BUSS 213: COST ACCOUNTING

1.0 NATURE AND SIGNIFICANCE OF COST ACCOUNTING

Objectives:
At the end of this topic, students should be able to:
o Describe the nature of cost and various ways in which cost may be classified
o Explain various users of accounting information and their respective information needs
o Prepare a manufacturing cost statement and a profit statement.

1.1 Definition of Cost Accounting

Cost accounting is a branch of accounting that is involved in the classification, recording and
ascertainment of costs of producing a given product or the cost of providing the service. Cost
accounting is a quantitative method that accumulates, classifies, summarizes and interprets
information in the following three major purpose
 Operational, planning and control
 Special decisions
 Product decisions

Cost accounting vs. Management accounting

Cost accounting is a source for management accounting whereas management accounting is broad
and covers all aspects of business information system. Cost accounting narrows itself to cost
determination and thus becomes an integral point of management accounting.

Costing vs. Cost accounting

Costing is ascertainment of costs. The value of resources required to produce any commodity /
provide any service is called cost. The costs should be recorded, charged to the relevant jobs and
presented to management for decision making. This helps evaluate the performance of the
organization. The costing deals with all aspects of cash ascertainment.

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.

1.2 The Users of Accounting Information

 The management:-they need to compare their performance with the previous years and with
other similar businesses so as to identify areas where urgent action nee to be taken to safeguard
the interest of the business. They require information for decision making and control activities eg
information is needed on th estimated selling price, costs, demand profitability of various
products that are made by the organization.
 Shareholders:- they need to know whether their funds are invested wisely.
 Government:- the revenue authority will need information on the amount of profit that is subject
to taxation. In addition, the central statistical office will collect accounting information and

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 require such information such as sales activity, profits, investments, stock, dividends paid etc for
determining policies to manage the economy.
 Potential investors: -they need to make decisions such as which shares to buy.
 Financiers:- To know whether the business is in a position to meet their claims.
 Employees:- require information on the ability of the firm to meet wage demands and avoid
redundancies.

An examination of the various users of accounting information indicates that they can be divided into two
categories:
 Internal parties within the organization
 External parties such as shareholders, creditors and regulatory agencies, outside the business.
Consequently, there are two branches of Accounting that reflect the internal and the external users of
accounting information: These are Management and Financial Accounting.

Management Accounting is concerned with the provision of information to people within the organization to
help them make better decisions and improve the efficiency and effectiveness of existing operations.
Management accounting is an integral part of management concerned with identifying, presenting and
interpreting information used for formulating strategy , planning and controlling activities, decision making,
optimism, use of resources, disclosure to intended parties and safeguarding assets.

On the other side, Financial Accounting information is concerned with the provision of information to the
external parties outside the organization. In other words, Financial accounting is a branch of accounting that
organizes accounting information for presentation to interested parties outside the business through financial
statements (profit & Loss account, Cash flow statement) discussing financial position and operating results of
a business.

Management accounting is defined as an integral part of management concerned with identifying,

presenting and interpreting information used for:
 Formulating strategy
 Planning and control ling activities
 Decision taking
 Optimizing the use of resources
 Disclosure to shareholders and others external to the entity
 Disclosure to employees
 Safeguarding assets.

There are similarities between the objectives of both management and cost accounting and indeed in practice
there is no true dividing line. In general, Management accounting is wider in scope and uses more advanced
techniques. However, it requires a sound costing system to provide basic data. Both management accounting
and cost accounting are in the main concerned with the provision of information (often in great detail) for
internal planning, control and decision making purposes with considerable emphasis on the costs of
functions, activities, processes and products.

Cost accounting has been defined as that part of management accounting which establishes budgets and
standards costs and actual costs of operation, processes, departments or products and analysis of the
variances, profitability or social use of funds.

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1.3 Differences between Financial and Cost Accounting

Point of Financial Accounting Cost Accounting

Distinction
1 Origin Since 1494, double entry and From 19th Century
bookkeeping has been practiced
2 Purpose To prepare financial statements To provide details of cost
i.e. P&L, B/Sheet, Cash flow information
statement etc.
3 Target Group Owners, Government, Investors, Management cost accounting
Lenders, Management etc. information i.e private and
confidential
4 Statutory Preparation of financial Maintenance of cost information
requirement statements ie. A legal is voluntary
requirement of the company’s
Act of Cap 486
5 Analysis of cost Financial statements show profit Shows detailed cost data of each
and profits and loss for a period of activity product or department
6 Periodicity of Financial statements are usually Preparation of cost statements is
reporting prepared periodically eg. a continuous process eg. Daily,
Annually, semi annually or weekly, monthly or as required
quarterly by the management.
7 Nature of records Concerned with historical Concerned with historical costs,
records present costs as well as pre
determined costs (future costs)
8 Auditing It a requirement for public No such requirement
requirements limited companies to have their
books audited

1.4 Overlap of Financial Accounting and Cost Accounting (Similarities)

i. In both branches of accounting, accounting is developed within the same accounting information
system that accumulates and classifies raw data and generates statements for the management.
ii. The manner in which the accountants measure the components of cost, assign cost periods and
allocate costs to segments or departments is similar I both branches of accounting.
iii. The two accounting systems are applicable to all forms of businesses i.e. Product and service business
iv. In both branches of accounting, financial reports about the firm’s activities are produced.
v. An accountant ca n serve as a financial accountant or a cost accountant or both at the same time

1.5 Objectives of Cost Accounting

i. Ascertainment of cost:
The cost of production is relevant when determining the selling price of a product or a service.
Selling price = cost + profit
ii. Determining profitability of the products
In cost accounting, revenue and costs will be presented for each product and it will be possible to find
out the profitable product and the ones which are not profitable to be discontinued.

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 iii. Cost control
Reports for each department on product are prepared and the actual cost is compared with the
expected cost. Any variances are identified and analyzed.
iv. Detection of wastage
Using the cost data, there will be figures showing the expected quantity of output. The actual
quantity will be compared with the expected quantity of output and the difference will help in
identifying wastages.
v. Evaluation of the efficiency of the firm
When cost are computed for each product and section it will be possible to make a comparison from
one month to the other to determine efficiency and improve on any poor performance.
vi. Making special decision and investigations
The cost accountant will be required to select information which will be required in ma king special
decisions e.g. whether to replace the old machine with a new one, whether to make a product or buy
it, whether to change the selling price e.t.c.
vii. Facilitating preparation of financial statements
The financial statements e.g. the profit and loss account will be prepared using some of the cost
accounting information e.g. the expenses in the profit and loss account are the costs in cost
accounting.

1.6 Definition of Common Cost Accounting Terms

i. Cost
This is the total expenditure incurred on a specific item or activity. It is the value of economic
resources used in production of a product or provision of a certain service. It is the number of resources
given up to obtain a good or a service.
ii. Cost unit
This is a quantitative unit of a product, time or service in relation to which cost may be ascertained eg.
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
iii. Cost object
To guide their decisions, managers want to know how much a particular thing such as a product, a
service a process etc costs thus a cost object is anything for which a separate measurement of cost is
designed.
Examples of cost object
- Product - Department
- Customer - Project
iv. Responsibility center
This is a part, segment, department or a part of an organization where the manager is accountable for a
specified set of activities, the higher the manager’s level, the broader the responsibility center and
generally the larger is the number of subordinates.
v. Responsibility accounting
This is a system that measures the plans (budgets) and action actual (results) of each responsibility
center. We have four major types of responsibility centers.
(a) Cost center - The manager is accountable for costs only
(b) Revenue center - The manger is accountable for revenues only
(c) Profit center - The manager is accountable for revenues and costs
(d) Investment center - The manager is accountable for the investments, revenues

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 and costs. He has a significant degree of control over his center’s
investment policy

1.7 Costing Systems

- This is a combination of procedures, records, rules etc designed to provide various types of
information required by the management in conducting operations of an organization

1.7.1Factors to Consider Before Installing a Cost Accounting System

i. Preliminary investigations should be made before installing cost system e.g. Type of business, the
nature of the products, method of production etc. in order to determine the type of costing system to
be applied.
ii. The organization structure of a business should be studied to ascertain the scope of authority with
minimum change in the existing structure .
iii. The method of purchases, storage and issue of materials should be examined and improved where
necessary.
iv. Design forms and accounting records which involve minimal clerical work and expenditure.
v. The existing records of remuneration labor, recruitment and the keeping of employees records should
be analyzed and imposed where necessary.
vi. The system installed should be simple and easy to operate
vii. The system should be introduced gradually.

