Bachelor of Commerce

in Accounting (Honours)

Cost Accounting

Module BACC 309

Author: Alphonce T. Shiri
MBA (Bellivuw University, USA)
BSc Business Administration Accounting (Midland
University, USA)
Diploma in Education (UZ)

Content Reviewer: Cuthbert Muza

MComm Accounting
BBA - Accounting (Solusi University)
CPF Acct (ICFA - Canada)
Certified Public Accountant (ICPAZ)
PAAB Registration Certificate

Editor: Kudzanayi Ruvharo

MSc in Statistics (UZ)
BSc Special Honours in Statistics (UZ)
BSc Mathematics and Statistics (ZOU)
Diploma in Education (Mathematics) (GTC)
(Cert )Community Development (UZ)
Published by: Zimbabwe Open University

P.O. Box MP1119

Mount Pleasant

Harare, ZIMBABWE

The Zimbabwe Open University is a distance teaching and open

learning institution.

Year: March 2013

Reprinted: November 2013

Cover design: T. Ndhlovu

Layout : S. Mapfumo

Printed By: ZOU Press, Harare

ISBN.: 978-1-77938-717-2

Typeset in Times New Roman, 12 point on auto leading

© Zimbabwe Open University. All rights reserved. No part of this

publication may be reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise, without the prior permission of the Zimbabwe Open
University.
 To the student
The demand for skills and knowledge
and the requirement to adjust and
change with changing technology, places
on us a need to learn continually
throughout life. As all people need an
education of one form or another, it has
been found that conventional education
institutions cannot cope with the
demand for education of this magnitude.
It has, however, been discovered that
distance education and open learning,
now also exploiting e-learning
technology, itself an offshoot of e-
commerce, has become the most
effective way of transmitting these
appropriate skills and knowledge
required for national and international
development.
Since attainment of independence in
1980, the Zimbabwe Government has
spearheaded the development of
distance education and open learning at
tertiary level, resulting in the
establishment of the Zimbabwe Open
University (ZOU) on 1 March, 1999.
ZOU is the first, leading, and currently
the only university in Zimbabwe entirely
dedicated to teaching by distance
education and open learning. We are
determined to maintain our leading
position by both satisfying our clients
and maintaining high academic
standards. To achieve the leading
position, we have adopted the course
team approach to producing the varied
learning materials that will holistically
shape you, the learner to be an all-round
performer in the field of your own
choice. Our course teams comprise
academics, technologists and
administrators of varied backgrounds,
training, skills, experiences and personal
interests. The combination of all these
qualities inevitably facilitates the
production of learning materials that
teach successfully any student, anywhere
and far removed from the tutor in space
and time. We emphasize that our
learning materials should enable you to
solve both work-related problems and
other life challenges.
To avoid stereotyping and professional
narrowness, our teams of learning
materials producers come from different
universities in and outside Zimbabwe,
and from Commerce and Industry. This
openness enables ZOU to produce
materials that have a long shelf life and
are sufficiently comprehensive to cater
for the needs of all of you, our learners
in different walks of life. You, the
learner, have a large number of optional
courses to choose from so that the
knowledge and skills developed suit the
career path that you choose. Thus, we
strive to tailor-make the learning
materials so that they can suit your
personal and professional needs. In
developing the ZOU learning materials,
we are guided by the desire to provide
you, the learner, with all the knowledge
and skill that will make you a better
performer all round, be this at certificate,
diploma, undergraduate or postgraduate
level. We aim for products that will settle
comfortably in the global village and
competing successfully with anyone. Our
target is, therefore, to satisfy your quest
for knowledge and skills through
distance education and open learning
Any course or programme launched by ZOU is
conceived from the cross-pollination of ideas
from consumers of the product, chief among
whom are you, the students and your employers.
We consult you and listen to your critical analysis
of the concepts and how they are presented. We
also consult other academics from universities
the world over and other international bodies
whose reputation in distance education and open
learning is of a very high calibre. We carry out
pilot studies of the course outlines, the content
and the programme component. We are only
too glad to subject our learning materials to
academic and professional criticism with the
hope of improving them all the time. We are
determined to continue improving by changing
the learning materials to suit the idiosyncratic
needs of our learners, their employers, research,
economic circumstances, technological
development, changing times and geographic
location, in order to maintain our leading
position. We aim at giving you an education
that will work for you at any time anywhere and
in varying circumstances and that your
performance should be second to none.
As a progressive university that is forward
looking and determined to be a successful part
of the twenty-first century, ZOU has started to
introduce e-learning materials that will enable
you, our students, to access any source of
information, anywhere in the world through
internet and to communicate, converse, discuss
and collaborate synchronously and
asynchronously, with peers and tutors whom
you may never meet in life. It is our intention
to bring the computer, email, internet chat-
rooms, whiteboards and other modern methods
of delivering learning to all the doorsteps of
our learners, wherever they may be. For all these
developments and for the latest information on
what is taking place at ZOU, visit the ZOU
website at www.zou.ac.zw
Having worked as best we can to prepare your
learning path, hopefully like John the Baptist
prepared for the coming of Jesus Christ, it is my
hope as your Vice Chancellor that all of you,
will experience unimpeded success in your
educational endeavours. We, on our part, shall
continually strive to improve the learning
materials through evaluation, transformation of
delivery methodologies, adjustments and
sometimes complete overhauls of both the
materials and organizational structures and
culture that are central to providing you with
the high quality education that you deserve. Note
that your needs, the learner ‘s needs, occupy a
central position within ZOU’s core activities.
Best wishes and success in your studies.
_____________________
Prof. Primrose Kurasha
Vice Chancellor
 The Six Hour Tutorial Session At
The Zimbabwe Open University
A s you embark on your studies with the Zimbabwe
Open University (ZOU) by open and distance
learning, we need to advise you so that you can make
the best use of the learning materials, your time and
the tutors who are based at your regional office.
The most important point that you need to note is
that in distance education and open learning, there
are no lectures like those found in conventional
universities. Instead, you have learning packages that
may comprise written modules, tapes, CDs, DVDs
and other referral materials for extra reading. All these
including radio, television, telephone, fax and email
can be used to deliver learning to you. As such, at
the ZOU, we do not expect the tutor to lecture you
when you meet him/her. We believe that that task is
accomplished by the learning package that you receive
at registration. What then is the purpose of the six
hour tutorial for each course on offer?
At the ZOU, as at any other distance and open
learning university, you the student are at the centre
of learning. After you receive the learning package,
you study the tutorial letter and other guiding
documents before using the learning materials. During
the study, it is obvious that you will come across
concepts/ideas that may not be that easy to understand
or that are not so clearly explained. You may also
come across issues that you do not agree with, that
actually conflict with the practice that you are familiar
with. In your discussion groups, your friends can bring
ideas that are totally different from yours and
arguments may begin. You may also find that an idea
is not clearly explained and you remain with more
questions than answers. You need someone to help
you in such matters.
This is where the six hour tutorial comes in. For it
to work, you need to know that:
· There is insufficient time for the tutor to
lecture you
· Any ideas that you discuss in the tutorial,
originate from your experience as you
work on the materials. All the issues
raised above are a good source of topics
(as they pertain to your learning) for
discussion during the tutorial
· The answers come from you while the
tutor’s task is to confirm, spur further
discussion, clarify, explain, give
additional information, guide the
discussion and help you put together full
answers for each question that you bring
· You must prepare for the tutorial by
bringing all the questions and answers
that you have found out on the topics to
the discussion
· For the tutor to help you effectively, give
him/her the topics beforehand so that in
cases where information has to be
gathered, there is sufficient time to do
so. If the questions can get to the tutor
at least two weeks before the tutorial,
that will create enough time for thorough
preparation.
In the tutorial, you are expected and required to
take part all the time through contributing in every
way possible. You can give your views, even if
they are wrong, (many students may hold the same
wrong views and the discussion will help correct
 The Six Hour Tutorial Session At The Zimbabwe Open University

the errors), they still help you learn the correct thing
as much as the correct ideas. You also need to be
open-minded, frank, inquisitive and should leave no
stone unturned as you analyze ideas and seek
clarification on any issues. It has been found that
those who take part in tutorials actively, do better in
assignments and examinations because their ideas are
streamlined. Taking part properly means that you
prepare for the tutorial beforehand by putting together
relevant questions and their possible answers and
those areas that cause you confusion.
Only in cases where the information being discussed
is not found in the learning package can the tutor
provide extra learning materials, but this should not
be the dominant feature of the six hour tutorial. As
stated, it should be rare because the information
needed for the course is found in the learning package
together with the sources to which you are referred.
Fully-fledged lectures can, therefore, be misleading
as the tutor may dwell on matters irrelevant to the
ZOU course.
Distance education, by its nature, keeps the tutor
and student separate. By introducing the six hour
tutorial, ZOU hopes to help you come in touch with
the physical being, who marks your assignments,
assesses them, guides you on preparing for writing
examinations and assignments and who runs your
general academic affairs. This helps you to settle
down in your course having been advised on how
to go about your learning. Personal human contact
is, therefore, upheld by the ZOU.

The six hour tutorials should be so structured that the

tasks for each session are very clear. Work for each
session, as much as possible, follows the structure given
below.

Session I (Two Hours)

Session I should be held at the beginning of the semester. The main aim
of this session is to guide you, the student, on how you are going to
approach the course. During the session, you will be given the overview
of the course, how to tackle the assignments, how to organize the logistics
of the course and formation of study groups that you will belong to. It is
also during this session that you will be advised on how to use your
learning materials effectively.
 The Six Hour Tutorial Session At The Zimbabwe Open University

Session II (Two Hours)

This session comes in the middle of the semester to respond to the
challenges, queries, experiences, uncertainties, and ideas that you are
facing as you go through the course. In this session, difficult areas in the
module are explained through the combined effort of the students and
the tutor. It should also give direction and feedback where you have not
done well in the first assignment as well as reinforce those areas where
performance in the first assignment is good.

Session III (Two Hours)

The final session, Session III, comes towards the end of the semester.
In this session, you polish up any areas that you still need clarification on.
Your tutor gives you feedback on the assignments so that you can use
the experience for preparation for the end of semester examination.

Note that in all the three sessions, you identify the areas
that your tutor should give help. You also take a very
important part in finding answers to the problems posed.
You are the most important part of the solutions to your
learning challenges.

Conclusion for this course, but also to prepare yourself to

In conclusion, we should be very clear that six
hours is too little for lectures and it is not
necessary, in view of the provision of fully self-
contained learning materials in the package, to
turn the little time into lectures. We, therefore,
urge you not only to attend the six hour tutorials
contribute in the best way possible so that you
can maximally benefit from it. We also urge you
to avoid forcing the tutor to lecture you.
BEST WISHES IN YOUR STUDIES.
ZOU
Contents

Overview __________________________________________________ 1

Unit: Introduction to Cost Accounting

1.0 _______ Introduction ________________________________________________ 3
1.1 _______ Unit Objectives ______________________________________________ 3
1.2 _______ What is Cost Accounting? _____________________________________ 3
1.3 _______ The Role of Cost Accounting ___________________________________ 4
1.4 _______ Comparison of Cost Accounting to Financial Accounting ____________ 4
_________ Activity 1.1 _________________________________________________ 4
1.5 _______ Cost Terms and Purposes ______________________________________ 5
_________ 1.5.1 Cost ___________________________________________________ 5
_________ 1.5.2 Cost unit _______________________________________________ 5
_________ 1.5.3 Cost centre _____________________________________________ 5
_________ 1.5.4 Cost object _____________________________________________ 6
1.6 _______ Cost Tracing and Cost Allocation ________________________________ 6
_________ 1.6.1 Direct costs_____________________________________________ 6
_________ 1.6.2 Indirect costs ___________________________________________ 6
_________ 1.6.3 Cost tracing ____________________________________________ 6
_________ 1.6.4 Cost allocation __________________________________________ 7
_________ Activity 1.2 _________________________________________________ 7
1.7 _______ Summary ___________________________________________________ 8
_________ References __________________________________________________ 9

Unit 2: Cost Behaviour Patterns

2.0 _______ Introduction _______________________________________________ 10
2.1 _______ Unit Objectives _____________________________________________ 10
2.2 _______ Cost Behaviour _____________________________________________ 10
_________ 2.2.1 Level of activity ________________________________________ 10
_________ 2.2.2 Cost behaviour pattern __________________________________ 11
2.3 _______ Classifying Costs According to Behaviour ________________________ 11
_________ 2.3.1 Fixed cost _____________________________________________ 11
_________ 2.3.2 Variable cost ___________________________________________ 12
_________ 2.3.4 Mixed cost ____________________________________________ 14
 _________ 2.3.5 Step cost ______________________________________________ 14
_________ Activity 2.1 ________________________________________________ 15
2.4 _______ Cost Estimation ____________________________________________ 16
_________ 2.4.1 Estimating cost function _________________________________ 16
_________ 2.4.2 Estimation methods ____________________________________ 16
_________ Activity 2.2 ________________________________________________ 18
_________ 2.4.3 Least squares regression _________________________________ 19
_________ Activity 2.3 ________________________________________________ 23
2.5 _______ Summary __________________________________________________ 24
_________ References _________________________________________________ 25

Unit 3: Overhead Cost Accounting and Control

3.0 _______ Introduction _______________________________________________ 26
3.1 _______ Unit Objectives _____________________________________________ 26
3.2 _______ Overhead Cost ______________________________________________ 26
_________ 3.2.1 Production overhead ____________________________________ 26
_________ 3.2.2 Administration overheads ________________________________ 26
_________ 3.2.3 Selling overheads _______________________________________ 27
_________ 3.2.4 Distribution overheads___________________________________ 27
3.3 _______ Absorption of Overheads _____________________________________ 27
_________ 3.3.1 Departmental rates _____________________________________ 28
_________ Activity 3.2 ________________________________________________ 29
3.4 _______ Support Department Cost Allocation ____________________________ 30
3.5 _______ Activity Based Costing (ABC) and Overhead Absorption ____________ 33
3.6 _______ Summary _________________________________________________ 36
_________ References _________________________________________________ 37

Unit 4: Job Costing

4.0 _______ Introduction _______________________________________________ 38
4.1 _______ Unit Objectives _____________________________________________ 38
4.2 _______ What is Job Costing? ________________________________________ 38
_________ 4.2.1 Job card ______________________________________________ 38
4.3 _______ Cost Flows _________________________________________________ 39
4.4 _______ Job Costing Plant-wide and Department Overhead Rates ___________ 40
4.5 _______ Multiple Jobs and Work in Progress ____________________________ 41
_________ Activity 4.1 ________________________________________________ 43
4.6 _______ Summary __________________________________________________ 43
_________ References _________________________________________________ 44

Unit 5: Process Costing

5.0 _______ Introduction _______________________________________________ 45
5.1 _______ Unit Objectives _____________________________________________ 45
5.2 _______ Characteristics of Process Costing _____________________________ 45
_________ 5.2.1 Type of industries that apply process costing ________________ 45
 5.3 _______ Process Costing Procedure ____________________________________ 46
5.4 _______ Process Losses and Wastages __________________________________ 47
_________ 5.4.1 Accounting treatment of normal and abnormal losses ________ 47
_________ The cost of normal process loss is absorbed and becomes part of the cost
_________ of producing the product under a process. The production cost excludes _
_________ abnormal loss which is transferred as a period cost to the statement of _
_________ comprehensive income. _______________________________________ 47
_________ Activity 5.1 ________________________________________________ 49
5.5 _______ Equivalent Unit ____________________________________________ 49
_________ Activity 5.3 ________________________________________________ 55
5.8 _______ Summary __________________________________________________ 56
_________ References _________________________________________________ 57

Unit 6: Inventory Costing Methods

6.0 _______ Introduction _______________________________________________ 58

6.1 _______ Unit Objectives _____________________________________________ 58
6.2 _______ Marginal Costing and Absorption Costing ________________________ 58
_________ 6.2.1 The Fundamental Differences between Marginal Costing and _____
_________ Absorption Costing __________________________________________ 58
6.3 _______ Production, Sales and Income Relationships _____________________ 62
6.4 _______ Reconciliation of Absorption Costing and Marginal Costing Net Profits 64
_________ Activity 6.1 ________________________________________________ 65
6.5 _______ Summary __________________________________________________ 66
_________ References _________________________________________________ 67

Unit 7: Cost Volume Profit Analysis

7.0 _______ Introduction _______________________________________________ 68
7.1 _______ Unit Objectives _____________________________________________ 68
7.2 _______ Uses of CVP Analysis ________________________________________ 68
7.3 _______ Cost Volume Profit Analysis Basic Assumptions __________________ 68
7.4 _______ Calculating the Break Even Point ______________________________ 68
_________ 7.4.1 Break even equation technique ____________________________ 72
7.5 _______ Other Cost - Volume - Profit Formulae ________________________ 73
_________ Activity 7.2 ________________________________________________ 75
7.6 _______ Summary __________________________________________________ 76
_________ References _________________________________________________ 76

Unit 8: Budgeting, Planning and control

8.0 _______ Introduction _______________________________________________ 77
8.1 _______ Unit Objectives _____________________________________________ 77
8.2 _______ What is a Budget? __________________________________________ 77
 _________ 8.2.1 Purposes of budgeting ___________________________________ 77
8.3 _______ Budgetary Control Process ____________________________________ 78
_________ 8.3.1 Establishment of objectives ______________________________ 78
_________ 8.3.2 Budget centres _________________________________________ 78
_________ 8.3.3 Budget coordination ____________________________________ 78
_________ 8.3.4 Board of directors ______________________________________ 78
8.4 _______ Type of Budgets ____________________________________________ 79
8.5 _______ Budgetary Improvement Techniques ____________________________ 79
8.6 _______ Preparation of Budgets ______________________________________ 81
_________ Activity 8.1 ________________________________________________ 82
_________ Activity 8.2 ________________________________________________ 86
8.7 _______ Flexible Budget _____________________________________________ 86
_________ Activity 8.3 ________________________________________________ 88
8.8 _______ Summary __________________________________________________ 88
_________ References _________________________________________________ 89

Unit 9: Standard Costing

9.0 _______ Introduction _______________________________________________ 90
9.1 _______ Unit objectives ______________________________________________ 90
9.2 _______ What is a Standard? _________________________________________ 90
_________ 9.2.1 The role of standards ___________________________________ 90
9.3 _______ Standard Product/ Services Costing _____________________________ 91
9.4 _______ Variance Analysis ___________________________________________ 91
_________ Activity 9.1 ________________________________________________ 96
9.5 _______ Overhead Variance __________________________________________ 96
9.6 _______ Summary _________________________________________________ 100
_________ References ________________________________________________ 100

Unit 10: Cost Allocation: Joint Products and By-Products

10.0 ______ Introduction ______________________________________________ 101
10.1 ______ Unit Objectives ____________________________________________ 101
10.2 ______ What are Joint Products? ___________________________________ 101
_________ 10.2.1 Characteristics of joint products ________________________ 101
10.3 ______ What is a By-Product? _____________________________________ 102
_________ 10.3.1 Examples of by-products ______________________________ 102
_________ 10.3.2 Scrap and Waste ______________________________________ 102
10.4 ______ Approaches to Allocating Joint Costs __________________________ 102
_________ 10.4.1 Sales value at split-off material _________________________ 104
_________ 10.4.2 Physical measure method ______________________________ 105
_________ 10.4.3 Estimated net realisable value method (NRV) ______________ 106
_________ Activity 10.1 ______________________________________________ 107
10.5 ______ Summary _________________________________________________ 109
__________ References ______________________________________________________ 110
__________ Appendix A _____________________________________________________ 111
__________ Solutions for Selected Activities _____________________________________ 111
_________ Activity 2.2 Question 2 Solution ______________________________ 111
_________ Activity 8:3 Solution ________________________________________ 112
_________ Activity 9.2 Solution ________________________________________ 113
_________ Activity 10.1 Solution _______________________________________ 114
Module Overview
 
Cost accounting has become an integral part of company strategic policy formulation due to the
globalisation of world economies. Production automation has grown at a rapid pace as efficient
production processes have become the real economic competitive advantage of the 21st Century.
Consequently, tracking the cost of these technologies and their effect on overhead costs can be a
major challenge for the modern cost accountant.

