work.

12.2 TYPES OF STANDARD IN COST ACCOUNTING

There are four types of standard namely:
i. Basic
ii. Ideal
iii. Attainable
iv Current

241
(i) BASIC STANDARD
It is a standard established for use over a long period of time from which a
current standard can be developed.
It is a long-term standard, which remain unchanged over the years. Its
main purpose is to show trends over time for such items as material prices,
labour rates and efficiency and the effect of changing methods.

(ii) IDEAL STANDARDS:

It is defined as a standard, which can be attained under the most favourable
conditions. These are based on the best possible operating conditions i.e.
no power failure, no break down of machines, no material wastage, no idle
time, in short, perfect efficiency.

(iii) ATTAINABLE STANDARD:

It is defined as a standard, which can be attained if a Standard Unit of work
is carried out efficiently, machine properly operated or material properly
utilised.

This is the most frequently encountered standard. It is a standard based on

efficient but not perfect operating conditions i.e. there are provisions for
normal material losses, machine break down, power failure, etc.

(iv) CURRENT STANDARD:

It is defined as a standard established for use over a short period of time related
to current conditions. It is a standard set over a limited period to reflect current
conditions. A particular example of the use of current standard is in inflationary
circumstances.

242
1 2.3 STANDARDS AND BUDGETS
Both Standards and Budgets are concerned with setting performance and cost
levels for control purposes. They therefore are similar in principle though
different in scope. Standards are a Unit concept where as Budgets are
concerned with totals.
Budgets are revised on a periodic basis, frequently as an annual exercise
whereas standards are revised only when they are inappropriate for current
operating conditions which can be more or less frequent than budget revisions.

Budgets are memorandum figures and do not form parts of the double entry
accounting system whereas standard and resulting variances comply with
double entry accounting system.

Lastly it is possible to have budgeting without standard costs. It is not possible

to have a standard cost system without a total cost budgeting system.

12.4 OBJECTIVES OF STANDARD COSTING:

The following are the objectives of standard costing:
i) To provide a formal basis for assessing performance and efficiency.
ii) To assist in budget preparation.
iii) To motivate management and staff.
iv) To enhance the use of principle of "management by exception"
i.e. concentration on access feeding afflation more than curse
operating as expected at the operational management level.
v) To assist in stock valuation
vi) To establish a basis for improving performance

243
 vii) To establish responsibility for deviation from standard in order to correct
deficiencies or capitalize on benefit.
viii) To keep abreast with time on this volatile business environment with
rapidly changing technology, rates and prices. Standards quickly become
out of date and thus lose their control and motivational effects.
ix) Overly too elaborate variances may be imperfectly understood thus
losing their control purposes.
x) Standard cost involves an analysis of variances on post events while
past events cannot be changed; the variances are therefore only useful
in guiding management in dealing with similar events in the future. And
this requires the same events which may not hold in reality.
xi) Lastly, some behavioural problems could arise owing to the operation
of standard costing techniques.

12.5 SETTING STANDARD

The line managers who have to work with and accept the standards must be
involved in establishing them. These managers and their superiors have the
ultimate responsibility for setting the standards. Work study staff,
accountants and other specialists provide technical support and information
but do not make the final decision upon standards and performance levels.
Considerable effort is involved in establishing standard costs and keeping them
up to date.
Standard must be set for each of the four elements of costs namely:
(i) Direct material
(ii) Direct labour
(iii) Variable Overhead
(iv) Fixed Overhead

244
12.5.1 STEPS IN SETTING STANDARD COSTING
1. Set performance target
2. Calculate the actual result.
3. Compare the actual results with the set performance standards to get
the difference which is the cost variable.
4. Investigate the course of the variance known as variance analysis .
5. Report variances to the officers in charge.
6. Management takes appropriate action which may lead to the revision of
standards to improve future performance.

12.6 BEHAVIOURAL ASPECTS OF STANDARDS

In view of the detailed nature of standard costing and its involvement with
Foreman and production workmen, communication becomes of even greater
importance. Production workers frequently regard any form of performance
evaluation with deep suspicion and if a cost conscious; positive attitude is to
be developed, close attention must be paid to the behavioural aspects of the
system. Full participation realistic standards, prompt and accurate reporting, no
undue pressure or censure - all contribute to an acceptable system.

12 6.1 REVISION OF STANDARDS

Standards can be revised under any of these circumstances:
(i) When there are changes in technology, methods, material usage, etc.
(ii) When there is a change in company's policy e.g. wage policy.
(iii) When they are no longer in conformity with the current practice.

245
12.6.2 PROBLEMS IN SETTING STANDARD COSTS
The following problems are encountered in setting standard cost:
i. Incorporating inflation into planned unit costs.
ii. Agreeing a labour efficiency standard.
iii. Deciding on the quality of materials to be used.
iv. The problem of forecasting error.
v. Estimating material prices where seasonal price variations or bulk
purchase discounts may be significant.
vi. Deciding appropriate mix of component materials.

12.7 SUMMARY
In this module you have learnt that:
1. Standard Costs are predetermined or forecast estimates of cost to
manufacture a simple unit, a number of units of a product during a
specific immediate future period.
2. Standard costing is a technique which establishes a predetermined
estimateof the costs of products and services and then compares these
predetermined costs with actual costs as they are incurred. The
difference is known as a variance. The process by which the total
difference between actual cost and standard cost are analysed is known
as variance analysis.
3. There are four types of standards namely: Basic. Ideal, Attainable
andCurrent.
4. Both standard and budget are concerned with selling performance and
cost level for control purposes. They are similar in principle though
differ in scope.

246
 EXERCISES
1. What is standard costing? Explain in one sentence.
2. State two objectives of standard costing?
3. Name and explain four types of standard costing?
4. Itemise steps in setting Standards?
5. What are the behavioural aspects of standard costing?
6. What are the problems in selling standard costs?

247
 CHAPTER 13
STANDARD COSTING 2
13.0 OBJECTIVES:
At the end of this module you should be able to:
1) Solve problems on Direct material cost variances.
2) Calculate Direct labour cost variance - rate, time/efficiency variance and idle
variance.
3) Determine overhead cost variance - variable overhead expenditure variance,
variable overhead efficiency variances.
4) Solve problems on fixed overhead cost variance- Budget, spending, volume
and capacity Variances.

13.1 MATERIAL COST VARIANCE

The direct material price variances consist of;
(a) Direct material price variance: It is the difference between the standard price
and actual price for the actual quantity of material. It can be calculated at either
the time of purchase or usage depending on the information provided.
The formular for the price variance (SP - AP) QP/AU
Where,
SP = Standard Price
AP = Actual Price
QP = Quantity Purchased
AU = Actual Usage.
(b) Direct Material Usage Variance: This is the difference between the standard
quantity of materials that should have been used, and the actual quantity of
materials used multiplied by the standard price.
The formulae for calculating the direct material usage variance is

248
 (SU-AU)SP
Where,
SU = Standard Usage
AU = Actual Usage

ILLUSTRATION I
A product Y has a standard direct material cost as follows:
5kg of material X at N4.00 per kg = N20 per unit of Y.
During April 2005,600 kgs ofX wers purchased, which cost N2,280 while 100 units
of product Y were manufactured, using 520kg of material X.

Required: Calculate the following variances:

(a) direct material price
(b) direct material usage.
(c) total direct material cost

SOLUTION 1:
(a) The material price variance:
Let MPV = Material price variance
MUV = Material usage variance
MCV = Material cost variance
A = Adverse
F = Favourable
SP = Standard Price = N4.00 per unit.

249
 AP = Actual Price = N4228.0 = N3.80 per unit.
600
SU = Standiird Usage = (5kg x 100 units) = 500kg
AU = Actua Usage = 520kg.
QP = Quantity Purchased = 600kg.

a) The Material Price Variance (MPV):

MPV = (SP-AP)QP
= (N4.00 - N3.80) 600
= (N0.20) 600
= N120(F)

b) The material usage variance (MUV)

MUV = (SU-AU)SP.
= (500-520) N4.00
= (20) N4.00
= N80(A)

c) The Material Cost Variance = MCV

MCV = MPC + MUV
= N120 (F) + N80 (A)
= N40 (F)

ILLUSTRATION II
In an engineering factory one product, snow, is produced. From every ton of raw
materials X consumed it is estimated that 200 articles will be produced. N240 per
ton is to be taken as the standard price of the material.