1.7.2 Advantages of Cost Accounting Systems

i. Helps in cost control
ii. It helps in decision making
iii. It guides in fixing of selling prices
iv. It reveals idle capacity either machines or staff who receive payment yet they don’t exist
v. It checks the accuracy of financial account especially in issues of cost
vi. Benefits the employees in terms of motivation, remuneration and improved working conditions
vii. It reveals profitable and non profitable activities / products

1.7.3 Difficulties in Installation of Cost Accounting System

i. Resistance from accounting staff due to increased work.
ii. Lack of support from top management
iii. Non Co-operation from working and supervisory staff

1.8 Classification of Costs

This involves the grouping of related costs under different basis

1.8.1 Purpose of Cost Classification

i. 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
ii. 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.
iii. To facilitate cost allocation

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

1.8.2 Bases of Cost Classification

i. Classification based on the nature of cost
Manufacturing based on the nature of costs
These are costs incurred in production of goods and services e.g. Cost of raw materials, factory
labor and manufacturing overheads (OH)
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.
ii. Classification based on traceability to the cost units.
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 cannot be identified with the products. They are also called overheads e.g. Manufacturing
overheads, selling and distribution overheads as well as administrative overheads.
iii. Classification based on controllability
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 unionizable workers
which are determined by the management in agreement with the trade unions
Uncontrollable costs
These are costs that manager cannot influence at their own discretion eg. Taxes, licenses,
pension contribution etc.
iv. Classification based on the behavior with output
Variable cost
These are costs that they vary or change with the level of output eg. Cost of raw materials, labor
and overheads
Fixed cost
These are costs that do not change with the level of output eg. 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.
v. Classification based on function
Production costs

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 These are costs incurred in the factory whether direct or indirect eg prime cost, depreciation of
the factory, power and electricity used in the factory, factory insurance et c.
Selling and distribution costs
These are costs incurred in transferring finished goods to the customers eg. Sales men
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 eg salaries of general
managers, accountants, secretaries, finance costs such as interest charged and bank charges etc.
vi. Classification based on avoidability of costs
Avoidable costs
These are specific costs of an activity or segment which will not be incurred if the segment was
discontinued eg. Cost of raw materials use to produce a product where production has been
discontinued.
Unavoidable costs
These are costs that must be incurred eg. Payment required in a valid contractual commitment.
vii. Classification based on the relevance of the decision making
Relevant costs
These are costs that ca n be changed by the decision of the management. When management
makes financial decisions regarding future opportunities, such as cost are relevant because they
ca n 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.
viii. 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.
ix. Classification based on the treatment of cost of alternatives
Differential costs
This is the difference between the costs of two alternative courses of action or decision
Aggregate costs
These are the total costs of a particular cost objective.

x. Classification based on the managerial discretion

Discretionary cost
These are fixed costs that are reversible after a short period of time eg. Rent on the factory
building, advertising costs etc .
Committed costs
These are fixed costs that continue for a long period of time they are also called non
discretionary costs eg. Cost of constructing a factory plant, a long-term lease for a machine etc.
Prime costs
This is equal to direct materials + Direct labor + Direct expenses

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1.8.3 OTHER CONCEPTS OF COST
i. Conversion Costs
These is the total direct labor and manufacturing overheads
ii. Opportunity costs
This is the value of any opportunity a person foregoes to engage in an alternative
activity
iii. Shut down/ Sunk costs
Shut down costs are costs incurred when production is not going on eg. Due to lack of
raw material, examples of shutdown costs include rent and insurance of buildings,
depreciation etc. sunk costs are historic or post costs which have already been incurred.
iv. Out of pocket costs
These are costs which that will vary with the decision made.
v. Joint costs
This is a common cost . when two or more products are produced out of one material or
process, the cost of the raw material will be a joint stock
vi. Research and development costs
This is a cost of searching for new improved products, new application of materials or
new improved methods of processing

1.9 Cost Behaviour

1.9.1 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

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 e.g. Linear variable cost
The materials contained in each assembly C530 are
3 Brackets @ sh 125 each
30 Screws @ sh 2 each
6 pulleys @ sh 67 each

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 What is the expected variable cost of materials for producing 40 assemblies?

Solution
Material Cost/ Assembly
3 X 125 375
30 X 2 60
6 X 67 402
Variable cost/assembly 837

Cost = bx
= sh 837 X 40
= sh 3348
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
Convex Concave
C C
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.

Illustration
Analysis of cost and activity records for a project show that the variable cost can be accurately represented
by the function

Cost = (bx + cx2 + dx3)

Where b = 8, c = 0.5 and d = 0.03
Calculate
(i) Variable cost when production is 10 units
(ii) Variable cost when production is 15 units
Is the function convex or concave?

(i) Cost = 8 x 10 + 0.5 x 102 + 0.03 x 103

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 = 160
(ii) Cost = 8 x 15 + 0.5 x 152 + 0.03 x 153
= 333.75
It will be seen that the increase from 10 to 15 units results in more that a doubling of variable cost. This
shows there’s a more than appropriate increase in the unit cost of extra production so that the function is
concave.

1.9..2 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
O Costs assumed to be constant
S at all level of activity
T

OUTPUT

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

1.9.3 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.
- They can be shown graphically thus

Linear Convex Concave

a a a

a = Fixed cost

- It can express algebraically as:

(1)Linear semi variable : Cost = a + bx
(2)Curvilinear semi variable: Cost = a + bx + cx2 + dx3 …….+ function
Illustration
Analysis of maintenance department cost shows that there is a fixed element of 500 per month and a variable
element related to machine hours amounting to 2.25 per machine hour.
What is the expected cost for a month when the planned activity level is

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 (i) 1500 machine hour
(ii) 1800 machine hours

Solution
(i) Total cost = a + bx
= 500 + 2.25 (1500)
= 3875
(ii) Total cost = 500 + 2.25 (1800)
= 4550

Illustration
High low method
Using the following data, find the fixed element and variable cost
Activity level ( units) 36 48 48 49 55 57 59 65 66 67 72 75 76 82 94 97
Cost 800 700 820 970 790 1050 900 880 1020 1180 950 1170 1020 1200 1310 1250

Solution
Low : 48 units at a cost of 700
High : 94 units at a cost of 1310
Difference 46 610

Variable cost = 610 = 13.26/unit

46

Fixed element of cost :L Cost at 48 units = 700

Less V.C.: 48@ 113.26 = 636
Fixed cost 64

1.10 Elements of Costs

Cost elements are categorized into three ie.
i. Direct material
ii. Direct Labor
iii. Direct expenses
Direct materials
These are the costs of raw materials that can be economically identified with each unit of the finished
product eg. Paper used to make a book the cost of raw materials that cannot be directly identified with a
product is the direct material eg. Glue used in making a book. Indirect materials are treated as
manufacturing overheads
Direct Labor
This represents the payroll costs of production workers who are directly employed and work in the
finished product. Direct labour cost include salaries and wages to the factory workers NSSF , NHIF
borne by the company. Indirect labour cost include foreman salaries, supervisors wages, factory
cleaning staff, production administration wages and salaries etc. indirect labour is considered as a
manufacturing overhead.
Direct expenses

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 These are other costs apart from direct materials and direct labour which are capable of being identified
economically with the finished product eg. Royalties paid per product, the cost of hiring specialized
equipment and tools, cost of purchasing specialized equipment tools cost of hiring specialized labour
Manufacturing overheads/ factory costs
All other costs which cannot be identified economically with the finished products although they are
incurred the manufacturing process are called manufacturing overhead.