This module therefore, aims to equip you with cost accounting skills necessary to provide
reliable and useful information that can be used to promote efficiency and provide competitive
advantage in today’s globalised economy.

This module shall define the common cost concepts and terms used in cost accounting. The role
of cost accounting in the modern business world shall also be discussed. We will conduct an
analysis of cost in respect of its behavioural patterns and its estimation process. Analysis of
behavioural patterns of cost is necessary in order to provide management with relevant
information for planning and controlling of limited resources. The module will then show you
how to allocate overhead expenditure and highlighting the nature and classification of overheads.
The module will illustrate how to use the simultaneous equation method of allocation and
apportionment of service cost centres. The concept of Activity Based Costing (ABC) will be
explained.

This module will show the difference between marginal costing and absorption costing, and how
the two methods affect inventory valuation and financial reporting. The importance of
cost – volume, profit analysis in decision making such as pricing of products and services shall
also be discussed. The inter-relationship between cost profit and sales production volume will be
analysed.

The principles and practices of budgeting and budgetary control will be highlighted. The
concluding unit of the module will illustrate methods for allocating joint costs to products and
services.

In Unit One, we will define the common cost concepts and terms used in cost accounting. The
role of cost accounting in the modern business world shall also be discussed.
In Unit Two, we will conduct an analysis of cost in respect of its behavioural patterns and its
estimation process. We will also show you how an understanding of cost behaviour patterns
helps management in planning and controlling a company’s resources.
In Unit Three, we will analyse overhead expenditure. We will also discuss how management can
control overheads as a competitive strategy.
1 
 
In Unit Four, we will discuss cost assignment under job costing. We discuss the use of job
costing in firms that produce heterogeneous products. We will show the treatment of different
types of costs such as raw material cost, direct labour cost and overhead cost.

In Unit Five, we will discuss the application of process costing in the manufacturing sector and
how it can be effectively used for accountability. We will also discuss the characteristics of
process costing, how products flow in the course of processing, the equivalent units of
production to be transferred to the next stage of production, accounting for spoilages and losses.

In Unit Six, we will explain the difference between marginal costing and absorption costing. We
will show you how the two methods differ in their treatment of fixed production overheads.

In Unit Seven, we will discuss the importance of cost volume profit analysis in decision-making,
such as, pricing of products and services.

In Unit Eight, we will discuss the principles and practices of budgeting and budgetary control.
The general purpose of budgets will also be discussed in addition to the budgetary improvement
techniques such as Zero Based Budgeting.
In Unit Nine, we will explain standard costing system. We will also show how standard cost
systems are adopted to improve planning and control and to facilitate product costing.

In Unit Ten, we will discuss joint costs. We will also examine methods used for allocating joint
costs of joint products such as sales value at split-off.

2 
 
Blank page
 Unit 1

Introduction to Cost Accounting

1.0 Introduction
The study of cost accounting helps us to understand the role of management and the accountant’s
contribution to management’s decision making process. In this unit, we define the common cost
concepts and terms used in cost accounting. The role of cost accounting in the modern business
world shall also be discussed.

1.1 Unit Objectives

By the end of this unit, you should be able to:
• define Cost Accounting
• explain the role of cost accounting in an organisation
• draw up a comparison between cost accounting and financial accounting
• explain the various terms used in cost accounting

1.2 What is Cost Accounting?

Arora (2009) defines cost accounting as the process of accounting for costs from the point at
which expenditure is incurred or committed to the establishment of its ultimate relationship with
cost centres and cost units.
Cost accounting is therefore an information system that facilitates collection and analysis of
economic data to produce meaningful reports such as product cost and profitability of business
activities.
Horngren, Foster and Data (1997:02) state that “Cost accounting measures and reports financial
and non-financial information related to the organisation’s acquisition or consumption of
resources”. The latter therefore propound the idea that cost accounting is a management tool for
making optimum use of scarce resources such as cash, and ultimately adding to the profitability
of business operations.
Examples of management decisions that can be aided by cost accounting tools and techniques:
a) What is the effect of product design changes on manufacturing costs?
b) How much of the marketing budget should be spent on advertising?

3 
 
1.3 The Role of Cost Accounting

In today’s world, cost accounting plays a much broader role than just providing the cost of
products and services. It provides useful information to management for:
a) Formulating and implementing plans and budgets that motivate employees toward the
achievement of company goals.
b) Controlling of operations, cost savings, and improving the quality of products and
services.
c) Pricing products and services in ways that are congruent with organisational goals and
maximising shareholders’ wealth.
d) Making prudent decisions that impact on both short-term and long-term flows of revenue
and expenses.

1.4 Comparison of Cost Accounting to Financial Accounting

Cost accounting is complimentary to financial accounting with respect to the supply of material
costs, labour costs and inventory valuation. This facilitates the preparation of financial
statements. However, there are fundamental differences between the two systems.
Table 1.1 Comparison of Cost Accounting to Financial Accounting
Financial Accounting Cost Accounting
Purpose For external reporting to For internal reporting to
shareholders, creditors, tax management
authorities and prospective
investors.
Reporting Follows generally accepted Is not bound by rules and procedures
rules accounting standards, (GAAP) but follows scientific and logical
and internal accounting standards reasoning.
(IAS)
Analysis of Discloses profit for the entire Shows the profitability of each
profit business as a whole. product or service, process or
operation.
Pricing Financial accounting information Cost accounting provides adequate
is not structured to assist in price data for formulating pricing policy.
determination.
Valuation Stock is valued at lower of cost or Stock is always valued at cost price.
of stock market value.
Time value. Is historical in nature. Is futuristic in nature.

Activity 1.1
Fill in the following table based on your understanding of cost accounting and financial
accounting.

4 
 
 A Comparison of Financial Accounting and Cost Accounting
. Characteristics of Characteristics of cost
financial accounting accounting
Users of information

Extent of formal
regulation.

Degree of uniformity
across different
organisations
Relevance for
managerial decision
making

1.5 Cost Terms and Purposes

Various cost terms and concepts help demonstrate the multiple purposes of cost accounting.

1.5.1 Cost
A cost is defined as a resource sacrifice or forgone to achieve a specific objective (Horngren
1997). Therefore, cost is what must be given up, for example money, machines, materials, in
order to obtain something of value.

1.5.2 Cost unit

This is a unit of quantity of product or service in relation to which costs may be ascertained or
expressed.
Examples of cost units are:
a. Units of product such as; b. Units of service such as ;
-Litre of milk -Medical doctor’s consulting hour
-Pair of shoes -Kilowatt hour (KWH) of Electricity
-Ton of cement -Hospital operation

In relation to each of the products or services above, cost (of materials, labour and other
expenses) can be ascertained. The cost accountant should be able to avail management with
information about total cost of a product or service per unit.

1.5.3 Cost centre

A cost centre can be defined as a location, a person or an item of equipment in relation to which
cost may be ascertained and used for the purpose of cost control (Arora, 2009).
A location : may mean a department/factory.
A person : may refer to a production manager, sales manager or human resources manager.
An item : of equipment maybe a machine, or a delivery vehicle.

5 
 
The purpose of a cost centre is to facilitate effective cost control within an organisation. All the
costs incurred should be charged to the relevant cost centre. For example a faculty at Zimbabwe
Open University; all the costs incurred by the faculty must be charged to that faculty as a cost
centre. Costs for the faculty can include stationery, lecturers’ salaries and vehicle maintenance.

1.5.4 Cost object

A cost object is any item such as a product, a customers, a department, a projects or activity for
which costs are measured and assigned, for example if a hospital wants to determine the cost of a
surgical department, then the cost object is the surgical department. If a toy manufacturer wants
to determine the cost of developing a new toy, the cost object is the new toy development
project. If a bank wants to determine the cost of a platinum credit card, then the cost object is the
platinum credit card.

Other examples of cost objects:

Cost object Illustration
Product A ten-speed bicycle
Service An airline flight from Harare to Kinshasa
Project An airplane assembled by Airbus for Air-France
Activity A test to determine quality level of a television set
Programme A university athletics programme

1.6 Cost Tracing and Cost Allocation

Costs have a direct and indirect relationship to a particular cost object.

1.6.1 Direct costs

Are costs that are related to the particular cost object and that can be traced in an economically
feasible (costs effective) way.

1.6.2 Indirect costs

Are costs that are related to the particular cost object but cannot be traced to it in an
economically feasible way. Indirect costs are allocated to the cost object using a cost allocation
method.

1.6.3 Cost tracing

Cost tracing is the assignment of costs to a cost object using an observable measure of resources
consumed by the cost object.

Tracing costs to cost objects can occur in two ways:

a) Direct tracing-Is the process of identifying and assigning costs that are exclusively and
physically associated with a cost object to that cost object. This is often accomplished by
physical observation, for example, How many bricks used in building a house.
b) Driver tracing-Is the use of cost drivers to assign costs to cost objects. Drivers are factors that
cause changes in resource usage and thus have a cause –and–effect relationship with the costs
associated with a cost object.

6 
 
Examples of cost drivers:

Table 1.2 Examples of Cost Drivers by Business Function

Business Function Cost Driver
Production Number of units produced
Number of set ups
Marketing Number of advertisements run
Number of sales personnel
Distribution Number of items distributed
Weight of items distributed

1.6.4 Cost allocation

Indirect costs are assigned to a cost object using an assumed linkage since there is no casual
relationship between indirect costs and the cost object. For example, the cost of air-conditioning
and lighting at a manufacturing plant which produces five different products. It is difficult to
observe any casual relationship. A convenient way to allocate this cost is simply to assign it in
proportion to the direct labour hours used by each product.

Cost assignment encompasses both cost tracing and cost allocation, with indirect costs being
allocated to the cost object, and direct costs traced to the cost object.

 
Cost Tracing
   Direct Costs  Cost Object 
e.g. 
A bicycle 
Cost
Assignment
  Cost Allocation
Indirect Costs 

Figure 1.1 Cost Assignment

Activity 1.2
A Toyota analyst is preparing a presentation on cost drivers. Unfortunately, both the list of
business function areas and the accompanying list of representative cost drivers is accidentally
randomised.

The two lists appear as follows:

7 
 
 Business Function Area Cost Driver
a) Design of Products/Processes 1. Number of cars recalled for defective parts

b) Customer service 2. Number of machine assembly hours

c) Marketing 3. Number of research scientists

d) Research and Development 4. Hours of computer aided design (CAD) work

e) Distribution 5. Number of sales personnel

f) Production 6. Weight of cars shipped

Required
1 a) Match each business function with its representative cost driver.
b) Give a second example of a cost driver for each of the business function areas of Toyota.
2 “Cost accounting is indispensible to the intelligent and economical management of a business”.
Discuss.
3. Explain the difference between a cost object and a cost centre.
 

1.7 Summary
In this unit we explained the meaning of cost accounting and made a comparison between cost
accounting and financial accounting. Important cost accounting terminology, such as, cost unit,
cost centre, cost object have been explained and exemplified. The role of cost accounting in
organisations was also discussed with a view to advancements in technology and how
information is processed.

8 
 
References
Arora, M.N. (2009). Cost and Management Accounting Theory, Problems and Solutions.
Mumbai: Global Media.

Horngren, C.T., Foster, G. and Datar, S.M. (1997). Cost Accounting: A Managerial Emphasis
(9th Edition). New Jersey: Prentice Hall, Inc.

Hansen, D.R. and Mowen, M.M. (2000). Management Accounting (5th Edition). Cincinnati:
South-Western College Publishing.

9 
 
Blank page
 Unit 2

Cost Behaviour Patterns

2.0 Introduction
In this unit we will conduct an analysis of cost in respect of its behavioural patterns and its
estimation process. Analysis of behavioural patterns of cost is necessary in order to provide
management with relevant information for planning and controlling of limited resources.

2.1 Unit Objectives

By the end of this unit, you should be able to:
• define cost behaviour
• classify costs according to behaviour
• use the high-low method to estimate elements within semi-fixed costs
• apply the regression analysis in measuring the goodness of fit
• calculate the coefficient of determination

2.2 Cost Behaviour

Cost behaviour refers to the way in which costs respond to decrease or increase in the activity
level of an organisation (Hansen and Mowen, 2000).
Factors influencing cost behaviour include:
• Activity level
The concept of activity level may be addressed by alternative terms depending on the
nature of business concerned. Common terms include throughput, output, volume and
capacity. Specific examples include sales volume, production volume, hours of work, and
number of invoices processed.

• Non-volume factors
Non-volume factors that might influence cost behaviour include technology applied,
methods of production, levels of efficiency, and price levels.

2.2.1 Level of activity

This refers to the amount of work done, volume of production, number of units sold, units of
electricity consumed or labour turnover. Level of activity is in relation to the quantity of product
produced or service rendered in a given period of time.

10 
 
2.2.2 Cost behaviour pattern
To understand cost behaviour patterns, one should determine for each item of cost:
a) in what way do costs rise, and
b) by how much, as the level of activity increases?

2.3 Classifying Costs According to Behaviour

Costs behave differently in response to changes in levels of activity. They are classified as
follows:

2.3.1 Fixed cost

A fixed cost is a cost that in total remains constant within a relevant range as the level of activity
output changes. A fixed cost can be described as a period cost in that it relates to a span of time
and not the level of activity.

TFC (Total fixed cost)

0 Level of activity
Figure 2.1 Fixed Cost

Figure 2.1 above shows that the total fixed cost would remain unchanged regardless of the
volume of activity.

Cost

FC /unit
0
Level of activity

Figure 2.2 Fixed Cost Per Unit

11 
 
Figure 2.2 shows that fixed cost per unit produced decreases as activity level increases. Assume
that total fixed costs remain the same at $10 000. The company increases production from 5 000
units per month to 7 000 units per month. To find out the change in the fixed cost per unit, divide
$10 000 by 5 000 units, and then divide by 7 000 units, the FC/Unit has decreased from $2 per
unit to $1.43 per unit. This therefore shows that the fixed cost per unit and volume of activity are
universally related. An example of a fixed cost is rent expense.

2.3.2 Variable cost

A variable cost is a cost whose total dollar varies in direct proportion to changes in the activity
level.

Cost

TVC (Total Variable Cost)

0
Level of activity
Figure 2.3 Variable Cost Graph

When level of activity is zero there will be no variable cost. As the level of activity rises upward
total variable cost (TVC) would rise.

\
Cost

VC/ unit

0 Level of activity
Figure 2.4 Variable Cost per Unit

12 
 
Variable cost per unit (VC/unit) however would remain unchanged regardless of changes in the
level of activity.

Examples of variable cost include: Cost of raw materials

Cost of direct labour
Sales commission

2.3.3 Non-linear variable costs

These are cost patterns where the costs do not vary in direct proportion with activity level.

Cost

0 Activity level

Figure 2.5 Variable Costs Convex Curve

Figure 2.5 shows that the variable cost graph becomes less steep as levels of activity increase.
Each additional unit adds less to the total variable cost than the previous unit. This means that an
extra unit of activity causes less than proportionate increase in cost (economies of scale). An
example of such a variable cost would be direct materials where quantity discounts are available.

Cost

0 Activity level
Figure 2.6 Variable Cost Concave Curve

Figure 2.6 shows that the variable cost graph becomes steeper as levels of activity increase. Each
additional unit of activity adds more to total variable cost than the previous unit. This means that

13 
 
an extra unit of activity causes more than proportionate increases in cost (that is diminishing
returns). The cost of direct labour where employees are paid a bonus which increases as output
increases might follow the cost behaviour pattern depicted in figure 2.6.

2.3.4 Mixed cost

Mixed cost can be defined as costs in which there is a standing basic charge and the variable
charge per unit of consumption.

Cost

TMC (Total mixed cost)

Variable cost component

TFC (Total fixed cost)

0 Level of productivity
Figure 2.7 Mixed Costs Graph

Examples of mixed cost include: an electricity bill, a telephone bill

 

2.3.5 Step cost

Total step costs are constant over a short range of cost driver activity but increase in steps as
level of activity increases.

Cost

Step cost

0
Level of activity
Figure 2.8 Step Cost Graph

14 
 
For example, depreciation charge would remain fixed if production remains within the capacity
of one machine. If another machine is purchased to meet a new level of demand, depreciation
charge on the new machine would make the total depreciation charge to go up a step. Therefore,
step costs are fixed costs that are subject to gradual changes in response to increased levels of
production.

Example 2.1
A company manufactures two products x and y. The following costs have been estimated:
Product x Product y
Direct materials cost per unit $14 $12
Direct labour hours per unit 1.5 hours 2.5 hours
Direct labour cost per hour $10 $10
Variable overhead cost per hour $2 $2

Fixed costs for the period are expected to be $220 000, and it expected that 5 000 units of
product x and 2 000 units of product y will be manufactured.

Required
Compute the total expected costs for the period.

Solution to example 2.1

Product x Product y Total
Units to be produced 5 000 units 2 000 units
$ $ $
Direct materials 70 000 24 000 94 000
Direct labour 75 000 50 000 125 000
Variable overhead costs 15 000 10 000 25 000
Total variable costs 160 000 84 000 224 000
Fixed costs 220 000
Total costs 464 000

Activity 2.1
1. A business makes two products C and D with the following sales prices and cost data:
C D
Selling price per unit $25 $30
Direct material cost per unit $8 $7
Direct labour cost (0.5 hrs. product D) $6 per unit $8 per hour
Variable overhead $1 per unit $2 per direct labour hour

Required
1. Determine the forecast of total costs and profits for a month when the business expects to
make and sell 1 200 units of product C and 1 800 units of product D.
2. The following information relates to the overhead costs of the production department of a
manufacturing company:
Units of output 5 000 7 000
Overheads $21 100 $26 100
15 
 
 If the variable overhead rate per unit is $2.50, what is the fixed overhead?
3. The following data are records of output levels and overhead costs:
January December
Hours worked 18 000 21 000
Total cost $86 800 $97 438
There was a 3% inflation between January and December.

Required
Ascertain the variable cost per hour worked at January levels to the nearest $0.01

2.4 Cost Estimation

Cost estimation is the determination of the relationship between the activity and cost. It is an
important part of cost management .variable and fixed cost can easily be estimated through
examining and analysing available accounting records for example a variable cost such as sales
commission might be determined to be 15% of sales. Mixed costs, however, are more difficult to
estimate.

2.4.1 Estimating cost function

A cost function is a mathematical function describing cost behaviour patterns, how cost change
with changes in the cost driver.

