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Unit 2
Module 1
Cost and Management Accounting

Management Accounting

Management accounting involves the provision of effective cost control, and preparation and

presentation of actual, and forecast financial information on accounting performance and

includes the following:

1. Systems of standard costing and budgetary control.

2. Computation of forecast and actual cost as a basis for detailed analysis. Management

accounting is concerned with the provision and interpretation of information required

by management of all levels for the following purposes:

1. Formulating the policies of the organization.

2. Planning the activities of the company in the short, medium and long term.

3. Controlling the activities of the organization.

4. Decision making.

5. Performance appraisal at the strategic, departmental and operational levels.

To carry out this task efficiently the management accountant will use data from

the financial and cost accounting systems. He or she will conduct special

investigations to gather the required data and use accounting techniques and

statistical analysis to derive the relevant information. The accountant must also

consider the human element in all activities and be aware of the underlying

economic factors.
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Management Accounting

Management accounting is primarily concerned with data gathering from internal and

external sources, analysing, processing, interpreting and communicating the resulting

information for use within the organisation so that management can more effectively plan,

make decisions and control the operations of the organization.

The characteristics of the information provided by the management accounting system

1. The quantitative information must be timely and relevant.

2. The information used for internal decision making does not have to fulfil the same

kinds of restrictions as the external information needed for financial accounting.

3. The information needed to make decisions is based on projections of future revenue

and expenses. Since these projections are merely estimates, they are not the recorded

actual cost of past transactions and they cannot be verified by third parties and as a

result they are not objective.

4. The only requirement that internal information must fulfil is that it be useful to

management and thereby enabling management to make the best decision on a timely

basis.

Cost Accounting

Cost accounting is that part of management accounting which establishes budgets,

standard cost and actual cost of operations, processes, departments or products and the

analysis of variances and profitability.

It is concerned with gathering accounting information for the specific purpose of

determining the cost of a product or service. Cost accounting provides management with

relevant information to help achieve control over cost.

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Interrelationship of Financial and Management Accounting

Financial accounting and management accounting are not completely separate disciplines.

Historical information used in financial accounting is often helpful in evaluating future

alternative courses of action that management is considering. Management makes a

decision about the best future cost of action based on what happened in the past. Later

when the results of that management decision occur, these results become financial

information to be interpreted into the financial statements.

Financial Accounting

Financial accounting is concerned with recording business transactions and preparing

financial reports to be used internally by management and externally by investors,

creditors and potential investors. Businesses are also responsible for providing financial

reports requested by government agencies in compliance with the particular governmental

agency regulations.

Relevance of Management Accounting for manufacturing entities

Manufacturing account – to determine the cost of goods manufactured

Manufacturing account - includes all manufacturing costs

Manufacturing costs – Direct and Indirect (overheads)

Direct – become a part of what is being manufactured. These costs can be easily and

conveniently assigned to what is manufactured.

Indirect – do not directly become a part of what is being manufactured. Cannot be easily

and conveniently assigned to what is manufactured.

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Name of Company

Schedule of cost of goods manufactured for the year ended ………

Raw materials inventory at Jan 1 xxxx

Purchases of raw materials xxxx

Raw materials available xxxx

Raw materials inventory at Dec 1 (xxxx)

Raw materials used xxxx

Direct labour xxxx

Direct expenses xxxx

Prime cost xxxx

Overheads

Depreciation: Plant and Machinery xx

Rent of factory building xx

xxxx

Total manufacturing cost xxxx

Work in progress at Jan 1 xxxx

xxxx

Work in progress at Dec 31 (xxxx)

Cost of goods manufactured xxxx

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Name of Company

Income Statement for the year ending…….

$ $

Sales xxxx

Less cost of goods sold:

Finished goods inventory Jan 1 xxxx

Cost of goods manufactured xxxx

Cost of goods available xxxx

Finished goods inventory Dec 31 (xxxx)

Cost of goods sold (xxxx)

Gross profit xxxx

Less: Administrative expense xxxx

Selling expense xxxx (xxxx)

Net income / loss xxxxx

Elements of Costs

Cost behaviour

Cost may be defined as a measurable sacrifice of resources exchanged for goods and services.

Cost behaviour – refers to the way in which cost vary with the level of activity in the
organization. The cost behaviour pattern of any single item of expenditure might be described
as follows:

1. Fixed cost

2. Variable cost
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3. Mixed cost or semi-variable cost

4. Step cost or semi-fixed cost

Fixed cost

A fixed cost is a cost which remains unchanged in total at all levels of activity. It is a cost
which accrues in relation to the passage of time and is therefore referred to as a period cost.

Variable cost

A variable cost is one which varies in direct proportion to changes in the volume of activity.
This means that if the volume of activity is doubled there will also be a doubling of the total
variable cost. As a result total variable costs are linear functions and variable unit cost is
constant.

Mixed or Semi-variable cost

This is a cost which contains a fixed element and a variable element which is linked to the
level of activity. The total cost tend to increase or decrease in response to changes in the level
of activity but not in direct proportion to those changes in the level of activity.

Example of semi-variable cost per unit

Fixed cost $1000

Variable cost per unit = $5

Units Total cost Cost per unit

1 1000 + (1 x $5) = $1005 1005 / 1 = $1005

10 1000 + (10 x $5) = $1050 1050 / 10 = $105

20 1000 + (20 x $5) = $1100 1100 / 20 = $55

30 1000 + (30 x $5) = $1150 1150 / 30 = $38.3

Semi-fixed or Step cost

Semi-fixed cost are fixed within specified activity levels within a given time period but will
increase or decrease by a constant amount at various critical levels of activity.
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Cost used for decision making

Cost used for decision making can be classified as either relevant or irrelevant.

Relevant costs are those costs that are different for the various alternatives that are being
considered. These costs are the ones which will affect the choices which are made when a
decision has to be made between alternative courses of action.

Irrelevant costs are those that are the same for all the alternatives that are being considered.
As a result they do not affect the choice which is made between competing alternatives.

Planning and Control

Controllable cost – these are costs that can be influenced by a manager who has the
responsibility for monitoring the particular department in which the cost were incurred. As a
result the manager’s performance is assessed by his or her ability to control these cost.

Non-controllable cost – these costs cannot be influenced by the manager responsible for the
department and therefore cannot be used in assessing the manager’s performance in terms of
his or her ability to control cost.

Actual cost – are costs which have been incurred by the business as evidence by the source
documents. They are the result of transactions which occurred in the past and recorded using
the historical basis of recording those transactions.

Budgeted cost – these are cost which the business expects to incur the future period. These
are based on plans which the business has made for the upcoming financial year. Actual costs
are normally compared to budgeted costs as a means of assessing performance to determine
whether appropriate measures should be introduced.

Inventory Valuation

Period cost – are those costs which are expensed in the period in which they were incurred.
They are not included in the costs of the product which is manufactured and therefore do not
become part of the cost of the product for inventory valuation purposes.

Product cost – are all costs incurred and assignable to the units produced and sold. They are
closely associated with units produced or purchased for resale. Product costs are considered
assets because they are resources that are expected to provide future economic benefits to the
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firm and therefore included in the valuation of inventory. When the units to which product
costs are assigned are finally sold these costs then become an expense in the form of cost of
goods sold.

Categories of product costs

1. Direct materials – these are raw materials that become an integral part of the
complete product and that are significant enough to warrant tracing the cost from raw
materials through to finished goods.

2. Direct labour – involves work that directly converts the raw materials into finished
goods. Direct labour should be clearly traceable to the product being worked on from
the stage of raw materials to the stage of finished goods.

3. Factory overheads – factory overhead costs represent the indirect cost of production,
they comprise those cost that are needed to produce the product but cannot be traced
directly to the product which is being worked on.

Prime cost = Direct materials + Direct labour + Direct expenses

Conversion cost = Direct labour + Factory overheads

Valuation of stock

Stock is valued at cost.

Value of stock = no. of items x cost per unit

Cash flow assumption used in determining the value of stock

1. First in First Out – F.I.F.O

2. Last in First Out – L.I.F.O

3. Average Cost – AV.CO

Cash flow assumptions used in determining the valuation of inventory

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1. First in First out. F.I.F.O

The FIFO method of costing inventory is based on the assumption that cost should be
charged against revenue in the order in which they were incurred as a result the items
which are sold first would come from the oldest purchases which were made in the
early periods of the financial year. The inventory remaining on hand is therefore
presumed to consist of the most recent purchases which were made in the latter
periods of the financial year. The FIFO method results in an inventory valuation
which approximates current cost and a cost of goods sold valuation which reflects the
original acquisition cost. In periods of rising prices the FIFO methods results in the
highest ending inventory value and the highest net income.

2. Last in First out. L.I.F.O

The LIFO method of costing inventory is based on the assumption that the most
recent cost should be matched with the current revenues. This means that the last
goods acquired are the first sold and the inventory remaining on hand is presumed
consist of the goods acquired first in the earlier periods of the financial year. This
method is often supported on the grounds that it usually produces an amount for cost
of goods sold that more closely reflects current cost levels. However in times of rising
prices the amount reported in the balance sheet for inventory valued using the last in
first out basis tends to be understated. In periods of rising prices the last in first out
method results in the lowest ending inventory value and the lowest net income.

3. Average Cost method

The weighted average is based on the assumption that cost should be charged against
revenue on the basis of the weighted average price paid for all units purchased. The
average price is applied to the ending inventory to find the total ending inventory
value.

AVCO

Ending inventory value = units in ending inventory x Average cost

The average cost of ending inventory held is recalculated with each receipt of goods.
Any subsequent issue is then made at that price until a further receipt of goods
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necessitates the AVCO of goods held being recalculated. This method considers that
each unit of inventory is incidental and can be sold for the same price and therefore
has equal significance to the firm. As a result it is argued that units having equal
significance should be assigned equal costs.

Inventory Valuation on a Periodic Basis

Perpetual basis – stock is calculated after each receipt and issue.

Inventory Control

Inventory control is defined as the system used by a firm to control the firm’s investment in
stock. The system involves the recording and monitoring of stock levels, forecasting future
demands and deciding when and how many to order. The overall objective of inventory
control is to minimize, in total the costs associated with stock.

The costs associated with stock can be categorized as:

1. Carrying cost

2. Cost of obtaining stock

3. Cost of being without stock which is called stock at cost

Determine the economic order quantity (EOQ)

The EOQ is defined as the ordering quantity which minimizes the balance of cost between
inventory holding cost and re-order cost.

Holding cost or carrying cost may include the following:

1. Interest on capital invested in stock

2. Storage charges

3. Handling cost

4. Audit and stock taking cost

5. Insurance

6. Deterioration and obsolescence

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7. Pilferage and vermin damage

The cost of obtaining stock includes the following:

1. The clerical and administrative cost associated with the purchasing, accounting and
goods received department.

2. Transportation costs.

3. The setup and tooling costs associated with each production run in situations where
the goods are manufactured internally.

This is the basic formula EOQ Assumptions

EOQ for constant ordering and holding costs, constant demand and instantaneous
replenishment = the square route of 2 x ordering cost per order x demand per annum

Carrying cost per item per annum

1. There is a known constant holding cost.

2. There is a known constant ordering cost.

3. The rates of the demand are known.

4. There is a known constant price per unit.

5. Replenishment is made instantaneously; that is, the whole batch is delivered at once.

6. No stock outs are allowed.

Variation to the basic EOQ formula

Where replenishment is gradual

EOQ = the square route of 2 x ordering costs per order x demand per annum

Carrying cost per item per annum x (1 – demand per annum

Production rate per annum)

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EOQ where stock outs are permitted

EOQ (with stock outs) = the square route of

2 x ordering cost per order x demand per annum

Carrying cost per item per annum

Multiplied by the square route of

Carrying cost per item per annum + Stock out costs per item per annum

Stock out costs per item per annum

Inventory Control Terminology

1. Lead or procurement time: this is the period of time between ordering (either
externally or internally) and replenishment, that is when the goods are available for
use.

