Management Accting

This seventh publication is 2015 by Hampton Press, Cape Coast
Eighth printing in 2016 by Rocky Printing Works, Accra

Nine publication in 2018 by Pulp Plus Printing Ltd., Accra
Tenth publication in 2019 by UCC Press, Accra
© COLLEGE OF DISTANCE EDUCATION, UNIVERSITY OF CAPE

COAST (CoDEUCC) 2007, 2008, 2009, 2010, 2011, 2012, 2014, 2015, 2016,
2018, 2019
ISBN 978 – 9988 – 8467 – 2 - 5
First Publication, 2007
All rights reserved. No part of this publication should be

reproduced, stored in a retrieval system or transmitted by
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otherwise without the prior permission of the copyright
holder.
Cover page illustrated by R. Y. Essiam—

ABOUT THIS BOOK
This Course Book “Management Accounting” has been exclusively

written by experts in the discipline to up-date your general knowledge
of English Language in order to equip you with the basic tool you will
require for your professional work as a basic school teacher and
administrator.
This three-credit course book of thirty-six (36) sessions has been

structured to reflect the weekly three-hour lecture for this course in the
University. Thus, each session is equivalent to a one-hour lecture on
campus. As a distance learner, however, you are expected to spend a
minimum of three hours and a maximum of five hours on each
session.
To help you do this effectively, a Study Guide has been particularly

designed to show you how this book can be used. In this study guide,
your weekly schedules are clearly spelt out as well as dates for
quizzes, assignments and examinations.
Also included in this book is a list of all symbols and their meanings.
They are meant to draw your attention to vital issues of concern and
activities you are expected to perform.
Blank sheets have been also inserted for your comments on topics that
you may find difficult. Remember to bring these to the attention of
your course tutor during your face-to-face meetings.
We wish you a happy and successful study.
Prof. Edward Marfo-Yiadom

Mr. Stephen Asante
Mr. Patrick Darkwa
CoDEUCC/ Post-Diploma in Commerce

ACKNOWLEDGEMENT
It has become a tradition in academic circles to acknowledge the

assistance one received from colleagues in the writing of an academic
document. Those who contributed in diverse ways toward the
production of this particular course book merit more than mere
acknowledgement for two main reasons. First, they worked beyond
their normal limits in writing, editing and providing constant support
and encouragement without which the likelihood of giving up the task
was very high. Second, the time span for the writing and editing of
this particular course book was so short that their exceptional
commitment and dedication were the major factors that contributed to
its accomplishment.
It is in the foregoing context that the names of Prof. Edward Marfo-

Yiadom, Mr. Stephen Asante and Mr. Patrick Darkwa University of
Cape Coast, who wrote and edited the content of this course book for
CoDEUCC, will ever remain in the annals of the College. This special
remembrance also applies to those who assisted me in the final editing
of the document.
I wish to thank the Vice-Chancellor, Prof. Joseph Ghartey-Ampiah

and the Pro-Vice-Chancellor, Prof. Dora Edu-Buandoh and all the
staff of the University’s Administration without whose diverse support
this course book would not have been completed.
Finally, I am greatly indebted to the entire staff of CoDEUCC,

especially Miss. Alberta S.F Gogovi for typing the scripts.
Any limitations in this course book, however, are exclusively mine.

But the good comments must be shared among those named above.
Prof. Isaac Galyuon

(Provost)
viii
TABLE OF CONTENTS
About this Book … … … … … … … i

Table of Contents … … … … … … ii
Symbols and their Meanings … … … … … vii
Acknowledgement … … … … … … viii
UNIT 1: OVERVIEW OF MANAGEMENT ACCOUNTING 1

Session 1: Meaning and Purpose of Management
Accounting … … … … … … 3
1.1 Meaning of Management Accounting … … 3
1.2 Application of Management Accounting … 3
1.3 Purpose of Management Accounting … … 4
Session 2: Role of Management Accountants … … 5
2.1 Activities of Management Accounting Department 5
2.2 Functions of Management Accountants … … 6
2.3 Characteristics of useful Management Accounting
Information … … … … … 6
Session 3: Differences between Financial, Cost and
Management Accounting … … … 9
3.1
Relationship of Financial, Cost and Management
Accounting … … … … … 9
3.2 Differences between Financial, Cost and Management
Accounting … … … … … 9
Session 4: Elements of Cost and Cost Classification ... 13
4.1 Elements of Cost … … … … 13
4.2 Classification of Cost … … … … 13
4.3 Functional Classification … … 13
4.4 The Nature Cost Behaviour … … … 14
4.5 Cost Behaviour … … … … … 14
4.6 Variable Costs … … … … … 15
4.7 Curvilinear or Non Linear Variable Costs … 16
4.8 Factors which Influences Costs Behaviour … 16
4.9 Problems or Limitation of Costs Behaviour … 16
Session 5: Cost Terms and Concepts ... … 19
5.1 Cost Accounting Terminologies … … 19
5.2 Cost … … … … … … 19
5.3 Cost Units … … … … … 19
5.4 Cost Centre … … … … … 20
5.5 Unit Cost … … … … … 20
5.6 Direct Cost … … … … … 20
5.7 Indirect Costs … … … … … 20
5.8 Conversion Cost … … … … 21
ii
5.9 Product Costs … … …… … 21
5.10 Period Costs … … …… … 21
5.11 Controllable Cost … …… … 21
5.12 Uncontrollable Cost … …… … 21
5.13 Distinctions between Direct and Indirect Cost
… 22
Session 6: Basic Management Accounting Concepts … 23
6.1 Relevant Cost … … … … … 23
6.2 Opportunity Cost … … … … … 23
6.3 Differential/Incremental Cost … … … 24
6.4 Sunk Cost … … … … … … 24
6.5 Committed Costs … … … … … 24
UNIT 2: MARGINAL AND ABSORPTION COSTING 27

Session 1: Meaning of Absorption Costing and Marginal
Costing … … … … … … 29
1.1 Meaning of Absorption Costing and Marginal Costing 29
1.2 Features of Marginal Costing … … … … 30
1.3 Advantages of Absorption and Marginal Costing 30
Session 2: Approaches to Profit Reporting using Absorption
Costing and Marginal Costing … … 33
2.1 Income Statement under Absorption Costing and
Marginal Costing … … … … 33
2.2 Reconciling Profits Reported under the Different
Methods … … … … … … 37
Session 3: Break-Even Analysis: Meaning, Assumptions,
and Uses … … … … … … 49
3.1 Break-even Analysis Assumptions and Uses
… 49
Session 4: Break-Even Chart – Graphical Approach … 51
4.1 Traditional Break-Even Chart … … … 51
4.2 Profit Volume Graph … … … … 55
Session 5: Break-Even Analysis - Contribution Approach 59
5.1 Break-Even Point – Equation Approach … … 59
5.2 Other Application of the Break-even Analysis … 62
Session 6: Cost-Volume Product Analysis for Multi-
Products … … … … … … 67
6.1 Step by Step Approach … … … … 67
UNIT 3: RELEVANT COSTS FOR DECISION MAKING 73

Session 1: The Concepts of Relevant Costs … … 75
1.1 Meaning and Identification of Relevant Costs … 75
1.2 Other Cost Terms that are the same as Relevant Costs 75
1.3 Irrelevant Costs … … … … … 76
iii
Session 2: The Relevant Cost of Materials and Machinery 79
2.1 Relevant Material Cost … … … … … 79
2.2 Relevant Machinery Cost … … … … 81
Session 3: Relevant Cost of Labour and Overhead … 85
3.1 Relevant Labour Cost … … … … … 85
3.2 Relevant Overhead Cost … … … … … 86
Session 4: Make or Buy Decision … … … … 87
4.1 Meaning of Make or Buy Decision … … … 87
4.2 Make or Buy Analysis and Idle Capacity … … 87
4.3 Make or Buy Analysis and Opportunity Cost … … 89
Session 5: Special Order and Shut Down or Drop a
Product Decisions … … … … … 93
5.1 Special Order Decisions … … … … … 93
5.2 Shut Down or Drop a Product Decisions … … 94
Session 6: Sell or Process Further Decisions … … 99
6.1 Analysis to Determine whether an Intermediate Product
should be Sold or Processed Further … … … 99
6.2 Analysis to Determine whether to Sell a Joint Product at a
Split-off-point or to Process Further … … … 101
UNIT 4: BUDGETING AND BUDGETARY CONTROL 105

Session 1: Meaning and Functions of Budgets … … 107
1.1 Definition of Corporate Plans … … … … 107
1.2 Definition of Budgets … … … … 107
1.3 Definition of Forecast … … … … … 108
1.4 The Functions Or Purpose Of Budgets … … … 108
Session 2: Major Features and Terms in Budgeting … 111
2.1 Major Features of a Good Budget … … … 111
2.2 Some Basic Budgeting Terminologies … … 112
2.3 Process of Budget Preparation … … … … 113
Session 3: Types of Budgets … … … … … 117
3.1 Types of Budgets … … … … … 117
3.2 Fixed Budget … … … … … 117
3.3 Flexible Budget … … … … … 117
3.4 Rolling or Continual Budget … … … … 118
3.5 Incremental Budgeting … … … … … 118
3.6 Zero-Based Budget (ZBB) … … … … 118
Session 4: Preparation of Functional Budgets … … 119
4.1 Functional Budgets … … … … … 119
4.2 Approaches to Building up the Functional Budgets … 119
4.3 Building up the Functional Budgets … … … 120
4.4 Sales Budget … … … … … … 120
iv
4.5 Production Budget … … … … 121
4.6 The Budgets of Resources for Production … 121
4.7 Detailed Illustration … … … … 123
Session 5: Preparation of Cash Budget and Problems of
Budgeting … … … … … … 133
5.1 Cash Budget and its Features … … … 133
5.2 Receipts of Cash … … … … 134
5.3 Payment of Cash … … … … 134
5.4 Format of Cash Budget … … … 134
5.5 Problems in Budgeting … … … … 135
5.6 Usefulness of Cash Budget … … … 135
Session 6: Budgetary Control and Behavioural Aspects of
Budgeting … … … … … 141
6.1 The Concept of Budgetary Control … … 141
6.2 What is Behavioural Aspect of Budgeting? … 142
6.3 Functions of Behavioural Aspects … … 142
UNIT 5: STANDARD COSTING AND VARIANCE

ANALYSIS … … … … … 145
Session 1: The Concept of Standard Costing … … 147
1.1 Meaning of Standard and Standard Costing … 147
1.2 Types of Standards … … … … 148
1.3 Advantages of Standard Costing System … 148
1.4 Disadvantages of Standard Costing … … 149
1.5 Setting Standards … … … … 149
Session 2: Direct Material Variances … … … 153
2.1 Review of Material Usage & Material Price Variances153
2.2 Material Mix and Yield Variances … … 156
Session 3: Direct Labour Variances … … … 161
3.1 Direct Labour Costs Variances … … … 161
3.2 Direct Labour Rate variance (DLRV) … … 162
3.3 Direct Labour Efficiency Variance (DLEV) … 162
3.4 Direct Labour Mix and Yield Variances … 163
Session 4: Variable Overhead Variances … … 165
4.1 Total Variable Overhead Variance (TVOV) … 165
4.2 Variable Overhead Expenditure (Spending) Variance
(VOSV) … … … … … … 166
4.3 Variable Overhead Efficiency Variance (VOEV) 167
Session 5: Fixed Overhead Variance … … … 171
5.1 Total Fixed Overheads Variance … … 171
5.2 Fixed Overhead Spending (Expenditure) Variance 172
5.3 The Fixed Overhead Volume Variance … 173
5.4 Fixed Overhead Efficiency and Capacity Variance 174
v
Session 6: Sales Variances … … … … 177
6.1 Total Sales Variance … … … … 177
6.2 Sale Price Variance … … … … 178
6.3 Sales Volume, Variance/Sales Profit Margin Variance179
6.4 Sales Mix and Sales Quantity Variance … 180
UNIT 6: DIVISIONAL PERFORMANCE EVALUATION

AND TRANSFER PRICING … … 185
Session 1: Decentralization of Operations … 187
1.1 Meaning of Decentralization … … … 187
1.2 Advantage of Decentralization … … … 187
1.3 Problems of Decentralization … … … 188
Session 2: Responsibility Centres … … … 189
2.1 Meaning of Responsibility Centre … … 189
2.2 Types of Responsibility Centres … … 189
2.3 Responsibility Accounting Systems … … … 190
2.4 The Need for Information about Responsibility
Centre Performance … … … … 190
Session 3: Measures for Evaluating Performance of
Divisions … … … … … 193
3.1 Evaluation Measures … … … 193
3.2 Using Average Total Assets/Net Assets … 196
Session 4: Meaning and Importance of Transfer
Pricing … … … … … 199
4.1 Introduction … … … … … 199
4.2 What is Transfer Price? … … … 199
4.3 Objectives of Transfer Pricing … … … 200
4.4 International Transfer Pricing Objectives … 200
Session 5: Transfer Pricing Methods … 203
5.1 Transfer Pricing Methods … … … 203
5.2 Negotiated Price … … … … 204
5.3 Advantages and Limitations of the Transfer
Pricing Methods … … … … 204
Session 6: Selecting the Right Transfer Pricing
Methods … … … … … 207
6.1 Factors to Consider in Selecting the Right Transfer
Price … … … … … … 207
References … … … … … … …
Glossary … … … … … … …
Answers to Self-Assessment Questions … … 209
vi
vii
SYMBOLS AND THEIR MEANINGS
INTRODUCTION
OVERVIEW
UNIT OBJECTIVES
SESSION OBJECTIVES
DO AN ACTIVITY
NOTE AN IMPORTANT POINT
TIME TO THINK AND ANSWER QUESTION(S)
REFER TO
READ OR LOOK AT
SUMMARY
SELF- ASSESSMENT TEST
ASSIGNMENT
CoDEUCC/Post-Diploma in Basic Education vi

OVE R E OVE R E
SUMMA RY SUMMA RY
UNIT 1
OVERVIEW OF MANAGEMENT ACCOUNTING
UNIT 1: OVERVIEW OF MANAGEMENT ACCOUNTING
Unit Outline
Session 1: Meaning and Purpose of Management Accounting
Session 2: Role of Management Accountants
Session 3: Differences between Financial, Cost and Management
Accounting
Session 4: Elements of Cost and Classification of Costs
Session 5: Cost Terms and Concepts
Session 6: Basic Management Accounting Concepts
You are welcome to unit 1 of the Management Accounting module. This

unit is going to be the pivot upon which the rest of the materials you will
study in this module will rotate. Management Accounting is a broad and
multidisciplinary subject which encompasses economics, finance and
management.
In this unit we will look at the meaning and purpose of Management

Accounting. We will also examine the relationships between financial,
Cost and Management Accounting. The roles of management accountants,
basic management accounting concepts as well as cost terms and concepts
are also dealt with. We will conclude this unit with a thorough discussion
on the ethical behaviour required of management accountants
Unit Objectives
When you have completed this unit you should be able to:
1. define the term Management Accounting;
2. state the main objectives of management accounting;
3. identify and explain basic cost terms and concepts;
4. state and the basic roles of management accountants;
5. identify and explain the main differences between; and
6. sate the main elements of professional ethics.
CoDEUCC Post Diploma in Commerce 1

UNIT 1
OVERVIEW OF MANAGEMENT ACCOUNTING
This is a blank sheet for your short notes on:
• difficult topics if any.
• issues that are not clear;
2 CoDEUCC Post Diploma in Commerce

OVERVIEW OF MANAGEMENT ACCOUNTING UNIT 11
UNIT
Session 11
SESSION
SESSION 1: MEANING AND PURPOSE OF MANAGEMENT

ACCOUNTING
You are warmly welcome to the session 1 of Unit 1 of this module. Take your
time to grasp the scope, principles and objectives of management accounting. As
rightly pointed out at the on set, this unit is designed to provide a solid
foundation upon which you can appreciate and build a comprehensive
knowledge (i.e. Sure Start) in management accounting.
Objectives
By the end of this session you should be able to:
a) explain the term Management Accounting
b) identify areas where management accounting is applied
c) outline the main objectives Management Accounting
Now read on…
1.1 Meaning of Management Accounting

A management accounting system is an information system that uses economic
events available to process required information to satisfy specific managerial
objectives. Management accounting otherwise known as managerial accounting,
therefore, is an area of accounting concerned with providing information to
managers which is intended to help them to make decisions, to plan and to
ensure that plans are, actually achieved (i.e. to control).
To carry out this task effectively and efficiently the management accountant will
use data from financial and cost accounting systems conduct special
investigation as well as apply appropriate techniques from statistics and
operational research to generate or produce information which is relevant for the
intended purpose.
Both financial and non-financial information should be provided by the

management accounting information system. Thus whereas non-financial
information provides insights into the best approaches to controlling business
operations by the functional managers financial information concentrates or
more critical on evaluating the success of operational control method adopted.
1.2 Application of Management Accounting

We have noted shortly ago that management accounting is concerned with the
area of accounting that is primarily concerned with data gathering, processing
and communicating useful information for use within an establishment such that
management can plan, make decisions and control operations more effectively
and efficiently.
Consequently, management accounting is applicable to all organizations -

manufacturing concerns, wholesaling, retailing, hotels and restaurants, transport,
hospitals, schools, churches etc must all have a good management accounting

UNIT 1
Session 1 MEANING AND PURPOSE OF MANAGEMENT
ACCOUNTING
information system. Management accounting concepts and techniques are not
restricted to anyone type of organization, rather, the users of management
accounting information are functional managers, and all operational workers in
an organization.
Anyone internal to an organization is a potential user of management accounting

information in so far as, as it were, they require such management accounting
information to determine the cost of products or services and to assist in
planning, controlling, evaluation, continuous improvement and decision making.
Broadly speaking, this course is very important for individuals, institutions,

governments and corporate organizations. The reason being that, a good
management accounting information system is the pivot, upon which all
sustainable operational performance rotates, be it, a manufacturing or service
industry. Fact is that, many individual firms, corporate organization as well as
governments are failing to achieve their desired targets or are far from their
corporate objectives due to poor planning, performance standards and feedback
reports.
1.3 Purpose of Management Accounting

Like financial management, management accounting, is also an information
system that uses financial and non-financial inputs (tools) and processes required
to generate relevant information to meet specific managerial objectives. Among
the numerous purposes of Management accounting are few enumerated below:
1. To help management determine and assign costs to various cost units
(i.e. products and services)
2. To provide useful information for planning and controlling growth
3. To determine the overall returns on various investment opportunities
4. To provide information for management evaluation and continuous
improvement
5. To provide information for management decision making
6. To minimize operational cost by avoiding under utilizing of plant
capacity
7. To ensure operational efficiency by avoiding overstretch of plant
capacity
8. To report to employees the true status of an organization
9. To effectively safeguard organizational assets
10. To help in the formulation of corporate strategy
Self-Assessment Questions
1. Briefly define Management Accounting
2. Mention four institutions that you think can benefit from
Management Accounting.
3. State three main objectives of Management Accounting

UNIT 1
OVERVIEW OF MANAGEMENT ACCOUNTING Session 2
SESSION 2: ROLE OF MANAGEMENT ACCOUNTANTS
You are warmly welcome to the session 2 of Unit 1 of this module. I am sure
that you have well digested the first session. Might I suggest that, you pause a
moment and try to define management accounting in your own words before you
proceeds. In this session, we will be looking, specifically, the roles of
management accountants and the features of good management accounting
information for continuous and improved organizational performance.
Objectives
a) state at least four roles of management accountants
b) outline the main characteristics of a useful Management Accounting
reports
Now read on…
2.1 Activities of Management Accounting Department

The principal role management accounting department is to provide information
for management to plan, control and make effective decisions. However,
information provided for management, may vary from organization to
organization depending on the nature of business and the needs of the
organization. For instance Energy Provision Company would require
information different from that of Water Provision Company.
To begin with, management accountants have, of late, been confronted with

radical changes. The reason being that, the environment in which business
operate has become increasingly dynamic, complex and highly competitive and
there have been rapid advances in production technology.
Consequently, there had been radical changes to the way and manner in which
businesses are organized as well as marketing and manufacturing strategies
employed. Therefore, the increasingly, successful businesses are those
distinguished by their ability to secure and maintain competitive advantage.
In the face of such changes, management accounting unit or department had to

design new approaches. To provide relevant information to managers,
management accountants have to become more outward looking than had been
in the past, when information provided to management has been largely
restricted to that collected within the business. Nevertheless, the current trend of
information relating to market share, innovations, customer evaluation and
suppliers loyalty, and cost of production compared with that of competitors are
immensely influenced by the outside environment.

UNIT 1
Session 2 ROLE OF MANAGEMENT ACCOUNTANTS
2.2 Functions of Management Accountants

Management accountants, as a matter of fact, is the one with whom the key
decision making function in the firm resides. As we noted under session 1 that
the objective of management accounting is to assist management determine and
assign costs to various cost objects and to select the best investment
opportunities with the best or highest returns. The management accountant is
specialists who analyses the financial and cost data and assess the general
business environment for the guidance of management action and decision
making.
Management accountants play the following typical roles by assisting

management through:
a. Evaluating and controlling capital projects and business ventures of the
firm.
b. Making a choice between producing one commodity or the other, make
or buy a certain product, shut down a product line or continue production
accept or reject an order
c. Budgeting and budgetary control activities that encompasses healthy cash
or liquidity status, material stock levels, labour utilization, capacity
utilization to mention only a few.
d. Determining the true cost of production and recommending alternative
means of cutting down costs
e. Estimating and analyzing departmental operational costs and revenues
f. Providing information for the planning of future activities of the firm
g. Preparing regular reports for undertaking corrective measures on
deviating aspects of the organizational activities or performance.
2.3 Characteristics of useful Management Accounting

Information
Management accountants provide economic information to management for
planning, evaluation and control and important decision making. The quality of
commodity (i.e. products or services) provided will be determined by the extent
to which the information requirements of the functional managers have been
met.
For management accounting information to be useful and beneficial to various

users (managements) then they should posses some key qualities. The following
features of useful accounting information have been identified:
1) Relevance: implies that, the information provided should be that which
is required to satisfy the needs of the information users. In other words
management accounting information must have the ability to influence
decision.
2) Reliability: denotes that management accounting reports should be free
from any material error or bias. It should be capable of being relied on by
all stakeholders to represent what it is supposed to represent.

UNIT 1
3) Comprehensibility: implies that the manner in which information is

presented must be capable of being understood by all users. Information
may be difficult to understand if it is incomplete, yet too much detail is
also a defect which can cause difficulty of understanding.
4) Completeness: also means that all information which is necessary to
influence or meet users needs should be included in the financial
statements.
5) Timeliness: implies that the management accounting information should
be available at reasonably frequent intervals because usefulness is totally
reduced if management information does not appear until long after the
period to which it relates or if it produced at unreasonably long intervals.
What constitute long intervals depends on the circumstances and
management the information.
6) Comparability: also means the same accounting treatment should be
adopted for the same event or transaction whenever possible. This makes
information to be produced on a consistent basis so that valid
comparisons can be made with information from previous accounting
periods as well as with information produced from similar companies
operating in the same industry.
7) Cost Effective: implies that the cost of preparing the accounting
information should not in any way exceed the benefits to be derived.
The first two characteristics – relevance and reliability – are really the most
important qualities of management accounting information. The remaining
features actually limit the usefulness of management accounting information to
the extent that they are missing. Equally, accounting information may possess all
the first five qualities yet may not be produced, if it is discovered that the cost of
providing such information is greater than the potential benefit to be derived.
1. Mention four functions of Management Accounting.
2. State and explain two features of accounting information which actually it
useful

UNIT 1
Session 2 ROLE OF MANAGEMENT ACCOUNTANTS


Session 3
SESSION 3: DIFFERENCES BETWEEN FINANCIAL, COST AND

MANAGEMENT ACCOUNTING
You are warmly welcome to the session 3 of Unit 1 of this module. I hope you
enjoyed reading session 1 and 2. I also believe that, the exposure so far is well
noted and that you will not forget them as we walk through the rest of the
module. We want to continue our lesson by looking at the relationship between
financial, cost and management accounting.
Objectives
a) mention the main branches accounting
b) briefly outline the major differences among these accounting systems
Now read on…
3.1 Relationship of Financial, Cost and Management

Accounting
Accounting is usually seen as having three main distinct strands notably,
financial accounting, cost accounting and management accounting. To begin
with, we can explain them as follows:
• Financial Accounting: This is concerned with preparing financial
reports for use by persons outside the organization. Such users include
shareholders, labour unions, bankers, creditors, government agencies and
the general public. External users are mainly interested in reviewing and
evaluating the organizational performance as well as the financial
position or standing of the business as a whole
• Cost Accounting: This deals with the appropriation or allocation of
resources to cover expenditure with respect to material, labour and
overheads to enable management to ascertain its cost of operation or
production, as well as to identify areas of inefficiencies for management
attention and consideration.
• Management Accounting: A management accountant uses the
techniques of both financial and cost accounting to achieve its objective
or goal of helping executives to formulate both short and long run plans
to measure success, in carrying out its plans, in identifying problems
requiring attentions and to choose among alternative methods of
executing or examining the company’s corporate objectives.
From the above explanations the relationship between financial, cost and
management accounting can be stated as follows:
1) Financial Accounting is concerned with external reporting to
shareholders and the investing public at large. It also provide a system
whereby the operations of an organisation can be checked or audited to
confirm that the establishment is being managed in a proper and
responsible manner. Financial accounting has been commonly referred to

UNIT 1
Session 3 DIFFERENCES BETWEEN FINANCIAL, COST AND
as ‘stewardship’ accounting because they are prepared to enable owners

of an organisation to assess the performance of the managers they have
appointed.
2) Cost Accounting, on the other hand, is concerned with the provision of
information to an organization’s own management. It attempt to report
the cost and profitability of different products or services, and to enable
management to estimate future costs. With such ‘internally generated’
information management can decide which product or service should be
made and sold, and in what quantities, what selling price should be set,
etc.
3) Management Accounting is also concerned with the provision of
information required by management for policies formulation, planning
and controlling of company’s activities, decision making, safeguarding
company’s assets to mention only a few.
3.2 Differences between Financial, Cost and Management

Accounting
The accounting systems can be grouped into two broad strands notably:
• Cost and Management Accounting both of which seek to meet the needs
of management
• Financial Accounting which seeks to meet the accounting needs of all of
the other users which were outside the business organization.
The differences between the two types of accounting reflect the different user
group which they address. Briefly, the main are as follows:
a) Regulations: financial reports, for many organizations are subject to
accounting regulations which try to ensure that they are produced in
conformity with a standardized format. These regulations are imposed by
law and accounting profession. But management accounting reports are
not guided by any such regulations from the external sources dictating
the form and content. Management reports are for internal use only and
can be tailored to meet the needs of a particular management.
b) Nature of the Reports Produced: financial accounting reports tend to
be general-purpose reports. That is the contain financial information that
can be useful for a wide range of accounting users as well as decisions
rather being specifically developed for the needs of a particular group or
set of decisions. Management accounting reports, on the other hand, are
often designed for specific purpose. They are designed either with a
particular decision in mind or for a specific management.
c) Level of Details: financial accounting reports provide users with a broad
overview of proposition and operational performance of the business for
s defined period. Consequently, information is generally aggregated and
detail is usually lost. Management accounting reports, however, often
provide management with considerable details to help them with a
particular operational decision.

Session 3
d) Reporting Intervals: for most businesses, financial accounting reports

are produced on an annual basis. However, large companies may produce
semi annual reports and few and a few also produce quarterly reports.
e) Management accounting reports may be produced as frequently as
required by management. In most businesses, Managements are provided
with certain reports on a weekly or monthly basis which permit constant
review of operational performance.
f) Time Horizon: financial accounting reports reflect the operational
performance and financial health of the business for the past period. In
short, financial accounting reports are backward looking. Management
accounting reports, on the other hand, often provide information
concerning future operations as well as past activities. It is an
oversimplification, however, to suggest that financial statements do not
incorporate future expectations. Occasionally, businesses do issue
financial forecast reports to other users in order to raise additional capital
or to fight off possible takeover bid.
g) Range and Quality of Information: financial accounting reports
concentrate on information which can be quantified in monetary terms.
Management accounting reports also produces such reports, but is also
more likely to include information of a non-financial nature such as
measure such as measures of physical quantities of stocks and output.
Financial accounting reports places much premium on the use of
objective, verifiable evidence when preparing annual reports.
Management accounting reports may use information which is less
objective and verifiable in order to provide managers with information
which they require.
In this session, we have learned that management accounting is concerned with

the provision of information internal report for management planning control and
decision making whereas financial accounting deals with external reporting to all
interest parties. Management accounting differs from financial accounting in the
following major ways notably: internally focused; no mandated rules, financial
and non-financial, subjective information are possible, emphasis on the future,
broad, multidisciplinary, internal evaluation and decisions based on very detailed
or comprehensive information.
1. Distinguish between financial accounting and Management Accounting.
2. State and explain three differences between the two main strands of
accounting.

UNIT 1
Session 3 DIFFERENCES BETWEEN FINANCIAL, COST AND


UNIT 1
SESSION 4: ELEMENTS OF COST AND COST CLASSIFICATION
You are welcome to session 4 of Unit 1 of this module. We have learned through
session 1 to 3 that, the main purpose of management accounting is to provide
information for management planning control and decision making. Knowledge of
cost behavior and nature allows a manager to assess changes in costs that results
from changes in level of output or operation. It also allows management to evaluate
the effects of choices that change operation.
We know that decision making is about making choices. For instance, if excess
capacity exists, orders that at least cover variable costs may be totally acceptable and
appropriate. Therefore, knowing what costs are variable and what costs are fixed can
help management make informed judgments and decisions.
Objectives
a) identify the elements of cost
b) state how costs may be classified
c) state the importance of costs classification
4.1 Elements of Cost

The cost accumulation is done under three heading namely material, labour and
overheads. Different costs are required for because they serve different managerial
purposes or objectives. The three cost elements that determine the cost of making a
product are direct materials direct labour and overheads.
4.2 Classification of Cost

Cost classification denotes the grouping of cost data to facilitate easy analyses,
evaluation and provision of information for management planning, control and
decision making purposes. It is essential to recognise that costs can be classified in a
variety of ways, depending upon the purpose of the classification. Costs may be
grouped in the following three different ways namely:
 By direct and indirect costs
 According to their function
 According to their behaviour
4.3 Functional Classification

By functional classification cost are analysed and grouped according to the
following functional or departmental units operating within an organisation or
establishment:
 Production or manufacturing costs
 Research and development costs
 Administrative
 Marketing or selling and distribution cost.
CoDEUCC Post Diploma n Commerce 13

UNIT 1
Session 4
ELEMENTS OF COST AND COST
CLASSIFICATION
4.4 The Nature Cost Behaviour

One common decision managers make involves how many units to produce or how
much service to provide during a certain time period. Making such decisions
requires an understanding of how cost changes with volume. Each product or service
and the corresponding method of production have different cost components as the
rate of output changes during a period of time. Hence, cost to a business in
accountants’ perspective is not as simple as a layman would think. In actual fact,
accountants spend a lot of time considering the nature of costs behaviour in order to
provide accurate cost estimates, which is appropriate to the purpose and needs of the
organisation.
4.5 Cost Behaviour

Cost behaviour is the way a cost reacts to a change in business activity. As rightly
pointed out, it is essential for managers appreciate and understand cost-behaviour
patterns if they are to accurately predict how a cost will respond to a contemplated
change in business operation.
Cost behaviour is best defined in relation to some activity, such as the number of
units produced, hours worked, miles driven, meals served, and ounce of gold mined.
While business managers are concerned with what their costs have been in the past,
they are naturally much more concerned with what their costs will be in the future.
Cost prediction (the estimating of future costs) is therefore of crucial importance to

business planning. Therefore, in order to able to predict costs, it is essential to
understand the behaviour of costs and how they will be affected by changes in level
of activity and methods of production.
The classification of costs according to their behaviour is therefore the basis of cost
prediction and this is usually undertaken in relation to changes in the activity level of
the respective organisation. It is in this context that, costs can be grouped by their
behaviour where two types are identified as fixed and variable costs.
4.5.1: Fixed Costs

A fixed cost remains unchanged in total as the level of activity (cost drive) varies. A
fixed cost is one which is not dependent upon the level of activity but which will be
incurred on a recurring basis, no matter what level of activity the company
undertakes. Examples of fixed costs include depreciation of plant and equipment at
Ghacem. For example, if plant is idle, expenditures such as property rates, insurance,
the salary of security men and plant management must be paid. Fixed costs are
relevant to time periods rather than activity level. Therefore, in terms of cost
predictions the fixed costs behaviour can be predicted into the future without regard
to the expected activity level. This can be depicted diagrammatically as follows
(Figure 1):

UNIT 1
Cost cost assumed to be constant
4.5.2: Discretionary Costs

These are also fixed costs incurred but reversible in the short term. They differ from
committed costs in that they are reversible after short periods of time. Advertising is
a good example of this kind cost because it is normally contracted for over short
periods of time. Other examples may include supervisor’s salary and security
guard’s salaries.
4.5.3: Step Change Fixed Cost

However, fixed costs are not fixed indefinitely for all activity levels, but at a certain
point in production or companies’ life additional fixed will be required. For instance,
if number of deliveries increases beyond a certain level in a distribution company
fixed costs will changed. This behaviour of fixed cost is known as a step change in
fixed costs and can be shown diagrammatically as in figure 2
Cost
4.6 Variable Costs

A variable cost changes in total in direct proportion to a change in the level of
activity (or cost drive). A variable cost is one which is directly related to the level of
activity of an organisation. Variable cost has direct relationship to volume of
production and can be predicted to increase or decrease in direct proportion to
output. For example the cost of aluminium sheets used by Ghanal will increase by
approximately 10 percent if roofing sheet production increases by 10 percent. This
can be shown diagrammatically as follows (figures 3a & 3b).
v/cost variable cost per unit
Level of activity Level of activity

(a) (b)

UNIT 1
Session 4
CLASSIFICATION
As it were, variable costs cannot be predicted for the future without a consideration
of the estimated level of activity, as any changes in such parameters will lead to a
change in cost. Although, costs are predicted in total for a time period, for variable
costs it is useful to understand the cost behaviour in terms of unit cost. The concept
of classifying costs into fixed and variable according to their behavioural
characteristics is an essential preliminary step to being able to undertake any
meaningful cost predictions into the future.
4.7 Curvilinear or Non Linear Variable Costs

Again, the assumption that variable cost per unit will remain the same over a period
of time is always true. But at times the relationship between variable cost per unit
can vary from one output level or batch to another resulting in curvilinear
representation or a curved line on a graph. Two common types are:
 Convex: where extra unit of output causes less than proportionate increase in
cost.
 Concave: where extra unit of output causes more than proportionate increase
in cost.
4.8 Factors which Influences Costs Behaviour

 Volume of output
 Technology advancement and changes
 Product mix changes
 Methods of production
 Seasonal and climatic conditions
 Economic changes
4.9 Problems or Limitation of Costs Behaviour

Although cost behaviour form the basis of cost prediction one needs to recognise the
fact that it does it not without limitations or problems. Among the numerous
bottlenecks associated with cost behaviour are:
i. Mixed Cost: Not all costs can be classified as purely fixed or purely variable
costs because the show features of both. Such costs, because they contain
both fixed and variable elements, are generally referred to as mixed costs.
Mixed costs may be subdivided into two categories namely, semi-variable
costs and step-variable costs.
ii. Semi-Variable Costs: A semi-variable cost is closely related to a variable
cost. It is made up of two components which are a basic fixed charge
(usually a monthly fee) and a variable charge based on the level of activity.
Typical examples include telephone, power and lighting charges and
photocopying machine which have fixed element of rent and variable
element depending upon usage. These costs are known as mixed, semi-fixed
or semi-variable.