Steps in calculating a cost function

1. Choose the dependent variable. This is the variable to be predicted, which is a type of
cost for example variable cost.
2. Identify the cost drivers. These are independent variables.
3. Collect data on the dependent variable and cost diverts.
4. Plot the data: -cost driver on the x-axis (independent variable) -dependent variable on the
y-axis.
5. Estimate the cost function.
6. Evaluate the estimated cost function.

2.4.2 Estimation methods

There are several ways in which fixed cost elements and variable cost elements within semi-
fixed cost may be estimated.
Some of the estimation methods are:
• High-low methods
• Scatter-plot graph
Volume of out put on x-axis and then drawing the line of best fit through the points of
intersection.
• Regression analysis

16 
 
High-low method
This is the most straight forward approach to determining the variable and fixed elements of
mixed costs. This method utilises data from two time periods.

Variable cost per unit = Difference in total cost

Difference in activity

Fixed cost = total cost – variable cost.

Example 2.2
Suppose Midlands Plastic Bottle Manufacturers has the following data for the year beginning
2012

Production volume Production cost

January 600 $1 700
February 900 $2 600
March 1 200 $3 200
April 1 000 $2 000

Required
a. Using the high-low method of cost estimation, determine the total fixed cost, variable
cost per unit and the cost function.
b. What should be the cost in May, 2012 if output is expected to be 1 300 units of plastic
bottles.

Solution
a) Periods of highest and lowest activity are March and January 2012.
March $3 200 = a + b (1 200)
January $1 700 = a + b (600)
Where: a are fixed costs per month, and
b are variable cost per month.

Solving for the estimated variable cost

b = Difference in total cost
Difference in activity

b = $3 200 - $1 700
1 200 - 600

b = $2.50
Next, estimated monthly fixed costs are determined by subtracting variable cost from costs of
either January or March.
Where: a = total costs – variable costs

March: a = $3 200 – ($2.50x 1 200)

a = $200

17 
 
 January a = $1 700 – ($2.50 x 600)
a = $200

Therefore the cost function is y = $200 + $2.50X

b) Cost in May = $200 + $2.50 (1 300)

= $3 450

Activity 2.2
1. The operating cost of Gweru Machinery Limited, a firm that produces special mining
equipment for the last six months are as follows.
Month Cost Production volume
June 250 000 150
July 260 000 185
August 220 000 145
September 255 000 151
October 288 000 153
November 230 000 148

Required
1a). Using the high-low method of cost estimation, determine the
i) total fixed cost
ii) variable cost per unit
iii) the cost function
b). What should be the cost in December when output is expected to 130 units of machinery?

2. Consider the following costs of XML limited over the relevant range of 5000 to 20 000
units produced.

Units Produced (U ) 5 000U 10 000U 15 000U 20 000U

Variable cost $200 000 $? $? $?
Fixed cost $1 800 000 $? $? $?
Total cost
Cost per unit
Variable cost $? $? $? $?
Fixed cost $? $? $? $?
Total cost $? $? $? $?
NB: Solution to Activity 2.2 question 2 is in the appendix

Scatter plot
A scatter plot is a graph of past activity and cost data, with individual observations represented
by dots.

18 
 
 ● ● ●
Total cost ● ● ●
●
●
●

Total activity

Figure 2.9 Scatter Diagram

A scatter plot diagram is used in determining whether costs can be reasonably approximated by
drawing a straight line as in figure 2.10 below.

Total cost

● ● ●
● ● ● ●
C0 ● ● ● ●
● ● ● ●
● ● ● ●

V0
Total activity
Figure 2.10 Scatter Plot Diagram with Estimate Line

Once a line is drawn, cost estimates at any representative volume can be made. For a given
volume V0, we can estimate the cost C0 as indicated by the broken line in figure 2.10.

2.4.3 Least squares regression

This is a method used to analyse mixed cost if a scatter graph plot reveals an approximately
linear relationship between the X and Y axis variables. It uses all of the data points to estimate
the fixed and variable cost components of a mixed cost. The goal of this mutual is to fit a straight
line to the data that minimises the sum of the squared errors.

19 
 
 ● estimated y
Set up cost ●
● error actual Y
●
●
● regression line (y = a + b x)

Set up hours
Figure 2.11 Least Squares Regression Graph

Least squares regression also provides a statistic. This statistic is called the coefficient of
determination, and is denoted by R2.

R2 is the percentage of the variation in the dependent variable (total cost) that is explained the
fitted model. In this case the regression model. The higher the percentage the better is the model.

Therefore R2 is the coefficient of determination.

The equation of the regression line is as follows: Total Cost = Fixed Cost + Variable Cost
y = a + bx

Example 2.3
The following are weekly manufacturing labour cost and machine hours of Elegant Rugs Pvt.
Ltd.
Week Manufacturing Machine
Labour cost Hours
1 1 190 68
2 1 211 88
3 1 004 62
4 917 72
5 770 60
6 1 456 96
7 1 180 78
8 710 46
9 1 316 82
10 1 032 94
11 752 68
12 963 48

20 
 
Required
a) Using the above data, estimate the regression line.
b) Calculate the coefficient of determination, R2.

Solution
a) The least-squares technique for estimating the regression line minimises the sum of
squares of the vertical deviations (distances) from the data points to the estimated
regression line.

The object is:

To find values of a and b
in the predicting equation y = a + bx, where y is the predicted cost value, and
Y is the observed cost value

In this question, we should find the numerical value of a and b that minimize ∑(Y-y)2.
This is done by use of two equations called normal equations as follows:
1) ∑Y = na + b(∑X)

2) ∑XY = a(∑X) + b(∑X2)

where, n is the number of data points; ∑X and ∑Y are, respectively, the sums of the given X and
Y values; ∑X2 is the sum of squares of the X values; and ∑XY is the sum of the amounts
obtained by multiplying each of the given X values by the associated observed Y value.

In the table below, substituting the normal equations will give us:

12 501 = 12a + 862b

and 928 716 = 862a + 64 900b

Week Machine Labour Variance Unexplained Variance

hours cost of Y variance of X

X Y XY y (Y- )2 (Y-y)2 (X-X)2

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1 68 1 190 4 624 80 920 100 206 21 968 35 321 15
2 88 1 211 7 744 106 568 120 826 28 646 8 261
3 62 1 004 3 844 62 248 94 020 1 425 4 070 97
4 72 917 5 184 66 024 104 330 15 563 15 952 0
5 60 770 3 600 46 200 91 958 73 848 22 374 140
6 96 1 426 9 216 139 776 129 074 171 603 27 311 584
7 78 1 180 6 084 92 040 110 516 19 113 5 601 38
8 46 710 2 116 32 660 77 524 110 058 4 256 667
9 82 1 316 6 724 107 912 114 640 75 213 28 764 103
10 94 1 032 8 836 97 008 127 012 95 56 701 491
11 68 752 4 624 51 136 100 206 83 955 62 530 15
12 48 963 2 304 46 224 79 586 6 202 27 936 568
TOTAL 862 12 501 64 900 928 716 12 501 607 699 290 824 2 979

21 
 
 a=

b=

a=

a = $300.98

b=

b = $10.31

Therefore, placing a and b in the equation of the least-squares line,

Y = $300.98 + $10.31X,
Where, y is the predicted labour cost for any given number of machine hours within the relevant
range.

1. The Efficiency of the regression model is the extent to which it reduces variance, which is
given by:

∑(Y- Y)2
Y = Observations on actual cost
Y = ∑Y/n
n = Total observations

2. The coefficient of determination, R2 is the explicit measure of the regression model efficiency.
It reflects the percentage reduction in variance attributable to the regression model. R2 is
given by explained variance as a percentage of total variance.

r2 = 1-

r2 = 1-

= 0.52

In this case r2 =0.52. Hence unexplained variance = 0.48. It is more desirable to have a
regression model with maximum efficiency, that is, r2 = 1 which means that the predicted cost
values exactly equal actual cost values, that is the regression model has perfectly explained
variations in actual cost Y. Generally, an r2 of 0.80 or higher is characteristic of a good model.

22 
 
Activity 2.3
1. The finance director at Ubuntu University of Science and Technology is concerned about
the overhead costs at her university. Cost pressures are severe and so controlling and
reducing overheads is very important. The director believes overhead costs incurred are
generally a function of the number of different academic programmes, and the number of
enrolled students.

The following data has since been collected for analysis:

Year Overhead Number of Academic Number of Enrolled
Costs Programmes Students
1 $13 500 29 3 400
2 19 200 36 5 000
3 16 800 49 2 600
4 20 100 53 4 700
5 19 500 54 3 900
6 23 100 58 4 900
7 23 700 88 5 700
8 20 100 72 3 900
9 22 800 83 3 500
10 29 700 73 3 700
11 31 200 101 5 600
12 38 100 103 7 600

Required
a) Using the above data, estimate the regression line.
b) Calculate the coefficient of determination.
c) What insights do the analyses provide about controlling and reducing overhead costs at the
university?

2. Midlands Machinery Corporation wishes to set a flexible budget for its electricity costs which
are primarily a function of machine hours worked. Data for the first four months of operations
is as follows:
Month Electricity Costs Machine Hours
January $3500 200
February 4500 300
March 3000 100
April 5000 400

Required
a) Compute the constant a, and slope coefficient b of the function y = a + bx, using
i) High-low method
ii) The regression approach
b) For the regression, compute the coefficient of determination r2. Comment on the results

23 
 
2.5 Summary
In this unit we explained what is meant by cost behaviour. The behavioural patterns of fixed
costs, variable costs, mixed costs and step costs were explained and graphically illustrated. The
High-Low method of segregating mixed costs into their fixed and variable components has been
explained. High-Low method is one of the methods of cost estimation that can be used with a
view to guide management on cost function and its use in determining the total cost of various
levels of activity in an organisation. Regression analysis was also explained in view of cost
estimation and analysis.

24 
 
References
Arora, M.N. (2010). Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions. Mumbai: Global Media.
Arora, M.N. (2009). Cost and Management Accounting: Theory, Problems and Solutions,
Mumbai: Global Media.

Horngren, C.T., Foster, G. and Datar, S.M. (1997). Cost Accounting: A Managerial Emphasis
(9th Edition), New Jersey: Prentice Hall, Inc.

Hansen, D.R. and Mowen, M.M. (2000). Management Accounting (5th Edition). Cincinnati:
South-Western College Publishing.

25 
 
 Unit 3

Overhead Cost Accounting and Control

3.0 Introduction
In this unit we discuss that management should be aware of the level of expenditure on
overheads. If left uncontrolled, overheads can erode significant proportions of gross profit and
reduce the firm’s competitiveness. Managers should know:
overhead expenditure per cost centre or department
overhead cost per unit produced or service rendered

3.1 Unit Objectives

By the end of this unit, you should be able to:
• explain what is meant by an overhead
• distinguish the type of overheads by function
• calculate departmental overhead rates
• allocate support department costs to production departments using direct, sequential and
reciprocal methods
• explain how an activity based cost system works
• assign overheads using activity based costing

3.2 Overhead Cost

An overhead cost is expenditure on labour, materials or services that can not be directly
identified with a specific cost unit or cost centre.

3.2.1 Production overhead

Refer to indirect costs associated with manufacturing activities. Examples of production
overheads include:
Depreciation of machinery
Supervisor’s salary

3.2.2 Administration overheads

Administration overheads include directing the organisation, and controlling the operations of an
organisation, which is not related to production, selling and distribution activities. Examples of
administration overheads include:
Office rent
Office electricity

26 
 
 Office printing and stationery

3.2.3 Selling overheads

These refer to indirect costs which are associated with marketing and selling activities. Examples
of selling overheads include:
Sales commission
Advertising expenses

3.2.4 Distribution overheads

These are indirect costs associated with the distribution of finished products. Examples of
distribution overheads include:
Warehouse rental
Haulage costs to customers

Activity 3.1
Discuss the problems associated with controlling selling and distribution overheads.

3.3 Absorption of Overheads

Overhead rates are used to assign indirect costs to products and services. Overhead absorption is
the allotment of overhead cost to units by means of predetermined rates. It is the total overhead
assigned to actual production at any given point in time. These can be plant-wide or departmental
rates.

A predetermined overhead rate is a rate based on estimated data and is computed using the
following formula:
Predetermined overhead rate =

Example 3.1
Plant-wide rate
Belring produces two types of computer keyboards, a wireless keyboard and a regular keyboard.
The company has the following data for the year ended 2011:
Budgeted Overhead $360 000
Expected activity (direct labour hours) 100 000
Actual activity (direct labour hours) 100 000
Actual Overhead $380 000

Required
Calculate the predetermined overhead rate for Belring Company

27 
 
Solution
Predetermined Overhead Rate =

=
= $3.60 per direct labour hour
Absorbed Overhead = Overhead rate × Actual activity output
= $3.60 × 100 000
= $360 000
Overhead variance = Actual Overhead – Absorbed Overhead
= $380 000-$360 000
= $20 000 under absorbed overhead

Example 3.2
The following data is also available for the Belring Company in 2011:
Wireless Keyboard Regular Keyboard
Units produced 10 000 100 000
Prime Cost $78 000 $738 000
Direct Labour Hours 10 000 90 000

Required
Calculate the unit manufacturing cost for each product.

Solution
Wireless Keyboard Regular Keyboard
Prime Cost $78 000 $738 000
Overhead cost
$3.6 × 10,000 36 000
$3.6 × 90,000 324 000
Total Manufacturing Cost $114 000 $ 1 062 000
Units produced ÷ 10 000 ÷ 100 000
Cost per unit $11.40 $10.62

3.3.1 Departmental rates

Some departments are more overhead intensive than others and should be assigned larger portion
of overhead costs through the application of departmental rates.

Example 3.3
Assume that Belring in example 3.1 and 3.2 has two production departments, fabrication and
assembly.

28 
 
The following data is available for the year 2011:
Fabrication Assembly
Budgeted overhead $252 000 $108 000
Expected and actual usage (direct labour hours)
Wireless 7 000 3 000
Regular 13 000 77 000
20 000 80 000
Expected and Actual Usage (machine hours)
Wireless 4 000 1 000
Regular 36 000 9 000
40 000 10 000

Belring bases its departmental overhead rates on machine hours in fabrication and on direct
labour hours in assembly. The two overhead rates are therefore calculated as follows:
Fabrication rate = Budgeted overhead
Expected machine hours

= $252 000
40 000

= $6.30 per machine hour.

Assembly rate = Budgeted overhead

Expected direct labour
= $108 000
$80 000
= $1.35 per direct labour hour.
Applied overhead = (6.30 × 4000) + ($1.35 × 80 000)
= $252 000 + $108 000
= $360 000
Unit cost computation using Departmental rates
Wireless Regular
Prime cost $78 000 $738 000
Overhead costs:
($6.30 × 40 000) + ($1.35 × 3 000) $29 250 -
($6.30 × 36 000) + ($1.35 × 77 000) - 330 750
Total manufacturing cost $107 250 $1 068 750
Units produced ÷10 000 ÷ 100 000
Unit cost $10.73 $10.69

Activity 3.2
Tree Top company produces two types of stereo units: deluxe and Regular. For the year 2010,
Tree Top had the following data:

29 
 
 Budgeted overhead $180 000
Expected Activity (Labour hours) 50 000
Actual activity (Labour hours) 51 000
Actual overhead $200 000
Deluxe Regular
Units produced 5 000 50 000
Prime cost $40 000 $300 000
Direct labour hours 5 000 46 000

Required
a) Calculate a predetermined overhead rate based on direct labour hours.
b) What is the absorbed overhead?
c) What is the under absorbed or over absorbed overhead?
d) Calculate the unit cost of each type of stereo unit.

3.4 Support Department Cost Allocation

Support departments provide essential support services for production departments. Support
departments are indirectly connected with an organisation’s products or services. Examples of
support departments include maintenance, housekeeping, and storage. Service department costs
are normally re-apportioned or allocated to production departments.

3.4.1 Objectives of allocating support department overheads

To obtain a mutually agreeable price for products/services
To ascertain product-line profitability
Tovalue inventory
For planning and Control

3.4.2 Methods of allocating service department overheads

Direct re-distribution method
Under this method, service department costs are apportioned over the production departments
only, ignoring the service rendered by one service department to the other.

Example 3.4
Mango Limited has the following data for its departments:
Support Departments Production Departments
Power Maintenance Grinding Assembly
Direct Costs $250 000 $160 000 $100 000 $60 000
Kilowatt-hours - 200 000 600 000 200 000
Maintenance hours 1 000 - 4 500 4 500

Step 1 Calculate allocation ratios

30 
 
 Grinding Assembly
Power
0.75

0.25
Maintenance
0.50

0.50

Step 2: Allocate support department cost using allocation ratios

Power Maintenance Grinding Assembly

Direct Cost $250 000 $160 000 $100 000 $60 000
Powera (250 000) - 187 500 62 500
Maintenanceb - (160 000) 80 000 80 000
$000 000 $000 000 $367 500 $202 500
a
Allocation of power based on allocation ratios from step 1: 0.75 × $250 000, 0.25× $250 000
b
Allocation of maintenance based on allocation ratios step 1: 0.50x $160 000, 0.50 x $160 000

Sequential or step method of allocation

This method gives cognizance to the service rendered by service department to other service
departments. However, the sequential method does not fully recognise support-department
interactions. Cost allocations are performed in step-down fashion, following a predetermined
ranking procedure. Usually, the sequence is defined by ranking the support departments in order
of the amount of service rendered, from the greatest to the least. Degree of service can be
measured by the direct cost of each support department; the department with the highest cost is
seen as rendering the greatest service.

Example 3.5 using the data in example 3.4

Step 1
Maintenance Grinding Assembly
Power
0.20 - -

- 0.60 -

- - 0.20

31 
 
 Maintenance
- 0.50 -

- - 0.50

First, support departments are ranked in accordance with direct costs; here power is first, then
maintenance.
Then, power costs are allocated to maintenance and two production departments.
Then, the costs of maintenance are allocated only to production departments

Step 2
Allocate support department costs using the allocation ratios

Power Maintenance Grinding Aseembly

Direct Cost $250 000 $160 000 $100 000 $60 000
Powera (250 000) 50 000 150 000 50 000
b
Maintenance - (210 000) 105 000 105 000
$000 000 $000 000 $355 000 $215 000
a
Allocation of power based on allocation ratios from step 1: 0.20 × $250 000; 0.60 × $250 000,
and 0.20 × $250 000
b
Allocation of maintenance costs based on allocation ratios from step 1: 0.50 × $210 000;
0.50×$210 000

Reciprocal service methods

These methods are used when different service departments render services to each other, in
addition to rendering service to production departments. In such cases, various service
departments have to share overheads of each other. The methods available for dealing with
reciprocal services include:
1. Simultaneous equation method
2. Repeated distribution method

Example 3.6
A company has three production and two service departments. The overhead analysis sheets
provide the following: $
Production departments X 48 000
Y 42 000
Z 30 000
Service departments B 14 040
C 18000

32 
 
The service departments cost are apportioned as follows:
Production departments Service departments
X Y Z B C
% % % % %
Service Dpt. B 20 40 30 - 10
Service Dpt. C 40 20 20 20 -
Required
Using simultaneous equation method, calculate the total overheads charged to the production
departments.
Solution
Let B represent total overhead of department B, and C total overhead of department C
B received 20% of C’s services
Thus B = 14 040 + 0.2C
C = 18 000 + 0.1B
Using substitution method of simultaneous equation
B = 14 040 + 0.2 (18 000 + 0.1B)
B = 14 040 + 3600 + 0.02B
B-0.02B = 17 640
0.98B = 17 640
B = 18 000

C = 18 000 + (0.1 × 18 000)

= 19 800
Overhead charged to production
Product X Y Z
Allocated overhead 48 000 42 000 30 000
Share of B’s services
(18000 × % served) 3 600 7 200 5 400
Share of C’s services
(19800 × % served) 7 920 3 960 3 960
59 520 53 160 39 360

Activity 3.3
Using information provided in example 3.4, allocate support departments’ overheads using the
reciprocal method.