1.11 Preparation of a Manufacturing Cost Statement

This is a statement that shows the total cost incurred by a business within a specified period of time
.
Format
shs shs
Cost of raw materials
Opening stock raw material XXX
Add purchases raw material XXX
Carriage inwards raw material XXX
XXX
Less Return outwards raw material (XXX) XXX
Total cost of raw material XXX
Less closing stock of raw material (XXX)
Cost of raw material in production XXX
Add direct labor XXX
Add direct expenses XXX
Prime cost XXX
Opening work in progress XXX
Less closing work in progress (XXX) XXX
XXX
Factory/Manufacturing/Production Overheads
Factory rent XXX
Depreciation of plant XXX
Depreciation of factory building XXX
Factory cleaning XXX
Factory electricity XXX XXX
Total cost of production XXX
Selling and distribution cost XXX
Administration cost XXX
Total cost incurred XXX

NB: When a profit and loss account has to be prepared, the selling and distribution costs as well as the
administration cost must be expensed in the profit and loss therefore, the manufacturing cost statement will
end at the point where the total cost of production is obtained.

Illustration
The following information is obtained from the books of Juhudi ltd for the year ended 31st December, 2006
Stocks 1st January 2006 000

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Raw materials 48
Work in progress 9.8
Finished goods 120
Wages paid to factory workers 148
Factory insurance 52
Plant balance1st Jan 2006 400
Factory plant 180
Cleaning costs 200
Purchases of raw materials 350
Stocks as at 31st December 2006
Raw materials 21
Work in progress 8
Carriage on raw materials 42
Returns of raw materials to suppliers 6.2
Salary of marketing manager 200
Fixed administration expenses 140
Salesmen commission 60

Additional information
iv. Out of the wages paid to the workers, 90% is considered direct
v. Cleaning costs should be apportioned as follows; 70% factory
20% warehouse
10% office
vi. Depreciation n on plant should be provided at the rate of 20% of the plant balance on 1 st January
2006
vii. Factory rent accrued on 31st December 2006 was shs 120,000/=
Required
Prepare a manufacturing cost statement for the year ended 31st December 2006

Juhudi Limited
Manufacturing Cost Statement
for the year ended 31ST December 2006

Sh 000 Sh 000
Cost of raw materials
Opening stock of raw, materials 48
Add purchases of raw material 350
Carriage inwards of raw material 42
392
less return inwards of raw materials (6.2) 385.8
Total cost of raw materials 433.8
Less closing stock raw materials (21)
Cost of raw materials used in production 412.8
Add direct labour 133.2 133.2
Prime cost 546
Opening work in progress 9.8

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Less closing work in progress (8) 1.8
547.8
Production/factory overhead cost
factory rent (18,000+120,000) 300
Depreciation on plant 80
Indirect labour(10%X148) 14.8
Factory Insurance 52
Cleaning cost(70%X200) 140 586.8
Total cost of production 1134.6
Selling& distribution cost
Cleaning cost warehouse(20%X200) 40
Salary of marketing manager 200
Sales men commission 60 300
Administration cost: 000 000
Cleaning cost of office(10%X200) 20
Fixed administration cost 140 160
Total costs incurred 1594.6

Illustration 2
Given the information in illustration 1, determine the total cost per unit and the selling price per unit
assuming
(a) The firm produced 1000 units
(b) The business needs to make a profit of 20% on cost

(a) Cost per unit = total cost incurred

Units produced
Cost /unit = 1,594,600
1000 = 1,594.6shs

(b) Selling price per unit= total sales

Unit sold
Total sales = 1,594,600 + (20%X1,594,600)= 1,913,520
 selling price per unit = 1,913,520
1000 = 1,913.52 shs

Illustration
The following balances remained in the books of Ujuzi Ltd and manufacturing co for the year ended 30 th
November 2005
Stocks 1st December 2004 000
Raw materials 500
Working in progress 200
Finished goods 1500
Purchase of raw materials 4000
Return outwards raw materials 50
Repairs to factory building 250
Salaries & wages
Factory workers 900

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Sales men 180
Administration staff 420
Insurance 500
Royalties paid 200
Depreciation on plant 120
Depreciation on buildings 400
Advertising expenses 40
Discount allowed 5
Cleaning expenses of the building 15
Bank charges 14
Depreciation delivery van 26
Stocks on 30th November 2005
Raw materials 480
Work in progress 300
Finished goods 1200
Rent 2000
Direct expenses 230
Sales 12000
Sales returns 500

Additional information
(i) The factory building has been damaged as result of faulty electricity wiring. A provision of shs
100,000 is required for the repairs.
(ii) The company building occupies an area of 10,000m2 of this area the factory occupies 5000m2,
warehouse occupies 2000m2 and the rest is occupied by administration office
(iii) Prepaid insurance amounted to shs 50,000 at the end of the year. Insurance is apportioned in the
ration 2:2:1 to the factory, warehouse and offices respectively.
(iv) A provision of shs 50,000 needs to be made for a bonus payable to the factory supervisors
Required
(a) Manufacturing cost statement
(b) Trading profit and loss account for the year ended 30th November 2005

Ujuzi ltd
Manufacturing Cost Statement
for the year ended 30th November 2005

sh 000 Sh 000
Cost of raw material
Opening stock raw materials 500
Add purchases of raw materials 4000
Less return outward raw material (50) 3950
Total cost of raw materials 4450
Less closing stock raw material (480)
Cost of raw materials used in production 3970
Add direct labour 900
Direct expenses 230

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Royalties paid 200 1330
Prime cost 5300
Opening work in progress 200
Less closing work in progress (300) (100)
5200
Production/factory overhead
Repairs to factory building ( 250+100) 350
Insurance(500-50=450) (2/3 X 450) 180
Depreciation on plant 120
Depreciatin on building (5000/10000X400) 200
Cleaning expenses of building(5000/1000x15) 7.5
Rent (5000/1000x2000) 1000
Bonus factory supervisors 50 1907.5
Total cost of production 7107.5

Ujuzi ltd
Trading profit & loss account
For the year ended 30th November 2005
Sh Sh
Sales of finished goods 12000
Less sales returns (500) 11500

Cost of sales
Opening stock of finished goods 1500
Add cost of production 1707.5
8607.5
Less closing stock of finished goods (1200) (7407.5)
Gross profit 4092.5

Selling and Distribution Expenses

Rent (2000/1000x2000) 400
Sales men commission 180
Insurance (2/5x450) 180
Dep. Building (2000/10000x400) 80
Advertising expenses 40
Discount allowed 5
Cleaning expenses (2000/1000x15) 3
Dep. Delivery vans 26 914
Administration expenses
Salaries Adm staff 420
Insurance (1/5x450) 90
Cleaning expenses (3000/10000x15) 4.5
Depreciation building(3000/1000x400) 120
Bank charges 14
Rent (3000/1000x2000) 600 (1248.5)
1930

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Summary
Cost accounting is concerned with ascertainment and control of costs. Its purpose is to provide detailed
information for control, planning and decision making. Costs can be broadly classified as either direct or
indirect. Direct costs are those that are readily identifiable to a cost unit. Direct material, direct labour and
direct expenses form prime cost. All those costs not identifiable with as direct are termed as indirect costs.
Indirect materials, indirect labour, and indirect expenses are collectively known as overheads.

Review Questions
Question One
Explain the advantages of centralized system of maintaining stores (5mks)
Question Two
Distinguish between the following accounting terminologies
a) Direct and indirect cost (4 marks)
b) Cost center and cost unit (4 marks)
c) Joint product and by product (4 marks)
d) Period cost and product costs (4 marks)
(Total 16 marks)
Question Three
a) Describe the duties of an accountant in an organization (4 marks)
b) Differentiate the following terminologies
(i) Relevant costs and irrelevant costs (4 marks)
(ii) Cost center and cost unit (4 marks)
(iii) Semi-fixed and semi variable costs (4 marks)
(iv) Sunk costs and product costs (4 marks)
(Total 20 marks)
Question Four
State and describe five factor which must be considered before installing a cost accounting system in a
manufacturing organization. (20 marks)

P 84 MTP3 Q1

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2.0 MATERIALS COTROL

Chapter Objectives:
At the end of this topic, students should be able to:
o Explain the need for material control
o Describe the material control processes
o Value materials issued using different methods
o Compute an estimate of various stock levels in a given situation

2.1 Introduction
Materials or inventory comprise of raw materials, semi finished goods (work in progress) and finished
inventory. Inventory control is the systematic control over procurement, storage and usage of materials so as
to maintain an even flow of materials and avoiding at the same time excessive investment in inventories.