UNIT 1
iii. Step-Variable Costs: A step-variable cost consists of series of fixed cost

increments over short ranges of production within the relevant range. In other
words a step-variable cost increases in discrete jumps rather than the
iv. continuous pattern of semi-variable costs. Typical examples of this kind of
cost are the salaries of a foremen and maintenance workers.
v. Short and Long Term Effects: Classifying costs into fixed and variable
cost for predictions is basically only valid for short-term predictions. The
reason being that, in the long-term all fixed costs can be regarded as variable,
in that, the factory cost themselves can be varied as existing factory
structures can be disposed off and new structures built given sufficient time.
Therefore, cost predictions cannot be made indefinitely into the future but
only for fixed relatively short time period.
vi. Linearity: In predicting cost, it is normally assumed that variable costs vary
in direct proportion to changes in the level of activity, but in reality this may
not be strictly true.
vii. Relevant Range: Both fixed and variable costs relationship with output level
only hold true within a specific range of activities termed the relevant range
and outside this range the relationship no longer holds true.
viii. Multiple Causes of Behaviour: It is often assumed that costs behaviour are
influenced and determined by the level or volume of activity, methods of
production etc. however, in reality there are a number of other factors that
are equally important which are not captured in the concept of fixed and
variable cost.
1. State the three main element of cost
2. Outline the three ways classifying costs

UNIT 1
Session 4
CLASSIFICATION


Session 5
SESSION 5: COST TERMS AND CONCEPTS
You are once again welcome to session 4 of unit 1. In order for you to understand
and appreciate the application and workings of management accounting tools, it is
essential that student should be aware of the broad basic terms and concepts, which
play significant role in classifying costs, costs accumulating and interpreting
management accounting reports or information.
The purpose of management accounting system is to provide information for

management planning and decision making. An understanding of costing terms,
concepts and costs classification as well as costs accumulation is fundamental in any
meaningful study of management accounting.
As you read the session, do well to note the meaning and rational of the various cost
terms and concepts. This is because the rest of the module makes reference to the
terms and concepts.
Objectives
a) identify the basic cost terms
b) explain with vivid examples the costs terms and concepts
c) distinguish between direct and indirect costs
Now read on……………
5.1 Cost Accounting Terminologies

An understanding of costing terms, concepts and costs classification as well as costs
accumulation is fundamental in any meaningful study of management accounting.
Enumerated below are few of such terms which help you in grasping the basic
rudiments of management accounting.
5.2 Cost
The word cost can have variety of meanings depending on the context in which it is
used. But for the purpose of our study the term cost may basically be defined as the
sacrifice made, usually measured by how much money or other economic resources
given up to achieve such a specified purpose (i.e. in exchange for goods or services).
5.3 Cost Units

By definition cost unit is quantitative unit of product or service in relation to which
costs are ascertained. The cost unit, otherwise known as cost object is the basic
control unit for costing purposes. Examples of cost units in manufacturing firms may
be a shoe in a shoe factory. A cost unit in a service industry like hospital might relate
to the number of beds occupied or the number of patients treated. Examples in this
respect might be patient/day (or bed/day) in a casualty each patient treated might

UNIT 1
Session 5
COST TERMS AND CONCEPTS
form a cost unit, in a hotel, a cost unit would be bed/day occupied or room/day
occupied, in transport business the obvious cost unit is ton/mile or passenger/mile
i.e. the cost involve in transporting one ton of freight or passenger over one mile
would be aggregated.
5.4 Cost Centre

A cost centre is defined as a location, function or place or items of equipment in
respect of which costs may be ascertained and related to cost units for control
purposes. Each cost centre acts as collecting point for certain costs before they are
analyzed further. The total cost of a cost centre may either be related to the cost units
which have passed through the cost centre, or the total cost might be re-allocated
over other cost centres. Typical examples of cost centres includes the various
production or service departments in a factory i.e. cutting, machining or finishing
departments, canteen, stores, administration, sales or distribution departments such
as personnel, accounting or purchasing department.
5.5 Unit Cost

Unit cost can simply be defined as the arithmetic average cost of producing only one
unit of output (goods and services). In other words unit cost can be calculated by
dividing the total cost of production by the number of units produced.
5.6 Direct Cost

Direct costs are those costs which can be directly identified with a particular product
or service which the business provides. These can be categorized into three distinct
types:
 Direct materials – the raw materials and components or those physical things
which go into the finished product.
 Direct labour – the cost of labour which is directly involved in the
production process. Put differently, it is the wages paid to production
workers for work directly related to the unit of production.
 Direct expenses – expenses which are incurred specifically in the making of
a particular product, such as royalties paid or hire of special piece of
equipment.
The total of all the direct costs is known as Prime Cost (i.e. direct materials + direct
labour + direct expenses)
5.7 Indirect Costs

Indirect cost are all those costs of materials, labour and expenses which are incurred
in the production process but which cannot be identified with one particular product.
Examples include the cost of foreman and maintenance staff in a business producing
a range of products, or consumables materials used by machinery involved in the
production process. The total of all the indirect costs is usually termed as Overheads
(i.e. indirect materials +in direct labour + indirect expenses).

Session 5
5.8: Conversion Cost

A conversion cost is the cost of producing a product excluding the direct material
cost. It refers to the sum of direct labour and manufacturing overheads. It stems from
the notion that direct materials are converted into finished goods through the input of
direct labour and production overheads. In short, it is usually taken as the aggregate
of direct labour and production overheads consumed.
5.9 Product Costs

A product cost is a cost assigned to goods that were either purchased or
manufactured for resale. These are costs associated with the actual production or
acquisition of the product itself. The product cost is used in stock valuation. The
product cost of a manufacturing establishment include the cost of raw materials
involved in the production, the labour time involved in the production process, and
variety of other costs such as the cost of running machinery which is necessary to
produce the finished goods. Product cost of retailers and wholesalers consist of the
purchase cost plus the shipping or freight charges. Product cost is similar to service
costs depending on the company’s business activity.
5.10 Period Costs

All costs that are not product costs are called period costs. These costs are identified
with the period of time in which they are incurred rather than with the units
purchased or goods produced. These are costs incurred by the business which are not
related to actual production but which are incurred because the company is in
business. They are known as period costs because they are generally associated with
a time period. For example, all research and development, selling and distribution,
administrative costs such as rent and rates, telephone bills and managing director’s
salary are treated as period cost. None of these costs can be considered to be directly
attributable to the costs of producing any particular product.
5.11 Controllable Cost

Another cost classification that can be helpful in cost control involves the
controllability of a cost item by a responsible manager. A cost is controllable if a
responsible manager can directly control or heavily influence the level of such cost
i.e. can even vary the number of times or the time period over which the cost is
incurred.
5.12 Uncontrollable Cost

Uncontrollable costs, on the other hand, are costs items for which responsible
manger cannot influence significantly such cost items. For instance, whereas
maintenance expenses in a transport company can be regarded as controllable cost,
the cost such as vehicle licensing fees and the cost per gallon of fuel must be
regarded d as uncontrollable.

UNIT 1
Session 5
COST TERMS AND CONCEPTS
5.13 Distinctions between Direct and Indirect Cost

The distinction between direct and indirect cost is very important due to a number
reasons. These reasons include:
• Pricing decisions may be greatly influenced particularly when using marginal
costing which cost determination is usually based on direct costs or when
using full absorption costing approach which is based on both direct and
•
• indirect costs. Ability to segregate the costs into direct and indirect will
enable management to set true and fair prices.
• The distinction also facilitates policy making on output and customer orders.
Since indirect costs usually do not vary with the level of output, management
is able to determine what increase in output level is acceptable. The
distinction helps to avoid overstretching production capacity as well as
preventing under utilization of capacity
• Direct costs are usually controllable by a responsible officer but indirect
costs are normally uncontrollable. The distinction therefore assists managers
in identifying and assigning responsibilities to the right persons, locations or
departments.
• Planning and decision making are improved tremendously as management
devout much time pondering over how to keep direct or variable costs under
control rather than concentrating on indirect cost which does not change in
relation to production volume.
• It directs management attention in sensitivity analysis knowing that much of
the problem centres on direct or variable costs.
1. Briefly explain the following cost terms: cost unit, unit cost, direct &
indirect costs,
2. Give two reasons why distinction between direct and indirect cost in so
important to management

Session 6
SESSION 6: BASIC MANAGEMENT ACCOUNTING CONCEPTS
You are welcome to session 6 of unit 1. I hope you enjoyed reading session 4 and 5
with regards to cost classification and cost terms. In this session we will consider the
identification and application of basic management accounting costs concepts in
making management decisions. We will see that not all costs surrounding an item or
a location are relevant to a particular decision.
Therefore it is imperative to distinguish carefully between costs and revenues which

are relevant and those which are not since failure to do so could well lead to bad
decisions being made.
Objectives
a) Identify and explain relevant costs
b) distinguish between opportunity and differential cost
6.1 Relevant Cost

Relevant costs are those costs which change depending upon the decision made or
that are incurred because a decision is made. In other words, it is defined as a cost
that is appropriate to aiding the making of specific management decision. A relevant
cost is a future cash flow arising as a direct consequence of decision under
consideration. For a cost to be relevant to a particular decision it must satisfy the
following criteria:
• It must relate to the objectives of the business: for instance, relevant costs
must have effect on the wealth of the business, if the organization has a
wealth improvement objective in place.
• It must differ from one possible decision outcome to the next: this means
that only items which are different between outcomes can be used to
differentiate between them. That is logic behind the irrelevance of historic
cost as it is the same whichever decision is taken.
6.2 Opportunity Cost

An opportunity cost is defined as the benefit that is sacrificed when the choice of
action precludes taking an alternative course of action. Put differently, an
opportunity cost is the value in monetary terms of being deprived of the next best
opportunity in order to pursue a particular objective. For instance you own an
undeveloped land at Kasoa which cost you GH¢3,000 when you bought it, much
below current price reigning in the area. You have just been offered GH¢4,000 for
this piece of land. The real economic cost of retaining that piece of land is
GH¢4,000, since it is what you are being deprived of to retain the plot of land. Any
decisions which you make with regards to the land should logically take into account
the GH¢4,000. This cost is the opportunity cost since it is the value of the
opportunity forgone in order to pursue the alternative course of action.

UNIT 1
Session 6
BASIC MANAGEMENT ACCOUNTING CONCEPTS
6.3 Differential/Incremental Cost

A differential cost is the difference between the costs of two alternative courses of
action. In short, a differential cost is the amount by which the cost differs under two
alternative courses of action. Suppose a district is considering two competing sites
for a waste recycling plant. If the northern site is chosen, the annual cost of
transporting refuse to the site is estimated to be ¢850 million. If the southern site is
selected, annual costs in respect of waste transportation are expected to be ¢700
million. The annual differential cost of carrying the waste is calculated as follows:
¢’000
Annual cost of transporting refuse to northern site 850,000
Annual cost of transporting refuse to southern site 700,000
Annual Differential Cost 150,000
A differential cost is also known as an incremental cost. Differential or incremental

costs are found in a variety of economic decisions. In other words, incremental cost
refers to additional cost arising only because of a particular project is moved from
one location to another. Incremental costs include both variable costs and additional
fixed cost acquired for undertaking the specified project.
6.4 Sunk Cost

Sunk costs are costs that have been incurred in the past and cannot be altered by any
current or future decision. Put differently, a sunk cost is any cost that has already
been incurred and cannot be reversed. Apart from its effects on income taxes, a sunk
cost is irrelevant for all decision-making purposes. For example, such costs include
the acquisition cost of equipment already purchased and manufacturing cost of stock
on hand. Regardless of the usefulness of the equipment or the stock, the costs of
acquiring them cannot be changed by any prospective action. Hence these costs are
irrelevant to all future decisions. Other example may be, assume Apostle Sarfo
Automobile Manufacturing Company spent $20 million to set up a plant to
manufacture an electric powered engines for the Ghanaian public in particular and
Africans in general. Nevertheless, a month later, electricity power crisis hit the
economy and the company is contemplating whether to discontinue the
manufacturing of an electric powered engine or invest in a gas-guzzling engines.
The $20 million expenditure is a sunk cost and as such has no bearing on the
decision, except for the tax write-off it would provide.
6.5 Committed Costs

Fixed costs that continue for long periods of time are called committed costs.
Committed costs are costs, once made, are not reversible in the short term. Typical
examples of committed costs may be the cost of constructing a factory building and
a long-term lease for an office building.

Session 6
1. Briefly explain the term opportunity cost, with vivid example.
2. Past cost are irrelevant costs does it mean that what happened in the past is
irrelevant?
3. A carpenter has an old delivery van which he bought several months ago for
GH¢5,000. The van needs a replacement engine for GH¢500. This would take
nine hours to fit by a shop mechanic who is paid GH¢6 an hour. Presently the
shop mechanic is very busy. If a mechanic is to be put on the engine
replacement job it will mean that other work which the mechanic could have
done during the nine hours, to earn other income will not be undertaken. The
shop mechanic’s labour charge is GH¢14 an hour. Without the engine the van
could be disposed off for an estimated value of GH¢5,700. What is the
minimum price should the shop quote to sell the van, with a reconditioned
engine fitted, price that will justify doing the work under the circumstances
specified.

UNIT 1
Session 6
BASIC MANAGEMENT ACCOUNTING CONCEPTS


UNIT 2
MARGINAL AND ABSORPTION COSTING
UNIT 2: MARGINAL AND ABSORPTION COSTING

Unit Outline
Session 1: Meaning of Absorption Costing and Marginal Costing
Session 2: Approaches to Profit Reporting using Absorption and
Marginal Costing
Session 3: Breakeven Analysis: Assumption and Uses
Session 4: Break-even Analysis: Graphical Method
Session 5: Break-even Analysis Equation Method
Session 6: Cost Volume Profit Analysis for Multiple Products
You are welome to Unit 5 of this module. I hope you enjoyed reading the
previous units and sessions. In this unit, we would like to examine the two main
techniques that accountants use to report the performance of a firm and to take
important decisions such as pricing and whether or not to stop producting a
particular product. The Unit begins with the meaning and purpose of absorption
costing and marginal costing, after which it examines how income statement is
prepared using absorption costing and marginal costing principles. The unit
also deals with break-even analysis for firms with single products and those
with multiple products.
Unit Objectives
By the end of this unit, you should be able to:
1. explain the difference between marginal costing and absorption
costing;
2. explain such terms as breakeven point, contribution and margin of
safety,
3. prepare profit statements based on absorption costing and marginal
costing,
4. reconcile the difference in profit under absorption costing and
marginal costing,
5. explain the assumptions underlying break-even analysis,
6. apply cost volume-profit analysis to single products and multiple
products,
7. calculate and interpret a breakeven part from information supplied;
and
8. describe the advantages and disadvantages of absorption and
marginal costing for a manufacturing business.
CoDEUCC/Post-Diploma in Commerce 27
UNIT 2 MARGINAL AND ABSORPTION COSTING

• issues that are not clear, and;
28 CoDEUCC/Post-Diploma in Commerce
MARGINAL AND ABSORPTION COSTING UNIT 2
SESSION 1
UNIT I: MEANING OF ABSORPTION COSTING AND

MARGINAL COSTING
Welcome to Session I of Unit 2. I hope you will enjoy studying it. This
session explains the meaning of absorption costing and marginal costing. It
also examines the features that differentiate absorption costing from marginal
costing.
Objectives
By the end of this session, you should be able to:
(a) explain absorption costing and marginal costing
(b) explain the term contribution; and
(c) differentiate between absorption costing and marginal costing
variable and fixed costs
Now read on…
1.1 Meaning of Absorption Costing and Marginal Costing

Absorption costing is the technique under which total cost (that is fixed cost
and variable cost) is charged as production cost. It is also known as full
costing.
An alternative to absorption costing is marginal costing, also known as

variable costing or direct costing.
Marginal costs refer to all variable costs incurred in production, selling and
distribution. These are direct material costs, direct labour costs and, in
addition, variable overhead costs. All the costs tend to vary in direct relation
to the volume of output.
Under marginal costing, the product cost is made up of variable production

costs. The fixed costs are considered as period costs and are thus charged
directly to product and loss account for the period.
Job costing is an example of all full costing. From the above, we have to note
that there are two costs that a cost accountant or decision maker is confronted
with, the total cost of production and variable cost of production. However, it
should be noted that in business particularly in short term decision making, it
is usually the total variable costs incurred in producing a product which is
important. The importance of marginal costing is decision making lies in the
fact that usually, in the short term, the only extra costs involved in a project
are the marginal costs.
UNIT 2
SESSION 1 MEANING OF ABSORPTION COSTING AND
MARGINAL COSTING
The following formulae enable us to quickly grasp most of the issues to be

discussed in the remaining sessions of this unit.
Total Cost = Fixed cost + Total Variable Cost
Contribution = Sales - Variable Cost (that is marginal cost)
Profit = Contribution - Fixed Cost
1.2 Features of Marginal Costing

There are certain features which are essential part of a system of marginal
costing. The above features distinguished marginal costing from absorption
costing. Some of these are as follows:
(a) The marginal (variable) costs are regarded as the costs of products.
(b) Stocks of finished goods and work in progress are valued on the
basis of marginal costs.
(c) Prices are based on marginal costs plus the contribution.
(d) A special form of profit and loss account or statement is employed
(marginal profit and loss account)
(e) Profit is calculated by deducting marginal costs from sales revenue
to arrive at the contribution after which fixed overheads are deducted
to determine profit.
(f) The relative profitability of departments of products is usually based
on a study of the contributions made available by each department or
product.
(g) Fixed costs are treated as period costs and are charged to profit and
loss account for the period in which they are incurred.
1.3 Advantages of Absorption and Marginal Costing

Absorption Costing Marginal Costing
It includes an element of fixed Contribution per unit is constant
overheads in inventory values unlike profit per unit which
varies with changes in sales
volume
Analyzing under/over absorption There is no under or over
of overhead is a useful exercise in absorption of overheads (and
controlling costs of an hence no adjustment is required
organization in the income statement)
Is small organizations, absorbing Fixed costs are a period cost and
overheads into the costs of are charged in full to the period
products is the best way of under consideration.
estimating job costs and products
on jobs.
It is useful in the decision-
making process
SESSION 1
Exercise 2.1
1. What is contribution?
2. Outline the features of marginal costing.
UNIT 2
SESSION 1 MEANING OF ABSORPTION COSTING AND
MARGINAL COSTING

SESSION 2
SESSION 2: APPROACHES TO PROFIT REPORTING USING

ABSORPTION COSTING AND MARGINAL
COSTING
You are welcome to Session 2 of Unit 2. I hope you understood the meaning
of absorption costing and marginal costing. Explain in your own words the
meaning of absorption costing and marginal costing before you continue.
We now proceeed with the lesson by looking at how profit is reported using
absorption costing and marginal costing techniques.
Objectives
(a) prepare income statement using absorption costing;
(b) prepare income statement using marginal costing; and
(c) reconcile the difference in profit reported under absorption costing
and marginal costing.
Now read on…
2.1 Income Statement under Absorption Costing and

Marginal Costing
We noted under session 1 that absorption costing uses full cost of manufacture
to value inventory while, marginal costing uses direct material cost, direct
labour cost and variable manufacturing overhead to value inventory. The
concepts that we need to take note are product cost and period cost.
Absorption Costing Marginal

Direct material
Product Cost Direct labour Product Cost
Variable manufacturing overhead
Fixed manufacturing overhead
Period Cost Selling and Administration expenses Period Cost
Note that fixed manufacturing cost and all selling and administration cost
constitute period cost under marginal costing.
Illustration Question
Let us use the question which follows to explain the points made so far:
ABC Company Ltd produces a single product with the following cost
structure.
UNIT 2 APPROACHES TO PROFIT REPORTING USING
SESSION 2
ABSORPTION COSTING AND MARGINAL COSTING
Required
(a) Compute the unit product cost under absorption costing approach.
(b) Compute the unit product cost under variable costing approach.
Solution
Absorption Costing Approach
Product cost per unit

$
Direct Material 2
Direct Labour 4
Variable manufacturing overhead 1
Fixed Manufacturing overhead
$30,000
6,000 = $12
Product Cost Per Unit $

Direct Material 2
Direct Labour 4
7
2.1.1 Income Statement

Now that it is clear to you, how to compute the total cost per unit and marginal
cost per unit let us continue by examining the formats for reporting for profit
under absorption costing and marginal costing. We begin with the absorption
costing statement. Note that the format is based on the outlined elements of
product cost and period cost under absorption costing illustrated under figure
2.1
Figure 2.2 Income Statement Absorption Costing

¢
Sales xxx
Less cost of goods sold
Cost of goods manufactured/produced xx
Add opening stock of finished goods xx
xx
Less closing stock xx
Gross Profit xx
Less selling and administration costs xx
Net Profit xx
SESSION 2
Note that cost of goods produced consists of direct material, direct labour cost,
variable production overhead and fixed production overhead.
Opening stock is valued at previous period’s production cost
Closing stock is valued at production cost of current period
In order to compare income statements prepared under absorption. Let us use

the following information about ABC Company Ltd.
Variable cost per unit: $

Direct material 2
Direct labour 4
Variable selling and administration expenses 3
Fixed cost per year:

Fixed manufacturing overhead 30,000
Fixed selling and administration expenses 10,000
Number of units produced each year is 6,000
Unit in beginning stock 0

Unit sold 5,000
Selling price per unit 20
Required
Prepare income statement for ABC Limited using absorption costing
ABC Company Limited

Income Statement
$ $
Sales (5000unit @ $ 20) 100,000
Less: Cost of Goods Sold:
Opening Stock -
Add: Cost of goods manufactured (6000 x $12) 72,000
Less: Closing Stock (1000 x $12) (12,000) 60,000
Gross Profit 40,000
Less: Variable Selling expenses (5000 x $3) 15,000

Fixed Selling and Administration 10,000 25,000
Net Income 15,000
Let us turn our attention to Marginal Costing income statement. The format is
like figure 2.3
SESSION 2
Figure 2.3 Marginal Costing Income Statement
Sales xxx
Less cost of goods sold:
Opening stock xx
Add variable cost of production xx
xxx
Less closing stock xx

Cost of goods sold xx
Variable admin., selling overhead xx
Total variable cost xxx
xxx
Contribution
Less fixed production, admin. and selling overhead xxx
Net Profit xxx
Opening stock is valued at variable cost of production of the previous

period.
Variable cost of production consist of direct material cost, direct labour
cost and variable production overhead.
Closing stock is valued at current variable cost of production
Using the ABC Limited question as illustration, the income statement under
marginal costing can be illustrated as follows:
ABC Company Limited

Income Statement
$ $
Sales (5000 @ $20) 100,000
Less Cost of goods sold:
Opening stock -
Add Cost of goods manufactured (6,000 @ $7) 42,000
Less Closing stock (1,000 @ $7) (7,000)
Variable Cost of Production 35,000
Add: Selling and Admin. (5000 @ $ 3) 15,000 50,000
Contribution 50,000
Less: Fixed manufacturing overhead 30,000
Fixed selling and administration 10,000 40,000
Net Income 10,000
The difference in net income of $5,000 between the two approaches is as

a result of stock valuation.
SESSION 2
Under the absorption, the closing stock was valued at $12 each, while
under the marginal costing it was valued at $7 each. The difference is
$5 each which when multiplied by the 1000 units gives $ 5,000.
2.2 Reconciling Profits Reported Under the Different

Methods
Table 2.1 presents a comparative analysis of the relationship between
production and sales for a period, its effect on stock valuation and the
relationship between profit reported under absorption costing and
marginal costing.
Table 2.1 Comparative Income effect of Absorption and Marginal

Costing of Profit Reporting
Relation between Relation between
Production and Sale Effect on Stock Absorption and
for the Period Marginal Costing
Production equal No change in stock Absorption costing
sales equal marginal costing
profit.
Production is greater Stock increases Absorption costing
than sales profit, will be greater
than marginal costing
profit
The production is less Stock decreases Absorption costing
than sales profit will be less than
marginal costing
Illustrative Question 2
Based on the principles we have discussed, let us use another example to
illustrate the preparation of income statements under absorption and marginal
costing techniques.
Saacat Company manufactures and sells a single product. The following costs
were incurred during the company’s first year of operation.
Variable cost per unit: $
Direct Material 6
Direct Labour 9
Variable selling and administration expenses 4
Fixed costs per year:
Fixed selling and administration expenses 190,000
During the year the company produced 25,000 units sold 20,000 units
The selling price of the company’s product was $50 per unit.
SESSION 2
Required:
1. Assume that, the company uses the absorption method:
(a) Compute the unit product cost
(b) Prepare an income statement for the year
2. Assume that, the company uses the variable costing method

(a) Compute the unit product cost
(b) Prepare an income statement for the year
Solution
(i) Saacat Company Ltd
Unit Product Cost
$ $
Direct material 6
Direct labour 9
25,000 12
Cost per unit 30
Saacat Company Limited

Absorption Costing Income Statement
$ $
Sales (20,000 @ $50) 1,000,000
Less: Cost of sale (20,000 @ $30) 600,000
Closing stock (5,000 @ $30) 150,000 450,000
Gross Profit 550,000
Less: Variable selling and expenses (20,000 @ $4) 80,000

Fixed selling and administration 190,000 270,000
Net Income 280,000
(ii) Saacat Company Ltd

Marginal Unit Product Cost
$
Direct material 6
Direct labour 9
Direct manufacturing overhead 3
Cost Per Unit 18
SESSION 2
Saacat Company Limited

Absorption Costing Income Statement
$ $
Sales (20,000 @ $50) 1,000,000
Less: Cost of sale (25,000 @ $18) 450,000
Closing stock (5,000 @ $30) (90,000)
Variable selling and admin. (20,000@$4) (80,000) 280,000
720,000
Less: Fixed Production:

Fixed selling overhead 190,000 490,000
Net Income 230,000
Once again, observe that there is a difference of $50,000 between two income
statement. The difference is due to the differences in the value of closing
stock. Under the absorption costing the closing stock is valued at $30 each
but it is valued at $18 each under marginal costing.
Glory Incorporated commenced business on 1st march, 2007 making one

product only. The standard cost card of each unit of the product is
as follows:
GH¢
Direct material 16
Direct labour 10
Variable production overhead 4
Fixed production overhead 10
Standard production cost 40
The fixed production overhead figure has been calculated on the

basis of a budgeted normal output of 36,000 units per annum. The
fixed production overhead incurred in March was GH¢30,000.
Selling, distribution and administration expenses are:

Fixed 10,000 per month
Variable 15% of the sales value
The selling price per unit is GH¢70 and the number of units
produced and sold were:
March (Units)
Production 2,000
Sales 1,500
SESSION 2
Required:
Prepare the absorption costing and marginal costing profit
statements for March 2007, and reconcile the two profits
Solution
Absorption Costing Profit Statement
GH¢ GH¢
Sales (1500 x GH ¢ 70) 105,000
Less Production Cost of Sales
Opening Stock -
Variable cost of production
(2,000 x GH¢30) 60,000
Fixed production overhead
absorbed (2,000 x GH¢10) 20,000
80,000
Less closing stock
(500 x GH¢40) 20,000 60,000
Gross Profit 45,000

Less Fixed production overhead
under absorbed
(GH¢30,000 incurred – GH¢20,00
absorbed) 10,000
Adjusted Gross Profit 35,000
Less Non-Production Costs:
Variable selling, distribution &
Admin. expenses
(15% x GH ¢105,000) 15,750
Fixed selling, dist. Admin expenses 10,000 25,750
Net Profit 9,250
Marginal Costing Profit Statement for March 2007

GH¢ GH¢
Sales (1500 x GH ¢ 70) 105,000
Less Marginal Production Cost of Sales
Opening Stock -
Variable cost of production
(2,000 x GH¢30) 60,000
60,000
Less closing stock

(500 x GH¢30) 15,000 45,000
Gross Profit 60,000
Less Marginal Non-Production Costs
SESSION 2
Variable selling, distribution and

Admin. expenses (15% x GH¢105,00) 15,750
Contribution 44,250
Less Fixed Costs:
Fixed production overhead 30,000
Fixed selling dist. & admin exps. 10,000 40,000
Net Profit 4,250
Reconciliation of Absorption Costing Profit to Marginal Costing

Profit
GH¢
Absorption Costing Profit 9,250
Less Fixed Production Overhead in Closing
Stock Value (500 x GH ¢10) 5,000
Marginal Costing Profit 4,250
Damsell and Co. makes and sells two products X and Y. The
following information is available for the month of September, 2007.
Product X Product Y
Production (units) 2,500 1,750
Sales (units) 2,300 1,600
Opening stock (units) 0 0
Product X Product Y
GH¢ GH¢
Selling price per unit 180 150
Direct materials cost per unit 30 24
Direct labour cost per unit 36 24
Variable production overhead per unit 24 16
Fixed production overhead per unit 60 40
Variable selling overhead per unit 2 2
Fixed production overheads for the period were GH¢210,000 and

fixed administration overheads were GH¢54,000.00.
Required:
Prepare a profit statement for the month of September, 2007 based
on:
(a) Marginal costing principles
(b) Absorption costing principles
(c) Reconcile the profits reported under the two costing
principles
SESSION 2
Solution
(a) Profit Statement under Marginal Costing Principles
GH¢ GH¢
Sales
Product X (2,300 x GH¢180) 414,000
Product Y (1,600 x GH¢150) 240,000
654,000
Less Marginal Production Cost of Sales:

Opening Stock:
Product X
Product Y
Variable cost of production:

X (2,500 x GH¢90) 225,000
Y (1,750 x GH¢64) 112,000
337,000
Less Closing Stock
X (200 x GH¢90) (18,000)
Y (150 x GH¢64) (9,600)
309,400
344,600
Less Marginal Non-Production Costs:

Variable selling overhead:
X (2,300 x GH¢2) 4,600
Y (1,600 x GH¢2) 3,200 7,800
Contribution 336,800
Less Fixed Costs:

