MERU UNIVERSITY OF SCIENCE AND TECHNOLOGY

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

BFC 5175 : MANAGERIAL ACCOUNTING

Rationale

This course is designed to equip students with the concepts in management accounting and enable them to
apply the concepts to enhance organizational operations and strategies. The students should be capable of
organizing, communicating and using accounting information effectively for planning and control, decision-
making, performance evaluation, and reporting purposes.

Course Objectives

By the end of this course the student should be able to:

1. Explain the different cost concepts, classification and estimation.

2. Apply the principles of marginal costing and absorption costing in reporting.
3. Use relevant cost information in decision making
4. Apply the principal of budgeting and budgetary control.

Course content

Week Topics Content Time

(Hours)

1 Nature & scope of

management
accounting  Introduction to management accounting 3
 Accounting as an information system
 Management use of accounting information
 Differences between Financial accounting and
Management Accounting
2 Cost concepts and  Cost concepts 3
classifications  Cost classification
 Cost behavior and estimation

3-4 Alternative Product  Absorption costing 3

Cost Concepts  Marginal costing
 Activity based costing

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 Week Topics Content Time
(Hours)

5-7 Cost- volume -profit  Single product CVP analysis 9

[CVP] analysis and  Multiple product CVP analysis
leverage CVP analysis and profit planning

8 CAT

9-10 Short run management  Product mix decision: limiting factor analysis 6
decisions based on  Joint product processing further decision
marginal costing  Make or buy decision
 Pricing of special order
 Dropping an unprofitable product line

11-12 Budgeting and  Purpose of budgets 6

budgetary control  Types of budgets
 Flexible budgets and variance analysis
 Preparation of operating budgets
 Budgetary control process
13 CAT II 3

13-14 End of Trimester Exams

Facilitation methods

 Lectures
 Class discussion
 Assignments and research

Course Assessment

 Assignments [2] 15%

 CATs [2] 25%
 End of trimester exam 60%
Total 100%

References

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Drury Colin (2004); Management and Cost Accounting, 6th Edition, Thomson Business Press. London

Pandy I.M (2005); Financial Management; 9th edition. Vikas Publishing House, India

Collins Drury management and cost Accounting 7th Edition (208) Book power

Ronald W. Hulton “Management Accounting” Irwin McGrawhill Boston

Robert P. Magee “Advanced Management Account” Harper and Raw publishers, New York.

Horngren C.T & Foster C “Cost Accounting, a managerial emphasis”- prentice hall, New Delhi.
Gwine & A Gitau “ Cost Accounting, a practical approach” 2010 foundation.

Hirsh, M.L (2008); Advanced Management Accounting, 3rd Edition, FWS-KENT

Frank F. (2005); Cost Accounting: Theory and Applications, South Western Publishing Company.

Garrison R. (2005); Management Accounting, 6th Edition, Irwin

Any other Relevant Material

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 N ATURE AND PURPOSES OF MANAGEMENT ACCOUNTING
Definition of accounting
Accounting is defined as the process of identifying, measuring and reporting economic
information to the users of this information to permit informed judgment
Many businesses carry out transactions. Some of these transactions have a financial implication
i.e. either cash is received or paid out. Examples of these transactions include selling goods,
buying goods, paying employees and so many others.

Accounting is involved with identifying these transactions, measuring (attaching a value) and
reporting on these transactions. For instance, If a firm employs a new staff member then this may
not be an accounting transaction. However when the firm pays the employee salary, then this is
related to accounting as cash involved. This has an economic impact on the organization and will be
recorded for accounting purposes. A process is put in place to collect and record this information; it
is then classified and summarized so that it can be reported to the interested parties

Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgments and decisions by users of information. It is therefore concerned with
providing information that will help decision makers make good decisions.

Accounting as an information system

The accounting system is the major information system in any organisation. The information provided
by accounting is for three major purposes namely
 Internal reporting to enable managers plan and control their routine operations
 Internal reporting to managers for use in making non-routine decisions and formulating major plans
and policies
 External reporting to shareholders, government, creditors and other interested parties

Types of information needed by managers

 Information that would enable the manger to judge whether he is doing well or not.

 Information, which would enable the manager to know the problem areas to look

 Information, which would enable the manager to choose the best among several alternatives.

To understand accounting one must understand:

 The attributes of good information

 Process of measuring and communicating information
 The decision making process
 Users of information

The above points are briefly discussed below:

Definition of Information
Information is the generic term that includes all the facts, figures, ideas, observations,
impressions, experience, insights and relationships that enhance our understanding of a decision-
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 making situation.

Task
Categories of Information
Basically, there are two broad categories of information:
If you wishQuantitative
to invest in a home, what are These
Information— the information that you
are information that would
can be seek? Listinthem and
measured
appraisequantitative
how each of them
terms would
such enhance
as time, the attainment
units, cost of yourlabour
data, sales revenue, objective.
hours etc.
Qualitative Information — These are those intangible factors, which do not lend
themselves to numeric expressions such as human factors, managerial insight, socio-
political repercussions, and change in attitude.

Illustration

Can you imagine a factory environment where a decision is to be taken on whether to buy a
certaincomponent“H5”forKsh400perunitfromasupplierortocontinuetomanufacture the
same component “H5” internally at a marginal cost of production of Kshs500 per unit. Well,
on the surface, the reasonable option would appear to be that of buying 'H5' from the
supplier and thus saving Kshs100 per unit purchased. However, the consequence of this decision
would be the retrenchment of certain categories of workers and its subsequent labour unrest.
Identify quantitative and qualitative information from the above two paragraphs.

Attributes of good information

Information is anything that is communicated and is sometimes said to be processed data. It is data
processed in such a way as to be of meaning to the person receiving it. Good information should
have the following attribute:
 It should be relevant to a user’s needs. For the communicator this requires the following:
o Identifying the user: Information must be suited and sent to the right person i.e. the
person who requires it to do his job.
o Getting the purpose right: It is effective only when it helps the user to make
decisions.
o Getting the volume right: Information must be complete for its purpose and should
not omit any necessary item. It should be no greater in volume than the users would
find helpful or be able to take in.
 It should be accurate within the user’s needs i.e. should be correct and error free.
 It should inspire the user’s confidence i.e. information should not give the user any reason
to mistrust it, disbelieve it or ignore it by making sure the information is neutral.

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  It should be timely: The information must be readily available within the time period which
makes it useful. It must be at the right place at the right time.
 It must be appropriately communicated: Information will lose its value if it is not clearly
communicated to the users in a suitable format and through a suitable medium.
 It should be cost effective: Good information should not cost more than its worth. Gathering,
storing, retrieving and communicating an item of information may require expenses in form
of time, energy and resources. If the expense is greater than the potential value of the item,
then it should not be communicated.

The Management Process

The management process has three components
i. Planning -strategic planning, tactical planning andoperational planning
ii. DecisionMaking
iii. Control

These are explained here below

i. Planning
This is the process of setting objectives for the future and the means of attaining them.

Types of planning and Information needed by different levels of management

Level of Type of decisions Type of information Examples
Managemen
t
Top  Long term plans Highly summarized  E ntering into a n ew market
( Strategic (5-10 years) for Many forward looking  Introduction of new product
Level) the business. estimates lines
 Unstructured Ad hoc  Acquisition of another
decisions External and internal company or a merger
 E ntering the export market.
Middle  Semi-structured Moderate details  Wh e t h e r to ma k e or b u y
(Tactical )  Medium Term, Present and future  Whether or not to drop a
level more detailed plans forecasts product line
 To buy or lease an equipment
 Whether to sell at present state
or process further a by-product.
 Preparing a budget for the
following year,
 How many staff to employ next
year
Lower  Short term and  Very detailed  C h o o s i n g c r ed i t c u s to
(Operational) Routine planning  Historical me r s
level and Decisions  Internal  Deciding on daily delivery
 Recording routes
transactions  which supplier to choose for a
purchase the following year

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ii. Decision making

Decision-making involves choosing from among alternative courses of action, the best
which seems to be the most effective and the most efficient. Whatever option you have chosen is a
decision and you should be ready for the consequences of your decisions.
The Characteristics of decision making are:
 Decision making deals with the future
 Decision making situation arises only when there are alternatives to be chosen
from
 Each decision covers a time period. The time period may be called
 Short range, Which is less than a year,
 Medium range, Which is between 2-3 years and
 Long range if the duration extends beyond three years.

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 Phases of decision making:
Decision making is the process of choosing among alternatives. There are 7 steps that should be
followed as shown in figure 1 below:

Figure: The decision-making, planning and control process

The figure above represents a diagram of a decision-making model. The first five stages represent
the decision-making of the planning process. Planning involves making choices between alternatives
and is primarily a decision-making activity. The final two stages represent the control process,
which is the process of measuring and correcting actual performance to ensure that the alternatives
that are chosen and the plans for implementing them are carried out. Let us now consider each of the
elements of the decision-making and control process.

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Identifying Objectives
Before good decisions can be made there must be some guiding aim or direction that will enable the
decision-makers to assess the desirability of favouring one course of action over another. Hence the
first stage in the decision-making process should be to specify the objectives of the organisation.

The Search for Alternative Courses of Action

The second stage of the decision-making model is a search for a range of possible courses of action
(or strategies) that might enable the objectives to be achieved. If the management of a company
concentrates entirely on its present product range and markets, and market shares and cash flows are
allowed to decline, there is a danger that the company will be unable to generate sufficient cash
flows to survive in the future. To maximise future cash flows, it is essential that management
identifies potential opportunities and threats in its current environment and takes any developments
which may occur in the future. In particular, the company should consider one or more of the
following courses of action:

1. Developing new products for sale in existing markets;

2. Developing new products for new markets;

3. Developing new markets for existing products.

The search for alternative courses of action involves the acquisition of information concerning future
opportunities and environments. It is the most difficult and important stage of the decision-making
process. Ideally, firms should consider all alternative courses of action, but, firms will in practice
consider only a few alternatives, with the search process being localised initially. If this type of
routine search activity fails to produce satisfactory solutions, the search will become more
widespread.

Gather Data about Alternatives

When potential areas of activity are identified, management should assess the potential growth rate
of the activities, the ability of the company to establish adequate market shares, and the cash flows
for each alternative activity for various states of nature. Because decision problems exist in an
uncertain environment, it is necessary to consider certain factors that are outside the decision-maker's
control, which may occur for each alternative course of action. These uncontrollable factors are
called states of nature. Some examples of possible states of nature are economic boom, high
inflation, recession, the strength of competition, and so on.

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The course of action selected by a firm using the information presented above will commit its
resources for a lengthy period of time, and the overall place of the firm will be affected within its
environment—that is, the products it makes, the markets it operates in and its ability to meet future
changes. Such decisions dictate the firm's long-run possibilities and hence the type of decisions it
can make in the future. These decisions are normally referred to as long-run possibilities and hence
the type of decisions it can make in the future. These decisions are normally referred to as long-run
or strategic decisions. Strategic decisions have a profound effect on the firm's future position, and it
is therefore essential that adequate data is gathered about the firm's capabilities and the environment
in which it operates. Because of their importance, strategic decisions should be the concern of top
management.

Besides strategic or long-term decisions, management must also make decisions that do not commit
the firm's resources for a lengthy period of time. Such decisions are known as short-term or
operating decisions and are normally the concern of lower-level managers. Short-term decisions are
based on the environment of today, the physical, human and financial resources presently available
to the firm.These are, to a considerable extent, determined by the quality of the firm's long-term
decisions. Examples of short-term decisions include the following:

1. What selling prices should be set for the firm's products?

2. How many units should be produced of each product?

3. What media shall we use for advertising the firm's product?

4. What level of service shall we offer customers in terms of the number of days required to
deliver an order and the after-sales service?

Data must also be gathered for short-term decisions; for example, data on the selling prices of
competitor's products, estimated demand at alternative selling prices, and predicted costs for
different activity levels must be assembled for pricing and output decisions. When the data has been
gathered, management must decide which course of action to take.

Select Appropriate Alternative Courses of Action

In practice, decision-making involves choosing between competing alternative courses of action and
selecting the alternative that best satisfies the objectives of an organisation. Assuming that our
objective is to maximise future net cash inflows, the alternative selected should be based on a
comparison of the differences between the cash flows. Consequently, an incremental analysis of the
net cash benefits for each alternative should be applied. The alternatives are ranked in terms of net
cash benefits, and those showing the greatest benefits are chosen subject to taking into account any
qualitative factors. We shall discuss how incremental cash flows are measured for short-term and
long-term decisions and the impact of qualitative factors.

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Implementation of the Decisions
Once alternative courses of action have been selected, they should be implemented as part of the
budgeting process. The budget is a financial plan for implementing the various decisions that
management has made. The budgets for all the various decisions are expressed in terms of cash
inflows and outflows, and sales revenues and expenses. The budgets are merged together into a
single unifying statement of the organisation's expectations for future periods. The statement is
known as a master budget. The master budget consists of a budgeted profit and loss account, cash
flow statement and balance sheet. The budgeting process communicates to everyone in the
organisation the part they are expected to play in implementing management's decisions.

Comparing Actual And Planned Outcomes And Responding To Divergences From Plan
The final stages in the process outlined in Figure 1 of comparing actual and planned outcomes and
responding to divergences from plan represent the firm's control process. The managerial function of
control consists of the measurement, reporting and subsequent correction of performance in an
attempt to ensure that the firm's objectives and plans are achieved. In other words, the objective of
the control process is to ensure that the work is done so as to fulfill the original intentions.

To monitor performance, the accountant produces performance reports and presents them to the
appropriate managers who are responsible for implementing the various decisions. Performance
reports consisting of a comparison of actual outcomes (actual costs and revenues) and planned
outcomes (budgeted costs and revenues) should be issued at regular intervals. Performance reports
provide feedback information by comparing planned and actual outcomes. Such reports should
highlight those activities that do not conform to plans, so that managers can devote their scarce time
to focusing on these items. This process represents the application of management by exception.
Effective control requires that corrective action is taken so that actual outcomes conform to planned
outcomes.

iii. Control

This is the comparison of actual results achieved with plans, and the extent and reasons for
deviations from the plans

The role of the management accountant in the management process.

The management accountant is concerned with the collection organisation and presentation of
information required for management processes.