3.5 Activity Based Costing (ABC) and Overhead Absorption

The major drawback of traditional approach to overhead absorption is that overhead is absorbed
into product cost on the basis of production volume (measured generally in machine hours and

33 
 
labour hours) regardless of the fact that most of the overhead expenses may not have been a
result of that production volume. This therefore results in inaccurate apportionment of overhead
costs and impacting on pricing and profitability.
Overhead Absorption
This is the process of recovering overheads of a department or any other cost centre from its
output. The process is called overhead recovery or overhead absorption

Activity Based Costing (ABC)

This is a system that first accumulates overhead costs for each of the activities of an
organisation, and then assigns the cost of activities to the products, services or other cost objects
that cause that activity.

To establish a cause and effect relationship between an activity and a cost object, cost drivers are
identified for each activity.

Activity based costing (ABC) attempts to find a causal relational between overhead costs and the
cost driver. A cost driver being, any factor which causes a change in the cost of an activity.

Examples of cost drivers and activities.

Activity Possible cost drivers
Production Number of production orders.
Number of production batches
Sales order processing Number of customers
Number of sales order
Production set up Number of production runs
Power Number of Kilowatt hours

ABC assigns cost to activities cost centres rather than department.

Example 3.7
Two products X and Y are made using similar equipment and methods.
Data for the previous year is as follows:
X Y
Units produced 6 000 8 000
Labour hours per unit 1 2
Machine hours per unit 4 2
Set ups in period 15 45
Orders handled in the period 12 60
Overhead for the period
Relating to production set ups $89 500
Relating to order handling $15 000
Relating to machine activity $27 500

Calculate the overhead to be absorbed per unit of each product based on

a) Conventional absorption costing using a labour rate.

34 
 
 b) An ABC approach using suitable cost drivers.

Solution
a) Labour hour rate = Estimated overhead
Estimated labour hours
= $132 000
22 000 hours
= $6 per hour
Amount of overhead absorbed
Product X = 6 000 ($6 × 1) = $36 000
Product Y = 8 000 ($6 × 2) = $96 000
$132 000
b) Production set ups = Cost driver rates
Production set ups
= $89 500
60
= $1 491.67 per set up.
Order handling = $15 000
72
= $208.33 per order handled
Machine costs = $27 500
40 000
0.6875 per machine hour.
X = 6000 × 4 = 24 000 hours
Y = 8000 × 2 = 16 000 hours
40 000 hours.
Overheads absorbed using ABC
Product X Product Y
Set ups (15 × 1 491.67) 22 375
(45 × 1491.67) 89 500
Orders (12 × 208.33) 2 500
(60 × 208.33) 12 500
Machine cost (24000 × 0.6875) 16 500
(16 000 × 0.6875) 11 000
$ 41 375 $90 625
Note the difference between the two approaches in the apportionment of overhead to the unit
costs- the products are as follows:
Products X Product Y
Traditional approach $36 000 $96 000
ABC approach $41 375 $90 625

35 
 
Activity 3.4
Tree Top Company produces two types of stereo units. Activity data for the year ended 31
December 2011 was as follows:
Product costing data
Activity usage
Measures Deluxe Regular Total
Units produced 5 000 50 000 55 000
Prime cost 39 000 369 000 408 000
Direct labour hrs 5 000 45 000 50 000
Machine hours 10 000 90 000 100 000
Production runs 10 5 15
Number of moves 120 60 180

Activity cost data

Activity Overhead activity
Setting up equipment $60 000
Material handling $30 000
Using power $50 000
Testing $40 000
Total $180 000

Required
1. Calculate the consumption rates for each activity.
2. Group activities based on consumption rates and activity level.
3. Calculate a rate for each pooled group of activities.
4. Using the pool rates, calculate unit product costs.

3.6 Summary
In this unit we highlighted the nature and classification of overheads. The simultaneous equation
method of allocation and apportionment of service cost centres was used rather than the
continuous allotment method. We emphasised the importance of concepts and terminology when
dealing with overheads. Examples were used to show how overhead costs are absorbed. The
concept of Activity Based Costing (ABC) was explained. Activity Based Costing is a modern
method for overhead absorption which demands that overheads be allocated on the basis of
activities that drive costs regardless of the department where costs were incurred.

36 
 
References
Arora, M.N. (2009). Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.
Arora, M.N. (2010). Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000). Management Accounting (5th Edition), Cincinnati:
South-Western College Publishing.
Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition) New Jersey: Prentice Hall.

37 
 
 Unit 4

Job Costing
 
 

4.0 Introduction
In this unit and the next unit we will deal with costing methods. A costing method is a system of
cost finding and ascertainment. Each costing method is designed to suit the way in which goods
are manufactured and services are provided. Costing is primarily concerned with ascertaining the
cost of producing a product or rendering a service. Such information is useful to management for
effective planning, controlling and decision-making. One costing method that can be applied is
known as job order costing. The definition and types of industry that use this method will be
discussed below.

4.1 Unit Objectives

By the end of this unit, you should be able to:
• identify the type of firms that use job costing
• describe the cost flow associated with job costing
• prepare accounts to show the flow of costs through manufacturing process
• compute the unit manufacturing cost for a job using departmental overhead rates and
plant wide predetermined overhead rates

4.2 What is Job Costing?

Job Costing is a costing method which applies where production of goods or services is carried
out to customer’s specific requirements. Examples of industries where job costing applies
include:
Printing
Construction
Furniture
Auto repair
Dental service
Landscaping

4.2.1 Job card

A distinct job number is assigned and a job card is opened for each job. The job number is
quoted on all material requisition orders for proper cost accumulation. The job card format varies
from one organisation to the other, but basic information contained includes:
Customer name
Job number

38 
 
 Job description
Columns for : material used, labour , overheads
Total cost accumulated for the job (price)

4.3 Cost Flows

Under job costing system the costs of manufacturing a product flow through a ledger system
which includes accounts:
Raw materials
Work in progress
Overhead control
Finished goods
Costs of goods sold

Raw materials       Work in progress 
1) 2 500     2)1 500                 2)        1 500       6)            2 320 
3) 1 530
4) 340

Salaries payable Finished goods

3) 1 530 6) 2 320 7) 2 320

Overhead control Cost of goods sold

5) 415 4) 340 7) 2 320
8) 75 8) 75

Figure 4.1 Example of manufacturing costs flows

Manufacturing costs in figure 4.1 were as follows:

1) Purchase of Raw Materials $2 500
2) Issue of raw materials $1 500
3) Incurrence of direct labour cost $1 530
4) Application /absorption of overhead 340
5) Incurrence of actual overhead cost 415
6) Transfer of Job to finished goods 2 320
7) Cost of goods sold of job 2 320
8) Under absorbed / under applied overhead 75

The manufacturing process starts with the raw materials needed to make the product, add the
labour and factory overhead costs, ends up with a finished product which becomes the inventory
that you sell. When you sell it you now have cost of goods sold. As a result of the manufacturing
process, at any given time a company will have three types or stages of inventory as follows:

39 
 
 1. Materials Inventory - consists of materials and supplies used in making the
product.
2. Work in Process Inventory - consists of units that we have started work on but
have not yet completed.
3. Finished Goods Inventory- consists of finished units that we have not yet sold to
customers.

4.4 Job Costing Plant-wide and Department Overhead Rates

The completion of a job rarely coincides with the end of a fiscal year. This means that if
overhead rates are not determined in advance by the use of a predetermined rate, then there will
be substantial delays in costing out jobs. The job costing system normally includes the following
types of costs:
actual material cost
actual direct labour cost
applied overhead based on predetermined rates
4.4.1 Importance of job costing
Companies need job costing information in order to:
generate financial statements
make decisions such as the price to charge for a job
Example 4.1
Rustenburg Company uses a normal job costing system. The company has two departments
through which jobs pass. Budgeted and actual data for the year 2011 was as follows.
Department A Department B
Budgeted overhead $100 000 $500 000
Actual overhead $110 000 $500 000
Expected direct
Labour hours 50 000 10 000
Expected machine hours 10 000 50 000
Actual direct labour hrs 10 500 52 000
During the year, several jobs were completed .data pertaining to job number 25 was as follows:
Direct materials $20 000
Direct labour cost
Department A (5 000 hrs @ $6) $30 000
Department B (1 000 hrs @$6) $6 000
Machine hours used
Department A 100 hours
Department B 1 200 hours
Units produced 10 000
Rustenburg uses a plant wide predetermined overhead rate to assign overheads to jobs. Direct
labour hours is used to compute the predetermined overhead rate.

40 
 
Required
1. Compute the predetermined overhead rate.
2. Using the predetermined overhead rate, compute the per –unit manufacturing cost for job
number 25.
3. Recalculate the unit manufacturing cost, using departmental overhead rates. Use direct
labour hours for department A and machine hours for department B.

Solution to example 4.1

1. Predetermined overhead rate = $ 600 000
60 000
= $10 per direct labour hr.
2. Direct material = $20 000
Direct labour = $36 000
Overhead ($10 x 6000) = $60 000
Total manufacturing cost $116 000
÷ 10 000 units
Unit cost $11.60
3. Predetermined Rate Department A = $100 000
50 000
= $2/DHL

Department B = $500 000

50 000
= $10/ machine hour.
Direct material $20 000
Direct labour $ 36 000
Overhead
Department A ($2 x 5 000) $10 000
Department B ($10 x 1 200) $12 000
Total manufacturing cost $78 000
Unit cost $7.80

Therefore, assignment using department rates is more accurate because there is a higher
correlation with the overhead assigned and the overhead consumed.

4.5 Multiple Jobs and Work in Progress

Gambiza Landscape Ltd designs landscape plans and plants the material for clients.
On 1 April there were 3 jobs in progress Job 68, 69 and 70. During April, two more jobs were
started Job 71 and 72. By 30 April, jobs 69, 70 and 72 were completed. The following data was
gathered:
Job 68 Job 69 Job 70 Job 71 Job72
1 April balance b/d $540 $1 230 $990 - -
Direct material 700 560 75 3 500 2 750
Direct labour 500 600 90 2 500 2 000

41 
 
Overheads are absorbed at the start and are 120% of direct labour. Jobs are sold at cost plus 40%.
Operating expenses for April totalled $3 670.

Required
a) Prepare job cost for each job at 30 April.
b) Calculate ending balance work in progress as at 30 April and the cost of goods sold for
April.
c) Construct an income statement to reflect profit/loss for April.

Solution
1. Job 68 Job 69 Job 70 Job 71 Job 72
1 April bal b/d $540 $1 230 $990 - -
Direct material 700 560 75 3 500 2 750
Direct labour 500 600 90 2 500 2 000
Overhead 600 720 108 300 2 400
Totals $2 340 3 110 1 263 9 000 7 150

Calculation of overheads (O/H)

Overhead cost is 120% of direct labour, therefore for each job the O/H is calculated as follows:
Job 68 Job 69 Job 70 Job 71 Job 72
Direct Labour 500 600 90 2 500 2 000
Rate(120%) × 1.20 × 1.20 × 1.20 × 1.20 × 1.20
Overhead absorbed = 600 720 108 300 2 400

2. Closing balance in work in progress = ∑all uncompleted jobs

= Job 68 + job 71
= $2 340 +9 000
= $11 340.

Cost of goods sold for April = job 69 +job 70+ job 72

= $3 110 +$1 263 +$7 150
= $11 523

3. Computing the Sales figure = Jobs are sold at cost plus 40%
= $11 523 × 1.40
= $16 132
Gambiza Landscape Ltd income statement for April
Sales $16 132
Cost of goods sold $11 523
Gross profit $ 4 609
Less operating expenses ($3 670)
Net profit $ 939

42 
 
Activity 4.1
1. Identify each of the following types of business as job order or process.
a) Paint manufacturing
b) Toy manufacturing
c) Custom cabinet making
d) Dental services
e) Hospital services
f) Architectural services
g) Light bulb manufacturing
h) Paper manufacturing
2. Brandt Company produces unique sculptures for export. On 1 January 2011 there were jobs in
process with the following costs.
Job 35 Job 36 Job 37
1 April bal b/d $100 $340 $ 37
Direct material 350 700 1 050
Direct labour 420 840 1 260
870 1 880 3 090
During the month of January, two more jobs were started, jobs 38 and 39. Materials and labour
costs incurred by each job in January were as follows:

Materials Direct labour

Job 35 $400 $300
Job 36 150 200
Job 37 260 150
Job 38 800 650
Job 39 760 700
Jobs 37 and 38 were completed and sold by 31 January 2011.

Required
a) If overhead is absorbed on the basis of direct labour costs, what is the overhead rate?
b) Prepare simple job order cost sheets for each of the 5 jobs in process during January.
c) Compute the work in Progress and cost of goods sold in January 2011.
d) Suppose that Brandt Company prices its jobs at cost plus 50% and marketing and
administrative costs were $1 200, prepare an income statement to reflect profit/loss for
January 2011.

4.6 Summary

Job order costing is one of the methods used in cost assignment. It is used in firms that produce a
wide variety of heterogeneous products. Raw materials and direct labour are charged to the Work
In progress account. Overhead are assigned to work in progress using a predetermine rate. The
cost of completed units is then credited to work in progress and debited to finished goods
accounts. The key document for accumulating manufacturing cost is the job order cost sheet. The
source documents include material requisition forms and clock in time cards.

43 
 
References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: global media.

Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South-Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis
(9th Edition), New Jersey: Prentice Hall.

44 
 
Blank page
 Unit 5

Process Costing

5.0 Introduction

In this unit we discuss that process costing is a method used in situations where production
follows a series of sequential stages. The method is used to ascertain the cost of a product or
service at each stage of production or manufacturing process. Process costing is generally
applied in industries where continuous mass production of identical goods is experienced. It is
used in a variety of industries including food production, paper milling, soap manufacturing,
paint and ink manufacturing

5.1 Unit Objectives

By the end of this unit, you should be able to:
• explain the characteristics of process costing
• define equivalent units concept
• prepare a departmental production report using the weighted average method
• perform account treatment of spoilages

5.2 Characteristics of Process Costing

The characteristics of process costing are as follows:
• The production is continuous and follows sequential processes.
• Costs are accumulated by processes
• The products are standardised and homogenous
• The finished products of each but last process becomes input for the next process in
sequence.
• The sequence of operations or processes is specific and predetermined.
• Loss of materials in processes (due to chemical action, evaporation and so on) is
avoidable.
• The processing of raw materials may give rise to production of several products. These
may be termed joint products or by-products.

Therefore, we may consider a process as made up of several sequential stages.

5.2.1 Type of industries that apply process costing

Examples of industries that use process costing include:
• Oil refining
• Food processing

45 
 
 • Soap industry
• Steel industry
• Paint manufacturing industry
• Cement industry
• Chemical industry

5.3 Process Costing Procedure

The essential stages in process costing are:
1) A factory is divided into a number of processes and an account is maintained for each
process.
2) Each process account is debited with material cost, labour cost and overheads allocated or
apportioned.
3) The output of a process is transferred to the next process in sequence.
4) The finished output of the last process is transferred to the Finished Goods Account.

Example 5.1
Process X Process Y process Z
Materials $2 250 $ 750 $ 300
Labour $1 200 $3 000 $ 900
Production overheads $1 890 $2 580 $1 875

Other indirect expenses in the amount of $1 275 should be apportioned on the basis of wages.

Required
Prepare process accounts and ascertain the total cost of production from the above data.
Solution to example 5.1
Process X Account
$ $
Materials 2 250
Labour 1 200 Transfer to process Y 3 750
Production overheads 1 890
Other Indirect expenses 300
3 750 3 750
Note: Other indirect expenses $1 275 have been apportioned to process X,Y,Z in the ratio
1200:3000:900 that is 4:10:3 respectively.

46 
 
 Process Y Account
$ $
Transfer 3 750
Materials 750
Labour 3 000 Transfer out 10 830
Production o/heads 2 580
Other indirect expenses 750
10 830 10 830

Note: Other indirect expenses $1 275 have been apportioned to process X,Y,Z in the ratio
1200:3000:900 that is 4:10:3 respectively.

Process Z account
$ $
Transfer in 10 830
Materials 300
Labour 900
Production O/heads 1 875
Other indirect expenses 225 Transfer to finished goods 14 130
14 130 14 130

Note: Other indirect expenses $1 275 have been apportioned to process X,Y,Z in the ratio
1200:3000:900 that is 4:10:3 respectively.

5.4 Process Losses and Wastages

Under process manufacturing, losses occur at various stages of production. Losses may arise due
to chemical reaction, evaporation and inefficiency. It is therefore important to keep accurate
records of both input and output.
Normal process loss
This is the amount of loss which is unavoidable because of the nature of material or process
involved, for example chemical reaction, evaporation.
Abnormal process loss
This is loss which occurs due to carelessness, machine break downs, use of defective materials
and accidents. Therefore abnormal loss arises due to factors outside normal operating conditions.

5.4.1 Accounting treatment of normal and abnormal losses

The cost of normal process loss is absorbed and becomes part of the cost of producing the
product under a process. The production cost excludes abnormal loss which is transferred as a
period cost to the statement of comprehensive income.

47 
 
Example 5.2
The following information is given in respect to process A
Materials 1 000kg @ $6 per kg
Labour $ 5 000
Production overhead $ 2 000
Normal wastage is 10% of input

Required
Prepare a process account to reflect normal loss when scrap arising out of normal loss has sale
value of $1 per unit.

Solution
Process A Account
Kg $ Kg $
Material 1 000 6 000 Normal loss (100units x $1) 100 100
Labour 5 000
Overhead 2 000 Transfer to Process B 900 12 900

1 000 13 000 1 000 13 000

Normal loss = 10% of input = x 1 000units

= 100units

Cost per unit =

=
= $14.33 per unit

Example 5.3
Fifty units are introduced into process B at a cost of $1 each. The total additional expenditure
(labour) incurred in the process amounted to $30. Of the units introduced, 10% are normally
spoiled in the cause of manufacture, and posses a scrap value of $0.25 each. Due to an accident,
only 40 units are produced.

Required
i) Prepare Process B Account
ii) Prepare Abnormal Loss Account

48 
 
Solution
Process B Account
Units $ Units $
Transfer in Labour 50 50 Normal loss (5 x $0.25) 5 1.25
30 Abnormal Loss 5 8.75
Transfer out 40 70.00
50 80 50 80.00

Cost of abnormal loss:

Cost per unit =  
 
             =    
=$1.75
Cost of abnormal loss = abnormal units × Cost per unit.
= 5 × $1.75
= $8.75 
 
Abnormal Loss Account
Units $ Units $
to process B 5 $8.75 sales 5 $1.25
P&L Account $7.50

 
    5  $8.75        5    $8.75 
 
 
Activity 5.1
Using the figures in example 5.3, except that units introduced were 30 units at a cost of S2 each,
show how the process account will be prepared. Also prepare an abnormal loss account.