2. Demand: this is the amount required by sales or production and is usually expressed
as a rate of demand per week, month and year.

3. Physical stock: the number of items in stock at any given time.

4. Free stock: this is physical stock plus outstanding replenishment orders minus
unfulfilled replenishment.

5. Buffer stock or minimum stock or safety stock: this is a stock allowance to cover
errors in forecasting the lead time or the demand during the lead time.

6. Maximum stock: a stock level selected as the maximum desirable level which is used
as an indicator to show when stocks have risen to height.

7. Re-order level: the level of stock at which a further replenishment order should be
placed. The re-order level is dependant upon the lead time and the demand during the
lead time.

8. Re-order quantity: the quantity of the replenishment ordered.

9.
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Calculations

Re-order level = maximum usage x maximum lead time

Minimum level = re-order level – average usage for average lead time

Maximum level = re-order level + EOQ – minimum anticipated usage in lead time

Determining the cost of a Product or Service under a system called Absorption Costing

Absorption costing is a process whereby the cost of a product or service is determined by

adding a share of indirect cost (overheads) to the direct cost of materials, labour and direct
expenses incurred in making the product or providing the service.

Cost of Product or Service = direct materials + direct labour + direct expenses + overheads

Usually absorption costing is restricted to production cost. As a result administration

overheads and selling and distribution overheads are charged as period costs in the profit and
loss account (income statement) without being absorbed into the cost of the product or
service.

Overheads

Allocated Apportioned

Cost Centres

Absorbed into the cost of every item which passes through the cost centre

NB. Overheads can either be allocated or apportioned to the respective cost centres

A cost centre is a point within a business organization at which cost can be recorded and used
for purposes of cost control. It could be a location, a function or an item of machinery or
equipment or any combination of the items mentioned before.
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A cost centre can be a productive cost centre, for example, the drilling department, welding
department in an engineering works.

There can also be non-productive cost centres such as canteen and maintenance departments.

Cost Allocation

Cost allocation is the charging of discreet identifiable items of cost to the appropriate cost
centres.

Cost Apportionment

Cost apportionment involves the sharing of common costs between two or more cost centres
so that the costs are shared between the cost centres in a fair proportion that reflects the
relative benefit the cost centre has received from such costs.

Apportionment of the overheads of the service departments to the production cost

centres

The second stage of overhead apportionment involves the apportionment of the overheads of
the service department (non-productive cost centres) to the production cost centres. It is
necessary to have all the overheads charged to the production cost centres because it is only
the production cost centres that are directly involved in the manufacture of the units.

The overheads of the service department can be apportioned to the production cost centres
using one of the following methods:

a) The direct method

b) The step or elimination method

c) The repeated distribution or continuos allotment method

d) The linear algebra or simultaneous equation method

The direct method

This method apportions the cost of each service cost centre in turn to the production cost
centres only.
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The step or elimination method

This service cost centres are listed in an order of priority on the basis of the percentage or
there work which is done for other service cost centres. Then the cost of the cost centre at the
top of the list is apportioned between the other service cost centres and production cost
centres. Next the cost of the second service cost centre on the list are apportioned between the
remaining service cost centres and production cost centres, and so on until all service cost
centres have been apportioned.

The repeated distribution or continuos allotment method

This method apportions the cost of each service cost centre to all service and production cost
centres which make use of its services. All the cost of all the service cost centres will
eventually be apportioned to the production departments alone by a process which involves
the repetitive apportionment of overhead cost.

Linear algebra or simultaneous equation method

Overheads of the service cost centres are apportioned to the production departments by using
the solutions to simultaneous equations.

Example:

H. Limited has 2 production departments (A and B) and 2 service departments (Stores and
Maintenance). The following information relates to a recent costing period.

Total overheads dept. A dept. B Stores Maintenance

$ $ $ $ $

Overhead costs 37,000 10,030 8,970 10,000(1st) 8,000(2nd)

Cost of materials

Requisitioned 30,000 50,000 20,000 (20%)

Maintenance hrs needed 8,000 1,000 1,000(10%)

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Required:

Apportion the total overhead cost of $37,000 between the 2 production departments A and B
using:

a) The direct method

b) The step or elimination method

c) The repeated distribution or continuos allotment method

d) The linear algebra or simultaneous equation method.

Direct method

Service dept’s Basis of apportionment Total cost dept. A dept. B

$ $ $

Stores Cost of materials req. (3:5) 10,000 3,750 6,250

Maintenance Maintenance hrs (8:1) 8,000 7,111 889

Overheads of A&B Directly allocated 19,000 10,030 8,970

37,000 20,891 16,109

The step or elimination method

Dept.A Dept.B Stores Maint. Total

Overheads 10,030 8,970 10,000 8,000 37,000

Apportionment: stores

Overheads (3:5:2) 3,000 5,000 (10,000) 2,000

- 10,000

Apportionment: Maint.

Overheads (8:1) 8,889 1,111 (10,000)

21,919 15,081 - - 37,000

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The repeated distribution or continuos allotment method

Dept.A Dept.B Stores Maint.

$ $ $ $

Overheads 10,030 8,970 10,000 8,000

Apportion: stores overheads (3:5:2) 3,000 5,000 (10,000) 2,000

- 10,000

Apport: maint. overheads (8:1:1) 8,000 1,000 1,000 (10,000)

Repeat app. Stores (3:5:2) 300 500 (1,000) 200

- 200

Repeat app. Maintenance (8:1:1) 160 20 20 (200)

20 -

Repeat app. Stores (3:5:2) 6 10 (20) 4

- 4

Repeat app. Maintenance (8:1:1) 3 1 - (4)

21,499 15,501 - -

Linear algebra or simultaneous equation

Let S represent the total amount of overheads from the stores department.

Let M represent the total amount of overheads from the maintenance department.

S = 10,000 + (10% x M)

S = 10,000 + .1M (1)

M = 8,000 + (20% x S)
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M = 8,000 + .2S (2)

S - .1M = 10,000 (1)

M - .2S = 8,000 (2)

(1) X 10

10S – M = 100,000

Add Equations

10S – M = 100,000 +

-.2S + M = 8,000

9.8S = 108,000

S = 108,000 / 9.8 = 11,020.4

M = 8,000 + (.2 x 11,020.4)

M = 10,204.1

Dept.A Dept.B Total

Overheads of A and B 10,030 8,970 19,000

Apportion overheads of Stores

30% x 11,020.4 3,306.1 3,306.1

50% x 11,020.4 5,510.2 5,510.2

Apportion overheads of Maintenance

80% x 10,204.1 8,163.3 8,163.3

10% x 10,204.1 1,020.4 1,020.4

21,499.4 15,500.6 37,000

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Production Cost Centres -

Absorption of Overheads or Recovery of Overheads

Overhead Absorption or Overhead Recovery

Overhead absorption or overhead recovery is the process by which overheads are charged to
individual cost units. Overhead absorption seeks to charge each product or job with a suitable
proportion of the overheads of each department through which that product or job has passed.
If a product or job takes longer in a department it is only fair to charge that product or job
with more overheads than one which is in the department for only a short period of time.

Overheads are absorbed into cost units using a predetermined absorption rate which is
calculated as follows:

Overhead Absorption Rate (O.A.R) = Budgeted or Estimated Overheads

Budgeted or estimated level of activity used as the base to absorb overheads

The base which is chosen to calculate the overhead absorption rate is the one which most
accurately reflects the incidents of overheads in the department. For example in a department
where most overheads are machine related, then machine hours would be the most
appropriate base to absorb overheads. It is generally accepted that the time based methods
such as labour hours and machine hours are more likely to reflect the load on a cost centre.

Overheads can be absorbed into production using anyone of the following basis:

1. A percentage of direct material cost

2. A percentage of direct labour cost

3. A percentage of prime cost

4. A rate per machine hour

5. A rate per direct labour hour

6. A rate per unit

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The merits of each basis of overhead absorption

1. The percentage of direct material cost

Generally this method of absorbing overheads is unsuitable because direct material

content is not necessarily indicative of production time for example; two types of a
particular product could be identical in design, construction and production time.
However if one type uses a material input which is twice as expensive as the other
then the first type will be charged with twice as much overheads.

2. Percentage of direct labour cost

This method is frequently used and it is simple to apply. Direct wages paid are related
to time but because of varying rates paid to different personnel, piece work and bonus
systems, there is not an exact correlation between wages paid and the time which has
elapsed. If there were only one rate per hour paid throughout a cost centre and no
form of incentive scheme then the direct wage system would give identical results to
the labour hour basis but this is hardly ever the case in reality.

3. Percentage of prime cost

The same criticisms which apply to direct material cost and direct labour cost apply to
this method but to a lesser extent.

4. Rate per direct labour hour

This method is best suited to a labour intensive cost centre. The system is easy to use
as the hours taken are normally recorded for wage payment purposes. However as
production becomes increasingly mechanised this method of overhead absorption is
likely to be less appropriate.

5. A rate per machine hour

This method is most appropriate for mechanised cost centres. In such cost centres
overheads are related to machinery usage so that an absorption rate based on machine
hours reflects the occurrence of overheads in a reasonably accurate way.
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6. A rate per unit

This method has the advantage of simplicity but it is not suitable when a business
produces a range of products which are appreciably different in there cost
composition and the production time required.

Absorption Costing

Cost per unit = direct materials + direct labour + production overheads

Example:

H. Limited uses a machine hour rate of overhead recovery (overhead absorption) in its
machining department and a direct labour hour rate of recovery in its assembly department.
The budgeted overheads in the machining department and the assembly department are
$40,000 and $64,000 respectively. The following information is also provided:

Machining dept. Assembly dept.

Budgeted machine hours 10,000

Budgeted direct labour hours 25,000 25,600

A job costs $400 in direct material and $600 in direct labour. It requires 20 machine hours in
the machining department and 200 hours in the assembly department. Required; calculate the
full production cost of the job using the current basis for absorbing overheads.

Full production cost of job: using the current basis

Direct material 400

Direct labour 600

Production overheads:

Machining department: 20hrs x $4 80

Assembly department: 200hrs x $2.50 500

1,580
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Overhead absorption rate: machining dept. = $40,000 / 10,000hrs

= $4 per machine hr

Assembly dept. = $64,000 / 25,600 labour hours

= $2.50 per direct labour hr

Assuming that the company changed the absorption rate in the machining department to a
direct labour rate per hour rate of absorption and the job requires 80 direct labour hours in the
machining department; calculate the full production cost of the job.

Full production cost of job:

Direct materials 400

Direct labour 600

Production overheads:

Machining dept. 80 direct labour hrs x $1.60 128

Assembly dept. 500

1,628

O.A.R Machinery dept. = $40,000/25,000 (based on direct labour hrs) = $1.60 per direct
labour hr.

Over absorbed or Under absorbed overheads (over recovery or under recovery of

overheads)

The rate of overhead absorption is based on estimates of both the expenditure level and the
activity level for production. However in most cases the amount absorbed will not agree with
the amount which was incurred. The result will either be an over or an under absorption of
overheads. Under or over absorption of overheads will occur if:

a) Actual overhead cost or

b) Actual activity volume or

c) Both are different from the budget or estimate.

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If absorbed overheads (Absorbed overheads = Actual activity level x O.A.R) are greater than
actual overheads this results in an over absorption of overheads. An over absorption will
occur when:

a) The total overheads incurred is less than the estimate

b) The actual level of activity e.g. hrs worked, exceed the estimate.

An over absorption of overheads is credited to the profit and loss account.

If absorbed overheads are less than actual overheads this results in an under absorption of
overheads. An under absorption of overheads will occur when:

a) The total overheads include exceed the estimate

b) The actual level of activity is less than the estimate.

An under absorption of overheads is debited to the profit and loss account.