Inventory Comprise of raw materials, semi finished goods (WIP) and finished inventory. Inventory control is
the systematic control over procurement, storage and usage of materials and avoids at the same time exercise
investment in inventories.

2.2 Essentials of Material Control

- Materials of the appropriate quality and specification should be purchased only when required and
appropriately authorized.
- The suppliers chosen should represent an appropriate balance between quality, service and delivery
- Materials should be properly received and inspected.
- Appropriate storage facilities should be provide and stock levels physically checked on regular basis.
- Direct materials used in production should be changed to production on an appropriate and
consistent pricing basis
- Indirect materials used in production and non production departments should be appropriately
changed to the correct cost center and included in the appropriate cost center.
- The documentation, accounting systems and controls at each stage should be well designed and
effective
- Stock taking must be well organized to ensure that stock quantities on hand are available when
required.

2.3 The Inventory Control Process

Material/inventory control involves the following:
- Purchasing of materials
- Receiving of materials
- Inspection of materials
- Issuing of materials
- Maintenance of stores records
 Store keeper in stores
 Costing office - Accountants
- Stores audit
 Periodic
 Continuous
The above control operations are described below:

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2.3.1 Purchasing of inventory
A large proportion of firm’s cost is represented by bought in materials. The crucial factors in
purchasing function are price, quality and delivery. Although the exact system varies from firm to
firm, the following procedure is typical

Production Inventory Store Keepers Departmental

Records Managers

Purchase requisition specifying:- Quantity, quality, specification, delivery requirements,

compatibility requirements e.t.c.

Suppliers Search for possible suppliers using own records,

Search directories, Trade Associations etc.

Request for Enquiries/Requests for tenders sent to possible

tender suppliers fully specifying requirements

Receipt of Receipt and vetting of quotations, tenders

Quotation frequently involving liaison with origination
source.

Supplier Selection Supplier Selection

Purchase Order Dispatch of purchase order and distribution of Copies to

copies - Supplier
- Accounts costing
- Originating
Progress chasing, monitoring of deliveries department
- Goods reception
- Inspection
- Progress chasers

Receipt of Goods

Fig: Outline of purchase procedures

2.3.2 Reception and Inspection Procedures

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 Receipt of goods in material reception

Quantities received checked and goods received note GRN Copies

raised. Details of goods received checked with purchased - Accounts payable
order - Purchase office
- Production control
- Inspection
- Stores
Inspection of goods for quality, specification etc. - File
inspection note raised
Inspection copies to:
- Accounts payable
- Purchase office
- Production control
Goods taken into store and GRN and / or inspection note - Stores
signed - File

2.3.3 Inventory Issues

Inventory must be appropriately authorized and amount issued recorded so that the appropriate charge can be
made to production. The usual way this is done is by a material requisition (MR). A Materials Requisition
Form contains: Quantity, Part Number, Description, Job to be done, Authorization
On presenting an MR to the store man, it would be checked for correction and authorization before an issue
is made. The MR is forwarded to stores records for updating the stock records and also the cost department.
2.3.4 Storage of Inventory
It involves following
- Checking the of materials
- Observance of stock levels
- Putting materials into bins and racks
2.3.5 Stock Audit
Its physical verification of stock with inventory records. It can be
Periodic stock verification
Continuous stock verification

2.4 Objectives of Materials Controls

(i) No stock outs
Under stocking leads to running out of stock leading to stoppage in productions, idle time, loss of
order, customer and goodwill.
(ii) No stock excess
Investment in materials must be kept as low as possible considering production customary
requirements and financial resources, overstocking leads to high storage cost, tied up capital
observation low profit etc.
(iii) Proper quality

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 A company should purchased inferior quality or sometimes very superior quality rather purchases
of specified quality
(iv) Minimize wastages
Proper storage conditions should be provided to avoid deterioration, theft, evaporation etc.
(v) Information about materials an up to date acing information materials is required.
(vi) Economy in purchasing
Purchasing at the most favorable prices is product thus reduction in purchasing cost.

2.5 Requirements of Good Material Control System

(i) Proper coordination and cooperation between various departments such as purchasing stores,
receiving, inspection, accounting etc.
(ii) If there is central purchasing it should be under control of competent purchasing management.
(iii) There should be proper classification and codification of materials
(iv) Materials requirements should be properly planned
(v) An up to date information on quality of materials in stores should be maintained.
(vi) Adequate records should be introduced to control materials during product and for finished goods
qualities.
(vii) Storage of motels should be well planned subject to adequate safeguard and supervision.
(viii) Stock levels should be fixed for each items of materials.
(ix) Purchases of materials should be controlled through budget.
(x) There should be regular reporting to the ,management regarding purchases issue s, stores materials
and special records should be prepared on obsolete item spoilage and returns to supplies.
Stores
The term stores means raw materials, work in progress, finished goods, tools , components, maintenance
materials, consumable stores etc. Stores are usually headed by a storekeeper or a store manager i.e. a man or
a woman of undevoted integrity suitable trained, experienced and well versed in the principle of good store
keeping.

2.6 Duties and Responsibilities of a Storekeeper

(i) Maintenance of materials in a tidy manner
(ii) Proper maintenance of records of material received, issued and in stores
(iii) Accepting materials into the stores having ascertain that the delivery complies with the specific
details on the goods received note
(iv) Issuing materials against duly authorized requisition forms
(v) Requisition further supply from the purchasing department when the recorder level is attained
(vi) Preventing the entry of any unauthorized persons in the stores rooms
(vii) Periodic comparison of bin card balances with physical qualities
(viii) Advising the management on obsolete and slow mining stock.

2.7 Recording Documents Involved

(i) Bin card
It is kept at physical actual location of the item. It is updated with physical stock movement. It
contains details on the type of stock quantities received and issued with dates but would not
necessarily show the value of such stock
(ii) Store control card

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 It is kept in the storekeeper office or some other premises away from the actual stock. It is updated
using documents such as materials requisition forms and goods received note. It shows quantities
and not necessarily values. It checks on the quantities reflected on the bin card and physical stock
item.
(iii) Store ledger account
It is kept in the account’s office. Its update of stock must suing various forms and supportive
documents such as requisition forms and goods revived noted. The mut will be shown in terms of
quantity and value pricing method such as FIFO, LIFO, and WEIGHTED AVERAGE etc. it is an
independent check on the stored activities

2.8 Procurement of Materials

This can be done in two ways
(i) Centralized purchasing
This is where there is a separate purchasing department with the task of making or pur chasing all
types of materials. The head of the department is the purchasing manager or the chief buyer.
Advantages
a) It is possible to have specialized purchasing staff in one department
b) Leads to foundation terms of purchasing e.g. better terms of payment higher discounts etc,.
c) Leads to standardization of quality of materials.
d) Better control of purchasing is possible reckless buying by vanar individual is avoided
e) All purchases record are in one place
Disadvantages
a) Creation and maintenance of centralized purchasing department leads to higher
administration cost which organization may not afford
b) It may not be suitable for branches which are far apart eg transport requisition and delays
in receiving materials

(ii) Decentralized purchasing

It is where each department/branch makes its own purchases. Its common where branches are
located in different geographical location. The branch manager purchases in local market.
Advantages
a) Leads to reduction of administration cost because there is no creation and maintenance of
purchasing department
b) its suitable for branches which are far apart
Disadvantages
a) its not possible to have specialized purchasing staff.
b) Standardizing of quality of material is not possible,
c) The purchasing records are maintained in different places.
d) It is not possible to bargain at favorable terms of purchasing e.g. better terms of
payment and higher discounts
2.9 Procedures of Procurements
(i) Orders will be placed by the user departments using material requisition forms
and the stores department is expected to fulfill the orders.
(ii) The stores department also has to monitor stock levels to ensure materials are
available when required

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 (iii) When any materials reached reorder could the stores department complete a
purchase requisition from instructing the purchasing department to obtain the required quality of
material
(iv) The purchasing department will then complete the purchase order form
specifying the material required and send it to the supplier.
(v) If the supplier is not yet identified the purchasing department will obtain
quotations from prospective suppliers eg through tender system
(vi) A schedule of quotation is then completed and then the document is used to
evaluate and identify the most suitable supplier.
(vii) The supplier will then send the goods normally with the suppliers invoice and
delivery note.
(viii) The goods received will be assessed quality and quantity by the receiving
department and a good received note will be issued which will be used to transfer goods to the store.
(ix) Any discrepancies are recorded in a purchasing discrepancy note which will
give raise to credit note when payment is being made.