250
50 tons of X material were issued for production during January. The actual price of
the material was N237 per ton. Production during the month was 10, 100 articles.

Required: Compute all relevant variances.

SOLUTION II:
Let: MPV = Material Price Variance
MUV = Material Usage Variance
MCV = Material Cost Variance
A = Adverse Variance
F = Favourable Variance
SP = Standard Price = N240 per Ton
AP = Actual Price = N237perTon
QP = Quantity Purchased = 50 tons
AU = Actual Usage = 10,100
200
= 50.5
a) The material price variance (MPV)
MPV = (SP-AP)QP
= ( N240 - N237) 50
= (N3.00)50
= N150 (F)

b) The material usage variance (MUV)

MUV = (SU – AU) SP
= (50.5 – 50) 409
= (0.5) N240
= N120 (F)

251
(c) The Total material Cost Variance (MCV)
MCV = MPV + MUV
= N150 (F) + N120 (F)
= N270 (F)

13.1.2 MATERIAL COST VARIANCES

a) Price Variances:
i) The rate of inflation is far greater than it had been possible to foresee.
ii) Extra taxes introduced by the government.
iii) Poor purchasing control materials have been placed too late for the
firm to manage to get the right price in the market.
iv) Materials have been bought in small lots at un-economic price instead
of in bulk.

b) Usage Variances
i) Inferior materials which bring a lot of waste
ii) Machinery unsuitable for the job.
iii) Materials Pug rage obviously aggravates a usage variance.

1 3 .2 LABOUR COST VARIANCE,

The total direct labour cost variance is subdivided into:
(a) Direct labour rate variance. This is the deference between the standard
direct labour rate per hour and the actual direct labour rate per hour
multiplied by the actual total hours worked.

252
 The formulae for the rate variance is (SR - AR) AH
Where AH is the Actual Hours worked
AR is the Actual Rate of pay per hour
SR is the Standard Rate of pay per hour

(b) Direct labour efficiency variance. It is the difference between the actual
hours taken to produce (i.e. excluding idle time) the actual output and the
standard number of hours that this output should have taken, multiply by the
standard rate per hour.

The formulae for the efficiency variance is (SH – AHT) SR.

Where SR = Standard Rate of pay per hour
AHT = Actual Hours Taken
SH = Standard Hours that should have been taken.

(c) Idle Time: It is caused by machine breakdowns, stock out, perhaps because
of bottlenecks in production or shortage of orders from customers. When idle
time occurs ths labour force is still paid for wages for time at work but no
actual work is done. In variance analysis, Idle time is an adverse efficiency
variance.

The formular for calculating the Idle Time is

= Hour(s) Idled per Employee X No. Of Employee X Standard Rate

ILLUSTRATION III
The standard direct labour cost of product Y 4 hours of grade 1.

253
Labour at N6.0 per hour = N24 per unit of product Y.
During May 2003, 200Units of product Y were produced and the direct labour
cost of grade 1 was N4880 for 785 hours of work.
Required:
Calculate the following variances:

(i) direct labour rate

(ii) direct labour efficiency
(iii) total direct labour Cost.

SOLUTION III
Let: DLRV = Direct Labour Rate Variance
DLEV = Direct Labcur Efficiency Variance
SR = Standard Rate = N6.00
AR = Actual Rate = N4880
785 = N6.217

AHT = Actual Hours taken = 785 hours

AH = Actual Hours worked = 785 Hours
SH = Standard Hours = 4 hrs x 200 = 800 hours
A = Adverse
F = Favourable

Direct Labour Rate Variance

(a) DLRV = (SR-AR)AH
= (N6.00- N6.217)785
= (N0.217) 785

254
 = 170.35 = N170 (A)

(a) Direct Labour Efficiency Variance = (DLEV)

DLEV = (SH-AHT)SR
= (800-785) N6.00
= (15) N6.00
= N90 (F)
(b) Total Direct Labour Cost Variance = DLCV
DLCV = DLRV + DLEV
= Nl70(A) + N90 (F)
= N80 (A)

ILLUSTRATION IV
Direct labour cost of product Y is as follows:
3 hours of grade 1 at N5.00 per hour = Nl5 per Unit of product Y.

During June 2003, 300 units of product Y were produced and the labour cost of
grade 1 was N4,400 for 910 hours. During the month, there was a machine break
down, and 40 hours were recorded as idle time.

Required: Calculate the following, variances.

a. direct labour rate.
b. direct labour efficiency.
c. idle time.
d. total direct labour cost

255
SOLUTION IV
Let: DLRV = The Direct Labour Rate Variance
DLEV = The Direct Labcur Efficiency Variance
SR = Standard Rate = N5.00
AR = Actual Rate = N4400
910 = N4,835

SH = Standard Hours = (3 hrs x 300 unit) = 900 hrs

AH = Actual Hours worked = 910 Hours
AHT = Actual Hours taken = (910 – 40) = 870 hours
Idle Hours = 40 hrs
F = Favourable
A = Adverse

(a) Direct Labour Rate Variance (DLRV)

DLRV = (SR-AR)AH
= (N5.00- N4.835)910
= (N0.165) 910
= N150.15 or N150 (F)

(b) Direct Labour Efficiency Variance = (DLEV)

DLEV = (SH-AHT)SR
= (900-870) N5.00
= (30) N5.00
= N150 (F)

256
(c) Idle Time Variance
= Idle time x SR
= 40 hrs x N5.00
= N200 (A)

(d) Total Direct Labour Cost Variance = DLCV

DLCV = DLRV + DLEV + Idle Time Variance
= Nl50(F) + N150 (F) + 200 (A)
= N100.00
LABOUR VARIANCE – CAUSES
i. Variance can arise owing to the use of, higher grade of labour than
necessary.
ii. Using Unsuitable Labour or unsuitable machinery.
iii. Workers trying to slow down work in order to earn more.
iv. The morale and the p hysical state of workers, using poor materials slows
down production.

13.3 VARIABLE PRODUCTION OVERHEADS VARIANCES

Variable Production Overheads:These are indirect production costs that are
usually assumed to vary with the labour hours worked.
The total variable production overhead variance can be sub-divided into:
(a) Variable Overhead Expenditure Variance: This is the difference between
the actual rate per hour for variable production overhead expenditure and
the standard rate per hour, multiplied by the hours worked (excluding any
idle time hours).

257
 The formulae for calculating the variable production overhead expenditure
variance is:
(SVOR-AVOR)AH
Where ,
AH = Actual hours worked excluding idle time
SVOR = Standard Variable Overhead Rate / per hour
AVOR = Actual Variable Overhead Rate per hour.

(c) Variable Overhead Efficiency Variance: this is the different between the
actual labour hour worked (excluding idle time) and standard labour hour
that should have been taken multiplied by standard variable overhead per
hour.
The formulae for calculating the variable production efficiency
variance is SVOR (SH-AHT).

ILLUSTRATION V
The Standard Cost card per unit for a spare part number X 2000 in a motor
assembly plant is given as follows:
Raw Materials 50 kgs at N5.00 per kg = 250.00
Direct Labour 14 hrs at N9.50 per hour = 133.00
Standard Unit Cost N383.00

During the month of May 2006, actual -esult was as follows:

Production 150 Units
Direct Material Purchase 7000 kg at a cost of N36,400
Direct Material Opening Stock 1300 kg
Direct Material Closing Stock 850 kg

258
Wages period for 2020 hours N19,796

You are required to calculate the total material and labour cost variances
SOLUTION
(a) The Material Price Variance (MPV)
MPV = (SP-AP)QP
= (N5.00 - N5.20) 7000
= N0.20 x 7000
= N1400.00 (A)

(b) The Material Usage Variance (MUV)

MUV = (SU – AU) SP
= (7500 – 7450) N5.00
= 50 x N5.00
= N250 (F)

(c) The Total Material Cost Variance (MCV)

Total MCV = MPV + MUV
= N1400 (A) + N250 (F)
= N1150.00 (A)

Working notes:
(i) AP = 36,400 = N5.20 per unit
7000

(ii) Standard usage (SU) = 50kg x 150 = 1500kg per unit

259
(iii) Actual usage (AU)
Opening stock = 1300kg
Add purchases = 7000kg
8300kg
Less closing stock (850kg)
Actual usage = 7450kg

(iv) Actual purchase = 7000kg

LABOUR COST VARIANCE

Let: LCV = Labour Cost Variance
LRV = Labour Rate Variance
LEV = Labour Efficiency Variance
2020
SH = Standard Hour = (14hrs x 150 units) = 2100 hours.
AH = Actual hour = 2020 hours
A = Adverse
F = Favourable
AHT = Actual Hour Taken = 2020 hours

(a) Labour Rate Variance = (LRV)

LRV = (SR-AR)AH
= (N9.50 - N9.80: 2020
= (N0.30)2020
= N606 (A)

260
(b) Labour Efficiency Variance = (LEV)
LEV = (SH-AHT)SR
= (2100-2020) N9.50
= (80) N9.50
N760 (F)

(c) Total Labour Cost Variance = LCV

LCV = LRV + LEV
= N606(A) + N760)(F)
= N154(F)

ILLUSTRATION VI
The variable production overhead of product Y is as follows:
2 hours at N 3 .00 per hour = N6.00 per unit.
During May 2003, 400 units of procuct Y were made. The labour force worked
820 hours of which 60 hours were recorded as idle time.
The variable overhead cost was N2,460.
Calculate the following variances:
a) Variable overhead expenditure variance
b) variable overhead efficiency variance.
c) variable overhead cost variance.