Fixed production overhead 210,000
Fixed administration overheads 54,000 264,000
Net Profit 72,800
SESSION 2
(b) Profit Statement under Absorption Costing Principles

GH¢ GH¢
Sales
Product X (2,300 x GH¢180) 414,000
Product Y (1,600 x GH¢150) 240,000
654,000
Less Production Cost of Sales:

Opening Stock:
Product X
Product Y
Variable cost of production:

X (2,500 x GH¢90) 225,000
Y (1,750 x GH¢64) 112,000
Fixed production overhead:

X (2,500 x GH¢60) 150,000
Y (1,750 x GH¢40) 70,000
557,000
Less Closing Stock:
X (200 x GH¢150) (30,000)
Y (150 x GH¢104) (15,600)
511,400
Gross Profit 142,600
Add Fixed Production Overhead

over Absorbed
(GH¢220,000 absorbed –
GH¢210,000 incurred) 10,000
Adjusted Gross Profit 152,600
Less Non-Production Costs:

Variable selling overhead:
X (2,300 x GH¢2) 4,600
Y (1,600 x GH¢2) 3,200
Fixed administration overheads 54,000
61,800
Net Profit 90,800
SESSION 2
(c) Reconciliation of Profit under Marginal Costing Principles to

Profit under Absorption Costing Principles
GH¢ GH¢
Profit under marginal costing principles 72,800
Add: Fixed production overhead in
Closing Stock:
X (200 x GH¢60) 12,000
Y (150 x GH¢40) 6,000 18,000
Profit under absorption costing principles 90,800
Maxim Ltd has the following data relating to its operation for June
and July, 2007
June July
Production (units) 20,000 24,000
Sales (units) 18,000 25,000
GH¢ GH¢
Variable Production Costs 60,000 72,000
Fixed Production Costs 24,000 24,000
Variable Selling Expenses 15,310 21,250
Fixed Selling Expenses 16,000 16,000
Sales revenue 126,000 175,000
The normal level of production is 20,000 units
Required:
Prepare profit statements using
(a) Marginal costing technique
(b) Absorption costing technique
(c) Reconcile the profits reported under the two techniques
SESSION 2
Solution
(a) Profit Statement using Absorption Costing Technique
June July
GH¢ GH¢ GH¢ GH¢
Variable costs:
Opening Stock - 6,000
Production (GH¢3
per unit) 60,000 72,000
Less: Closing Stock
(2,000 x GH¢3) (6,000) (1,000 x GH¢3) (3,000)
54,000 75,000
Selling 15,300 (69,300) 21,250 (96,250)
Contribution 65,700 78,750

Fixed costs:
Production 24,000 24,000
Selling 16,000 (40,000) 16,000 (40,000)
Net Profit 16,700 38,750
Workings
variable production costs
Variable production cost per unit =
production units
June July
GH¢60,000 GH¢72,000
= =
20,000 units 24,000 units
= GH¢3 = GH¢3
SESSION 2
(b) Profit Statement using Absorption Costing Technique

June July
GH¢ GH¢ GH¢ GH¢
Production costs:
Opening Stock - 8,400
Variable (GH¢3
per unit) 60,000 72,000
Fixed costs absorbed
(20,000 x GH¢1.2) 24,000
(24,000 x GH¢1.2) 28,800
84,000 109,200
Less: Closing Stock

(2,000 x GH¢4.2) (8,400) (1,000 x GH¢4.2) (4,200)
54,000 75,600 105,000
Gross Profit 50,400 70,000
Fixed cost
over-absorbed - (28,800- 24,000) 4,800
Adjusted gross
Profit 50,400 74,800
Non-Production Costs:
Variable selling 15,300 21,250
Fixed selling 16,000 16,000
31,300 37,250
Net profit 19,100 37,550
Workings
Fixed production costs
Variable production cost per unit =
Normal level of production
June July
GH¢24,000 GH¢24,000
= =
20,000 units 24,000 units
= GH¢1.2 = GH¢1.2
SESSION 2
Reconciliation of profit under marginal costing technique to that reported

under absorption costing technique
June July
GH¢ GH¢
Marginal costing profit 16,700 38,750
Fixed Production cost in
closing stock value:
(2,000 x GH¢1.2) 2,400 (1,000 x GH¢1.2) (1,200)
Absorption costing profit 19,100 37,550
SESSION 2
Exercise 2.2
As cost accountant to a medium sized manufacturing company, you have been
asked by the Managing Director for information the profit made in the month of
June. The Managing Director wants to know what profit would be shown if
marginal costing principles are adopted in the profit computation rather than the
absorption costing now used.
¢000
Significant data is- Selling price per unit 100
Direct material cost per unit 36
Direct labour cost per unit 8
Variable production overhead per unit 6
The fixed costs per month are production overhead ¢198,000,000, selling
expenses ¢28,000 and administration expenses ¢52,000,000.
A commission of 10% on sale values is paid to sales executives and this

represents a variable overhead expenses.
The factory budgets to product 11,000 units per month and there were no
stocks in existence on June 1st. Actual production was 12,200 units in
June and 10,200 unit were sold.
You are required to:

(a) Compute the full cost per unit and the absorption costing income
statement.
(b) Compute the marginal cost per unit and marginal costing income
statement.
MARGINAL AND ABSORPTION COSTING
UNIT 2
SESSION 3
SESSION 3: BREAK-EVEN ANALYSIS: MEANING,

ASSUMPTIONS, AND USES
Welcome to Session 3! I hope you enjoyed the first two sessions. In this
session we deal with one of the oldest planning and decision making tools
used by managers, the break-even analysis. We will discuss the assumptions
and used of break-even analysis. This will provide a good foundation for the
next two sessions, where we will examine the graphical approach and
equation approach to break-even analysis for single product.
Objectives
(a) explain the term break-even point;
(b) list the assumptions and limitations of break-even analysis; and
(c) explain the uses of break-even analysis
Now read on…
3.1 Break-even Analysis Assumptions and Uses

Break-even analysis is the term given to the study of inter-relationship
between cost, volume and profit at various levels of activity. It involves the
application of marginal costing techniques and it is sometimes called Cost-
Volume-Profit (C.V.P). Analysis which is often used in budget planning by
marketing managers as well as the accountants.
3.1.1 Assumptions Underlying Break-even Analysis

The break-even analysis is based on the following assumptions:
(a) All costs can be segregated into fixed and variable
elements/components
(b) Fixed cost will remain constant and variable cost will vary
proportionately with activity.
(c) The only factor affecting cost and revenue is volume that is price is
fixed as well as cost.
(d) Over the activity range being considered, cost and revenue behave
in a linear fashion
(e) The technology, production methods and efficiency remain
unchanged
(f) The analysis relates to one product only or to constant product mix
(g) There are no stock level changes or that stock are valued at
marginal cost only
(h) There is no change in the general price level.
UNIT 2 BREAK-EVEN ANALYSIS MEANING
SESSION 3 ASSUMPTIONS, AND USES
3.1.2 Uses of Break-even Analysis

(a) It helps in determining the selling price which will give the
desired profit
(b) It helps in determining the costs and revenues at different
levels of outputs
(c) It helps in determining the quantity of goods to produce to
break-even
(d) It can be used to examine the effect of change in selling price
or of price differentiation in different markets
(e) It can be used to examine the impact on changes in fixed and
variable costs on profits.
Exercise 2.3
1. What is the break-even point?
2. State four assumptions of break-even analysis.
3. Give three uses of break-even analysis.
SESSION 4
SESSION 4: BREAK-EVEN CHART – GRAPHICAL

APPROACH
Weclome to Session 4 of Unit 2. Having examined the assumptions and uses

of the break-even analysis, we want to continue the lesson by looking at the
tools for analysis. We will deal with the graphical method in this session.
You will learn how to construct the traditional break-even from a given data.
Objectives
(a) explain the procedure for constructing a break-even chart;
(b) draw a break-even chart from a given data; and
(c) determine the break even point and margin of safety from a break.
Now read on…
4.1 Traditional Break-Even Chart

The break-even point can be determined graphically. The break-even chart is
prepared showing on the horizontal axis the sales (in units or value) and on the
vertical axis values for sales and cost.
The fixed cost line is drawn parallel to the horizontal axis at a point on the
vertical axis denoting the total fixed cost. The total cost line which starts at
the point where the fixed cost line meets the vertical axis, the ends at the point
which represents on the horizontal axis the anticipated sales in units and on
the vertical axis the sum of the total variable cost of those units plus the total
fixed cost.
The total revenue line is drawn from the point of origin in a linear form to the
point representing revenue on the vertical axis and the anticipated sales level
in the horizontal axis.
The break-even point is the intersection of the sales line and total cost line.
By projecting the lines horizontally and vertically from this point to the
appropriate axis it is possible to read of the BEP in sales value and sales units.
UNIT 2 BREAK-EVEN CHART – GRAPHICAL APPROACH
SESSION 4
Figure 4.1 Break-even chart

Total
Cost and revenue ¢ Million
12
10 Total cost
8
4 Fixed cost
2
0
20 40 60 80 100 120
Scale Units (‘000)
Let us use the question below to systematically explain the construction of a
traditional break-even chart and the determination of break-even sales value and
units of output.
The budgeted output for a factory is 120,000 units. The fixed overhead amounts
to ¢4,000,000 and variable cost are ¢50 per unit. The average selling price is
¢100 per unit. Present this information on a traditional break-even chart.
Step 1
(a) Determine the total cost as follows: fixed cost + [variable cost unit x
total output]
From our example it will be ¢4,000,000 + [¢50 x 120,00] =
¢10,000,000
(b) Determine the total revenue as selling price per unit x total output.
From the example this will be ¢100 x 120,000 = ¢12,000,000
Step 2
The next step involves drawing the axes on suitable graph paper, inserting the
costs and sales values and then drafting the fixed cost line at the appropriate
point on the chart. From our example, the fixed costs amount to: ¢4,000,000.
the fixed cost line is drawn parallel to x-axis, starting from 4,000,000 on the y-
axis as shown in figure 4.2.
SESSION 4
Figure 4.2 Fixed Cost line
12
Cost and Revenue ¢ Million 10
6
4 Fixed cost
2
0
20 40 60 80 100 120
Output
Step 3
Draw the total cost line. The total cost line is drawn starting from the point on
the Y-axis which represents fixed cost. For example, from our question, total
cost is ¢10,000,000 a total cost line is drawn from ¢4,000,000 the fixed cost
point on Y-axis, to ¢10,000,000 cost point on the right side of the Y-axis. This
is shown in figure 4.2.
Note that the distance between the total cost line and fixed cost line represent
variable cost.
Figure 4.3 Total Cost line
12 Total Cost
Cost and Revenue ¢ Million
10
6
Fixed cost
4
2
0
20 40 60 80 100 120
Output
SESSION 4
Step 4
The total revenue line is drawn commencing at zero and finishing at the point
of maximum sales. From the question, total revenue is ¢12,000,000. The total
revenue line is as shown in figure 4.3
Figure 4.3 Total Revenue line
Total Revenue
12
10
8
6
4 Fixed Cost
0
20 40 60 80 100 120
Output
Now we can put all the lines together and represent the traditional break even
chart as shown in figure 2.4. From the completed break-even chart other
important facts such as profit, loss and margin of safety can be shown.
Figure 4.4 Break-Even Chart

12 Total Revenue
Total cost
10 Break even Point Profit
8
6
Margin of Safety
4 Fixed cost
0
20 40 60 80 100 120
Output
SESSION 4
Below the break-even point the business will be making loss since total
revenue will be less than total cost. On the other hand, a point above the
break-even point represents profit, since total revenue exceeds total cost. At
the break-even point there is no profit nor loss since total revenue equals total
cost.
Another important concept is the margin of safety. The margin to safety

represents the difference between sales at a given activity and sales at the
break-even point. From our example, the margin of safety is ¢4,000,000, that
is ¢12,000,000 - ¢8,000,000. The margin of safety can be expressed as a
percentage of sales. In the example, under discussion it will be 331/3%, that
is [¢4,000,000 ÷ ¢12,000,000] x 100. The greater the margin of safety the
more advantageous it is for the business.
4.2 Profit Volume Graph

We explained under session 3, that the break-even analysis is also called cost-
volume-profit analysis. The reason being that, it is an analysis of how profits
change as costs change in response to changes in production or sales volume.
The analysis can also be depicted by a profit-volume chart/graph.
Profit-volume charts exhibit the relationship between profit and sales volume.
The traditional break-even charts suffer from one limitation. Profit cannot be
read directly from the chart. It can only be deduced by deducting the total
cost reading from the total revenue reading. A profit graph overcome this by
plotting the profit directly against activity.
The construction of the profit graph involves drawing the sales curve/line and
the profit curve/line.
Let us use the same data we used for the traditional break-even chart to
construct a profit graph.
Step 1 : Draw the horizontal and vertical axis.

Step 2 : The negative range of the vertical axis should be equal to the
fixed cost (that is the loss) and the positive range equal to profit
(that is total revenue-total cost). From the example, fixed cost
is ¢4000,000 and profit is ¢4,000,000 [that is ¢12,000,000 -
¢8,000,000]
Step 3 : The horizontal axis represents the sales.
Step 4 : The break-even point is determined by joining the profit line to
the fixed cost line intersects the sales line in the break-even
point. Figure 4.5 illustrates the profit-volume chart.
SESSION 4
Figure 4.5 Profit-Volume Chart
Profit
(¢’million)
2 4 6 8 10 12 Sales
(¢’million)
-2
B.E.P.
-4
-6
Loss/ FC
(¢’million)
SESSION 4
Exercise 2.4
Esi Sam Enterprise produces a single product. The following data relates
to a forth coming year:
¢
Material cost per unit 40
Labour cost per unit 20
Fixed cost per annum 400,000
Budgeted output 16,000

(a) Present the above acts on a traditional break-even chart and
determine the break even point in units and sales value.
(b) Present the above facts on the profit-volume graph.
(c) Calculate the margin of safety.
SESSION 4

SESSION 5
SESSION 5: BREAK-EVEN ANALYSIS - CONTRIBUTION

APPROACH
You are welcome to Session 5! I hope you have understood the previous
sessions. That’s good. You may want to pause and refresh your mind about
the assumptions and uses of the break even analysis before you continue.
The equation approach to break-even analysis is the subject of study under

this session. As you read, please pay attention to the various equations that
can be used to determine break-even point under differenct situations.
Objectives
(a) determine contribution per unit (contribution margin) from a given
data;
(b) compute the contribution margin from a given data;
(c) compute the break-even point in units and in sales value from a
given data and
(d) determine the level of sales to achieve a target level of profit from
a given data
Now read on…
5.1 Break-Even Point – Equation Approach

The break-even point is the level of activity where total cost equal total
revenue. Thus, at this level of activity no profit or loss is made.
As we noted either session 4, the break-even point can be calculated in sales

units and sales.
Fixed Cost
(1) Break-even point in units =
Contribution Per Unit
Fixed Cost x SP
(2) Break-even point in sales value (a)
or
Fixed Cost
(b)
Contribution Sales Ratio
You can also find the break-even in sales value by simply multiplying the
break-even in units by the selling price per unit.
Contribution
(3) Contribution-Sales Ratio =
Sales
The contribution to sales ratio is also called contribution margin ratio.
UNIT 2 BREAK-EVEN ANALYSIS- CONTRIBUTION
SESSION 5 APPROACH
Let us illustrate the computation of break-even point using the equation above.
Nkwa Enterprise makes a single product with a sales price of $100 and
marginal cost of $60 fixed costs are $69,000 per annum.
Calculate
(a) Number of units to break-even
(b) Sales value at break-even
(c) Contribution to sales ratio
Solution
Fixed Cost $60,000
(a) Break-even in units = =
Contribution Per Unit $100 - 600
$60,000
= 1,500 units
$40
$60,000
(b) Break-even sales value = x 100 = 150,000
$40
$60,000
(c) Contribution to sales ratio = x 100 = 40%
$40
(d) What number of units will need to be sold to achieve a profit of

$20,000 per annum
(e) What level of sales will achieve a profit of $20,000
(f) If the tax rate is 40%, how many units will be needed to be sold to
make a profit after tax of $20,00
(g) Because of increasing cost, the marginal cost is expected to rise to

$63 per unit and fixed cost to $70,000 per annum. If the selling
price cannot be increased, what would be the number of units
required to maintain a profit of $20,000 per annum?
Before you continue, use the formulae to find the break even point in units and
sales value and contribution sales ratio based on the question under session 4.
Apart from the three formulae we have discussed, there are other formulae that
can be used to compute the break even point under different situations.
SESSION 5
(4) Level of sales of achieve a target profit (units)

Sometimes on organization might wish to know how many
units of a product it needs to sell in order to earn a certain level
of profit (or target profit). Under such a case, break-even can
be calculated using the following formula.
Fixed Cost + Target Profit

=
Contribution per Unit
(5) Level of sales in value to achieve a target profit

= x S .P
or

=
C/S Ratio
(6) Level of sales to achieve target profit after tax

Fixed Cost + Target Profit 1
= x or
Contribution Per Unit 1 - Tax Rate
T arg et Pr ofit
Fixed Cost +
1 − Tax
Contribution PerUnit
Based on our illustration question let us add questions (d) – (g) to illustrate
the equation (4) – (6).
Solution
(d) Level of sales (units) to achieve a target profit

=
Contribution per Unit
$60,000 + $20,000
=
$40
= 2000 units
SESSION 5 APPROACH
(e) Level of sales in value to achieve a target profit

=
Contribution/ Sales Ratio
$60,000 + $20,000
=
$40 / $100
= 200,00
You could also multiply the answer in (d) by the selling price per unit, that is
2,000 units x $100 = $200,000.
(f) Level of sales (units) to achieve after tax profit.
T arg et Pr ofit
Fixed Cost +
= 1 − Tax
Contribution PerUnit
$20,000
$60,000 +
= 1 − 40
$40
$60,000 + $33,333
=
$40
= 2,333 units

(g) Break-even in units =
$70,000 + 20,000
=
$ 37
= 2,432 units
5.2 Other Application of the Break-even Analysis

We outlined a number of uses of the break-even analysis under session 3. Jot
down some of the uses before you continue with the lesson.
In this session, we want to explain how to fix selling price and also the margin
of safety.
SESSION 5
Fixing Selling Price

Abotar Limited wishes to sell 14,000 units of its product which has a variable
cost of $15 to make and sell. Fixed costs are $47,000 and the required profit
is $23,000.
Solution
$
Fixed Cost 47,000
Expected profit 23,000
Expected contribution 70,000
Expected quantity of sale 14,000 units
70,000
∴ Expected contribution per unit =
14,000
= $5
Add marginal cost = $15
Selling price $20
The selling price is the same as (marginal cost + expected contribution)

÷expected units to be sold – ($210,000 + 70,000) ÷ 14,000 = $20.
Margin of Safety
It shows the measure by which total sales exceeds the break-even point.
Margin of safety is a measure by which the budgeted volume of sales is
compared with the volume of sales required to break even. It is the difference
in units between the budgeted sales volume and break even point.
It is sometimes expressed as a percentage of the budget sales volume. Thus
Budgeted Sales Volume - Break Even Sales

x 100
Budgeted Sales Volume
Example
Maame Enterprise makes and sells a product which has a variable cost of
$30.00 and which sells for $400.00. Budgeted fixed cost are $70,000 and
budgeted sales are 8,000 units. What is the BEP and the Margin of
Safety?
Solution
Fixed Cost $70,000
(a) BEP = = = = 7,000 units
Contribution per Unit $10
SESSION 5 APPROACH
Budgeted Sales Volume - Break - even

(b) Margin of Safety = x 100
Budgeted Sales Volume
8,000 - 7,000
= x 100
8,000
1,000
= x 100
8,000
= 12½%
Note
The margin of safety indicates to management that the actual sales can full short
of budget by one thousand (1,000) units or 12½% before BEP is reached.
Exercise 2.5
1. Give the following information
Sales (40,000 units) 400,000
Variable costs 240,000
Fixed costs 100,000
Profit 60,000
Compute:
(a) the contribution per unit
(b) the variable cost per unit
(c) the level of sales (unit) which will enable the firm to break-even.
(d) the level of sales (units) that will earn a profit of ¢120,000
2. Fine Products Ltd makes plastic garden chairs. An analysis of its

costing records revealed.
Variable cost per bucket $20
Fixed cost $500,000
Capacity 20,000 chairs per year
Selling price per chair
Required
(a) find the break-even point
(b) find the number of chairs to be sold to get a profit of $300,000
(c) if the company can manufacture 600 chairs with an additional
fixed cost of $20,000 what should be the selling price to
maintain the profit per chair as in (b) above.
SESSION 5
Step 3 : The horizontal axis represents the sales.

Step 4 : The break-even point is determined by joining the profit line to
the fixed cost line intersects the sales line in the break-even
point. Figure 4.5 illustrates the profit-volume chart.
Esi Sam Enterprise produces a single product. The following data relates
to a forth coming year:
¢
Material cost per unit 40
Labour cost per unit 20
Fixed cost per annum 400,000
Budgeted output 16,000

(a) Present the above acts on a traditional break-even chart and
determine the break even point in units and sales value.
(b) Present the above facts on the profit-volume graph.
(c) Calculate the margin of safety.
SESSION 5 APPROACH

SESSION 6
SESSION 6: COST-VOLUME PRODUCT ANALYSIS FOR MULTI-

PRODUCTS
Welcome to the last Session of Unit 2. I hope you have enjoyed the unit. We
conclude the unit, by examining how the cost-volume profit analysis can be
applied to a firm that has more than one product line. You will recall that, one
of the assumptions of the break-even analysis that it can be applied to a form
with a single product or products with a constant sales unit.
Objectives
(a) compute contribution margin ratio;
(b) compute percentage of sales of each product in a product mix; and
(c) calculate and interpret break-even for a firm with multiple products.
Now read on…
6.1 Step by Step Approach

The computation of break-even point for multiple products is not as straight
forward as that of a single product. A number of computations are required.
Let us examine some of them.
1. Computation of contribution per unit for each product.

The analysis begins with determining the contribution by each product.
Remember that contribution per unit can be calculated as selling price per
unit – variable cost per unit.
It must be noted that the contribution per unit can also be referred to as
contribution margin. The use of contribution margin is particularly useful
where the total sales and total variable cost are given rather than selling
price per unit and variable cost per unit.
2. Calculation of Contribution to sales ratio

The next step involves calculation of contribution to sales ration (or
contribution margin ratio) for each product using the formula

Selling price Per Unit
3. Calculation of percentage to sales

The sales by each product should be expressed as a percentage of the total
sales by the firm for each period.
Sales of Individual Products x 100

Total Sales of the firm
UNIT 2 COST-VOLUME PRODUCT ANALYSIS FOR MULTI-
SESSION 6 PRODUCTS
4. Computation of the Weighted Average Contribution Margin Ratio

The denominator for the formula for calculating the break-even point for multi-
products is the weighted average contribution margin ratio. It is calculated as
follows:
C 1 P 1 + C 2 P 2 + C 3 P 4 + ‘’’ C n P n
That is multiplying each products contribution margin ratio by its percentage to

sales and summing up. In the formula, C represents contribution margin ratio of
each product and P is the percentage of each product’s sales to total sales.
5. The Break-even point

The break-even point can be calculated using the formula:
Fixed Cost
Weighted Average Contribution Margin Ratio
6. Allocation of the Break-even sales to the individual products

The percentage of each products sales to total sales is used to share the break-
even sales to the products
7. Break-even units of each product.

The results obtained under step 6 for each products is divided by its selling price
in order to determine the break-even sales in units.
8. Checking the Results

The computations are checked for their correctness by multiplying each products
sales in units by its contribution per unit. The computations can also be checked
by multiplying the contribution margin ratios of each product by the BEP for
each product. In either case, this should sum up to the fixed cost.
Let us use a question to illustrate each of the steps.
Glory Ltd. produces three products Alpha, Beta and Delta. The following are the
results for one year:
Product Sales Variable Cost

GH¢ GH¢
Alpha 50,000 20,000
Beta 30,000 18,000
Delta 20,000 25,000
Total 100,000 63,000
Fixed overhead 22,200
SESSION 6
Let us use the question on Glory Ltd to illustrate the step by step approach,
1. Computation of contribution margin for each product.

Alpha Beta Delta Company
GH¢ GH¢ GH¢ GH¢
Sales 50,000 30,000 20,000 100,000
Variable Cost (20,000) (18,000) (25,000) (63,000)
Contribution
margin 30,000 12,000 (5,000) 37,000
2. Calculation of Contribution Margin ratio (Contribution to sales ratio or

Profit-Volume ratio)
Contribution Margin ratio = Contribution
Sales
Alpha Beta Delta Company
CM ratio = GH¢30,000 = GH¢12,000 = (GH¢5,000) = GH¢37,000

GH¢50,000 GH¢30,000 GH¢20,000 GH¢100,000
= 0.60 = 0.40 = -0.25 = 0.37
Note that the overall CM ratio for the company can also be computed using the
weighted average contribution margin ratio, as computed in step 4 below. This is
illustrated as follows:
3. Calculation of percentage to sales

The sales by each product should be expressed as a percentage of the total sales
by the firm for each period.
Product Percentage to Sales
Alpha 50,000 x 100 = 50%

100,000
Beta 30,000 x 100 = 30%

100,000
Delta 20,000 x 100 = 20%

100,000
4. Computation of the Weighted Average Contribution Margin Ratio
SESSION 6 PRODUCTS
Product Weights CM ratio Weights x CM ratio

Alpha 0.50 0.60 0.50 x 0.60 = 0.30
Beta 0.30 0.40 0.30 x 0.40 = 0.12
Delta 0.20 -0.25 0.20 x -0.25 = -0.05
0.37
5. The Break-even point

The break-even point can be calculated using the formula:
Fixed Cost
Weighted Average Contribution Margin Ratio
= GH¢22,200
0.37
= GH¢60,000
6. Allocation of the Break-even sales to the individual products
Product B.E.P.
Alpha 0.50 x GH¢60,000 = GH¢30,000
Beta 0.30 x GH¢60,000 = GH¢18,000
Delta 0.20 x GH¢60,000 = GH¢12,000
7. Break-even units of each product.

In this question, since the selling price per unit of each product were not given, it
would be impossible to determine the break-even sales in units.
8. Checking the Results
Product CM ratio CM ratio x B.E.P

GH¢
Alpha 0.60 0.60 x GH¢30,000 = 18,000
Beta 0.40 0.40 x GH¢18,000 = 7,200
Delta -0.25 -0.25 x GH¢12,000 = (5,000)
Fixed Cost 22,200
SESSION 6
Exercise 2.6
1. ABC Limited has prepared a budget for the next twelve months when it intends
to make and sell four products, details of which are shown below:
Product Sales in Units Selling price per Variable cost
(thousands) unit (GH¢) per unit (GH¢)
J 10 20 14.00
K 10 40 8.00
L 50 4 4.20
M 20 10 7.00
Budgeted fixed costs are GH¢240,000 per annum and total assets employed are
GH¢570,000.
You are required

(a) to calculate the total contribution earned by each product and their
combined total contributions
(b) to plot the data of your answer to (a) above in form of a contribution to
sales graph (profit-volume graph);
(c) to explain your graph to management, to comment on the results shown
and to state the break-even point;
(d) to describe briefly three ways in which the overall contribution to sales
ratio could be improved
SESSION 6 PRODUCTS

UNIT 3
RELEVANT COSTS FOR DECISION MAKING
UNIT 3: RELEVANT COSTS FOR DECISION MAKING
Unit Outline
Session 1: The Concepts of Relevant Costs
Session 2: The Relevant Cost of Raw Material and Machinery
Session 3: The Relevant Cost of Labour and Overhead
Session 4: Make or Buy Decisions
Session 5: Special Order and Shut Down a Plant or Drop a Product
Session 6: Sell or Process Further Decisions.
Dear Student you are welcome to Unit 3 of the module. In our previous units
we have been looking at the various cost concepts. As you know managers are
required to frequently make decisions which involve alternative choices. It is
not all costs concepts that are relevant in decision making. In this unit we are
going to look at how to identify and analyse relevant costs for making
decisions.
Unit Objectives
By the end of this unit you should be able to
1. explain the concepts of relevant costs
2. identify and prepare a statement to determine relevant material and
machinery costs.
3. identify and prepare a statement to compute relevant labour and
overhead costs
4. explain a make or buy decision and prepare a make or buy analysis
5. prepare a statement showing whether a special order should be
accepted or to shut down a plant.
6. prepare an analysis to show whether a product or department
should be dropped or retained and a product is to be sold or
processed further
UNIT 3
RELEVANT COSTS FOR DECISION MAKING

UNIT 3
RELEVANT COSTS FOR DECISION MAKING SESSION 1
SESSION 1: THE CONCEPTS OF RELEVANT COSTS
A manager is sometimes faced with the problem of identifying costs which are
relevant to making a particular decision. Such decisions include make or buy;
taking on a special order; adding or dropping a product line or department and
to sell a product or process further. In taking decisions of these nature calls for
the identification of relevant costs and irrelevant costs.
In this session we are going to look at the meaning of relevant cost and other
cost terms that connote the same meaning as relevant cost.
Objectives
By the end of the session you should be able to
(a) define and identify relevant costs
(b) state and explain a general rule for differentiating between relevant
and irrelevant costs in decision making
(c) state and define at least four cost terms which have the same
meaning as relevant cost.
Now read on…
1.1 Meaning and Identification of Relevant Costs

What costs are relevant in decision making? The answer is simple Relevant
costs are costs which arise as a result of carrying on a particular project or as a
result of taking a particular decision
CIMA defines relevant costs as costs that are appropriate to aiding the making
of specific management decisions. Relevant costs are costs that will be
incurred in future and can be either variable or fixed.
On the other hand if costs are not relevant to a particular decision the cost are
referred to as irrelevant costs. A cost which has already been incurred or
committed is an example of irrelevant cost. It has no effect on the decision to
be made.
1.2. Other Cost Terms that are the same as Relevant Costs
Certain cost terms connote the same meaning as relevant cost and are
therefore relevant to decision making. Let us look at some of them.
1.2.1 Avoidable Cost

An avoidable cost can be defined as a cost that can be eliminated as a result of
choosing one alternative over the other. They are usually identified with a
particular activity or sector and can be avoided if the activity or sector is not
in existence.
UNIT 3
SESSION 1
THE CONCEPTS OF RELEVANT COSTS
1.2.2 Opportunity Cost

Opportunity cost may be defined as the benefit cost as a result of choosing one
alternative and foregoing the next best alternative. It is a key factor in make or
buys decisions.
1.2.3 Differential Cost

Differential cost is the difference in costs between two alternative activities or
course of action. For example, if alternative X will cost GH 200 extra and
alternative Y will cost GH 250 extra, then the differential cost is GH50 in
favour of alternative X.
1.2.4 Incremental Cost

Incremental cost is the additional cost incurred as a result of a decision. It can
also be described as an increase in cost from one alternative to another.
1.2.5 Future Cost

Relevant cost is future oriented. Future cost is cost not yet incurred. It is a cost
that will be incurred as a result of a decision.
1.3 Irrelevant Costs

We have learnt about relevant costs. We have seen that relevant costs are costs
that change as a result of a decision. They are costs to be incurred in the future
if a particular decision is taken. What happens if costs have already been spent?
Costs which have already been incurred in the past are irrelevant and are
referred to as sunk costs or past cost costs. This sunk cost is a cost that has
already spent and cannot be avoided irrespective of whatever course of action a
manager takes.
Also a cost which will be incurred irrespective of whether a decision is made or

not is an irrelevant cost. Such cost cannot be avoided no matter the decision
and is not relevant for decision making. So in making decisions the irrelevant
costs that cannot affect the decision can be simply put as (1) past or sunk costs
and (2) unavoidable costs.
Examples of sunk costs are fixed assets already purchased, and fixed costs
already paid out.
Examples of unavoidable costs are wages of employees who are redundant and
are on the payroll already who can be used for a new project.
UNIT 3
Self – Assessment Questions
Exercise 3.1
1. What is relevant cost?
2. Define the following cost concepts

a. Avoidable cost
b. Unavoidable cost
c. Incremental cost
d. Opportunity cost
3. Distinguish between sunk cost and future cost.
UNIT 3
SESSION 1
THE CONCEPTS OF RELEVANT COSTS

UNIT 3
SESSION 2: THE RELEVANT COST OF MATERIALS AND

MACHINERY
In the last session we learnt that relevant cost is a cost that is applicable to a
particular decision and will change between alternative decisions. We also
learnt that past or sunk costs are irrelevant costs which do not affect the
decision to be made. In this session we are going to look at relevant cost of
labour and machinery.
Objectives
(a) identify relevant and irrelevant material costs;
(b) identify relevant machinery cost; and
(c) prepare a statement of relevant material and machinery costs.
Now read on…
2.1 Relevant Material Cost