Example:

B. Limited has a budgeted production overhead expenditure of $50,000 and a budgeted

activity level of 25,000 direct labour hours. Overheads are absorbed on the basis of direct
labour hours. Required; calculate the under or over absorbed overheads and state the reasons
for the under or over absorption overheads in the following situations:

a) Actual overhead cost $47,000 and 25,000 direct labour hours are worked.

b) Actual overhead cost $50,000 and 21,500 direct labour hours are worked.

c) Actual overhead cost $47,000 and 21,500 direct labour hours are worked.

(a) Absorbed overheads 25,000 x $2 50,000

Actual overheads (47,000)

(Under) / Over absorbed overheads 3,000

O.A.R. = budgeted expenditure / budgeted level of activity = 50,000/25,000 = $2

(b) Absorbed overheads 21,500 x $2 43,000

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Actual overheads (50,000)

Under absorbed overheads (7,000)

O.A.R. = 50,000 / 25,000 = $2

(c) Absorbed overheads 21,500 x $2 43,000

Actual overheads (47,000)

Under absorbed overheads (4,000)

Over absorbed overheads are credited to the Profit and Loss account or deducted from the
cost of goods sold.

Under absorbed overheads are debited to the Profit and Loss account or added to the cost of
goods sold.

Preparation of an Income Statement under a system of absorption costing

Example:

B. Limited has provided the following information for a 3month period:

Month1$ Month2$ Month3$

Opening inventory (units) 2,000 2,000

Production (units) 12,000 10,000 8,000

Sales (units) 10,000 10,000 10,000

Fixed production costs 50,000 50,000 50,000

Selling price per unit 10 10 10

Variable production cost per unit 3 3 3

Selling and administration overheads 16,000 15,000 14,000

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Overheads are absorbed on the basis of a budgeted fixed cost of expenditure of $50,000 per
month and a normal budgeted volume of 10,000 units. Required; prepare an income
statement for each month based on a system of absorption costing.

Absorption Costing Income Statement for the period;

Month1 Month2 Month3

Sales 100,000 100,000 100,000

Less cost of sales (full prod. Cost)

Inventory at start 0 16,000 16,000

Add full prod. Cost 96,000 80,000 64,000

Cost of goods available 96,000 96,000 80,000

Less inventory at end (16,000) 80,000 (16,000) 80,000 - 80,000

Gross profit 20,000 20,000 20,000

Over/(under) absorbed overheads 10,000 0 (10,000)

Selling and administration over. (16,000) (15,000) (14,000)

Net Income/Loss 14,000 5,000 (4,000)

Cost of production = 12,000 x (3 + fixed ($5))

= 12,000 x $8

O.A.R. = $50,000 / 10,000 units

= $5 per unit

Closing inventory = 2,000 x $8 = $16,000

Absorbed overheads = actual level x O.A.R

= 12,000 x $5 = 60,000
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Actual overheads = 50,000

Over / under absorbed = 10,000

Arguments in favour of absorption costing

1. Closing inventory values, b including a share of fixed production overheads, will be

valued according to a well established accounting principle which states that all
output should contain a portion of fixed production cost.

2. It aims to evaluate the cost of sales and therefore the profits made during the period in
a manner which is consistent with the principle used to determine the value of the
closing inventory.

3. It ensures that all products are earning enough revenue to cver both variable cost and
fixed cost.

Marginal costing or Direct costing

Marginal costing can be defined as a principle whereby only variable costs are charged to
each unit produced or to the service which was provided. The fixed cost attributable to the
relevant period is written off in full against the contribution for that period.

Contribution is the difference between the selling price and the marginal cost of the item. It
represents the contribution each unit of production makes toward covering fixed costs and the
profit in that order. Contribution is therefore that part of the sales revenue which remains
after a product has paid for its marginal costs out of its selling price and which is available to
pay for fixed cost and any remaining surplus will give rise to a profit.

Marginal cost is the total of the variable cost incurred in producing one additional unit of a
good or service. It is often defined as the cost of producing one additional item and includes
direct labour, direct materials, direct expenses and the variable part of overheads.

Marginal cost = Variable cost = direct labour + direct materials + direct expenses + variable
overheads.

Marginal cost is therefore the amount, at any given level of activity by which aggregate
(total) cost are changed if the volume of activity is increased or decreased by one unit.
 27

Example continued:

Additional info on B. Limited

Selling and administration overheads;

Month1 Month2 Month3

Variable 5,000 4,000 3,000

Fixed 11,000 11,000 11,000

Contribution = sales – marginal cost (variable cost)

Marginal costing Income statement for the period;

Month1 Month2 Month3

Sales 100,000 100,000 100,000

Less variable cost:

Opening inventory 0 6,000 6,000

Add variable prod. Cost 36,000 30,000 24,000

Goods available for sale 36,000 36,000 30,000

Closing inventory (2000x3) (6,000) (6,000) 0

Cost of sales 30,000 30,000 30,000

Variable sell. & admin. Over. 5,000 (35,000) 4,000 (34,000) 3,000 (33,000)

Contribution 65,000 66,000 67,000

Less fixed costs (overheads):

Production 50,000 50,000 50,000

Selling and administration 11,000 (61,000) 11,000 (61,000) 11,000 (61,000)

Net Income / (Loss) 4,000 5,000 6,000

 28

Question

M. Limited manufactures a single product the variable cost structure which has not changed
for several years and is as follows;

Selling price per unit 20

Variable cost per unit:

Direct materials 3

Direct labour 8

Direct production expense 3

Direct selling expenses 1 15

Normal production level is 180,000 units per annum.

Fixed production overheads $108,000 per annum

Fixed selling and administration expenses $75,000 per annum

Unit production and sales for the past 2 years have been:

Year ended 30th April 2002 2003

Units units

Opening inventory 40,000 20,000

Production 190,000 160,000

Sales (210,000) (150,000)

Closing inventory 20,000 30,000

You may assume that fixed cost have remained constant for several years. Required; prepare
income statements for years ended 30th April 2002 and 2003 using firstly the marginal costing
method and secondly the absorption costing method.
 29

M. Limited

Marginal costing Income statement for years ended

30th April 2002 30th April 2003

$000 $000 $000 $000

Sales 4,200 3,000

Less variable cost

Opening inventory 560 280

Variable production cost 2,660 2,240

Cost of goods available 3,220 2,520

Closing inventory (280) (420)

Cost of goods sold 2,940 2,100

Direct selling expenses 210 3,150 150 2,250

Contribution 1,050 750

Less fixed production expenses 108 108

Less fixed selling expenses 75 (183) 75 (183)

Net Income / Loss 867 567

 30

M. Limited

Absorption costing Income statement for the year ended

30th April 2002 30th April 2003

$000 $000 $000 $000

Sales 4,200 3,000

Opening inventory 584 292

Production cost 2,774 2,336

Cost of goods available 3,358 2,628

Closing inventory (292) (438)

Cost of goods sold (3,066) (2,190)

Gross profit 1,134 810

Over / (Under) absorbed overheads 6 (12)

1,140 798

Less direct selling expenses 210 150

Fixed selling and admin. Expenses 75 (285) 75 (225)

Net Income / (loss) 855 573

(b) Give figures to reconcile the differences in operating income for both years between the 2
methods.
 31

Statement to Reconcile Differences in operating income for years

30th April 2002 30th April 2003

$000 $000

Net income under absorption costing 855 573

Add: Fixed production overheads absorbed in opening

Inventory 40,000 x $0.60 20,000 x $0.60 24 12

Less: Fixed production overheads absorbed in closing

Inventory 20,000 x $0.60 30,000 x $0.60 (12) (18)

Net income under marginal costing 867 567

Arguments in favour of Marginal Costing

1. Marginal costing shows in clear and simple terms the exact relationship between cost,
selling price and volume.

2. There is no apportionment of fixed cost to products. Apportionment of fixed cost is

frequently done on an arbitrary basis since most fixed costs are indivisible by there
nature.

3. Where sales are constant but production fluctuates, marginal costing shows a constant
net income where as absorption costing shows variable amounts of income.

4. Under / over absorption of overheads is avoided. The usual reason for under / over
absorption is the inclusion of fixed cost into overhead absorption rates and the level of
activity being different to that which was planned.

5. Fixed costs are incurred on a time basis and do not relate to activity. Therefore it is
logical to write them off in the period in which they were incurred as is done under
the Marginal costing system.

6. It shows the relative contributions to profit which are made by each product and
shows where the sales effort should be concentrated and discloses how the greatest
overall profit can be made.
 32

7. By separating the fixed and variable cost, marginal costing provides a means of
controlling production and selling cost and the volume and mixture of sales.

Job Costing

Job costing is that form of specific order costing which applies where work is undertaken to
customers’ special requirement and each order is of comparitably short duration.

The work is usually carried out within a factory or workshop and moved through processes
and operations as a continuos identifiable unit. The term may also be applied to work such as
property repairs and the costing of capital expenditure jobs.

It relates to a costing system that is required in organizations where each or batch of output or
service is unique. This creates the need for the cost of each unit to be calculated separately.
Job costing systems are used in industries that provide customised products or services. For
example; accounting firms provide customised services to clients which each client requiring
services that consume different quantities of resources. In all of these organizations cost must
be traced to each individual customers order.

Pre-requisites for Job Costing

The main purposes for job costing are to establish the profit or loss on each job and to
provide a valuation of work in progress. To do this a considerable amount of clerical work is
needed and to ensure an effective and workable system the following factors are necessary:

a) A sound system of production control.

b) Comprehensive works documentation such as bills of materials, work orders etc.

c) An appropriate time booking system using either time sheets or piece work tickets.

d) A well organised basis to the costing system with clearly defined cost centres, good
labour analysis, appropriate overhead absorption rates an a relevant materials issue
pricing system.
 33

Flow of Cost in a Job Costing System

1)
Manufacturing Costs 
 Raw materials
 Factory Labour
 Manufacturing overheads Assigned to
 
 
 

2)
Work in Progress inventory 
 
 
 
 xxxx Completed
 
 

3)

 Finished Goods Inventory

 
 
 
 xxxx Sold
 
 
4)

Cost of Goods Sold 

 
 
 
 xxxx
 
 

Job Order Cost Accounting
 Transaction
 Direct labour required / incurred
 Indirect labour
 Payment of actual labour cost
Factory overheads applied
Factory supplies
Direct materials
Purchase of materials
Cost of jobs completed
Cost of goods sold
Overheads incurred
Overheads under applied
Overheads over-applied
Raw Materials Inventory
 Purchases of materials:
  Direct
  Indirect (factory supplies)
34
 Accounting Entries
Debit work in progress
Credit factory payroll or factory labour
Debit factory overhead
Credit factory payroll or factory labour
Debit factory payroll or factory labour
Credit cash or bank
Debit work in progress
Credit factory overheads
Debit factory overheads
Credit materials inventory
Debit work in progress
Credit materials inventory
Debit materials inventory
Credit creditors or cash or bank
Debit finished goods inventory
Credit work in progress
Debit cost of goods sold
Credit finished goods inventory
Debit factory overheads
Credit accruals or cash or bank
Debit income statement
Credit factory overheads
Debit factory overheads
Credit income statement
 
Materials used:
Direct
Indirect
 35

Factory Labour or Factory Payroll 

 Factory labour incurred Factory labour used:
  Direct
  Indirect
 
 
 

 Manufacturing Overheads or Factory Overheads

 Actual overheads incurred Overheads applied
 e.g. Depreciation insurance etc
 Indirect Materials
 Indirect labour used
 Overheads over applied Overheads under-applied
 (difference) or (difference)

Work in Progress Inventory 

 Direct materials used Cost of completed jobs
 Direct labour used
 Overheads applied
 
 
 

Finished Goods Inventory 

 Cost of goods completed Cost of goods sold
 
 
 
 
 

Cost of goods sold 

 Cost of goods sold
 
 
 
 
 
 36

Process Costing

This is a form of operating costing used where production follows a series of sequential
processes. It is used by firms having a continuos flow of identical products where it is not
possible to distinguish one unit from another. Process costing is used to ascertain the cost of
the product at each process operation / stage of manufacturing. The processes are carried on
and may have one or more of the following features:-

- Where the product is produced in a single process

- Where the product of one process becomes the material input of the subsequent
process.