2.10 Pricing Materials Issues

2.10.1 Objectives of inventory valuation

1. To change to production of a consistent and basis the cost of materials used.
2. To provide a satisfactory basis of valuation for inventory on hand.

2.10.2 Problems of inventory pricing / valuation

1. Rapidly changing prices for bought in materials and components
2. The stock of any given material is usually made up of several deliveries which may have been made at
different prices.
3. The frequent impossibility of identifying items with their delivery consignment.
4. The sensitivity of profit calculations to the pricing method adopted particularly where materials form a
large part of total cost.

2.10.3 Methods of Valuing Inventory Issues

When materials are issued by storekeeper, they are valued in order to determine the material cost of different
jobs or products. The following methods are used:-

i. First In First Out (FIFO)

- The goods issued are those which have been longest on hand and that those remaining in stock
represent the latest purchases or
- The stocks whose cost is to be carried forward were acquired most recently.
- Under this method, the materials are issued at the cost price of that consignment which was received
first.
- When this consignment is finished, then cost price of next consignment is charged to value material
issues.

Advantages
(i) Based on realistic assumptions i.e. materials are issued in order of receipts
(ii) Materials are issued at actual cost thus no unrealized profits of loses which arises

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 (iii) Valuation of closing stock is at cost as well as the latest price
(iv) The method is easy to understand and operated provided the purchases are few and prices do not
fluctuate frequently.
Disadvantages
(i) Materials are charged to production and oldest prices thus cost of production may lag behind the
current economic conditions
(ii) Similar jobs/cost units worked on simultaneously may be charged differently from materials
(iii) Frequently changes in material prices or frequent purchases bring in cumbersome calculations.
ii. Last In Last Out (LIFO)
- Under this method, goods issued on any particular date are those which were most recently acquired
and therefore stocks whose cost is to be carried forward are those which were acquired earliest
- The materials are issued at the cost price that consignment which was received most recently.

Advantages
(i) Materials are changes to produce products at the latest prices and therefore in time of raising prices
quotations will be safe and profitable
(ii) Like FIFO materials are issued at actual cost hence no unrealized profit or loses
(iii) The method is easy to operate especially when prices are fairy constant and purchases are few.
Disadvantages
(i) The method is not realistic as it does not confirm to physical flow of materials
(ii) Closing stock is valued at oldest prices which may not represent the current economic value
(iii) Like FIFO similar jobs done simultaneously may have different prices
(iv) The method is cumbersome if prices fluctuate frequently and there on numerous purchases

iii. Simple Average

- This method uses a simple average of prices of all consignment in stock is calculated and this average
price is used to value material issues.
- When the first consignment is exhausted, then the price of that consignment is eliminated and simple
average of remaining prices is calculated and so on.
NB quantities are not taken into consideration.

iv. Weighted Average (W.A)

Under this method, the total value of goods in stock is divided by the number of units of stock to give
Weighted Average price.

Advantages
(i) It smoothens out fluctuation in purchases price thus advents where prices variation are wide.
(ii) A new issue price is calculated at the time of each purchase and not at every issue hence if receipt
are few, calculation are reduced.
(iii) There are no unrealized profits since item cost are averaged.
Disadvantages
(i) Issues may not be at the current market price
(ii) If purchases are frequent then will be numerous calculations of issue price
(iii) To attain accuracy, sufficient number of places have to be made which is tedious
(iv) Excessively high or low prices paid in the past are reflected in the issue price for a consideration
time even after the materials is considered.

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Other Methods
v. Base Stock
- Under this method, a fixed quantity is carried as base stock. It’s assumed that a fixed minimum stock
base of stock of the material is always carried at original cost. It’s kept for emergencies and stock
level is not allowed to fall below this level.
- Its similar to FIFO method coz after deducting the base stock figure, the remaining issues are valued
at FIFO basis

vi. Replacement Cost (Next In First Out)

- Under this method, materials are valued at replacement cost or market value. Thus materials issued
are valued at replacement cost/ market price i.e. material issued are valued according to cost of
replacing such materials.
- This method is logical but difficult to ascertain the price of the next purchase.
vii. Standard Price
- This is a pre determined price that is arrived after considering factors like consumption of materials
expected changes in price of materials etc.
- All material issues are priced at a standard price. This method is simple, stable and provided a check
on efficiency of the enterprise.

Illustration
The following details were extracted from the stores ledger card of a small manufacturing company
during the month of November 1987
November 2 Received 500 units @ shs 20 each
8 Received 300 units @ shs 22 each
10 Issued 400 units
15 Issued 200 units
20 Received 600 units @ shs 25 each
25 Issued 300 units
27 Received 200 units @ shs 26 each
30 Issued 100 units
Standard price for each unit after the month of may id shs 25/. Market price of this material on December
is shs 27/ unit and 400 units were purchased on that day
required

2.11 Stock Controls

This is a function of ensuring that the stocks are available to meet production requirements
The main objective of stock control is to minimize costs associated with stocks which include;
a. Purchase cost: This can be minimized by bulk buying to enjoy quantity discounts
b. Stock holding cost: e.g. rent, security, pilferage, theft etc.
c. Stock ordering cost: e.g. telephone, postage, inspection etc.

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 d. Stock out cost: These are costs associated with running out of stock e.g. loss of goodwill.

2.11.1 Setting stock levels / limits

This is done to avoid stock out and stock excesses. A scientific approach is adopted in fixing the stock
levels which should be reviewed periodically. There are various levels to be computed for each stock
item this include:
i) Reorder level
This is the level at which a new order is initiated. It takes into account the worst possible condition e.g.
the maximum consumption and maximum reorder period/ lead time
Re-order level = Maximum Consumption x Maximum reorder period/ lead time.
Nb. Maximum re-order period / lead time is the time taken from when the order is initiated to the time
when the goods are received.
ii) Minimum Stock Level/ safety/ buffer level
This is the level below which the stock should not be allowed to fall and therefore, there will be no risk
of stock out
Minimum stock level = Re-order level – (Average stock x Average Re-order period)
iii) Maximum Stock level
This is the level above which stocks should not normally be allowed to rise as it may lead to
overstocking.
Maximum stock level = reorder level + Reorder quantity – (Minimum Stock x Minimum reorder period)
In fixing the maximum stock level the following factors are to be considered
a. Ratio of consumption
b. Delivery time
c. The risk of obsolescence and deterioration
d. Storage space available
e. Cost of storage
f. Availability of funds to purchase the stocks
g. Seasonal considerations e.g. bulk purchasing during low price season
h. Restrictions imposed by the government e.g. quotas.
iv) Average stock level
viii. The average stock level = Minimum stock level + Maximum stock level
2
v) Stock turnover
This shows the average number of times the stock item is replaced in a given period.
Stock turnover = Annual Demand
Average Stock

2.11.2 Formulation of Stock Level

1. Re-order level = Max usage X Max lead time (reorder period)
2. Min Stock level = RL – (Normal Consumption X Normal reorder period )
3. Max S. L. = Min SL + Reorder Quantity + (Min Cons x Min Reorder period)
4. Reorder Quantity = Max Stock Level – Min Stock Level – (Min C X Min reorder period)