The interrelationship between management activities and management accounting is shown

below:

Managerial activity Accounting activity

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 * Planning for the future - Preparation of budgets
- Setting up of standards
* Decision making - Providing data on alternatives
- Advising on consequences of possible actions
* Control - Comparing actual results with standards and
budget
- Interpretation and identification of problem areas.
Do you collect, organize and present your information in a manner that would assist you to
take the right decision? If you do, list the activities you perform for your company as a
manager in terms of planning, decision-making and control.

Users of information

The users of information can be divided into two:

 Internal users who are parties within the organization e.g. the management or the employees.
 External users who on the other hand, are parties outside the organisation e.g. the
shareholder, creditors, government, customers, etc

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From the users point of view accounting can be divided into two- management accounting and
financial accounting:

Management Accounting
Management accounting is the application of the professional knowledge and skills in preparation
and presentation of accounting information in such a way as to assist management in formulation
of policies and planning and control of the operations of undertakings. It measures and reports
financial and non-financial information that helps managers make decision to fulfill the goals of an
organization.
It is focused on internal reporting.
It is concerned with the provision of information to people within the organization so as to help
them make decision and improve efficiency and effectiveness of existing operations.
Management accounting provides information required by management for such purposes as:-
1. Formulation of policies
2. Planning and controlling activities of the enterprises
3. Decision making on alternative causes of action.
4. Disclosure to those external to the entity
5. Disclosure to employees
6. Safeguarding assets
The above involves participative management to ensure that there is effective:-
1. Formulation of long tern plans to meet objectives
2. Formulation of short term operation plans
3. Recording of actual transactions
4. Corrective actions required to bring future actual transactions into line.
5. Obtaining and controlling finance
6. Reviewing and reporting on systems and operations

Role of management accounting in management process

i) To allocate and accumulate data and provide reliable results for internal and external
profit reporting
ii) To provide relevant information to help managers make better decisions iii)
To provide information for planning,
iv) To provide information for control and
v) To provide information for performance measurement
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Management accounting can also be said to be concerned with data gathering (both 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 operations.

Managers use management accounting information to choose strategy to communicate it and to

determine how best to implement it. They use management accounting information to coordinate
their decisions about designing, producing and marketing a product or service

Financial Accounting
Which is concerned with the provision of information to external parties outside the organization.
It’s the process of measuring, classifying, summarising and reporting financial information used in
making economic decisions. It’s concerned with the preparation of financial statements to be used by
the firm’s external stakeholders.

The key differences between Management Accounting (MA) and Financial Accounting (FA) can be
summarised as follows:

Table:Differences between Financial and ManagementAccounting

Point of Financial Accounting Management Accounting
Distinction
1. Origin Since 1494, double entry and From 19th Century
bookkeeping has been practiced
2. Purpose To prepare financial statements To provide information to interested
i.e. P&L, B/Sheet, Cash flow parties usually the management
statement etc. for interested
users outside the organization
3. Statutory Preparation of financial Management accounting information is
requirement statements ie. A legal voluntary
requirement of the company’s
Act of Cap 486
4. Nature of Financial statements show profit Shows detailed data of each product,
Analysis and loss for a period of activity region or department (More detailed)
for the company as a
whole(Summarised)

5. Periodicity of Financial statements are usually Preparation of cost statements is a

reporting prepared periodically eg. continuous process eg. Daily, weekly,
Annually, semi annually or monthly or as required by the
quarterly management.
6. Nature of Concerned with historical Concerned with historical costs, present
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 records records costs as well as pre determined costs
(future costs)
7. Auditing It is a requirement for public It is not a requirement for public limited
requirements limited companies to have their companies to have their books audited
books audited
8. Standard of Preparation and presentation is There is no specific rules, whatever
presentation guided by GAAPs and income information is important to a manager.
tax regulations.

D i s t i n c t i o n B e t w e e n M a n a g e m e n t A c c o u n t i n g a n d
Financial Accounting

The 12 principal differences between management and financial ac-countingaredescribedhere.

1. N e c e s s i t y / l e g a l r e q u i r e m e n t s
Financial accounting must be done. Preparation of financial statements is a legal requirement of the
company’s Act of Cap 486. Enough effort must be expended to collect data in acceptable form andwithanacceptable
degree of accuracy to meet the requirements of the Financial Accounting Standards Board(FASB) and other outside
parties, whether or not the management regards this information as useful. Management accounting, by
contrast, is entirely optional, no outside agencies specify what must be done or indeed that anything need be done.
Because it is optional, there is no point in collecting a piece of (management accounting information unless its value
to management’s believed to exceedthecostofcollectingit.

2. P u r p o s e -

The purpose of financial accounting is to produce financial statements for outside users. When the statements
have been produced, this purpose has been accomplished. Management accounting in-formation, on
the other hand, is only a means to an end, the end being the planning, implementing, and controlling
functions of management.

3. Users

The users of financial accounting information (other than management itself) are essentially a “faceless” group. The
managements of most companies’ do not personally know many of the shareholders, creditors, or
others who use the information in the financial statements. Moreover, the information needs of most
of these external users must be presumed; most external users do not individually request the information
they would like to receive. By contrast, the users of management accounting information are known
managers plus the people who help these managers ana1yze the information. Internal users information needs are
relatively well known because the controller’s office solicits these needs in designing or revising the management
accounting system.

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 4. U n d e r l y i n g S t r u c t u r e -

Financial accounting is built around one fundamental equation: Assets= Liabilities + Owners’ Equity. In
management accounting, there is no such an underlying principle.

5. S o u r c e o f P r i n c i p l e s

Financial accounting information must be reported in accordance with generally accepted accounting principles (GAAP). Outside
users need assurance that the financial statements are prepared in accordance with a mutually understood set of
ground rules; otherwise, they cannot understand what the numbers mean. GAAP provide these
common ground rules. An organization’s management, by contrast, can employ whatever accounting rules it
finds most useful for its own purposes. Thus, in management accounting, there may be information
on unfilled sales orders, even though these are not financial accounting transactions; fixed assets may be stated at
current values rather than historical cost; certain production overhead costs may be omitted from inventories;
or revenues may be recorded before they are realized-even though each of these concepts is inconsistent with GAAP. Rather than
asking whether it conforms to GAAP, the basic question in management accounting is the pragmatic one: Is
the information useful?

6. T i m e O r i e n t a t i o n

Financial accounting records and reports the financial history of an organization. Entries are made in the accounts only
after transactions have occurred. Although financial accounting information is used as a basis, for making future
plans, the information itself is historical. Management accounting includes, in its formal structure, numbers
that represent estimates and plans for the future as well as information about the past. The objective
of financial accounting is to “tell it like it was,” not like it will be.

7. I n f o r m a t i o n C o n t e n t

The financial statements that are the end product of financial accounting include primarily monetary information.
Management accounting reports deal with no monetary as well as monetary information. These
reports show quantities of material as well as its monetary cost, number of employees and hours worked as well as
labour costs, units of products sold as well as monetary amounts of revenue, and so on.

8. I n f o r m a t i o n P r e c i s i o n

Management needs information rapidly and is often willing to sacrifice some precision in order to gain speed in
reporting. Thus, in management accounting approximations are often as useful as, or even more useful than,
numbers that are more precise. A l t h o u g h financial accounting cannot be absolutely precise either, the
approximations used in management accounting are broader than those in financial accounting.

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 9. Report Frequency

Corporations issue detailed, financial statements only annually and less detailed interim reports quarterly by contrast, fairly
detailed management accounting reports are issued monthly in most larger organizations; and reportsoncertain
activitiesmaybepreparedweekly,daily,or-inafewinstancesinrealtime.

10. Report Timeliness

Because of the needs for precision and a review by outside auditors, plus the time requirements
of typesetting, financial accounting reports are distributed several weeks after the close of the ending December
31generally are not received by shareholders until March or April. By contrast, because management accounting reports
may contain information on which management needs to take prompt action, these reports are
usually issued within a few days of the end of a month.

11. R e p o r t E n t i t y

Financial statements describe the organization as a whole. Although companies that do business in several
industries are required to report revenues and income for each industry, these are large segments of the whole enterprise.
Management accounting, by contrast focuses, mainly on relatively small parts of the entity that is, on individual products,
individual activities, or individual divisions, departments and other responsibility centers.

12. L i a b i l i t y P o t e n t i a l

Although it happens infrequently, a company may be sued by its shareholders or creditors for allegedly reporting
misleading financial information in its annual report. By contrast, as previously stated, management accounting reports
need not be in accord with GAAP and are not public documents. Although a manager may be held liable for
some inappropriate action and management accounting information conceivably may have played some role in his or
her taking that action, it is the action itself, not the management accounting documents that gives rise
to the liability

Role of the Management Accountant in the Management Process

The management process involves planning, organising, controlling, directing, communicating and
motivating. We will explain each of these functions:

Planning
Planning is the basic function of the management by means of which the managers decide:

 What goals are to be accomplished

 How they will be accomplished
 Planning gives the manager a warning of possible future crisis and therefore they avoid the
need to make unplanned decisions.
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  The management accountant helps to formulate future plans by providing information to
assist in deciding what product to sell, in what market and at what prices and in evaluating
proposals for capital expenditure.
 In the budgeting process the management accountant provides data on past performance,
establishes budget procedures and budget time tables.

Control
 Control involves a comparison of actual performance with the plan so that deviation from the
plan can be identified and corrective action taken.
 It can be defined as the process of compelling events to conform to a plan. The management
accountant aids the control process by providing performance reports that compare the
actual performance with the planned outcome for each responsibility centre.
 A responsibility centre may be defined as a segment (e.g. a division) of an organisation where
an individual manager holds delegated authority and is responsible for the segments
performance.
 The management accountant also draws a manager’s attention to those specific activities
that do not conform to a plan. This aids the process of Management By Exception

Organizing
 It is the establishment of the framework within which the required activities are to be
performed and the designation of who should perform these activities. It involves the
establishment of decision units such as departments, sections, branches, etc.
 The management accountant will provide information on the performance of each of these
segments.

Motivation
Motivation involves influencing human behaviour so that the participants identify with the objectives
of the organisation and makes decisions that are in harmony with these objectives. Budgets and
performance reports produced by management accountants motivate the firm’s employees. To be
motivating however, targets should be challenging but achievable.

Communication
To communicate means to make known, impart or transmit the information. The management
accountant aids the communication process by installing and maintaining an effective
communication system such as the Management Accounting Information System (MAIS). An
example of a MAIS is the budgetary system.

A management accountant performs the following specific duties:

i. T h e p r o v i s i o n o f relevant i n f o r m a t i o n f o r m a n a g e m e n t - reports,
statements, spreadsheets, etc. as and when required to enable management to respond to
emerging problems/situations as soon as possible.

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 ii. A d v i s i n g m a n a g e m e n t economic consequences and implications of its (proposed) decisions and
alternative course of action
iii. F o r e c a s t i n g , p l a n n i n g a n d c o n t r o l - budgetary control and standard costing,
strategic planning, e.g. the setting of objectives and the formulation of policy. The forecasting process will involve
accountingforuncertainty(risk)viastatisticaltechniques.
iv. C o m m u n i c a t i o n s , i . e . e s t a b l i s h m e n t o f a good, sound, reliable and efficient
communication system. Such a system should communicate clearly by providing information in a form,
which the user, i.e. managers and their subordinates, can easily understand(reports, statements,
tabulations, graphs and charts).However, great care should be taken to ensure that managers do not
suffer from ‘information overload’, i.e. having too much information much of which they
could well do without
v. Systems
Involves design of cost control systems and financial reporting systems etc
vi. Flexibility
Management accounting should be flexible enough to respond quickly to changes in the
environment in which the company/organization operates. Where necessary information/ systems
should be amended/modified. Thus, there is a need for the management accounting
section/ department to be involved with the monitoring of the environment on a
continuing basis.

vii. An appreciation of other business functions

A management accountant should communicate effectively with other business functions, they also need
to secure their cooperation and coordination, e.g. the budget preparation process relies on the existence
of good communications, cooperation and coordination.

 S t a f f E d u c a t i o n

The management accounting department/ section needs to ensure that all the users of the
information it provides, e.g. managers and their subordinates, are educated about the techniques used,
their purpose and their benefits,etc.

19
 COST CONCEPTS AND CLASSIFICATION
Cost

It is the amount of resources given up in exchange for some goods or services or the amount
of expenditure (actual or notional) incurred on or attributable to a given thing or activity.

Cost unit

This is a quantitative unit of a product, time or service in relation to which cost may be
ascertained, e.g. A kilogram of sugar, a litre of milk, a tone of sand etc. It can be a unit of
service like a passenger seat, a patient bed, etc

Cost Center

It’s a location, person or an equipment for which cost may be ascertained and used for
purposes of cost control and accountability by those responsible for them.

Cost Driver
Its an activity that makes an organization incur cost. An activity can have more than one cost
driver attached to it. For example, a production activity may have the following associated
cost-drivers: a machine, machine operator(s), floor space occupied, power consumed, and the
quantity of waste and/or rejected output
Costing is ascertainment of costs.

Cost accounting

has a wider scope than costing. The main objective of cost accounting are to establish
budgeted and standards cost and to analyze the variances between actual and budgeted
results. Thus costing is part of cost accounting which covers costing techniques in addition to
cost ascertainment.

Cost classification

It may be defined as “the arrangement of cost items in a logical sequence having regard to
their nature and purpose to be fulfilled’. The term cost must be qualified when in use in order
that its precise meaning is established in a particular situation; however, cost refers to the
amount of resources that have been diverted from other uses or sacrificed so as to achieve the
desired objective. But the term is used to refer to various aspects of cost depending on the
base of argumentation that one is approaching the issue from.

Note: the word cost without further qualification is relative and thus should be tagged to some
quantity or measure to become ascertainable.
20
Purpose of Cost Classification

To facilitate cost predictions

There is need to forecast the cost expected to be incurred in a business organization. Prediction
facilities budgeting and hence cost control.

Managerial Efficiency

Cost classification enables the grouping of costs that a manager can control. Managers are said to be
efficient if they can control costs which fall within their discretion.

To facilitate cost allocation

Cost allocation is the charging of costs to a specific department which incurred the cost. Allocation
is only possible if costs are properly classified and summarized in their rightful categories.

Ascertainment of profits

The concept of profit is judged as gross, net or retained. Costs must be appropriately classified to
facilitate the computation of the above profit concept.

To facilitate cost control

By understanding what causes cost and the behavior of cost, managers are able to control the cost
that fall within their discretion.