- Where there is simultaneous production at one or more processes of different products

with / without by products.

- Where during one or more processes / operations of a series the products of materials
are not distinguishable from one another.

An account is kept for each process where the materials, labour and overheads that relate to
the process are debited to the account. Materials modified at the 1st stage of the process are
past on to the subsequent process and becomes the input material for that process.

An account is kept for each process where the materials, labour and overheads that relate to
the process are debited to the account. Materials modified at the first stage of the process are
passed on to the subsequent process and becomes the input material for that process.

Example:

Recording costs

Process 1 Process 2

Direct materials 10,000 15,000

Direct labour 12,000 18,000

Overheads 3,600 5,400

Production system consists of two processes

 37

Total number of units 20,000

Required: calculate the cost of each unit

 Process 1 Account
 Direct materials  10,000  Balance transferred to  
 Conversion costs:    Process 2  25,600
 Direct labour  12,000    
 Overheads  3,600    
   25,600    25,600
       
       

 Process 2 Account
 Input materials from    Transferred to finished  
 Process 1  25,600  goods  64,000
 Added materials  15,000    
 Direct labour  18,000    
 Overheads  5,400    
   64,000    64,000
       

 Finished Goods Account

 Process account  64,000    
       
       
Cost of each unit = $64,000 / 20,000 units

= $3.20

Process Losses

In many forms of production the quantity, weight or volume of the process output will be less
than the quantity, weight or volume of the materials input. This may be due to reasons such
as evaporation, unavoidable handling, breakage and spoilage and the withdrawal of samples
for testing and inspection. If losses are in accordance with normal practice that is at standard
levels they are referred to as normal process losses. If the losses are above expectation they
are known as abnormal process losses.
 38

Normal Process Losses

Normal process losses are unavoidable losses arising from the nature of the production
process and these costs of such losses are included as part of the cost of the goods which are
produced.

Abnormal Process Losses

Abnormal losses are those losses above the level that is deemed to be the normal loss rate for
the process. Abnormal losses cannot be foreseen and are due to such factors as plant
breakdowns, industrial accidents or defects in materials etc. When unexpectedly favourable
results occur which result in actual losses being lower than the normal loss rate such a
situation gives rise to an abnormal gain.

Abnormal loss or (gain) = Actual loss – Normal loss

Example:

A manufacturing process has a normal wastage of 5% which can be sold as scrap at $5 per
ton. In a given period the following information was recorded.

Input materials 160 tons at $23 per ton

Labour and overheads $2,896

Required prepare the process account and show the other relevant accounts in the following
circumstances:

1. Losses were at the normal level

2. Actual production output was 148 tons

3. Actual production output was 155 tons

 39

1.

Process Account 
   tons  $    tons  $
 Material  160  3,680  Good production  152  6,536
 Labour and overheads    2,896  Normal losses  8  40
   160  6,576    160  6,576
           
           

 Scrap Account
     $      $
1. Process a/c    40      
2. Abnormal loss    20      
           
           
           

2.

Process Account 
   tons  $    tons  $
 Material  160  3,680  Good production  148  6,364
 Labour and overheads    2,896  Normal losses  8  40
       Abnormal losses  4  172
   160  6,576    160  6,576
           

Abnormal loss or (abnormal gain) = Actual loss – normal loss

= (160 – 148) – 8

= 12 – 8

Abnormal loss = 4 tons

 40

Abnormal loss account 

     $      $
 Process a/c    172  Scrap    20
       Profit and Loss a/c    152
     172      172
           
           
152 good production = 6,536

1 = 6,536 / 152

= $43

3.

Process Account 
   tons  $    tons  $
 Materials  160  3,680  Good production  155  
 Labour and overheads    2,896  Normal losses  8  40
 Abnormal gain  3  129      
           
           

Abnormal Gain 
     $      $
       Process account    129
           
           
           
           
The concept of Equivalent units

At the end of any given period there are likely to be units which are partly complete. To be
able to spread cost equitably over partially finished goods and fully completed units the
concept of equivalent units is used. The number of equivalent units, for cost calculation
purposes, is the number of equivalent fully complete units which the partially complete units
represent. For example, if for a given period production was 2,200 fully completed units and
600 partially complete units which were deemed to be 75% complete. The total equivalent
production is calculated as follows.
 41

Total equivalent units = completed units + (percentage complete for partially complete units
x number of units which are partially complete)

= 2,200 + (75% x 600)

= 2,200 + 450

= 2,650

Cost per unit = total cost / total equivalent production

Sometimes the overall estimate of completion is not possible and it becomes necessary to
consider the % completion of each of the cost elements to consider the % completion for each
of the cost elements namely materials, labour and overheads. The same principles are used to
calculate equivalent units but each cost element must be treated separately and then the cost
per unit of each element is added to give the cost of a complete unit.

Example: the production and cost data for a given period was as follows:

Materials $5,115

Labour $3,952

Overheads $3,000

Total cost $12,067

Production was 1,400 fully completed units and 200 partially complete units. The degree of
completion of the 200 units was as follows:

Materials 75% complete

Labour 60% complete

Overheads 50% complete

Required, calculate;

a) The total equivalent production

b) The cost per complete unit

 42

c) The value of the 200 partially completed units (work in progress) W.I.P

Cost element Fully completed units + Equiv. units in W.I.P = Total equiv. production

Material 1,400 + (75% x 200) = 150 = 1,550

Labour 1,400 + (60% x 120) = 120 = 1,520

Overheads 1,400 + (50% x 100) = 100 = 1,500

Total cost Cost per unit

5,115 5,115 / 1,550 = 3.3

3,952 3,952 / 1,520 = 2.6

3,000 3,000 / 1,500 = 2

12,067 7.9

Cost of complete unit = $7.90

Value of W.I.P

Method 1: Total cost 12,067

Less cost of completed units 11,060

Value of W.I.P 1,007

Value of completed units = no. of completed units x cost of each completed unit

=1,400 x 7.9

= $11,060

Method 2:
 43

Cost element Equiv. units in W.I.P Cost per unit Value of W.I.P

Materials 150 3.3 495

Labour 120 2.6 312

Overheads 100 2 200

1,007

Opening Work in Progress

In most practical situations there are values for both opening and closing W.I.P and in such
cases the problem arises of how to value the closing W.I.P and the completed units which
were transferred out. There are two approaches to this problem:

1. The F.I.F.O method of valuation: under this method it is assumed that units are dealt
with on a F.I.F.O basis so that it is assumed that the first work done in a period is the
completion of the opening work in progress. The effect of this is that the closing work in
progress is valued at current period cost. Part of the previous periods cost brought
forward in the opening W.I.P valuation and some of the current periods cost comprised
the cost of the completed units.

2. Average Cost of valuation: under this method an average unit cost is calculated using
the total of the opening W.I.P valuation plus the current period cost. The effect of this is
that both closing W.I.P and the completed units are valued using the same average unit
cost. This means that the previous periods cost influence the closing W.I.P valuation
which is carried forward to the next accounting period.

Example: A company has 2 processes. Material is introduced at the beginning of the

process in department A, and additional material is added at the end of the process in
department B. Conversion cost are applied uniformly throughout both processes. As the
process in department A is completed, goods are immediately transferred to department B;
as goods are completed in department B, they are transferred to finished goods. Data for the
month of March include the following:

Dept A Dept B
 44

W.I.P at beginning 10,000 units 12,000 units

(2/5 converted $7,500 (2/3 converted $21,000

Materials $6,000 Transferred in costs $9,800;

Conversion costs $1,500) Conversion costs $11,200)

Units completed during March 48,000 44,000

Units started during March 40,000

W.I.P at end 2,000 (1/2 converted) 16,000 (3/8 converted)

Material cost added during March 22,000 13,200

Conversion costs add. during Mar. 18,000 63,000

Required: compute the cost of goods transferred out of each department and the ending
inventory cost for goods remaining in each department (W.I.P). Assuming:

a) The F.I.F.O of valuation is used

b) The AVCO is used

F.I.F.O basis of valuation

 45

Dept. A

Equivalent Units

Quantities Physical flow Materials Conversion costs

W.I.P at start 10,000 (2/5)

Units at start 40,000

Units to account for 50,000

Units completed at end

transferred out during

current period 48,000 48,000 48,000

Add W.I.P at close 2,000 (1/2) 2,000 (1/2 x 2000) 1,000

Units accounted for 50,000

Less equivalent units in

Opening W.I.P 10,000 (2/5) (10,000) (4,000)

Total equivalent units 40,000 45,000

Total Equivalent Production under F.I.FO = Completed units + Equivalent units in

closing W.I.P – Equivalent units in opening W.I.P

Total Cost Equivalent units Unit Cost

 46

Work in progress at start 7,500

Current costs;

Materials 22,000 40,000 $0.55

Conversion costs 18,000 45,000 $0.40

Total cost to account for 47,500

Work in progress at end

Materials 2,000 units x $0.55 1,100

Conversion costs

(2,000 units x 50% x $0.40) 400 1,500

Completed units (47,500 – 1,500) 46,000

Total cost accounted for 47,500

Process Account 
 W.I.P at start 7,500  Completed units  46,000 
 Materials 22,000   W.I.P at close 1,500 
 Conversion costs 18,000     
   47,500    47,500
       

AVCO Total Equivalent units = Completed units + Equivalent units in closing W.I.P

AVCO
 47

Dept. A

Equivalent units

Physical flow Materials Conversion costs

W.I.P at start 10,000

Units started 40,000

Units to account for 50,000

Units completed 48,000 48,000 48,000

W.I.P at end (2,000 units) 2,000

Materials 2,000

Conversion costs (2,000 x ½) 1,000

50,000

Total equivalent units 50,000 49,000

W.I.P at start Current cost Total cost Total Equi. Cost Avg. unit cost

Materials 6,000 $22,000 28,000 50,000 $0.560

Conv. Cost 1,500 $18,000 19,500 49,000 $0.398

7,500 40,000 47,500 $0.958

Cost of completed units

48,000 x $0.958 = 45,984

Cost of W.I.P at end

 48

Materials 2,000 x $0.560 = 1,120

Conversion costs 2,000 x ½ x $0.398 = 398

= 1,518

FIFO Dept. B

Equivalent units

Physical flow Transferred in costs Materials Conv. Costs

W.I.P at start 12,000 (2/3)

Units transferred in 48,000

Units to account for 60,000

Units completed 44,000 44,000 44,000 44,000

W.I.P at end 16,000 (3/8) 16,000 6,000

Less W.I.P at start

(12,000 2/3) (12,000) (8,000)

Units accounted for 60,000

Total equivalent units 48,000 44,000 42,000

Total cost Equivalent units Unit costs

 49

W.I.P at start 21,000

Current costs;

Transferred in costs 46,000 48,000 $0.95833

Materials 13,200 44,000 $0.30

Conversion costs 63,000 42,000 $1.50

Total cost to account for 143,200 $2.75833

W.I.P at close

Transferred in cost 16,000 x 0.95833 15,333

Materials

Conversion costs 16,000 x 3/8 x 1.50 9,000 24,333

Completed units (143,200 – 24,333) 118,867

Total cost accounted for 143,200

Activity Based Costing

With the advent of advanced manufacturing technology overheads are likely to be far more
important and direct labour may account for a very small portion of a products costs. The
accessibility of information now allows for more sophisticated overhead allocation methods
than were previously used.