SOLUTION
(a) Variable i.e. overhead expenses
(b) Expenditure variance = VOEV
= SVOR – AVOR (AH)
= (N3.00 – N3.237) 760 hrs

261
 = N0.237 x 760 hrs
= N180.12 or N180 (A)

(c) Variable overhead expenditure variance VOEV

VOEV = (SH – AHT) SVOR
= (800 – 760) N3.00
= 40 x N3.00
= N120.00 (F)

(d) Total Variable overhead Cost Variance VOCV

VOCV = VOCV + COFU
= N180 (A) + N120(F)
= N60 (A)

Working Note
VOEV = Variable overhead expenditure variance
VOFV = Variable overhead efficiency variance
VOCV = Variable overhead cost variance
F = Favourable
A = Advance
SVOR = Standard Variable overhead rate = N3.00
AVOR = Actual variable overhead Rate = 2460 = 3.237
760
AH = Actual Hour worked (excluding idle time) = 820 – 60 = 760hrs
AHT = Actual Hour takeni = (820 – 60) Hrs = 760 hrs
SH = Standard Hours = (2hrs x 400) = 8hrs.

262
The variable overhead cost was N2,460.
Calculate the following variances:
a) The variable overhead expenditure
b) The variable overhead efficiency
c) The variable overhead cost variance

FIXED PRODUCTION OVERHEAD VARIANCES

FPOHU

Expenditure Volume

Capacity Efficient

Fixed production overheads are indirect production costs which remain constant
irrespective of production in the short run. Variances may arise because of changes in
the volume of output and changes in expenditure.

263
The total fixed production overhead variance can be sub-divided into:
a) Fixed Overhead Expenditure Variance
This is the difference batween budgeted fixed overhead and actual fixed
overhead.
Formula: BFO - AFO
Where:
AFO = Actual Fxed Overhead
BFO = Budgeted Fixed Overhead

b) Fixed Overhead Volume Variance

This is the difference between actual production overhead and budget
production overhead multiplied by the standard fixed overhead rate. Formulae:
AFPO – BFPO
Where: AFPO = Actual fixed production overhead
BFPO = Budgeted fixed production overhead

ILLUSTRATION VII
Tony Ltd produces product 3K which requires 3 standard hours. Fixed overheads
are budgeted at N24,000 and are absorbed on a labour hour basis. Budgeted output
is2000 units. Actual results:
Labour hours 220 hours
Overhead incurred N26000.

Determine:
a. Fixed overhead expenditure variance.
b. Fixed overhead volume variance.
c. Fixed overhead cost variance.

264
SOLUTION VII
a. Fixed overhead expenditure variance
It is the difference between the budgeted fixed overhead and the actual fixed
overheads incurred.
N
Actual fixed overhead 26,000
Budgeted fixed overhead 24,000
Fixed overhead expenditure 2,000 (U)

b. Fixed Overhead Volume Variance

It is the difference between actual production and budgeted
production multiplied by standard fixed overhead rate. It can be
determined by either:
1. (Actual production - budgeted production) x Absorption rate per hour
OR
2. (Actual hours - Budgeted hours) x Absorption rate per hour
Fixed overhead volume variance = (2000 -2200) x 12
= N2400 (F)
c. Expenditure variance plus volume variance is equal to fixed overhead cost.
= N1000 (A) + N2400 (F) = N1400 (F)

In volume variance, fixed overheads do not fluctuate in relation to output in the short
run. When actual production is less than budgeted production, the volume variance
will be unfavourable. When the actual production is greater than the budgeted
production, the volume variance will be favourable.
Causes of variances

265
 Expenditure/ spending
1. Using the wrong grade of labour
2. Changes in market price or labour rates
3. Wrong budgeting -

Volume variance
1. Avoidable machine breakdowns
2. Lack of tools and operations
3. Wrong budgeting
4. Wrong and poor instructions

ILLUSTRATION VIII
Tolorunju Ltd uses standard costing system for its production. Its standard and
actual data are:
Budgeted variable overhead cost = N15,000
Budgeted Fixed overhead cost = N20,000
Budgeted production level = 10,000 labour hours
Each unit of production needs 5 labour hours
Actual unit of output 1900 units
Actual labour hours used 9400
Actual fixed overhead cost N21,000
Actual variable overhead cost N14,000
Calculate:
a. Total overhead cost variance.
b. Variable overhead spending/expenditure variance.
c. Labour efficiency variable overhead variance.
d. Fixed budget/expenditure variance.

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 e. Fixed overhead volume variance.

SOLUTION VIII
Working:
Standard variable overhead rate per diisct labour hour = N15,000 = Nl.50 per
labour hour N10,000
Standard fixed overhead rate per direct labour hour = N20,000 =N2 per standard
direct N10,000 labour hour
Total standard overhead cost per direct labour hour = N3.50
The standard overhead cost per unit of output putting into consideration 5 labour
hours for each unit of output = N3.50 x 5 = N17.50

a. Standard total overhead cost for : N

1900 units of production = 1900 x N17.50 33,250
Less units of production overhead cost 35,000
Total overhead cost variance (U) 1.750

b. Actual labour hours taken 9,400 hours

Variable overhead budget allowed for N
9,400 labour hours = 9400 x N1.50 14,100
Actual variable overhead cost 14.000
Variable overhead spending variance 100 (F)
c. Actual hours of labour used 9,400
Standard hours of labour alloweDdfor production =1900 x 5 9,500
Hours of labour saved 100
Labour Efficiency Variance = 100 x N1.50 = N150 (F)

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 N
d. Fixed overhead Budget 20,000
Less actual fixed overhead cost 21,000
1000(U)

e. Budgeted labour hour 10,000

Standard labour hours of production 9,500
Volume variance 500 x N2=- N1000 (U)

SUMMARY
In this module you have learnt that:
1. Standard costing involves comparison of actual costs with pre-
determined costs and analysing the differences known as variances.
2. Standard relates to individual items, processes and product; budgets relate
to totals.
3. Standards are set for each of the elements of cost-materials, labour
and overhead.
4. Variance analysis is the process of analysing the differences between
standard and actual performance if materials, labour and overhead into
favourable and unfavourable parts for decision making.
5. The total cost variance is the total of all the variances of direct labour
cost variance and the variable and fixed overhead variances

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 EXERCISE
Morohuntodun Ltd uses a standard cost system. Its product E21 has the
standard unit cost as follows:
Standard material cost per unit= 2kg of material at N10 per kg
Actual details:
Output: 1000 Units
Material purchased and used 2200kg
Material cost N20,900

Determine:
1. The material Price variance
a. N900(F)
b. N900(A)
c. N898(A)
d. N1,100(F)
e. N1000(A)

2. The material usage variance

a. N1900(F)
b. N2000(A)
c. N2100(A)
d. N1800(P)
e. N1000(A)
Use the following information to answer questions 3 - 5
May Ltd, a manufacturer of a single product has the following budget data
Budgeted production - 1000 units
Budgeted labour hours - 3000 units

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 Budgeted labour cost - N15,000
Actual result
Output 1100 units
Hours paid for 3400 hours
Labour cost N17,680

Determine:
3. The labour rate variance
a. N680(A)
b. N600 (F)
c. N680(F)
d. N700(A)
e. N600(F)

4. The labour efficiency variance

:
a. N500(F)
b. N500(A)
c. N600 (F)
d. N510(A)
e. N520(F)
5. The idle time variance
a. N11-20(F)
b. Nl10(A)
c. N1200(F)
d. N1000 (A)
e. N1120(F)
6. What is the purpose of variance analysis and what variances should be calculated?