26
 Illustration i
The following information relates to BB Ltd for a stock item X with an annual demand of 50,000 units.
Reorder period is 3-5 months. Consumption rate is 2500-45000 units per month and reorder quantity has
been calculated as 20000 units
Required
i) Reorder level
ii) Minimum stock level
iii) Maximum stock level
iv) Average stock level
v) Stock turnover
Solution
i) Reorder level = maximum consumption x maximum reorder period
= 4500 x 5
= 22,500,units
ii) Minimum stock level= reorder level – ( average stock x Average reorder period)
= 22500-(3500 x 4)
= 8500 units
iii) Maximum stock level= Reorder level + reorder quantity – (Minimum stock x minimum
reorder period)
= 22500+20000-(2500x3)
=35000 units
iv) Average stock level = minimum stock level + maximum stock level
2
= 5800+35000
2
= 21750 units
v) Stock turn over = annual demand
Average stock
= 50000
21750
= 2.30
= 2 times
Illustration ii
The following information has been extracted from the books of ABC ltd which uses component Y which
has minimum usage of 400kg per day and maximum usage of 800 kg per day. Lead time is 10-14 working
days and annual demand of 69600 kgs. Reorder quantity is 12000 kgs
Required
Calculate the relevant stock levels.
i) Reorder level = maximum consumption x minimum reorder period
= 800 x 14
= 11200kgs
ii) Minimum stock level = reorder level – (average stock x average reorder period)
= 11200-(600x12)
= 4000 kgs
iii) Maximum stock level = reorder level + reorder quantity – (minimum stock x minimum

27
 reorder period)
= 11200+1200-(400x10)
= 19200 kgs
iv) Average stock level = Minimum stock level + maximum stock level
2
= 4000+19200
2
=11600kgs
v) Stock turnover = annual demand
Average stock
= 69600
11600
=6 times

Illustration iii
The following is provided for material PQ 251
Max usage = 6000 units/wk
Min usage = 4000 units/wk
Reorder period/lead time = 4-6 wks
Reorder quantity = 30,000 units
Required
(a) Reorder level
(b) Min SL
(c) Max SL
(d) Ave Sl
Solution
(a) Reorder l = Max usage x Max reorder period
6000X6=36000 units

(b) Min SL = Reorder level – (normal usage X Normal reorder period)

36000-(5000X5wks) = 11000 units
(c) Max SL = Min SL + RQ + Min C X Min RP
11000 + 30000 + (4000X4) = 57000 units
(d) Av SL = Max SL + Min SL = 57000+11000=34000
2 2

2.11.3 Economic Order Quantity (EOQ)

This is a special-order quantity at which the cost of having stocks is minimum. The cost of having stock
ca n be broken down into 2 parts
a. Holding cost
 Cost of capital tied up
 Warehousing cost
 Cost associated with deterioration
 Obsolescence cost
 Insurance cost
b. Ordering cost

28
  Clerical cost
 Telephone charges
 Stationery
 Postage
 Inspection costs
 Salaries to receiving employees.

EOQ = 2cd
ip
Where c = delivery cost per batch i = stock holding cost per annum
d = annual demand of product p = cost price per item

a company has an annual demand for material P of 25000 tonnes per annum. The cost price per ton is
shs 2000 and the stock holding cost is 25% per annum of the stock price . Delivery cost per batch is
shs 400
required
calculate EOQ

EOQ = 2cd = 2 x x400 x x25000 = 2 x 400 x 25000

ip 25% x 2000 500
= 200 units
Number of orders per year = annual demand = 25000
EOQ 200
= 125 orders
Illustration iv
Bidii ltd uses a component whose demand is fairly constant at 100 units per day. For 200 days in a year. The
cost of ordering is shs 400 and the cost per unit is shs 5. the holding cost is 25% of the purchase price
Required
a. Calculate EOQ
b. The number of orders per day
c. Operating cycle
d. Holding costs at EOQ
e. Ordering cost at EOQ
f. Total costs
a. EOQ = 2cd = 2 x 400 x 20000 = 16000000
Ip 25% x 5 1.25
EOQ = 3578 units
b. No. of orders per year = annual demand = 20000
EOQ 3578
= 6 orders
c. Operating cycle = No. of days during the period = 200
No. of orders during the year 6
= 33 times
d. Holding cost at EOQ = EOQ x holding cost
2
= 3578 x 1.25

29
 2
=shs 2236.25
e. Ordering cost at EOQ = demand x ordering cost
EOQ
= 100 x 200 x 400
3578
=2235.89
f. Total cost = holding costs + ordering costs
= 2236.25 + 2235.89
= shs 4472.14
Illustration v
Material BZ has an annuals demand of 4500 units. Ordering cost is shs 20 per order, carrying cost is 20% of
the basic item price which is shs 10
Required
a. EOQ
b. Holding cost at EOQ
c. Ordering cost at EOQ
d. Total cost at EOQ
e. No. of orders during the period
f. Operating cycle

Assumptions of EOQ
1. There is only one type of product
2. The price per unit of material is fixed and no quantity discount even with bulk buying
3. Annual demand is known
4. There is instantaneous replenishment i.e. lead time is zero
5. There is no stock out
6. Annual stock holding cost per unit is known and is constant
7. Cost per order is known and is constant
8. The rate of consumption is uniform

Limitations of EOQ model

1. The material price may not always be fixed especially where there is bulk buying
2. The firm will always experience stock out
3. In most cases, the rate of consumption is not uniform
4. The cost per order is not always known and is constant as it may change due to inflation political
instability etc.

Summary
There should be a consistent, reasonably simple method of pricing issues so that the production is
charged a realistic figure for materials consumed. The problems involved in pricing issues arise form
changing purchase price, frequent impossibility of identifying materials with particular purchases.
The major pricing methods are First in first Out (FIFO), Last In First Out (LIFO), Simple Average
method and Weighted Average method. Others include replacement method, standard price method
and base stock method.

30
CAT I
Answer the questions below and send them to your instructor for marking.
Question one
a) State and briefly the essential requirements of an effective stock control system( 12 marks)
b) State and explain the possible causes of discrepancies revealed by physical stock counts and
explain how they can be addressed. ( 8 marks)
( 20 Marks)
Question Two
Distinguish between continuous stocktaking and annual stocktaking and explain the advantages and
disadvantages of each of them. (Total 20 marks)
Question Three
A business firm which is engaged in manufacturing should adequately control materials used in the
production process from the point of procurement up to the point the materials are issued to production
Required
Clearly explain how a business firm would reasonably achieve this objective.(10 marks)

Question Four
The following information relates to item P003 stocked by 2000 products Ltd. For the month of April 2000
Date Receipts (units) Issues (units) Unit cost (sh)
April 3 2400 18
4 3200
6 2600 20
12 2700
14 3000 22
18 2800 21
20 2200
22 2600 23
25 3800
26 3100 24
27 2500 25
28 3200 25
29 6900

The closing balance for March 2000 was a batch of 3000 units received at a unit price kof sh 19
Required
a) Stores perpetual inventory record for item P003 for May 2000 under LIFO system of stores issues
(14mks)
b) Closing stock valuation (6mks)

Question five
a) Explain the advantages of centralized system of maintaining stores (5mks)
b) Explain the assumptions behind the Economic Order Quantity (EOQ) (5mks)
c) The following information is given for material Y-20
Consumption
Annual 360,000 units
Maximum 1,200 units/day

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 Minimum 800 units /day
Normal 900 units/day
Re-order period 12-24 days
Re-oder quantity 32,000 units

Required
a) Reorder level (3mks)
b) Minimum stock level (3mks)
c) Maximum stock level (3mks

Question six
Nyali mbali ltd are retailers who sell ceramic tiles. During the month of July to September 2000 there were
price fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 July Opening stock was 5000 tiles value d at Sh 825,000
10 July Orders placed with the company increased, so, extra tiles had to be obtained from Mombassa.
Therefore, 22000 tiles were purchased at a cost of Sh 140 each but in addition, there was a
freight and insurance charge of Sh 5 per tile
31 July During the month 20000 tiles were sold at a price of Sh 220 e ach
4 August A new batch of 14000 tiles were purchased at a cost of Sh 175 per tile
30 August The sales for the month of August were 14000 tiles at a selling price of Sh 230 each
1 September A further 24000 tiles were purchased at a cost of Sh 195 each
30 September 270000 tiles were sold during September at a price of Sh 240 each
The cost accountant of Nyali Mbali Ltd decided he would apply first in first out basis and weighted average
methods of material pricing for the purpose of comparison.
Required
(i) A stores ledger account using the two methods and showing stock values at 30 September 2000
(14 marks)
(ii) The trading accounts using each of the above methods (6 marks)