BASES OF COST CLASSIFICATION

Costs can be classified according to the objective one what to achieve from the intended
classification. The following are the broad bases or categories under which costs can be classified.

a) Classification based on the nature of cost

Under this classification costs can either be classified as either manufacturing or non manufacturing
costs.

Manufacturing costs; these are costs incurred in production of goods and services e.g. Cost
of raw materials, factory labor and manufacturing overheads (OH).

21
 Non manufacturing costs; these are costs which are not incurred in the production of goods
and services but are incurred in activities other than production e.g. Selling and distribution costs,
administration cost etc.

b) Classification based on traceability to the cost units.

Here costs are either classified as direct costs or indirect costs.

Direct costs; these are costs that are directly associated with the cost units e.g. Direct
materials, direct labor and other direct expenses – prime cost

Indirect cost; these costs cannot be identified with the products. They are also called
overheads e.g. manufacturing overheads, selling and distribution overheads as well as administrative
overheads.

c) Classification based on controllability

Under this classification costs are either:

Controllable costs; these are costs which fall within managers discretion and therefore the
costs can be influenced by the manager

Semi controllable costs; these are costs that the management have partial control e.g.
Salaries of unionisable workers which are determined by the management in agreement with the
trade unions.

Uncontrollable costs; these are costs that managers cannot influence at their own discretion
e.g. Taxes, licenses, pension contribution etc.

d) Classification based on the behavior with output

Variable cost; these are costs that they vary or change with the level of output e.g. Cost of
raw materials, labor and overheads.

Fixed cost; these are costs that do not change with the level of output e.g. Rent, depreciation
of buildings and machinery etc.

Semi variable./ Semi fixed costs; these are costs which remain fixed up to a given level of
output and then increase as the level of output increases.

e) Classification based on function

Costs can be classified according to the major functions of the organization namely:

Production costs; these are costs incurred in the factory whether direct or indirect e.g. prime
cost, depreciation of the factory, power and electricity used in the factory, factory insurance et c.

22
 Selling and distribution costs; these are costs incurred in transferring finished goods to the
customers e.g. Salesmen commission, salaries of marketing staff, advertising, discounts, depreciation
of delivery vans, warehousing costs, carriage outwards etc.

Administration cost; These are costs incurred in the management and running of the
business e.g. salaries of general managers, accountants, secretaries, finance costs such as interest
charged and bank charges etc.

f) Classification based on avoidability of costs

Avoidable costs; these are specific costs of an activity or segment which will not be incurred
or which can be avoided if management takes certain decision e.g. if the segment was discontinued
cost of raw materials use to produce a product where production has been discontinued.

Unavoidable costs; these are costs that must be incurred e.g. Payment required in a valid
contractual commitment.

g) Classification based on the relevance of the decision making

Relevant costs; these are costs that can be changed by the decision of the management.
When management makes financial decisions regarding future opportunities, such costs are relevant
because they can be altered by the management.

Irrelevant costs; these are costs not affected by the decision of the management eg. Current
fixed costs such costs should be ignored when making a decision.

h) Classification based on the time period the cost is incurred

Product costs; these are costs incurred in purchasing or manufacturing inventory, they can
be identified with the goods purchased or produced.

Period costs; these are costs not assigned to productive activity expressed in the time period
to which they are charged to the profit and loss as expenses.

23
 COST BEHAVIOUR AND ESTIMATION

Cost Behavior

Introduction
If costs always remained unchanged and completely under control and if an organization’s activities
and operations remained the same from period to period , then there would be little point in studying
cost behavior. Knowledge of cost behavior is necessary across the whole range of cost and
management accounting activities particularly in the areas of control, planning and decision making.

Cost behavior and the volume of activity

Whist other factors influence costs, a major influence is the level or volume of activity and many of
the reasons for studying cost behavior relate to changes in the level of activity. The level of activity
is expressed in many varied ways, e.g. tons produced, hours worked, standard hours produced,
passengers per mile and so on.

Cost behavior and time

Normally the situations where cost behavior is analyzed for planning and decision making are ‘short
run’ in nature. This means that the relationship between cost and activity and the classifications of
the costs themselves are most appropriate over a relatively short time span only.

Variable Cost Behaviour

There are two main divisions of variable cost patterns ie. Linear and non linear (curvilinear)

a) Linear Variable Cost

Is where the relationship between variable cost and output can be shown as a straight line on a
graph

C
O

S
T

OUTPUT OUTPUT
OUTPUT
Fig: Linear Variable Cost

For calculations and analysis, its usually more convenient to express the linear relationship
algebraically this:

Cost = bx where x=volume of output in units, & b = a constant representing variable cost per unit

24
 b) Non linear/ Curvilinear Variable Costs
In general where the relationship between variable cost and output can be shown as a curved line on
a graph, it would be said to be curvilinear. Two typical curvilinear variable costs or convex and
concave

C Convex C Concave
O O

S S
T T

OUTPUT OUTPUT

Convex : Where each extra unit of output causes a less than proportionate increase in cost

Concave Where each extra unit of output causes a more the proportionate increase in cost eg.
Where a piecework scheme for individual workers with differential rates. If rates
increased by small amount at progressively higher output levels the graphing of
wages for a number of workers would result in a concave cost function. Other
statistical function which may represent such a cost function is compound interest
curve.

Fixed cost
It’s a cost which is incurred for a period which within certain output and turnover limits, tends to be
unaffected by fluctuations I the levels of activity (output or turnover)e.g., rent rates, insurance,
salaries of executives. An alternative term for fixed cost is period cost

C
Costs assumed to be
O
constant at all level of
S
T

OUTPUT

Fig: Fixed cost

Fixed cost can be expressed algebraically: Cost = a where a is a constant

Semi variable costs (also semi fixed or mixed costs)

- It’s a cost containing both fixed and variable components and which is thus partly affected by
fluctuation in the level of activity.
- Rarely is a cost purely fixed or purely variable, frequently there are elements of both
classifications in a cost e.g. Electricity changes contain a fixed element, the standing charge
and a variable element , the cost per unit consumed.

25
 - They can be shown graphically thus

a a a

Linear Convex Concave

a = Fixed cost

It can expressed algebraically as:

(1)Linear semi variable : Cost = a + bx
(2)Curvilinear semi variable: Cost = a + bx + cx2 + dx3 …….+ function

Cost Estimation

Meaning of cost

The scope of the term 'cost' is extremely broad and general. It is, therefore, not easy to define or
explain this term without leaving any doubt concerning its meaning. Cost accountants, Economists
and others develop this concept of cost according to their needs. This concept should therefore be
studied in relation to its purpose and use. Some of the definitions of cost are given hereunder:
 "A cost is the value of economic resources used as a result of producing a product or service"
(WM. Harper)
 Cost is "the amount of expenditure (actual or notional) incurred on or attributable to a given
thing" (ICMA)
 Cost is "an exchange price, a foregoing, a sacrifice made to secure benefit" (A tentative set of
Broad Accounting Principles for Business Enterprises)

Level of activity
The level of activity is the amount of work done or the number of events that has Occurred.
The type of activity which influences cost varies according to the nature of work done in the
organisation or department, and the nature of the items of cost whose behaviour is being analysed
depending on the circumstance. The level of activity may refer to:
 the volume of production in a period,
 the number of items sold,
 the value of items sold,
 the number of invoices issued,
 the number of invoices received,
 the number & units of electricity consumed,
 the number of units registered by a student, etc.

26
27
 Concept of Cost Behaviour

Cost behaviour is the study ofthe ways in which cost react or do not react to changes in the
level of activity of an organisation. Knowledge of cost behaviour is the basis of all cost-
volume-profit (C.V. .P) analyses. When we know the behaviour of costs, then financial
planning is made simpler.

Reasons for studying cost behavior

There are three principal reasons for studying how costs respond to changes in the level of activities:
 For the prediction of cost to facilitate budgetary and corporate planning
 For performance evaluation when a system of flexible budgetary control is in operation
 For the estimation of costs for various decision making processes e.g. pricing decisions, make
or buy decision, optimal product mix, shut-down decisions etc

Determining how cost will change with output and other measurable factors of activities is of
vital importance for decision making planning and control. Knowledge of cost behaviour is
necessary across the whole range of cost account and management activities particularly in areas
of cost extra planning and decision making. The preparation of budgets, the productions of
performance reports, and the calculation of production cost on the provision of relevant costs for
pricing and other decision all depends on reliable estimates of costs and distinguishing between
fixed and variable costs at different activities levels. Unfortunately costs are not easy to predict
since they behave differently on different circumstances.

Need for Cost Estimation

Recall there exists a mixed cost or semi-variable cost or semi-fixed cost. These are said to be costs
which are partly fixed and partly variable i.e. a cost which is a composite of a standing basic charge
plus a variable change per unit of consumption. If all costs are to be classified as either a fixed cost
or a variable cost, then a mixed cost has to be so separated into its variable and fixed costs

Illustration

Imagine the telephone bill received from Telkom Even in situations where the
telephone is still out of service, you still receive a bill for the month. You would
wonder where the charges came from. Well, it is the standing charge for having a
line, which would carry a fixed charge. And in addition to this, you pay a
constant variable charge per usage. The two changes would have been added
together and sent to you as a bulk, which you may have to separate for planning
purposes and budgeting.
components.

Method of Estimating Costs: Include:-

28
1. Engineering methods
2. Inspections of Accounts Methods
3. High-Low Method
4. Graphical and Scatter Graph Methods
5. Regression (Least Square Methods)

1. Industrial Engineering methods

Engineering methods of analysis cost behaviour are based on the use of engineering analysis of
technological relationship between inputs and outputs. The approach is appropriate when there is
a physical relationship between cost and cost driver. The procedure when undertaking an
engineering study to make an analysis based on direct observations of the underlying physical
qualities required for a activity and then to convert the final results with cost estimate.

Engineers who are familiar with the technical requirements estimate the quantities of materials,
labour and machine hours required for various operations. Prices and rates are then applied tot eh
physical measures to obtain the cost estimates.

The engineering method is used for estimating costs of repetitive processes where input/output
relationships are clearly defined.

2. Inspection of the Accounts Method

This method requires that the department managers and the accountant to inspect each item
of expenditure within the accounts for a particular period and then classify each item of
expense as wholly fixed, wholly variable or semi-variable costs. A single average unit cost
figure is selected for the items that are categorized as variables whereas a simple total cost
for the period is used for the items that are categorized as fixed cost. For semi-variable
items, the departmental managers and the accountants agree a cost function that appears to
best describe the cost behaviour.

Cost function == C= a + bx, Where: a= fixed cost, b= variable cost/unit, and c= quantity

There is a need to obtain an estimate of a & b so that once a sales forecast (demand), x is
obtained, then T.C. can be predicted.

Illustration

29
The following cost information has been obtained from latest monthly accounts for an
output level of 10,000 units for a cost centre

Direct materials 100,000/=

Direct labour 140,000/=

Indirect labour 30,000/=

Depreciation 150,000/=

Repair and maintenance10,000/=

295,000

Required

Determine the cost of function using the accounts analysis method

Solution

Variable cost Fixed cost

Direct material 100,000

Direct labour 140,000

Indirect labour 30,000

Depreciation 150,000

Repairs and maintenance 10,000

240,000 55,000

= = 24

y= a + bx

cost fn = 55,000 + 24x

Weaknesses of Inspection of Accounts Method

30
 The analysis of cost in to variable and non- variable element is very subjective. The latest
cost details that are available from the account will normally be used. What happens today
may not be4 repeated in the future/ this may not be typical of either past or future cost
behavior? Cost estimated based on this methods involves individual and often arbitrary
judgment and they may therefore lack the preceptor necessary when they are to be used in
making decision that involve large sums of money and that are sensitive to measurement
errors. The general cost fn is given by y= a + bx & from the scatter diagram, the value of a
is 240.

Class Exercise

The following data was extracted from records of an assembling department in a particular
period.

Cost Fixed Variables

D. Materials - 4,000,000

D. Labour - 3,500,000

Rent 1,000,000

Salaries 1,500,000

Electricity 200,000 300,000

2,700,000 7,800,000

Suppose the activity level for the period in question was x=20,000 units and assume fixed costs
will remain so: Determine (a) the cost function

(b) The predicted cost for next year if x is expected to be 22,000 units.

Solution: (a) a=2700000

b= 7800000 390/=
20 000
Therefore the predictive cost function is C = 2,700,000 + 390q

(b) When q= 22000 units, C = 2700000 + 390 (22000)

31
 = 11,280,000

The following illustration will be used to demonstrate how the other three methods are used:

Illustration
ABC Corporation wishes to set flexible budget for each of its operating department. A separate
maintenance departments performs all routine and major repair work on the corporation
equipment and facilities. It has been determined that costs is primarily ‘a function of the machine
hours worked in various production departments. The actual machine hours worked and
maintenance costs incurred during the first four month of 2004 are as follows:
Period Machine hours Maintenance cost

January 800 350

February 1200 350

March 400 150

April 1600 550

Required:

a. Draw a scatter diagram

b. Compute variable maintenance cost/ machine hours and fixed maintenance cost per month
using with the high- low method.

c. Compute variable maintenance cost per month using with least square regression method

Methods 3: Scatter graph technique

Under this method, the coordinates of the cost and the associated level of activity in respect of historical
records for a defined period of time are plotted on a graph. A line of best fit is then drawn usually
across the coordinates crossing the cost axis. This technique fits a trend line to a series of historical
data points and then projects the line into the figure for medium to long-term forecasts.

Solution to illustration 1 (a)

32
C
O Series2

S
T

Machine Hours

33
Methods 4: High- low method

Under this method, a previous data relating to a defined period of time is extracted from the
historical records and in particular, two previous data corresponding to the highest level of activity
during the same period and the lowest level of activity during the same period, together with their
associated corresponding costs form the basis for the derivation of the cost function. The differences
between the total cost of the high output and the total cost of the low output will be the variable
cost of the different output levels.

The non-variables cost can be estimated at any level of activity by subtracting the variable cost
from the total cost. The variable element is given by

b=

Solution to illustration 1 (b)

Activity level Machine hour cost

Highest 1600 550

Lowest 400 150

1200 400

Variable costs = = =
0.33

Fixed cost: total cost= F.C + 0.33 x 1600→FC = 550- (0.33 X1600)

Cost Function = $17

Machine Hours = $ 17 + 0.33 machine hours.

Advantage of high- low method

Easy to use especially when a rough forecast is needed.
Disadvantages
 It doesn’t consider all the observations. Actually it ignores all the observations except two
of them.
 It can’t measures the size of probable error

34
 Only one independent variable is considered
 The method assumes that relationship exists between the independent variables and
dependent variables and that this relationship is linear.