5.5 Equivalent Unit

At the end of a given period, some items in the production process will only be partly completed,
that is work in Progress. Some of the cost is therefore attributable to these partly completed units.
In order to spread the costs equitably over part finished and fully completed units, the concept of
equivalent units is used.

The number of equivalent units is the number of equivalent fully completed units the partly
completed units present.

Example 5.4
In May 2011 production was 3 000 completed units and 1 600 partly completed units which were
deemed to be 60% complete.

49 
 
Total equivalent production = Completed units + equivalent units produced in work in progress
= 3 000 + (60% of 1 600)
= 3 000 + 960
= 3 960 units

Total costs for the period would be spread over the total equivalent production as follows:
Cost per unit =  
 
Example 5.5
The production and cost data of kings world for the month of January 2010 were as follows:
Materials $422 400
Labour $ 395 600
Overhead $ 225 000
Total cost $1 043 000

Production was 8 000 fully completed units and 2 000 partly completed units. The percentage
completion of the 2 000 units work in progress was:
Materials 80%
Labour 60%
Overhead 50%

Required
Ascertain the value of completed production and value of work in progress to be reflected in the
process account.

Solution
Workings
Cost Equivalent Units Fully Total Cost
Elements Units in WIP Completed Cost Per Unit
Total (4) ÷ (3)
(1) (2) (1) + (2) (4) (5)
(3)
Material 80% of 2 000 = 1 600 8 000 9 600 $422 400 $44

Labour 60% of 2 000 = 1 200 8 000 9 200 $395 600 $43

Overhead 50% of 2 000 = 1 000 8 000 9 000 $225 000 $25

Cost Eqv units Completed Total Total Cost/unit

Elements WIP Units Production Cost
Material 1 600 8 000 9 600 $422 400 44
Labour 1 200 8 000 9 200 395 600 43
Overhead 1 000 8 000 9 000 225 000 25
$1 043 000 112

50 
 
Value of completed units = $112 × 8 000
= $ 896 000

Value of WIP = TC – value of completed units

= 1 043 000 – 896 000
= $147 000

Alternative method of ascertaining the value of WIP

Element of Units No. of Equivalent Cost/unit Total Value
In WIP WIP
Material 1 600 $44 70 400
Labour 1 200 $43 51 600
Overhead 1 000 $25 25 000
$147 000

Process Account
Element Units Total cost Element Units Total cost
Materials 10 000 422 400
Labour 395 600 Goods transferred
to next stage 8 000 896 000
O/heads 225 000 WIP c/d 2 000 147 000
10 000 1 043 000 10 000 1 043 000
WIP b/d 2 000 147 000

Activity 5.2
The following data belongs to the mixing department of a chemical processing plant:
1. Opening work in progress on 1st February was 100 000kg, 40 percent complete with respect to
conversion costs. The costs assigned to this work are as follows:
Material $20 000
Labour $10 000
Overhead $30 000
2. Closing work in progress on 28 February was 50 000kg, 60% complete with respect to
conversion costs.
3. Units completed and transferred out: 370 000kg, with the following costs added during the
Month:
Materials $211 000
Labour $100 000
Overhead $270 000

Required
a) Prepared a schedule of equivalent units.
b) Compute the cost per equivalent unit.
c) What is the cost of goods transferred out and the cost of ending work in progress?

NB. Solution for this activity can be accessed in appendix A

51 
 
5.6 Weighted Average Process Costing Method (WAP)
The weighted average process costing method assigns the average equivalent unit cost of all
work done to date (regardless of when it was done) to equivalent units completed and transferred
out, and to equivalent units in closing inventory. The major benefit of WAP is simplicity. By
treating units in opening work in progress as belonging to the current period, all equivalent units
belong to the same category when it comes to calculating unit costs, thus unit cost computations
are simplified. However, the main drawback of this method is reduced accuracy if the price of
manufacturing inputs increases significantly from one period to the next. The unit cost of current
output is understated, and the unit cost of opening work in progress units is overstated.

5.7 First In First Out (FIFO) Method

With FIFO, the equivalent units in opening work in progress (work completed in the prior
period), are not counted as part of the total equivalent work. Only the equivalent work to be
completed in the current period is counted. The equivalent work to be completed for units from
the prior period is computed by multiplying the number of units in opening work in progress by
the percentage of work remaining.

The effect of excluding prior period effort is to produce the current period equivalent output. A
major advantage of FIFO is that it gives managers information from which they can judge their
performance in the current period independently from that in the preceding period. Work done
during the current period is vital information for planning and control purposes.

Example 5.6
Use Weighted Average Process costing (WAP) and FIFO methods of stock valuation in the
following data for the month of August.

Process 1
Opening WIP 35 000 units
Materials $210 000
Conversion (2/5 complete) $52 500
Completion of units in August 168 000 units
Units commenced in August 140 000 units
Closing WIP (1/2 complete) 7 000 units
Material introduced in August $770 000
Conversion cost added in August $630 000
Process 2
Opening WIP 42 000 units
Materials from process 1 $343 000
Conversion (2/3 complete) $392 000
Completion of units in August 154 000 units
Closing WIP (3/8complete) 56 000 units
Materials introduced in August $462 000
Conversion cost added in Aug $2 205 000

52 
 
Required
a) Show the cost of finished production and WIP using weighted average price.
b) Show the cost of finished production and WIP for the month of August using FIFO.

Solution
a) Using weighted average price

Process 1
Physical flow of units of material;
Opening WIP 35 000
Material introduced 140 000
Total units accounted for 175 000
Equivalent units
Material Conversion
Units completed & transferred out (100%) 168 000 units 168 000 units
Closing WIP (100%, ½ of 7000) 7 000 3 500a
Total equivalent units (TEU) 175 000 171 500
Less opening WIP 35 000 14 000b
Current Equivalent Units 140 000 157 500

Calculation for conversion WIP

a
Conversion Closing WIP = × 7 000 = 3 500 units
b
Conversion Opening WIP = × 35 000 = 14 000 units
NB
Conversion Costs = The cost of converting raw materials into finished products, thus
labour and production overheads.

a) Cost of production using weighted average price

Cost Element Opening WIP Current Cost Total Cost Total Cost
[(1) + (2)] Equivalent Per Unit
Units {(3)÷(4)}
(1) (2) (3) (4) (5)
Material $210 000 $ 770 000 $ 980 000 175 000 $5.60
Conversion $ 52 500 $ 630 000 $ 682 500 171 500 $3.98

$262 500 $1 400 000 $1 662 500 $9.58

Cost of units completed and transferred out = 168 000 x $9.58
= $1 609 440

Cost of closing WIP

Material 7 000 × 1 × $5.6 = $39 200
Conversion 7 000× ½ × $3.98 = $13 930
$53 130

53 
 
Process 2
Physical flow of units of material
Opening WIP 42 000
Units transferred in 168 000
Units to be accounted for 210 000
Equivalent Units
Transferred in Material Conversion
Units completed 154 000 154 000 154 000
Closing WIP 56 000 - 21 000
Total equivalent units 210 000 154 000 175 000
Less; opening WIP (42 000) - (28 000)
Current equivalent units 168 000 154 000 147 000

Cost statement
Cost WIP Current Total TEU Cost/unit
Opening Cost Cost
(1) (2) (3) (4) (5)
Transfer in $343 000 $1 609 440 $1 952 440 210 000 Units $9.29
Material 0 462 000 462 000 154 000 Units 3.00
Conversion 392 000 2 205 000 2 597 000 17 500 Units 14.84
b
$735 000 $4 276 440 $5 011 440 (Total cost/unit) $27.13

Cost of complete units = 154 000 × 27.13

= $4 178 020

Cost of WIP (closing)

Transfer in 56 000 × 1 ×$9.2973 = $ 520 648.80
Material 56 000 × 0 × $3 = 0
Conversion 56 000 × 3/8 × $14.84 = $ 311 640.00
(Closing WIP was 3/8 Complete as to conversion)
Total = $ 832 288.80

b) Cost of production report using (FIFO) method

Process1
Current Equivalent Unit
Cost units cost
Material $770 000 140 000 $5.50
Conversion $630 000 157 500 $4.00
Cost of closing WIP
Material 7 000 × 1 × $5.5 = $38 500
Conversion 7 000 × ½ × $4.0 = 14 000
$52 500
Units competed and transferred out = 168 000 units
Cost of completed units = TC –Cost of closing WIP
= $1 662 500 – 52 500
= $1 610 000

54 
 
Process 2
Current Equivalent Unit
Cost Units Cost
Transfer in 1 609 440 168 000 $9.58
Material 462 000 154 000 3.00
Conversion 2 205 000 147 000 15.00
27.58
Cost of closing WIP
Transferred in 56 000 × 1× $9.58 = $536 480
Material 56 000 × 0 × $3 = 0
Conversion 56 000 × 3/8 × $15 = 315 000
$ 815 480a

Units completed and transferred out = 154 000 units

Cost of completed units = TC (Column (3) of cost statement (WAP) – Closing WIP
= $5 011 440b– $851 480a
= $4 159 960

Activity 5.3
Midlands Nutritional Supplements Company (MNSC) had the following data for November
2011:
Production
Units in progress 1st November
(50% with respect to conversion costs) 10 000 units
Units completed and transferred out 60 000 units
Units in progress 30 November (40% complete with respect to conversion
costs) 20 000 units
Costs
Work in progress on 1st November
Materials $1 600
Conversion costs $ 200
Current Costs
Materials $12 000
Conversion costs $ 3 200

Required
Assuming that MNSC uses the weighted average process costing method, show:
a) the cost per equivalent unit
b) the cost of goods transferred out
c) the cost of goods in closing work in progress

55 
 
5.8 Summary
In this unit, we introduced you to the meaning of process costing, its application in the
manufacturing sector and how it can be effectively used for accountability. The characteristics of
process costing, how products flow in the course of processing, the equivalent units of
production to be transferred to the next stage of production, accounting for spoilages and losses,
have all been explained in this unit.

56 
 
References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South-Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition), New Jersey: Prentice Hall.

57 
 
Blank page
 Unit 6

Inventory Costing Methods

6.0 Introduction

Different product costing methods will affect the value of goods stored in inventory. Two most
common methods of inventory valuation are marginal costing and absorption costing. This unit
will show how these two methods are different and affect inventory valuation and financial
reporting.

6.1 Unit Objectives

By the end of this unit, you should be able to:

• define Marginal and Absorption Costing

• explain the differences between Marginal Costing and Absorption Costing
• prepare an income statement using Absorption Costing
• prepare an income statement using Marginal Costing
• use Marginal Costing in planning and control

6.2 Marginal Costing and Absorption Costing

What is Marginal Costing?

Marginal Costing is a method of inventory in which all variable manufacturing costs are included
as inventorable costs (Horngren, Foster and Datar, 1992) .This means that all fixed
manufacturing costs are excluded from the cost of inventory and are treated as period costs.
What is Absorption Costing?
Absorption Costing is a method of inventory valuation which assigns all manufacturing costs to
the product, (Hansen and Mowen 2000). This means that all variable and fixed manufacturing
costs are included (absorbed) as part of the cost inventory.
6.2.1 The Fundamental Differences between Marginal Costing and Absorption Costing
Fundamental differences of the two costing methods are as follows:
1) Treatment of fixed production cost

Absorption costing recognizes the cost as part of:

i) the cost of goods sold
ii) the cost of closing stock

58 
 
 while Marginal Costing treats fixed production cost as a period cost which must be
incurred whether or not there is production.

2) Cost of closing stock

Under marginal costing closing stock is made up of variable costs only.

Under absorption costing, the cost of closing stock includes fixed production costs.

3) Preparation of income statement

Since the unit product costs are the basis for cost of goods sold, the absorption and
marginal costing methods can lead to different net profit figures. The difference arises
because of the amount of fixed overhead recognized as an expense under each of the two
methods.

-Marginal Costing technique is only for managerial decision making (Short-term, tactical
decisions);
-Absorption Costing is used for financial reporting suitable for publication.

Classification of costs as Product Costs or Period Costs under Absorption and Marginal Costing
Absorption Costing Marginal Costing
Product Costing Direct Materials Direct Materials
Direct Labour Direct Labour
Variable Overhead Variable Overhead
Fixed Overhead

Period Costs Selling Expenses Fixed Overhead

Administration Expenses Selling Expenses
Administration Expenses

Example 6.1
Wang Lei Zhu’s new factory at Gweru Light Industries produced 1 100 units and sold 1 000
units of running shoes during 2011. On 31 December100 units remained unsold.

59 
 
The cost per unit data was as follows:

Cost per unit

Variable costs $
Direct Materials 3.50
Direct Manufacturing Labour 1.60
Indirect Manufacturing Costs 0.90
6.00
Direct Marketing Costs 0.80
Indirect Marketing Costs 1.60
2.40
Total Variable Costs 8.40
Fixed Costs
Direct Manufacturing Costs 0.30
Indirect Manufacturing Costs 1.70
2.00
Direct Marketing Costs 2.10
Indirect Marketing Costs 3.40
5.50
Total Fixed Costs 7.50

Required
Using the above data show the unit inventorable costs for Wang Lei Zhu under Marginal Costing
and Absorption Costing.
Solution
Unit inventorable costs under the two methods:

Variable Manufacturing Costs Marginal Costing Absorption

Costing
Direct Materials $ 3.50 $ 3.50
Direct Manufacturing Labour 1.60 1.60
Indirect Manufacturing Costs 0.90 0.90
6.00 6.00
Fixed Manufacturing Costs
Direct Manufacturing Costs -------- 0.30
Indirect Manufacturing Costs -------- 1.70
0.00 2.00
Total Inventorable Costs $ 6.00 $8.00

60 
 
Example 6.2
Green Vegetables Grocery Limited provides the following details for the year ended 31
December 2010.
Sales 1 000 units @ $10 per unit
Fixed Manufacturing Costs $2 200
Variable Manufacturing Costs1, 100 units @ $6 per unit
Closing Stock 100 units
Fixed Selling and Admin exp $500
Variable Selling and Admin exp $400
Required
Prepare an income statement using:
a) Absorption Costing
b) Marginal Costing
Solution to example 6.2
a) Green Vegetable Grocery Income Statement for the year ended 31/12/2010
(Under Absorption Costing)
Sales 1000 units @ $10 each $10 000
Less Cost of Sales
Variable Manufacturing Cost:
1100 units @ $6 $6 600
Fixed Manufacturing Cost 2 200
Less Closing Stock 8 800
100 units @ $8 each 800
8 000
Gross Profit 2 000
Less Total Selling and Admin exp 900
Net Profit 1 100

Cost of Closing Stock Calculation

Units Manufactured 1 100

Closing Stock 100

Ratio of Closing Stock 100 = 1
1 100 11
Cost of Closing Stock 1 ×8 800 = $800
11 1

61 
 
b) Green-Vegetable Grocery Income Statement for the year ended 31/12/2010

(Marginal Costing)
Sales 1 000 units @ $10 each $10 000
Less Variable Cost of Sales:
Variable Manufacturing Cost
1 100 units @ $6 each $6 600
Less Closing Stock
100 units @ $6 600
$6 000
Contribution Margin $4 000
Less Variable Selling & Admin 400
3 600
Less Fixed Costs:
Fixed Manufacturing Cost 2 200
Fixed Selling & Admin exp 500
2 700
Net Profit 900
*Working for Closing Stock
Ratio of Closing Stock Inventory:
100 = 1
1 100 11
Cost of Closing Stock 1 x 6 600 = $600
11

6.3 Production, Sales and Income Relationships

The relationship between Marginal Costing Income and Absorption Costing Income changes as
the relationship between production and sales changes. If more is sold than was produced,
Marginal Cost Income is greater than Absorption Cost Income.
The relationship can be summarised as follows:

IF THEN
1. Production > Sales Absorption Net Profit > Marginal Net Profit
2. Production < Sales Absorption Net Profit < Marginal Net Profit
3. Production = Sales Absorption Net Profit = Marginal Net Profit

Example 6.3
The following Data belong to Dustin Ltd for the years 2009, 2010 and 2011.
Variable Cost per unit:

62 
 
 Direct Materials $ 4.00
Direct Labour 1.50
Variable Overhead 0.50
Variable Selling and Administration 0.25

Estimated fixed overhead was $150 000 each year. Actual fixed overhead was also $150 000
each year. Normal production volume was 150 000 units per year. The sales price was $10 per
unit each year. Fixed selling and administration expenses amounted to $50 000 per year.
Other operating data was as follows:
                                          2009 2010 2011
Opening stock …….. …….. 50 000
Production 150 000 150 000 150 000
Sales 150 000 100 000 200 000
Closing stock ………. 50 000 ………

Required
a) Prepare a marginal costing income statement for each of the years 2009, 2010 and 2011.
b) Prepare an absorption costing income statement for each of the years 2009, 2010 and 2011.
c) Reconcile the difference between the two methods.

a) Income statement under marginal costing.

2009 2010 2011
($000) ($000) ($000)
Sales 1 500c 1 000d 2 000e
Variable cost of sold goodsf (900) (600) (1 200)
Variable selling and adming (37.5) (25) (50)
Contribution margin 562.5 375 750
Less fixed expenses
fixed overhead (150) (150) (150)
fixed selling and admin (50) (50) (50)
net profit 362.5 175 550

Sales Figure Computation

Year 2009 2010 2011
c
150 000 units × $10 = $1 500 000
d
100 000 units × $10 = $1 000 000
e
200 000 units × $10 = $2 000 000

Workings
f.
2009 2010 2011
($000) ($000) ($000)
Opening stock …… ……. $300z
Variable cost of goods manufactured $900k $900k $900k
Less closing stock …… $300q ……
Variable cost of goods sold $900 $600 $1 200
63 
 
 k
Variable cost per unit = DM + DL + V/OH=$4+$1.50+$0.50=$6
Variable cost of goods manufactured = $6 x 150 000 units = $ 900 000
q
Closing stock = $6 x 50 000 units = $300 000
z
Opening stock = same figure as closing stock from the previous period
g
0.25 per unit x units sold.

b) Absorption costing income statement

2009 2010 2011
($000) ($000) ($000)
Sales 1 500 1 000 2 000
Less cost of goods sold (1 050)d (700)h (1 400)s
Gross profit 450 300 600
Less selling and admin 87.5 75 100
Net profit 362.5 225 500

Workings
Under Absorption cost each unit produced is assigned $1 of fixed overhead. Estimated fixed
overhead was $150 000, with normal production volume of 150 000 units giving us fixed
overhead of $1 per unit produced!
2009 2010 2011
($000) ($000) ($000)
Opening stock …… ……. $350
w
Cost of goods manufactured $1 050 $1 050 $1 050
Goods available for sale $1 050 $1 050 $1 400
Less closing stock (……) ($350)x (……)
d h
Cost of goods sold $1 050 $700 $1 400s
w
Absorption cost per unit = DM+DL+V/OH+F/OH = $4+$1.50+$0.50+$1 = $7
$7 x 150 000 units = $1 050 000
x
50 000 units x $7 = $350 000

6.4 Reconciliation of Absorption Costing and Marginal Costing Net Profits

The difference between absorption costing, net profit and marginal costing. Net profit can be
expressed as follows:
Absorption costing profit – marginal costing profit
= fixed overhead rate × (units produced-units sold)

The difference centres on the recognition of expense associated with fixed factory overheads as
shown above where the absorption product cost is equal to direct material ($4) + direct labour
($1.50)+ variable overhead ($0.50) + fixed overhead ($1), totalling $7, whereas marginal product
cost only consists of variable expenses, thus direct materials($4) + direct labour ($1.50) +
variable overhead($0.50), totalling $6.