We saw in cost Accounting, that material cost is one of the three elements of
cost. Therefore, in computing the cost of a product or service, you need to
compute the material cost and add it to labour cost and expense to arrive at
total cost.
When considering the relevant costs of material for decision making there are
certain considerations you have to take note. These are
(i) Estimated purchase price would be the relevant material cost if the
material is not in stock.
(ii) If the material is already in stock and will be replaced if used for a
particular activity, then the relevant cost is the replacement cost of
that material.
(iii) If the material is already in stock and has no further use apart from
being used on a particular activity, then the relevant cost of the
material is the realizable value of the material if any.
It should be noted that if the material has no realizable value, the relevant cost
is zero.
Example 1.1
Koo Nimo Ltd has got an order to supply a product called PATOO to Koo
Nsiah Lt. To make the product PATOO, the following materials and cost data
are available.
UNIT 3 THE RELEVANT COST OF MATERIALS AND
SESSION 2
MACHINERY
Material M2 which will have to be purchased specially for the order cost GH
¢250.00. Material M3 is already in stock. It was purchased at GH¢100.00 and
has no other use, but could be resold for GH¢45.00.
Material M4 is already in stock and used regularly in the company. It was

purchase at GH¢300.00 and if used for the order will have to be replaced at
GH¢350.00. Compute the relevant material cost for the order.
Solution 1.1
Computation of Relevant Material Cost
GH¢
Material M2 (Purchase Price) 250.00
Material M3 (Realisable value) 45.00
Material M4 (Replacement cost) 350.00
Total Relevant Cost 645.00
Example 1.2
Kwanena Dwomo Ltd has been approached by Kwakye Ltd to do a special job
for the company. Three types of material would be required for the job as
follows:
Material Already Required Purchase Realisable Replacement
in stock for the job price of value/unit cost /unit
stock
× (units) (units) GH¢ GH¢ GH¢
0 200 2 2
Υ 250 300 2.50 2.80 2.85
Ζ 160 120 3.50 3.20 3.40
Y is in regular use within the company and any units that will be used for the
job will have to be replaced.
Z has no other use in the company and could be sold if not used for the job.
Compute the relevant material cost for the job.
Solution 1.2
Material X is not in stock. It has to be purchased so the relevant cost of
Material X 200x GH ⊄2 = GH ⊄ 400; Material Y is used regularly in the
company, so any units used would have to be replaced.
∴ The relevant cost of material Y = 300 x GH ⊄2.85 = GH ⊄ 855.00
Material Z will not be replaced, but if used for the job there would be lost
revenue of GH ¢3.20 on each unit.
∴ The relevant cost of material Z = 120x GH ⊄ 3.20 = GH ⊄ 384.00.
UNIT 3
Total Relevant Material Cost

GH ¢
Material X 400.00
Material Y 855.00
Material Z 384.00
1639.00
2.2 Relevant Machinery Cost

The historical cost of machinery is a sunk cost and therefore, not relevant for
decision making. Also depreciation is not a relevant cost. However, the
incremental cost of using machinery is a relevant cost. These include:
(i) the hiring charges
(ii) the fall in resale value through use
(iii) the extra repair costs that would be incurred through use.
Example 2.3
Determine the relevant cost of the following Machinery for a contract work, to
be executed this year.
a. A special machine that will be needed for the contract cost GH ¢
1000.00 two years ago and has been depreciated on straight line basis
at the rate of 25%. The machine can be sold for GH ⊄ 600.00 now or
in a year’s time for GH ¢ 150.00.
b. Another machinery required for the contract has been purchased
already on hire purchase terms. The cash price of the machinery is GH
¢2100.00 which was purchased three years ago and has been
depreciated on straight line basis at the rate of 20%. The monthly hire
purchase payment for this machinery is GH ¢35.00 and this machinery
would be used for this contract for ten months. It is estimated that the
machinery would loose GH ¢320.00 in sales value if it is used for the
contract work.
c. An equipment which cost GH ¢1500.00 four years ago is currently
lying idle and can be used on the contract. The equipment could be
sold now for GH ¢600.00 or at the end of the contract for GH ¢250.00.
You are required to compute the relevant cost of machinery for the contract.
Solution 2.3
a. The relevant cost of the machine is the lose in sales value which is GH
¢600.00 - GH ¢ 150.00 = GH ¢450.00.
b. The relevant cost of the machinery is the lose in sales value which is
GH ¢320.00.
c. The relevant cost of the equipment is also the lose in sales value which
is (GH ¢600.00 - GH ¢250.00 = GH ¢350.00
Hence total relevant machinery cost = GH ¢450.00 + GH ¢320.00
+ GH ¢350.00
= GH ¢1,120.00
SESSION 2
MACHINERY
Exercise 3.2
1. Determine whether the following item of cost is relevant or not and
state the relevant material cost (if any).
a. Material X is already in stock which cost GH ¢250.00 and has
no other use and no salvage value.
b. Material Q is already in stock; purchase price was GH¢900.00
and replacement cost of ⊄ 1200 will be used
c. Material R will be specially ordered for a project at a cost of
GH ¢150.00.
d. Material K already in stock and would cost GH ¢50.00 to
dispose off will be used.
2. Kumchacha Ltd has got an order to supply a product Patuo to

Akroma Ltd. To make the product Patuo, the following materials
and cost data are available.
Material Y2 which will have to be purchased specially for the order

cost GH ¢150.00. Material Y3 is in stock. It was purchased at GH
¢250.00 and has no other use but could be resold for GH ¢50.00.
Material Y4 is in stock and used regularly in the firm. It was

purchased at GH ¢500.00 and if used for the order will have to be
replaced at GH ¢650.50. However, the realizable value is GH
¢700.00.
You are required to compute the relevant material cost of the order.
3. Abukati Ltd has got a contract to do a special job for Tutugyagu.

Four types of material would be required for the job as follows:
Material Already Required Cost Realizable Replacement

in stock for the job /Unit of value/unit cost /unit
(units) (unit) stock
GH ¢ GH ¢ GH ¢
P 0 25 4.40 - 4.40
Q 25 30 5.20 6.80 6.50
R 60 50 2.50 3.40 3.20
S 30 30 3.50 5.20 6.20
UNIT 3
Material P will have to be purchased

Material Q is used regularly in the firm and when used will have to be
replaced.
Material R has further use, but could be resold.
Material S is used as a substitute for 40 units of material T in another job
which currently sells at GH⊄ 600.00. The firm has no units
of T in Stock.
You are required to compute the relevant material cost.
4. Determine the relevant cost of the following machinery for a contract

work, to be executed in ten months.
a. An old machine which cannot be used for the contract and
purchased some years ago at GH ¢500.00 has book value of GH
¢150.00. This machine can be traded in now for GH ¢120.00 and
at the end of the contract be sold for GH ¢40.00. Maintenance
costs for the traded in machine will be GH ¢30.00 for the period.
b. A machine currently lying idle, and purchased three years ago at
GH ¢6000.00 can be used for the contract. The machine could be
sold now for GH ¢4500.00 or at the end of the project for GH
¢1500.00.
c. A special equipment will have to be purchased for the contract at
GH ¢6000.00 which will have a scrap value of GH ¢500.00 at the
end of the contract.
d. Another machine will be hired for 8 months at a monthly charge of
GH ¢250.00.
SESSION 2
MACHINERY

UNIT 3
SESSION 3: RELEVANT COST OF LABOUR AND OVERHEAD
In the last session we learnt about relevant cost of material and machinery. In
this session we are going to look at relevant cost of labour and overhead.
Labour, like material is one of the elements of cost.
Objectives
(a) distinguish between relevant labour cost and irrelevant labour cost;
(b) identify relevant overhead cost; and
(c) prepare a statement of relevant labour and overhead costs.
Now read on…
3.1 Relevant Labour Cost

When you are determining relevant costs for decision making you need to
consider that.
(i) the variable cost of labour is relevant
(ii) the cost contribution if labour is diverted from current use is
relevant
Example 3.1
Koo Paa Ltd has received an order to supply a special component that will
require 2250 hours of skilled Labour at GH ¢3.50 per hour and 3000 hours of
unskilled labour at GH ¢2.00 per hour, to Arnanse Ltd. The skilled Labour is
in short supply and Koo Paa Ltd would have to employ skilled labour to
manufacture the component.
The unskilled labour will have to be diverted from other work which is
expected to earn a contribution of GH ¢3.50 per hour.
Compute the relevant labour cost.
Solution 3.1
GH ¢
Skilled labour (2250 x GH¢3.50) 7875.00
Unskilled labour (lost contribution: 3000x GH¢ 3.00) 9000.00
Total Relevant Labour Cost 16875.00
UNIT 3 RELEVANT COST OF LABOUR AND OVERHEAD
SESSION 3
3.2 Relevant Overhead Cost

Generally, variable overhead costs which are avoidable is relevant cost and
fixed overhead cost which relates to existing fixed facilities and therefore
unavoidable is irrelevant.
Example 3.2
Afriko Ltd has received an order to make a special component for Paa Joe
Ltd. To make the component,
a) Three new workers will have to be taken at a cost of GH ¢3.00 per
hour per worker for 300 hours
b) An employee earning GH ¢3600 per annum will be made redundant,
but receive redundancy pay of GH ¢600.00.
c) A highly skilled labour paid GH ¢5.00 per hour will have to be
transferred from another work and the lost contribution is GH ¢6.00
per hour for 200 hours
d) Variable and fixed overheads are absorbed at the rate of GH¢ 7.00
per skilled labour hours as follows:
GH¢
Fixed Overheads 3.50
Variable Overheads 2.50
6.00
You are required to determine the relevant cost in each case and compute
the total relevant cost if the component is to be made.
Solution 3.2
GH¢
a) Relevant cost = 3x 300 x GH ¢ 3.00 2700.00
b) Relevant cost (Redundancy pay) 600.00
c) Relevant cost (lost contribution: 200 x GH ¢ 6.00) 1200.00
(i) Relevant cost (Variable cost: 200 X GH ¢2.50) GH ¢500

(ii) Fixed overheads cost is irrelevant
Total Relevant Cost = GH ¢(2700 + 600 + 1200 + 500)

= GH ¢5,000.00
UNIT 3
SESSION 4: MAKE OR BUY DECISION
Sometimes management may have to make a choice between manufacturing a

component of a product or buying it from outside suppliers. The decision to
manufacture or buy depends an a number of factors which include quality,
reliable suppliers, capacity and costs. These can broadly be categorized into
qualitative and quantitative factors.
In this session we are going to concern ourselves with the quantitative factors.
Objectives
(a) explain make or buy decision; and
(b) prepare make or buy analysis
Now read on…
4.1 Meaning of Make or Buy Decision

As mentioned in the overview management sometimes have got to make a
choice between manufacturing a component of a product or buying it from
outside suppliers. Making decisions as to whether to manufacture a
component or buy it from outside supplier are called make or buy decisions.
It is to be noted that make or buy decisions normally depend upon both
qualitative and quantitative factors. According to Horgren (1997) qualitative
factors are outcomes that are measured in numerical terms while quantitative
factors are outcomes that cannot be measured in numerical terms.
Examples of quantitative factors are direct materials, direct labour, variable

overheads, marketing and reduction in production time. Employee morale,
dependable suppliers and quality of products are examples of qualitative
factors.
4.2 Make or Buy Analysis and Idle Capacity

Make or buy analysis is made to decide whether management should produce
a component or buy the component. The major factors to consider are the
differential costs of the make and buy alternatives and what will be the
alternative uses of the idle capacity. In deciding to make the component the
relevant costs would include the variable costs, namely direct material, direct
labour and variable overheads and those fixed costs which are avoidable.
Costs relevant to the buy alternative would include the purchase price and all
incidental costs e.g. ordering costs.
Let us go through few examples to show how to do the analysis.
UNIT 3 MAKE OR BUY DECISION
SESSION 4
Example 4.1
Akonta Limited is manufacturing a product which requires a part that is
produced by Akonta Limited.
The unit cost of producing this part is given as follows:
GH ¢
Direct Materials 10
Direct Labour 12
Variable Manufacturing Overhead 4
Depreciation of Equipment 3
Other fixed Overheads 5
34
Other fixed overheads consists of 60% supervisory salaries which is

unavoidable and 40% avoidable costs.
An outside supplier has offered to sell the part to Akonta Limited for GH¢
29.50 based on an order of 600 parts. Should Akonta limited make or buy the
part?
Solution 4.1
Unit Cost Total cost for 600

Make Buy units
Purchase from Outside Make Buy
cost of making part internally GH¢ GH¢ GH¢ GH¢
Direct Materials 29.50 17700
Direct Labour
Variable manufacturing Overhead 10 6000
Other fixed Overhead (avoidable) 12 7200
Total cost 4 2400
2 1200
28 29.50
Difference in favour of make GH¢1.50 GH¢900.00
UNIT 3
Comments
1. Depreciation of equipment is not a relevant cost because the
equipment has already been purchased, and therefore, represents a
sunk cost.
2. Supervisors salaries which is unavailable is not a relevant cost.
4.3 Make or Buy Analysis and Opportunity Cost

In example 4.1, the assumption was that forgone when management decide to
make the part internally. Now would the decision change if the facility could
be used in some other way? Idle facility which has no alternative use has no
opportunity cost. Its opportunity cost is zero. However, I the facility would
not sit idle but could be used in some other way, the facility has an
opportunity cost, and this could influence the decision.
Example 4.2
Let us assume in example 4.1 that the facility would not sit idle but could be
used to manufacture and sell 600 units of a product K at a price of GH¢ 32.00
per unit.
The same labour force would be required to manufacture product K. the

materials for manufacturing the part would not be required but additional
materials required for making product K and would cost GH¢ per unit.
The variable manufacturing overheads, depreciation of equipment and other

fixed overheads would remain unchanged. Should Akonta Limited make or
buy the part?
Calculation of Profit forgone
Sales (600x GH¢ 32.00) 19200.00

Less: Direct materials 7200.00
Direct Labour 7200.00
Variable manufacturing Overhead 2400.00
Fixed manufacturing Overhead 1200.00 18000.00
Profit 1200.00
SESSION 4
Exercise 3.4
1. Kofi Kay Limited currently produces 1000 units of a part per annum
with the following cost structure:
Cost Per Unit Cost Total Cost of 1000 Units

GH¢ GH¢
Direct Material 8.00 8000.00
Direct Labour 10.00 10000.00
Variable Overhead 5.00 5000.00
Fixed Overhead 6.00 6000.00
29.00. ` 29000.00
A supplier is negotiating to sell the 1000 units to Kofi Kay Limited at

GH¢ 25.00 per unit should Kofi Kay Limited make or buy the part?
Assume idle capacity.
2. Koo Dwomo Limited is considering proposals to purchase from outside

suppliers any one or more of certain parts that are now being
manufactured in the company. None of the equipment used now will be
required for any activity if any of the proposals is accepted. The
requirements, cost structure, and the purchase prices for these parts are as
follows:
Direct manufacturing cost per unit
Estimated Direct Direct Purchase

Requirement material Labour Price Unit
PA GH¢ GH¢ GH¢
Part A 1500 10 8 24
Part B 2000 12 10 23
Part C 1000 8 6 18
UNIT 3
Analysis of other costs is as follows:
PART
A B C
GH¢ GH¢ GH¢
Variable overhead per Unit 4 5 2
Depreciation per Unit 4 3 6
Other fixed charge per Unit 2 1.50 3
An investigation conducted reveals that if the proposals are accepted

purchasing and handling charges will be GH¢ 2.00 per unit for all the parts.
Submit a recommendation for the proposals.
SESSION 4

UNIT 3
SEESSION 5: SPECIAL ORDER AND SHUT DOWN OR DROP

A PRODUCT DECISIONS
Sometimes a firm is faced with problems of accepting special orders which

are of nonrecurring nature. Prices may have to be fixed for such orders and
invariably management are tempted to use full cost method in quoting prices.
Whether this is the right thing to do or not will be examined in this session.
Also management may be faced with the problem of shutting down a

department or dropping a product found to be unprofitable. These situations
call for decisions which must be carefully made taking into account the
overall improvement of the firm financially.
Objectives
(a) prepare a statement to advice whether a special order should be
accepted and to quote a reasonable price; and
(b) prepare a statement to show whether to shut down a department or
drop a product
Now read on…
5.1 Special Order Decisions

As indicated in the overview, management sometimes are faced with the
problem of accepting or rejecting special orders which are not recurring when
there is idle production capacity. The contribution approach is very useful in
situations like this in deciding whether to accept or reject the order.
Example 5.1
A company has capacity to produce 1000 units of a product Q per annum. The
company current production is 750 units. The cost structure to produce
product Q is as follows:
Unit cost
GH¢
Direct materials 4
Direct Labour 6
Overheads 2
Total 12
The annual fixed costs are GH¢3000.00 and the selling price per unit is GH¢
20.00.
The company receives an offer to buy an additional 200 units at a price of
GH¢ 14.00 per unit.
Should the offer be accepted?
UNIT 3 SPECIAL ORDER AND SHUT DOWN OR DROP A
SESSION 5
PRODUCT DECISIONS
Solution 5.1
Without special With special Difference
order order
GH¢ GH¢ GH¢
Sales (750×GH¢ 20) 15000 15000 0
(200×GH¢ 14) 2800 2800
15000 17800 2800
Variable costs:
Direct materials 3000 3800 (800)
Direct labour 4500 5700 (1200)
Variable overheads 1500 1900 (400)
Total variable costs 9000 11400 (2400)
Contribution 6000 400
The solution seems to be information overhead and an alternative solution is

given.
Relevant Revenues and Expenses for the Special Order

GH¢
Revenue (200×GH¢ 14) 2800
Less: Variable Costs:
Direct material 800
Direct labour 1200
Variable overhead 400 2400
Contribution 400
The special order would increase contribution by GH¢ 400. Therefore, the
special order should be accepted.
5.2 Shut Down or Drop a Product Decisions

Shut down or drop a product decisions involves decisions to close a
department or drop a product line where the department or product is making
losses. Once again the contribution approach is an appro0riate way of taking
the decision to shut or not to that the fixed costs will continue to be incurred
whether a department is shut down or a product line is dropped. The fixed cost
that would be relevant in such situation is the incremental fixed cost. That is,
the fixed cost that would not be incurred if the department is shut down or a
product is dropped is relevant.
UNIT 3
Example 5.2
Rnanse Limited manufactures three products P, Q and R and has the following
income statement
Product P Product Q Product R Total
GH¢ GH¢ GH¢ GH¢
Sales 200,000 150,000 240,000 590,000
Less Variable Costs 100,000 90,000 140,000 330,000
Contributions 100,000 60,000 100,000 260,000
Less: Fixed Costs
P Q R Total
Avoidable 30,000 40,000 30,000 100,000
Unavoidable 30,000 30,000 40,000 100,000
60,000 70,000 70,000 200,000
Operating profit/(Loss) 40,000 40,000 30,000 60,000
Looking at the income statement, product Q is unprofitable and management

is thinking of dropping it. Advise the management.
Solution 5.2
Keep product Q Drop product Q Differences
GH¢ GH¢ GH¢
Sales 590,000 440,000 150,000
Less Variable costs 330,000 240,000 90,000
Contribution 260,000 200,000 60,000
Less: fixed costs
Avoidable 100,000 60,000 40,000
Unavoidable 100,000 100,000 0____
Total 200,000 160,000 40,000
Operation Profit 60,000 40,000 20,000
It can be seen that dropping product Q will result in the reduction in operating
profits by GH¢ 20,000. Therefore, product Q should not be dropped.
SESSION 5
PRODUCT DECISIONS
Exercise 3.5
1. A company has capacity to produce 2000 units of a product TM per
annum. Currently the company produces 1500 units per annum at
the following costs per unit:
GH¢
Direct 2.50
Direct 4.00
Variable manufacturing Overhead 1.50
Fixed cost is GH¢ 4000.00 per annum. The marketing overheads are
expected to be GH¢2 per unit, made up of GH¢2000 fixed and
GH¢1 per unit variable cost. The company normally sells product
TM for GH¢15.00 per unit.
The company now receives a special order of 500 units with special
design at a price of GH¢12.00.
Suppose the special order will require a further expenditure of

GH¢400 to do the special design. Should the company accept or
reject this special order?
2. Kuntu Limited manufactures a special set of furniture that it sells at

GH¢450. It currently manufactures and sells 6000 sets per year. The
manufacturing costs include GH¢170 for materials and GH¢90 for
labour per set. The overhead charge per set is GH¢70, which
consists entirely of fixed costs. Kuntu Limited is considering a
special purchase offer from a large retail firm, which has offered to
buy 600 sets per year for two years at a price of GH¢300 per set.
Kuntu Limited has the available plant capacity to produce the order
and expects no other orders or profitable alternative uses of the plant
capacity.
Should Kuntu Limited accept the offer?
3. Dwomo Limited is planning to drop one of its divisions that has a

contribution of GH¢35,00 . In addition GH¢65,000 of Dwomo
Limited’s overhead is allocated to the division. Of the GH¢65,000,
GH¢45,000 can be eliminated if the division is discontinued.
What would be the increase or decrease in Dwomo Limited’s net

income by dropping this division?
UNIT 3
4. Koo Pia Limited manufactures three products X, Y and Z and has

the following income statement:
Product X Product Y Product Z Total

GH¢ GH¢ GH¢ GH¢
Sales 340,000 260,000 200,000 800,000
Less Variable Costs 136,000 78,000 140,000 354,000
Contribution 204,000 182,000 60,000 446,000
Less Fixed Costs:
Avoidable 60,000 80,000 70,000 210,000
Unavoidable 30,000 30,000 20,000 80,000
Total Costs 90,000 110,000 90,000 290,000
Profit /(loss) 114,000 72,000 (30,000) 156,000
Product Z is not profitable and management is planning to drop it. Advise

management.
SESSION 5
PRODUCT DECISIONS

UNIT 3
SESSION 6: SELL OR PROCESS FURTHER DECISIONS
Managers are sometimes faced with problems as to whether to sell an

intermediate product or process further before selling or to sell a joint product
at the split-off point or process further. If there is enough capacity to process
the product further managers may want to process the product further and sell
it as a finished product. To make a decision to sell or process further, the
impact of differential cost of further processing on profits should be
considered.
Objectives
(a) prepare an analysis to determine whether an intermediate product
should be sold or processed further; and
(b) prepare an analysis to determine whether a joint product should be
sold at the split-off point or processed further.
Now read on…
6.1 Analysis to determine whether an Intermediate Product should

be Sold or Processed Further
A firm may produce and sell an intermediate product but if facilities are
available, the managers may decide to process the product further before
selling. As mentioned in the overview to choose between sell and process
further alternatives, the impact of differential cost of further processing on
profits should be examined properly. Let us take some examples to illustrate.
Example 6.1
A company currently produces and sells 10,000 units of an intermediate
product Q at a price of GH¢ 20.00 per unit.
The following cost estimates are provided;

Direct materials GH¢6.00 per unit
Direct Labour GH¢4.00 per unit
Variable Overheads GH¢2.00 per unit
Fixed costs GH¢25000
The company has the capacity to process product Q further into product R and
sell it for GH¢30.00
UNIT 3 SELL OR PROCESS FURTHER DECISIONS
SESSION 6
The additional costs for processing further are:

Direct Materials GH¢2.00
Direct Labour GH¢3.00
Variable Overheads GH¢1.00
Fixed Costs GH¢15,000.00
Should the company sell product Q or process further into product R?
Solution 6.1
Analysis of sell or process further
GH¢
Sale value after further processing 300,000
Sale value at intermediate stage 200,000
Incremental revenue from further processing 100,000
Less; cost of further processing:
Direct material 20,000
Direct Labour 30,000
Variable Overheads 10,000
Fixed costs 15,000 75,000
Net income from further processing 25,000
Processing further will increase profit by GH¢25,000. Therefore, product Q
should be processed further.
Example 6.2
A company currently produces and sells an intermediate product at GH¢20.00
per unit. The cost and revenue details are as follows:
GH¢
Sales (6000 x GH¢20.00) 120,000
Less Variable Costs
Direct Materials (6000 x GH¢4.500 27,000
Direct Labour (6000 x GH¢5.00) 30,000
Variable Overheads (6000 x GH¢2.50) 15,000 72000
Contribution 48000
Fixed Costs 24,000
Net Income 24,000
The product can be processed further and sold for GH¢28.00.
The additional costs for processing further are
GH¢
Direct materials (per unit) 2.50
Direct Labour (per unit) 3.00
Variable Overheads (per unit) 1.50
Fixed costs 8000

UNIT 3
Should the product be sold at the intermediate stage or processed further?

Solution 6.2
Analysis of sell or process further
GH¢
Sales value after further processing 168,000
Sales value at intermediate stage 120,000
Incremental revenue from further processing 48,000
Costs of further processing:
Direct materials 15,000
Direct labour 18,000
Variable overheads 9,000
Fixed costs 8,000 50,000
Net loss from further processing (2,000)
The product should not be processed further as the net income would be
reduced by GH¢2000.00
6.2 Analysis to determine whether to Sell a Joint Product

at a Split-off-point or to Process Further
Certain products are produced from a single raw material input. For example
in the petroleum industries, petrol, diessel, Kerosene etc. are produced from a
single product, the crude oil. Two or more products which are produced from
a common raw material input are known as joint products. The cost incurred
in producing joint products up to the split-off point is called joint cost. The
split-off point is that point in the manufacturing process at which the joint
products can be recognized as separate products. In the sell or process further
decisions, joint costs are irrelevant. Why do you think so? The reason is that at
the split-off point the joint costs have already been incurred and therefore are
sunk costs. The relevant revenues and costs to consider are the Incremental
revenues and cost as a result of processing a joint product further.
Example 6.3
A company produces two products X and Y from a joint process.
Information about the tow joint products are as follows:
X Y
Anticipated levels of production 10000 units 15000 units
Selling price per unit at split-off GH¢20.00 GH¢15.00
Additional processing cost after split-off GH¢7.50 GH¢6.50
Selling price per unit after further processing GH¢30.00 GH¢20.00
The cost of the joint process is GH¢145000.00
Determine whether each of the products should be sold at the split-off or

processed further.

SESSION 6
Solution 6.3
Analysis to sell or process further X Y
GH¢ GH¢
Sales value after further processing 300,000 300,000
Sales value at split-off point 200,000 225,000
Incremental Revenue 100,000 75,000
Additional Processing Cost 75,000 97500
Net Income (Loss) 25,000 (22,500)
It can be seen that product X should be processed further while product Y

should be sold at the split-off point.
Example 6.4
A company produces three product A, B, and C from a joint processing cost
totaling GH¢180,000.
Product A can be sold at the split-off point at GH¢24,000 or processed further

at the cost of GH¢32000 and sold for GH¢78,000. Product B can be sold at
split-off point for GH¢28,000 or processed further at the cost of GH¢38,000
and sold for GH¢46,000.
Product C can also be sold at the split-off point for GH¢40,000 or processed
further at the cost of GH¢30,000 and sold for GH¢75,000.

processed further.
Solution 6.4
Product A Product B Product C
GH¢ GH¢ GH¢
Sales value after processing further 78,000 46,000 75,000
Less sales value at split-off point 24,000 28,000 40,000
Incremental Revenue 54,000 18,000 35,000
Less Additional Costs 32,000 38,000 30,000
Net Income (Loss) 22,000 (20,000) 5,000
It is profitable to process products A and C further and sell, while it is

profitable to sell products B at the split-off point.

UNIT 3
Exercise 6.6
1. A firm is currently selling 10,000 units of an intermediate product at
GH¢15.00 per unit. The cost structure of production is as follows:
GH¢
Sales (10,000 x GH¢15.00) 150,000
Less: Variable Costs;
Direct materials (10,000 x GH¢3.50) 35,000
Direct labour (10,000 x GH¢3.00) 30,000
Variable overheads (10,000 x GH¢1.50) 15,000 80,000
Contribution 70,000
Fixed Costs 20,000
Net Income 50,000
The product can be processed further and sold for GH¢22.00.
The additional costs for processing further are:

GH¢
Direct materials (per unit) 1.50
Direct labour (per unit) 1.00
Variable Overheads (per unit) 0.50
Fixed Costs 5000.00
Should the product be processed further?
2. A company produces three joint products with the following

revenue and cost information:
A B C
Anticipated production 5000kg 1500kg 2000kg
Selling price per kg at split-off point GH¢6.00 GH¢15.00 GH¢8.00
Additional processing cost per kg GH¢4.00 GH¢10.00 GH¢14.00
after split-0ff.
Selling price per kg after further GH¢12.00 GH¢24.00 GH¢26.00
processing.

processed further

SESSION 6


UNIT 4
BUDGETING AND BUDGETARY CONTROL
UNIT 4: BUDGETING AND BUDGETARY CONTROL
Unit Outline:
Session 1: Meaning and Functions of Budgets
Session 2: Major Features and Terms in Budgeting
Session 3: Types of Budgets
Session 4: Preparation of Functional Budgets including Master
Budget
Session 5: Preparation of Cash Budget and Problems of Budgeting
Session 6: Behavioural Aspects of Budgets and the Concept of
Budgetary Control
You are welcome to unit 4 of the Management Accounting module. I am sure

that you have well digested units 1, 2 and 3. Might I suggest that, you pause a
moment and try to reflect on the concept of marginal and absorption costing,
breakeven analysis, relevant costs and short term decision making in your own
words before you proceeds.
Budgets are very vital tool for management planning and control. In this unit,
we will be looking at the function and nature of budgeting and budgetary
control and specifically see how to prepare budgets. We shall also consider
the major features of budgets, types of budgets, all the functional areas
including cash budget, behaviourial aspects of budgeting as well as the
concept of budgetary control. It is important to iterate here that budgets are an
integral part of planning framework usually adopted by most successful
business organisations. Therefore, in order to appreciate and understand fully
the nature and purpose of budgeting and budgetary control, there is the need to
understand the arena within which budgets and budgetary control measures
are designed and established.
Unit Objectives
When you have completed this unit you should be able to:
1. define a budget and indicate its relationship with forecasts and
corporate plans
2. state the role and objectives of budgeting and budgetary control
3. identify and explain basic types of budgets
4. give at least two advantages and disadvantages each of various types
of budgets
5. prepare the functional budgets and master budget
6. prepare the cash from relevant data.
7. state and explain at least three Behavioural factors of Budgeting

UNIT 4
BUDGETING AND BUDGETARY CONTROL


BUDGETING AND BUDGETARY CONTROL UNIT 4
SESSION 1
SESSION I: MEANING AND FUNCTIONS OF BUDGETS
You are warmly welcome to the Session I of Unit 4 of this module. Take your
time to grasp the meaning, functions and process of budgeting. Once again,
this session seeks to provide a solid foundation upon which you can appreciate
and build a comprehensive knowledge in planning and preparing a good
budget for an organization. It is vitally important that business organization,
institutions, and nations develop plans for the future. The reason being that,
whatever an organization seeks to achieve is unlikely to be materialized,
unless its managers or government have a clear sense of direction of where
they are going to be. Corporate plans and budgeting are the map and the
vehicle that directs and transport businesses and nations to their final
destinations.
Objectives
a) define a budget and indicate its relationship with forecasts and
corporate plans;
b) state and explain the major terms in budgeting; and
c) state at least three roles functions of budgeting.
Now read on…
1.1 Definition of Corporate Plans

Corporate plan is basically the broad aims and objectives usually codified in a
form of mission statement. This statement is usually brief and will often
articulate the high standards set for an organization. According to Lucey
(2005) corporate plan can be defined as the systematic planning of the
direction and total resources of an organization so as to achieve specific
objectives over the medium to long term. In other words, the plan should
show not only the new tasks, but how existing operations will dovetail into the
new targets over, say the next five to ten years. Thus, such strategic plan (as
sometimes referred to) will be used by tactical or top people of an
organization to prepare operational plans, budgets and short term targets.
1.2 Definition of Budgets

A budget is a financial plan for the short term, typically one year.
According to Institute of Cost and Management Accountants (ICMA) a
budget is a plan, quantified in monetary terms showing the income to be
generated, the costs to be incurred and the resources to be utilized for a
defined future period of time. The main import is to convert the long-term
plans into actionable statements for the immediate future. Budgets will
indicate clearly targets in respect of:
(a) cash receipts and payments

UNIT 4
SESSION 1
MEANING AND FUNCTIONS OF BUDGETS
(b) sales, broken down into amounts and prices for each of the products
or services provided by the organization
(c) detailed stock or material budget
(d) detailed labour (skilled and unskilled) budget
(e) specific production plan
The interrelationship between corporate plans and budgets is that the aims and
objectives (corporate plans) once set are for an organizational life time. Thus,
whereas a corporate plan identifies how the aims and objectives is to be
pursued, a budget identifies a long-term plan is to be achieved. It is worth
mentioning here that a budget is a plan and not a forecast. The reason being that
whereas budgets is a plan and suggest an intention or determination to achieve
the planned targets forecast tend to be predictions of the future state of affairs or
the environment.
1.3 Definition of Forecast

A forecast is a predictions or an estimate of what will happen as a result of a
given set of circumstances. Forecast is an estimate of what can happen in the
light of circumstances that are expected to prevail. A budget on the other hand
is what management wants to happen as a result of a given set on circumstances.
Budget therefore takes into account special actions which management may
take in order to alter a course of events so as achieve what they want to happen.
1.4 The Functions or Purpose of Budgets

A budget provides a focus for the organization, aids coordination of activities
and facilitates control. Usually budgets covering financial aspects quantify
management’s expectations regarding future income, cash flows, and financial
standing of the organization. Therefore, the functions or purposes of a good
budget can be identified in the following ways:
1. Co-ordination: the existence of a budget ensures that different
departments’ actions are co-ordinated to a common goal and will
avoid dysfunctional behaviour. For instance production department
budgets will be linked directly to sales department targets. Thus,
budgets help to maintain harmony within an organization.
2. Responsibility: different staff can be made responsible for their own

areas of the budget, which will encourage maximum participation.
3. Utilisation of Scarce Resources: if sales demand is not the limiting

factor it may be that other factors of production such as labour hours
may constrain a specific production budget or plan. In such a case,
tools like key factor analysis or linear programming can be
employed to appropriate resources into the most profitable
production mix or plan.