The Traditional Costing Method

 50

The cost of more resources that are used in proportion to the number of units produced of a
particular product. Such resources include direct labour, materials and machine related cost
such as power and lubricants. Many resources, however, are used in non-volume related
support activities such as cost associated with setting up production scheduling, inspection
and data processing.

These support activities assist the efficient manufacture of products and are not affected by
changes in production volume. They tend to vary in the long run according to the range and
complexity of the products manufactured rather than the volume of output. Traditional
costing systems which assume that all products consume all resources in proportion to their
production volumes tend to allocate to great a proportion of overheads to high volume
products and to small a proportion of overhead to low volume product.

Activity based costing attempts to overcome this problem. The major ideas behind activity
based costing are as follows:

1. Activities cause cost

2. Producing products creates a demand for the activities. Activities include ordering,
materials handling, machining, assembly, production scheduling and dispatching.

3. Cost to assign to a product or the basis of the products consumption of the activities.

Outline of an Activity Based Costing System

Activity based costing system operates as follows:

1. Identification of an organizations major activities.

2. Identification of the factors which determine the size of the cost of an activity or
call the cost of an activity. These are known as cost drivers. A cost driver is
therefore a factor which causes the cost of an activity. Typical cost drivers for
particular activities within the organization are as follows:

Activity Cost Driver

Ordering Number of orders

Materials handling Number of production runs

 51

Production scheduling Number of production runs

Dispatching Number of dispatches

For those cost that vary with production levels in the short term, activity based
costing uses volume related cost drivers such as labour or machine hours.

3. Collection of the cost of each activity into cost pools. A cost pool is the grouping
of all cost associated with the same activity or the same cost driver.

4. Charge support overheads to the products or the basis of their usage of the
activity. A product usage of an activity is measured by the number or the activities
cost driver that it generates.

Example:

C. Limited manufactures 4 products namely W, X, Y,Z. output and cost data for the period just
ended are as follows:

Product Output units No. of Material cost Direct labour Machine

production per unit hours per hours per
runs in the unit unit
period

W 10 2 20 1 1

X 10 2 80 3 3

Y 100 5 20 1 1

Z 100 5 80 3 3

14

Direct labour cost per hour is 5hrs

 52

Overhead costs are as follows:

Short run variable cost $3,080

Set up cost $10,920

Expenditing and scheduling cost $90,100

Materials handling cost $7,700

Total $30,800

The company uses an activity based costing system where the number of production runs is
the cost driver for set up cost expenditing and scheduling cost and materials handling cost.
Machine hours are the cost drivers for short run variable cost. Required, calculate the
product cost using an activity based costing system.

Calculation of product cost

W X Y Z Total

Direct materials 200 800 2,000 8,000 11,000

Direct labour 50 150 500 1,800 2,200

Short run variable 70 210 700 2,100 3,080

Set up cost 1,560 1,560 3,900 3,900 10,920

Expenditure and 1,300 800 3,250 3,250 90,100

scheduling cost

Materials 1,100 1,100 2,750 2,750 7,700

handling cost

4,280 5,120 13,100 21,800 44,000

Activity Cost Driver Rate = $7 / machine hrs

 53

Short run var. cost Machine hrs 3,080 / 440

Production Machine hrs Total Production

W 10 1 10

X 10 3 30

Y 100 1 100

Z 100 3 300

440

Expenditure scheduling costs 90,100 / 14 = 650

Materials handling cost 7,700 / 14 = 550

Cost per unit 4,280 5,120 13,100 21,500

10 10 100 100

= 428 512 131 215

Comparison between activity based costing system and traditional costing systems

Activity based costing and absorption costing are similar in many respects. Both systems
adopt the two stage allocation process. In the first stage traditional costing systems allocate
overheads to production departments which are called cost centres. ABC systems assign
overheads to each major activity called cost pools. In addition with ABC systems many
activity based cost pools are established whereas with traditional systems overheads tend to
be pooled by departments which can result in extensive reapportionments of service.
Traditional systems therefore tend to use fewer cost centres than ABC uses cost pools. ABC
establishes separate cost pools for support activities such as dispatching and as the cost of
there activities are assigned directly to products through cost driver rates, reapportionment of
service department cost is avoided.

The principal difference between the two systems however, lies in the manner in which
overheads are absorbed into the products. Absorption costing usually uses two absorption
 54

basis namely labour hours and or machine hours to charge overheads to products. However
ABC uses many cost drivers as absorption basis. Therefore absorption rate under ABC should
be more closely linked to the causes of overhead cost and hence produce more realistic
production cost.

The merits of activity based costing

1. The system has the appeal of simplicity since once the implication has been obtained
it is similar to traditional absorption costing.

2. ABC focuses attention on the nature of cost behaviour and attempts to provide
meaningful product cost especially in a manufacturing environment where overhead
cost are a significant proportion of total cost.

3. Activity based costing is more meaningful since it is only this costing system which
recognises transaction based overhead cost that arise out of diversity and complexity
of operations. ABC uses multiple cost drivers to allocate overheads to activities and
then to products and do not use meaningless direct labour hour recovery rate or
machine hour recovery rate that associates overhead cost with volume of activity
only.

4. Activity based costing is broader in its outlook and impact. The complexity of
manufacturing has increased with wider product ranges, shorter product life cycles, a
greater importance being attached to quality and more complexed production
processes. ABC recognises this by employing multiple cost drivers.

5. ABC gives a meaningful analysis of cost which should provide a suitable basis for
product performance measurement in a competitive modern manufacturing
environment.

6. ABC is concerned with all overhead cost including non-factory floor activities and
therefore takes cost accounting beyond its traditional factory floor boundaries. Non-
factory floor activities include product design, planning and customer service.

Service Sector Costing

 55

Service organizations do not make or sell tangible goods. Service costing differs from the
other costing methods for a number of reasons;

1. In many services the cost of direct materials consumed will be relatively small
compared to the labour, direct expenses and overhead cost. This is in contrast to
product costing where direct materials are often a greater proportion of the total cost.

2. The output of most service organizations is difficult to define and hence a unit cost is
difficult to calculate.

3. The service industry includes such a wide range of organizations which provide such
a diverse range of services and have such different cost structures that costing will
vary considerably from one to another.

In service costing it is difficult to define a realistic cost unit that represents a suitable
measure of the service which is provided. Frequently a composite cost unit may be
deemed more appropriate if the service is a function of two activity variable. For
example; hotels may use the “occupied bed night” as an appropriate unit for cost
ascertainment and cost control. The following are the typical cost units which are used by
companies operating in a service industry.

Service Cost units

1. Road, rail and transport services Passenger per mile or kilometre, ton per
mile or per kilometre

2. Hotels Occupied bed night

3. Education Full time students

4. Hospitals Patients

5. Catering establishment Meals served

Each organization will need to ascertain the cost unit which is most appropriate to its
activities. If a number of organizations within an industry use a common cost unit, valuable
comparisons can be made between similar establishments. Whatever cost unit is decided
upon the calculation of a cost per unit is calculated as follows;
 56

Cost per unit = Total cost for the period

No. of service units in the period

The difficulties of costing businesses in the service sector means that attention should be
focused on other measures rather than the traditional cost per unit approach. Attention may be
given to the following areas;

1. Competitive performance

2. Financial performance

3. The quality of service

4. Flexibility which deals with the speed of delivery, response to customer specifications
and the ability to cope with fluctuation in demand

5. Resource utilization

6. Innovation

Module 3

Standard Costing

Standard costing is a method of ascertaining costs whereby statistics are prepared to show:

1. The standard cost

2. The actual cost

3. The difference between the standard cost and the actual cost which is termed the
variance.

When the actual results are better than expected the result is a favourable variance which is
indicated by writing F (capital F) after the variance. When actual results are worse than
expected the result is an adverse variance which is indicated by writing A (capital A) or
unfavourable U (capital U).

A standard cost is defined as a predetermined calculation of how much costs should be under
specified working conditions. Its main purposes are
 57

1. To provide bases for control through variance accounting.

2. For the valuation of inventory and work in progress.

3. For the fixing of selling prices.

They are therefore predetermined or forecast estimates of cost to manufacture a single unit or
a number of units of a product during a specific future period. They are used as a measure
with which the actual cost, as ascertained, maybe compared.

Costing and Educational Establishment

A university offers a range of degree courses the university organization structure consists of
3 facilities each with a number of teaching departments. In addition there is a university
administrative management function and a central service function. The following cost
information is available for the year ended 30th June 2003.

1) Occupancy cost totalling 1.5 billion dollars. Such cost are apportioned on the basis of
floor area used which is as follows;

Department Square metres

Facilities 7,500

Teaching departments 20,000

Administrative – management 7,000

Central services 3,000

2) Administrative – management cost:

Direct cost 1.775 million

Indirect cost; an apportionment of occupancy cost. Direct and indirect costs are
charged to degree courses on a percentage basis.

3) Facility cost:

Direct cost $700,000

 58

Indirect cost; apportionment of occupancy cost and central services cost. Direct and
indirect costs are charged to the teaching department.

4) Teaching departments:

Direct cost $525,000

Indirect cost; an apportionment of occupancy cost and central service cost and all
facility cost. Direct and indirect costs are charged to degree courses on a percentage
basis.

5) Central services:

Direct cost $1,000,000

Indirect cost; an apportionment of occupancy cost. Direct and indirect cost central
services have in previous years appeared charged to users on a percentage basis for
the year ended 30th June 2003. The apportionment of central services cost is to be
recalculated in a manner which recognises the cost savings achieved by using the
central services facilities instead of using external service companies.

This is to be done by apportioning the overall savings to user areas in proportion to

their share of the estimated external cost of service provision are as follows:

Teaching department 800,000

Faculties 240,000

Degree courses, business studies 32,000

Mechanical engineering 48,000

Catering studies 32,000

All other degrees 448,000

Total 1.6 million

Additional data relating to the degree courses

 59

Degree courses

Business Studies Mechanical Catering Studies

Engineering

No. of graduates 80 50 120

Apportioned costs 3% 2.5% 7%

(as % of totals)
Teaching dept.

Administrative 2.5% 5% 4%
management

Central services are to be apportioned as indicated in section 5 above. The total

number of undergraduates from the university in the year 30th June 2003 was 25,000
students.

Required;

(a) Calculate the average cost per undergraduate for the year ended 30th June 2003

(b) Calculate the average cost per undergraduate for each of the degrees in business
studies, mechanical engineering and catering studies showing all relevant cost
analysis.

Calculation of average cost per undergraduate student.

(a)

Total cost from the university $

Occupancy 1,500,000

Administration – management 1,775,000

Faculty 700,000
 60

Teaching department 5,525,000

Central services 1,000,000

10,500,000

Total no. of undergraduate students = 2,500

Cost per undergraduate = 10,500,000 / 2,500

= $4,200

(b) Cost per undergraduate for the following specified courses

Business studies Mechanical Eng. Catering

Teaching dept. cost 241,590 201,325 503,710

Administrative – management 51,375 102,750 82,200

Central services – costs 22,400 33,600 22,400

315,365 337,675 668,310

Number of students 80 50 120

Cost per student 315,365 337,675 668,310

80 50 120

= $3,942 $6,754 $5,569

Teaching department cost

Direct cost 5,525,000

Occupancy costs 800,000

Central services cost 560,000

Faculty cost

Central services costs

 61

Direct cost 1,000,000

Occupancy cost 1,500,000 x 3,000 = 120,000

37,500 1,120,000

1,120,000 x 800

1,600

= 560,000

Faculty cost

Direct cost 700,000

Occupancy cost 300,000

Central services 168,000

1,168,000

Central services cost

Direct cost 1,000,000

Occupancy cost 1,500,000 x 3,000 = 120,000 x 240 = 168,000

37,500 1,120,000 1,600

Administrative – management costs

Direct cost 1,775,000

Occupancy cost apportioned 1,500,000 x 7,000 = 280,000

37,500
 62

Total Profit Variance

Sales Variance Variable cost Fixed Production

Variance Overhead Variance

Sales Price Sales Volume Total Direct Total Direct Total Fixed Production Fixed Production
Variance Variance Materials Labour Cost Variable Overhead Overhead
Variance Variance Production Expenditure Volume Variance
Overhead Variance
Variance

Direct Direct Direct Direct Variable Variable

Materials Materials Labour Labour Production Production
Price Usage Rate Efficiency Overhead Overhead
Variance Variance Variance Variance Expenditure Efficiency
Variance Variance

Efficiency Idle Time

Variance in Variance
active hours
Worked

Total Direct Materials Variance

The difference between the standard direct material cost of the actual production volume and
the actual cost of direct materials.