Practice Question with solution (students are advised to attempt the question without checking the answer
and then compare their solution with the solution given below).

The costs of operating the maintenance department of AB.C. Manufacturing Limited

for the last four months have been given as
follows:

Month Total cost Production

KSh volume
1 111,000 7,000
2 115,000 8,000
3 113,000 7,700
4 97,000 6,000

You are required to compute total cost for month five (5) when output is expected to be
7,500 standard hours.

Solution
Steps (a) Identify the highest activity and its corresponding total cost.
(b) Identify the lowest activity and its corresponding total cost
(c) Determine the difference in activities and the total costs
(d) The change in total cost due to the corresponding change in activities
would be the variable cost per standard hour
(e) Make necessary substitutions in either the high or low volume cost.
Standard Total
Hours Cost
Ffigh output 8,000 115,000
Low output 6,000 97,000
2,000 18,000
Variable cost per standard hour is
18.000
2000 = KSh 9 per standard hour

Substituting in either the high or low volume cost:

High Low
KSh KSh
Total cost KSh
115,000 97,000
Variable cost (800 x 9) 72,000 (6,000 x 9) 4.000
Fixed cost 43,000 43,000

35
 22

36
 The estimated cost of 7,500 standard hours of output would be:

Fixed cost 43,000

Total variable cost (7,500 x KSh 9) 67,500
Total cost 110,500

Method 5: Least Squares Method

This method determines mathematically the repression line of best fit. It is based on the
principals that the sum of the square of the vertical deviation from the line that is
established using the method is less than the sum of square of the vertical deviation from
any other live that might be drawn. The regression equation for a straight line (y=a + bx)
that meets this requirement can be found from the following normal equation by solving for
a and b.
Normal equations:
∑y = n a + b∑x
∑xy = a∑x +b∑x2
Where n= Number of Observations
y= dependent variables
x = independent variable
a = fixed elements
b = variables element per units.

Solution to illustration 1 (c): Least Square Method

Observations x y x2 xy
1 January 800 350 6,400,000 280,000
2 February 1200 350 1,440,000 420,000
3 March 400 150 160,000 60,000
4 April 1600 550 2,560,000 880,000
∑x=4000 ∑y=1400 ∑x2=4,890,000 ∑xy=1,640,000

37
1400 = 4a + 4000b x 1000
1640000 = 4000 a + 4890000 b
1,400,000 = 4000 a + 4,000,000 b
1,640,000 = 4000 a + 4,890,000 b
-240,000 = - 890,000 b

Therefore, b = = 0.274

Illustration 2
The management account of Chania ltd provides the cost and activity data taken from past
records as follows:
Cost (y) activity (units) .x
56 4
62 5
80 7
72 7
88 9
94 10
Required:
a) Calculate the fixed and variable element of cost using the least square methods
b) Forecast the total cost when the activity is 12 units

Solution
y x xy x2

56 4 224 16

62 5 310 25

80 7 560 49

72 7 504 49

88 9 792 81

38
94 10 940 100

€y = 452 €x= 42 €xy = 3330 €x2= 320

Substitute
(452 = 6a + 42b)
3330 = 42 a + 320 b
3164 = 42a + 294b
3330 = 42a + 320b
166 = 166b
b= 6.385
a = 30.6
thus y= 30.6 + 6.385

for 12 units cost = 30.6 + 6.585 (12)

Practice Question One

The management account of Chania ltd provides the cost and activity data taken from past
records as follows:
Cost Activity (units)
56 4
62 5
80 7
72 7
88 9
94 10
Calculate the fixed and variable element of cost using the least square methods. Forecast the
total cost of the activity in 13units

QUESTION TWO

39
The following data has been provided by a catering company that prepares banquets and
parties for both individuals and business functions through the year. The data indicates that
overhead expenses vary with the direct labour hours expended.

Month Labour hours Overhead costs(sh.)

January 2,500 55,000

February 2,700 59,000

March 3,000 60,000

April 4,200 64,000

May 4,500 67,000

June 5,500 71,000

July 6,500 74,000

August 7,500 77,000

September 7,000 75,000

October 4,500 68,000

November 3,100 62,000

December 6,500 73,000

Total 57,500 805,000

Required
(a) Using regression analysis, calculate the variable cost per person for a cocktail party, if
the following additional information is given. The cost structure on a person basis is;

Food and beverages sh.15.00

Labour (0.5) 5.00

(15 marks)

(b) The company has asked you to prepare a bid for a 200 person cocktail party to be given
next month. Determine the minimum bid price the company would be willing to submit
to earn a profit. (5 marks)
c) The following costs and activity data were taken from factory records.
Cost incurred Activity (units)

40
 Sh Sh

656 80

692 86

683 87

698 94

707 95

703 97

712 104

i) Draw a scatter graph to represent the above information

ii) Determine a cost function using high low method
iii) Determine the regression equation using the least square method and interpret the
regression equation obtained (4 marks)
iv) Calculate the cost incurred when the activity level is 250 units (3 marks)

41
MARGINAL COSTING AND ABSORPTION COSTING.

The above are costing techniques. They are explained below.

Marginal Costing: - marginal costing distinguishes between fixed costs and variable costs
as conventionally classified. The marginal cost of a product is its variable cost. This is
normally taken to be:

 Direct labour
 Direct material
 Direct expenses and
 The variable part of overheads.
Therefore

Marginal Cost/variable cost = Direct Labour + Direct Materials + Direct expenses +

variable overheads.

Contribution = sales - marginal cost.

NB: Alternative names for marginal costing are “contribution approach” or “direct Costing”

Uses of marginal costing

There are two main uses for the marginal costs concept.

a) As a basis for providing information to management for planning and decision

making. It is particularly appropriate for short run decisions involving changes in
volume or activity and the resulting cost changes.
b) It can also be used in the routine cost accounting system for the calculation of costs
and the valuation of stocks.

ABSORPTION COSTING

Absorption costing sometimes known as total absorption is the basis of all financial
accounting statements. Using absorption costing, all costs are absorbed in to the production
and thus operating statements do not distinguish between fixed and variable costs.
Consequently the valuation of stocks and Work-In-Progress contains both fixed and
variable elements. On the other hand, using marginal costing, fixed costs are not absorbed
in the cost of production, they are treated a period costs and written off each period in the
costing profit and loss account.

42
Illustration 1

In a period, 20 000 units of Z were produced and sold costs and revenue were:

£
sales 100 000
Production costs variables 35 000
fixed 15 000
Admin. & selling overheads: fixed 25 000
RQD: Show operating statements using (i) marginal costing

(ii) Absorption costing

Absorption Costing Approach Marginal Costing Approach

£ £
Sales 100 000 Sales 100 000
Less Production Cost of sales (50 000) Less Marginal Cost (35 000)

Gross profit 50 000 Contribution 65 000

Less Administration & Selling (25 000) Less fixed costs:
Net profit 25 000 Production (15000)
Admin & Selling (40 000)

25 000

Illustration 2

A Company produces a single product. The following is the budget for the product
Budget
i) Selling price Ksh.10
ii) Direct material cost per unit Ksh.3
iii) Direct wages per unit Ksh.2
iv) Variable overhead per unit Ksh.1
v) Fixed production overhead Ksh.10,000 per month
vi) Production volume 5,000 units per months
Actual
i) Production 6,000 units
ii) Sales 4,800 units
iii) Assume that all costs were as budgeted

43
Required;
Prepare a profit statement using:
i) Absorption costing
ii) Marginal costing
iii) Prepare a reconciliation statement to reconcile the two reported profit figures
under absorption and marginal costing

Solution
Use units budgeted to absorb fixed overhead to product units
O A R = Fixed overheads / No of units
= 10,000 / 5000 units
= Ksh. 2 per unit
Marginal costing Absorption costing
Direct material 3 3
Direct labor 2 2
Variable overhead 1 1
Fixed overhead 0 2
Cost per unit (E) 6 8
Absorption overhead (6,000 × 2) = 12,000
Actual overhead = 10,000
Over absorption = 2,000

Profit and loss statement

i) Absorption costing
Ksh Ksh
Sales (4,800×10) 48,000
Cost of sales
Opening stock 0
Production cost (8 × 6,000) 48,000
Less closing stock (6,000 - 4,800) × 8 9,600
Cost of sales 38,400

44
 Unadjusted gross profit 9,600
Add: under recovery 2,000
Adjusted profit 11,600
Note: If it is over recovery we subtract.

ii) Marginal costing

Ksh Ksh
Sales (4,800 × 10) 48,000
Marginal cost
Opening stock 0
Add production cost (6 × 6,000) 36,000
Less closing stock (6000 - 4,800) × 6 7,200
Cost of sales 28,800
Gross profit 19,200
Less fixed overheads 10,000
Net profit 9,200

Reconciliation statement under marginal and absorption costing

Profit under absorption costing = 11,600
Difference in opening stock (0 - 0) 0
Less: difference in closing stock (9,600-7,200) = (2,400)
Profit under marginal costing = 9, 200

Alternative method
Profit Statement
Marginal cost Absorption costing
Ksh Ksh Ksh Ksh
Sales (4 800× 10) 48,000 48,000
Less: Variable cost of sales
Direct material (6 000× 3) 18,000 18,000
Direct labor (6 000× 2) 12,000 12,000
Variable overhead (6000×1) 6,000 6,000
Fixed production (6000× 2) Nil 12,000
Total cost 36,000 48,000
Less closing stock 7,200 9,600

45
 Cost of sales 28,800 38,400
Contribution to gross profit 19,200 9,600
Less fixed cost 12,000 Nil
Unadjusted profit 7,200 9,600
Add over recovery of o/h Nil 2000
Net profit 9200 11,600

Illustration 3

The following information has been extracted from the books of Solarcross Ltd for the year to 31
March 2000:
Units ‘000’
Production 30
Sales 24
Production cost incurred: Sh ‘000’
Direct material 7,200
Direct labour 1,800
Variable overheads 1,500
Fixed overheads 2,700
Selling and administrations costs:
Sales and salaries 450
Variable sales commission 300
Promotion and advertising 480
Other fixed costs 720
The company’s unit selling price is Sh 550.
Required:
a) Profit and loss statement under direct costing approach. (8 marks)
b) Profit and loss statement under indirect costing approach. (8 marks)
c) An explanation of the difference in profit or loss in (a) and (b) above. (4 marks)

Illustration 3
Asante Sana Ltd. is a manufacturing company which produces and sells a single product “Dawa
MOTO”.

Cost Shs.

Variable manufacturing 45

Fixed manufacturing 35

46
 Variable selling and administration 8

Fixed selling and administration 30

118

Fixed manufacturing costs per unit are based on a predetermined rate established at a normal
activity level of 18,000 production units per period. Fixed selling and administration costs are
absorbed into the cost of sales at 20% of the selling price. Under/over recovery of overheads are
transferred to the profit and loss account at the end of each period.

The following information has been provided for two consecutive periods:

Period 1 Period 2

Sales: (units) 17,000 18,000

Value Sh 2,550,000 Sh 2,700,000

Variable manufacturing costs Sh 720,000 Sh 828,000

Variable selling and administration costs Sh 136,000 Sh 144,000

Fixed manufacturing costs Sh 640,000 Sh 630,000

Fixed selling and administration costs Sh 540,000 Sh 540,000

Production (units) 16,000 18,400

Required:

a) Income statements for each of the periods under the full costing method. (5 marks)
b) Income statements for each of the periods under the direct costing method. (5 marks)
c) Reconciliation for each period of the profit/loss obtained under the two methods in (a) and
(b) above (4 marks)
d) Outline three arguments in favour of
i) The full costing method (3 marks)
ii) The direct costing method (3 marks)
(solution given t he end of the chapter)

Illustration 4

X limited commenced business in 1st March making one product only, the standard cost of which
is as follows

47
 £

Direct labour 5

Direct material 8

Variable production overhead 2

Fixed production overhead 5

Standard production cost £20

The fixed production overhead figure has been calculated on the basis of a budgeted normal
output of 36,000 units per annum.

You are to assume that there were no expenditure or efficiency variances and that all the
budgeted expenses are incurred over the year. March and April are to be taken as equal period
months. Selling distribution and administration expenses are;

Fixed: £ 120,000 per annum

Variable: 15% of the sales value.

The selling price is £35 and the number of units produced and sold was:

March units April units

Production 2,000 3,200

Sales 1,500 3,000

You are required;

a) Prepare profit statements for each of the months of march and April using :
i. Marginal costing and
ii. Absorption costing
b) Present a reconciliation of the profit and loss figures given in your answers (a) i and (a) ii
accompanied by a brief explanation.

48
c) Comment briefly on which of the costing principle i.e. marginal or absorption should be used
for what purposes and why referring to any statutory or other mandatory constraints
Solution

Profit statements using marginal costing.

March April

Sales (1500 x 350 52,500 (30,000 x 35) 105,000

Less: marginal cost of sales

Opening stock - (500 x15) 7,500

Manufacturing cost (2000 x 15) 30,000 (3,200 x 15) 48,000

Closing inventories (500 x 15) (7500) 22,500 (700 x 15) (10,500) 45,000

G.P 30,000 60,000

Less other variable costs (.15x52,000) 7,875 (15% x 105,000) 15,750

Contribution 22,125 44,250

Less fixed costs selling,

distribution & admin (120,000/12) 10,000

Production (3000x5) 15,000 (25,000) 25,000

Net profit. (2875) 19,250

ii Profit statements using absorption method

march April

sales 52,500 105,000

less cost of sales

opening - 10,000

manufacturing cost 20 x 2000 40,000 64,000

Goods available for sale 40,000 74,000

less closing stock (500 x 20) (10,000) (30,000) 14,000 (60,000)

49
 Under/over- absorption (3000 - 2000) x 5 (5,000) 1,000

gross profit 17,500 46,000

Less: selling Dist & Adm costs 7,879 15,750

Non manufacturing costs 10,000 (17,875) 10,000 25,750

(375) 20,750

iii). Reconciliation of profit

March April

Marginal cost result (2,875) 19,250

Fixed overhead (1500 x 5) carried forward

in 500 units 2,500 (2,500)

Fixed overhead in 700 units c/f (700 x 9)

Absorption . 3,500

(375) 20,250

d) As pointed out earlier either method could be used for internal purposes but because of IAS 2
recommendations, absorption costing is generally preferred for reporting purposes. For
decision making marginal costing could be of value.