64 
 
Reconciliation of marginal and absorption costing
2009 2010 2011
Net profit
Absorption costing $362.5 $225 $500
Marginal costing $362.5 $175 $550
0 $50 $50

Reconciliation

Units produced 150 150 150

Units sold 150 100 200
Change in inventory 0 50 (50)
Fixed overhead rate $1 $1 $1
Difference explained 0 $50 $(50)

Activity 6.1
Bellingham line has just completed its first year operations. The unit costs on a normal costing
basis are as follows:
Manufacturing cost per unit

Direct materials (2kgs @ $2) $4.00

Direct hours (1.5hrs @ $9) $13.50
Variable overhead (1.5hrs @ $2) $3.00
Fixed overhead (1.5hrs @$3) $4.50
Total $25.00
Selling and administrative costs:
Variable cost per unit $5.00
Fixed cost $190.00

During the year the company had the following activities:

Units produced 24 000
Units sold 21 500
Unit selling price $42
Direct labour hours worked 36 000

Actual fixed overhead was 12 000 less than the budgeted fixed overhead.
Budgeted variable overhead was $5 000 less than the actual variable overhead. The company
used an expected activity level of 36 000 direct labour hours to compute the predetermined
overhead rates. Any overhead variances are closed to cost of goods sold.

Required
a) Compute the unit cost using
i. Absorption costing.
ii. Marginal costing.
b) Prepare the absorption costing income statement.
c) Prepare the marginal costing income statement.
65 
 
 d) Reconcile the absorption costing income and the marginal costing income.

6.5 Summary
In this unit we explained the difference between marginal costing and absorption costing.
Absorption and marginal costing differ in their treatment of fixed production overheads. This
means that unit production cost under marginal costing consist of direct materials, direct labour
and variable factory overhead. Absorption costing treat fixed production overhead as a
production cost. Marginal costing divides the income statement according to cost behaviour,
separating between variable cost and fixed cost.

66 
 
References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South- Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition), New Jersey: Prentice Hall.

67 
 
 Unit 7

Cost Volume Profit Analysis

7.0 Introduction
Cost-volume-profit analysis involves the analysis of how cost, revenue and profits are related to
sales volume. It is concerned with predicting the effects of changes in cost and sales volume on
profit. In this unit we deal with the mechanics and terminology of CVP analysis and show how
CVP is part of financial planning and decision making.

7.1 Unit Objectives

By the end of this unit, you should be able to:
• explain the interrelationship between cost, volume and profit
• compute the number of units that must be sold to break even or to earn target profit
• apply cost-volume-profit analysis in a multiple product setting
• discuss the impact of risk, uncertainty and changing variables of cost-volume-profit
analysis

7.2 Uses of CVP Analysis

Cost-volume-profit analysis is helpful in:
• Budget planning: the volume of sales required to make a profit can be determined in
advance
• Pricing of product and services
• In sales mix decision, that is in what proportions should each product be sold
• Decisions affecting the cost structure and production capacity of a company

7.3 Cost Volume Profit Analysis Basic Assumptions

Some of the basic assumptions of CVP analysis are as follows:
• Costs can be analysed into fixed and variable components
• Fixed costs remain constant
• Variable costs vary proportionally with volume
• Selling price does not change and volume changes
• There is only one product and in case of multiple product sale mix remain constant

7.4 Calculating the Break Even Point

The break even point is the point where total revenue equals total cost, that is, where profit or
loss is zero.

68 
 
The break-even point
The break-even point is the point in the volume of activity where the organisation’s revenue and
expenses are equal.

The following is an example of break even point where the company sale revenue equalled total
expenses
Sales $250 000
Less: variable expenses 150 000
Contribution margin 100 000
Less: fixed expenses 100 000
Net income -

Contribution-Margin Approach
What is Contribution-Margin?
This is where Sales – Variable Expenses = Contribution Margin
The excess amount over variable costs contributes toward covering fixed expenses and then
towards toward providing a profit. Contribution margin ratio is the contribution margin divided
by sales.

Example 7.1
Consider the following information developed by the accountant at Midlands Computers
Total Per Unit Percent
$ $ %
Sales (500 Computers) 250 000 500 100%
Less: variable costs 150 000 300 60%
Contribution margin 100 000 200 40%
Less: fixed costs 80 000
Net income 20 000

For each additional Computers sold, Midlands Computers generates $200 in contribution margin.

= Break-even point (in units)

= 400 Computers

Proof
Sales (400 × $500) = $200 000
Less Variable Expenses (400 × $300)= $120 000
$ 80 000
Less Fixed costs $ 80 000
Net income 0

69 
 
Equation Approach
Sales – Variable Costs – Fixed Cost = Profit (ZERO at break even)
(Unit sale price × sales volume in units) – (Unit variable expense × sales volume in
units)-FC = 0
($500 ×SV) - ($300 × SV) - $80 000 = 0
$200 (SV) - $80 000 = $0
SV = 400 Computers

To calculate the break even point (BEP) in sales dollars rather than units; we follow the
following steps:

1) Contribution Margin Ratio =

=
= 40%

2) BEP in dollars =

 $200 000 

To ascertain the break even point using the cost volume profit graph method,
First we need to arrange the data as follows in order to plot it on a graph:

Computers sold 100 units 200 units 300 units 400 units 500 units 600 units
Sales $50 000 $100 000 $150 000 $200 000 $250 000 300 000
Less: Variable Costs 30 000 60 000 90 000 120 000 150 000 180 000
Contribution Margin 20 000 40 000 60 000 80 000 100 000 120 000
Less: Fixed Costs 80 000 80 000 80 000 80 000 80 000 80 000
Net Profit/(Loss) (60 000) (40 000) (20 000) 0 20 000 40 000

Next we derive data for plotting from the above table

Units FC TC TR
- 80 000 80 000 -
100 80 000 110 000 50 000
200 80 000 140 000 100 000
300 80 000 170 000 150 000
400 80 000 200 000 200 000
500 80 000 230 000 250 000
600 80 000 260 000 300 000
700 80 000 290 000 350 000

70 
 
 800 80 000 320 000 400 000

FC = Fixed Cost
TC = Total Cost
TR = Total Revenue

The last step is to plot the Cost- Volume-Profit graph and it appears as follows:

450,000

400,000 Break-even Total sales

point
350,000

300,000

250,000Total expenses

200,000

150,000 Fixed expenses

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units Sold

Figure 7.1 Cost Volume Profit Graph

Activity 7.1
A company makes and sells a single product, the variable cost of the production is $3 per unit
and variable cost of selling is $1 per unit, fixed cost totalled $600, and the selling price per unit
was $6. The company budgeted to make and sell 3 000 units in the next year.

Required
Prepare a break even chart showing the expected amount of the output and sales required to
break even.

71 
 
7.4.1 Break even equation technique
This technique uses a formula which expresses the relationship of the items of the income
statement.
Sales = variable cost + fixed cost + profit.

Contribution margin technique

This is based on the concept of marginal costing.
Contribution margin is the difference between sales and variable cost. Thus:
Unit selling price - unit variable cost = unit contribution towards fixed cost.

The unit contribution is divided into total fixed expenses of units which should be sold to break
even.

That is
BEP = Fixed Cost
Contribution per unit

Example 7.2
Farai Gangaidzi plans to sell printed T-shirts at Harare show in August 2013. The T-Shirts costs
$5 each. The booth rental at Harare Show Ground is $2 000 payable in advance. The T-shirts
will be sold at $9 each.

Required
1) Determine the number of T-shirts which must be sold to break-even.
2) What is the number of T-shirts to be sold in order to yield a 20% operating margin on sales?

Solution to example 7.2

a) Using the Equation Technique
Sale = variable costs + fixed costs + Profit
Assuming that x is the number of units to be sold to break even, the values can be
expressed as:
9x = 5x + $2 000 + 0
9x- 5x = $2 000
4x = $2 000
x = 2 000/4
= 500 units
b) To yield 20% of margin of sales
Sales = variable costs + fixed costs + profit
Assuming that x is the number of units to be sold to yield desired profit:
9x = 5x + $2 000 + 0.2 (9x)
9x = 5x + $2 000 + 1.8x
9x - 1.8x - 5x = 2 000
2.2x = 2 000

72 
 
 x = 909.09 units

7.5 Other Cost – Volume – Profit Formulae

a) Break even point in dollars ($) = Fixed costs × sales price/units
Contribution per unit

b) Contribution to sales ratio = Contribution per unit × 100

Selling price per unit

c) Level of sales to result in target profit (in units) = Fixed cost + Target profit
Contribution per unit

d) Level of sales to result in target profit after tax in units

Target profit = Fixed cost + (1- tax rate)
Contribution per unit

Example 7.3
Rogers Ltd manufactures and sells a special cell phone for $20.
The summarised income statement from 2010 is as follows:

Sales $800 000

Direct Materials 120 000
Direct wages 160 000
Variable production O/H 80 000
Fixed production O/H 100 000
Fixed Administration O/H 75 000
Fixed selling and Distribution O/H 60 000
$595 000
Net Profit before tax $205 000
Less: Provision for tax (40%) $ 82 000
Net profit after tax $123 000

Required
a) Calculate the breakeven point in dollars and in units for 2010.
b) Determine the number of units to sell in 2011 in order to achieve after tax profit of $150 000
c) Calculate the sales value required to achieve a net profit before tax of 15% of total revenue.

Solution
Workings before the solution
Units produced = $800 000÷ $20
= 40 000units
Variable costs

73 
 
 Direct materials $120 000
Direct wages $160 000
Variable production O/H $ 80 000
$360 000

1) Therefore Variable cost per unit = $360 000÷40 000

= $9 per unit

2) Unit Contribution Margin (UCM) = Selling price per unit – Variable cost per unit
= $20-$9
= $11

3) Contribution Margin Ratio = Contribution Margin (CM) ÷ SP

= 11÷20
= 0.55

4) Fixed costs = Fixed production O/H $100 000

Fixed Administration O/H $ 75 000
Fixed selling and Distribution O/H $ 60 000
$235 000

Solution
a) i. Break even in dollars ($) = Fixed Costs x Selling per unit
Contribution Margin (UCM)

= $235 000 x $20

$11

= 427 273

ii. BEP in units = FC

UCM

= $235 000
$ 11
= 21 364 Units

Workings
Calculation of fixed costs
i) Production O/H = $ 100 000
Administration O/H = $ 75 000
Selling &Dist O/H = $ 60 000
$ 235 000
ii) Contribution per unit = Selling price per unit – variable cost per unit
= $20 - $9
= $11

74 
 
 b) Target profit = Fixed cost + target Profit
(1-tax rate)

Contribution Margin

=$235 000 + 150 000

(1-0.4)
11

= 235 000 + 250 000

11
= 44 091 units
c) Level of sales to result in net profit before tax of 15% of total revenue
y = Fixed Cost + Target Profit
Contribution Margin ratio

y = $235 000 + 0.15y

0.55

0.55y = $235 000 + 0.15y

0.55y- 0.15y = 235 000

0.40y = 235 000
y = 235 000
0.4
= 587 500

Activity 7.2
Using data provided in example7.3, answer the following:

1. Assuming no change in unit selling price and cost structure, calculate the
percentage increase in sales volume required in the year 2011 to produce a profit before tax
of 20% higher than the previous year.
2. Calculate the selling price per unit that the company must charge in 2011 to
cover a potential increase of 12% in variable production costs, such that 2011 contribution
margin ratio remains the same as that of 2010.
3. Recalculate 2010’s result if sales representatives commission of 10% is
introduced, selling price is reduced by 13%, and volume increase by 30%.

75 
 
7.6 Summary
In this unit we discussed the importance of cost – volume, profit analysis in decision-making,
such as, pricing of products and services. The inter relationship between cost profit and sales
production volume was also analysed through the break even analysis graph and methods to
ascertain the units required to break even given the selling price per unit and variable costs and
fixed.

References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South- Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition), New Jersey: Prentice Hall.

76 
 
Blank page
 Unit 8

Budgeting, Planning and control

8.0 Introduction
Budgeting is a necessary tool for planning and controlling of organisational activities. It
involves the allocation and prioritization of limited resources for optimal output efficiency of an
organisation. Budgeting is practiced by government through a national budget announced
annually, and by private companies and organisations. In this unit we shall discuss the
importance of a budget, the various types of budgets and show how they are prepared.

8.1 Unit Objectives

By the end of this unit, you should be able to:
• define a budget
• discuss the role played by a budget in planning, control and decision making
• prepare the various type of budgets

8.2 What is a Budget?

A budget can be defined as a plan for future business activities which allocates resources such as
cash, manpower towards accomplishing of organisation goals and objectives.

8.2.1 Purposes of budgeting

A budgetary system helps to promote the following:

Accountability and control

Accountability leads to the establishment of a pattern of control over expenditure. It permits a
determination of the whether funds have been used for the purpose for which they are intended.
Accountability is achieved through specific allocation of funds and responsibilities to
departments.

Management
Budget as a management tool, represents an operational document which specifies the cost, time
and nature of expected results of specific budgeting outlays.

Planning
Forecasts and estimates as to what resources should be mobilised and utilised are made in the
budget. Planning is looking ahead and determining the actions to betaken in order to achieve
specific goals.

77 
 
Setting standards
A budget helps to set standards for performance evaluation. This helps in controlling resources
through comparison of budgeted quantities and amounts against the actual results.

8.3 Budgetary Control Process

Budgetary control is the establishment of quantitative and financial statements that compare
actual results with previous estimates. The following processes are necessary for effective
budgetary control.

8.3.1 Establishment of objectives

There should be well established overall and departmental objectives

8.3.2 Budget centres

These are divisions or departments, sections or units within an organisation. The centres use
guidelines given to them by the budget committees to prepare their budgets.

8.3.3 Budget coordination

The estimates made by various budget centres on the cost of various projects and programmes
and the revenue to be generated to be compiled by a responsible official (in some cases, budget
officer or a finance manager/director of finance). The compiled budget is then presented to the
budget committee for consideration.

8.3.4 Board of directors

After the committee’s deliberations and adjustments on the compiled budget, approval is then
sought from the board of directors.

78 
 
8.4 Type of Budgets

Operating budgets
These are budgets that reflect day-to-day activities or operations of an organisation. Examples of
operating budgets include: Sales, purchases, production.

Financial budget
This relates to financing of assets, and generally indicates cash inflow and outflow.

Master budget
This is the summary of all the operating and financial budgets and it consists of a budgeted
statement comprehensive income and a statement of financial position, as well a statement of
cash flows.

8.5 Budgetary Improvement Techniques

Budgets preparation in any organisation is a continuous exercise. There are techniques that can
be employed to improve on budgeting process. These include:

8.5.1 Incremental Budgeting (IB)

This involves adding a percentage to the previous year’s budget to come up with the current
year’s budget.

Advantages of IB
a) Moderation of conflicts
Conflicts between managers of different departments or units of an organisation can easily be
moderated or avoided since the decision on how much to allocate is based on prior year’s
budget

b) Cost reduction
Feasibility studies would be avoided or reduced to the barest minimum

c) Saving time
The IB technique saves time since it is based on a previous budget

Disadvantages of IB
a) Future cost implications are ignored
The focus of the technique is one year or below, without looking at the future cost
implications of the decision to be taken in the short period.

b) Transferring inefficiency to the future

By beginning the budgeting process for each period with the funding level of the previous
period, the technique assumes that the activity performed in the previous period were efficient
and cost effective. As a result, any inefficiencies of the past are enshrined as standards for the
future.

79 
 
c) No evaluation of alternatives
The technique does not provide any meaningful way of evaluating alternative courses of
action to executing projects or programmes.

d) Flexibility budgeting is ignored

The emphasis of IB is on line items and does not permit the use of flexible budgeting where
one can relate costs with level of activity performed or achieved.

8.5.2 Zero-Based Budgeting (ZBB)

This technique assumes that current operations will start from zero level therefore calling for a
total review of all proposed activities.

Zero-based budgeting involves allocation of the resources on the basis of cost-benefit-analysis to

be conducted on each of the organisation is activities.

Advantages of ZBB
a) Availability of alternatives
The budgeting process involves presentation of various alternative courses of action to
achieving a given objective.
b) Future cost implications of decisions are considered
This technique considers all the future cost implications of current decisions as part of the
cost-benefit analysis to be conducted on each proposed project or activity.

c) Elimination of low priority programmes

The decision to allocate scarce resources would be based on the ranking made after a
comprehensive cost-benefit –analysis.

Disadvantages of ZBB
a) Conflict among departments
Since ZBB encourages defence of budget proposals, the competition for favourable allocation
of the company’s scarce resources may bred conflict among departments or units.

b) High cost
The cost of preparing the budget which must be drawn afresh from bottom upwards would be
high.

c) Time consuming
A lot of time is consumed as preparation of departmental budgets begins from scratch.

8.5.3 Continuous (Rolling) Budgeting (CB)

This is the continuous updating of short-term budgets so that previously prepared budgets for
future periods could reflect current conditions. This is therefore an attempt to create short-term
budgets which are very realistic.

80 
 
This budgetary improvement technique has the same philosophy as ZBB model. The only
difference between the two is that, while ZBB is about starting afresh always, CB is about rolling
the assessed result of the previous period to adjust the budget prepared for the present period.

Advantages and disadvantages of CB

The budgets to be initiated under the rolling budgeting thinking are to be based on the principles
of ZBB. Therefore, all the advantages and disadvantages of ZBB technique are applicable to CB
technique.

8.6 Preparation of Budgets

Example 8.1
Takudzwa Retail Ltd plans the following inventory levels at cost on one of the items sold in the
store. The closing inventory is as follows: end of May $1 700 000
June $1 500 000
July $1 900 000
August $1 600 000
Sales are expected to be: June $3 500 000
July $2 500 000
August $3 300 000
Cost of goods sold is at 60% of sales value
The business estimated purchases to be in April $1 900 000, and
May $1 900 000

A given month’s purchases are to be paid as follows: 10% during the month
80% in the next month, and
10% two months later

Required
a) Prepare a purchases budget for the months June, July and August.
b) Prepare a disbursements budget on purchases for the three-month period solution

Solution
Purchases Budget
June July August
Cost of goods sold $2 100 000 $1 500 000 $1 980 000
Add cost of Closing stock $1 500 000 $1 900 000 $1 600 000
Cost of Units Available $3 600 000 $3 400 000 $3 580 000
Less: Cost of Opening Units (Closing
units in May were $1 700 000, making
it opening in June, and so on) ($1 700 000) ($1 500 000) ($1 900 000)
Purchases $1 900 000 $1 900 000 $1 680 000

Disbursement on Purchases Budget

81 
 
 June July August
10% During the Month $190 000 190 000 168 000
80% following Month $1 280 000 $1 520 000 $1 520 000
10% 2 months later 90 000 160 000 190 000
$1 660 000 1 870 000 1 878 000

Activity 8.1
A retailer has the following budgeted sales:
May $3 000 000
June $2 500 000
July $2 200 000
August $2 800 000
The store employees earn fixed monthly salaries totalling $120 000 and 10% commissions of
current monthly sales. Disbursements are made semi- monthly, that is half to be paid a month
after salaries and commissions are earned. Other expenses are: Rent $30 000 paid 1st day of each
month miscellaneous expenses 6% of sales insurance $3 000 per month, related to a one year
policy that way paid on 2nd of January.
Depreciation $19 000 per month.