270
7. Define the material variances and give their formulae
8. Define the labour variances and give their formulae
9. Alagbede Ltd, a manufacturer, purchased 40,000 kgs of material at a cost of N3 per kg. The
standard cost is N2.80. 30,000 kgs of material were used for production costing N81,200. You
are required to:
a. Calculate material price variance.
b. Calculate other relevant variance
c. Calculate total material cost variance

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 CHAPTER 14
BUDGET AND BUDGETING TECHNIQUES I
14.0 OBJECTIVES:
At the end of this module you should be able to:
1. Define budget and budgeting.
2. State the purpose of budget
3. State 3 objectives of budgeting
4. Identify 5 problems associated with budgeting
5. State the steps involved in the installation of budget system
6. Explain functional budget with illustrations.
7. Explain master budget
8. Identify flexible budget
9. Understand zero - based budgeting (ZBB)

14.1 INTRODUCTION
A budget, according to the institute of cost and works accountants (ICWA) could be
defined as "a financial and/or quantitative statement, prepared and approved prior to a
defined period of time, of the policy to be pursued during that period for the purpose of
attaining a given objective. It may include income, expenditure and the employment of
capital"

BUDGETING:
Budgeting is the process engaged in formally expressing plans in quantitative terms in other
expressions. It is a process of quantized plan targeted at achievement of an objective or
objectives.

272
THE ESSENTIAL ELEMENTS OF THIS DEFINITION ARE:
i) A budget may be expressed in monetary and non-monetary terms like units of
products, units of time, etc.
ii) A budget is concerned with a plan. It therefore relates to a definite future period and is
therefore prepared in advance of that relevant period.
iii) The purpose of the budget is to implement the policies formulated by the management
for attaining the given objective.
iv) The budget is not in itself the objective but a means to achieving it

14.2 PURPOSE OF BUDGETS:

The purpose of a budge t might be to:
a) Compel planning: this is regarded as the most important feature of budgeting, because
planning makes management to look ahead, set targets, anticipate problems and give
the organization purpose and direction. Corporate planning would regard budgeting as
an important technique whereby long-term strategies are converted into short-term
action plans.
b) Communicate ideas and plans to everyone affected by them. A formal system is
necessary to ensure that each person is aware of what he or she is supposed to be
doing. Furthermore, communication can be a one-way or two-way dialogue.
c) Coordinate the activities of different departments or subunits of the organization.
This implies that the purchasing department should base its budget on production
requirements, and that the production budget should in turn be based on sales
expectations, etc.
d) Establish a system of control by having a plan against which actual results can be
progressively compared.

273
 e) Motivate employees to improve their performance.

THE BENEFITS/OBJECTIVES OFBUDGETING INCLUDE:

i) Compels planning and enhances coordination;
ii) Provides a medium of communication ;
iii) Enhances motivation;
iv) Provides a mechanism for the performance evaluation;
v) Instills financial awareness;

14.3 BUDGETARY CONTROL:

The CIMA defines budgetary controls as "the establishment of budget relating the
responsibilities of executives to the requirements of a policy and the continuous comparison
of actual with budgeted results, either to secure by individual action the objectives of that policy,
or to provide a basis for its revision.
The following fundamental principles may be established from the definition:
a) Executive responsibility: all managers should ensure that their work should be geared
towards the overall objectives of the business.
b) Establish a plan or target of performance.
c) Comparison of the actual performance with that planned.
d) Revision of policy: Policy must not be static but must take into account the
difference between required objectives and attainable objectives.

14.3.2 THE OBJECTIVES OF BUDGETARY CONTROL

The general objectives of a system of budgetary control are as follows:
i. To plan the policy of a business.
ii. To coordinate the activities of a business so that each is of an integral total.
iii. To control each function so that the best possible results may be obtained.

274
14.4 SHORT TERM BUDGETING AND LONG TERM PLANNING
Budgeting is a planning exercise, usually carried out once every year, which
establishes targets and plans for a one-year period. This one-year period is then broken
down into control periods of one month or four weeks. It may be readily apparent that
budgets do not concern themselves with:
i. The long-term plans of the company i.e. 'strategic' planning or 'long-range'
planning,
ii. Short-term management control, as exercised by front -line supervisors on a daily
basis i.e. operational control.
If a company has a corporate plan, planning is likely to extend to about five-or ten years or more:
a. The strategic objectives of the company will be defined in a mixture of
financial terms and non-financial terms.
b. Strategic targets are set which would enable the company to achieve its long- term
objectives.
c. Strategic plans are then developed which should enable the company to achieve
its strategic target and objectives.
d. Budgets are plans, expressed in financial terms, which are set each year within the
framework of strategic plans. They should attempt to provide short-term targets
within the framework of long-term strategic plans.

A serious problem in budgeting is the difficulty in reconciling short-term plans with long-term
targets. Some examples may help to illustrate this potential conflict.
a. A company may be faced with a choice about which market to sell into, owing to a
limited amount of funds available. The company can produce goods for market A
or market B but not for both markets together.

275
 b. A company faced with a market recession might decide to make a large proportion
of its skilled workforce redundant so as to reduce the cost of production.
However, if the recession is temporary, it might be more prudent to retain the
skilled employees, without whom the company might be unable to raise output
levels once the recovery occurs.
c. Training is often cut back when profits are squeezed, as a short-term cost -
cutting measure. However, the longer-term consequences of failing to train
adequate numbers of employees to suitable levels of skill can be catastrophic.

14 5 PROBLEMS IN BUDGETING
Planning for the future of an organization even in the relatively short-term is bound to
create numerous difficulties. For example:
a. The rate of inflation might be hard to predict so that budgeting for price levels will be
largely guesswork
b. The volume of activity (prediction, sales) cannot be foreseen with certainty.
c. There will be problem of coordination in the organisation. An attempt to coordinate
plans of different departments into an optima master budget may be unsuccessful.
d. The problem of motivation in which budget expenditure claims by cost centre managers
are likely to be excessive.

14.6 STEPS IN THE INSTALLATION OF BUDGET SYSTEM:

a. The preparation of organization charts: An organizational chart defines the financial
responsibilities of each member of management in terms of position and relationship
with others.
b. The budget period:
It covers a fixed period of time, most commonly one year; this will be divided
into shorter time periods known as control period for purpose of reporting control

276
 with a one-year period of budget. Control periods may be 4 weeks (13 periods
each year) or one month (12 periods each year). Long-term budgets (e.g. capital
expenditure budgets) may be for periods of up to five or ten years or even longer.
Budget Manual:
The organization involved in budgeting and budgetary control should be
documented in a Budget Manual which has been described as a procedure, or
rule which sets outstanding instruction governing the responsibilities of persons,
and the procedure, forms and records relating to the preparation and use of
budgets.
d. Budget Committee:
The overall responsibility for budget administration should be given to a budget
committee, normally chaired by the chief executive of the organization, with
departmental heads or senior managers as members. The purposes of this
committee are inter alia;
i. Ensuring the active cooperation of departmental managers; and to act as
a forum in which the differences or opinions can be argued out and
reconciled.
ii Ensuring that managers in the organization understand what other
departments are trying to do;
iii. Establishing long-term plans around which the budgets should be built,
and then to identify budget objectives.
iv. Reviewing departmental budgets:
v. Comparing the actual performance with budget targets and expectations
e. The Budget Officer:
Controls the budget administration on a day-to-day basis. He will be responsible to the
budget committee and should ensure that its decisions are transmitted to the appropriate
people and the relevant data and opinions are presented for its consideration. He also has to

277
 educate and set the budget idea.

f. The Introduction of Adequate Accounting Record:

It is imperative the accounting system should be able to record and analyze the information
required.
g. The General Instruction In Technique of All Concerned In Operating The
System: Each person must know what a budget is, what it hopes to accomplish and how
he/she fits into the plan.
h. Budget Centres:
It is a section of the organization of an undertaking created for the purpose of budgeting
control. Each selected budget centre must be clearly definable and should be the natural
responsibility of one particular manager (or supervisor). A separate budget is prepared
for each budget centre. The "budget centre budgets" are known as departmental
budgets,
i. Principal Budget Factor.
This is also known as the KEY budgeting factor or LIMITING budget factor i.e. the
factor which imposes limitation or ceilings on the level of activity. It is usually sales
demand; but it may also be limitations on resources used - materials, labour, machine
time, working capital etc.
Once this factor is identified, the rest of the budget can be prepared,
j Level of Activity:
It will be necessary to establish the normal level of activity i.e. the level of the
company can reasonably be expected to achieve.