Total direct materials Cost Variance = (Actual Production x Standard Quantity x Standard
Direct Material Cost per unit) – (Actual Production Quantity x Actual Direct Material Cost
per unit)
 63

The Direct Materials Price Variance is the difference between the standard price and the
actual price for the actual quantity of direct materials. It can be calculated either at the time of
purchase or at the time of usage. Usually it is calculated at the time of purchase.

Direct materials Price Variance = (Standard Price – Actual Price) x (Actual quantity of
materials

Or

= (Standard Price x Actual Quantity) – (Actual Price x Actual Quantity)

Direct Materials Usage Variance

Direct materials usage variance represents the difference between the standard quantity of
materials specified for the actual production volume and the actual quantity used value at the
standard price per unit.

Direct Materials Usage Variance = (Standard Quantity of materials – Actual Quantity of

materials) x Standard Price

Or

= (Standard Quantity x Standard Price) – (Actual Quantity x Standard Price)

Example:

A product has a standard direct material cost of 5kg at $2.00 per kg. During the month 100
units of the product were manufactured using 520kg of materials which cost $1,025.

Required; Calculate:

a) The total direct materials total variance

b) Materials price variance

c) Direct materials usage variance

 64

a) Total direct materials variance = (100 units x standard 5kg x $2) – actual $1,025

= 1,000 – 1,025

= $25 (A)

b) Material price variance = (std. price – act. Price) x AQ

= (std. price x AQ) – (act. Price x AQ)

= ($2 x 520kg) - $1,025

= $1,040 - $1,025

= $15 (F)

c) Materials usage variance = (std. qty – act. Qty) x std price

= (100 units x 5kg)

= (500kg – 520) x $2

= 20 x 2

= $40 A

Price 15 F

Usage 40 A

25 A

Direct Labour Total Variance

The direct labour total variance is the difference between the standard direct labour cost and
the actual direct labour cost incurred for the actual production which was achieved.

Total Direct Labour Cost Variance = (Standard Direct Labour cost per unit – Actual Direct
Labour cost per unit) x Actual Quantity Production

Or
 65

(Standard Direct Labour cost per unit x Actual Quantity) – (Actual Direct Labour cost per
unit x Actual Quantity)

Direct Labour Rate Variance

This is the difference between the standard and the actual direct labour rate per hour for the
total hours worked.

Direct Labour Rate Variance = (Standard Rate – Actual Rate) x Actual Hours

Or

= (Standard Rate x Actual Hours) – (Actual Rate x Actual Hours)

Direct Labour Efficiency Variance

The direct labour efficiency variance represents the difference between the standard hours for
the actual production achieved and the hours actually worked valued at the standard labour
rate.

Direct Labour Efficiency Variance = (Standard Hours – Actual Hours) x Standard Rate

Or

= (Standard Hours x Standard Rate) – (Actual Hours x Standard Rate)

Example:

The standard direct labour cost of a product is 4hrs of labour at $3.00 per hr. During the
month 200 units of the product were made and the direct labour cost was $2,440 for 785hrs of
work. Required; Calculate:

a) The total direct labour cost variance

b) The direct labour rate variance

c) The direct labour efficiency (productivity) variance

 66

a) ($12 x 200) - $2,440

$2,400 - $2,440

= 40 A

b) ($3 x 785) - $2,440

$2,355 - $2,440

= 85 A

c) (4hrs x 200) – 785) x $3

15hrs x $3 = 45 F

Idle Time Variance

Idle time may be caused by machine breakdowns, bottle necks in production, shortage of
orders from customers etc. When idle time occurs the labour force is still paid wages for time
at work although no production actually takes place. Time paid for without any work done is
unproductive and therefore inefficient. As a result the idle time variance is always an adverse
variance. The idle time variance is calculated as follows:

Idle Time Variance = Hours Idle x Standard Rate per hour

Example:

The direct labour cost of a product is 3hrs of labour at $2.50 per hr. During the month 300
units of the product were made and the labour cost was $2,200 for 910hrs. During the month
there was a machine breakdown and 40hrs were recorded as idle time. Required;

a) The direct labour total cost variance

b) The direct labour rate variance

c) The idle time variance

d) The direct labour efficiency variance

 67

a) (300 units x 3hrs x $2.50) - $2,200

2,250 – 2,200

= 50 F

b) ($2.50 x 910hrs) – 2,200

2,275 – 2,200

= 75 F

c) 40hrs x $2.50

= 100 A

d) (300 units x 3hrs – [910 – 40]) x $2.50

(900 – 870) x 2.50

30 x 2.50

= 75 F

Variable Production Overhead Variances

Variable production overheads are indirect production costs that are usually assumed to vary
with the labour hours worked.

The total variable production overhead variance is the difference between the standard
variable production overhead cost of actual output and the actual variable production
overhead cost of actual output.

Total variable production overhead variance = (Standard variable overhead cost per unit x
Actual output) – (Actual variable overhead cost per unit x Actual Output)

Variable Overhead Expenditure Variance

This is the difference between the standard variable overhead cost per hour for the actual
labour hours and the actual variable overhead cost. Actual hours do not include idle hours.
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Variable Overhead Expenditure Variance = (Standard variable overhead cost per unit –
Actual variable overhead cost per unit) x Actual hours

Or

= (Standard variable overhead cost per hour x Actual hours) – (Actual variable overhead cost
per hour x Actual hours)

Variable Overhead Efficiency Variance

The variable overhead efficiency variance represents the standard labour hours and the actual
labour hours valued at the standard variable overhead cost per hour.

Variable Overhead Efficiency Variance = (Standard hours – Actual labour hours) x

Standard variable overhead cost per hour

Or

= (Standard labour hours x Standard variable overhead cost per unit) – (Actual hours x
Standard variable overhead cost per hour

Example;

The variable production overhead cost of a product is 2hrs at $1.50 per hr. During the month
400 units of the product were made. The labour force worked 820hrs of which 60hrs were
recorded as idle time. The actual variable overhead cost was $1,230. Required;

a) The total variable overhead cost variance

b) The variable overhead expenditure variance

c) The variable overhead efficiency variance

Total variable production overhead variance = (Standard variable overhead cost per unit x
Actual output) – (Actual variable overhead cost per unit x Actual Output)

a) $3 x 400 units - $1,230

 69

1,200 – 1,230

= 30 A

Variable Overhead Expenditure Variance = (Standard variable overhead cost per unit –
Actual variable overhead cost per unit) x Actual hours

Or

= (Standard variable overhead cost per hour x Actual hours) – (Actual variable overhead cost
per hour x Actual hours)

b) $1.50 x (820 – 60) - $1,230

$1.50 x 760 - $1,230

$1,140 - $1,230

= 90 A

Variable Overhead Efficiency Variance = (Standard hours – Actual labour hours) x

Standard variable overhead cost per hour

Or

= (Standard labour hours x Standard variable overhead cost per unit) – (Actual hours x
Standard variable overhead cost per hour

c) (400 units x 2hrs) – 760 x 1.50

800 – 760 x 1.50

40 x 1.50

= 60 F

Fixed Production Overhead Variance

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The total fixed production overhead cost variance is the total under or over absorbed fixed
production overhead in the period. It is calculated as the standard fixed overheads for actual
production and the actual fixed overhead expenditure.

Total Fixed Production Overhead Variance = Standard Fixed production overhead cost for
actual output – Actual fixed production overhead cost

Where Standard fixed production overhead cost of actual production = Standard fixed
overhead cost per unit x Actual Output

Where Standard fixed overhead cost per unit = Standard hours to make one unit x Standard
fixed overhead rate per hour

Where Standard fixed overhead rate per hour = Budgeted fixed overhead expenditure

Budgeted hours of work

Fixed Overhead Expenditure Variance

This is the difference between the budgeted fixed overhead expenditure and the actual fixed
overhead expenditure.

Fixed Overhead Expenditure Variance = Budgeted fixed overhead expenditure – Actual

fixed overhead expenditure

The Fixed Overheads Volume Variance

The fixed overhead volume variance is the difference between the budgeted output volume in
units and the actual output volume multiplied by the standard fixed overhead cost per unit.

Fixed Overhead Volume Variance = (Budgeted Quantity – Actual Quantity) x Standard

fixed overhead cost per unit

Example;

A company makes a single product for which the fixed overhead budget is $100,000. The
company plans to make 5,000 units of the product which should have a standard time of 4hrs
 71

each to make. Actual production in the period was 5,200 units made in 19,600 hours of work.
The actual fixed overhead expenditure is $115,000. Required, Calculate;

a) The total fixed production overhead cost variance

b) The fixed overhead expenditure variance

c) The fixed overhead volume variance

a) Total fixed production overhead variance = $104,000 - $115,000

= 11,000 A

Where Std. fixed prod. Overhead cost of Act. Prod. = $20 x 5,200 units

= $104,000

Where Std. fixed overhead cost per unit = 4hrs x $5

= $20

Where Std. fixed overhead rate per hr = $100,000

5,000 units x 4hrs

= $5 per hr

b) Fixed overhead expenditure variance = $100,000 - $115,000

= 15,000 A

c) The fixed overhead volume variance = (5,000 – 5,200) x $20

= 200 x $20

= 4,000 F

Fixed Overhead Volume Variance

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Efficiency Variance Capacity Variance

The analysis of fixed overhead variances can go further by sub-analysing the fixed
production overhead volume variance into an efficiency variance and a capacity variance to
answer the question why was actual production volume different from the budgeted volume.
The two possible reasons are as follows:

1) The work force might be more or less efficient than budgeted and therefore might
produce more or less output than standard in the time they work. This can be
quantified as the fixed overhead efficiency variance. The fixed overhead efficiency
variance is the difference between the standard labour hours for actual output and the
actual labour hours excluding any idle time valued at the standard fixed overhead rate
per hour.

Fixed Overhead Efficiency Variance = (Standard labour hours for actual output –
Actual labour hours) x Standard fixed overhead rate per hour

2) The work force might have worked more hours than budgeted and so would have had
more time in which they should have produced more output. Alternatively the work
force might have worked fewer hours than budgeted and so would not have had
enough time to achieve the budgeted output if they at the standard rate of efficiency.
This can be quantified as a fixed overhead capacity variance. This is the difference
between the budgeted hours of work and the actual hour worked (excluding any idle
time) multiplied by the fixed overhead rate per hour.

Fixed Overhead Capacity Variance = (Budgeted Labour hours – Actual Labour

hours) x Standard Fixed overhead rate per hour

Fixed overhead efficiency variance = ([4hrs x 5,200 units] – 19,600) x $5

= (20,800 – 19,600) x $5

=1,200 x $5

= 6,000 F
 73

Fixed overhead capacity variance = ([4hrs x 5,000] – 19,600hrs) x $5

= (20,000hrs – 19,600hrs) x $5

= 400hrs x $5

= 2,000 A

Standard Costing

a) Actual performance is readily comparable with the predetermined standards to show

separately favourable or adverse variances.

b) The principle “Management by acception” can be applied. This means that

management does not have to spend time searching through unnecessary information,
but can instead concentrate on only those variances which exceed acceptable
tolerance limits.

c) Gains and losses due to market fluctuations in prices of raw materials as distinct from
variations due to manufacturing conversion are revealed.

d) A target of efficiency is set for employees to reach and cost consciousness is

stimulated.

e) Standard cost and variance analysis can provide a means of motivating mangers to
achieve better performances. However care must be taken to distinguish between
controllable and non-controllable cost.