BUDGETING AND BUDGETARY CONTROL UNIT 4
SESSION 1
4. Motivation: it is generally accepted that corporate plans are more

likely to be achieved if they are broken down and expressed as
quantified targets, often in the form of budgets. If a budget is set
as a target, we may need to motivate our staff towards achieving it
either through positive or negative means (i.e. bonuses or
disciplinary hearing).
5. Planning: by planning ahead, managers are forced to consider the

future rather than reacting to crisis spontaneously as they occur. A
plan will definitely provide for alternative course of action should
such crises arise.
6. Evaluation: the budgets can be used as a yard stick for evaluating

how well (or poor) responsible officers or managers are actually
doing. Put differently, budget may be used to evaluate the results
of a department of the business organization such as a cost centre,
where a manager is held responsible for the control of expenditure.
It may further be used to evaluate the actions of a manager within
the organization and therefore ensures effective and efficient
performance.
7. Telling (i.e. Communication): a budget will set out lines of

communication and responsibility within an establishment. In
large organizations, particularly if they are organized along
divisional lines, it is often difficult to communicate to people the
broad objectives and plans of the entire organization. The budget
is a plan of action expressed in quantitative terms. Staff will
therefore be better informed and will feel highly motivated as
being part of a team.
8. Control: Once a period has elapsed, one can compare the actual
results of the organization for the period with budgeted results to
see how close it came to achieving the plan. This will enable the
company to potentially bring about improvements for the future.
The budget therefore acts as a comparator against which the actual
results may be compared.

UNIT 4
SESSION 1
MEANING AND FUNCTIONS OF BUDGETS
Exercise 4.1
1. Define the term budget.
2. How is a budget different from a forecast?
3. State and explain four functions of budgeting.

UNIT 4
BUDGETING AND BUDGETARY CONTROL SESSION 2
SESSION 2: MAJOR FEATURES AND TERMS IN BUDGETING
Again, I welcome you to the session 2 of Unit 4 of this module. I hope you
enjoyed reading the first session. Might I suggest that, you pause a moment
and try to explain the terms corporate plan budget and forecast in your own
words to a friend. In this session, we will concentrate on some of the essential
characteristics of good budget, the basic terms which commonly encountered
in budgeting process as well as main stages in budget preparation.
Objectives
a) state and explain three essential features of a good budget;
b) state and explain at least three basic terms encountered in
budgeting process; and
c) outline three stages in budgeting
Now read on…
2.1 Major Features of a Good Budget

The unique features of a budgets emanates from the fact that budgets as a
quantitative statement which outline or summarises the planned policies and
procedures prior to a defined future period. Again its main import is to
provide a focus for the business organisation, directions, aids coordination of
activities and facilitates control. Usually budgets covering financial aspects
quantify management’s expectations regarding future income, cash flows, and
financial standing of the organisation. The following are some of the common
characteristics of a good budget:
a. A good budget provides the best methods of applying capital and
other scarce resources.
b. A good budget also permits as well as promotes delegation of

duties of manager to subordinates thereby ensuring management
successions.
c. A good budget keeps running cost to the barest minimum by

making responsible managers or officers more cost conscious in an
organisation.
d. A good budget is a plan of action for an ensuing period of time. It

stipulates the objectives, policies and procedures to be pursued in
order to achieve the overall financial targets of an organisation.
e. A good budget coordinates the activities of the business

establishment. In other words, budget must blend individual
departments’ goals so as to bring harmony into the organisation

UNIT 4
SESSION 2
MAJOR FEATURES AND TERMS IN BUDGETING
f. A good budget reduces capital employed to the barest minimum. A

good budget in most cases avoids misapplication of resources by
carefully recommending and including relevant items in the budget.
g. A good budget motivates. A good budget is such that a hard

working manager will achieve his target in order to merit a good
reward and praises and that will encourage all managers to work
hard so as to realize their goals.
2.2 Some Basic Budgeting Terminologies

To appreciate and comprehend the preparation of budget statements there is the
need for us to understand the following terms:
i. Budget Period: The budget period is the time period to which the
plan of action relates. A detailed budget for each responsibility
centre is normally prepared for one year. The annual budget may be
divided into either twelve monthly or thirteen four-weekly periods.
ii. Budget Manual: The procedures for preparing the budget are
contained in the budget manual. Accountants are usually charged
with the responsibility issuing the budget manual. The manual will
describe the objectives and procedures involved in the budgeting
processes and will provide a useful source of reference for managers
responsible for budget preparation. The manual must state among
other things:
a. which budgets must be prepared, when and by whom
b. what each functional budget should contain
c. directions on how to prepare budgets and where appropriate the
standard forms used etc.
The use of a budget manual actually enables organisations to develop

improved techniques for forecasting sales and costs.
iii. The Budget Committee: The preparation and administration of

budget is usually the responsibility of a budget committee, chaired
by the managing director (chief executive). The other members of
the committee will be the high level executives or senior
departmental managers, who represent the major sections
(segments) of the business. The functions of a budget committee
include:

UNIT 4
• Instructing departments to carry out budget preparation procedures

for instance gathering historical cost data to facilitate budget
preparation, to produce draft budgets for their department, giving
guidelines for budget preparation.
• discussing foreseeable problems with departmental managers
• ensuring that the budgets are prepared on schedule
• co-ordinations the budgets of different departments and resolving

discrepancies and differences in opinion
• agreeing the final budgets and assembling the master budget
• issuing approved budgets to sectional managers
iv. The Principal Budget Officer: The committee should appoint a

budget officer who will normally be the accountant. The major role of
the principal budget officer is to co-ordinate the individual budgets
into a master budget for the whole organisation. This must be done in
such manner that budget committee and department heads can see the
impact of an individual budget on the organisation as a whole.
v. Master Budget: The master budget coordinates all the financial

projection in the organisation’s individual budgets in a single plant-
wide set of budgets for the defined financial period. Master budget
embraces the impact of both operating decisions and financing
decisions. The term master in “master budget” only refers to it being a
detailed, organisation wide set budgets. Thus, operating decisions
centre on the acquisition and use of scarce resources and financing
decisions centre on how to raise the needed funds to acquire resources.
2.3 Process of Budget Preparation

The important stages are as follows:
1. Communicating Budget Aims

A meeting is held by the budget committee to establish the aims, policy
administration and underlying assumptions affecting the budget. The aims will
be general targets such as profit or market share linked to the longer term
strategic plan.

UNIT 4
SESSION 2
2. Determining the Principal Budget Factor

This factor limits the level activity at which the organisation can operate.
It could be a factor of production such as restricted machine capacity or
labour hours, but is more normally sales demand at least in the longer
term, except for non-profit making establishments where it is often cash
resources. Prior to the preparation of the budgets it is necessary for top
management to identify the factor which restricts performance as this
factor becomes the pivot upon which the annual budgeting process
rotates.
3. Prepare Sales Budget

The most difficult budget to prepare because it involves considering the
relationship between price and demand. Every effort must be made to
ensure this is as accurate as possible as all other budgets will be affected
by management decisions at this point.
4. Prepare all Other Functional Budgets

Given the sales budget we can then work backwards through the
production process to prepare costs. Functional or departmental managers
will prepare their own budgets. The preparation of the budget should be a
‘bottom-up’ process. This means that the budget should originate at the
lower levels of management and be refined and co-ordinated at higher
levels. This approach will encourage managers to participate in the
preparation of their budgets and thereby increase the probability that they
will accept the budget and also strive to achieve the budget targets. This
participatory approach is considerably more time consuming than a more
centralised approach but has distinct advantages.
5. Negotiation of Budgets
The junior manager will meet with his/her senior manager to refine the
budget prepared. The senior manager will use his/her wider scope of
experience to co-ordinate the budget with other linked budgets. In
addition, senior managers will attempt to eliminate slack (excess cost)
from the budget, to counter the inclination of managers to make their
targets easy to achieve.
6. Review
The individual functional budgets are brought together to form a whole.
The budget is then assessed and reviewed. This is usually a management
accounting function. Initially the budget must be assessed for feasibility
or ‘does it work’. The budget will be reviewed to consider acceptability
or ‘does it achieve the budget aims’

UNIT 4
7. Acceptance
The budget is summarised for the company or organisation as a whole in the
master budget and accepted by the budget committee as the target for the
coming year. It is expressed as budgeted financial statement and is also used
to prepare cash budgets and more detailed production and sales plan.
Stages in Budget Preparation:
Stages 1
Isolate principal budget factor
Stage 2
Produce functional budgets
Stage 3
Produce master budgets
As rightly pointed out the principal budget factor is a factor that restricts the
organisation’s level of activity. It is indeed the major limiting factor. The
principal budget factor could relate to material or labour availability but is
more likely to emanate from the magnitude of the sales demand. Sales
demand is a limiting factor because there is no point in producing more than
customers are willing to buy.
Exercise 4.2
1. What is budget committee and what purpose does it serve?
2. State and explain three vital features of a good budget.
3. State and explain the first three important steps in budgeting

process.

UNIT 4
SESSION 2


UNIT 4
SESSION 3: TYPES OF BUDGETS
You are welcome you to session 3 of Unit 4. I hope you enjoyed reading
sessions 1 and 2. I also believe that the exposure so far is well noted. We
want to continue our study by discussing the various types of budgets which
an organization can adopt for planning and control its costs operations and
indicate how they impact on overall business performance.
Objectives
a) identify and explain at three types of budgets; and
b) discuss at least two advantages and disadvantages each of variety
of budgets
Now read on…
3.1 Types of Budgets

For a particular period and organisation, there are varieties of budgets that can
be prepared to facilitate the smooth running of an organisation. Popular
among the various types of budgets are:
• Fixed budget
• Flexible budget
• Incremental budget
• Rolling budget
• Zero based budget
3.2 Fixed Budget

Budgeting can be undertaken on a fixed or flexible basis. A fixed budget is a
budget which is designed to remain for a particular period usually one year.
Managers will agree the budget for the year and then allow the budget to run
its course regardless to the actual level of output attained. Although, it may be
necessary to review and alter the budgeted costs and revenues on some
occasions, fixed budget, in essence, is a one-off exercise during an accounting
period.
3.3 Flexible Budget

A flexible budget keeps changing to reflect the difference between fixed,
semi-variable and variable costs in relation to the level of activity achieved.
The budgeted cost against which the actual costs will be compared is adjusted
to the prevailing activity level. Flexible budgets will usually be based on level
activity and after production, the budgeted costs are flexed to the level of
operation. The main distinction between fixed and flexible budget is that,
whereas fixed budget do not change even where actual production is not at
parity with the budgeted output, flexible budget costs changes with the level
of output.

UNIT 4
SESSION 3
TYPES OF BUDGETS
3.4 Rolling or Continual Budget

A rolling budget, as the name suggests is constantly updated. Fact is that,
annual budget will normally be broken down into smaller time intervals (i.e.
monthly periods) so as to facilitate smooth planning and control of
organizational operations. What rolling budget does is that, it will add a new
month to replace the month which has just elapsed thereby ensuring that at all
times there will be a budget for a full planning period. Rolling budgets are also
referred to as continual budgets
3.5 Incremental Budgeting

Traditionally, much setting of budgets has tended to be on the basis of what has
happened in the past year, with some adjustment for any changes in any factors
which are anticipated to influence the operations of the ensuing financial year.
(for example inflation, hosting of CAN 2008). This approach of preparing
budget is generally referred to incremental budgeting. It is often applied in
situations, such as budgeting for research and development, staff training and
development, where budget-holders or responsible managers for the budget, is
allocated a specific lump sum of money to be spent in the area of activity
concerned. Incremental budgets are also referred to as discretionary budgets
3.6 Zero-Based Budget (ZBB)

This is usually based on organizational policy that all spending needs to be
justified. Hence in establishing each sectional budget (i.e. personnel
department) each year, it is not automatically acceptable that a training and
development must be financed in the future, on a simple premise that, they
were undertaken this year. The training and development budget will start from
a zero base and will only be allowed increased if a plausible case can be
presented or defended for the expected increase. Top management will need to
be convinced that the proposed activities represent value for money or such
expenditure is actually worthwhile
Activity 3.0: Think of the advantages and disadvantages of the types of

budgets enumerated above in a group discussions
Exercise 4.3
1. State and explain two types budget.
2. Give two disadvantages of using ZBB.
3. Give two advantages of using flexible Budget.

UNIT 4
SESSION 4: PREPARATION OF FUNCTIONAL BUDGETS
You are welcome you to session 4 of Unit 4. I hope you enjoyed reading
sessions 3. I believe that you are making great progress in your attempt to
grasp the planning framework usually adopted by most successful business
organisations. Having successfully gone through planning framework and
process of preparing budget, we would move straightaway into the actual
preparation of functional budgets in this session.
Objectives
a) prepare the functional budgets; and
b) prepare the master budget
Now read on…
4.1 Functional Budgets

The functional budgets (i.e. the budgets for each functional area in an
organisation) build up the various costs to arrive at the figure for inclusion in
the profit and loss account of the entire organisation. As has been pointed out
earlier in this unit, there will always be some aspect of the business which will
stop it achieving its objectives to the maximum extent. This is often a limited
ability of the business to sell its products. This will quiet often be the sales
budget since the ability to sell is frequently the limiting factor which simply
cannot be eased. For entirely, practical reasons, it is the limiting factor which
determine the overall level of activity for all the departments or functional
budgets of the organization.
4.2 Approaches to Building up the Functional Budgets

Basically, there are two broad approaches to setting functional budgets
namely top-down approach and bottom-up approach. Top-down approach is
where the senior management of each functional budget originates the budget
targets, perhaps discussing them with lower levels of management and
consequently, refining them before the final draft is produced. The bottom-up
approach, on the other hand, is where the targets are fed upwards from the
lowest level. For instance, junior sales managers will be asked to set their own
sales targets which are subsequently incorporated into the submissions of the
higher level management until the overall budget is produced.
Activity 4.0: Think of the advantages and disadvantages of each type of

budgeting approach.

UNIT 4
SESSION 4
PREPARATION OF FUNCTIONAL BUDGETS
4.3 Building up the Functional Budgets:

Sales budget
Production budget
Material usage budget
Material Purchase budget
Labour budget
Overhead budget
Note the Logical Sequence or Order

1. Begin with the sales budget because sales in this case is assumed to be the
principal budget factor and the therefore the pivot upon which all other
budgets rotates.
2. Achieving a given sales level has implications for the required production
levels.
3. This in turn has implications for the amount of production materials

required. The next stage is therefore material usage budget followed by
the labour budget and others accordingly. A series of illustration now
follow to show how a budget is build up.
4.4 Sales Budget

It is generally the first budget statement to be produced. The sales budget
shows the units of each product and their respective sales value. It is usually
done concurrently with finished stock budget where necessary. Finished stock
budget basically determines the planned increase or decrease in finished goods
stock levels.
Illustration 1
S & J Enterprise estimates that its sales of Product X in the coming period will
be 20,000 units and of Product Y 30,000 units. At these volumes Product X is
likely to sell for ¢60 per unit and Product Y for ¢50 per unit. You are required
to produce a sales budget for S & J Enterprise.

UNIT 4
Solution Product X Y
Sales (units) 20,000 30,000
Selling price ¢60 ¢50
Total Sales (in value) ¢1,200,000 ¢1,500,000 ¢2,700,000
4.5 Production Budget

The next budget to be compiled is the production. It is worth mentioning here
that production volumes will be different from sales volumes if stocks of
finished goods change over the time. This is the sales budget in units plus the
budgeted increase in finished goods stocks or minus the budgeted decrease in
finished goods stocks. Goods may be produced for buffer stock or sold out of
stock, hence, planned production and sales are not necessarily the same
amount. A production budget is stated in units of each product.
Illustration 2
S & J Enterprise has 2,000 units Product X and 10,000 of Product Y in stock.
At the end of the coming year S & J wants to increase stocks of X by 10% and
reduce stocks of Y by 50%. You are required to produce a production budget
for S & J Enterprise
Products
Solution X Y
Budgeted Sales (units) 20,000 30,000
Opening stocks (2,000) (10,000)
Closing stocks: X: 2000 x 110% 2,200
Y: 10,000 x 50% 5,000
Budgeted Production 20,200 25,000
Alternatively, the production budget could also appear in the form like this
(i.e. equally one could also add or subtract the increase or decrease amount to
or from the budgeted sales units).
Solution Product
X Y
Budgeted Sales (units) 20,000 30,000
Add increase in stock: X (2000 x 10%) 200

Less reduction in stock: Y (10,000 x 50%) 5,000
Budgeted Production 20,200 25,000
4.6 The Budgets of Resources for Production: These include material,

labour, machine utilizations etc.
4.6.1 Material usage budget

This is prepared for all types of materials required for production either directs
or indirect. Once production volume is established then one can proceed to
produce a materials usage budget.

UNIT 4
SESSION 4
Illustration 3
Each unit product X requires 4kg of material M and 2kg of material N. Each
unit of product Y requires 5kg of M. Material M cost ¢10 per kg and N ¢8 per
kg.
You are required to produce a material usage budget for S & J Enterprise
Solution Materials M (kg) N (kg)

Production of X 20,200 x 4 80,800
20,200 x 2 40,400
Production of Y 5,000 x 5 125,000
Budgeted Material Usage (units) 205,800 40,400
Price per kg (¢) 10 8 Total
Material Usage (in value) (¢) 2,058,000 323,200 2,381,200
4.6.2 Material Stock Budget

Again, if opening stocks raw materials are different closing stocks then
materials usage and purchases are not the same.
Illustration 4
Assuming S & J Enterprise’s opening stocks of material M are 12,000kg and of
material N 10,000kg. Desired closing stocks are 50% higher for both materials.
You are required to prepare a material purchases budget for S & J Enterprise
Solution Material M (kg) N (kg)

Budgeted material usage 205,800 40,400
Opening stocks (given) (12,000) (10,000)
Closing stock: 12,000 x 150% 18,000
10,000 x 150% 15,000

Material usage (units) 211,800 45,400
Price per kg (¢) 10 8 Total

Material Purchase (¢) 2,118,000 363,200 2,481,200
4.6.3 Labour Budget

The next budget to be prepared is the labour budget. The labour budget can
only be prepared after the production budget. As an example consider the
following information. Each unit of product X requires 1 hour of skilled labour
and 2 hours of unskilled labour. A unit of product Y takes ½ hour of skilled
labour and 2 hours of unskilled labour. Skilled labour is paid at ¢12 per hour
and unskilled at ¢8 per hour. You are required to prepare a labour budget for S
& J Enterprise.

UNIT 4
Solution
Labour Type
Skilled Unskilled
Hours worked on X (20,200 x 1) 20,200 (20,200 x 2) 40,400
Hours worked on Y (25,000 x ½) 12,500 (25,000 x 2) 50,000
Total labour hours required 32,700 90,400
Labour rate per hour (¢) 12 8 Total
Labour costs (¢) 392,400 723,200 1,115,600
4.6.4 Production Overheads Budget

If absorption rates are used these are usually calculated after the labour
budgets as labour hours are often used for the calculation. S & J Enterprise
absorbs variable production overhead at ¢4 per skilled labour hour used and
fixed overheads are expected to be ¢50,000 for the period.
Solution
Factory Overheads
Variable overheads: (32,700 x ¢4) ¢130,800
Fixed overheads 50,000
Total Production Overhead 180,800
It is assumed here that S & J uses marginal costing and therefore, there was
no need for fixed overhead absorption rate as well as the determination of
under or over absorbed fixed cost.
4.7 Detailed Illustration

Kwasante Engineering Limited produces three bathroom accessories namely
Q. S. T. for the building industry. The budget for the forthcoming year to 31st
December 2007 is to be prepared. Expectations for the forthcoming year
include the following:
Budgeted Sales
Products Quantity Unit Price
Q 3,000 ¢60
S 7,000 ¢70
T 5,000 ¢80

UNIT 4
SESSION 4
Materials used in the manufacture of the company’s products are:

Components reference code A B C D
Components unit cost ¢2 ¢3 ¢4 ¢5
Quantities used: Q 5 3 1 2
S 4 4 2 3
T 3 2 1 5
Totals 12 9 4 10
Two main departments are, Styling and Decorating used in the production
processes, and the standard unit times for each product being:
Products Styling Department Decorating Department
(Hourly wage rate ¢0.50) (Hourly wage rate ¢0.60)
Q 3 hours 1.5 hours
S 4 hours 2 hours
T 5 hours 2.5 hours
Production overhead, which is absorbed into product cost on a direct labour
basis, is budgeted as follows:
¢
Building occupancy 30,050
Equipment utilisation 16,100
Personnel Service 12,150
Material handling 9,310
Production planning 9,790
Selling and distribution cost budgeted for the period are:
Representation 101,300
Sale office 30,100
Advertising 29,100
(i.e. and these are charged to products in proportion to the sales income of
the period).
Stocks at the commencement of the year 1/1/07 are expected to be:
F/goods Quantity Raw Materials Quantity Unit Price
Q 1,000 A 40,000 ¢2
S 3,000 B 20,000 ¢3
T 2,000 C 10,000 ¢4
D 30,000 ¢5
The company plans an increase of 10% in the quantities of finished goods
stocks held by the end of the year and a reduction of 20% in the quantities of
raw materials components stocks.
a) You are required to prepare budget for the
i. sales (in units and value)
ii. production quantities
iii. material usage in quantities
iv. material purchases (in quantities and value)
v. direct labour utilisation and cost

UNIT 4
b) Prepare a statement showing the valuation of finished good stocks

at the year end.
c) Prepare a budgeted profit statement for the period showing the
amount of profit contributed by each product.
Solution
a) i. Sales Budget
Products Quantity Selling Price/Unit Sales Value
Q 3,000 ¢60 ¢180,000
S 7,000 ¢70 ¢490,000
T 5,000 ¢80 ¢400,000
Total Sales ¢1,070,000
ii. Production Budget (Quantities Only)

Products Sales Budget Stock Increase Production Required
Q 3,000 100 3,100
S 7,000 300 7,300
T 5,000 200 5,200
iii. Material Usage Budget (in Quantities)

Product Production Material Components
Type Requirement A B C D
Q 3,100 15,500 9,300 3,100 6,200
S 7,300 29,200 29,200 14,600 21,900
T 5,200 15,600 10,400 5,200 26,000
Totals 60,300 48,900 22,900 54,100
iv. Material Purchase Budget (in Quantities and Value) Material

Components
Details A B C D
Budgeted usage 60,300 48,900 22,900 54,100
Less stock decrease 8,000 4,000 2,000 6,000
Materials to be purchased 52,300 44,900 20,900 48,100
Unit cost/price ¢2 ¢3 ¢4 ¢5
Material Purchases Value ¢104,600 ¢134,700 ¢83,600 ¢240,100
IV. Direct Labour Budget

Product Production Styling Dept. Hours Decorating Dept. Hours Total
Q 3,100 9,300 4,650
S 7,300 29,200 14,600
T 5,200 26,000 13,000
Totals Labour Hours 64,500 32,250 96,750
Budgeted labour rate/hour ¢0.50 ¢0.60
Total labour Cost 32,250 19,350 51,600

UNIT 4
SESSION 4
b) Calculation f Unit Product Cost:

Details Products
Direct material (¢) Q S T
A (usage & cost as/budget) 10 8 6
B 9 12 6
C 4 8 4
D 10 33 15 43 25 41
Direct labour cost (¢)
Styling Dept (hrs & rate as/budget) 1.5 2.0 2.5
Decorating 0.9 2.4 1.2 3.2 1.5 4.0
Prime Cost 35.4 46.2 45.0
Production overhead (0.8x4.5) 3.6 (0.8x6) 4.8 (0.8x7.5) 6
Cost/Unit 39.0 51.0 51.0
Production Overheads Workings

Total overheads ¢ (30,050 + 16,100 + 12,150 + 9,310 + 9,790) = 77,400
Total direct labour hours (64,500 + 32,250) = 96,750
Overhead Absorption Rate per hour (77,400 / 96,750) = 0.80

Statement of Finished Stock Valuation
Opening Stock Closing Unit Stock
Products Stock Increase Stock Cost Value
Q 1,000 100 1,100 39 ¢42,900
S 3,000 300 3,300 51 ¢168,300
T 2,000 200 2,200 51 ¢112,200
Total Closing Stock Value ¢323,400
Budgeted Profit Statement for Kwasante Ltd. for Year Ended

31/12/07
Q S T Totals
Sales (Units) 3,000 7,000 5,000 15,000
Revenue 180,000 490,000 400,000 1,070,000
Production cost 117,000 357,000 255,000 729,000
Selling & distribution exp. 27,000 73,500 60,000 160,500
Estimated Profit 36,000 59,500 85,000 180,500
Note: Selling and Distribution Cost Apportionment

Total Cost/ Sales Revenue = ¢160,500/¢1,070,000= 15%
Q S T
S/Price ¢60 ¢70 ¢80
Selling & Distribution Cost/Unit Sold (15%) ¢9 ¢10.5 ¢12

UNIT 4
Exercise 4.4
1. Bertha Enterprise Limited produces two products Nike and Adidas
sports wear. The budget for the year ending 31/03/2007 is currently
under consideration for approval. Expectation for the said period include
the following:
a) Bertha Enterprise Limited Balance Sheet as at 1/04/06
Fixed assets ¢’000 ¢’000 ¢’000
Land and buildings 45,000
Plant and Equipment at cost 187,000
Less: accumulated depreciation 75,000 112,000
Current Assets 157,000
Raw materials 7,650
Finished goods 23,600
Debtors 19,500
Cash 4,300 55,050
Less: Current Liabilities
Creditors 6,800
Taxation 24,500 31,300 23,750
Net Assets 180,750
Financed By:
Capital 150,000
Retained Profit 30,750
180,750
b) Finished Products: Nike Adidas

The sales director has estimated the following:
i. demand for the company’s products will be 4,500 units 4,000 units
ii. They will market at a selling price per unit of ¢32,000 ¢44,000
iii. Closing stock of finished goods at 31/3/07 is to be 400units 1,200 units
iv. Opening stock of finished products at 1/4/06 is 900units 200 units
v. Unit cost of this opening stock will be ¢20,000 ¢28,000
vi. The amount of plant capacity required/Unit is:
Cutting and Pressing 15 minutes 24 minutes
Assembling and Packing 12 minutes 18 minutes
vii. The raw material component per unit is
Material A 1.5kg 0.5kg
Material B 2.0kg 4.0kg
viii. Direct labour hours required per unit is 6hours 9hours
Finished goods are value on a FIFO basis at full factory cost.
c) Raw materials: Material A Material B
Closing stock requirement 31/03/07 600kg 1,000kg
Opening stock at 1/04/06 is made up 1,100kg 6,000kg
Budgeted cost of raw material per kilogram ¢1,500 ¢1,000

UNIT 4
SESSION 4
Actual costs per kilogram of opening stock are as budgeted cost for the coming
year.
d) Direct labour: The standard wage rate of direct labour is ¢1,600 per hour.
e) Factory overhead: Factory overhead is absorbed on the basis of machining
hours, with a plant-wide absorption rate for all departments.
The following overheads are anticipated in the production cost centre budgets:
Cutting & Pressing Assembling & Packing
Details ¢’000 ¢’000
Supervision 10,000 9,150
Power 4,400 2,000
Maintenance 2,100 2,000
Consumables 3,400 500
General expenses 19,600 5,000
39,500 18,650
Depreciation is taken at 5% reducing balance on plant and equipment. a

machine costing the company ¢20,000,000 is due to be installed on 1/10/06 in
the Cutting & Pressing department, which already has machinery installed to
the tune of ¢100 million (at cost).
f) Selling and administration expenses: ¢’000

Sales commissions and salaries 14,300
Travelling and distribution 3,500
Office salaries 10,100
General expenses 2,500
30,400
g) There is no opening or closing work in progress and inflation is to
be ignored.
h) You are required to prepare the following budgets for the year
ended 31/03/07 for Bertha Enterprise Limited:
i. sales budget
ii. Production budget (in quantities)
iii. plant utilisation budget
iv. direct material usage budget
v. direct labour budget
vi. factory overhead budget
vi. direct material purchase budget
vii. cost of goods sold budget
viii. budgeted profit and loss account

UNIT 4
Suggested Solution
i. Sales Budget
Products Quantity Selling Price/Unit Sales Value
Nike 4,500 ¢32,000 ¢144,000,000
Adidas 4,000 ¢44,000 ¢176,000,000
Total Sales ¢320,000,000
ii. Production Budget (Quantities Only)

Products Sales Budget Stock Increase/Decrease Production
Required
Nike 4,500 (500) 4,000
Adidas 4,000 1,000 5,000
iii Plant Utilisation Budget

Hours Machining Hours Assembling
Product Production /Unit Dept. Hrs /Unit Dept. Hrs
Nike 4,000 0.25 1,000 0.20 800
Adidas 5,000 0.40 2,000 0.30 1,500
Totals Hours 3,000 2,300
iv. Material Usage Budget (in Quantities)

Product Production Material Components
Type Requirement A (kg) B (kg)
Nike: 4,000 x 1.5kg 6,000

4,000 x 2.0kg 8,000
Adidas: 5,000 x 0.5kg 2,500
5,000 x 4.0kg 20,000
Totals 8,500 28,000
Unit cost/price ¢1,500 ¢1,000
Cost of Material to be Used ¢12,750,000 ¢28,000,000
vii. Material Purchase Budget (in Quantities and Value)

Material Components
A (kg) B (kg)
Budgeted closing stock 600 1,000
Production requirement 8,500 28,000
9,100 29,000
Less opening stock 1,100 6,000
Purchase requirement 8,000 23,000
Unit cost/price ¢1,500 ¢1,000
Material Purchases (in Value) ¢12,000,000 ¢23,000,000

UNIT 4
SESSION 4
v. Direct Labour Budget

Product Production Hours/Unit Total Hours Rate/Unit Total cost
Nike 4,000 6 24,000 ¢1,600 ¢38,400,000
Adidas 5,000 9 45,000 ¢1,600 ¢72,000,000
Totals labour hours/cost 69,000 ¢110,400,000
vi. Factory Overhead Budget: Machining Dept. Assembling Dept.

Overhead allocated (excluding depreciation) ¢39,500,000 ¢18,650,000
Depreciation provisions:
Existing Plant (5% of ¢100,000,000 - Machining) 5,000,000
(5% of ¢87,000,000 – Assembling) 4,350,000
Proposed Plant (5% of ¢20,000,000 x 6/12) 500,000 0_____
Total Factory Overhead 45,000,000 23,000,000
Total Machine Hours (III) 3,000 2,300
OAR (using Machine hours) ¢15,000/hr. ¢10,000 /hr
viii. Calculation of Product Cost/Unit: Products Type

Details Nike Details Adidas
D/Material: ¢ ¢
A 1.5kg x ¢1,500 2,250 0.5kg x ¢1,500 750
B 2.0kg x ¢1,000 2,000 4.0kg x ¢1,000 4,000
D/Labour cost 6 x ¢1,600 9,600 9 x ¢1,600 14,400

Prime Cost 13,850 19,150
P/Overhead:
Machining Dept. 15/60 x ¢15,000 3,750 24/60 x ¢15,000 6,000
Assembling Dept. 12/60 x ¢10,000 2,000 18/60 x ¢10,000 3,000

Factory Cost/Unit 19,600 28,150
viii. Cost of Goods Sold Budget

Products Type
Units Details Nike Units Details Adidas
¢ ¢
O/Stock 900 x ¢20,000 18,000,000 200 x ¢28,000 5,600,000
P/Cost 4,000 x ¢19,600 78,400,000 5,000 x ¢28,150 140,750,000
4,900 96,400,000 5,200 146,350,000
C/Stock 400 x ¢19,600 7,840,000 1,200 x ¢28,150 33,780,000
COS 4,500 88,560,000 4,000 112,570,000
NB: The cost of sales of Nike consist of 900 units at ¢20,000 and 3,600 at ¢19,600
each.
The cost of sales of Adidas consist of 200 units at ¢28,000 and 3,800 at ¢28,150
each.