Exam type Question with solution

A company manufactures a single product with the following variable cost per unit.

Direct materials £7.00

Direct labour £5.50

Manufacturing overheads £2.00

The selling price of the product is £36.00 per unit. Fixed manufacturing costs are expected to be
£1,340,000 for a period. Fixed non-manufacturing costs are expected to be £875,000. Fixed
manufacturing costs can be analyzed as follows:-
50
 Production dept 1 Production dept 2 Service Dept General Factory

£ 380,000 £469,000 £269,000 £230,000

General factory costs represent space cost, for example rates, lighting and heating. Space is as
follows:

Production department 1 40%

Production department 2 50%

Service department 10%

60% of service department costs are labour related and the remaining 40% machine related.

Normal production department activity is:-

Direct labour hours Machine hours Production units

Department 1 80,000 2,400 120,000

Department 2 100,000 2,400 120,000

Fixed manufacturing overheads are absorbed at a pre-determined rate per unit of production for
each production departments based upon normal activity.

Required:

a) Prepare a profit statement for the period using the full absorption costing, showing each
element of cost separately. Costs for the period were as expected except for additional
expenditure of £20,000 on fixed manufacturing overheads in the production department 1.
Production and sales were 116,000 and 114,000 units respectively for the period.
b) Prepare a profit statement for the period using marginal costing principles instead.
c) Contrast the general effect on profit of using absorption and marginal costing systems
respectively. (Use the figures calculated in (a) and (b) above to illustrate your answer.

Solution

a) Fixed manufacturing overhead absorption rate.

Production Services General

Department Department factory Total

51
 1 2

1,340,00
Allocated 380,000 469,000 265,000 230,000 0

Share of general
factory 92,000 115,000 23,000 (230,000)

288,000

76,800 96,000 (172,800) (60%x288)

57,600 57,600 (115,200) (40%x288)

606,400 733,600

Per unit 606,400 =5.053 733,600 = 6.113

120,000 120,000

Total manufacturing costs per unit based on normal activity

Direct material 7.00

Direct labour 5.50

Variable overhead 2.00

Fixed overhead Dept 1 5.053

2 6.113

25.665

b) Profit statement using absorption.

£’000’

Sales: 114,000 units x £36 4,104

Less cost of sales 114,000 units x 25.665 2,926

Gross profit 1,178

Non manufacturing cost 875

52
 Net profit (before adjustment) 303

Under–absorbed overhead Dept 1: (20,000 + (4000 x 5.053) (40.2113)

Dept 1 (4000x 6.113) (24.453)

Profit adjustment 238.3

Profit statement – margin costing

Sales 114,000 units x £36 4104

Less variable cost of sales (11000 x 14.5) (1653)

Contribution 2451

Less: Fixed costs of manufacturing (1340 + 20) 360

Non manufacturing 875 2,235

Net profit 216

c) There is a £ 22,300 increase in profit shown by the absorption costing approach. This
represents the fixed costs carried in stock i.e. 2,000 (5.05 + 6.113)

Arguments for marginal costing or absorption costing

Arguments for marginal costing.

i) Simple to operate
ii) No apportionment, which are frequently on an arbitrary basis of fixed costs to the products or
departments. Many fixed costs are indivisible by their nature e.g. managing director’s salary.
iii) Where sales are constant but production fluctuates (possibly on unlikely circumstances)
marginal costing shows a constant net profit whereas absorption costing shows variable
amount of profit.
53
iv) Under or over absorption of overheads is almost entirely avoided. The usual reasons for
under/ over absorption is the inclusion of fixed costs into overheads absorption rates and the
level of activity being different to that planned.
v) Fixed costs are incurred on a time basis e.g. salaries, rent. Rates etc and do not relate to
activity. Therefore it is logical to write them off in the period they are incurred and this is
done using marginal costing.
vi) Accounts prepared using marginal costing are nearly approach the actual cash flow position.

Arguments for the use of total absorption in routine costing.

i) Fixed costs are a substantial and increasing proportion of costs in modern industry.
Production cannot be achieved without incurring fixed costs which thus forms an inescapable
part of the cost of production, so should be included in stock valuations; marginal costs may
give the impression that the fixed costs are somehow divorced from the production.
ii) Where production is constant but the sales fluctuate, net profit fluctuations are less with
absorption costing than with marginal costing.
iii) Where stock building is a necessary part of operations e.g. timber is seasoning, spirit
manufacturing, fireworks manufacture the inclusion of fixed cost in the stock valuation is
necessary and desirable: otherwise a series of fictitious loses will be shown in earlier periods
to be offset eventually by successive profits when the goods are sold.
iv) The calculation of marginal costs and the concentration upon contribution may lead to the
firm setting prices which are below total costs although producing some contribution.
Absorption costing makes this less likely because of the automatic inclusion of fixed charges.
v) IAS 2 (stocks and W-I-P) recommends the use of absorption costing for financial accounts
because costs and revenues must be matched in the period when the revenue arises not when
the costs are incurred. Also it recommends that the stock valuation must include production
overheads incurred in the normal course of business even if such overheads are time related
that is fixed. The production must be based upon normal activity levels.

Solution to illustration 3
(a)

Asante Sana Ltd

Income Statement (Absorption /Full Costing Method)

For the Period I

Shs. Shs.

54
Sales 2,550,000

Less Cost of Sales

Opening Stock 80,000

Add Production Costs:

Variable Manufacturing Costs: 720,000

Fixed Manufacturing Costs: 560,000

1,360,000

Less Closing Stock: _______

Cost of Sales: (1,360,000)

GROSS PROFIT 1,190,000

Expenses

Under absorbed Fixed Manufacturing Costs

(560,000 – 640,000)
80,000

Variable Selling and Administration Costs: 136,000

Fixed Selling and Administration Costs: 540,000 (756,000)

NET PROFIT 434,000

55
Asante Sana Ltd

Income Statement (Absorption /Full Costing Method)

For the Period II

Shs. Shs.

Sales 2,700,000

Less Cost of Sales

Opening Stock -

Add: Production Costs:

Variable Manufacturing Costs: 828,000

Fixed Manufacturing Costs: 644,000

1,472,000

Less Closing Stock: 32,000

Cost of Sales: (1,440,000)

GROSS PROFIT 1,260,000

Add: Over absorbed Overheads:

Fixed Manufacturing Costs: (644,000 – 14,000

630,000)

Variable Selling and Administration Costs

(147,200 – 144,000)
3,200

Fixed Selling and Administration Costs

(552,000 – 540,000) 12,000 29,200

1,289,200

Expenses:

Variable Selling and Administration Costs: 147,200

Fixed Selling and Administration Costs: 552,000 (699,200)

NET PROFIT: 590,000

56
b)
Asante Sana Limited
Income Statement (Marginal Costing Method)
For the Period:
I II

Shs. Shs. Shs. Shs.

Sales 2,550,000 2,700,000

Less Cost of Sales

Opening Stock 45,000 -

Add: Production Costs:

Variable Manufacturing Costs: 720,000 828,000

765,000 828,000

Less Closing Stock: - (18,000)

Cost of Sales: (765,000) (810,000)

GROSS CONTRIBUTION: 1,785,000 1,890,000

Less Variable Selling and Administration

Costs:
(136,000) (144,000)

NET CONTRIBUTION: 1,649,000 1,746,000

Add:

Over absorbed Overheads:

Fixed Manufacturing Overheads: - 14,000

Fixed Selling and Administration Costs: ________- 12,000 26,000

1,649,000 1,772,000

Period Expenses:

Fixed Manufacturing Costs: 560,000 644,000

Under absorbed Fixed Manufacturing 80,000

costs:

640,000

57
 Fixed Selling & administration Costs: 480,000 552,000

Add Under absorbed Overheads: 60,000 540,000 (1,180,000) _______ (1,196,00

0)

NET PROFIT: 469,000 576,000

(c) Reconciliation of Profits for Period I

Shs
Net Profit as per Absorption Costing 434,000
Add: Over-valuation of opening stocks as
per Absorption costing: (80,000 – 45,000) 35,000
Net Profit as per Marginal Costing: 469,000

Reconciliation of Profits for Period II

Shs
Net Profit as per Absorption Costing: 590,000
Less: Over-valuation of closing stocks as
per Absorption Costing: (32,000 – 18,000) (14,000)
Net Profit as per Marginal Costing: 576,000

Workings:
Absorption Costing: Marginal Costing:
Standard Cost Per unit of Variable Manufacturing
Stock: Costs 45 45
Fixed Manufacturing
costs 35 _-
80 45

Units of Opening Stock: = Sales – Production

= 17,000 – 16,000 B/F = 0
= 1,000

Value of Opening = 100 x 80 -

Stocks: = 80,000

Units of Closing Stocks Production – sales = 18,400 – 18,000

- = 400

Value of Closing Stocks: - = 400 x 45

= 18,000

b) Arguments in favour of Absorption (Full) Costing:

1. Fixed Manufacturing Costs are not divorced from production. They are very significant especially in
the modern automated industry. Thus, they should be included in the cost of production and
consequently in stock valuation.
2. Where production is constant but sales fluctuate (which is what happens in real business life), the
net profit does not fluctuate as significantly as in marginal costing.

58
3. Where stock building or piling is necessary part of operations, (for example, in timber seasoning)
inclusion of fixed costs in stock valuation is necessary and desirable for statements to show a true
and fair view. Otherwise, a series of fictitious losses will be shown in earlier periods, only to be
offset eventually by excessive profits when the goods are sold.
4. Calculating the total costs of producing a good makes a firm to set a selling price that is NOT below
total cost. Calculating marginal cost and contribution may make a firm to set prices that are below
total cost while still producing some contribution.
5. Matching concepts advocates for absorption costing: Costs and revenues must be matched in the
period when revenue arises, and not when costs are incurred. SSAP (Stocks and Work in Progress)
advocates for the matching concept and recommends that stock valuations must include
production overheads incurred in the normal course of business even if not time related.

Arguments in favour of Marginal Costing:

 Simple to understand and operate.

 No apportionment of overhead costs (which are frequently based on arbitrary basis) to products
and departments are necessary.
 Where sales are constant and production fluctuates, marginal costing shows a constant net
profit while absorption costing net profit would be varying.
 Over or under absorption of overheads (due to levels of activities being different from the
budgeted) is almost entirely avoided.
 Fixed costs are incurred on a time basis e.g. rent, rates, salaries, and they should therefore be
written off or expensed in the period in which they are incurred.
 Accounts prepared using marginal costing more nearly approach the actual cashflow position.

59
 COST – VOLUME – PROFIT ANALYSIS

This is a systematic method of examining the relationship between changes in activity (output)
and changes in total sales revenue, expenses and net profit. M .A. can be of assistance in
providing answers to questions about consequences of the following particular courses of a
solution. Such questions might include:

- How many units must we sell more units?

- What would be the effect on profit if we reduce our selling price and sell more units?
- What sales volume is required to meet additional fixed charges arising from an
advertising campaign? These are other questions can be answered using CVP analysis.

The objective of CVP analysis is to establish what will happen to the financial results if a
specified level of activity or volume fluctuates. This is important information to management
since one of the most important variables influencing total sales revenue total costs, and profits
in output. CVP analysis is based in relationship between volume and sales revenue, costs and
profits in the short run, the short run being a period of one year, or less.

BREAKEVEN ANALYSIS

This is the term used to study the interrelationship between costs, volume and profit at various
levels of activity. The term breakeven analysis implies that the only concern is with that level of
activity which produces neither profit nor loss. The breakeven point which is misleading because
the behavior of costs and profits at other levels is usually of much greater significance because of
this an alternatives term, cost volume-profit analysis or CVP analysis, is frequently used and is
more descriptive.

Concept of Relevant Range:

This is the range in which all assumptions about the level of activities and cost will remain
valid. Within this range, most items of cost will settle into a basic pattern or behaviour and cost
can be classified into either fixed or variable cost.

Illustration
Have you ever heard of installed capacity before this time? If you have, then think about
a car that has the capacity to carry just five persons or a machine that can work
continuously for just twelve hours., if you want the car to carry more than five persons,
then you have to procure another car to extend your relevant range, or if you want the
machine to work continuously for twenty-four hours, you may have to procure the
second machine because that machine has just twelve hours as its Stalled capacity.

60
CVP analysis Assumptions

Before any formulae are given or graph drawn, the major assumptions behind CVP analysis must
be stated Its essential that everyone preparing/interpreting CVP information is aware of the
underlying assumption on which the information is prepared. If these assumptions are not
recognized, serious errors may result, and increased conclusions may b drawn from the analysis.

The assumptions are:

1. All other variables remain constant expect volume through out the analysis.
2. Particularly for the graphical method, that the analysis relates to one product only.
3. Within the relevant range, Total Cost and Total Revenue are linear functions of output.
4. Analysis applies to relevant range only.
5. Costs can be accurately divided into their fixed and variable elements.
6. Fixed cost will remain constant at all levels within a given range.
7. The analysis applies only to a Short term. time horizon.
8. That technology, production methods and efficiency remain unchanged.
9. That the only factors affecting costs and revenues is volume.

It will be seen that these are over simplifying assumptions for many practical situations. It is
because of this that CVP analysis can only be an approximate guide for decision making. Never
the less, by highlighting the interaction of costs, be provided for managers making short run,
tactical decision.

Uses of CVP chart

The CVP chart as a management tool has the following benefits (advantages).

i) This chart is helpful to find the breakeven point and profit or loss at a specific level of
output.
ii) It shows the behavior trend of costs and sales.
iii) It establishes the relationship between costs, sales and profits. This information can
be further used to make the proper decision.
iv) It helps to find the safety level at a particular level of activity.

Limitations of BEF chart

- The chart shows cost, volume and profit relationship a simplified and approximation
manner. They can be useful aids, but whenever they are used the following limitations
should be forgotten.
a) The chart is reasonable pointer to performance within normal activity ranges, e.g.
between 70%-120% of average production. Outside this relevant range, the relationship
depicted almost certainly will not be correct.

61
 b) Fixed costs are likely to change at different activity levels. A stepped fixed cost line is
probably the most accurate representation.
c) Variable costs and sales are unlikely o be linear. Extra discounts, overtime payments,
special delivery changes etc. make it likely that variable cost and revenue lines are form
of a curve rather than c straight line.
d) The chart depicts relationships which are essentially short term. This makes them
inappropriate for planning purposes where the time scale stretches over several years.