Question seven
Samba Ltd produces three joint products in two processes. All the units pass through process I to process II.
At the end of process II, the joint product emerge. The data below relates to the operations for the first
quarter of 2001

Process I Process II
Sh Sh
Direct materials (40,000 kg @ sh 2.50) 100,000
Direct labour 60,000 92,000
Overheads 40,000 118,000
Normal loss as a percentage of input 10%
Scrap values per unit Sh 2
Output in units 35,000
No loss is expected in process II
There were no opening or closing work in progress. The output and the selling prices were as follows:

32
Joint product Output (Kg) Selling price (Sh)
X 10,000 20
Y 16,000 15
Z 9,000 16
Required
a) Process I account (6 marks)
b) Abnormal loss/ gain account (4 marks)
c) Determine the profits or losses from each joint product if costs are apportioned using sales value
method (6 marks)
d) Briefly explain how the physical limits is different from sales value method in (c ) above(4 marks)
(Total 20 marks)
Question eight
Tindo Ltd buys and sells product Q-3. It values stock on the basis of Last in first out (LIFO). At 1 June 2001,
stock in hand consisted of 4,500 units which were acquired at sh 50 per unit. The operations for the month
were as follows:
Date purchases Sales
4 5,000 @ sh 48
5 6,000 @ sh 60
7 5,500 @ sh 49
11 4,000 @ sh 50
12 7,000 @ sh 61
13 5,000 @ sh 50
18 6,000 @ sh 47
19 8,000 @ sh 64
20 6,000 @ sh 49.50
21 5,000 @ sh 65
22 7,000 @ sh 50
25 6,000 @ sh 49
26 2,000 @ sh 47
28 500 @ sh 60
29 14,000 @ sh 64

The company incurred operating costs of sh 450,000 during the month

Required
a) Stores ledger cards (14 marks)
b) Closing stock valuation (2 marks)
c) Trading account for the month (4 marks)
(Total 20 marks)

33
 3.0 LABOUR COSTING

Objectives:
At the end of this topic, students should be able to:
o Describe different methods of labour costing
o Compute labour cost using those methods

3.1 1ntroducion
In chapter one, we mentioned direct and indirect labour. Direct labour is labour directly engaged in
production work and can be conveniently identified wholly to a particular job product, process, etc. It
involves the cost incurred in the construction, composition and conditioning of the product. On the other
side, indirect labour cost includes salaries paid to those workers who are not directly engaged in converting
raw materials to finished goods, e.g. supervisors, inspectors, watchman, cleaners, e.t.c.

There is need for adequate system of recruitment, selection and placement of workers to jobs. The company
should ensure that employees are well remunerated. it should also provide healthy working conditions
consistent with legal requirement and competitive undertaking.e.g physical conditions.
Personnel Department is concerned with recruitment, discharge and transfer of labour.requisition for new
personnel is made to other departments. On receipt of such requisition, the personnel manager proceeds to
recruit persons from various sources such as technical institutes, employment agencies, internal transfers,
advertisement in newspapers, poaching from other company’s e.t.c.
On recruitment of new employees, the following departments are notified:
a) Department where the employee has to report to his duties.
b) The payroll department
c) Time office for recording attendance.

3.2 Labour Remuneration

The term remuneration or emolument is used to cover gross earnings of the employee. It includes wages and
salaries according to time or piece rate or other financial benefits as well as fringe benefits. The efficiency
can be increased by using improved equipment more effective utilization of plant and by adoption of better
methods of production.

However, the most important contribution must come from the labour. The methods of remuneration which
allows high wages to be paid have the effect of increasing labour cost but may also result in increased
production and productivity thereby reducing labour cost per unit. On the other hard low wages generally
results in high labour cost per unit due to low productivity and high rate of labour turnover.

3.3 Labour Turnover

It is the rate of change in composition of the labour force in an organization. a controlled labour turnover is
good for a healthy employer-employee relationship as it creates

vacancies for internal promotion and maintains a high morale for young and ambitious workers who may
bring in new ideas and methods of performing work from other employers. Labour turnover may be
expressed in a rate as follows:

34
Labour turnover = Number of workers that left during a period x 100
Average number of workers during a period.

Average number of workers = workers at the beginning + workers at the end

2

Labour turnover reports should be prepared regularly giving a breakdown of the cost.

Causes of Labour Turnover

There are 2 major causes of labour turnover:

(i.) Avoidable Causes

This includes:-
 Low wages and allowances
 Unhappy relations with supervisors and co-workers.
 Unsatisfactory working conditions.
 Lack of medical facilities, housing, transport. e.t.c.
 Inadequate job security and recruitment benefit.

(ii.) Unavoidable Causes

This includes:-
 Death
 Retirement
 Accident or illnesses.
 Discharge on disciplinary grounds.
 Domestic disputes like marriages
 Transfer of spouses to other towns.
 Personal dislikes for jobs or environment
 Incapacitation such as insanity.

Labour turnover is expensive and generally may be minimized because it results in increased cost of
production, classified under 2 categories.

Preventive Cost
It is cost incurred to keep the labour force satisfied so as to prevent/discourage the employee from leaving the
firm through:-
a) Adequate salaries and wages
b) Cost of personal management, i.e. efforts by the personnel management in maintaining good relations
between management and workers.
c) Cost of welfare activities and services such as canteen, co-operative societies education, transport
facilities and housing schemes.
d) Cost of medical services and medical schemes.
e) Pension schemes to provide security and retirement benefit.
f) Extra bonus and other prerequisites in excess of those given by other similar firms to discourage
employees from the job.

35
Replacement Cost
It is cost for replacing an employee who has left. This cost may include:-
a) Cost of recruitment and selection of new workers.
b) Cost of training new workers
c) Loss of output due to some damages time-gap in obtaining new workers.
d) Cost of accidents due to lack of experience of new workers.
e) Loss due to inefficiency of new workers
f) Cost of defective work by new
g) Cost of tools and main breakdown due to faulty handling by the new workers,e.t.c

Reduction and Control of Labour Turnover.

a) Devising a suitable and satisfactory wage policy
b) Providing working conditions conducive to health and efficiency.
c) Impartial and sympathetic attitude of personal management
d) Introducing financial and non-financial incentive plans.
e) Providing promotional opportunities
f) Introducing labour participation in management
g) Introducing affective grievances/complains procedures
h) Strengthening the welfare measures.

Features/Characteristics of a Satisfactory Labour Remuneration System

1) The system should produce the best quality and quantity of work
2) It should be satisfactory from the point of view of both the employer and employee and should be
related to effort.
3) The scheme should be clearly defined and understandable to workers
4) The system should guarantee a minimum living wage to each worker irrespective of his efficiency.
5) No maximum limit should be placed on the amount of individual earnings.
6) The earning of the workers should not be affected by matters beyond their control.
7) It should reduce labour turnover and labour absenteeism
8) The system should be flexible so as to allow room for changes.
9) Should be capable of operation without excessive clerical work
10) Methods demanding detailed recording of time, quality work and quantity of output should be avoided.
11) Should be one which is in use in that particular industry or in the locality if possible.

3.4 Methods of Labour Remuneration

1. Time-based method.
a) Basic system.
This is based on the number of hours worked times basic rate per hour, e.g,,40 hours per week is
expected for each employee. additional hours worked is classified as overtime and paid at a higher
rate,e.g,a time and quarter or a time and half,e.t.c.however,the performance also has to be
monitored,i.e,,there is need for close supervision such that worker are not paid for attendance but are
paid for working.

Advantages
i) Simple to understand and operate as calculation of wages is based on the number of hours
worked.