Required
a) Prepare an operating expenses budget for the months of June, July and August
b) Prepare a disbursement budget on the operating expenses for the same period in a) above.

Example 8.2
Gorangoza Textile Company produces and sells textile material. The company provides you the
following information for budget purposes.

Materials
Number 111 = $12.00 per unit
Number 112 = $26.00 per unit
Direct labour = $20.50 per direct labour
Overhead is applied on hour basis of direct labour hours
Input / output Relationship
Cost Elements
Contents per unit Product F Product C
Mat 111 12 units 12 units
Mat 112 6 units 8 units
Direct labour 14 hours 20 hours

Finished products
Product F Product G
Expected sales in units 5 000 units 1 000 units
Selling price/ unit $1 054 $1 640
Desired closing stock 1 100 units 50 units
82 
 
 Opening stock 100 units 50 units

Direct Materials
Mat 111 Mat 112
Opening stock 5 000 units 5 000 units
Desired closing stock 6 000 units 1 000 units

The statement of financial Position for the year just ended was as follows:
Property, Plant and Equipment NBV
Land 500 000
Building & Equipment 3 800 000
Accumulated Depreciation ( 750 000)
3 050 000
3 550 000
Current Assets
Cash 100 000
Debtors 250 000
Materials 190 000
Finished Goods 144 800 684 800
4 234 800

Current Liabilities
Creditors 82 000
Tax Payable 50 000
132 000

Equity
Ordinary share Capital 3 500 000
Retained Earnings 602 800
4 234 800

At anticipated volume levels, the following costs would be incurred:

Factory overhead
Suppliers 300 000
Indirect labour 700 000
Payroll costs 250 000
Electricity(variable portion) 200 000
Maintenance (variable) 80 000
Depreciation 250 000
Property taxes 40 000
Property insurance 5 000
Supervision 200 000
Electricity (fixed portion) 10 000
Maintenance (fixed portion) 45 000
2 080 000
Selling and Administration cost

83 
 
 Sales Commission 200 000
Advertising 30 000
Sales Salaries 100 000
Travelling expenses 50 000
Clerical wages 100 000
Supply 10 000
Aggregated Salaries 10 000
Miscellaneous expenses 50 000
550 000

The Expected cash flow for next year are:

Qtr 1 Qtr 2  Qtr 3  Qtr 4 
$000 $000 $000 $000
Collection from customers 1 250 1 500 1 600 2 210
Disbursements:
For Materials 200 350 350 542
Other costs 250 200 200 170
Income tax 900 950 950 1092
Income tax 50 - - -
Machine purchase - - - -

The company decides to Maintain $150 000 as the minimum cash balance at the end of each
quarter. Money can be borrowed and repaid in multiples of $5000 at 10% per annum. Assurance
that borrowing takes place at the beginning and repayment at the end of each quarter. Income tax
payable next year is $200 000.

You are required to prepare

a) Sales budget
b) Production budget
c) Direct material purchases budget
d) Direct labour cost budget
e) First quarter cash flow budget

Solution
a) Sales Budget
Product Units to be Selling Price Total
Sold Per unit Sales
F 5 000 1 054 $5 270 000
G 1 000 1 640 $1 640 000
$6 910 000

b) Production Budget
F G
Planned Sales 5 000 1 000
Add closing Units 1 100 50
Total required 6 100 1 050

84 
 
 Less: Opening stock 100 50
Units to be produced 6 000 1 000

c) Direct Material purchases Budget in units

Mat 111 Mat 112
Units required Production 84 000 44 000
Add Desired Closing stock 6 000 1 000
9 000 45 000
Less Opening stock 5 000 5000
Units to be purchased 85 000 40 000

Workings
1) Units needed for production for 111
F = 12 × 6 000 = 72 000
G = 12 × 1000 12 000
84 000

For 112:
F = 6 × 6 000 = 36 000
G= 8 × 1 000 = 8 000
44 000
ii) Total cost of materials to be purchased
111 = 85 000 × $12 = $1 020 000
112 = 40 000 × $26 = $1 040 00
2 060 000

iii) Total cost of materials to be used in production

111 = 84 000 × $12 = $ 1 008 000
112 = 44 000 × $26 = $1 144 000
$2 152 000
d) Direct labour cost budget

Product Units to be Labour hrs Total labour Rate Total cost

produced per unit
F 6 000 14 84 000 20.50 1 722 000
G 1 000 20 20 000 20.50 410 000

85 
 
 e) Cash Flows Budget
Qtr. 1
Opening cash balance 100 000
Add: Collection from customers 1250 000
1 350 000
Less: Cash disbursements
Materials (200 000)
Other Costs (250 000)
Pay roll (900 000)
Income tax 50 000
Machinery 1 400 000
Desired Ending balance 1 500 00
Total Estimated corn 1 550 000
Excess/ Deficit (200 000)
Borrowing 200 000
Loan repayment -
Loan Interest (10%) -

Activity 8.2
Using Data from example 8.2 (Gorangoza Textile company), prepare the cash flow Budget for
Qtr. 2, Qtr. 3 and Qtr. 4.

8.7 Flexible Budget

Flexible budget is a budgeting system which recognises the difference in behaviour between
fixed and variable costs in relation to fluctuations in output or turnover. Under flexible
budgeting, a budget is adjusted to the level of activity level attained.

86 
 
Example 8.3
Gazimbi Limited’s budget for the month of August 2011 for 10 000 units of its product were as
follows:
Direct material 2 000
Direct labour 2 000
Variable overheads 1 000
Fixed overheads 1 000
6 000
The output of the company in the month of August was 8 000 units with the following costs.
Direct material 1 800
Direct labour 1 575
Variable overheads 800
Fixed overheads 1 050
5 225
Required
Prepare a flexible budget.

Solution

Flexible Budget Actual Variance

Direct material 1 600 1 800 (200)
Direct labour 1 600 1 575 (25)
Variable overhead 800 800 -
Fixed overheads 1000 1 050 (50)
5 000 5 225 225

Workings: flexible budget column

Working Flexible
Budget
Direct material x 8 000 units = $1 600 1 600
Direct labour x 8 000 units = $1 600 1 600
Variable overhead x 8 000 units = $800 800
Fixed overheads 1 000
5 000

87 
 
Activity 8.3
Red Gum Manufacturing Company Limited, makers of product Y, has prepared its budget for
2010, based on two activity levels of 80% and 100% with production units of 2 800 and 3 500
units respectively. The budget is as follows:

80% 100%
Sales $224 000 $280 000
Direct material 84 000 105 000
Direct labour 50 400 63 000
Production overhead 48 800 53 000

The company’s actual result for the period is as follows:

Sales in units 3 150 units
$
Sales 252 000
Direct material 94 000
Direct labour 60 000
Overhead (60% of amount is fixed) 50 000
Required
Prepare a flexible budget for a production level of 70% and 90% and compare the flexed budget
at 90% level of activity with the actual result.
NB: The solution for activity 8.3 is in Appendix A

8.8 Summary

In this unit, the principles and practices of budgeting and budgetary control have been
highlighted. The general purpose of budgets was discussed. Budgetary improvement techniques
such as Zero Based Budgeting were also highlighted. The unit also illustrated how to prepare
operating, financial and flexible budgets.

88 
 
References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South- Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition), New Jersey: Prentice Hall.

89 
 
Blank page
 Unit 9

Standard Costing

9.0 Introduction

Planning and control can be enhanced through developing standards for the production of goods
and rendering of services. In this unit we shall discuss the type of standards applied in the
production of goods and why they are adopted by companies and organisations.

9.1 Unit objectives

By the end of this unit, you should be able to:
• explain how standards are set and why standard cost systems are adopted
• describe the basic concepts underlying variance analysis
• compute material and labour variances
• explain when variances should be investigated

9.2 What is a Standard?

Standards can generally be classified as either ideal or currently attainable.
Ideal standards demand maximum efficiency and can only be achieved if everything operates
perfectly, that is where there are no machine break downs, slack or lack of skilled human
resources.
Currently attainable standards can be achieved under efficient operating conditions. Allowance
is made for less than perfect operating conditions. Allowance is made for normal breakdowns,
interruptions and less than perfect skilled human resources.

9.2.1 The role of standards

Standards are adopted in order to:
a) Facilitate planning and control
Standard costing system enhances planning and control and at the same time help to improve
performance measurement. Through comparison of planned prices and actual prices of materials
and budgeted material versus actual used material, management can read specific signals
regarding the usage of resources and take corrective action.
b) Help in determining product prices
Under a standard costing system, costs are assigned to products and services using quantity and
price standards for materials, labour and overheads. The advantage of a standard costing system
over one that uses actual prices include:

90 
 
 • Standard costing provides greater capacity for control

• Standard costing provides readily available unit cost information that can be used for
pricing decisions

• This is helpful for bidding on contracts

9.3 Standard Product/ Services Costing

A standard cost is a pre-determined calculation of how much costs should be, under specified
working conditions. Standard costing therefore involve:
a) Determining the actual cost in advance.
b) Correlating quantity of materials and labour with prices and wage rates.
c) Applying standard costing in stock valuation, fixing selling prices.
d) Comparison of predetermined costs with actual cost. The results of the comparison of
variances which are then reported to management for corrective action.

9.4 Variance Analysis

The major application of standard costing is for control through variance analysis and
reporting. A variance is simply the difference between planned or budgeted costs and actual
costs, and similarly for revenues. Variance analysis is important as it leads to the elimination of
factors that would have caused the difference between pre-determined standards and actual
results.
Material cost variance
This is the difference between the actual cost of materials consumed to achieve a given
production level and what it should have cost at standard material cost. It is given by the formula
standard cost – actual cost. This can also be analysed through the material price variance and the
material usage variance:

91 
 
 Material Cost Variance

Price Variance Usage Variance

Material price variance

This is the variance that arises from buying materials at a price different from the standard
buying price. It is calculated by the formula (Standard Price – Actual Price) × Actual Quantity.
This is a purchase price variance.

Material usage variance

This is that part of material cost variance arising from the use of more or less quantity of raw
materials to achieve the actual production. It is given by the formula:
Material usage variance = (Standard Quantity – Actual Quantity) × Standard Price

Example 9.1
Dombo Sculptures provides you with the following data: For every ton of material consumed,
it is estimated that 500 units will be produced.
The standard price of the material is $18 000 per ton.
In June 2011, 210 tons of material were issued to production.
The actual price was $17 000 per ton. Production during June 2011 was 108 000 units.
Required
Compute the following variances
a) Material cost
b) Material Price
c) Material usage

Solution
a) Standard cost data (cost per unit)

Material = x 18 000

= $36 per unit

Standard production = 108 000
500

92 
 
 ` = 216 units
Material cost variance
= standard cost of Actual production minus Actual cost of material consumed
= ($18 000 × 216) - ($17 000 × 210)
= $3 888 000 - $3 570 000
= $318 000 F
b) Material price variance
= (Actual Qty Purchased x Actual price) - Actual Qty purchased x Standard prices
= (AP × AQ) – (SP × AQ)
= (210 × $17 000) – (210 × $18 000)
= $210 000F.

c) Material usage variance

= The difference between actual Quantity of Material used and Quantity that should
have been used, valued at standard price.

= (210 – 216) $18 000

= $108 000F
Note F = Favourable variance
A = Adverse variance/ U (for Unfavourable), for example, is the actual price of the
material was more than the standard price, then the variance is unfavourable.

Material mix and material yield variances

These variances are common where there are two or more raw materials used in the production
of a product.

Material mix variance

This arises due to the use of more or less quantities of raw material in substitution for another.
Any usage in a proportion different from the standard proportion will give rise to a usage
variance due to mixture called material mix variance.

Yield variance
This is the residual material variance or the absolute quantity difference assuming materials were
used at the standard mix.

93 
 
Example 9.2
Indigenous Juice Ltd makes a fruit juice for the Gweru and Kwekwe consumers.
The following data is available:
Materials
100 litres concentrated juice at $2 per litre
200 litres of distilled water @ $2.50 per litre
10 labour hours at $9 per hour
The budgeted monthly production and sales is 500 containers and the selling price is $1 000 per
container. The following details relate to August 2010, when 510 containers of juice were
produced and sold.
Sales $506 500
Materials used:
Concentrated juice 51 600 litres 102 500
Distilled water 10 500 litres 258 800
Labour 5 000 hours at 45 750
Required
a) Calculate the wage rate and efficiency variances
b) Compute the material mix and material yield variances

Solution
Labour cost variances
Standard labour cost of Actual production = 510 containers @ $90 per container = $45 900
Actual wages cost $45 750
150F
Labour rate variance
Variance due to remunerating labour at a different rate
(AH × AR) – (AH × SR)
Actual hours @ Actual rate = $45 750
Actual hours @ Std rate = $45 000
(750)
Labour efficiency variance
This variance is caused by spending more or less hours than should have been spent to produce
the actual production, valued at the standard wage rate.
Labour Efficiency Variance = (SH-AH) SR
Where: SH = Standard hours

94 
 
 AH = Actual hours
SR = Standard rate
Actual hours = 5000hrs
Hours expected to have been spent (standard hours) = 510 × 10
= 5 100 hrs
Hours Efficiency variance = (5 100 – 5 000) × $9
= 100 hrs × $9
= $900F

Material mix variance

Usage of material in a proportion different from the standard proportion will give rise to a usage
variance due to mixture (material mix variance).

In the above question the ratio is 1:2, that is 100 litres of juice to 200 litres of distilled water. We
then use this to restate the actual quantity of materials used, to obtain actual quantity at standard
proportion. Thus Actual Quantity of Raw Materials used = 153 100 litres as follows:
Concentrate Juice = 51 600
Water = 101 500
Total 153 100

Therefore Actual Qty at Std proportion = ×153 100 = 51 033

× 153 100 = 102 067

Actual Qty Actual Qty Difference Std Price Mix Variance

@ Actual @ Standard
proportion proportion
Concentrated 51 600 51 033 (567) $2.00 (1 134A)
Juice
Water 101 500 102 067 567 $2.50 1 417.5F
153 100 153 100 283.5F

Material yield variance

The yield variance is the residual material variance or the absolute quantity difference assuming
that materials were used at the standard mix.

Std Qty Required Actual Qty Difference Std price Material

for Actual & Std Mix (litres) Yield
production Variance
Juice 51 000 51 033 (33) $2.00 $ (66) A
Water 102 000 102 067 (67) 2.50 (168) A
153 000 153 100 100 234 A

95 
 
NB Std Qty required for containers produced = 510 × 100 = 51 000
= 510 × 200 = 102 000
153 000

Activity 9.1
Using data in Example 9.2 (Indigenous Juice Ltd), calculate
a) Material Price variance
b) Material usage variance

9.5 Overhead Variance

Overhead variances are easy to understand if overhead absorption concept is considered.

a) Fixed overhead cost variance
This is the difference between the actual fixed overhead incurred and the fixed overhead using
the pre-determined absorption rate.

b) Fixed overhead expenditure variance

This is that part of fixed O/H cost variance which was due to the failure to budget the amount
of fixed O/H correctly.

c) Fixed overhead volume variance

This is that part of fixed overhead cost variance which was due to the failure to budget
production volume correctly. Under overhead absorption, an absorption rate is pre-determined
by estimating the amount of overhead and the estimated volume.

d) Fixed overhead capacity

This is investigating the volume variance further, in order to reveal the capacity and efficiency
of labour force. Capacity is the planned work in terms of the number of hours. If workers fail
to work the budgeted hours, it is under-utilisation of available capacity. If they work above the
normal budgeted hours, then the efficiency of the labour force could be questioned.

Example 9.3
Randolf Business Limited manufactures a single product which has a standard cost of $80 made
up as follows:
Direct Materials
(15 Square Mtrs at $3/Sq. Mtr) $ 45

96 
 
 Direct labour 5 hours @ $4 / hour $20
Variance overheads 5hrs @ 2/hr $10
Fixed overheads 5hrs @ $1/hr $ 5
$80
The standard selling price of the product is $100 per unit. The monthly budget projects
production and sales of 1 000 units. Actual figures for the month of April are as follows:
Sales 1 200 units at $102
Production 1 400 units
Direct materials 22 000 square metres at $4 per square metre
Direct wages 6 800 hrs at $5 variable overheads $11 000
Fixed overheads $6 000

Required
Compute the:
a) Fixed overhead cost variance
b) Fixed overhead expenditure variance
c) Fixed overhead volume variance
d) Fixed overhead capacity
e) Fixed overhead Efficiency variance

Solution
a) Fixed overhead cost variance
This is the difference between the actual fixed overhead incurred and the fixed overhead using
the pre-determined absorption rate.

Actual Fixed O/H incurred = $6 000

Absorbed Fixed O/H (based on actual production) = 1 400 units x $5
= $ 7 000

97 
 
 Fixed O/H cost variance = 6 000-7 000
= 1 000F (over- absorbed)
b) Fixed overhead expenditure variance
This is that part of fixed O/H cost variance which was due to the failure to budget the amount
of fixed O/H correctly, that is

Budgeted fixed O/H (1 000 units × $5) = 5 000

Actual Fixed O/H Expenditure = 6 000
1 000A
c) Fixed overhead volume variance
This is that part of fixed overhead cost variance which was due to the failure to budget
Production volume 1 000 units
Actual production volume 1 400 units
Difference 400 units
Therefore, fixed overhead would be over-absorbed at $5 in the sum of 400 x $5 = $2 000F

d) Fixed overhead capacity

The capacity budgeted to work was based on 1000 units and a working period of 5 hours per
unit. The company therefore had planned a working capacity of 5 000 hrs.
Failure to work 5 000 hours means under utilisation of available capacity.
Fixed overhead capacity variance
Budgeted Capacity (1000 x 5HRS) = 5 000 hrs
Actual hours worked = 6 800 hrs
1 800 hrs
Fixed O/H Capacity variance (1 800 x $1/Hr) = $1 800F
It is favourable because more hours worked should result in increased production volume.
e) Fixed overhead Efficiency variance
This is the effect of the efficiency of labour on overhead absorption.
Actual hours allowed for actual output = 1 400 x 5 hrs
= 7 000 hrs
Actual hours worked = 6 800 hrs
Hours saved = 200 hrs
Fixed O/H efficiency variance = 200 x $1
= $200

98 
 
 Reconciling fixed overhead volume variance
$2 000F

Fixed overhead Fixed O/H

Capacity efficiency
Variance Variance
$1 800F $200F
Activity 9.2
The standard cost card of a process for the month of February showed the following:
Material input
A 30 units costing $60 per unit $1 800
B 25 units costing $40 $1 000
C 45 units costing $50 per unit $2 250
100 $5 050
Normal -
Loss 10 -
90 $5 050
During the month, the following transactions actually took place.
135 units A@ 65 = $ 8 775
130 units of B @ 35 = $ 4 550
235 units of C @ 45 = $10 575
500 units $23 900
The output for the period was 480 units

Required
Using the above information, ascertain the following materials variances
a) Price
b) Mixture
c) Yield
NB: Solution for activity 9.2 can be accessed in Appendix A (Solutions for Selected
Activities).