CVP analysis

CVP can be undertaken by:

i. Graphical means

The following steps are used:

1. The sales line
Plot the sales volume on the horizontal axis. Sale volume can be in terms of shillings
units, or as a percentage of capacity.
2. Cost and revenue lines
Revenues, variable costs and fixed cost are represented on the vertical axis.
3. Fixed cost line
They are down parallel to the horizontal axis.

Illustration

A company makes a single product with a capacity of 400,000litres per annum and sales data
are as follows: sales price of sh 100/ liter and a marginal cost of sh 50/ liter. Fixed is sh
10,000,000. Required: Draw a traditional break even chart showing the likely profit at the
expected production level of 300,000 liters.

ii. Formulae

The following formulae are used:

a) Breakeven point in sales =

b) Breakeven point in sales = x sales price/unit

= fixed costs x

c) ratio =

x 100

62
 d) Level of sales to result in target profit (in units) =

e) Level of sales to result in target profit after tax (units) =

f) Breakeven point (sales is shs.) for a multi-product firm =

Margin of safety
This is the amount by which actual sales may fall before incurring a loss. It measures the
risk that the company might make a loss if it fails to achieve the target. A high margin of
safety means a high profit expectation even if the budget or target is not achieved.
Margin of safety is given by:

Margin of safety = Expected sales- B E P sales X 100

Expected sales

Illustration 1

A company makes a single product with a sales price of sh.100 and a marginal cost of sh.60.
fixed costs are sh.600,000 p.a. calculate

a. Number of units to breakeven.

b. Sales at breakeven point.
c. Cost per sale ratio.
d. What level of sales will achieve a profit of sh.200, 000 p.a?
e. Because of increasing costs the marginal cost is expected to rise to sh.65 per unit and
fixed costs to sh.700,000 p.a. if the selling price cant be increased what will be the
number of units required to maintain a profit cost of shs.200,000 p.a.
f. It the taxation is 40% how many units will be sold to make a profit of sh.200,000 p.a.

Solution:

a) Breakeven point (in units) = = 15,000 units

b) B/EP in sales (sh.) = 15,000 units x sh.100 = 1,500,000

c) C/S ratio = = 40%

d) Number of units for target profit =

63
 = 20,000 units

e) Sales for target profit = 20,000 x sh.100 = sh.200,000

Fixed Cost, Marginal Cost and contribution have changed, thus

Number of units for target profit = = 25,714

units

f) Number of units for target profit after tax = = 23,333

units.

Illustration 2

Novik Enterprises operate in the leisure and entertainment industry and one of its activities is to
promote concerts in Nairobi. The company is considering the viability of a concert in Nyeri
town. Estimated FC is sh.60, 000. These include fee to perform, the hire of venue and
advertisement cost. Variables costs of a pre-pocked buffet, which will be provided by a firm of
caterers at a price, which is currently being negotiated, but its likely to be in the region of sh.100
per ticket sold. The projected price for the sale of a ticket is sh.200. The management of Novik
have requested the following information:

i. The number of tickets that that must be sold to breakeven.

ii. How many tickets must be sold to earn sh.30000 target profit.
iii. What profit would result of 8000 tickets were sold?
iv. What selling price would be charged to give a profit of sh.300000 from the sales of 8,000
units?
v. How many additional tickets must be sold to cover the extra cost of television
advertisement of sh.8000?

Illustration 3

XYZ Company manufactures a product called “PERMA”. Pertinent cost and revenue data
relating to the manufacture of this product is given below:
Shs
Selling price per unit 66
Variable production cost per unit 44
Variable selling cost per unit 4

64
 Fixed production cost (total) Shs.200,000
Fixed selling and administrative cost (total) Shs.99,000
Required
a) Calculate the break-even sales level in shillings;
b) Suppose the company desires to make a profit of shs.195, 000, what should be the output in
units?
c) A new machine, which is more efficient, is installed. This machine increases the fixed
production cost by 20% but reduces the variable production cost per unit by 30%. What is
the new break-even point in sales revenue?

C-V-P Analysis

Practice Question 1

The following data relate to Kenya Ltd for the year ended 31 December 2009.
Sh ‘000’
Sales 24,000
Less: Total costs 20,000
Net profit 4,000
Fixed costs account for 40% of the total costs.
Required:
i) Margin of safety. (2 marks)
ii) Break-even point in sales (2 marks)
iii) Sales required to earn profit of Sh 6,000,000. (2 marks)
iv) In order to increase sales, the management has the following two options:
1. To increase sales by 25% on incurring a sales promotion cost of
Sh 2,500,000.
2. To increase sales by 15% on reducing selling price by 5%.
Advise the management on which option they should take. (8 marks)

Practice Question 2
Auto Robot Ltd which manufactures two products P & Q has provided the following
Information.
P (shs) Q (shs)
Selling price per unit 10 12
Variable cost per unit 2 8
Fixed cost 50,000 34,000
Required:-
i. Calculate the B. E. P. of each product in units and in shs.
ii. Calculate the margin of safety if budgeted sales are 10,000 units each
iii. Compute the profit of each product if sales in units are 20% above the B. E. P.

65
ASSIGNMENT QUESTION 1
a) State and briefly explain three assumptions underlying the break-even theory. (6 marks)
b) Jamii Company Ltd manufactures and sells a single product. The following information
regarding the company’s operations for the year ended 30 September 2001 was presented
to you.
Profit and loss account for the year ended 30 September 2001
Sh’000 Sh’000
Sales 30,000
Less:
Production costs
Direct material 6,500
Direct labour 5,400
Production overhead variable 7,000
Prime costs 18,900
11,100
Other expenses:
Selling – Variable 2,600
- Cost 1,997
Administration 2,100 6,697
Net profit 4,403

The following changes are expected to occur during the year ending 30 September 2002:

1. Selling price will be adjusted downward by 3% in order to attract more customers.

2. Material prices will rise by 2% due to inflation.
3. There will be a reduction in labour cost of 4%.
4. Production overheads will increase by 3%.
5. Increase in the efficiency of sales persons will reduce direct selling costs by 5%.
All other factors are expected to remain constant.

Required:

a) Break-even point in sales value (4 marks)

b) The margin of safety in sales value (2 marks)
c) The sales value at which profit of Sh 4.5 million will be achieved (2 marks)
66
d) A summary operating statement that shows the net profit of Sh 4.5 million in (c) above.
(6marks)

ASSIGNMENT QUESTION 2
Assume that a company intends to sale product in the market, at a selling price
of sh.9 per unit. The variable Cost is shs.5 per unit and the total Fixed Cost is sh.2000
Required:
i. Compute the B E P in units and in shs.
ii. Assume that the company intends to make a profit before tax of 20% of sales,
determine the number of units that must be sold.
iii. Assume that the corporate tax rate is 30% and the company has a target profit
of sh.1640 after tax. Compute the number of units that must be sold to earn this
target profit.
iv. If the company expects to sale 600 units, compute the marginal of safety.
Practice Question 3
A tour company has fixed cost estimates costs of Ksh 60,000 a variable cost of Ksh 10 for each
ticket sold and a proposed ticket sale price of Ksh 20. Use the graphical method to determine the
break-even point.

SOLUTION TO ASSIGNMENT QUESTION 1

Assumption of Break-even analysis

1) The behaviour of total costs and total revenues applies to relevant range only.

CVP analysis is appropriate only for decisions taken within the relevant production range. It
is incorrect to project cost and revenue figures beyond the relevant range.

Relevant range refers to the output range at which the firm expects to be operating in the
future and is equivalent to normal capacity. It represents the output levels which the firm
has had experience of operating in the past and for which cost information is available.

2) All costs can be divided into fixed and variable elements.

67
 CVP analysis assumes that costs can be accurately analyzed into their fixed and variable
elements.

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

CVP analysis assumes that either a single product is sold, or if a range of products is sold that
sales will be in accordance with a predetermined sales mix.

4) Volume is the only relevant factor affecting costs: all other variables remain constant.

It is assumed that all variables other than volume remain constant throughout the analysis.

i.e changes in other variables such as production efficiency, sales mix price levels and
production methods do not have an influence on sales revenue and costs.

5) Single product or constant sales mix.

CVP analysis assumes that either a single product is sold or if a range of products are sold
those sales will be in accordance with a predetermined sales mix.
6) Profits are calculated on variable costing basis i.e. the volume of sales or changes in
beginning and ending inventory levels are insignificant in amount. The analysis assumes that
fixed costs incurred during the period are charged as an expense for that period. Therefore
variable costing profit calculations are assumed. I f absorption costing profit calculations are
used; it is necessary to assume production is equal to sales.

7) Total costs and total revenue are linear functions of output.

The analysis assumes that unit variable cost and selling price are constant.

(B)
Shs. ‘000’

68
Sales 30,000 x 0.97 29,100

Less Cost of Sales

Materials 6,500 x 1.02 6,630

Labour 5,400 x 0.96 5,184

Production overhead (7,000 x 1.03) 7,210

Cost of Sales (19,024)

10,076

Less other variable costs (2,600 x 0.95) (2,470)

CONTRIBUTION 7,606

Less Expenses

Fixed 1997

Administration 2100 (4,097)

NET PROFIT 3,509

a) B.E.P (shs) = Fixed Costs = 4,097,000 x 29,100,000

C/S ratio 7,606,000

= shs 15,674,823

b) Margin of Safety = Budgeted sales – Break even sales

= 29,100,000 – 15674823
= shs 13,425,177

c) Sales value at which profit of sh. 4.5m will be achieved.

Use:
69
Profit = Contribution – Fixed costs, thus,
Profit = (P – V) X – Fixed costs
when X is sales in units.

or

Profit = C/S X – Fixed Costs.

when X is sales in shs.

P – selling price per unit

V- variable cost per unit

C/S – contribution sales ratio

Profit = C/S X – Fixed costs.

4,500,000 = 7,606 X – 4,097,000

29100

X = Shs. 32,891,493.

d) Sales 32,891,493

Less Variable Cost 24,294,493 {32,891,493/29,100,000 x

(19,024,000+2,470,000)}

CONTRIBUTION 8,597,000

Less Expenses (4,097,000)

NET PROFIT 4,500,000

Solution assignment question 2

i) B.E.P (in units) = 2000/4= 500 units

B.E.P (in Shs) = 2000/4*9 = Sh 4,500/=
ii) No of units = F.C + Target Profit
Contribution/unit
x = 2000+0.2*x*9 = approx. 909 units

70
 4
iii) No. of units = 2,000 +
1640 = 1085.7
1- 0.3
iv) M.O.S = 600-500=100 units

71
RELEVANT COSTS FOR NON ROUTINE DECISION

The concept of cost relevance to decision making

Relevant costs are those expected future costs that differ among the alternative cause of action being
considered.

A relevant cost is appropriate to a specific management decisions and therefore are affected by the
decision at hand. The main features of relevant costs are:

1. Future costs

2. Incremental cost

1. Future Cost

A decision is usually at the future and may not change what has been done. A cost incurred in
the past is totally irrelevant to any decisions being made now. Such costs include sunk and
committed cost.

2. Incremental cost

A relevant cost occurs as a direct consequence of making a decision. It must therefore be a

differential cost i.e. the cost if the decision is not taken e.g. make or buy decision etc.

Assumptions of Relevant Costing

72
 1. The cost behavior pattern are known e.g. fixed, variable etc.

2. Units of fixed costs, variable costs, selling prices and demand are known with certainty.

3. The objective of decision making is to maximize short term profits.

4. The information on which the decision is based is complete and reliable.

Quantitative and qualitative factors in decision making

Quantitative factors are outcomes that can be measured in numerical terms. Some
quantitative factors are financial. Qualitative factors are outcomes that cannot be measured in
numerical terms. Relevant cost analysis generally emphasizes quantitative factors that can be
expressed in financial terms. It should be noted however that qualitative factors that can not be
easily measured in financial terms are very important and managers should give more weight to
these factors

Limiting factors in decision making

A limiting factor may be defined as ‘any factor, which has a limiting effect on the activities of an
undertaking at a point in time over a specific period’. In the short term, sales demand may be in excess
of current productive capacity. Output may for example be restricted by shortage of skilled labor,
equipment or space. These scarce resources are known as limiting factors

When limiting factors are present, profit is maximized when the greatest possible contribution to
profit is obtained each time a scarce resource or limiting factor is used.

Where a single limiting factor exists the decision making sequence may be implemented as follows:-

- Calculate the contribution per unit of limiting factor for each product
- Rank the products in order of size and contribution per unit of limiting factor
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 - Use up the total units of the limiting factor in order to fulfill the forecast quantities in
order of product ranking.

Illustration

Kawasaki Company Ltd manufactures a broad range of engines for commercial products. At its
Kenyan plant it assembles power saw engines and lawnmower engines. Information on these
products is as follows:

Engine type Power Lawnmower Motor

saw bike

Selling price Ksh 80,000 Ksh 100,000 Ksh 125,000

Variable cost per unit Ksh 56,000 Ksh 62,500 Ksh 75,000
Contribution per unit Ksh 24,000 Ksh 37,500 Ksh 50,000
Contribution margin percentage 30% 37.5% 40%

Estimated daily demand in units 60 60 60

Assume that only 600 machine hours are available daily for assembling engines,

additional capacity can not be obtained in the short run. The limiting factor is machine hours. It takes
2, 5 and 5 machine hours produce one power saw, one lawnmower and one motor bike engine
respectively.