UNIT 4
ix. Budgeted Profit Statement for Bertha Enterprise Ltd. for Year 31/12/07
Nike Adidas Totals
Sales (Units) 4,500 5,000 9,500
Sales Revenue 144,000,000 176,000,000 320,000
Less cost of sales 88,560,000 112,570,000 201,130,000
Budgeted Gross Profit 55,440,000 63,430,000 118,870,000
Less Selling &Distribution Exp. 30,400,000
Budgeted Net Profit 88,470,000

UNIT 4
SESSION 4


UNIT 4
SESSION 5: PREPARATION OF CASH BUDGET AND

PROBLEMS OF BUDGETING
You are welcome to session 5 of unit 4. I hope you enjoyed reading the
previous sessions. As it were, I presume you can state and describe the two
main budgeting approaches for setting functional targets. At this juncture, we
shall concentrate in some detail on one particular budget, the cash budget.
Fact is that, most economic facets of a business are reflected in cash which
makes the cash budget more important than any other budget. Let us continue
the lesson, by looking at the need for cash budgets, its features and other
accompanying issues.
Objectives
a) prepare cash budgets;
b) state the features and usefulness of cash budgets; and
c) explain advantages of trade creditors and bank overdrafts
Now read on…
5.1 Cash Budget and its Features

A cash budget is prepared to show the expected receipts of cash and payments
of cash during the next accounting period. The annual cash budget may be
divided into smaller time periods or control periods, commonly of one month
or four weeks. We can conveniently say that, in most cases, organisations cash
budgets would have the following characteristics:
a) cash budget period are well defined and broken down into sub-periods
usually monthly
b) it is always in a columnar form i.e. a column for each month
c) receipts of cash are identified under various headings and total for
each month’s receipts well casted and depicted
d) payments of cash are also identified under various headings and total
for each month’s payments well casted and depicted
e) the excess of total cash receipts over payments or of payments over
receipts for each month are ascertained
f) the running cash balance for the period, which are obtained by taking
into account the appropriate opening or previous month’s cash balance
and adjusting accordingly, is also depicted.

UNIT 4 PREPARATION OF CASH BUDGET AND
SESSION 5 PROBLEMS OF BUDGETING
5.2 Receipts of Cash

Receipts of cash may be from cash sales, payments by debtors, the sale of fixed
assets, the issue of fresh shares or loan stock, the receipt of interest and
dividend form investment outside the business etc. It is important to note that,
all these are not profit and loss account items, for instance, the issue of new
shares or loan stock is a balance sheet items and the cash received from sale of
an asset also affect the balance sheet. That portion of asset sale transaction,
which appears in the profit and loss account, is not the cash received but
difference between cash received and the written down value of the asset.
5.3 Payment of Cash

Payments of cash may be for purchases of stocks payment of wages or other
expenses, the purchase of capital items, payment interest, dividends, or
taxation. Again, not all payments are profit and loss account items (i.e. the
purchase of capital equipment or payment of VAT). It may be seen from the
above description that receipts and payments are not the same as sales and cost
of sales because:
• not all receipts affect profit and loss account income ,
• not all payments affect profit and loss account cost
• some costs in the profit and loss account (i.e. loss or profit on sale of
assets, depreciation etc) are not cash items but are costs derived from
accounting conventions,
• the timing of receipts and payments does not coincide with the profit
or loss accounting period.
5.4 Format of Cash Budget

The approach to cash budget questions in an examination should be as follows.
• Use a format convenient to you but should be easy to understand,
• insert the easy cash flows onto the schedule first to gain easy marks,
• do not back up working for the more difficult cash flows
• never include depreciation, profit/loss on asset.
Inflows January February March
Cash received from: ¢ ¢ ¢
Cash sales xxx xxx xxx
Customers/Debtors xxx xxx xxx
Proceeds: asset disposal xxx xxx xxx
Proceeds: fresh share issues xxx xxx xxx
Total receipts xxx xxx xxx

UNIT 4
Outflows:
Cash paid to suppliers’ xxx xxx xxx
Wages xxx xxx xxx
Expenses xxx xxx xxx
Dividends xxx xxx xxx
Purchase of fixed assets xxx xxx xxx
Total payments xxx xxx xxx
Net inflow (outflow) xx xx xx
Balance b/f XX XX XX
Balance c/f XX XX XX
5.5 Problems in Budgeting

1. The rate of inflation might be hard to predict so that budgeting for price
levels will be largely guess work
2. The volume of activity i.e. sales and production cannot be foreseen with
certainty so that a budget to produce and sell say 3,000 units of a product
might quickly be overtaken by events and sales demand could either
exceed or fall short of expectation.
3. The problems of organisation and attempt top coordinate the plans of
different department into an optimal master budget
4. Problems of motivation and where these exist, budgeted expenditure on
claims by cost centre or cost centre managers are likely to be excessive,
and where they are non-existent, individual participation or involvement
tends to dwindle.
5.6 Usefulness of Cash Budget

Cash budgets are extremely useful for decision making purposes. They allow
managers to see the likely effect on the cash balance of the plans which they
have set in place. Cash is an important asset and it is necessary to ensure that
it is properly managed. Failure to do so can have disastrous consequences for
the business. Where the cash budget indicates a surplus balance, managers
must decide whether this balance should be reinvested in the business or
whether it should be distributed to owners. Where the cash budget indicates a
deficit balance, managers must decide how this deficit should be financed or
how it might be avoided
Detailed Example
1. Success Ltd was incorporated on 1/7/07. The content of the opening
balance sheet of the company was as follows: Assets (Cash at bank)
GH¢60,000 and Capital GH¢60,000. During July the company intends
to make payments of GH¢40,000 in respect of Office Building,
GH¢10,000 for Mainframe Computers and GH¢6,000 for Automobile.
Surprise Ltd will also purchase initial stock of quality life jackets
costing GH¢22,000 on credit. Surprise Ltd has produced the following
projections:

a. Sales for July will be GH¢8,000 and will increase at the rate of
GH¢3,000 per month until October. In November sales will rise to
GH¢22,000 and in subsequent months sales will be maintained at
this level.
b. The gross profit margin on goods sold will be 25%
c. There is a possible risk that supplies of trading stock will be
interrupted getting to the end of the accounting period. Surprise Ltd,
therefore, intends to build up its initial stock figure (GH¢22,000) by
purchasing GH¢1,000 worth of stock each month in addition to the
monthly purchases necessary to cover monthly sales. All purchases
of stock (including the initial stock) will be subject to one month
credit.
d. Sales will be divided equally between cash and credit sales. Credit
customers are expected to pay two (2) months after sale is agreed.
e. Wages and salaries will be GH¢900 per month. General
administrative expenses will be GH¢500 per month for the first four
months and GH¢650 thereafter. Both types of expenses will be
payable as and when incurred.
f. 90% of sales will be generated by salespersons who will in return
receive 5% commission on sales. Such commission is payable one
month after the sales is agreed.
g. Success Ltd intends to acquired further improved work stations in
December 2007 for GH¢7,000 cash.
h. Depreciation is to be provided at the rate of 5% per annum on
Office Building and 20% per annum on Mainframe Computers.
(Depreciation has not been included in the overheads mentioned in
(e) above.

Prepare a cash budget for Success Ltd for the six months ended 31/12/07 and
briefly state why a cash budget is required for a business.
Q1. Success Ltd Cash Budget to 31st December, 2007

Jul Aug Sept. Oct Nov Dec
¢ ¢ ¢ ¢ ¢ ¢
Cash sales 4,000 5,500 7,0008, 500 11,000 11,000
Receipts –credit/Sales - - 4,000 5,500 7,000 8,500
4,000 5,500 11,000 14,000 18,000 19,500

UNIT 4
Payments
Purchases - 29,000 9,250 11,500 13,750 17,500
Overheads 500 500 500 500 650 650
Wages 900 900 900 900 900 900
Commission - 360 495 630 765 990
Equipment 10,000 - - - - 7,000
Motor vehicle 6,000 - - - -
Freehold 40,000
57,400 30,760 11,145 13,530 16,065 27,040
Cash Flow (53,400) (25,260) (145) 470 1,935 (7,540)
Opening Balance 60,000 6,600 (18,660) (18,805) (18,335) (16,400)
Closing balance 6,600 (18,660) (18,805) (18,335) (16,400) (23,940)
Exercise 4.5
Sankwan Ltd was incorporated on the 1/6/06. The opening balance sheet
of the company was as follows:
Assets ¢’000
Cash at bank 984,000
Share capital
60,000ordinaary shares of ¢16,400 each 984,000
During June the company intends to make payments of ¢656,000,000 for a

freehold property, ¢164,000,000 for equipment and ¢98,400,000 for a motor
vehicle. The company will also purchase an initial trading stock costing
¢360,800,000 on credit.
The company has produced the following estimates:

i. Sales for June will be ¢131,200,000 and will increases at the rate
of ¢49,200,000 per month until September. In October sales will
rise to ¢360,800,000 and this will be maintained for the subsequent
months.
ii. the gross profit margin on goods sold will be 25%
iii. There is a risk that supplies of trading stock will be interrupted
towards the end of the accounting year. The company, therefore,
intends to build up its initial level of stock (¢360,800,000) by
purchasing ¢16,400,000 of stock each month in addition to the
monthly purchases necessary to satisfy monthly sales. All
purchases of stock (including the initial stock will be on one
month’s credit.
iv. Sales will be divided equally between cash and credit sales. Credit
customers are expected to pay two months after the sale is agreed.

v. Wages and salaries will be ¢14,760,000 per month. Other overheads

will be ¢8,200,000 per month for the first four months and
¢10,660,000 thereafter. both types of expenses will be payable when
incurred
vi. 80% of sales will be generated by sales people who will receive 5
percent commission on sales. The commission is payable one month
after the sale is agreed. The company intends to purchase further
equipment in November 2006 for ¢11,480,000 cash.
vii. Depreciation is to be provided at the rate of 5% per annum on
freehold property and 20% per annum on equipment. (depreciation
has not been included in the overheads mentioned above in (v)
above)
Required: Prepare a cash budget for Sankwan Ltd for the six month period to
30/11/06.
2. a) Explain three benefits and two problems associated with budgets.

b) McGill Ltd is a new business, which would start operations on the 1st
May, 2007.
Planned sales for the next eight months are as follows:

Period Sales Units
June 5,000
July 6,000
August 7,000
September 8,000
October 9,000
November 9,000
December 9,000
January 8,000
February 7,000
The following additional information is also available:

a) The selling price per unit will be a consistent ¢16,000 and all sales
will be made on one month’s credit.
b) It is planned that sufficient finished goods stock for each month’s
sales should be available at the end of the previous month.
c) Materials purchase will be such that there will be sufficient
materials stock available at the end of each month precisely to meet
the following month’s planned production. This planned policy will
operate from the end of May.
d) Purchase of materials will be on one month’s credit. The cost of raw
materials is ¢6,400 per unit of finished product.
e) The direct labour cost, which is variable with the level of production
is planned to be ¢3,200 per unit of finished production.

UNIT 4
f) Production overheads are planned to be ¢3,200,000 each month,

including ¢480,000 for depreciation.
g) Non-production overheads are planned to be ¢1,760,000 per month
of which ¢160,000 will be depreciation.
h) Various fixed asset costing ¢40,000,000 will be bought and paid for
during May.
i) The business will raise ¢48,000,000 in cash, from a share issue in
April.
Except where specified, assume that all payments take place in the same
month as the cost is incurred.
You are required:

Draw up the following for the six months ending 31st October, 2007.
i. a production budget, showing just physical quantities,
ii. a raw materials stock budget showing both physical quantities
and values
iii. a cash budget.



UNIT 4
SESSION 6: BUDGETARY CONTROL AND BEHAVIOURAL

ASPECTS OF BUDGETING
You are welcome to the final session of unit 4. I hope you enjoyed reading the
previous sessions. I believe you have tried your hands on all the self
assessment questions regarding the preparation of functional budgets and the
cash budgeting. In this session, we would be looking at the concept budgetary
control and behavioural aspects of budgetary control.
Objectives
a) explain the concept of budgetary control; and
b) state and explain at least three behavioural aspects of budgeting
Now read on…
6.1 The Concept of Budgetary Control

The ICMA has defined budgetary control as ‘the establishment of budgets
relating the responsibilities of executives to the requirements of a policy and
the continuous comparison of actual with budgeted results, either to secure by
individual actions, the objectives of that policy or to provide a basis for its
revision’.
The main import of this definition, actually stresses on the fact that, individual
managers are held responsible for investigating the discrepancies between
budgeted and actual results, and are therefore expected to take the necessary
remedial actions or amend the existing plan in the light of actual level of
activity.
The execution of budgetary control may be the responsibility of the budget

committee, in that, most of the detailed work of communicating variance
information and co-ordinating planning and control efforts organized on
behalf of the committee by the budget officer (i.e. accountant) or the
accounting department. The cost (management) accountant will normally
prepare the periodic statement of variances and ensure that, managers
responsible are aware of the need to consider control action about particular
variances which have arisen.
The wrong approach to budgetary control is to compare actual activity level

with a fixed budget. However, the correct approach is to first, identify fixed
and variable costs and secondly produce a flexible budget. It is preferable to
use variable costing techniques and keep fixed costs at the same amount in the
flexed budget as in the original master budget.

UNIT 4 BUDGETARY CONTROL AND BEHAVIOURAL
SESSION 6 ASPECTS OF BUDGETING
Activity6.0: Think of the purpose, advantages and disadvantages of budgetary

control.
6.2 What is Behavioural Aspect of Budgeting?

The concept of behavioural aspect of budgeting denotes that the mere
understanding of the technical aspects or the planning framework of the
budgetary process is not sufficient for the management accountant.
Nevertheless, the human, social, and organizational factors which are involved
at all stages in budgeting are of critical importance and cannot be ignored.
Consequently, Lucey (2005) posits that, ‘budgeting is not a mechanistic,
technical procedure. Its success is totally dependent upon the goodwill and co-
operation of the participants. Thus, without the behavioural aspects, budgeting
will become merely a paper work with no real impact on the operations of the
organization except perhaps negatively.
The ideal budgeting system is one that must encourage goal congruence, thus,
the goal of individuals and groups should coincide with the aims and objectives
of the organisation as whole. This is an idea which is difficult to achieve
completely however, management must place some premium on the fact that,
organisational objectives cannot be imposed through the budgeting system
without due regards to the influences of individual, team or department
objectives.
There is growing evidence that authority imposed from above is less effective
than authority accepted from below and that goal congruence is highly
improved when there top management adopts a participative approach in
budgeting processes rather than the traditional style of management with its
strong emphasis on hierarchy and authority.
Participation of the budget holder can also promote understanding regarding

objectives as well as the acceptance of the set targets. The whole process of
budget preparation and subsequent performance evaluation (i.e. next unit) by
budgetary controls are carried out so as to motivate managers rather than create
resentment and unfavourable reactions.
6.3 Functions of Behavioural Aspects

The following behavioural aspects need to be addressed:
a) Level of difficulty: what this means is that budgets needs to be set

at some degree of difficulty if they are to motivate staff, but if set
too high, will be quickly become demoralized and may simply give
up. If they are too easy then people will beat the budget without
over exerting themselves. The optimum level of difficulty will be
somewhere in between the two extremes.

UNIT 4
b) Participation: Top-down approach is where the senior management of

each functional budget originates the budget targets, may probably be
too difficult and may not reflect actual day to day operating conditions,
as management may be far removed from shop floor of the business.
Bottom-up approach, on the other hand, is where the targets are fed
upwards from the lowest level may not reflect longer-term strategic
plans of the business organization and may be perched at an understating
level.
Again, somewhere in the middle will be necessary to ensure a

reasonable degree and good fit with establishment policy.
c) Appraisal: Staffs need to be appraised only on factors over which they

have an influence. For instance, materials may have an adverse price
variance. It would not be practical to blame the purchaser if the goods
were imported and the price movement had been caused by exchange
rate movement.
d) Balanced scorecard: Budgetary targets need to be set to cover a wide

variety of indicators. If bonuses are based on individual areas, staff will
concentrate on these areas at the expense of others.
e) Non financial factors: qualitative factors should be considered when

setting a budget, but will be difficult to measure. For example pollution
of the local environment could be to organisation having a low budget
for waste disposal and therefore, skimping on environmentally friendly
waste disposable. However, this factor may not be captured in a budget
statement.
Exercise 4.6
1. Explain the term budgetary control.
2. What do you understand by the concept of behavioural aspect of

budgeting?
3. State and explain with vivid examples three behavioural aspects.

UNIT 4 BUDGETARY CONTROL AND BEHAVIOURAL
SESSION 6 ASPECTS OF BUDGETING


STANDARD COSTING AND VARIANCE ANALYSIS UNIT 5
UNIT 5: STANDARD COSTING AND VARIANCE ANALYSIS
Unit Outline
Session 1: The concept of standard costing
Session 2: Direct material standards and variances
Session 3: Direct labour standards and variances
Session 4: Variable overheads variances
Session 5: Fixed overheads variances
Session 6: Sales margin variances and reconciliation
Standards are very important in all facets of life. As Garnson and Noreen
(1997) put it, students are expected to perform to certain standards, the
vehicles we drive are built under exacting engineering standards and the
food we eat is prepared under standards of both cleanliness and nutritional
content.
Managers are expected to perform to certain standards in their

organisations. Standard costing is a system of financial control instituted
to ensure effective control of costs and use of resources. Standard costing
provides a means of evaluating and comparing the operating performance
of managers.
It allows the deviations from standard to be analysed in detail. This is

made possible where actual costs are compared with standard costs and
deviations noted for investigation. In this unit we shall be looking at how
standard costs are set for the various cost elements and the calculation and
interpretation of variances.
Unit Objectives
By the end of this unit you should be able to:
(a) define standard costing and explain how standard costs are set;
(b) explain and calculate direct material cost variances;
(c) explain and calculate direct labour cost variances;
(d) compute and explain variable overheads variances;
(e) compute and explain fixed overheads variances; and
(f) compute and explain sales variances and reconcile actual profit
with budgeted profit.

UNIT 5 STANDARD COSTING AND VARIANCE
ANALYSIS
This is a blank sheet for your short notes on;

• issues that are not clear, and

UNIT 5
STANDARD COSTING AND VARIANCE ANALYSIS SESSION 1
SESSION 1: THE CONCEPT OF STANDARD COSTING
Standard costing is a system of financial control instituted in certain

organisations to ensure prudent use of resources; in the manufacture of goods
and provision of services. Quantity and cost standards are set by managers for
the elements of cost and compared with actual quantities and costs to see
whether operations are within the limits set by management.
In this session we are going to take a look at the meaning of standards and
standard costing, setting of standards, types of standards and advantages and
disadvantages of standard costing.
Objectives
a) explain standards and standard costing system;
b) describe the standard setting technique;
c) list and explain the types of standard; and
d) list at least five advantages of standard costing.
Now read on…
1.1 Meaning of Standard and Standard Costing

According to Pendey (1995) standard has been variously defined as a
“measure of comparison for qualitative and quantitative values” “a norm”, “a
criterion of excellence”, “a model or example of comparison”. Simply put, he
goes on to state that a standard is a measure of desired performance; a
predetermined criterion for evaluating the actual performance. For example, if
the standard cost per unit of a product is GH¢13.50, a cost centre manager is
judged on the basis of this standard.
Standard costing is a managerial device of using predetermined costs for

performance evaluation and control. It establishes predetermined estimates of
the cost of a product or service, collects actual costs and output data, and
compares the actual results with the predetermined and the differences
(variances) noted for corrective measures.
We can now take a look at the meaning of standard cost. What is a standard?
Good. A standard cost is a carefully determined cost that a firm or
organisation sets for its operation. It is usually expresses on a per unit basis.
Standard costs form the bases for planning and controlling the activities of an
organisation such as preparation of budgets, monitoring and evaluating
performance.

UNIT 5
SESSION 1 THE CONCEPT OF STANDARED COSTING
1.2 Types of Standards

Standards are set based on different expectations and levels of performance.
Different expectations and levels of performance lead to different standards.
Basically, four types of standards can be identified and the type to be used in a
particular organisation depends on the requirements and objectives of the
standard costing system. The types of standard include: basic standards, ideal
standards, attainable standards and current standards
1.2.1 Basic Standards

These are standards which remain unchanged for a long period of time once
they are established. They form the basis for comparing actual results over
many years and thus making it possible to see the trends of variances easily.
1.2.2 Ideal Standards

These are standards that can be attained under optimal operating conditions
where no breakdowns no wastage, no lost time are expected. Ideal standards are
the most tight standards which demand perfect and extremely high degree of
efficiency in the use of resources. Ideal standards are adjusted periodically
when there are improvements in methods of production, technology, labour and
materials. Ideal standards are extremely difficult to attain in practice and are
unlikely to be used for routine reporting purposes. However, a firm can meet
the ideal standards set for its operations when all relevant operating factors
occur as expected. An ideal standard is future oriented and may be used for
long term development purposes.
1.2.3 Attainable Standards

Attainable standards are standards which are based on efficient operating
conditions but not perfect conditions. They are attainable over a period of time
and emphasize normality and allow for some deviations. Attainable standards
aim to provide high but realistic targets and should be based on high
performance levels which can be achieved. They serve to motivate employees
since these standards are possible to achieve.
1.2.4 Current Standards

Current standards are the widely used in practice. They are established for use
over a short period of time to reflect current conditions. They are standards
which are realistic and attainable under efficient economic and operating
conditions for the coming period.
1.3 Advantages of Standard Costing System

The main advantages of standard costing include the following
a) Standard costing system provides data which help in setting budgets

and evaluating managerial performance.

UNIT 5
b) It acts as a control device where by actual performance is

compared with the standard set and the variance analysed for
suitable corrective actions to be taken
c) Standard costs set can be used in pricing stock issues and stock
valuation as an alternative to FIFO, LIFO and weighted or simple
average methods.
d) It provides a prediction of future costs that can be used in setting
selling prices of products.
e) It provides management with an early warning about possible
losses and inefficiencies
f) It helps to achieve uniformity in the costing of products and /
services.
1.4 Disadvantages of Standard Costing

Standard costing has some disadvantages and these include the following:
a) Prices and efficiency change from year to year and so can make
the standards meaning -less for short-term control purposes.
b) Setting of standards is extremely difficult and complicated in
practice. For example it is not possible to forecast costs as some
of the factors which influence costs are very unpredictable.
c) There is inflexibility of standards since standards have the
tendency of becoming rigid overtime and frequent revision is
difficult as well as expensive.
d) Use of standard costing may be demodulating especially where
standards set are difficult to meet.
e) Standard costing system may not be suitable to small firms, where
a detailed system of analysis may not be necessary.
1.5 Setting Standards

In the standards setting process all business functions should be involved
since this will have impact upon their function?
Discussions to evaluate, review and amend standards should be done at

regular intervals. Let us now go through the setting of standards for the
various cost elements and sales.
1.5.1 Direct Material Standards

Direct materials cost per unit of raw material will have to be estimated by the
purchasing department. Data relating to usage would be supplied by the
production department from stores records and the material analysis. The work
of the purchasing department is facilitated by their knowledge of purchase
contracts already made; forecast of prices in the market; discussions with
regular suppliers; and availability of trade discounts.

UNIT 5
1.5.2 Direct Labour Standards

Setting of direct labour standards require that activities should be analysed by
the different operations. The various operations are studied and time allowed
calculated after carrying out a time and motion study. Account should be taken
of changes in working practices, production methods, equipment and operating
conditions,
One of the major sources of data is the payroll analysis of direct labour and the
rates per hour will be set by reference to the payroll and any agreements on pay
increases with labour union representatives of the employees. It is to be noted
that:
i) a separate rate per hour week is set for each type / grade of labour
ii) an average rate per hour or week will be applied for each grade.
The agreed labour rates are applied to the standard time allowed to determine
the standard labour cost for each operation.
1.5.3 Overhead Standards

Different rates for fixed and variable overheads are essential for planning and
control. Direct labour hours are usually used us a basis for determining standard
overhead rates as well as for absorbing overheads in majority of the cases, so
that the standard cost per unit is standard labour hours X standard absorption
rate per hour. The overheads standards as has been said earlier on must be
analysed into fixed and variable overheads standards, and formulae for
calculating the overheads absorption rates (OAR) are
Standard Variable OAR = Budgeted variable overheads for cost centre

Budgeted standard Labour hours for cost centre
and
Standard Fixed OAR = Budgeted fixed overheads for cost centre

Budgeted standard labour hours for cost centre
The prices and rates of pay would use the same criteria as described for direct
materials and direct labour.

UNIT 5
Exercise 5.1
1. Explain the following terms:

a) Standard cost
b) Ideal standard
c) Current standard
2. Describe the four major types of standards.
3. Outline four advantages and four disadvantages of standard

costing.
4. Explain the procedure to establish direct materials and direct

labour costs standards.

UNIT 5


UNIT 5
SESSION 2: DIRECT MATERIAL VARIANCES
In cost accounting we introduced you to direct material variances. We

discussed the causes of direct materials variances and took you through some
simple problems in the calculation of materials usage variance and material
price variances.
In this session we are going to go deeper by introducing the mix and yield
variances
Objectives
By the end of this unit you should be able to:
(a) calculate material price and usage variances and interpret the result
(b) compute the mix and the yield variances and interpret the results
Now read on . . . .
2.1 Review of Material Usage and Material Price Variances

Let us now revise what we learnt in our Cost Accounting course on material
cost variances.
We saw that material cost = quantity × price/unit and therefore, in calculating

material cost, variance we can break if into quantity variance (usually referred
to as the usage variance) and price variance.
We hope you remember the causes of the material price variance and material
usage variance. If you have forgotten, then refer to Cost Accounting module,
unit 6, session 5.
For the purpose of computing material cost variances, the following

abbreviations are going to be used.
MCV = Material Cost Variance

MPV = Material Price Variance
MUV = Material usage Variance
AQ = Actual Quantity
SQ = Standard Quantity
AP = Actual Price
SP = Standard Price
Symbolically, the Materials Cost Variance (MCV) can be stated as

MCV = (SQ × SP) − (AQ × AP)
CoDEUCCE/Post-Diploma in Commerce 153

UNIT 5 DIRECT MATERIAL VARIANCES
SESSION 2
Material Usage Variance (MUV) is calculated using the formula

MUV = (SP × SQ) – (SP × AQ)
= SP (SQ – AQ)
and the Material Price Variance (MPV) is also calculated using the formula
MPV = (AQ × SP) – (AQ × AP)
= AQ (SP – AP)
You will remember that variances are either classified as favourable (F) and
unfavourable (U) depending on its effect on profit. For example if the standard
cost to make a batch of 500 units of a product is GH¢1250 and the actual cost
incurred is GH¢1500, then there is an unfavourable variances of GH¢250
(GH¢1500 – GH¢1250). On the other hand if the actual cost is GH¢ 1000 then
there is a favourable variance of GH¢ 250
(i.e. GH¢1250 – GH¢100)
Example 2.1
The following information was extracted from the standard cost card and actual
cost card of Arnanse Ltd in the production of 500 units of a product.
Standard Cost Card

Material Type Quantity (kg) Price/kg Amount
A 400 3.50 1400
B 600 3.00 1800
C 300 2.50 750
Total 3950
Actual Cost Card

A 420 3.60 1512
B 610 2.80 1708
C 280 2.70 756
Total 3976
Calculate the material cost price and usage variances for each type of material
and interpret the results.
Solution 2.1
The material cost variance for each type of material

A 1512 1400 112 (U)
B 1708 1800 92 (F)
C 756 750 6 (U)
3976 3950 26 (U)

UNIT 5
The Price Variance for each type of material

Material A (SP – AP)AQ = (GH¢3.50 – GH¢3.60)420 = GH¢42 (U)
“ B (SP – AP)AQ = (GH¢3.00 – GH¢2.80)610 = GH¢122 (F)
“ C (SP – AP)AQ = (GH¢2.50 – GH¢2.70)280 = GH¢56 (U)
Total Price Variance GH¢24 (F)
Material Usage Variance for each type of Material

Material A (SQ – AQ)SP = (400 – 420)GH¢3.50 = GH¢70 (U)
“ B (SQ – AQ)SP = (600 – 610)GH¢3.00 = GH¢30 (U)
“ C (SQ – AQ)SP = (300 – 280)GH¢2.50 = GH¢50 (F)
Total Price Variance GH¢50 (U)
You can see that
The Material Cost Variance = Price Variance + Usage Variance

= GH¢24 (F) + GH¢50 (U)
= GH¢26 (U)
Let us take another example.
Example 2.2
The following activity took place in Abass Company Ltd during December:
Number of units produced 800 units
Materials purchased and used in production 1600kg
Cost per kilogram of material purchased GH¢4.00
The standard cost card indicates that 1.5kg of materials are allowed for each
unit of product and the standard cost of the materials is GHC4.20 per kg.
You are required to compute the material cost variance, material price
variance and material usage variance.
MCV = (SQ × SP) – (AQ × AP)

= (800 × 1.5 × GH¢4.20) – (1600 × GH¢4.00)
= GH¢5040 – GH¢6400
= GH¢1360 U
MUV = (SQ – AQ)SP = (800 × 1.5 – 1600)GH¢4.20

= GH¢1680 U
MPV = (SP – AP)AQ = (GH¢4.20 – GH¢4)1600
= GH¢320 F
It can be seen that
MUV + MPV = MCV
GH¢1680 U + GH¢320 F = GH¢1360U

SESSION 2
2.2 Material Mix and Yield Variances

We have so far been considering material price and material usage variances.
These are the two basic material cost variances. For better information to
management the usage variance in some cases is sub-divided into mix and yield
variances. When specifications are set for mixing the different kinds of
materials to manufacture a product, material mix and yield variance arises.
2.2.1 Material Mix Variance

Material mix variance (MMV) occurs when there is a mixture of materials in
the production of a product. The standard mix of a product determines the
combination of raw materials input to obtain a given output. The materials mix
variance will rise if a different mix of materials is used than specified. The
formula for computing the material mix variance is given by (Quantity in
actual mix – Quantity in standard mix proportions) × standard Price.
This can be stated as the difference between the actual quantity of material
priced at the standard price and the total quantity in standard proportion, priced
at the standard price.
2.2.2 Direct Materials Yield Variance (DMYV)

Yield in manufacturing terms is the quantity of the finished product (output)
expected from a given combination of input of materials. A yield variance
arises if the yield (output) obtained is different form the yield (output)
expected from the actual input. Direct materials yield variance may be defined
as the difference between the actual yield and the standard yield of the actual
material input both valued at the standard price of the materials. The formula
to calculate the materials yield variance is as follows:
DMYV = (Actual yield – Standard yield) × Average standard material

price.
Example 2.3
To produce one unit of a product, the standard specifications of a company are
as follows:
GH¢
Material X : 3kg @ GH¢1.50 per kg 4.50
Material Y : 2kg @ GH¢2.00 per kg 4.00
Mixed material X and Y : 5kg 8.50
The units of the product produced during January amounted to 1500. The
material used were as follows:
Material X : 5800kg
Material Y : 2200kg

UNIT 5
You are required to compute the

(a) Total material usage variance
(b) Material mix and material yield variances.
Solution 3.2
Usage Variance
X: (AQ – SQ)SP = (5800 – 3 × 1500)GHC1.50 = GH¢1950 U
Y: (AQ – SQ)SP = (2200 - 2 × 1500)GHC2.00 = GH¢1600 F
Total Usage Variance GH¢350 U
Direct Material Mix Variance (DMMV)

We are going to present the solution in a tabular form
Material AQu SQa Difference SP DMMV
GH¢ GH¢
X 5800 4800 1000 U 1.50 1500 U
Y 2200 3200 1000 F 2.00 2000 F
500 F
The direct material mix variance is GH¢500 favourable.
Direct Material Yield Variance (DMYV)

Again we present the solution in a tabular form.
Material AQu SQa Difference SP DMMV
X 5800 4500 1300 U 1.70 2210 U
Y 2200 3000 800 F 1.70 1360 F
8000 8000 850 U
The direct material yield variance is GH¢850 unfavourable.
Note that the material usage variance (DMUV)

DMUV = DMMV + DMYV
= GH¢500 F + GH¢850 U = GH¢ 350 U

SESSION 2

Exercise 5.2
1. You have been provided with the following information about the
use of materials:
Standard price GH¢6.50 per kg
Standard usage 4kg per unit of product;
Actual price GH¢8.00 per kg;
Actual usage for 1500 units of product was 7200kg
You are required to calculate:

(a) total material cost variance
(b) price variance
(c) usage variance and interpret your results.
2. You have been provided with the following information about the
use of materials:
Standard price GH¢8.00 per kg
Standard usage 4kg per unit for product;
Actual price GH¢6.50 per kg
Actual usage for 1500 units of product was 7200kg.
You are required to calculate:

(a) total material cost variance
(b) price variance
(c) material usage variance and interpret your results.
3. The following information was extracted from the standard cost

card and actual cost card of Ntikuma Ltd in the production of 500
units of a product:
Standard Cost Card

Material Quantity(kg) Price/kg Amount
GH¢ GH¢
A 400 3.60 1440
B 600 2.80 1680
C 300 2.70 810
3930

UNIT 5
Actual Cost Card

Material Quantity(kg) Price/kg Amount
GH¢ GH¢
A 420 3.50 1470
B 610 3.00 1830
C 280 2.50 700
4000
You are required to calculate the

(a) direct material cost variance
(b) direct material usage variance
(c) direct material price variance.
4. The standard specifications of a company requires a combination

of 5gm of material A and 3gm of materials B, to produce one unit
of a product.
The standard prices are:

Material A GH¢1.60/gm and Material B GH¢C2.00/gm
Actual production in a given month was 2600 units. To produce
the 2600 units of output, the actual materials used were:
Material A: 12000kg
Material B: 8000kg
You are required to compute the total material usage variance

and analyse it into material mix and yield variances.