99 
 
9.6 Summary

In this unit we explained standard costs as those amounts that should be expended to produce a
product or service. Ideal standards are those achievable under maximum efficiency or ideal
operating conditions. Currently attainable standards are those that can be achieved under
efficient operating conditions. Standard cost systems are adopted to improve planning and
control and to facilitate product costing.

References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South- Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition), New Jersey: Prentice Hall.

100 
 
Blank page
 Unit 10

Cost Allocation: Joint Products and By-Products

10.0 Introduction
In some industries, two or more products are simultaneously produced from the same raw
material. An example of simultaneous production of two or more products from the same raw
materials is in oil refinery. When crude oil is processed, products such as petrol, kerosene and
diesel are simultaneously produced from the same raw materials. Such products are known as
joint products. In this unit we examine methods for allocating joint costs to products and
services.

10.1 Unit Objectives

By the need of this unit, you should be able to:
• define joint products and by products
• state characteristics of joint products and by products
• use different methods to allocate joint costs

10.2 What are Joint Products?

The term joint products is used for two or more products of almost equal value which are
simultaneously produced from the same manufacturing process and the same raw materials
(Arora, 2010).

10.2.1 Characteristics of joint products

Joint products have the following characteristics:
they are produced simultaneously by a common process
they are comparatively of almost equal value
they may require further processing after their point of separation (split-off Point)

10.2.2 Examples of joint products

Industry Products of split off point
Agriculture
Meat (beef, lamb) Lamb Cuts, Tripe, Hides
Raw milk Cream, Skimmed Milk

Extractive industries
Coal Coke, Gas, Tar, Ammonia
Salt Hydrogen Soda

Chemical Industry
Raw LPG (Liquid Petroleum gas) Butane, Ethane, Propane

101 
 
10.3 What is a By-Product?
By–products are products of relatively small value which are unavoidably produced in the
course of manufacturing the main product (Hansen and Mowen, 2000). For example, in a sugar
mill, sugar is the main product, but baggasse and molasses of comparatively smaller value are
incidentally produced and are by- products.

10.3.1 Examples of by-products

1. Sugar Mill – Baggasse, Molasses
2. Rice Mill- Husk
3. Edible Oil Mill- Oil Cake
The by- products may be sold in their original form without further processing. However, some
by-products may require further processing in order to be saleable.

10.3.2 Scrap and Waste

Waste is material which has no value and may carry a negative value. The negative value arises
if the waste material has to be disposed at a cost. Examples of waste are gases, smoke and other
unsalable residues from the manufacturing process.

Scrap is the left over part of raw materials whereas by – products are different from the material
which went into the production process. For example, metal sheet pieces left in utensil
manufacture is scrap. However accounting treatment for scrap and by products is similar.

10.4 Approaches to Allocating Joint Costs

Accounting for joint products means the allocation of joint costs to each of the joint products.
Such allocation services the following objectives:
• to determine the cost per-unit of products
• to help in inventory valuation
• to determine the price of each product /service
• to determine the profit/loss of producing each product/service

The joint cost allocation approaches include the following:

Benefits-received approaches, which include the following methods:

• Physical units method

• Weighted average method

Allocation based on the relative market value, using the following methods:

• Sales-value-at-split-off method
• Net realizable value method
• Constant gross margin percentage method

102 
 
 • Sales-to-production-ratio method

Benefits-Received Approaches
Physical Measure of Units Method
Under the physical units method, units of physical output, such as volume, or weight, that
measure the benefits received are used to distribute joint costs. This method allocates to each
joint product the same proportion of joint costs as the underlying proportion of units.
Example: Manufacturers of forest products use the physical units method to apply the average
conversion cost to all finished products, regardless of their type, grade, or market value.
Disadvantages of the physical units method include the following:
It ignores the fact that not all costs are directly related to physical quantities.
It may result in incorrect managerial decisions because high profit may be reflected from the sale
of high-grade products, with low profit or losses reflected from the sale of low-grade products.
Weighted Average Method
The weighted average method uses the weight factors to include such diverse elements as
amount of material used, difficulty to manufacture, time consumed, difference in type of labour
used, and size of unit.
Weighted physical units = Number of units × Weight factor
For example, the canning industry uses weight factors to distinguish between can sizes or quality
of product. The weighted average method allocates relatively more of the joint cost to the high-
grade products because they represent more desirable and profitable products.
Allocation based on relative market value
The methods in this approach try to assign costs based on the product’s ability to absorb joint
costs. They are based on the assumption that the joint costs would not be incurred unless the
products yield enough revenues to cover all costs plus a reasonable profit.
The relative market value approach of allocation is better than the physical units approach if:

• the physical mix of output can be altered by incurring more (or less) total joint costs
• this alteration produces more (or less) total market value

Sales-Value-at-Split-Off Method
The split off point is the juncture in the process when the products become separately
identifiable.

• The sales-value-at-split-off method allocates joint cost based on each product’s

proportionate share of market or sales value at the split-off point.

103 
 
 • In this method, the higher the market value, the greater the joint cost assigned to the
product.
Net Realizable Value Method

• The net realisable value method allocates joint costs based on hypothetical sales values
because there may not be a ready market for the product at the split-off point.

• This method is particularly useful when one or more products cannot be sold at the split-
off point but must be processed further.
Hypothetical Sales Value = Market price – Further processing costs after split-off point

10.4.1 Sales value at split-off material

Farmers’ Dairy purchases raw milk from individual farms and processes it up to the split-off
point, where Cream and Liquid Skim are obtained.
Data for May 2010 was as follows:
a) Raw Milk processed: 110 gallons
110 gallons of raw milk yield 100 gallons of good product, with a 10 gallon shrinkage.
b) Product Sales
Cream 25 gallons 20gallons @ $8 / gallon
Liquid skim 75 gallons 30 gallons@ $4/gallon
c) Inventories
Opening Stock Closing stock
Raw milk 0 gallons 0 gallons
Cream 0 gallons 5 gallons
Liquid skim 0 gallons 45 gallons
d) Cost of purchasing 110 gallons of raw milk and processing it up to the split-off point was
$400.

Required
Ascertain the cost of closing stock for cream and liquid skim using the sales value at split-off.

Solution
The sales value at split off method allocates joint costs on the basis of the relative sales value at
the split off the accounting period of each product.
Assign a weight to each product which is a percentage of total sales value as follows:

104 
 
 Cream Liquid
Skim
1. Sales value $200 $300
(25 × $8, 75 × $4)
2. Weighting
($200 ÷ 500, 300÷ 500) 0.4 0.6
3. Joint Cost Allocated 0.4 × $400 $ 160
0.6 × $400 Liquid skim $240
4. Joint production cost per gallon
($160 ÷ 25; 240 ÷ 75) $ 6.4 $3.2

Farmers’ Dairy Joint Cost Income Statement May 2010

Cream Liquid skim
Sales (20 × $8; 30 × $4) $160 $120
Joint Costs $160 $120
Less closing stock 32 140
Cost of goods sold 128 96
Gross Profit 32 24

10.4.2 Physical measure method

The physical measure method allocates joint costs on the basis of their relative proportions at the
split-off point, using a common physical measure such as weight or volume of total production
of each product.
Example 10.2 using data in example 10.1
Cream Liquid skim Total
1. Physical measure of production 25 75 100
2. Weighting
(25÷100; 75 ÷ 100) 0.25 0.75
3. Joint cost allocated
(0.25 × $400; 0.75 × $400) $100 $300 $400

105 
 
 4. Joint production costs per gallon
($100÷25; $300÷75) $4 $4
Farmers Dairy Income Statement For May 2010
Cream Liquid skim
Sales $160 $120
Joint costs (0.25 × $400; 0.75 × $400) 100 300
Closing Stock (5 × $4; 45 × $4) 20 180
Cost of goods sold 80 120
Gross Profit $80 $0

10.4.3 Estimated net realisable value method (NRV)

The estimated net realisable value (NRV) method allocates joint costs on the basis of the
relative estimated net realisable value (expected final sales value in the ordinary course of
business minus the expected separable cost of production).
Example 10.3
Assume the same situation as in example 10.1, except that both cream and liquid skim can be
processed further.
a) Cream can be processed further to produce Butter cream: 25 gallons are further processed to
yield 20 gallons of butter cream at an additional separable cost of $280. Butter cream is sold
for $25 per gallon.

b) Liquid Skim can be processed to produce Condensed Milk: 75 gallons liquid skim are
further processed to yield 50 gallons of condensed milk at an additional processing cost of
$520 Condensed milk is sold for $22 per gallon.

c) Sales during the month of May were 12 gallons of butter cream and 45 gallons of condensed
milk.

d) Closing stock is as follows

Liquid Butter Condensed
Cream skim cream milk
Closing stock 0 0 8 5
Opening stock 0 0 0 0

106 
 
Solution
NRV Method
Butter Condensed
1. Expected final sales Value of production
(20 gallons × $25; 50g $22) $500 $1100
2. Deduct Experiences Separable to complete
production
Weighting (220 ÷800; 580 ÷ 800) 0.275 0.725
3. Joint cost allocated
(0.275 × $400; 0.725 × $400) $110 $290
6. Production cost / gallon
[($110+ $280)/20,($290 + $520) ÷ 50] $19.50 $16.20

Farmers’ Dairy – Income Statement for May 2010

Butter Condensed milk
Sales (12 × $25; 45 × $22) $300 $990
Cost of goods sold
Joint costs (0.275 × 400) $110 290
0.725 × 400 $280 $520
$390 $810
Closing stock
8 gallons × $19.50 156 81
5 gallons × 16.20
Cost of goods sold $234 $729
Gross Profit $ 66 $261

Activity 10.1
Inorganic chemicals purchases slat and processes it into more refined products such as caustic
soda, chlorine and PVC (polyvinyl chloride) In July 2011, inorganic chemicals purchased salt for
$40 000. Conversion costs of $60 000 were incurred up to the split-off point, at which time two
saleable products were produced:
Caustic soda
Chlorine

Chlorine can be further processed into PVC. The July production and sales information was as
follows:

107 
 
 Production Sales Selling Price
Caustic soda 12 00 tons 1 200 tons $50
Chlorine 800 tons - -
PVC 500 tons 500 tons $200

All 800 tons of chlorine were further processed at an incremental cost of $20 000 to yield 500
tons of PVC. There were no by products or scrap from this further processing of chlorine. There
were no beginning or ending inventories of chlorine at $75 a ton.
Required
Calculate how the joint costs of $100 000 would be allocated between caustic soda and chlorine
under each of the following methods:
a) Sales value at split-off
b) Physical measure (tons)
c) Estimated net realisable value
(Question adopted and modified from Horngren, 1997)

NB. Solution to the activity can be accessed in appendix A (Solutions for Selected Activities)

Activity 10.2
Panhondo Chemicals produces four products from a joint process costing $150 000 per month.
After leaving the joint process, the products must be further refined before they are saleable. You
have been provided with the following information:
Product Volume Further Processing Costs Selling Price per Unit
A-1 15 000 $350 000 $80
B-3 25 000 400 000 40
C-2 10 000 100 000 22
Q-9 50 000 250 000 10
Required:
1. Allocate the joint costs using the physical units method.
2. Allocate the joint costs using the net realisable value method.

Solution
1. Physical Units Method
Product: A-1 B-3 C-2 Q-9 Total
Units 15 000 25 000 10 000 50 000 100 000
Allocation % 15% 25% 10% 50%
Joint cost allocated
(% × $150000) $22 500 $37 500 $15 000 $75 000 $150 000

108 
 
2. Net Realisable Value Method
Product: A-1 B-3 C-2 Q-9 Total
Units 15 000 25 000 10 000 50 000
Unit price × $80 × $40 × $22 × $10
Total revenue $1 200 000 $1 000 000 $220 000 $500 000
Less:
Further processing
costs 350 000 400 000 100 000 250 000
NRV $850 000 $ 600 000 $120 000 $250 000 $1 820 000
Allocation % 46.7% 33.0% 6.6% 13.7%
Joint cost allocated
(% × $150000)* $70 054.95 $49 450.55 $9 890.11 $20 604.40 $ 150 000
*
Differences due to rounding off

10.5 Summary

In this unit a joint cost was defined as the cost of a single process that yields multiple products or
services. The split-off point is the juncture in the process when the products become separately
identifiable. Joint products have relatively high sales value and are not separately identifiable as
individual products until the split-off point. A by product has a low sales value compared with
the sales value of a joint product.
The purposes for allocating joint costs to products and services is for inventory valuation for
external financial reporting, internal reporting, profitability analysis and cost reimbursement
under contract accounting. The unit also examined methods used for allocating joint costs of
joint products, such as, sales value at split-off.

109 
 
References
Arora, M.N. (2009) Cost and Management Accounting Theory, Problems and Solutions,
Mumbai: Global Media.

Arora, M.N. (2010) Methods and Techniques of Cost Accounting: Theory, Problems and
Solutions, Mumbai: Global Media.
Hansen, D.R. and Mowen, M.M. (2000) Management Accounting (5th Edition), Cincinnati:
South- Western College Publishing.

Horngren, C.T., Foster, G. and Datar, S.M. (1997) Cost Accounting: A Managerial Emphasis (9th
Edition), New Jersey: Prentice Hall.

110 
 
Appendix A

Solutions for Selected Activities

Activity 2.2 Question 2 Solution

a) Missing figures

Units Produced (U) 5 000U 10 000U 15 000U 20 000U

Variable cost $200 000 $400 000 $600 000 $800 000
Fixed cost $1 800 000 $1 800 000 $1 800 000 $1 800 000
Total cost 2 000 000 2 200 000 2 400 000 2 600 000

Computing the missing figures can be done using the regression line equation as follows:
Total Cost = Fixed Cost + Variable Cost
y = a + b (x)
y = $1 800 000 + $40 (10 000 units)
y = $1 800 000 + $400 000
y = $2 200 000
Cost per unit
Variable cost $ 40 $ 40 $ 40 $ 40
Fixed cost $360 $180 $120 $ 90
Total cost $400 $220 $160 $130
Note that:
Variable Cost per unit at 5 000units = $200 000 ÷ 5 000
= $40 per unit

Fixed Cost per unit at 5 000 units = $1 800 000 ÷ 5 000

= $360

b) Total cost of producing 18 000 units = ($40 × 18 000units) + $1 800 000 FC

= $2 520 000

Activity 3.1 Solution

Problems of controlling selling and distribution overheads include:
a) External factors such as distance of market, nature of competition and so on, which are beyond
the control of management.
b) They depend upon customers’ behaviour.
c) Policy costs which are not amenable to control.
Control of selling and distribution costs could be achieved through several ways including:
1) Carrying out trend analysis and taking necessary measures to control the costs.

111 
 
2) Carrying out variance analysis and taking necessary steps to address the problem.

Activity 5.2 Solution

1. Schedule of Equivalent units

Material Conversion
Units Completed 370 000 370 000
Units in WIP × Fraction complete:
Materials (50 000 × 100%) 50 000 -
Conversion (50 000 × 60%) - 30 000
Equivalent units of output 420 000 400 000

2. Cost per equivalent unit:

Direct materials unit cost = ($20 000 + $211 000)/420 000 = $0.55
Conversion unit cost = ($40 000 + $370 000)/420 000 = $1.025
Total unit cost = $1.575per equivalent unit

3. Cost of goods transferred out = $1.575 × 370

= $582 750

Cost of WIP = ($0.55 × 50 000) + ($1.025 × 30 000)

= $58 250

Cost Reconciliation (Process Account)

Opening WIP = $ 60 000
Costs incurred during the period = 581 000
641 000

Cost of goods transferred out = $582 750

Closing WIP = 58 250
$641 000

Activity 8:3 Solution

a) The first step is to separate the production overhead into fixed and variable elements using
high – low method
Production level Cost
(units)
3 500 $53 000
2 800 48 800
700 4 200
Variable cost per unit 4 200 = $6.00
700

112 
 
 Fixed cost = 53 000 – (46 × 3 500)
= $32 000
Flexible budget at 70% and 90% levels of activity
70% 90%
Sales (units) 2 450 3 150
$ $
Sales 196 000 252 000
Direct Materials 73 500 94 500
Direct labour 44 100 56 700
Variable Production O/H 14 700 18 900
Fixed production O/H 32 000 32 000
164 300 202 100
b) Comparison of fixed budget at 90% level of activity with actual.
Activity level 90% 90%
Flexible Budget Actual Variance
Sales (units) 2 450 2 450
$ $
Sales 252 000 252 00
Direct Materials 94 500 94 000 500F
Direct labour 56 700 50 000 6 700F
Variable Production overhead 18 900 20 000 1 100A
Fixed production Overhead 132 000 30 000 2 000F
202 100 194 000 8 100F

Activity 9.2 Solution

a) Price variance
Product A 135 ($60-$65) = $675A
B 130 ($40-$35) = $650 F
C 235 ($50 -$45) = $1 175F
$1150 F
b) Mixture variance
Standard price of the standard mixture
$5 050 × 500 = $ 25 250
100
Std Price of Actual Mixture
A 135 units @ 60 $8 100
B 130 units @ 40 $5 200
C 125 units @ 50 $6 250
$19 550
Variance $ 5 700F

113 
 
c) Yield variance
Expected yield is 90% of input
Expected output from 500 units (90% × 500) = 450
Actual output = 480
Yield Variance in Units 30F
Yield variance in (dollars) = $5 050 × 30
90
= $1 683F

Activity 10.1 Solution

a) Sales value at split-off Method
Caustic Soda Chlorine
1. Sales value at
Split- off
Caustic 1 200 x $50
Chlorine 800 x $75 $60 000 $60 000

2. Weighting
$60 000 ÷ $120 000
$60 000 ÷ $129 000 0.5 0.5

3. Joint Costs allocated

Caustic 0.5 × $100 000 $50 000 $50 000
Chlorine 0.5 × $100 000

b) Physical measure method

Caustic soda Chlorine
1. Physical measure (tons) 1 200 800
2 Weighting
1 200 ÷ 2 000
800 ÷ 2 000 0.6 0.4

114 
 
 3. Joint costs allocated
Caustic 0.6 × $100 000 $60 00 $40 000
Chlorine 0.4 × $100 000

c) Estimated NRV Method

Caustic soda Chlorine
1. Expected final sales value
Caustic 1200 × $50
PVC from Chlorine 500 x $200 60 000 1 000 000

2. Expected Separable costs (20 000)

3. Estimated NRV at - -
Split off point $60 000 $80 000

4. Weighting

$60 000 ÷ $140 000

$80 000 ÷ 140 000 3/7 4/7

5. Joint costs allocated

Caustic 3/7 × $ 100 000
Chlorine 4/7 × $100 000 $42 857 $57 143

 
 

115