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14.7 FUNCTIONAL BUDGET
A functional budget is one which relates to any of the functions of an undertaking.
Functional budgets are subsidiary to the master budget, that is the summary budget,
incorporating its component functional budgets, which is finally approved, adopted
and employed.

There are many types of functional budgets, of which the following are frequently
used:
i. Sales budget
ii. Production budget
iii. Production cost budget
iv. Plan utilization budget
v. Capital expenditure budget
vi. Selling and distribution cost budget
vii. Purchasing budget
viii. Cash budget.

14.8 SALES BUDGET:

This is the most difficult functional budget to prepare because it is not easy to
estimate consumers' future demands especially when a new product is being
introduced. It is the most important subsidiary budget because if the sale figure is
wrong, then practically all the other budgets will be affected especially the master
budget.
The sales budget is usually prepared in terms of quantities, then evaluated at budgeted

279
 unit prices. It is classified under a number of headings, of which the following are in
common use:
a. Products: Estimates must be prepared of sales for each product.
b. Territories: Sales of each product, expressed in quantities and values to be sold in
each territory.
c. Type of customer: This may be important if different customers
receive special discounts, special rates, etc.
d. Salesmen: The sales to each salesman or agent in a territory.
e. Month: comparison of actual results .with those budgeted for each period
is important In addition, it is necessary when calculating budgeted stock
positions to know monthly sales.

The sales manager will be responsible for the preparation of the sales/ budget. If the
principal budget will be determined by output, preparation of the budget will be relatively
easy.
However, if sale is the key factor, then the production budget will be determined by
estimated sale.

ILLUSTRATION 1
In the Colour Co. Ltd, there are four sales divisions, each consisting of four areas,
North, South, East, and West. The company sells two products Blue and White. Budgeted
sales for the six months ended 30th June, 2005, in each area were as follows:
North: Blue 20,000 units at N10 each
White: 12,000 units at N5 each
South: White 24,000 units at N5 sach
East: Blue 30,000 units at N10 each

280
 West: Blue 16,000 units at N10 each
B/d 10,000 units at N5 each

Actual sales for the same period were as follows:

North: Blue 23,000 units at N10 each
White 14,000 units at N5 each
South: White 25,000 units at N5 each
East: Blue 33,000 units at N10 each
West: Blue 19,000 units at N10 each
White 10,500 units at N5 each

From the salesmen's reports and observations of the area sales managers, it is thought that
sales could be budgeted for the six months ended June 30, 2006, as follows:
North Blue Budgeted increase 4000 units on June 2005 budget
White Budgeted increase 1000 units on June 2005 budget
South White Budgeted increase 2000 units on June 2005 budget
East Blue Budgeted increase 4000 units on June 2005 budget
West Blue Budgeted increase 1000 units on June 2005 budget
White Budgeted increase 2000 units on June 2005 budget
At a meeting of area sales managers with the divisional sales manager it is decided that sales
campaigns will be undertaken in areas South and East.
It is anticipated that those campaigns will result in additional sales of 6,000 units of Blue in the
South area and 10,000 units of White in the East area.
Prepare for presentation to top management the sales budget for the six months ended June 30,
2006, showing also the budgeted and actual sales for June 30, 2005. Which are to be provided
as a guide in fixing the sales budget?

281
 SOLUTION 1:
COLOUR CO. LTD.
SALES BUDGET FOR SIX MONTHS ENDED JUNE 30, 2006
BUDGET JUNE 30, 2006 BUDGET JUNE 30, 2006 ACTUAL JUNE 30, 2005
Area Product Quantity Unit Amount Quantity Unit Amount Quantity Unit Amount
units price N units price N units price N
N N
North Blue 24,000 10 240,000 20,000 10 200,000 23,000 10 230,000
White 13,000 5 65,000 12,000 5 60,000 14,000 5 70,000
Total 37,000 305,000 32,000 260,000 37,000 300,000
South Blue 6,000 10 60,000 10 10
White 26,000 5 130,000 24,000 5 120,000 25,000 5 125,000
Total 32,000 190,000 24,000 120,000 25,000 125,000
East Blue 34,000 10 340,000 30,000 10 300,000 33,000 10 330,000
White 10,000 5 50,000 5 5
Total 44,000 390,000 30,000 300,000 33,000 330,000
West Blue 18,000 10 180,000 16,000 10 160,000 19,000 10 190,000
White 11,000 5 55,000 10,000 5 50,000 10,500 5 52,500
Total 29,000 235,000 26,000 210,000 29,500 242,5000

Total Blue 82,000 10 820,000 66,000 10 660,000 75,000 10 750,000

White 60,000 5 300,000 46,000 5 230,000 49,500 5 247,000
Total 142,000 1,120,000 1,120,000 890,000 124,000 997,500

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14.9 PRODUCTION BUDGET
This shows the quantity of product to be manufactured. It is prepared by the production
manager and is based upon the following:
a. The sales budget
b. The factory capacity
c. The budgeted stock requirements

ILLUSTRATIONS II
Colour Ltd. manufactures three products White, Blue and Red. You are required:
a. Using the information given below, prepare budgets for one month ended January, 2006
i. Sales budget in value
ii. Production quantities
iii. Material usage budget quantity
iv. Material purchases in quantity and value including total value.
Data for preparation of January Budgets

PRODUCT QUANTITY PRICE/UNIT N

White 2,000 100
Blue 4,000 120
Red 3,000 140

Materials used in the company's products are:

Material Ml M2 M3
Unit Cost N4 N6 N9
Material Ml units M2 units M3 units

283
Product White 8 4 -
Blue 6 4 4
Red 4 2 2

Finished Stocks
White Blue Red
Units Units Units
1st January 2,000 3,000 1,000
31st January 2,200 3,300 1,100

Material Stocks M1 M2 M3
Units Units Units
1st January 52,000 40,000 24,000
31st January 62,400 48,000 28,800

SOLUTION II
COLOUR LTD
FOR ONE MONTHS ENDED JANUARY, 2006
Sales Budget Quantity Price/Units (N) Value (N)
White 2,000 100 200,000
Blue 4,000 120 480,000
Red 3,000 140 420,000
1,100,000

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PRODUCTION BUDGET FOR ONE MONTH ENDED
31ST January, 2006
White Blue Red
Units Units Units
Sales Unit from sales budget 2,000 4,000 3,000
Add Closing Stock 2,200 3,300 1,100
4,200 7,300 4,100
Less Opening Stock 2,000 3,000 1,000
2,200 4,300 3,100

MATERIAL USAGE BUDGET (QUANTITY)

Production M1 M2 M3
Budget Unit Unit/Production Total Unit/production Total
White 2,200 8 17,600 4 8,800
Blue 4,300 6 25,800 6 25,800 4 17,200
Red 3,100 4 12,400 2 6,200 2 6,200
55,800 40,800 23,400

MATERIAL PURCHASES BUDGE T (QUANTITY AND VALUE)

M1 UNIT M2 UNITS M3 UNIT TOTAL
Material Usage for 55,800 40,800 23,400
budget
Add closing stock 62,400 48,000 28,800
(units)
118,200 88,800 52,200
Less Opening Stock 52,000 40,000 25,000
66,200 48,800 28,200

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 Unit cost Unit Cost Total N
M1 66,200 N4 264,800
M2 48,800 N6 292,800
M3 28,200 N9 253,800
Total 811,400
Value

14.10 PRODUCTION COST BUDGET

This is the quantity of products to be manufactured, expressed in terms of
cost. It is classified under various headings e.g.
a. Productions
b. Manufacturing departments
c. Months
d. Element of cost

Many companies prepare a raw material budget, labour budget and overhead
budget, which analyse figures of the element of cost section of the production cost
budget.