SESSION 2


SESSION 3
SESSIONS 3: DIRECT LABOUR VARIANCES
You are welcome to session 3 of the unit 6. In session 2 we discussed direct

material variances. We saw that the material usage variance can divided into
material mix and material yield variances in this session, we are going to talk
about direct labour variances.
Objectives
(a) calculate direct labour rate variance
(b) compute direct labour efficiency variance
(c) determine labour yield variance.
Now read on …
3.1 Direct Labour Costs Variances

As we did for the material cost variances, we are now going to review the
labour cost variances before we add a new concept. As you will remember
labour cost = Hours worked × Rate per Hour. In the same vein, labour cost
variance can be calculated by adding labour efficiency variances and labour
rate variance Refer to the causes of the labour efficiency and labour rate
variances in the cost Accounting Module.
Unit 6 Sessions 3
For the purpose of computing Labour cost variances the following
abbreviations are going to be used.
DLCU = Direct Labour cost variance
DLRV = Direct Labour Rate variance
DLEV = Direct Labour efficiency variance
AH = Actual Hours
SR = Standard Rate.
SH = Standard Hours
AR = Actual Rate
Direct Labour cost variance is the difference between the actual direct labour
cost and the standard direct labour cost for the actual production.
Symbolically, the labour cost variance (LCV) can be stated as LCV = (SH
× SR) – (AH ×AR) or SC – AC
Example 3.1
The standard labour cost of production of a product M is GH¢ 20.00 per unit.
The actual cost of production of 5000uints of product M is GH 112,500.
Find t he labour cost variance.

UNIT 5 DIRECT LABOUR VARIANCES
SESSION 3
Solution 3.1
Labour cost variance (LCV) = SC – AC = (5000 × GH¢ 20.00) -GH¢112,500.
= GH¢100,000 – GH¢ 112500 = GH¢ 12500U
The variance is unfavorable because the actual cost is greater than the standard
cost.
Example 3.2
Koo Dwomo Ltd paid GH¢4.00 per hour for 2800 direct labour hours in
December. The standard cost sheet shows a direct labour rate of GH¢ 3.50 per
hour for 3000 hours December. Calculate the total direct labour cost variance
Solution 3.2
DLCV = (AH × AR) – (SH × SR)
= (2800 × GH ¢4.00) – (3000×GH¢3.50)
= GH¢ 11200 - GH¢10500)
= GH¢ 700 U.
The variance is unfavorable because the actual labour cost is greater than the
standard cost.
3.2 Direct labour Rate variance (DLRV).

Direct labour Rate variance (DLRV), Occurs when there is difference between
actual rate paid and the standard rate .It is calculated by multiplying the
difference between actual rate paid and the standard by the actual hours
worked.
Symbolically,
DLRV = (AR- SR) AH
This can be likened to the Direct material rate variance.
3.3 Direct Labour Efficiency Variance (DLEV)

Direct Labour efficiency variance (DLEV) like the Direct material usage
variance is a quantity variance, and occurs when the total direct labour hours
worked is different from the total standard direct labour hours for the output for
the period.
It is computed by multiplying the difference between actual hours worked and

the standard hours allowed for the period by the standard direct labour ratio.
The formula for computing the direct labour efficiency variance (DLEV) is
DLEV = (AH – SH) SR.

SESSION 3
Example 3.3
Koo Dwomo Ltd paid GH¢4.00 per hour for 2800 direct labour hours in
December. The standard cost sheet shows a direct labour rate of GH¢ 3.50 per
hour for 3000 direct labour hours for December.
You are required to compute

(a) the direct labour rate variance
(b) the direct labour efficiency variance.
Solution 3.3
(a) DLRV = (AR- SR) AH
= (GH¢4.00 - GH¢3.50) 2800 =GH¢1400 U
The labour rate variance is unfavorable (u) because Koo Dwomo Ltd paid
GH¢ 0.50 (i.e. (GH¢ 4.00 - GH¢3.50) more than the standard rate.
(b) DLEV = ( AH – SH)SR

= (2800 – 3000) GH¢3.50
= GH¢700F.
The variance is favorable because the actual hours paid for was less than the
standard hours allowed.
Remember that the Direct Labour cost variance is equal to the direct labour
rate variance plus the direct labour efficiency variance
(i.e. DLCV = DLEV).
Summary
Direct labour Rate variance GH¢1400U
Direct labour efficiency variance 700F
Direct Labour cost variance
700U
3.4 Direct Labour Mix and Yield Variances

As we saw with material variances, material mix variance may be calculated
when there is more than one item of material used in production. In the same
way a labour mix variance may be calculated when more than one type or
grade of labour are involved in the production process.
Like the materials yield variance, a labour yield variance can also be
calculated and this gives a clear idea of the efficiency (or inefficiency)
attributable to a favorable (or unfavorable) yield.

UNIT 5 DIRECT LABOUR VARIANCES
SESSION 3


UNIT 5
SESSION 4: VARIABLE OVERHEAD VARIANCES
We have seen the variances of the direct costs, that is direct material cost and
direct labour cost. As you know already, direct costs are costs that can be
traced directly to the product or service rendered. Direct costs vary directly
with the volume of activity and are therefore variable cost. In the same way,
as you will remember, variable overhead vary directly with the volume of
activity. This means that as production increases, variable overheads also
increase. However, the unit variable cost remains the same as the level
production increases.
In this session we are going to look at variable overheads variances which are
calculated along the same lines as direct material and direct labour costs
variances.
Objectives
By the end of the session you should be able to:
a) calculate the total variable overhead variance;
b) compute variable overhead expenditure variance; and
c) compute variable overhead efficiency variance
Now read on…
4.1 Total Variable Overhead Variance (TVOV)

The total variable overheads variance is calculated in the same way as the
total direct material and direct labour variances. The total variable overheads
variance is the difference between the actual variable overheads and the
standard variable overheads.
The formula is AVO – SVO = TVOV
The overhead variances may be calculated in terms of labour hours or

production units so that
TVOV = (AH × AVOR) – (SH × SVOR)

Where AVO = Actual Variable Overhead
SVO = Standard Variable Overhead
AH = Actual Hours
AVOR = Actual Variable Overheads Absorption Rate
SH = Standard Hours
SVOR = Standard Variable Overheads Absorption Rate

UNIT 5 VARIABLE OVERHEAD VARIANCES
SESSION 4
Example 4.1
The following data is in respect of Kwaata Ltd for one of its products. Output
5000 units
Standard variable overheads per unit GH¢ 2.50

Actual variable overheads incurred GH¢ 13000.00
You are required to compute the total variable overheads variance
Solution 4.1
TVOV = AVO – SVO

= GH¢ 13000.00 – 5000 × GH¢2.50
= GH¢13000.00 - GH¢12500.00
= GH¢500.00 U
The actual variable overheads is greater than the standard variable overheads,
thus giving an unfavorable variance of GH¢500.00
The total variable overhead variance is made up of two variances vis. Variable
overhead expenditure (spending) variance and variable overhead efficiency
variance and we are going to look at them one by one.
4.2 Variable Overhead Expenditure (Spending) Variance (Vosv)

The variable overhead expenditure variance which is also called variable
overhead spending variance is a price variance. This can be likened to the
material price variance and the labour rate variance. Do you remember the
formulae for computing the two variances?
The variable overhead expenditure variance is the difference between the

standard variable overheads for the actual hours and the actual variable
overheads incurred.
The formula for computing the variable overhead expenditure variance

(VOSV) is given by VOSV = AVOR × AH – SVOR × AH
= (AVOR – SVOR) AH
Where VOSV = Variable overhead Spending Variance

AVOR = Actual Variable Overhead Absorption Rate
SVOR = Standard Variable Overhead Absorption Rate
AH = Actual Hours (usually labour hours)
166 CoDEUCC Post-Diploma in Commerce

UNIT 5
4.3 Variable Overhead Efficiency Variance (VOEV)

The quantity or efficiency variance for variable overhead is the variable
overhead efficiency variance.
The variable overhead efficiency variance shows the extent of coat saved or
excess cost incurred due to efficient or inefficient performance. It is the
difference between the actual hours taken for the actual volume or output and
the standard hours allowed for the actual volume or output multiplied by the
standard variable overhead absorption rate.
The formula for this variance is

VOEV = (AH X SVOR) – (SH x SVOR)
= (AH – SH) SVOR
Where
AH = Actual hours (usually labour hours)
SH = Standard hours allowed for the actual output
SVOR = Standard Variable Overhead absorption rate
Example 4.2
Otis Ltd has developed the following variable overheads standard for one of
its products. Variable overhead: 5 hours at GH¢3.50 per hour. The following
activity occurred during the month of February.
Units produced; 900 units

Direct labour: 5000 hours costing GH¢48000.00
Actual variable overheads: GH¢15000.00
You are required to compute the Total Variable O.V.
Variable overheads spending and efficiency variances
Solution 4.2
Total Variable Overhead Variance
= AVO - SVO
= GH¢15000.00 – 5 X 900 X GH¢3.50
= GH¢15000.00 - GH¢15750.00
= GH¢750.00 F
Variable overhead Spending Variance

= (AVOR x AH) – (SVOR x AH)
= GH¢15000.00 - GH¢3.50 X 5000
= GH¢2500 F

SESSION 4
Variable Overhead Efficiency Variance

= (AH x SVOR) – (SH x SVOR)
= (5000 x GH¢3.50) – ( 5 x 900 x GH¢3.50)
= GH¢17500.00 - GH¢15750.00
= GH¢1750.00 U
Variable overhead spending variance GH¢2500 F

Variable overhead efficiency variance GH¢1750 U
Total variable overhead variance GH¢750 F
Exercise 5.4
1. Koo Nsiah Ltd manufactures a product called Koosh.
The standard variable overheads rate is GH¢2.40 per labour hour for
3 hour per unit. During the month of May, the company produced
600 units of Koosh in 2100 hours at a cost of GH¢4620.00.

(a) total variable overhead variance
(b) variable overhead spending variance
(c) variable overhead efficiency variance and comment on the
results
2. The data below relate to Ajasco Ltd for the month of March.
Standard Cost Card
Variable overheads GH¢48000.00
Labour hour 16000 hours
Actual Cost Card

Variable overhead GH¢41250
Labour hours 16500 hours
You are required to calculate the variable overhead variance and

interprete your result.
3. The following information was extracted from the accounting

records of Oti Ltd.
Standard variable overheads card per unit

3.5 hours @ GH¢5.00 per hour GH¢10.00

UNIT 5
The following information is available regarding the company’s operations for

a period.
Units produced 10000 Units

Direct labour 30,000 hours costing GH¢285000
Variable overhead incurred GH¢120.000.00

(a) the total variable overhead variance
(b) the variable overhead spending variance
(c) the variable overhead efficiency variance and interprets you
results.

SESSION 4


UNIT 5
SESSION 5: FIXED OVERHEAD VARIANCE
You are welcome to sessions discussion do far. We hope you have enjoyed the
discussions so far. We hope to take you through a mother interesting session.
As you learnt in your cost Accounting module, overheads are either fixed
overheads or variable overheads. Fixed overheads remain the same within
certain activity level and therefore, the per unit fixed cost has no meaning in
the computation of fixed overhead variances. This makes the fixed overhead
variances very different.
Objectives
By the end the session you should be able to
(a) compute the total fixed overhead variance;
(b) calculate fixed overhead expenditure variance; and
(c) calculate fixed overhead volume variance and analysed it into
efficiency and capacity variances
New read on ….
5.1 Total Fixed Overheads Variance

Fixed overheads have to be applied or absorbed at a predetermined rate. This
predetermined rate is calculated by dividing the budgeted fixed overheads by
the budgeted, volume or activity to level. The predetermined rate is applied to
cost absorption. If the actual fixed overheads uncured is different from the
fixed overhead absorbed, an under – or over- absorption of overheads will
occur. The fixed overhead variance is the sum of under – or over –absorbed
fixed overheads – in the period.
The formula for finding the total fixed overheads variance is given by
TFOV = AFO – SFO where
TFOV = Actual fixed overheads variance
AFO = Actual fixed overheads incurred
SFO = Standard fixed overheads absorbed.
Problem 5.1
Asenso Ltd makes a single production Q for which the fixed overhead budget
is GH¢15000.00.the company plans to manufacture. 2500units of Q which
should take 3 hours each to manufacture.
The actual production in the month of February y is 2600 units of Q and done
fixed overheads incurred is GH¢ 20020.00
CoDEUCC/Post Diploma in Commerce 171

UNIT 5
SESSION 5
FIXED OVERHEADS VARIANCES
We are going to use problems 1 to illustrate the carious fixed overheads

variances.
Example 5.1
Using problem 1, calculate the total fixed overhead variance.
Solution 5.1
Standard fixed overhead absorption rate per hour
SFOR = Budgeted overhead
Standard hours allowed
= GH¢15000.00
2500 ×3 hours
= GH¢ 2.00 per hours

Standard overhead cost per unit of Q will be 3 hours × GH¢2.00 per hour =
GH¢ 6.00
This is the standard fixed cost that is used as the fixed overhead fixed cost that
is used as the fixed overhead cost absorbed into every unit of Q that is
manufactured .
Actual fixed overhead incurred GH 20020 .00
Standard fixed overhead absorbed (2600 ×6) 15600.00
Total fixed overhead cost variance 4420.00(U)
Note that
Under-absorbed overhead is an unfavourable variance.
Over – absorbed overhead is a favourable variance.
5.2 Fixed Overhead Spending (Expenditure) Variance

The fixed overhead spending variance is variously known as expenditure,
expense or budge variance.
This variance is the difference between the fixed overhead cost which is
actually incurred and the fixed overhead cost which should have been incurred,
assuming the normal volume of production .or the difference between the actual
fixed overhead incurred and the budgeted fixed overhead expenditure
The formula for computing the budget is
FOSU = AFO – BFO
Where
FOSV = Fixed overhead spending variance
AFO = Actual fixed overhead incurred
BFC = Budgeted fixed overhead expenditure
172 CoDEUCC/Post Diploma in Commerce

UNIT 5
Example 5.2
Using problems 1, Calculate the fixed overhead spending variance.
Solution 5.2
GH¢
Actual fixed overhead expenditure 20020.00
Budgeted fixed overhead expenditure 15000.00
Fixed overhead spending variance 5020.00(U)
The actual expenditure exceeded the budgeted expenditure, so the variance is

unfavourable.
5.3. The Fixed Overhead Volume Variance

The fixed overhead volume variance is t he difference between the actual
output and the budgeted output in units, multiplied by the standard fixed
overhead absorption rate alternatively the volume variance is the difference.
The formula for calculating the fixed overhead volume variance is
FOUV = (SFOR × AQ) – (SFOR × BQ) = SFOR (AH – BH)
Where
FOUV = Fixed overhead volume variance
SFOR = standard fixed overhead volume variance
AQ = the actual production volume
BQ = the budgeted production volume.
Example 5.3
Using problem 1 calculate the fixed overhead volume variance.
Solution 5.3
FOUV = SFOR (AQ – BQ)
= GH¢ 600 (2600 – 2500)
= GH¢ 600.00(F)
The volume variance is favourable, because actual output volume is greater
than budgeted.
Summary
GH ¢
Fixed overhead spending variance 5020(U)
Fixed overhead volume variance 600(F)
Total fixed overhead variance 4420(U)
Note that the same the fixed overhead spending variance and the fixed
overhead volume variance equals the total fixed overhead cost variance.

UNIT 5
SESSION 5
5.4 Fixed Overhead Efficiency and Capacity Variance

The fixed overhead volume variance can be further sub-analysed into an
efficiency variance and a capacity variance. These explain why the production
volume was different from the budgeted volume. We can, therefore, express the
fixed overhead volume variance as equal to the sum of the fixed overhead
efficiency variance and the fixed overhead capacity variance.
5.4.1 Fixed Overhead Efficiency Variance

The fixed overhead efficiency variance will be the same in hours as t he labour
efficiency the same in hours as the labour efficiency variance and the variable
overhead efficiency variance, but is valued at the standard fixed overhead
absorption rate per hour.
The formular for computing fixed overhead efficiency variance is given by

FOEV = SFOR (AH-SH) where by
SFOR = the standard fixed overhead absorption rate.
AH = the standard labour hours to produce
SH = the actual cut put.
5.4.2 Fixed Overhead Capacity Variance

The fixed overhead capacity variance is the difference between the actual hours
worked and budgeted hours of work multiplied by the standard fixed overhead
absorption rate per hour.
The formular for computing the fixed overhead capacity variance is given by
FOCV = SFOR (AH – BH) where
FOCV = Fixed overhead capacity variance
SFOR = standard fixed overhead absorption rate
AH = Actual labour hours
BH = Budgeted labour hours.
Illustration 5.4
Using problems 1, calculate the fixed overhead efficiency and capacity
variances and comment on your results.
Solution 5.4
FOEV = SFOR (AH – SH)
= GH ¢ 2.00 (9100 – 7800)

= GH ¢ 2600 (U)

UNIT 5
The variance is unfaurable because there was no efficiency in the use id hours.
FOCV = SFOR (AH – BA)
= GH ¢ 2.00 (9100 – 7500)
= GH ¢ 3200F
The variance is favourable because actual hours were more than budgeted
meaning more units were produced than planned.
Summary
Total .Fixed overhead variances
GH ¢
Spending Variance = 5020(U)
Efficiency variance = 2600(U)
Capacity variance = 3200(F)
Volume variance = 600(F)
Total Fixed overhead variance 4420(u)

Exercise 5.5
1. The following date relate to Akushika Ltd for a particular period:
Budget labour hours
Budgeted production units
Budgeted fixed overhead
Actual labour hours worked 8050hours

Actual production units 2300units
Actual fixed overhead incurred GH ¢38640
You are required to compute the fixed overhead variances
2. The following data rate to Koo Nsiah Ltd for a particular period:
Budgeted labour hours 8050hours
Budgeted production units 2300units
Budgeted fixed overhead GH¢38640
Actual labour hours worked 9600hours
Actual production units 2400units
Actual fixed overhead incurred GH ¢43200
You are required to compute the fixed over head variances

UNIT 5
SESSION 5
3. Nsonyameye Ltd makes a single product KM for which the fixed

overhead budget is GH ¢ 60,000. The company plans to
manufacture 60,000 units of KM which should take 4 hours each
to manufacture.
The actual production in the month of January is 6500 units of

KM and done in 29250 hours. The actual fixed overheads incurred
is GH ¢67275.00.
You are required to calculate

(a) the total fixed overhead variance
(b) the fixed overhead spending (expenditure) variance
(c) the fixed overhead volume variance and analysis it into
efficiency and capacity variances.

UNIT 5
SESSION 6: SALES VARIANCES
You are welcome to the last session of the unit. Much as the have cost
variances so the have sales variances so we have sales variances. In this
session we are going to consider the various sales variances.
Objectives
By the end of the session you should be able to compute
(a) total sales variance;
(b) selling price variance;
(c) sales volume variance and analyse it into sales mix variance
and sales quaints variance and interpret the results.
Now read and on
6.1 Total Sales Variance

The difference between the actual sales in the budget is the total sales
variance of the period.
Fore example if the budgeted sales for a period is GH¢24000.00 and the
actual sales for the say it is period is GH¢22500.00 then the difference is
1500 which is unfavourable. Why do the than budgeted .the effect is that the
actual sales revenue is less than budgeted. The effect is that budgeted profit
will be reduced.
Remember that sales revenue like cost is a product of two items –selling
price per unit and the sales volume in units. The total sales variance,
therefore, is a result of deviation in either selling prices or sales volumes or
both.
The total sales margin variance can be depicted in the diagram below:
Total sales margin variance
Sales price variance Sales volume variance
Sales mix variance Sales quantity variance
CoDEUCC/Post- Diploma in Commerce 177

UNIT 5 SALES MARGIN VARIANCES AND
SESSION 6 RECONCILIATION
6.2. Sale Price Variance

The sales price variance measures the impact of the deviations of actual
selling price from the budgeted selling prices on net profit. The sales price
variance is the difference between the actual selling price the period and the
budged selling prince multiplied by the quantify sold.
The formula for computing the sales price variance is given by

SPV = (ASP – BSP) AQ where
SPV = Sales price variance
ASP = Actual selling price
BSP = Budgeted selling price
AQ Actual quantity sold.
Example 6.1
The following data relate to Dwomo Ltd for a particular period.
GH ¢
Standard selling price per unit 4.50
Budgeted units to be sold 3000
GH¢
Actual selling price per unit 4.30
Actual units sold 3500
You are required to compute the sales price variance and comment on your
results.
Solution 6.1
SPV = (ASP – BSP) AQ
= (GH ¢ 4.30 - GH ¢ 4.50) 3500
= GH ¢ 700.00(U).
The variance is unfavourable because the actual selling price is less than the
standard or budgeted selling price.
Example 6.2
The following data relate to Oti Ltd for a period.
GH ¢
Standard selling price per unit 6.00
GH¢
Actual units sold 6.50
You are required to compute the sales price variance and comment on
your result.
SPV = (ASP – SSP) AQ

= (GH ¢ 6.50 - GH ¢ 6.00) 2300
= (GH ¢11500 (F)
178 CoDEUCC/Post- Diploma in Commerce

UNIT 5
The variance is favourable because the actual selling price is greater than the
standard selling price.
6.3 Sales Volume, Variance /Sales Profit Margin Variance

The sales volume variance is the difference between the number of units
sold and the corresponding amount in the master budget for the period. In
order words, sales volume variance is the difference between the actual
volume and the budgeted sales volume at standard contribution/profit
margin per units.
The formula for computing the sales volume variance B

SUV = (ASU – BSV) BCM or
SVV = Sales volume variance
ASV = Actual sales volume
BSM = Budgeted contribution margin.
Depending on the technique of costing in the use and /or pose can use
Budgeted contribution margin or budgeted profit margin or budgeted selling
prince when do we use each one of them?
Good.
In absorption costing, the difference between actual sales volume and

budgeted sales volume is multiplied by the budgeted profit margin where as
in marginal costing the difference is multiplied by the budgeted contributed
margin.
Example 6.3
The following data relate to Apusiga Ltd for a particular period;
Standard selling price per unit
Budgeted units to be sold
Budgeted variance cost per unit
Budgeted fixed cost per unit
Actual selling price per unit
Actual units sold
You are required to compute the sales volume variance under
(a) absorption costing method
(b) margined costing method and interpret your results.
Solution 6.3
(a) Working
Budgeted Selling price per unit
Budgeted cost per unit;
Variable
Fixed

Budgeted Profit per unit

SVU = (ASV – BSV) BPM
= (3500 – 3000) GH ¢2.00
= GH ¢1000.00 (F)
(b) Working
Budgeted selling price per unit
Less Budget variable cost per unit
Budgeted contribution margin
SVV = (ASV – BSV) BCM

= (3500 – 3000) GH ¢ 4.50
= GH ¢2250 (F)
The sales volume variance is favourable because the actual sales are eater
than the budgeted sales.
6.4 Sales Mix and Sales Quantity Variance

Where several different products are sold that have volume variance can be
stubanalysed into a sale quality variances into a sale quantity variance and
sales mix variance.
The sales quantity variance measures the effect deviation in physical
volume (i.e the number of units sold on contribution or total profits. The
sales mix variance measures the effect of change on total contribution or
total profits arising from the actual sales mix being different from the
budgeted sales mix. Also depending on the technique of costing in
operation, the variances can be measured either in terms of contribution
margins or profit margins.
The sales mix variance is calculated by multiplying the difference in the
sales mixes by the number of total units sold and the budget contribution
margin /profit mar gain per unit.
The formula for computing the sales mix variance is
SMV = (ASM –BSM) AQ x BCM where
AMV = Sales mix variance
ASM = Actual sales mix of the product
BSM = Budgeted sales mix of the product
AQ = Actual Quantity sold
BCM = Budgeted contribution margin.
Also the formula for calculating the sales quantity variance is given by
SQV = (AQ – BQ) x BQ X BSM x BCM
SQV = Sales Quantity variance
AQ = Actual Quantity of all products sold
BQ = Budgeted quantity of the product
BSM = Budgeted sales mix of the product
BCM = Budgeted contribution margin

UNIT 5
Example 6.4
The following data relate to Kofigo Ltd for the month of March
Product Budgeted Budgeted Selling Budgeted Actual Sales

Sales in units Price contribution in units
Per unit
GH ¢ GH ¢
A 4000 40 20 5000
B 6000 60 30 3000
10,000 8000
You e required to compute the

(a) Sales volume variance
(b) Sales mix variance
(c) Sales quantity variance.
Solution 6.4.1
A: (ASV –BSV) BCM = (5000 – 4000) GH¢ 20 = GH¢20000(F)
B: (ASV – BSV) BCM= (3000 – 6000) GH¢ 30 = GH¢90,000(U)
Sales volume variance = GH¢ 70,000(U)
(b) Workings
Actual mix: A 5000 x 100% B. 3000 x 100%
8000 8000
= 0.625 = 0.375
Budgeted mix: A 400 x100% 6000x100%

10,000 10,000
= 0.40 = 0.60
Sales mix variance = (ASM-BSM)x AQxBCM

A : (0.625 – 0.40) 8000xGH¢20 .00 = GH¢36000(F)
B: (0.375 – 0.60) 8000 xGH¢30 .00 = GH¢5400(U)
Sales mix variance 18000(U)
(c) Sales Quantity variance = (TQ –BQ) x BSM x BSM x BCM

A: (8000- 10000) x 0.40 x GH=¢ 20.00 = GH¢ 16000 (U)
B: (8000 –10000) x 0.60 x GH=¢ 30.00 = GH¢ 36000 (U)
Sales Quantity variance = GH ¢ 5200 (U)

Summaries
Sales mix variance GH¢1800(U)
Sales quantity variance GH¢52000(U)
Sales volume variance GH¢70000(U)

Exercise 5.6
1. The following data relate to Dwomo Ltd for a particular period.
Budgeted selling price per unit GH¢10.50
Actual selling price per unit GH¢11.50
Actual unit sold 1800
Budgeted variance cost per unit GH¢5.00
Budgeted fixed cost per unit GH¢2.00
You are requires to compute
(a) total sales variance
(b) sales price variance
(c) sales volume variance
2. The data below relate to Kwakye Ltd for the month of March.
Budgeted selling price per unit GH¢20.00
Actual units sold 1600
Actual selling price GH¢18.50
Budgeted variable cost per unit GH¢8.50
Budgeted fixed cost per unit GH¢2.50
(a) total sales variance
(b) sales price variance
(c) sales volume variance
3. A company sells two products A and B and the budgeted
contribution margin of A is GH¢ 7.00 per unit and that of B is
GH¢ 10.00 per unit.
The budgeted sales for February are A – 3000 units and B –
2000 Units.
Actual sales in March happened to be A – 2500 units and B-
3500 units.

(a) the sales price variance for each product
(b) the sales volume variance and analysed I t into sales mix
variance and sales quantity variance.

UNIT 5
4. The budgeted sales for the Adisco company for a period where
Product Units Unit Total Contribution
X 5000 15 GH¢
Y 3000 12 75000
Z 2000 10 36000
20000
131000
The actual sales where

Product Units Unit Total Contribution
X 4000 14 GH¢
Y 3500 15 56000
Z 4500 9.50 52500
42750
151250



DIVISIONAL PERFORMANCE EVALUATION AND UNIT 6
TRANSFER PRICING
UNIT 6: DIVISIONAL PERFORMANCE EVALUATION

AND TRANSFER PRICING
Unit Outline
Session 1: Decentralization of Operations
Session 2: Responsibility Centres
Session 3: Measures of Evaluating Performance of Divisions
Session 4: Meaning and Importance of Transfer Pricing
Session 5: Transfer Pricing Methods
Session 6: Selecting the Right Transfer Pricing Methods
In large or complex organizations, there are many product lines and even
operation many be at different locations. In such organizations, it is often
necessary to find a desirable method of determining the profitability of the
various products or territories. Decentralization of operations is introduced in
large organizations and there should be a way of measuring the performance
of various divisions.
This unit examines the concept of decentralization techniques used to evaluate

divisional performance and transfer pricing.
Unit Objectives
At the end of this unit, you should be able to:
1. explain some of the advantages and disadvantages of
decentralization;
2. identify the types of responsibility centres and explain the
differences among them;
3. explain the use of return on investment (ROI) and identify its
advantages and limitations;
4. calculate explain and compare return on investment and residual
income for divisional performance; and
5. explain the objective of transfer pricing. The different transfer
pricing methods and when each method should be used.

UNIT 6 DIVISIONAL PERFORMANCE EVALUATION AND
TRANSFER PRICING


SESSION 1
TRANSFER PRICING
SESSION 1: DECENTRALIZATION OF OPERATIONS
Welcome to Session I of the final unit in the Management Accounting Course.

In this session, we will deal with the concept of decentralization and how
companies make use of the concept. Specifically, we will deal with the
meaning of decentralization, benefits of decentralization and problems
associated with decentralization.
Objectives
a) explain decentralization;
b) explain the benefits of decentralization; and
c) explain the problems associated with decentralization
Now read on…
1.1 Meaning of Decentralization

You should be familiar with the terms decentralization and delegation. Define
each of them before you continue. Decentralization refers to the distribution
of powers for decision making to lower management level in an organization.
In most large decentralized organizations, the primary operating units are

called divisions. Each division is largely autonomous, with the division
manager being responsible for sales, production and administration of the unit.
Thus division or responsibility centre managers are almost autonomous; they

are responsible for all activities of their units and only report to the head office
on regular basis.
1.2 Advantage of Decentralization

The following are some of the advantages provided by proponents of
decentralization.
(a) Better Decision Making - Managers closest to an operation are

allowed to makes decision based on local situations. The
experience gained also prepare lower level manager for higher
level positions when they become available.
(b) Quick Decisions - Managers at the local level can also act more
quickly because they need not report to headquarters and wait for
approval of their proposed actions.

UNIT 6 DECENTRALIZATION OF OPERATIONS
SESSION1
(c) Specialization - Corporate management can concentrate on

strategic planning and policy, and divisional management can
concentrate on operating decisions.
(d) Motivation - Managers who actively participate in decision making

are more committed to the success of programmes and are more
willing to accept responsibility for the consequences of their
actions than are managers who have little participation in the more
important decisions of the organization.
(e) Time - Higher level management’s time is freed up for other tasks.
1.3 Problems of Decentralization

Decentralization has its problems, including:
(a) Sub Optimisation - Managers operating in nearly autonomous
units might make decisions that harm the company. The problem
of decentralisation is achieving goal congruence while at the same
time promoting and maintaining divisional autonomy.
(b) Lack of Competent Personnel - Division management may not be

able to carry out and control its operations in accordance with
company policy because of a lack of competent personnel.
(c) Performance Measurement - In organizations with many

decentralized units, it is difficult to keep all operating units on the
same measurement system. This includes reporting periods,
methods of reporting and consistency of data collection.
(d) Duplication - Multiple units may be performing the same

functions because of increased autonomy allowed by
decentralisation. This increases the cost of operations especially in
such areas as payroll processing, employee luring and training and
legal work.
Exercise 6.1
1. Explain the term “decentralization”.
2. List three merits ant two demerits of decentralized operations.