Required:

Advise on the product mix that Kawasaki should produce during the period

Solution:

74
 Engine type Power Lawnmowe Motor
saw r bike

Ksh 24,000 Ksh 37,500 Ksh 50,000

Machine hrs required to produce 1 2 5 5
engine
Contribution per machine hr Ksh 12,000 Ksh 7,500 Ksh 10,000

Rank per contribution 1 3 2

The limited 600 machine hours should be used to produce the products as per as per the rankings i.e.
120 machine hrs (60 × 2) for power saw engines, 300 machine hrs (60 × 5) for motor bike engines and
the rest 180hrs (600 – 120 - 300) for 36 lawnmower engines (180/5 = 36)

Illustration 2
A company manufacturers and sells three products A,B & C. The unit cost and revenue structure for
each product and its maximum forecast demand for the coming period are as follows:-

Product A B C
Selling price per unit (Shs.) 140 100 120
Variable cost per unit (Shs.) 70 60 80
Maximum demand (units) 500 300 300
Machine hours required per unit 10 4 5

The company has a maximum of 6000 machine hours available during the coming period

Required

1. Calculate the number of units of each product A, B, and C which should be produced and sold in
order to maximize profit
2. Calculate the maximum profit earned from the decision strategy per 1
3. Suggest other factors which management may wish to consider which could result in a change in
their decision
4. Calculate the product units to be produced and sold and the net profit earned if the company wish
to maximize sales of product A because it is thought to be a future market leader
5. Calculate the product units to be sold and the net profit earned it the company agree to produce a
minimum of 70% of the maximum demand of each product in order to maintain market spread.
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Solution
A B C Total
Maximum demand (units) 500 300 300
Machine hours per unit 10 4 5
Machine hours required 5000 1200 1500 7700
Machine hours available 6000
Shortfall 1700

The above calculation confirms that machine time is a limiting factor, which will restrict the number
of products, which can be produced and sold

Product A B C Total
Contribution per unit (Shs.) 70 40 40
Contribution per machine hr (Shs.) 70 10 8
Product ranking (3) (1) (2)
Machine hours utilized 3300 1200 1500
1. Product units produced and sold 330 300 300
Contribution earned (Shs.) 23100 12000 12000 47100
Less fixed cost 20000
2. Net profit 22710

3. The profit maximizing mix may not be implemented where management wish to maintain a more
balanced market mix or where there they wish to concentrate on a future market leader. In addition
they may wish to explore the possibility of sub contracting some production or of acquiring
additional machinery either on hire or part of a long term expansion of capacity
1. Where the sales of product A are to be maximized because it is thought that it will be a future
market leader, the analysis sequence is:

a) Utilize the machine hours required to maximize production of A i.e. 500 units x 10 hour = 5000
hours
b) Use the remaining 1000 machine hours to produce B and C in their ranking order

Product B has a higher contribution per machine hour. The 1000 machine hours available are sufficient
to produce 1000/4 = 250 units of B. This is less than its maximum demand. There are no hours left in
which to produce product C.

76
The sales and profit strategy is therefore:
Units Contribution per unit Shs. Total
Product A 500 70 35000
Product B 280 40 10000
Product C Nil
45000
Less fixed cost 20000
Net profit 25000

2. Where sales have to be spread in order to satisfy 70% of the maximum demand of each product
as the first criterion the analysis sequence is
a) Utilize the machine hours required to produce 70% of the maximum production of each product
b) Use the residual hours up to the maximum of 6000 hours to produce additional units of the
product in their ranking up to the maximum demand in each case so far as it is possible
A B C Total
Maximum units 500 300 300
70% of max units 350 210 210
Machine hours 3500 840 1050 5390
Residual hours usage - 360 250 610
Total machine hours used 3500 1200 1300 6000
Total units 350 300 260
Total contribution Shs.
24500 12000 10400 46900
Less fixed cots 20000
Net profit 26900

77
 Special Order or Special Pricing Decisions

Special pricing decisions typically involve one time only orders or orders at a price below the
prevailing market price. Differential or marginal costing is usually employed in such decisions.
Differential costing examines all revenue and cost differences between alternatives so as to determine
most appropriate decisions.

Example:

A company currently operating at full capacity manufacturers and sells, product X at Ksh

2 per unit each. The current volume is 100,000 units per annum with the following cost structures.

Operating Statement for the Year

Sales100,000 units @ sh.2 each 200,000

-Direct 50,000 (130,000

Contribution materials ) 70,000
Less: Fixed cost (30,000)
Operating profit 40,000

An opportunity has arisen to supply an additional 30,000 units per annum at sh.1.80.

Acceptance of this order would incur extra overtime premium of 20% for extra direct labor
required. Required: Should the order be accepted?

78
Solution

Without special order With special order Difference

Sales (100,000 @ Ksh 2 & 30,000 @

Ksh 1.8) 200,000 254,000 54,000

Less: Variable cost- Direct labor (80,000) (80,000 + 28,000)= (108,800) (28,800)

-Direct materials (50,000) (50,000 + 15,000)= (65,000) (15,000)

Contribution 70,000 80,200 10,200

Less: Fixed cost (30,000) (30,000) 0

Operating profit 40,000 52,200 10,200

Accept the order because of an extra contribution net profit of 10,200

Babariga Company which manufactures rubber soles for use in its production cycle,
has the following unit cost for production of 40,000 units.

s
Director labour 30
Direct material 8
Manufacturing overheads 36
74
75% of the manufacturing overhead is fixed. Buba Ltd has offered to sell 40,000 units
of the rubber soles to Babariga Ltd for sh55 per unit. If Babatiga accepts the offer,
part of the facilities presently used to manufacture the rubber shoes could be

79
rented to
Kaftan Ltd at a rent of sh72, 000. Also, per unit of the fixed overhead costs applied to
the rubber shoes would be avoided.

The Managing Director, Mallam Danbaba has called you to advise him on whether or
not to accept the offer. You are also required to state other matters that should be
noted before taking the decision.

SUGGESTED SOLUTION EVALUATION OF BUBA LTD’S OFFER

KSh KSh
Buba Ltd’s Quotation (KSh55 x 40,000) 2,200,000

Less incremental outlay

Direct Materials (Ksh8 x 40,000) 320,000
Direct Labour (sh30 x 40,000) 1,200,000
Valuable manufacturing overhead

(25% of N36 x 40,000) 360,000

1,880,000

Applicable fixed overhead

(sh10 x 40,000) 400,000

2,280,000
Opportunity cost -

rent to Kaftan Ltd. 72,000 2,352,000

(152,000)

80
Decision: Since Buba Ltd's quotation of sh2,200,000.is fess the cost
of producing within (sh2,352,000), it is hereby recommended that the offer should
be accepted from Buba Ltd. Subject to other qualitative factors.

However, there are several other factors which would need to be considered before
a final decision is taken. These include:
(a) Will the acceptance of one order at a lowered price lead other customers
to demand lower prices as well?
(b) Is this special order the most profitable way of using the spare capacity?
(c) Will the special order lock up capacity which could be used for future full price
business?
(d) Is it absolutely certain that fixed costs will not alter?

Make or buy decisions

A make or buy problems involves a decision by the organization about whether it should make of
product or carry out an activity its all intend resources or whether it should pay another
organization make the product or carry out the activity.

Examples of these decisions include:

i) Whether a company should manufacture its own components or buy from

suppliers.

ii) Whether a company should do some work with its own employees or it should sub
contract the work.

iii) Whether repair or maintenance should be dealt with by in house engineers or

maintenance contracts should be made with specialist organizations.

81
Example
A company currently makes a component which has the following unit cost structure
Direct Material Shs. 100
Direct Wages Shs. 200
Variable overhead Shs. 50
Fixed Overhead Shs. 140
Total Shs. 490

Required
Advice management whether the component should be bought in from an outside company for Shs. 330
per unit

Solution
1. The total cost of manufacture of the component is Shs. 490 per unit
2. The apparent saving by buying in the component is Shs. (490 – 330) = 160
3. If the fixed overhead cost is an apportionment of the company fixed overhead, which will be
avoidable if production is discontinued, the relevant cost of manufacture is Shs. 350. This assumes
that the direct material, direct wages and variable overheads are all directly variable with the
production of the component. This still leaves the purchase of the component for Shs. 330 a cheaper
option than manufacture at a relevant cost of Shs. 350
4. Other factors which are non quantifiable in short term should be considered however before a final
decision is made
a) Will the quality of the bought in component be as acceptable as that manufactured internally?
b) Will the outside supplier be able to supply the components as required or will there be
production delays because of late delivery?
c) Will there be industrial relations problem because of the loss of jobs by workers who currently
make the component?
5. Further analysis of the solution may reveal that the production capacity currently used to make the
component could be used as an alternative manufacturing opportunity which could be sold
externally and yield a contribution equivalent of Shs. 20 for each component it replaces

PRACTICE QUESTIONS

QUESTION ONE (Total: 10 marks)

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Lotus Ltd manufactures mobile telephones. The current operating level is 400,000 phones but full capacity is
550,000. The phones normally sell for Sh 1,500 per phone. Manufacturing cost data of 400,000 phones is as
shown below:

Manufacturing costs Sh‘000’ Sh‘000’

Variable costs 300,000
Fixed costs 187,500 487,500
Selling and administration costs
Variable (freight and commissions) costs 30,000
Fixed costs 60,000 90,000
577,500

A vendor offers to buy 100,000 phones for export at Sh 1,125 per phone. The buyer will pay for freight and
no commissions will be paid. The acceptance of this offer will not affect the present sales. The managing
director is reluctant to accept that offer because he believes that the offer price of Sh 1,125 is well below the
manufacturing cost per unit.
Required:
(i) Should the offer be accepted? (7 marks)
(ii) What factors should be considered before accepting the order? (3 marks)

QUESTION TWO (Total: 10 marks)

Wassant Ltd manufactures a product that uses components made by the company. Due to market
liberalization, the same component can be bought from an importer of the component. The management
accountant of Wassant Ltd. has provided the following manufacturing data for the component:
Shs.
Direct material
10 kg of zero 1 @ Sh 25 per kg 250
Direct labour
Department 1 0.75 hours x Sh 120
2 0.6 hours x Sh 125 165
Variable overheads 80

Production overheads are recovered on basis of 20% of labour cost in both departments. The cost accountant
anticipates that three-quarters of fixed overhead will be incurred irrespective of the decision made. The
importer is willing to sell the component at Sh 510 per unit.

Required:
a) Advise the management of Wassant Ltd whether to make or buy the component. (7
marks)
b) What other factors would Wassant Ltd consider before making the decision? (3 marks)
(Total: 20 marks)

83
 QUESTION THREE (Total: 15 marks)

Mburu Ltd. has been manufacturing and selling three products in Nyeri. The market demand for the products
on average has been as follows:

Product Annual demand

Units
Kooly 20,000
Pestle 25,000
Zedex 48,000

The manufacture of the products requires time on a machine as follows:

Product Time required

Kooly 30 minutes
Pestle 45 minutes
Zedex 20 minutes

The following details are available for each of the products:

Kooly Pestle Zedex

Sh Sh Sh
Direct materials 15 12 14
Direct labour 25 20 23
Variable overheads 5 3 6
Fixed overheads 7 5 8
Profit per unit 8 8 8
Selling price 60 48 59

Due to the prevailing drought and power rationing, the company can only manage to get a maximum of
30,000 hours on the machine per year.

Required:
a) Rank the products in order of priority if there is a limitation of the machine hours.
(9 marks)
b) Advise the management on the most profitable product mix. (3 marks)
c) Determine the resultant net profits from the mix in (b) above. (8 marks)

84
 BUDGETING
Nature and Purposes of Budgets
A budget is a detailed plan for acquiring and using financial and other resources over a specified period of time. It
represents a plan for the future expressed in formal quantitative terms. The act of preparing a budget is called
budgeting. The use of budgeting to control a firm's activities is called budgetary control.
Budgeting refers to the process of quantifying the plans of an organization so as to enable it achieve its
objectives in the defined period. The result of the process is budgets, which are used for cost control,
performance evaluation and future decision making.

Budgetary Planning and Control may be seen as short-term quantification and monitoring of long-term
strategic plans of the organizations. Strategic planning involves preparation of strategic plans, which
define the objectives to be pursued within the framework of corporate policy. It is by budgeting that a
long-term corporate plan is put into action.

Budgets may be prepared for departments or functions such as sales, production, distribution,
and financing activities and resource items such as a cash budget. Master budget is a summary of
a company's plan that sets specific targets for sales, production, distribution, and financing
activities. It generally culminates in cash budget, a budgeted income statement, and a budgeted
balance sheet. In short, it represents a comprehensive expression of management's plans for the
future and how these plans are to be accomplished. In fact, some people refer to budgeting as a
means of coordinating the combined intelligence of the entire organization into a plan of action.
OBJECTIVES OF BUDGETARY PLANNING
1) Coordination
The budgetary process requires that visible detailed budgets are developed to cover each activity,
department or function in the organization. This is only possible when the effort of one
department’s budget is related to the budget of another department. In this way, coordination of
activities, function and department is achieved.

2) Communication
The full budgeting process involves liaison and discussion among all levels of management. Both
vertical and horizontal communication is necessary to ensure proper coordination of activities.

3) Control
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 This is the process for comparing actual results with the budgeted results and reporting upon
variances. Budgets set a control gauge, which assists to accomplish the plans set within agreed
expenditure limits.

4) Motivation
Budgets may be seen as a bargaining process in which managers compete with each other for scarce
resources. Budges set targets, which have to be achieved. Where budgetary targets are tightly set,
some individuals will be positively motivated towards achieving them.

5) Clarification of Responsibility and Authority

Budgetary process necessitates the organization of a business into responsibility and budget centres
with clear lines of responsibilities of each manager. This reduces duplication of efforts.

6) Planning
It is by Budgetary Planning that long-term plans are put into action. Planning involves determination
of objectives to be attained at a future predetermined time. When monetary values are attached to
plans they become budgets.

Limitations of Budgeting
 Too much reliance may cause resistance (inflexibility) to change.
 Difficult to set levels of attainment. This may result into too tight budgets that cause loss of morale.
 Antagonism where budgets exert undue pressure.
 Budgeting control is a terminate exercise and therefore any report from investigation of variances
may b of little use to the current operations.

Organization of budgetary control

Budgetary control ideally involves the following steps:

1. The creation of budget centres.

2. The introduction of adequate accounting records.
3. The preparation of organization charts.
This defines the functional responsibilities of each member of management.

4. The establishment of a budget committee:

It will consist of operating and financial managers, who will be required to review,

discuss and co-ordinate business activities. The main function of this committee

involves:

86
  To issue instructions regarding budget requirements, deadline dates for the receipt of budgets
e.t.c.
 Draw up the budget preparation timetable. It takes the form of network analysis whereby some
activities are preceded by some others.
 To define the general policies of management in relation to the budget.
 Checking initial draft and problems considered. Limiting factors are usually considered.
 Ensuring that the budgets are synchronized within the boundaries of available resources.
 To analyze comparison of budgets and actual results and to recommend corrective action where
necessary.
 Review of budgets.
 Prepare the master budget after functional budgets have been prepared.
 The preparation of a budget manual. This is a document, which sets out the responsibilities of the
persons engaged in the routing of, and the forms and records required for budgeting control.
Such manual will provide such information as:

- Description of the system and its objectives.