Long- term Decision making:

Capital Investment Appraisal Techniques or

Capital Budgeting

Capital investment appraisal or capital budgeting involves the following:

1. The generation of investment proposals

2. The estimation of cash flows for the proposals

 74

3. The evaluation of those cash flows

4. The selection of projects based upon an acceptance criteria

5. The continuous re-evaluation of the investment projects after there acceptance

Investment involves the sacrifice of current consumption opportunities in order to obtain the
benefit of future consumption possibilities. Long-term decision making involves the
commitment of funds to capital projects which gives rise to a management decision problem,
the solution of which, if incorrectly arrived at may seriously impair the companies
profitability and growth. The proper use of evaluation techniques and criteria should enable
management to make effective decisions which result in future success. The purpose of
investment appraisal is to evaluate whether or not the current sacrifice is worthwhile. Capital
investment decisions have certain characteristics which are not always present in other
management decision situations and as a result special techniques are required to ensure that
only the best information is available to the decision maker. These characteristics are as
follows:

1. They normally require a significant outlay of cash

2. The long-term involvement results in greater risk and uncertainty because forecast of
the future are less reliable.

3. The irreversibility of some project due to the special nature of the plant and
equipment which have been bought with a specific project in mind may have little or
no scrap value.

4. There is usually a significant time lag between the commitment of resources and the
receipt of the resulting benefits.

5. Management ability is often stretched to the limit since some projects often demand
an awareness of all relevant diverse factors.

6. The limited resources available require priorities on capital expenditure.

7. The projects completion time requires adequate and continuous control information
since there is always the possibility that cost can be exceeded by a significant amount.

8. Errors of judgement made in capital expenditure decisions cannot be easily reversed.

 75

Factors to consider when analysing Capital Projects

1. The initial cost of the project

2. The phasing of the expenditure

3. The estimated life of the investment

4. The amount and timing of the resulting cash flow

5. The effect, if any on the rest of the companies operations

6. The working capital which is required

Evaluation Techniques

The following techniques are used in evaluating capital expenditure projects:

1. The accounting rate of return (A.R.R) or Return on Capital Employed (R.O.C.E) or

Return on Investment (R.O.I)

2. The payback period

3. The net present value (N.P.V)

4. The internal rate of return (I.R.R)

The Accounting Rate of Return Method

The A.R.R is the ratio of average annual profits, after depreciation, from an investment to the
average amount invested in the project.

A.R.R = Average Annual Profit x 100 = n%

Average Investment

Where the Average Investment = Original cost of the project + Scrap Value

Example:
 76

A company is considering 2 projects mainly project A and project B which are neutrally exclusive. The
following information is provided

Project A B

Capital Expenditure $75,000 $75,000

Accounting Profit/ (Loss)

Year

1 $30,000 $43,000

2 $30,000 $6,000

3 $20,000 $25,000

4 $(10,000) $(1,000)

5 $(10,000) $(13,000)

Scrap value at end of year 5 $5,000 $5,000

Depreciation is calculated on the straight line method. The company’s cost of capital is 15%

A.R.R Average annual profit = 60,000/ 5 = 12,000

Average investment = (75,000 + 5,000) / 2 = 40,000

A.R.R = (12,000 / 40,000) x 100 = 30%

A.R.R = (12,000 / 40,000) x 100 = 30%

If it is only one project which is being considered the project will be accepted if its
accounting rate of return exceeds a pre-determined required rate of return established by
management. Usually for a company which is already in existence the accounting rate of
return is normally compared to the companies existing return on capital employed. For
 77

mutually exclusive projects preference is given to the proposal with the highest accounting
rate of return.

Alternative ways of calculating the Accounting Rate of Return

1. The profit figure which is used may be the profit before or after tax.

2. The capital invested in the project may or may not include working capital

3. Capital invested may be taken to be only the initial capital invested or the average
capital invested.

The Advantages of the Accounting Rate of Return

1. The calculations are simple and the results are easy to understand

2. The method allows for the comparison of the profitability of various competing
projects or a prospective project and the results of the existing business.

The Disadvantages of the A.R.R

1. The method is based on net income (net profit) which is subjectively determined since
items such as depreciation, methods of stock valuation etc. depend on the choice
made by the accountant.

2. It ignores the time value of money since it assigns equal importance to cash flows
received in early and late periods.

3. There is no universally accepted way of calculating the accounting rate of return since
there are different definitions which are given to profit and the capital invested in the
project.

4. It ignores the risk factor associated with the different projects since it does not
indicate whether the original investment will be recovered, or if it is recovered how
long such recovery would take.

The Payback Period

 78

The payback period is the length of time necessary to recover the entire cost of an investment
from the resulting annual net cash inflows generated by the investment.

Cash Flow = Net Profit or Net Income + Depreciation

Project A

Year Net Profit / (Loss) + Depreciation = Cash flow

1 30,000 + 14,000 = 44,000

2 30,000 + 14,000 = 44,000

3 20,000 + 14,000 = 34,000

4 (10,000) + 14,000 = 4,000

5 (10,000) + 14,000 = 4,000

5 Scrap = 5000 9,000

Annual depreciation charge = Cost – Scrap Value

Estimated Life

= 75,000 – 5,000

5 yrs

= 14,000

Year Net Cash Inflow Outlay Outstanding

0 (75,000)

1 44,000 (31,000)

2 44,000

Payback period = 1 + (12 months x [31,000/ 44,000])

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= 1 yr 8 ½ months

Project B

Year Net Profit/ (Loss) + Depreciation = Cash Flow

1 43,000 + 14,000 = 57,000

2 6,000 + 14,000 = 20,000

3 25,000 + 14,000 = 39,000

4 (1,000) + 14,000 = 13,000

5 (13,000) + 14,000 = 1,000

5 Scrap = 5,000 6,000

Year Net Cash Inflow Outlay Outstanding

0 (75,000)

1 57,000 (18,000)

2 20,000

Payback Period = 1 yr + (12 months x [18,000 / 20,000])

Payback Period

The payback period is usually compared to a pre-determined payback period to determine

whether or not a project should be accepted. If it is only one project that is being considered
its acceptance depends on whether its payback period is less than the payback period required
by management. In selecting amounts mutually exclusive investment opportunities preference
is given to the proposal with the shortest payback period that is the one which recovers its
initial outlay first. A short payback period is considered desirable because the sooner the
 80

investment is recovered the earlier the funds can be put to other uses to generate investment
income. A short payback period also reduces the risk that changes in economic conditions
will prevent the full recovery of the initial investment.

Advantages

1. The calculations are simple and easy to understand.

2. The calculations rely on cash flows rather than profit and are therefore more objective
than the A.R.R method.

3. The method favours quick return projects which may result in faster growth for the
company and therefore enhance its liquidity.

4. Where competing projects are being considered the risk factor for those competing
projects may be compared.

5. Giving preference to those projects which pay back the quickest will tend to minimize
the risk facing a company which are related to time.

Disadvantages

1. It ignores the life expectancy of the project since it does not consider those years after
the payback period.

2. Although different projects may have similar payback periods the pattern of there
cash flows may be different and this is ignored by the payback period.

3. It does not consider the time value of money.

Net Present Value Method

The net present value of a proposal is the difference between the total present value of the net
cash flows and the cost of the investment. The cash flows are discounted by using an
appropriate discount rate which is usually the companies cost of capital.

Project A Project B

Year 15% Discount Net Cash flow Present Value Net Cash flow Present Value
 81

factor

0 1 (75,000) (75,000) (75,000)

1 .870 44,000 38,280 57,000

2 .756 44,000 33,264 20,000

3 .658 34,000 22,372 39,000

4 .572 4,000 2,288 13,000

5 .497 9,000 4,473 6,000

N.P.V 25,677

If the N.P.V is positive it means that the cash inflows from the investment will yield a return
in excess of the cost of capital and therefore the project should be accepted. If the N.P.V is
negative it means that the cash inflows from the investment would yield a return which is less
than the cost of capital and therefore should be rejected.

If it is only one project which is being considered it should be accepted if its N.P.V is
positive. For mutually exclusive projects preference is given to the project with the highest
positive N.P.V.

The Internal Rate of Return

The internal rate of return is the rate of interest which when applied to the cash flows will
equate the investment outlay and the total present value of the net cash flows. It is therefore
the discount sale which when used to discount the cash flows will give a net present value of
zero.

Year 15% Dis. Factor Net cash flow Present Value 30% Dis. Factor Present Value

0 1 (75,000) (75,000) 1 (75,000)

1 .870 44,000 38,280 .741 32,604

2 .756 44,000 33,264 .549 24,156

3 .658 34,000 22,372 .406 13,804

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4 .572 4,000 2,288 .301 1,204

5 .497 9,000 4,473 .223 2,007

N.P.V 25,677 N.P.V 1,225

I.R.R = 15 + [(30 – 15) x (25,677 / {25,677 + 1,225})]

Formula:

IRR=Lower rate + [(Higher rate – Lower rate) x (Higher NPV/Sum of the NPV’s ignoring
negative sign)]

If it is only one project which is being considered the project is accepted if its internal rate of
return is above managements required rate of return. For mutually exclusive projects
preference is given to the project with the highest interest rate of return.

Advantages

1. This method examines the cash flows over the entire life of the project and takes into
account both the magnitude and timing of those cash flows.

2. Since this method relies on the cash flows it takes into account the time value of
money.

Disadvantages

1. The cost and time which are involved in gathering information and making the
necessary calculations to calculate the internal rate of return may not be merited by
the results which were achieved.

2. In some cases there may be more than one internal rate of return eg. If there are net
cash outflows in more than one period and those outflows are separated by one or
more periods of net cash inflows.

Determining the Relevant Cash Flows

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All capital investment appraisal situations involve the same two main factors. They are;

1. The Net incremental investment

2. The incremental cash flows

The net incremental investment represents the outlay of resources made at the very beginning
of a new capital project. In most cases the term net incremental investment means the
required cash outlay to obtain a fixed asset and to prepare it for productive use. The
incremental investment for the purchase of fixed asset includes:

1. Purchase price

2. Transportation costs

3. Receiving and handling cost

4. Set up cost

5. Cost of testing the new asset prior to its production use

When an old asset is sold prior to purchasing a new one, the proceeds from the sale of the old
asset are deducted from the cost of the new asset in determining the net incremental
investment. If the asset is constructed by the business instead of purchased from outside
supplier then the net incremental investment is the accumulation of production costs required
to prepare it for productive use. The productive costs will consist of;

1. Direct materials

2. Direct labour

3. Factory overheads

The incremental cash flows represent the additional cash generated by the firm during the life
of the project due to the net incremental investment which was made at the beginning of the
project. They are either;

1. The incremental cash operating receipts in excess of the incremental cash operating
cost from the use of newly acquired fixed assets, or
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2. The cash operating savings that result from the replacement of one fixed asset with a
new and more efficient fixed asset.

Sometimes the incremental cash flows are the cash flows that are continuos and repetitive in
nature. For example if a company is considering the purchase of a new machine that will
produce ten thousand (10,000) units per year then the cash receipts expected from the sale of
those units and the cost associated with the production of those units will occur in a
continuous and repetitive manner for each year of the machines life. In other situations the
incremental cash flows may occur only once or twice during the life of the project. For
example cash flows which are not repetitive in nature are:

1. An extra ordinary or major repair

2. An advertising or promotional campaign

3. The disposal of the fixed asset at the end of the projects useful life

Short-term Decision Making

Decision making is concerned with the future and involves a choice between alternatives both
qualitative and quantitative factors need to be considered. For many decisions financial
information is a critical factor. Therefore it is important that relevant information on cost and
revenues be available.