SESSION 2
TRANSFER PRICING
SESSION 2: RESPONSIBILITY CENTRES
You are welcome to session two. I hope you enjoyed reading Session 1. We
want to continue our lesson on divisional performance evaluation by dealing
with the concept of responsibility centers. An understanding of the concept,
responsibility center and the types of responsibility centers serves as the
platform for divisional performance evaluation.
Objectives
a) explain the term responsibility centre; and
b) distinguish among cost centres, profit centres and investment centres
Now read on…
2.1 Meaning of Responsibility Centre

We noted in the previous session that most businesses are organized into a
number of different sub-units that perform different functions. Organizing a
business in this manner enables managers and employees to specialise in
specific types of business activity. It also made managers to be held
accountable. A responsibility centre is unit such as a department within an
organization that a manager controls.
2.2 Types of Responsibility Centres

The four basic types of responsibility centres (reporting units) are cost centres,
revenue centres, revenue centres, profit centres and investment centres. The
type of responsibility centre depends on the breadth of control of the manager.
Cost Centres: A cost centre is a unit/segment whose manager is responsible

for costs but not for revenues. A cost centre can be the office of the chief
executive of the legal department. A cost centre is a business section that
incurs costs (or expenses) but does not directly generate revenue. For
example, the laundry and janitorial functions in a hospital which does not sell
services directly to patients.
Cost Centres are evaluated primarily on

(i) their ability to control costs and
(ii) the quantity and the quality of services that they provide.
Because cost centres do not directly generate revenue, income
statements are not prepared for them. However, accounting
systems must accumulate separately the cost incurred by each
cost centre.

UNIT 6 RESPONSIBLILITY CENTRES
SESSION 2
Revenue Centres: Revenue centres are responsibility centres whose managers

are held responsible for earning revenues, but not for the costs of generating
revenues. Hospitals are the principal users of revenue centres, largely because
of cost allocation issues. A revenue centre focuses primarily or the
accumulation of sales. A revenue centre manager is evaluated on the generation
of sale revenue and has responsibility for pricing and market choice decisions.
Profit Centre: A profit centre is a part of a business that generates both revenue
and costs. For example, in hospital, the pharmacy, radiology and laboratory can
be viewed as profit centres. A profit centre manager has decision-making
responsibility over both input and output related sources. Profit centres are
evaluated primarily on their profitability.
Investment Centres: An investment centre is a segment/unit of a business

whose manger is responsible not only for revenues and costs, but also for the
investment required to generate profit.
2.3 Responsibility Accounting Systems

So far, we have identified four responsibility centres. In order, to measure the
performance of a responsibility centre, an accounting system should be
designed. Such a system designed to measure the performance of each centre
within on organization is referred to as responsibility accounting system. A
responsibility accounting system holds individual managers accountable for the
performance of the centres under their control. In addition, such systems
provide top management with information useful in identifying strengths and
weaknesses among divisions throughout the organization.
The operation of a responsibility accounting system according to Williams,

Haka, Bettner and Meigs (2002), involve three basic steps:
1. Budgets are prepared for each responsibility Centre
2. The accounting system measures the performance of each
responsibility Centre
3. Timely performance reports are prepared that compares the actual
performance of each centre with the amounts budgeted. The
performance reports help division managers keep their performance
“on target”. They also assist top management in evaluating the
performance of each manager.
2.4 The Need for Information about Responsibility Centre

Performance
The measurement of the performance of responsibility centres provide useful
information that assists managers in the following tasks:

SESSION 2
TRANSFER PRICING
1. Planning and allocating resources: Management needs to know

how well various segments of the organization are performing to
set future performance goals and to allocate resources to those
responsibility centres offering the greatest profit potential.
2. Controlling operations: One use of responsibility accounting

system is to identify those portions of the business that are
performing inefficiently or below expectations. When revenue
lags, or costs become excessive, responsibility centre information
helps to focus management’s attention on those areas responsible
for the poor performance.
3. Evaluating the performance of Centre managers: As each centre

is an area of management responsibility, the performance of the
centre provides one basis for evaluating the sills of the centre
manager.
Exercise 6.2
1. What is a responsibility accounting system?
2. List the three steps in operationalizing a responsibility

accounting system.
3. Distinguish among a cost centre, a profit centre and an

investment centre.

UNIT 6 RESPONSIBLILITY CENTRES
SESSION 2


SESSION 3
TRANSFER PRICING
SESSION 3: MEASURES FOR EVALUATING

PERFORMANCE OF DIVISIONS
So far, we have been dealing with the fundamental issues in divisional

performance evaluation. You may want to refresh your memory about the
meaning of decentralization and responsibility center before you continue. In
this session, we want to examine the commonly used measures of evaluating
the performance of divisions (responsibility centres) and their managers.
Objectives
a) describe the methods for evaluating performance of divisions;
b) compute return on investment, residual income and economic value
added from a given data; and
c) assess performance of decentralized divisions.
Now read on…
3.1 Evaluation Measures

We noted in the previous session that profitability is the primary measure for
assessing the performance of profit centre and revenue centre. We were
however, silent on the measure for evaluating investment centres. Because
investment centres are the complete autonomous division/units since they
incur cost, generate revenue and make investment in assets, evaluating their
performance on profitability is not good enough.
Three of the most common measures of investment centre performance, return

on investment, residual income, and economic value added are discussed in
the following section.
3.1.1 Return on Investment

The return on investment (ROI) is a measure of the earnings per cedi of
investment. It is computed by dividing the income (that is operating income)
of an investment centre by its asset base (usually total assets). The ROI can
be computed as asset turnover times operating profit margin.
That is Sales x Operating Profit

Total Asset Sales
= Operating profit
Total Asset

UNIT 6 MEASURES FOR EVALUATING PERFORMANCE
SESSION 3
The computed ROI is compared to some previously identified performance

criteria. These include the investment centre’s previous ROI, overall company
ROI, or the ROI of similar divisions.
The following information is available concerning the 2007 operations of
Happy Times Ltd.
Division Net Assets Sales Divisional Profit (Income)

North 16,000 24,000 2,880
Central 8,000 16,000 1,920
South 15,000 10,000 3,300
Solution
The return of investment can be computed for the three divisions as follows:
Performance Evaluation Data

Division Asset Turner x Operating Margin = Return of Investment
North 1.50 0.12 0.18
Central 2.00 0.12 0.24
South 0.67 0.33 0.22
From the computation, the central division had the best performance followed
by the South division and North division respectively.
The ROI has a distinct advantage are income/profit as a performance measure,

because companies usually have divisions of different sizes. ROI makes it
possible to compare the efficiency of different sizes divisions by relating output
(income) to input (investment).
3.1.2 Residual Income

Another measure for evaluating divisional performance is residual income.
Residual income (RI) is the excess of investment centre income over the
minimum required (desired, target) rate of return set by top management. Some
companies set different minimum rates of return for different divisions to reflect
differences in risks associated with their businesses. A division in a risky
industry should earn higher returns than one in a more stable industry. Residual
income is computed as follows:
Divisional income xx
less minimum return(i.e. investment x target
required rate of return) xx
Residual Income xx

SESSION 3
TRANSFER PRICING
For example the residual income of a division of the company that has net
income of GH¢40,000 and asset (investment) bases of GH¢30,000 and
minimum required rate of return of 12% is as follows:
Divisional income 40,000

less minimum return (12% x 30,000) 3,600
Residual Income 36,400
3.1.3 Economic Value – Added (EVA)

In recent years, a variation of residual income, referred to as economic value –
added residual income, or just economic value – added, is also used as
measure of evaluation. The three significant changes from the residual
income computation are:
a. the use of an organization’s weighted average cost of capital as the

minimum required rate of return,
b. net assets as the evaluation bases, and
c. after-tax income
Note that weighted-average cost of capital is an average of the after-tax cost

of all long-term debt and the cost of equity; net assets are total assets less
current liabilities. Economic value added is the excess of division’s taxable
income over its net cost of investing.
Economic value – added is computed as follows:

Division income after tax xx
Less cost of capital employed (i.e. net assets X WACC) xx
Economic value – added xx
For example, if Division A of XYZ % Ltd has income of GH ¢40,000, weight

average cost of capital of 15% and an investment base of GH¢30,000 then its
economic value-added will be GH¢
That is
GH¢
Division income 40,000
less cost of capital (.15 x 30,000) 4,500
Economic value-added 35,500

SESSION 3
3.2 Using Average Total Assets/Net Assets

So far, in the computation of ROI, RI and EVA we have used total asset
(investment)/net asset at year end as the denominator. In practice, accountants
use the average of the beginning and ending balances of the year for total assets
in calculating ROI, RI, and EVA. The reason is that since net profit/income is
applicable to the entire year, then using a simple average of the amount of total
assets for the year is more consistent with income, than simply using the year
end amount. Let us use a complete question to go over the measures of
evaluation.
The manager of Division C of All Fine Company Ltd has given you the
following information related to budgeted operations for the year 2008.
GH¢
Sales (100,000 units @ GH¢10) 1,000,000
Variable cost @ GH¢4 per unit 400,000
Contribution margin 600,000
Fixed costs 240,000
Divisional Profit 360,000
Divisional investment 1,600,000
Minimum required rate of return is 20%
Required:
(a) Determine division C’s expected ROI
(b) Determine the division’s RI
(c) The manager has the opportunity to sell on additional 10,000 units at
GH¢59.00 each. Variable cost per unit would be the same as
budgeted, but fixed costs would increased by GH¢20,000.
Additional investment of GH¢100,000 would also be required. If the
manager accepts the special order, by how much and in what
direction will RI charge?
Solution
(a) Return on Investment = Divisional Profit
Divisional Investment
= 360,000 x 100
1,600,000
= 22.5%
(b) Divisional Profit GH¢360,000

Less minimums required return
(1,600,000 x 20%) 320,000

SESSION 3
TRANSFER PRICING
(c) Increase in sales (10,000 x GH¢9.00) 90,000

Increase in variable costs (10,000 x GH¢4) 40,000
Increase in contribution 50,000
Increase in fixed costs 20,000
Increase in profit 30,000
Increase in minimum required return
(100,000 x 20%) 20,000
Increase in residual income 10,000
A new income statement and calculation of new total residual income shares
the following:
GH¢
Sales (1,000,000 + 90,000) 1,090,000
Variable costs (400,000 + 40,000) 440,000
Fixed costs (240,000 + 20,000) 260,000
Divisional Profit 390,000
Minimum required return (70,000 x 20%) 340,000
The new GH¢50,000 residual income is GH ¢10,000. More than the residual
income based on budgeted operations without the special order in (b) above.

SESSION 3


SESSION 4
TRANSFER PRICING
SESSION 4: MEANING AND IMPORTANCE OF TRANSFER

PRICING
We want to shift our attention to a related subject in decentralized operations

regarding how divisions charge for goods and services supplied between
them. We will cover the subject of transfer pricing in sessions 4 to 6.
In this session, we begin by examining the meaning of transfer pricing and its
importance.
Objectives
a) explain the term, transfer pricing;
b) describe how transfer pricing is important in decentralised operations
Now read on…
4.1 Introduction
In a large organization with many divisions, it is normal for one or two of the
divisions to do business between themselves. For example, if an automobile
company has division for manufacture of windscreen and another for
manufacture of tyres, it is possible for the assembly division to buy
components such as windscreen and types from the two divisions respectively.
Don’t forget, however, that the windscreen and tyre divisions sell to outside
companies as well. Under such circumstance, there will be the need to decide
on the price at which the assembly division should buy the windscreen and
tyre. Remember, that each division is a responsibility centre, and their
managers must be evaluated. These raises the issue to transfer pricing – the
type of pricing used when products or services are exchanged between quasi-
independent segments of an organisation.
4.2 What is Transfer Price?

A transfer price is the internal value assigned to a product or service that one
division provides to another.
Transfer-pricing transactions normally occur between profit or investment

centres rather than between cost centres of an organizations.
Explain profit centre, cost centre and investment centre before you continue.

UNIT 6 MEANING AND IMPORTANCE OF TRANSFER
SESSION 4 PRICING
Transfer prices are important because they are revenues to the selling division
and costs to the buying division and therefore affect divisional performance.
The objective of transfer pricing is to transmit financial data between
departments or divisions of a company as they use each other’s goods and
services.
Transfer prices usually are not paid in cash (except if the transfer of products is
between subsidiaries); they are only entries made in the accounting records to
record the “flow” of goods and services among divisions/departments within an
organization.
4.3 Objectives of Transfer Pricing

I hope you now understand the concept of transfer price. Because managers of
investment centres are evaluated independently, Lucey (1998) has observed that
transfer prices should be set in a manner at a level to fulfill three objectives:
(a) Goal congruence – the prices should be set so that the divisional
manager’s desire to maximize divisional income is consistent with
the objective of the company as a whole.
(b) Performance evaluation – the prices should enable reliable

assessments to be made of divisional performance. The prices form
part of information which should guide decision making, appraise
managerial performance and evaluate the contribution made by the
division to overall company profits.
(c) Divisional autonomy – the prices should seek to maintain the

maximum divisional autonomy so that the benefits of
decentralization are maintained.
4.4 International Transfer Pricing Objectives

Apart from the above objective of transfer pricing between divisions operating
within one country settings appropriate transfer prices becomes much more
complicated if parts of a business are located in different countries. If goods are
shipped across international borders the transfer price may be affected by taxes,
duties and tariffs, and international trade agreements. In addition, the market
value of the goods may be quite different in the country in which they are
manufactured and the country to which they are shipped. Blocher, Chen,
Cokins and Lin (2005) explain other objectives of transfer pricing for
companies engaged in international business include minimizing customs
charges, dealing with currency restrictions of foreign governments and dealing
with the risk of expropriation by foreign governments.

SESSION 4
TRANSFER PRICING
(a) Minimization of customs charges – the transfer price amount can

affect the overall cost, including the customs charges, of goods
imported from a foreign unit. For example, if customs charges are
significant on the parts and components imported by the domestic
manufacturing unit a relatively low transfer price on these imports
would be beneficial to reduce the amount of customs charges.
(b) Currency restrictions – as a foreign unit accumulates profits a

problem arises in some countries that limit the amount and/or
timing of repatriation of these profits to the parent firm. One way
to deal with these restrictions is to set the transfer price so that
profits accumulate at a relatively low rate. This objective must be
considered with other transfer pricing objectives
(c) Risk of expropriation – when a significant risk of expropriation

exists, the firm can take appropriate actions such as limiting new
investments, developing improved relationships with the foreign
government and setting the transfer price so that funds are removed
from the foreign country as quickly as possible.
Exercise 6.4
1. What is “transfer price”?
2. Mention three objectives of setting transfer prices.
3. List the problems associated with fixing transfer prices in

multinational companies.

UNIT 6 MEANING AND IMPORTANCE OF TRANSFER
SESSION 4 PRICING


SESSION 5
TRANSFER PRICING
SESSION 5: TRANSFER PRICING METHODS
You are welcome to Session 5. This session is devoted to explanation of the

various transfer pricing methods.
Objectives
a) explain the different transfer pricing methods;
b) explain the situation in which each transfer pricing method should be
used; and
c) explain the merits and demerits of each transfer pricing method
Now read on…
5.1 Transfer Pricing Methods

Deferring the transfer price of goods and services is not an easy task. In this
session, we discuss the four most widely used methods for determining the
transfer price. These are variable cost, full cost, market price and negotiated
price.
Variable Cost: The variable cost method sets the transfer price equal to the
selling unit’s variable cost plus markup. This method is preferred when the
selling unit has excess capacity and the transfer price’s main objective is to
satisfy the internal demand for the goods. The relatively low transfer price
encourages buying internally. This method is not suitable when the selling
unit is a profit or investment centre, because it adversely affects the selling
unit’s profit.
Full (Absorption) Cost: The full cost method sets the transfer price equal to
variable costs plus selling unit’s allocated fixed cost and markup. Advantages
of this method are that it is well understood and that the information is readily
available in the accounting records.
Market price:The market price method sets the transfer price as the current
price of the selling unit’s product in the market. If divisions are free to buy
and sell outside the firm, the use of market prices preserves divisional
autonomy and leads divisions to act in a manner that maximizes corporate
goal congruence. Thus the key advantage of this method is objectivity; it best
satisfies the arm’s length criterion desired both management and tax purposes.
The main demerit is that the market price, especially for intermediate
products, is often not available.

SESSION 5
5.2 Negotiated Price

Negotiated transfer price is used when the selling and buying divisions
independently agree on a price. As with market price, negotiated transfer
price is believed to preserve divisional autonomy.
Negotiated transfer prices may lead to some sub-optional decisions, but this is
regarded as a small price to pay for other benefits of decentralization. When
negotiated transfer prices are used, some companies establish arbitration
procedures to help settle disputes between divisions. The limitation is that the
method can reduce the desired autonomy of the units.
According to Morse, Dans and Hartgraves (2000), negotiated prices should

have market prices as their ceiling and variable costs as their floor. Although
frequently used where an external market for the product or component exists,
the most common use of negotiated prices is where no identical product
external market exists.
5.3 Advantages and Limitations of the Transfer Pricing

Methods
The advantages and limitations of the four transfer pricing methods which we
have discussed are summaries in Table 6.1.
Table 6.1 Advantages and limitations of transfer pricing methods.
Method Advantages Limitations
Variable cost Provides the proper Inappropriate for
motivation for the manager long-term decision
to make the correct short- making in which
term decision, in which the fixed costs are
seller’s fixed costs are not relevant, and prices
expected to change. When must cover fixed as
the seller’s variable cost is well as variable costs.
less than the buyer’s
outside price, the variable Unfair to seller if
cost transfer price will seller is profit or
cause internal sourcing, the investment SBU.
correct decision
Full cost Easy to implement Irrelevance of fixed
Intuitive and easily cost in short-term
understood decision making;
Preferred by tax authorities fixed costs should be
over variable cost ignored in the buyer’s
Appropriate for long-term choice of whether to
decision making in which buy inside or outside
fixed costs are relevant, the firm.
and prices must cover fixed

SESSION 5
TRANSFER PRICING
as well as variable costs. It uses, should be

standard rather than
actual cost (allows
buyer to know cost in
advance and prevents
seller from passing
along inefficiencies)
Market price Helps to preserve unit Intermediate products
autonomy often have no market
Provides incentive for the price
selling unit to be Should be adjusted
competitive with outside for cost savings such
suppliers as reduced selling
Has arm’s-length standard costs, no
desired by taxing commissions and so
authorities on.
Negotiated Can be the most practical Need negotiation rule
price approach when significant and/or arbitration
conflict exists procedure, which can
reduce autonomy
Potential tax
problems; might not
be considered arm’s
length
Source: Blocher, Chen, Cokins and Lin (2005) p. 784
Exercise 6.5
1. List the four transfer pricing methods.
2. Distinguish between variable cost and full cost basis of transfer

pricing.
3. Explain the advantages and limitation of market price and

negotiated price.

SESSION 5


SESSION 6
TRANSFER PRICING
SESSION 6: SELECTING THE RIGHT TRANSFER PRICING

METHODS
You are welcome to the last session of Unit 6. In Session 5, we noted that
there are four most widely used transfer pricing methods. List the methods
before you continue.
We also observed that there are circumstances when each of them will be
suitable. In this session, we continue the lesson, by examining the key factors
that will influence the setting of transfer price.
Objectives
By the end of this session you should be able to identify the key factors to
consider in setting transfer price;
Now read on…
6.1 Factors to Consider in Selecting the Right Transfer Price

The three key factors to consider in deciding whether to make internal
transfers, and if so, in setting the transfer price follow:
1. Is there an outside supplier?
2. Is the seller’s variable cost less than the market price?
3. is the selling unit operating at full capacity?
Table 6.2 shows the influence of these three factors on the choice of a transfer
price and on the decision to purchase inside or out.
First: Is there an outside supplier? If not, there is no market price, and the
best transfer price is based on cost or negotiated price. If there is an outside
supplier, we must consider the relationship of the inside seller’s variable cost
to the market price of the outside supplier y answering the second question.
Second: Is the seller’s variable cost less than the market price? If not, the
seller’s costs are likely far too high, and the buyer should buy outside. On the
other hand, if the seller’s variable costs are less than the market price, we must
consider the capacity in the selling unit by answering the third question.

UNIT 6 SELECTING THE RIGHT TRANSFER PRICING
SESSION 6 METHODS
Table 6.2 Choosing the Right Transfer Price

Transfer price
Decision to transfer
Cost or negotiated price
First: Is there an outside supplier? If there is no outside supply Buy inside
If there is an outside supply, answer the second question
Second: Is the seller’s variable cost less than the outside price?
If it is greater than the outside price, the seller must look No transfer price
for ways to reduce cost. Buy outside
If seller’s variable costs are less than the outside price,
answer the third question.
Third: Is the selling unit operating at full capacity?

If seller has excess capacity, then Buy inside Low transfer cost
High marker price
If the seller is at full capacity And if the contribution of the outside

purchase to the entire firm is No transfer price
greater than the coutinbution of
the inside purchases Buy outside
And if the contribution of the outside
. purchase to the entire firm is
less than the contribution of the
Buy inside Market price
inside purchases
Source: Blocher, Chen, Cokins and Lin (2005) p. 784
focus on variable costs in this second step because commonly the transfer
pricing decision is made in the context of a short-term decision in which fixed
costs are not expected to differ whether the internal transfer is made or is not
made. The fixed costs of the seller are irrelevant since they will not change
Third: Is the selling unit operating at full capacity? That is, will the order
from the internal buyer cause the selling unit to deny other sales opportunities?
If not, the selling division should provide the order to the internal buyer at a
transfer price some where between variable cost and market price. In contrast,
if the selling unit is at full capacity, we must determine and compare the cost
savings of internal sales versions the selling division’s opportunity cost of lost
sales. If the cost savings to the inside buyer are higher than the cost of lost sales
to the seller, the buying unit should buy inside, and the proper transfer price
should be the market price.

Answers
Unit 1
Exercise 1.1
Q1. Management Accounting otherwise referred to as ‘managerial
accounting’ is a management information system which
provides management with financial and non financial
information to ensure effective planning, control and decisions
making.
Q2. Manufacturing, Wholesaling, Retailing, Hotels and Restaurants,

Transport, Hospitals, Schools, Government Agencies/Ministries
Churches as well as individuals families can all benefit from the
use of sound financial management practices.
Q3. The three main purposes Management Accounting:

- To help management determine and assign costs to various
cost units (i.e. products and services)
- To provide useful information for planning and controlling
growth
- To determine the overall returns on various investment
opportunities
- To provide information for management evaluation and
continuous improvement
- To provide information for management decision making
Exercise 1.2
Q1. Management accountants play the following typical roles by
assisting management through:
a. Evaluating and controlling capital projects and business
ventures of the firm.
b. Making a choice between producing one commodity or the
other, make or buy a certain product, shut down a product line
or continue production accept or reject an order
c. Budgeting and budgetary control activities that encompasses
healthy cash or liquidity status, material stock levels, labour
utilization, capacity utilization to mention only a few.
d. Determining the true cost of production and recommending
alternative means of cutting down costs
e. Estimating and analyzing departmental operational costs and
revenues
f. Providing information for the planning of future activities of
the firm
g. Preparing regular reports for undertaking corrective measures
on deviating aspects of the organizational activities or
performance.
Q2. For management accounting information to be useful and

beneficial to various users (managements) then they should posses
CoDE/UCC Post-Diploma in Commerce 209

Answers
some key qualities. The following features of useful accounting
information have been identified:
1. Relevance: implies that, the information provided should be that

which is required to satisfy the needs of the information users. In other
words management accounting information must have the ability to
influence decision.
2. Reliability: denotes that management accounting reports should be
free from any material error or bias. It should be capable of being
relied on by all stakeholders to represent what it is supposed to
represent.
Exercise 1.3
Q1. The relationship between financial and management accounting
can be stated as follows:
a. Financial accounting is concerned with external reporting to
shareholders and the investing public at large. It also provide a
system whereby the operations of an organization can be checked
or audited to confirm that the establishment is being managed in a
proper and responsible manner. Financial accounting has been
commonly referred to as ‘stewardship’ accounting because they
are prepared to enable owners of an organization to assess the
performance of the managers they have appointed.
b. Management accounting is also concerned with the provision of
information required by management for policies formulation,
planning and controlling of company’s activities, decision making,
safeguarding company’s assets to mention only a few.
Q2. The differences between the two types of accounting reflect the
different user group which they address. Briefly, the main are as
follows:
a) Regulations: financial reports, for many organizations are
subject to accounting regulations which try to ensure that they
are produced in conformity with a standardized format. These
regulations are imposed by law and accounting profession. But
management accounting reports are not guided by any such
regulations from the external sources dictating the form and
content. Management reports are for internal use only and can
be tailored to meet the needs of a particular management.
b) Nature of the reports produced: financial accounting reports
tend to be general-purpose reports. That is the contain financial
information that can be useful for a wide range of accounting
users as well as decisions rather being specifically developed
for the needs of a particular group or set of decisions.
Management accounting reports, on the other hand, are often
designed for specific purpose. They are designed either with a
particular decision in mind or for a specific management.
c) Level of details: financial accounting reports provide users
with a broad overview of proposition and operational
210 CoDE/UCC Post-Diploma in Commerce

Answers
performance of the business for s defined period.

Consequently, information is generally aggregated and detail is
usually lost. Management accounting reports, however, often
provide management with considerable details to help them
with a particular operational decision.
d) Reporting intervals: for most businesses, financial
accounting reports are produced on an annual basis. However,
large companies may produce semi annual reports and few and
a few also produce quarterly reports. Management accounting
reports may be produced as frequently as required by
management. In most businesses, Managements are provided
with certain reports on a weekly or monthly basis which permit
constant review of operational performance.
Exercise 1.4
Q1. The three cost elements that determine the cost of making a
product are direct materials direct labour and overheads.
Q2. Costs may be grouped in the following three different ways

namely:
 By direct and indirect costs
 According to their function
 According to their behaviour
Exercise 1.5
Q1. Cost Units: By definition cost unit is quantitative unit of product
or service in relation to which costs are ascertained. The cost unit,
otherwise known as cost object is the basic control unit for costing
purposes. Examples of cost units in manufacturing firms may be a
shoe in a shoe factory. A cost unit in a service industry like hospital
might relate to the number of beds occupied or the number of patients
treated. Examples in this respect might be patient/day (or bed/day) in a
casualty each patient treated might form a cost unit, in a hotel, a cost
unit would be bed/day occupied or room/day occupied, in transport
business the obvious cost unit is ton/mile or passenger/mile i.e. the
cost involve in transporting one ton of freight or passenger over one
mile would be aggregated.
Unit Cost: Unit cost can simply be defined as the arithmetic average
cost of producing only one unit of output (goods and services). In
other words unit cost can be calculated by dividing the total cost of
production by the number of units produced.
Direct Cost: Direct costs are those costs which can be directly
identified with a particular product or service which the business
provides. The total of all the direct costs is known as Prime Cost (i.e.
direct materials + direct labour + direct expenses)
Indirect Costs: Indirect cost are all those costs of materials, labour
and expenses which are incurred in the production process but which
cannot be identified with one particular product. Examples include the
cost of foreman and maintenance staff in a business producing a range

Answers
of products, or consumables materials used by machinery involved in
the production process. The total of all the indirect costs is usually
termed as Overheads (i.e. indirect materials +in direct labour +
indirect expenses).
Q2. The distinction between direct and indirect cost is very important
due to a number reasons. Among such reasons are few enumerated
below:
• Pricing decisions may be greatly influenced particularly when
using marginal costing which cost determination is usually
based on direct costs or when using full absorption costing
approach which is based on both direct and indirect costs
• The distinction also facilitates policy making on output and
customer orders. Since indirect costs usually do not vary with
the level of output, management is able to determine what
increase in output level is acceptable. The distinction helps to
avoid overstretching production capacity as well as preventing
under utilization of capacity
• Direct costs are usually controllable by a responsible officer
but indirect costs are normally uncontrollable. The distinction
therefore assists managers in identifying and assigning
responsibilities to the right persons, locations or departments.
• Planning and decision making are improved tremendously as
management devout much time pondering over how to keep
direct or variable costs under control rather than concentrating
on indirect cost which does not change in relation to
production volume.
• It directs management attention in sensitivity analysis knowing
that much of the problem centres on direct or variable costs.
Exercise 1.6
Q1. Opportunity Cost: An opportunity cost is defined as the benefit
that is sacrificed when the choice of action precludes taking an
alternative course of action. Put differently, an opportunity cost is the
value in monetary terms of being deprived of the next best opportunity
in order to pursue a particular objective. For instance you own an
undeveloped land at Kasoa which cost you GH¢3,000 when you
bought it, much below current price reigning in the area. You have
just been offered GH¢4,000 for this piece of land. The real economic
cost of retaining that piece of land is GH¢4,000, since it is what you
are being deprived of to retain the plot of land. Any decisions which
you make with regards to the land should logically take into account
the GH¢4,000. This cost is the opportunity cost since it is the value of
the opportunity forgone in order to pursue the alternative course of
action.

Answers
Q2. No it does not mean this. The fact that the business has an asset
which it can deploy in the future is highly relevant. What is not
relevant, however, is how much it cost to acquire that asset. Another
reason why the past is not irrelevant is that it generally, though not
always, provides us with the best guide into the future.
Q3. The minimum price is:

Opportunity cost 5,700
Cost of reconditioned engine 500
Labour cost (9hrs x GH¢14) 126
Total 6,326
The relevant labour cost here is that which the shop will have to
sacrifice in making the time available to undertake the engine
replacement job. While the mechanic is working on this job, the shop
is also losing the opportunity to earn other income.

Answers

Management Accting

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This seventh publication is 2015 by Hampton Press, Cape Coast

Eighth printing in 2016 by Rocky Printing Works, Accra

© COLLEGE OF DISTANCE EDUCATION, UNIVERSITY OF CAPE

ISBN 978 – 9988 – 8467 – 2 - 5

First Publication, 2007

All rights reserved. No part of this publication should be

Cover page illustrated by R. Y. Essiam—

This Course Book “Management Accounting” has been exclusively

This three-credit course book of thirty-six (36) sessions has been

To help you do this effectively, a Study Guide has been particularly

We wish you a happy and successful study.

Prof. Edward Marfo-Yiadom

CoDEUCC/ Post-Diploma in Commerce

It has become a tradition in academic circles to acknowledge the

It is in the foregoing context that the names of Prof. Edward Marfo-

I wish to thank the Vice-Chancellor, Prof. Joseph Ghartey-Ampiah

Finally, I am greatly indebted to the entire staff of CoDEUCC,

Any limitations in this course book, however, are exclusively mine.

Prof. Isaac Galyuon

About this Book … … … … … … … i

UNIT 1: OVERVIEW OF MANAGEMENT ACCOUNTING 1

UNIT 2: MARGINAL AND ABSORPTION COSTING 27

UNIT 3: RELEVANT COSTS FOR DECISION MAKING 73

UNIT 4: BUDGETING AND BUDGETARY CONTROL 105

UNIT 5: STANDARD COSTING AND VARIANCE

UNIT 6: DIVISIONAL PERFORMANCE EVALUATION

Answers to Self-Assessment Questions … … 209

NOTE AN IMPORTANT POINT

TIME TO THINK AND ANSWER QUESTION(S)

SELF- ASSESSMENT TEST

CoDEUCC/Post-Diploma in Basic Education vi

UNIT 1: OVERVIEW OF MANAGEMENT ACCOUNTING

You are welcome to unit 1 of the Management Accounting module. This

In this unit we will look at the meaning and purpose of Management

CoDEUCC Post Diploma in Commerce 1

2 CoDEUCC Post Diploma in Commerce

SESSION 1: MEANING AND PURPOSE OF MANAGEMENT

Now read on…

1.1 Meaning of Management Accounting

Both financial and non-financial information should be provided by the

1.2 Application of Management Accounting

Consequently, management accounting is applicable to all organizations -

CoDEUCC Post Diploma in Commerce 3

Anyone internal to an organization is a potential user of management accounting

Broadly speaking, this course is very important for individuals, institutions,

1.3 Purpose of Management Accounting

4 CoDEUCC Post Diploma in Commerce

SESSION 2: ROLE OF MANAGEMENT ACCOUNTANTS

Now read on…

2.1 Activities of Management Accounting Department

To begin with, management accountants have, of late, been confronted with

In the face of such changes, management accounting unit or department had to

CoDEUCC Post Diploma in Commerce 5

2.2 Functions of Management Accountants

Management accountants play the following typical roles by assisting

2.3 Characteristics of useful Management Accounting

For management accounting information to be useful and beneficial to various

6 CoDEUCC Post Diploma in Commerce

3) Comprehensibility: implies that the manner in which information is

CoDEUCC Post Diploma in Commerce 7

This is a blank sheet for your short notes on:

8 CoDEUCC Post Diploma in Commerce

SESSION 3: DIFFERENCES BETWEEN FINANCIAL, COST AND