- Definition of the responsibilities and duties.
- Reports and statements required for each budget period.
- Deadline dates by which data are to be submitted.

PREPARATION OF BUDGETS
THE MASTER BUDGET FRAMEWORK
The master budget is the overall quantifications of the budgeting plan. In it, functional budgets are
incorporated. A functional budget is a budget if income and/or expenditure for a particular function. The
master budget therefore combines all the budgets of the various departments in an organizations. It is
useful in ensuring that all the individual budgets are consistent with one another and also presents a ‘unit’
picture of the entire organization.

1 Sales Budget

It gives volume of sales and sales mix of the current operations. The sales forecast is initially prepared
and upon completion the sales budget is finalized. The following are usually considered in coming up
with the sales forecast.

 Actual sales in the previous periods.

 Reports from salesmen.
 Market research information.
 Level of orders already obtained in advance.

It essentially forecasts what the company can reasonably expect to sell to the customer during the budget
period.

87
Production budget
It is the forecast of the products to be manufactured during the budget period to most forecasted sales
above.

It is expressed as units of each type of product. The following are usually considered:
 Available production capacity.
 The sales forecast.
 Finished goods stock level policy.

The cycle for the preparation of the above budget usually is determined by the budget committee. It is
as follows:

i. Determine the production capacity available.

ii. Consider the possible ways in which the available production capacity may be expanded if
required.
iii. Linkage of production capacity available to the stock level.
iv. Determine the detailed budgets within the production budget.

Format

6 (Units) P (Units) J (Units)

Required Stock 31/12/19-0 xx xx xx

Add: Sales during the year xx xx xx

Less: Estimated Stock 01/01/19-0 (xx) (xx) (xx)

Production Requirements xx xx xx

It has two purposes

 Ensures that production is sufficient to meet sales demand.

 Ensures that economic stock levels are maintained according to the stock policy.

Direct Materials Budget

88
This budget shows the estimated quantities and costs of all the raw materials and components needed for
the output demand by the production budget. This consists of:

i. Direct Materials Usage Budget: Which shows the estimated quantities of materials required
for budgeted production.
ii. Direct Materials Purchases Budget: It ensures that materials are within the planned
materials stock levels i.e. after considering both usage material stock required.

Direct Labour Budget

It represents the forecasts of direct and indirect labour requirements to meet the demands of the company
during the budget period. The budgeted direct labour cost is therefore determined by multiplying direct
labour hours with the wage rates for every category of labour.

Factory Overhead Budget

This budget represents the forecasts of all the production fixed and variable and semi-variable overheads
to be incurred during the budget period. The summation of budgeted costs of production for the budget
period makes up Production Cost Budget. It includes:

 Budgeted Materials Cost

 Budgeted Labour Cost
 Budgeted Overhead Cost

Non-Production Budgets
a) Selling and Distribution Cost Budget
It is the forecast of all costs incurred in selling and distributing the company’s product during the
budget period. It is closely concerned with the sales budget in that it is mainly based on the volume
of sales projected for the period.

Expenses included are:

 Selling office costs

 Salesman salaries and commission
 Advertising expenses

b) Administration Costs Budget

It represents the costs of all administration expenses. Each department or budget centre will be
responsible for the preparation of its own budget. Management, Secretarial, Accounting and
Administration costs which cannot be directly related to the production are included here.

89
 The budget will be mainly incremental i.e. previous year’s figure will tend to apply for its next budget
with an allowance for inflation.

c) Research and Development Cost Budget

These are costs, which are discretional in nature i.e. they are determined on need basis by the
managers concerned. Research cost is the cost of original investigation undertaken in order to gain
new scientific or technical knowledge and directed towards a specific practical aim objective.

Development cost is the cost of using scientific or technical knowledge in order to produce new or
substantially improved materials, devices, products, processes systems or services prior to the
commencement of commercial production.

d) Capital expenditure Budget

It represents the expenditure on all fixed assets during the budget period. Addition intended to
benefit future accounting periods, or expenditure which increases the production capacity, efficiency
lifespan or economy of an existing fixed assets are also incorporated.

e) Cash budget
It records the cash inflows and outflows, which are expected to take place in respect of each
functional budget. It may be prepared for a period span of one week, month or quarter of the budget
period. It has the following benefits/advantages:

 It ensures that sufficient cash is available when required.

 It shows whether capital expenditure projects can be financed internally.
 It indicates the cash needed for current operating activities.
 It indicates the effect the position of each seasonal requirements, large stocks, unusual receipts
and laxity in collecting account receivable.
 It indicates the availability of cash for taking advantage of discounts.
 It reveals the availability of excess cash so that short-term investments may be considered.
 It serves as a basis for evaluating the actual cash management performance of responsible
managers.

Illustration

90
On 1 January the summary Balance Sheet of CH Ltd was as follows:

Shs. Shs.

Share capital 40,000 Machinery at cost 80,000

Reserves 20,000 less Accum. Dep. (19,200)

Loan 15% 40,000 Stocks 24,200

Proposed dividends 1,000 Debtors 25,000

Overdraft 9,000 _______

110,000 110,000

The following are expected during the next three months:

Sales Purchases Expenses

January 150,000 100,000 20,000

February 200,000 150,000 25,000

March 300,000 280,000 30,000

All sales are on credit and the collection has the following pattern: During the month of sale 80% (a 4%
discount is given for payment in this period). In the subsequent month 20%

Payment for purchase is made in the month of purchase in order to take advantage of a 10% prompt
settlement discount calculated on the gross purchase figures shown above. Stock levels are expected to
remain constant throughout the period. Depreciation of machinery is calculated at the rate of 12% p.a. on
cost. The appropriate portion for each month January – March is included in the expenses figures above.
Expenses are paid for in the month in which they are incurred. The proposed dividend will be paid in
January. Loan interest for the three months will be paid in March.

Required:

i) Prepare a cash budget for each of the three months January to March.

ii) Prepare a forecast Trading, Profit and Loss Account for the period.

iii) Prepare forecast Balance Sheet as at 31 st March.

iv) Briefly explain why the change in Cash Balance between 1 January and 31 March is not the same as
the profit or loss figure for the period.
91
Cash Budget

Jan Feb March

Opening Balance (9,000) 21,000 45,400

+ Receipts 140,200 183,600 270,400

Cash available 131,200 204,600 315,800

Payments

Creditors 90,000 135,000 152,000

Expenses 19,200 24,200 29,200

Interest 1,500

Dividends 1,000 ______ ______

110,200 159,200 282,700

Balance c/f 21,000 45,400 33,100

Working January February March

December 29,000

Jan Sales (80% x 150,000) 96% 115,200 30,000

Feb 96% (80% x 200,000) 153,600 40,000

March 96% (80% x 300,000) ______ ______ 230,400

140,200 183,600 270,400

Payments to creditors

Purchases 100,000 150,000 280,000

Discount 10,000 15,000 28,000

90,000 135,000 152,000

Expenses 20,000 25,000 30,000

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Less Deposit (non-cash item) 800 800 800

19,200 24,200 29,200

Loan interest = 18% x 40,000 = 6,000 x 3 = 1,500

12

Discounts Jan 150,000 x 0.8 x 0.04 = 4,800

Feb 200,000 x 0.8 x 0.04 = 6,400

March 300,000 x 0.8 x 0.04 = 9,600

20,500

Budgeted Profit & Loss Account

Shs.

Sales 650,000

Less Cost of sales 530,000

Gross Profit 120,000

Discount received (530,000 x 10%) 53,000

Less expenses

General expenses 72,600

Depreciation 2,400

Discount allowed 20,800

Loan interest 1,500 97,300

75,700

Balance Sheet

Fixed Assets
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Share capital 40,000 Machinery 80,000

P & L a/c 75,700 Acc. Dep. (2,400 + 19,200) 21,600

Reserves 20,000 58,400

135,700

Current Assets

Loan 40,000 Stocks 24,200

Debtors 60,000

_______ Cash 33,100 117,300

175,700 175,700

Debtor = 20% x 300,000 = 60,000

REVIEW QUESTIONS

QUESTION ONE
a) In the context of budgetary control explain the main functions and importance of a cash budget
( 5 marks)
b) You are in charge of making forecast and preparing budgets. You have been supplied with cost
and revenue forecasts and details of payments as follows:
Forecast of revenue and cost for the quarter ending 31 March 2001

January February March

Direct Shs Shs Shs

Materials (purchase) 112,000 100,000 135,000

Wages 90,000 80,000 100,000

Over head

- Production 34,000 32,000 40,000

- Administration 22,000 20,000 27,000
- Selling & distribution 13,000 11,000 18,000
Sales 360,000 350,000 440,000

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 Forecast of revenue and costs for the quarter ending 30 June 2001

April May June

Direct Shs Shs Shs

Materials (purchase) 90,000 67,000 79,000

Wages 72,000 54,000 63,000

Overhead:

Production 45,000 36,000 40,000

Administration 22,000 25,000 27,000

Selling & distribution 13,000 11,000 16,000

Sales 350,000 360,000 360,000

Cash balance on 1 April 2001 Sh. 90,000

Other details

 Period of credit allowed by suppliers averages two months

 Debenture to the value of shs. 125,000 are being issued in May 2001 and the amount is
expected to be received during the month.
 A new machine is being installed at the end of March 2001 at a cost of shs 150,000 and
payment is promised in early May 2001
 Sales commission of 3% is payable within one month sales.
 A dividend of sh. 100,000 is to be paid in June 2001
 There is a delay of one month in the payment of the overheads. There is also a delay in
payment of wages averaging a quarter of a month.
 Twenty per cent of the debtors pay cash, receiving a cash discount of 4% and 70% of
debtors pay within one month and receive a cash discount of 21/2%. The other debtors
pay within two months
REQUIRED
A cash budget on a monthly basis from the second quarter of the years 2001 (15 marks)

PRACTICE QUESTIONS WITH ANSWER

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The following information related to the proposed budget for K.K Ltd for the months ending 31
December 1996.

Material Production Administration

Month Sales Purchases Wages Overheads Overheads

Sh. ‘000’ Sh. ‘000’ Sh. ‘000’ Sh. ‘000’ Sh. ‘000’

July 72000 250000 10000 6000 55000

August 97000 31000 12100 6300 6700

September 86000 25500 10600 6000 7500

October 88600 30600 25000 6500 8900

November 102500 37000 22000 8000 11000

December 108700 38800 23000 18200 11500

Additional Information
1. Depreciation expenses are expected to be 0.5%of sales.
2. Expected cash balance in hand on 1 July 1996 is Sh. 72,500,000
3. 50% of total sales are cash sales
4. Assets are to be acquired in the months of August and October at Shs. 8,000,000 and Shs. 25,000,000
respectively
5. An application has been made to the bank for the grant of a loan of Shs. 30,000,00 and it is hoped that
it will be received in the month of November
6. It is anticipated that a dividend of Shs. 35,000,000 will be paid in December
7. Debtors are allowed one month’s credit
8. Sales commission at 3% on sales is paid to the salesmen each month
Required
A cash budget for the six months ending 31 December 2003.

SUGGESTED SOLUTION:

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K.K LTD

Workings I: Depreciation = 0.5% of sales

July Aug Sept Oct Nov Dec

Sales 72000 97000 86000 88600 102500 108700

Depreciation 360 485 430 443 512.5 543.5

II Cash Production Overheads

July Aug Sept Oct Nov Dec

Production overheads 6000 6300 6000 6500 8000 8200

Less: Depreciation 360 485 430 443 512.5 543.5

Cash production overheads 5640 5815 5570 6057 7487.5 7656.5

III Receipt from sales

July Aug Sept Oct Nov Dec

Total sales 72000 97000 86000 88600 102500 108700

Cash Sales (50%) 36000 48500 43000 44300 51250 54350

Receipt from Debtors - 36000 48500 43000 44300 51250

Total cash receipts 36000 84500 91500 87500 95550 15560

IV Sales Commission (3% of Sales)

July Aug Sept Oct Nov Dec

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Sales 72000 97000 86000 88600 102500 108700

Sales Commission 2160 2910 2580 2658 3075 3261

KK

CASH BUDGET FOR SIX MONTHS ENDING 31 DECEMBER 1996

July Aug Sept Oct Nov Dec Total

RECEIPTS ‘000’ ‘000’ ‘000’ ‘000’ ‘000’ ‘000’ ‘000’

Opening b/d 72500 96340 121690 156495 152567 207485 72500

Cash receipts 36000 84500 91500 87500 95550 105600 500450

Loan - - - - 30000 - 30000

108500 180840 213190 243795 278117 313085 602950

PAYMENTS

Materials - 25000 31000 25500 30600 37000 149100

Wages 10000 12100 10600 25000 22000 23000 102700

July Aug Sept Oct Nov Dec Total

RECEIPTS ‘000’ ‘000’ ‘000’ ‘000’ ‘000’ ‘000’ ‘000’

Pdtn overheads - 5640 5815 5570 6057 7487.5 3056.5

Admin overheads - 5500 6700 7500 8900 11000 39600

Cash assets - 8000 - 25000 - - 33000

Dividends - - - - 35000 - 35000

Sales commission 2160 2910 2580 2658 3075 3261 16644

Total payments 12160 59160 56695 91278 70362 . .

Closing balance c/d 96340 121690 156495 152567 207485 196336.5 196336.5
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PRACTICE QUESTIONS WITHOUT ANSWER

Stop over industries ltd, a recently incorporated company plans to go into production next year. The
following standard cost matrix has been assembled for one of the products it proposes to manufacture.

Cost per unit

Shs. Shs.

Direct materials 18.00

Direct labour 10.00

Variable factory overhead 8.00

Salaries 6.00

Rent 5.00

Depreciation 3.00 4.00

Total standard cost 50.00

The following recent information is available.

1. The company anticipates to manufacture and sell 198,00 units in the 2000 financial year.
2. Sales in the second and fourth quarters of the year are expected to be twice those of the first and
third quarters.
3. Direct materials are ordered and paid for a month in advance.
4. 20% of the company sales are in cash. 60% of the credit sales are collected in the month
following the month of sale and the balance the following month.
5. Expenses are settled in arrears at month end.
6. Overdraft facilities have been agreed at 30% p.q and the company’s bank balance at 31 December
19x9 is expected to be Sh. 50,000.
7. The product is expected to retail at Sh. 80@ unit.

Required
1. Budgeted profit and loss for the first quarter.
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2. Sales collection and schedule for the months of January, February and March 2000.
3. Cash flow for the months of January, February and March 1999.

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