14.11 PLANT UTILIZATION BUDGET

This represents the plant requirements to meet the production budget. This
budget may be very important because:
a. It details the machine load in every manufacturing department
b. It draws attention to any overloading in time for any corrective action to
be taken e.g. shift working, purchasing of new machinery, overtime
working, sub-contracting.

286
 c. It draws attention to any under-loading so that the sales manager can
be requested to investigate possible increased sales.

SUMMARY
In this module, you have learnt that:
1. A budget is a financial and quantitative statement prepared and approved
prior to a defined period of time of the policy to be pursued during that
period to attain given objectives.
2. Budgeting is a process of expressing plans in qualitative terms and
expressions.
3. A budget may be expressed in monetary and non-monetary terms e.g. units
of products, unit of time, etc.
4. A budget relates to a definite future period of time and is prepared in
advance of that time.
5. The purpose of a budget is to implement policies formulated by
management for attaining set objectives
6. Benefits of budgeting include include completed planning, enhanced
coordination and motivation, performance evaluation and instilled financial
awareness.
7. Problems in budgeting includes unpredictable rate of inflation, uncertainty
of the volume of production etc.
8. There are many types (if fundamental budgets such as cash, sales,
capital expenditure production, production cost, plan utilization, selling
and distribution and cost purchasing.

287
EXERCISE
1. Cash budget consist
a. Cash receipt section
b. Cash disbursement section
c. Financing section
d. None of the above
e. All of the above
2. The sales budget can be classified as
a. A capital budget
b. An operating budget
c. A master budget
d. A financial budget
e. All of the above
3. Give six benefits of a properly organized budgetary system?
4. What problems may be encountered in implementing and operating a
budget system?
5. Explain the necessary steps to be taken in the installation of budget system?

288
 CHAPTER 15
BUDGET AND BUDGETING TECHNIQUES II
15.0 OBJECTIVES
At the end of this module, you should be able to:
1 prepare a selling and distribution cost budget
2. prepare a purchasing budget
3 Prepare a cash budget
4. state additional budgets,- research and development budget
5. draft a master budget
6. prepare a flexible budget
7. explain zero-based budgeting, its advantages and disadvantages
8. solve problems on budget and budgeting control.

5.1 CAPITAL EXPENDITURE BUDGET

This represents the 'estimated expenditure on fixed assets during the
budget period. It is based on information such as the following:
i. Overloading shown in the plant utilization budget.
ii. Reports of the production manager requesting new production machinery.
iii. Reports of the distribution manager requesting new transport.
iv.Reports of the sales manager requesting new cars.
v. Reports of the accountant requesting new office machinery.
vi Decision of the board to extend building etc.

SELLING AND DISTRIBUTION ON COST BUDGET

This represents the cost of selling, and distributing the quantities shown in' the sales
budget. The sales manager, advertising manager and sales office manager will
cooperate with the budget officer in the preparation of this budget.

289
ILLUSTRATION I
Selling expenses were budgeted for the six-month period ended June 30, 2008 as
shown below:
The sales budget illustrated previously is used as a basis for the preparation of
this budget.
For the budget for the six months ending 30th June, 2009,
a. Sales commission is based on 2% of the sale (see Budgeted sales
on illustration I, chapter 14.)
b. Salesmen's salaries to be increased by 5%
c. Sales men's expenses to be increased by 15%
d. Car expenses to be increased by 15%
e. Warehouse wages to be increased by 7 ½ %
f. Lorry expenses to be increased by 15%
g. Sales office salaries to be increased by 15%
h. One extra clerk to be engaged by east area at N15/week
i. Postage, stationery and telephone to be increased by 7 ½%
j. Press and TV advertising to be increased in all areas by 15% .
k. Coupon offers in area south and east to be N20,000 and
N30,000 each respectively.
l. Shop-widow schemes in area; South and East to be N1,500 and N2,500
each respectively.

An additional commission of 7 ½ % will be paid for sales of the introductory offer of

Blue and White.
Prepare the selling cost budget for the six months ended 30th June, 2009

290
 SOLUTION
AREA
ELEMENT OF COST NORTH SOUTH EAST WEST TOTAL
Direct selling expenses
Salesmen's Salaries 45,000 22,500 46,800 31,200 145,500
Salesmen's Commission 26,000 12,000 30,000 21,000 89,000
Salesmen's Expenses 4,400 2,200 5,380 3,520 15,500
Car Expenses 30,000 15,000 36,000 24.000 105,000
105,400 51,700 118,180 79,720 355,000
Distribution Expenses
Warehouse Wages 20,000 15,000 25,000 15,000 75,000
Warehouse rent, Rates Electricity 3,000 3,000 4,000 2,500 12,500
Lorry Expenses 25,000 18,000 28,000 19,000 90,000
General Expenses 4,000 4,000 5.000 4,500 17,500
52,000 40,000 62,000 41,000 195,000
Sales Office
Salaries 26;000 19,000 30,000 25,000 100,000
Rent, Rates, Electricity 6;000 3,000 7,000 4,000 20,000
Depreciation 3:000 1,000 4,000 2,000 10,000
Postages, Stationery, Telephone 13,000 5,000 15,000 7,000 40,000
General Expenses 6,000 4.000 5,000 5,000 20,000
54,000 32,000 61,000 43,000 190,000
Advertising
Press 10,)00 10,000 10,000 10,000 40,000
Television 20,000 20,000 20,000 20,000 80,000
Company Offers 15,000 12,000 27,000
Shop Window displays 15,000 2,000 2,000 4,000 13,000
50,000 32,000 32,000 46,000 160,000
Total 261,400 155,700 273,180 209,720 900,000

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 SOLUTION III
SELLING AND DISTRIBUTION COST BUDGET FOR THE PERIOD SIX
MONTHS TO JUNE 30,2009.

BUDGET JUNE 30 BUDGET FOR SIX MONTHS TO 30

2009 AREA JUNE 30 2008 AREA
North South East West Total North South East West Total
Direct selling
expenses
Salesmen’s 47,250 23,625 49,140 32,760 152,775 45,000 22,500 46,800 31,200 145,500
Salaries
Salesmen’s 6,100 8,300 11,550 4,700 30,650 5,200 2,400 6,000 4,200 17,800
Commission
Salesmen’s 5,060 2,530 6,187 4,048 17,825 4,400 2,200 5,380 3,520 15,500
Expenses
Car expenses 34,500 12,350 41,400 27,600 120,750 30,000 15,000 36,000 24,000 105,000
92,910 51,705 108,277 69,108 322,000 84,600 42,100 94,180 62,920 283,800
Distribution
expenses
Warehouse 21,500 16,125 26,875 16,125 80,625 20,000 15,000 25,000 15,000 75,000
wages
Warehouse rent 3,000 3,000 4,000 2,500 12,500 3,000 3,000 4,000 2,500 12,500
& rates,
Electricity
Lorry 28,750 20,700 32,200 21,850 103,500 25,000 18,000 28,000 19,000 90,000
Expenses
General Exp. 4,000 4,000 5,000 4,500 17,500 4,000 4,000 5,000 4,500 17,500
57,250 43,825 68,075 44,975 214,125 52,000 40,000 62,000 41,000 195,000
195
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Sales Office
Salaries 29,900 21,850 34,500 28,750 115,000 26,000 19,000 30,000 25,000 100,000
Rent, Rates & 6,000 3,000 7,000 4,000 20,000 6,000 3,000 7,000 4,000 20,000
Electricity

Depreciation 3,000 1,000 4,000 2,000 10,000 3,000 1,000 ,4,000 2,000 10,000
Postage, 13,975 5,375 16,125 7,525 43,000 13,000 5,000 15,000 7,000 40,000
stating &
Telephone
General Exp 6,000 4,000 5,000 5,000 20,000 6,000 4,000 5,000 5,000 20,000
58,875 35,225 66,625 47,275 208,000 54,000 32,000 61,000 43,000 190,000
Advertising *
Press 11,500 11,500 11,500 11,500 46,000 10,000 10,000 10,000 10,000 40,000
Television 23,000 23,000 23,000 23,000 92,000 20,000 20,000 20,000 20,000 80,000
Coupon Offers 15,000 20,000 30,000 12,000 77,000 15,000 12,000 27,000
Shop window 5,000 1,500 2,250 4,030 12,750 5,000 2,000 2,000 4,000 13,000
Display 54,500 56,000 66,750 50,530 227,750 50,000 32,000 32,000 46,000 160,000

15.3 PURCHASING BUDGET

Purchasing Budget consists of the total purchases to be made in the budget
period. It is composed of direct material, indirect materials and research and
development requirements.