Relevant information is information about the following:

1. Future cost and revenues: - it is the expected future cost and revenues that are of
importance to the decision maker. Cost which have been incurred in the past (sunk
costs) and past revenues are irrelevant. Past cost and revenues are only useful in so far
as they provide a guide to the future.

2. Differential and revenues:- only those cost and revenues which change as a result of
a decision are relevant. Where costs and revenues are the same for all the alternatives
which are being considered they can be ignored.
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Short-term decisions seek to make the best use of existing facilities. Usually in the short-term
fixed cost remains unchanged so that the marginal cost, revenue and contribution of each
alternative is relevant. Therefore in these circumstances the selection of the alternative which
maximizes contribution is the correct decision rule. If fixed costs do change as a result of
different alternatives then differential costs must include any changes in the amount of the
fixed cost.

Cost-Volume-Profit (CVP) Analysis or Break Even Analysis

Cost- Volume-Profit analysis involves an analysis of how total cost, total revenue and total
profit are related to sales volume, and is therefore concerned with predicting the effects of
changes in costs and sales volume on profit. It is a technique which is central to short-term
decision making and is used to provide information on the following:

1. The break even point

2. The short fall in sales which cannot occur before the business starts making a loss

3. The margin of safety of the business

The Break Even Point

The break even point is the level of sales in the business at which no profit is made and no
loss is incurred. It is therefore that level of sales at which total cost is equal to total revenue.

At break even point;

1. No profit or loss

2. Total revenue = Total cost

Total Revenue = Fixed cost + Variable cost

Fixed cost = Total revenue – Variable cost

Contribution = Fixed cost

Calculating the break-even point

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Break-even point in units = Total fixed costs / Contribution per unit = n units

Break-even point in sales value = 1) Break-even units x Selling price / unit

Or

2) Total fixed costs / Contribution to sales ratio

Where contribution to sales (c/s) ratio = Contribution x 100

Sales

= n%

The contribution to sales ratio expresses the relationship between contribution and sales and
shows the % of contribution in relation to changes in the volume of sales. The contribution to
sales ratio is constant at all levels of sales.

Example:

L. Limited makes a product which has a variable cost of $7.00 per unit and a selling price of
$12.00 per unit. Total fixed cost are $26,000 per annum. Required, calculate the break-even
point:

1. In units

2. In sales value

1) $26,000 / (12 – 7)

= 5,200 units

2) 5,200 x 12 = $62,400

Or 26,000 / (5/12) = $62,400

Determining the level of sales to achieve a target profit

Sales in units = Total fixed costs + Target profit

Contribution per unit

Sales revenue = 1) Unit sales to achieve profit x Selling price per unit
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Or

2) Total Fixed cost + Target profit

Contribution to sales ratio

The Margin of Safety

The margin of safety is the amount by which actual sales may fall short of the budgeted sales
without incurring a loss. It is therefore the difference between the budgeted sales level and
the break-even point. It is used as a measure of the risk that the company might make a loss if
it fails to achieve its budgeted sales level. A high margin of safety indicates a good
expectation of profits even if the budgeted sales level is not achieved.

The margin of safety is calculated as follows:

Margin of safety in units = Budgeted sales units – Break-even sales units

Margin of safety in sales value =

1) Margin of safety in units x Selling price per unit

Or

2) Profit at the budgeted sales level

Contribution to sales ratio

Margin of safety as a percentage =

1) Margin of safety in units x 100

Budgeted sales units

Or

2) Margin of safety in sales value x 100

Budgeted sales revenue

Example:
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B. Limited budgeted to manufacture and sell 5,000 units of a product with a variable cost of
$15 per unit and a selling price of $20 per unit. Fixed costs were $24,000 per annum.
Required; calculate the margin of safety in;

1. Units

2. Sales value

3. As a percentage of budgeted sales

1. 5,000 units – 4,800 units = 200 units

Working 1: Contribution = $20-$15 = $5

Fixed cost = $24 000

Break-even units = 24,000/5 = 4,800

2. 200 units x $20 = $4,000

3. 200/5000 x100 = 4%

The Break-even Chart

The break-even chart shows the amount of fixed cost, variable cost, total cost and total
revenue at all volumes of sale and at a given sales price.

Assumptions of Cost Volume Profit Analysis

1. The behaviour of cost and revenue has been reliably determined and is linear over the
relevant range. The relevant range is the normal range of output levels where the
linear assumptions about cost behaviour are considered to be relatively accurate.

2. All costs may be divided into fixed and variable elements.

3. Fixed cost remains constant over the relevant range.

4. Variable costs are proportional to volume.

5. Sales price remains unchanged.

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6. Efficiency and productivity remains constant.

7. The analysis either covers a single product or it assumes that a given sales mix will be
maintained as total volume changes.

8. Volume is the only relevant factor affecting cost.

9. Changes in the beginning and ending inventory levels are insignificant in amount.

10. Revenue and cost are being compared on a common activity based, for example, sales
value of production or sales units produced.

Limitations of Break-even Charts

1. Its usefulness is restricted since it applies to a single product or a single mix of a

group of products.

2. It is assumed that fixed costs are the same in total and variable cost are the same per
unit at all levels of output. However this assumption is an over simplification for the
following reasons;

i) Fixed cost will change if output falls or increases substantially.

ii) The variable cost per unit will decrease where economies of scale are made at
higher output volumes and may also eventually increase where dis-economies
occur.

Acceptance of an Order at a Special Price

General Rule: Accept the special offer if the asking price is > the marginal cost of the
item.

Example:

S. Company produces 100,000 blenders per month which is 80% of plant capacity. Variable
manufacturing costs are $8 per unit and fixed manufacturing cost are $400,000. The blenders
are normally sold at $20 each. S. Company has now received an offer from a foreign
wholesaler to purchase an additional 2,000 blenders at $11 per unit. Acceptance of the offer
would not affect normal sales and the additional units can be manufactured without
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increasing plant capacity. Required, advise management on whether or not it should accept
the offer and if so show the effect of the acceptance on managements net income.

Accept the special offer if the asking price ($11) > the marginal cost of the item ($8)

Therefore Company should accept offer.

Effect on Net Income using Incremental Analysis

Net Income

Increase/Decrease

Revenue 2,000 x $11 22,000

Cost 2,000 x $8 (16,000)

Net increase 6,000

Make or Buy Decisions

If Existing production will not be displaced

If Existing production will not be affected

If existing production would not be affected if company decides to manufacture

General Rule: Manufacture item if variable cost of manufacturing item < purchase
price of item if obtained from an outside supplier.

Example:

A company incurs the following annual cost in producing 25,000 ignition switches for its
motors:

Direct materials 50,000

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Direct labour 75,000

Variable manufacturing overheads 40,000

Fixed selling and distribution overheads 100,000

Fixed manufacturing overheads 60,000

The switches can be purchased from an outside supplier at a price of $8 per unit. If the
switches are purchased from the outside supplier there will be a reduction in fixed
manufacturing cost of $10,000. Required, should the company make or buy the ignition
switches.

Net Income

Make Buy Increase/Decrease

Direct materials 50,000 - 50,000

Direct labour 75,000 - 75,000

Variable manufacturing over. 40,000 - 40,000

Fixed overhead - - 10,000

Purchase price (25,000 x 8) - 200,000 (200,000)

Net decrease (25,000)

Company should continue manufacturing items

If existing production would be affected if company decides to manufacture.

General Rule: Manufacture item if variable cost of manufacturing item + opportunity

cost < purchase price of item if obtained from an outside supplier.

If there is an opportunity to use the productive capacity in some other manner rather than
manufacturing the items then this opportunity cost must be considered. The opportunity cost
is the potential benefit that may be obtained by following an alternative course of action.

Example cont…
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Note: the fixed selling and distribution overheads would be the same if the company makes
or buys the items. The company can use the productive capacity which is presently used to
make the items to generate additional income of $28,000. Should the company make or buy
the item?

Make Buy

Materials 50,000 -

Labour 75,000 -

Variable manu. Over. 40,000 -

Purchase price - 200,000

Opportunity cost 28,000 -

Budgeting

A budget is a plan quantified in monitory terms prepared and approved prior to a defined
period of time, usually showing planned income to be generated and or expenditure to be
incurred during that period. They are therefore financial plans prepared in advance which
deal with all aspects of the business and are intended to guide the business during the
forthcoming period in achieving its objectives.

Operating budgets are those prepared for departments, or functions within the business and
indicate the budget responsibility of each manager. The master budget is comprised of the set
of the budgeted income statement and budgeted balance sheet. It is a set of inter-related
budgets that constitutes a plan of action for a specified time period.

Steps in the preparation of a Master Budget

1. The sales budget

2. The production budget

3. Materials usage budget

4. Materials purchases budget

5. Direct labour cost budget

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6. Manufacturing overheads budget

7. The closing inventory budget

8. The selling and administrative expense budget

9. Capital expenditure budget

10. Cost of goods sold budget

11. Cash budget

12. Budgeted income statement

13. Budgeted balance sheet

Sales Budget

Year ending Dec 31st

Quarter

1 2 3 4 Total

Expected unit sales

Unit selling price

Total sales

Production Budget
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Year ending Dec 31st

Quarter

1 2 3 4 Total

Expected unit sales

Add desired ending

Finished goods

Total required

Less beginning finished goods units

Required production in units

The sales budget is the starting point of the budgeting process because inventory levels and
production are generally geared to the rate of sales activity. It gives an estimate of the sales
quantities and sales revenue for the budget period.

The production budget is a budget prepared for the production of finished goods. It is
designed to plan the resources required to produce the output envisaged by the sales forecast.
The production budget is prepared in units.

Direct Materials Usage Budget

Year ending Dec 31st

Quarter

1 2 3 4 Total

Units to be produced

Direct materials per unit

Total quantity needed for production

Direct Materials Purchases Budget

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Year ending Dec 31st

Quarter

1 2 3 4 Total

Total quantity needed for production

Add desired ending quantity of materials

Total quantity material required

Less beginning quantity of materials

Quantity of direct material purchases

Unit cost

Total cost of direct material purchase

Direct Labour Cost Budget

Year ending Dec 31st

Quarter

1 2 3 4 Total

Units to be produced

Direct labour hrs per unit

Total direct labour hrs required

Direct labour cost per hr

Total direct labour cost

Manufacturing or Production Overheads Budgets

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Year ending Dec 31st

Quarter

1 2 3 4 Total

Units to be produced

Variable overheads:

<Power $n per unit>

<Maintenance $n per unit>

Total variable overheads

Fixed overheads:

<Rent>

<Insurance>

Total fixed overheads

Total manufacturing overheads

Closing Inventory Budget

Units Unit Cost Value

Direct Materials

Finished goods

Selling and Administration Expenses Budget

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Year ending Dec 31st

Quarter

1 2 3 4 Total

Selling expenses:

<Sales commission>

<Freight>

Total selling expenses

Administrative expenses:

<Office salaries>

<Depreciation>

Total administrative expenses

Total selling and administrative expenses

Capital Expenditure Budget

Year ending Dec 31st

Quarter

1 2 3 4 Total

Plant and equipment

Motor vehicles

Total

Cost of Goods Sold Budget

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Year ending Dec 31st

Material Cost xxx

Direct labour cost xxx

Manufacturing overheads xxx

Total manufacturing cost xxxx

Add finished goods at start xxx

Less finished goods at end (xx) xxx

Cost of goods sold xxxx

Cash budget

Year ending Dec 31st

Quarter

1 2 3 4 Total

Opening cash balance

+ Receipts from debtors

+ Sales of capital items

+ Any loans received

+ Proceeds for share issues

+ Any other cash receipts

Total cash available

- Payments to creditors

- Cash purchases
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- Wages and salaries

- Loan repayments

- Capital expenditure

- Dividends

- Taxation

- Any other cash disbursements

Closing cash balance b/f