Purchases will normally be in line with budgeted requirements, with the

exception of orders already placed with suppliers and any adjustments to
budgeted stock position.

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 For illustration see the production budget II

15.4 CASH BUDGET

Cash budget represents the cash receipts and payments, and the estimated
cash balance for each month of the budget period. Its main functions are:
i. To ensure that sufficient cash is made available when required.
ii. To reveal any expected shortage of cash, so that action may be
taken e.g. a bank overdraft or arranged loan.
iii. To disclose any expected surplus of cash, so that cash may
be invested or loaned as desired by the management.

ILLUSTRATION II
Prepare a cash budget for Colour Ltd. For the six months to December 30, 2009
from the information given in the table below, cash balance on July was
expected to be N150,000.

OVERHEADS
Month Sales Material Wages Production Admin. Selling Distribution Research and
development
April 100,000 40,000 10,000 4,400 3,000 1,600 800 1,000
May 120,000 60,000 11,200 4,800 2,900 1,700 900 1,000
June 80,000 40,000 8,000 5,000 3,040 1,500 700 1,200
July 100,000 60,000 8,400 4,600 2,960 1,700 900 1,200
August 120,000 70,000 9,200 5,200 3,020 1,900 1,100 1,400
September 140,000 80,000 10,000 5,400 3,080 2,000 1,200 1,400
October 160,000 90,0000 10,400 5,800 3,120 2,050 1,250 1,600
November 180,000 100,000 10,800 6,000 3,140 2,150 1,350 1,600
December 200,000 110,000 11,600 6,400 3,200 2,300 1,500 1,600

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ADDITIONAL INFORMATION
i. Plant and machinery to be installed in August at a cost of N40,000 Will be
payable on September 1
ii. Extension to research and development department amounting to N10,000 will
be completed on August 1. Payable N2,000 per month as from completion date
iii. Under a hire-purchase agreement N4,000 is to be paid each month,
iv. A sales commission of 5% on sales is to be paid within the month following
actual sales.
v. Period of credit allowed by suppliers -3 months.
Period of credit allowed to customers -2 months.
Delay of overheads -1 month.
Delay in payment of wages -1/8 month.
vi. Taxation of N100,000 is due to be paid on October 1.
vii. Preference shares dividend of 10% in capital of N2,000,000 is to be paid on
November 1.
viii. 10% calls on ordinary share capital of N400,000 is due on July 1 and
September 1.
ix. Dividend from investments amounting to N30,00 is expected on November 1
x. Cash sales of N2,000 per month are expected and no commission is payable.

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SOLUTION II
Notes
In preparing the figures for debtors and creditors, the student may find it
convenient to arrange the work first oh a spare sheet of paper. This gives a
check on opening and closing debtors and creditors which is useful if a
balance sheet has to be prepared, and it also gives the figures to be copied into
the cash budget.

B/F July Aug. Sept. Oct. Nov. Dec. C/F

N’000 N’000 N’000 N’000 N’000 N’000 N’000 N’000
Sales(‘000) 100,000 100 120 140 160 180 200
Debtors May 120 180 Nov
June 80 120 80 100 120 140 160 200 Dec
Materials
Creditors 40 90 Oct.
April
May 60 100 Nov
June 40 40 60 40 60 70 80 110Dec.

Wages are calculated thus:

(N) (N)
July 1/8 June (N8,000) 1000
7/8 July (N8,400) 7,350 8,350
August 1/8 July (N8,400) 1,050
7/8 August (N9,200) 8,050 9,100

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 COLOUR LTD.
CASH BUDGET
FOR THE SIX MONTHS ENDING DE MEMBER 31, 2009
MONTHS
Details July August September October November December
Receipts N N N N N N
Balance b/d 150,000 244,210 234,750 262,230 187,800 51,230
Debtors 120,000 80,000 100,000 120,000 140,000 160,000
Cash sales 2,000 2,000 2,000 2,000 2,000 2,000
Capital 40,000 40,000
Dividend 30,000
Total 312,000 326,210 376,750 384,230 359,000 213,230
Payments
Materials 40,000 60,000 40,000 60,000 70,000 80,000
Wages 8,350 9,100 9,900 10,350 10.750 11,500
Production o/h 5,000 4,600 5,200 5,400 5,800 6,000
Admin o/h 3,040 2,960 3,020 3,080 3,120 3,140
Selling o/h 1,500 1,700 1,900 2,000 2,050 2,150
Distribution o/h 700 900 1,100 1,200 1,250 1,350
Research o/h 1,200 1,200 1,400 1,400 1,600 1,600
Commission 4,000 5,000 6,000 7,000 8,000 9,000
Capital
Plant & machinery - - 40,000
Research & Dev. 2,000 2,000 2,000 2,000 2,000
Hire purchase 4,000 4,000 4,000 4,000 4,000 4,000
Taxation 100,000
Dividend 200,000
Total 67,790 91,460 114,520 196,430 308,570 120,740
Balance % 24,4210 234,750 262,230 187,800 51,230 92,490

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ADDITIONAL BUDGETS
In addition to the afore-mentioned budgets, there may be many more
budgets prepared, but it is unnecessary to explain them here, for example,
budgets will be prepared for the administration and research and
development departments, but these are rather similar to the selling and
distribution cost already explained.

15.6 THE MASTER BUDGET

When the functional budgets have been fully prepared, the budget
officer will prepare a master budget in the form of a budget profit and
loss account shown below, which will include production, sales and
cost estimated for the budget period.

The board of directors, having considered the budget and if they

are satisfied will call for amendment. However, when the budget is
finally approved it represents a standard which each department must
achieve.

Notes would be given to management explaining why the budgeted

net profit of the current budget period was less than the previous year.

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 15.7 BUDGETED PROFIT AND LOSS ACCOUNT

CURRENT YEAR PREVIOUS YEAR

DETAILS AMOUNT N % AMOUNTS %
Net Sales 3,600,000 100.0 3,400,000 100.0
Production cost (1,920,000) 53.3 (1,820,000) 53.5
Gross Profit 1,680,000 46.7 1,580,000 46.5
Less Operation
Less Expenses
Administration (154,000) 4.3 (142,000) 4.2
Selling (212,000 5.9 (196,000) 5.8
Advertising (660,000) 18.3 (600,000) 17.6
Distribution (224,000) 6.2 (212,000) N 6.2
Researched and (28,000) 0.8 (24,000) 0.7
Development
Financial (42,000) 1.2 (40,000) 1.2
Total (1,320,000) 36.7 (1,214,000) 35.7
Operating Profit 360,000 10.0 366,000 10.8

Add other Income 4,000 0.1 4,000 0.1

Net Profit before Tax 364,000 10.1 370,000 10.9

Less: Company Tax (170,000) 4.7 (172,000) 5.1

Net profit after tax 194,000 5.4 198,000 5.8

ILLUSTRATION III
X,Y,Z Ltd manufactures three products P1,P2 and P3. These are made in
three production departments from four materials: M1, M2, M3 and M4.
The following information is supplied.

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STANDARD PRODUCT COST DETAIL:
Material Used in Dept. Cost per Unit in N PI P2 P3
Units per article
M1 Dl 0.5 - 1 2
M2 D2 0.2 1 - 2
M3 D2 0.25 2 - -
M4 D3 0.15 2 12 1
*

Rejection on final Inspection at end of the period.

Process considered normal 5% 10% 10%

Budget Details N N N
Sales for the year in ‘000s 260 580 450
Sales price each 5 10 6
Stocks in thousands of articles
January 1 5 10 15
December 10 15 30
Raw materials M1 M2 M3 M4
Stocks: in thousands of Units
January 1 30 40 10 60
December 31 40 30 20 50
You are required to prepare:
a) Standard Material Costs per article for P1, P2 & P3.
b) For the year:
i. The production budget;
ii. Production cost budgets for direct materials for
departments D1.D2&D3;

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iii. The purchasing budget
iv. SOLUTION III
Calculation of Budgeted Units of Sales: = Sales
Selling Price
PI P2 P3
Sales = 260,000 580,000 450,000
Selling Price 5 10 6
= 52,000 Units; 58,000 Units 75,000 Units

PI P2 P3
Closing Stock 10,000 15,000 30,000
Add Sales Units 52,000 58,000 75,000
62,000 73,000 105,000

Less Opening Stock (5,000) (10,000) (15,000)

57,000 63,000 90,000
Normal Loss 5% 10% 10%
Good Finished Product 95% 90% 90%
Total Production 57,000 63,000 90,000
0.95 0.90 0.90
60,000 units 70,000 units 100,000

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 PRODUCTION COST BUDGET
Material Department Cost/Unit PI P2 P3 Total Value.
N
60,000 70,000 100,000 -
Ml Dl 0.5 - 70,000 200,000 270,000
M2 D2 0.2 60,000 - 200,000 260,000
M3 D2 0.25 120,000 70,000 - 190,000
M4 D3 0.15 120,000 140,000 100,000 360,000

M1 M2 M3 M4
Closing Stock 40,000 30,000 20,000 50,000
Production Required 270,000 260,000 190,000 360,000
310,000 290,000 210,000 410,000
Less Opening Stock 30,000 40,000 10,000 60,000
280,000 250,000 200,000 350,000
Cost/Unit N0.5 N0.2 N0.25 N0.15
N140,000 N50,000 N50,000 N52,500
= N292,500
Standard Material Cost per Article

Department Cost/Unit PI P2 P3
M1 Dl 0.5 0.5 1.00
M2 D2 0.2 0.20 0.40
M3 D2 0.25 0.50 0.25
M4 D3 0.15 0.30 0.30 0.15
1.00 1.05 1.55

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 15.8 FLEXIBLE BUDGET
The CIMA defines "a flexible budget as a budget which is designed to
change in accordance with the level of activity attained” This is in
contrast to fixed budgetary control, which is defined is "the budget
which is designed to remain unchanged irrespective of the level of activity".

A flexible budget recognizes the existence of fixed, variable and semi

variable cost and it is designed to change in relation to the actual volume of
output or level of activity in a period.

ILLUSTRATION IV
Colour Ltd. is operating a system of flexible Budgetary Control. Her
budget for the year one is as follows:
70% 80% 90% 100%
1400 Units 1600 units 1800 Units 2000 Units
N N N N
Price cost 28,000 32,000 36,000 40,000
Variable overhead 4,200 4,800 5,400 6,000
product
Semi Variable 6,800 7,200 7,600 8,000
O/H
Other Fixed O/H 10,000 10,000 10,000 10,000
49,000 54,000 59,000 64,000

You are required to present the above to the management separating the
semi-variable overhead from variable and also including the cost "attaining
of 20% level of activity" fixed cost remains unchanged.

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 SOLUTION IV
70% 80% 90% 100% 120%
1400 Units 1600 units N 1800 Units 2000 Units 2400 units
N N N N
Price cost 28,000 32,000 36,000 40,000 48,000
Variable 4,200 4,800 5,400 6,000 7,200
overhead
product
Variable sell 2,800 3,200 3,600 4,000 4,800
& Dist. Cost 35,000 40,000 45,000 50,000 60,000
Fixed cost 14,000 14,000 14,000 10,000 14,000
49,000 54,000 59,000 64,000 74,000

WORKING NOTE: Adopting high and low method to determine both fixed cost and
variable costs:
70% 80% Difference Cost/Unit
N N N N
Prime cost/unit Cost 28,000 32,000 4,000 4,000
200
Unit 1,400 1,600 200 N20/Units
N N N N
Variable Prod. O/H
Cost 4,200 4,800 600 600
200
Units 1,400 1,600 200 N3/Units
N N N N
Semi Variable Cost 6,800 7,200 400 400
Units 1,400 1,600 200 +

N2/Unit

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Variable is N2/Unit
Fixed Selling & Distribution 70% 80%
1,400 1,600
Semi –Variable overhead 6,800 7,200
Less Variable (140 Units x N2) (2,800) 1,600 x 2) (3,200)
Fixed 4,000 4,000

ZERO-BASED BUDGETING (ZBB)

ZBB is a cost-benefit approach whereby it is assumed that the cost
allowance for an item is zero, and will remain so until the manager
responsible justifies the existence of the cost item and the benefits the
expenditures entails. It is a forward looking approach as opposed to the
all too common method of extrapolating past activities and costs,
which is a feature of the incremental budgeting approach.
ZBB is formally defined by CIMA as "a method of budgeting whereby all
activities are re-evaluated each time a budget is formulated. Each
functional budget starts with the assumption that the function does not
exist and is at zero cost. Incremental costs are compared with increments
of benefits culminating in the planning maximum benefit for a given
budgeted cost".

15.9.1 ADVANTAGES:
i. It results in a more efficient allocation of resources.
ii. It is possible to identify and remove inefficient or obsolete
operations
iii. Psychologically, it encourages employees to avoid wasteful
expenditure
iv. It enables the organization to look very closely into its cost behavior

305
 patterns to make decisions as to an alternative course of action.
v. A coordinated in-depth knowledge of an organization's
operation is made available to management

15.9.2 DISADVANTAGES:
i. Emphasis is laid on short-term benefits to the detriment of long-term
benefits
ii. It calls for management skills in decision analysis, which the
organization is lacking.
iii. It encourages a false idea that all decisions have to be made in the
budget. Circumstances change and new opportunities and threats
can emerge at any time and organization must be flexible enough to
deal rapidly with these circumstances when they arise.
v. It is time consuming and can generate volume of paper work
especially for the decision making packages.

15.10 SUMMARY
In this module you have learnt that:
1. Flexible budget is designed to change according to the level of
production activity in a period of time.
2. Master budget is in the form of a budget profit and loss account shown
in the text.
3. Zero-based budgeting is a method of budgeting which starts from
zero. All activities are revalued each time a budget is designed or
formulated.
4. Advantages of zero-based budgeting include efficient allocation of
resources, avoidance of wasteful expenditure, encouragement of

306
 alternative course of
action etc.
5. Disadvantages of zero-based budgeting include emphasis on short-
term
benefits to the detriment of long-term benefits. It is time consuming etc.

PRACTICE QUESTIONS:
1. What do you consider to be the main objectives of budgetary
control? List with brief descriptions, three of the main subsidiary
budgets which make up the main budget.
2. Briefly explain a master budget. Into what sections is it normally
divided, and what are the purposes of the divisions?
3. Having completed budgets for all the functions of a company, how
would you ensure that they were put to use?
4. ABC Ltd has produced the following budgets for two activity levels:
Expense Budget for 1 0,000 units Budget for 1 2,000 units
N N
Wages 32,000 34,400
Materials 50,000 60,000
Salaries 45,000 46,000
Depreciation 36,000 36,000
Other overheads 37,000 42,000

Required:
Prepare a budget for an activity level of 12,400 units.

5. ABC Ltd has drawn up a budget for the current year, the proportion

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 of the
expected cost, etc being as follows:
%
Direct material 34.0
Direct labour 22.0
Variable factory overheads 16.5
Fixed factory overheads 12.0
Other variable costs 5.5
Other fixed costs 4.0
Profit 6.0
Total 100.0

After six months working it becomes apparent that the volume of business
anticipated will not be obtained, and management considers that a figure of
approximately 75% of budgeted sales will be obtained, i.e. N660,000 for the
full year. As the Cost Accountant of the business, present information to
management, which will enable elections to be made on matters of policy.

6. ABC Ltd has a cash balance of N54,000 at the beginning of July and
you are required to prepare a cash budget for July, August and September
having regard to the following information:
Creditors give 1 month credit
Salaries are paid in the current month.
Fixed costs are paid one month in arrears and include a change
for depreciation of N10, 000 per month.
Credit sales are settled as follows: 40% in month of sale, 45% in next
month, and 12% in the following month. The balance represents bad debts.

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 N N N N N
May 148,000 110,000 18,000 60,000
June 164,000 122,400 18,000 60,000
July 40,000 160,000 120,000 19,000 60,000
Aug. 44,000 180,000 138,000 19,000 64,000
Sept. 50,000 200,000 150,000 20,000 64,000

Further Reading
1. Lucey, I. (2002). Costing (6th.ed), London: Thompson.
2. Horngren,C.T, Datar, S and foster G. (2006). Cost Accounting: A
managerial emphasis (12th ed), lanai: Pearson prentice Haee.
3. Lucey, T. (1989). Costing (3rd ed.) London: Book power.
4. Omolehiuwa, E.O. (2000). Coping with cost Accounting (2nd ed.) Lagos:
Pumak Nigeria Limited.

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