36
 ii) Workers concentrate on quality and hence avoid over-speeding which compromises quality.
iii) The system is certain as the workers are assured of the basic rate.
Disadvantages
(i.) Constant supervision may be necessary which increases cost of production.
(ii.) May lead to decrease in production hence cost per unit
(iii.) Employees of the same grade are paid the same irrespective of experience.
(iv.) No real incentive to increase output
b) High Pay Rate System
It is a fixed rate rather than the usual rate .it provides a strong incentive by paying rates well above
average performance. With higher rates the managers demand higher levels of performance and
efficiency.

Merits
i) Simple to operate and understand as calculation of wages is based on the number of hours worked.
ii) Provides a direct incentive without complication of work done.
iii) Requires less supervision.
iv) Reduce labour turnover
v) Attracts high grade of workers
vi) Leads to increased production
vii) Workers concentrate on quality.
viii) The system is certain as the workers are sure of basic rate.

Demerits
i) Causes other employers to raise their rates to attract better workers
ii) It defeats the purposes if the original target is not met
iii) Close supervision is required hence it increases cost of production.

c) Graduated Time Rate System

Wages are paid at time which varies with changes of living index hence the rates are adjusted periodically
according to the index.
The method takes into account the changing economic conditions hence the living conditions.

Common Bonuses Found in Time Rate System

i) Shift bonus-an extra amount is paid to working in shifts
ii) Time keeping bonus-if one has kept a good time over the week he is remunerated on time keeping.
iii) Continuous working bonus-it is where the factory has achieved continuous production without go
slows, machines breakdowns, power failure,e.t.c hence workers receive weekly bonuses..

Illustration I
Mr. George has worked for 53 hours. the normal working hours are 40 hours per week. the wage rate is 25
per hour and overtime is paid at a rate of 1/3.calculate the gross earnings.

Solution
Normal pay 40 hours x ksh 25 = ksh1, 000
Overtime pay 13 hours x (ksh 25+ 1/3 x 25) ksh 433
Ksh 1433

37
2. Piece Rate Plan/Output Or Performance Leased System
Each employee is paid for the quantity of work done at a specified rate per piece which is fixed in
advance,e.g.if the rate per piece is shs 200, the worker who completes 40 pieces is paid Shs 8,000. The
method should specify causes where a worker completes a number of pieces and some are found defective.
Areas where the method is recommended
a) Where the nature of work done is such that it is repetitive,e.g.putting of price tags,packaging,loading,etc
b) Where the work done is closely related to the employee’s skills and efforts e.g., painting a
house,ploughing a land,etc.
c) Where the business has maintains other records to ensure workers report to work punctually.
d) Where it is easy to compute labour cost per unit in advance
e) Where it is easy to compute labour cost per unit in advance
f) Where the business has sufficient production to guarantee employees adequate quantity of work.

Merits
 There is direct connection between wages, production and efforts of individuals,i.e the more the units
produced, the units produced, the higher the wages earned.
 Direct incentives to make workers produce more units and earn higher wages.
 Due to the increased number of units, the total cost per unit is reduced.
 The labour cost is fixed in advance and hence it is possible to compute total cost in advance before the
item is produced.
 Every employee is interested in maximizing the output and hence no need for strict supervision. The only
supervision required is inspection of finished products and to ensure materials and machines are not
damaged.
 Since workers are interested in maximizing the output, there will be few cases of absenteeism and idle
time.

Demerits
 It difficult to set a piece rate which is far and acceptable to the employees.
 Workers aim at maximizing the quantity but not the quality.
 Increased damages of machines due to workers rushing in their jobs.
 Poor health and fatigue on the part of the workers as they strive to produce as many units as possible.
 The normal flow of work may be affected due to absenteeism, where the workers feel they have earned
enough.
 The system fixes uniform rate per piece therefore compromising good workmanship/quality job in the
product.
 There is no minimum wages to be paid and hence no security on the product.

Types of Piece Rate

a) Straight/flat piece rate
A rate per piece is fixed and used to compute wages for all employees without taking into account the
levels of output and efforts of individual’s employees.

b) Different piece rate

Different rates per piece are fixed for different levels of production, e.g .from:
1-50 units pay at shs.10 per unit.

38
 51-100 units pay at shs 15 per unit
101-200 units pay at shs 20 per unit

Illustration ii
AB Ltd produces and sells table covers. Employees are paid Shs 30 per table cover. Compute wages of john
who completes 100 table covers in a week and peter who completes 150 tables covers in the same week

Solution
John pay = 100 Tables × Ksh 30 per table = Ksh 3000
Peter pay = 150 Tables × Ksh 30 per table = Ksh 4500

Illustration iii
XY Ltd makes pegs and used differential piece rate as follows;
Quantity Rates per peg (Shs)
1-100 20
101-200 30
201-300 40
301-400 50
Above 400 60
Find wages for each of the following:
A-150 pegs
B-250 pegs
C-200 pegs
D-450 pegs

Solution
A (100×Ksh 20) + (50× Ksah 30) = Ksh 3500
B (100×Ksh 20) + (50× Ksah 30)+ (50×Ksh 40) = Ksh 7,000
C (100×Ksh 20) + (50× Ksah 30) = Ksh 5,000
D (100×Ksh 20) + (50× Ksah 30) + (100×Ksh 40) + (100×Ksh 50) + (50×Ksh 60) = Ksh 17,000

3.5 Premium Bonuses Plan

These are computed on either time rate or piece rate. An extra reward above the ordinary rate per hour or per
piece is paid to an employee where performance is superior to the required standard / above standards. for
example, if an employee is expected to complete 20 packing bags in a day and the employee completes 35
bags in the same day, an extra wage is paid for 15 bags.

Features of a Good Premium Bonus Plan/Scheme

 The standards set for an employee to achieve should be determined, accurate and within the limits,
i.e., achievable.
 The system should be acceptable by the workers.
 Wages paid should be having a connection with the worker’s efforts.
 Wages paid should be sufficiently high to attract greater efforts in the job.
 The system should be easy and simple to understand.
 The system should be economical and aims increasing the firm’s production.
 It should put a maximum limit on the amount earned by the worker.

39
  It should have a laid down procedure on how wages are to be settled.

Types of Premium Bonus Plan/System

i. Individual premium plan
The worker or labourer is recognized and remunerated / rewarded individually. Under this plan bonus
are determined as follows:

a). Halsey scheme

Each individual is allowed a given time for a specific task The time taken to complete the task is reconded.if
time taken is less than time allowed, the difference is called time saved.

NB: there is no time saved if time taken is more than time allowed.

Bonus = 50% (time saved × wages rate)

Where; time saved = time allowed – time taken
Wage rate is basic rate per hour or per specific time.

Defective Units
These are units completed but found defective, i.e damaged and are acceptable. If defective units are to be
paid for, they are excluded in computing the time allowed.

Illustration iv
The wage rate per hour is shs.10 and time allowed to complete a unit is one hour.
Peter completed 100 units within a time of 45 minutes per unit.

Required
Calculate the bonus paid under Hasley scheme.
Solution
Time allowed for 100 units 100 × 60 minutes = 6,000 minutes
Time taken 100 × 45minutes = 4,500 minutes
Time 1,500 minutes

Bonus 50% × 1,500/60 × ksh 10 = Ksh 125

b) Hasley Weir Scheme

It is similar to Hasley Scheme but bonus is paid at the rate of 30% of time saved

Formula
Bonus = 30% (Time saved × Wage rate)
Using above illustration – the answer is Shs. 83

c) Rowan Scheme
Under this scheme any other fraction is used other than 50%x or 30%
Formula
Bonus = Time taken (Time save × wage rate)
Time allowed

40
Illustration iv
The standard time to complete a job is 40 hours. An employee takes 30 hours to complete the same job. The
rate per hour is Shs. 25.
Required:
Calculate an employee’s earning under
1. Hasley Scheme (30 Hrs × Ksh 25) + (10 × .5 × Ksh 25) = Ksh 875
2. Hasley Weir scheme (30 Hrs × Ksh 25) + (10 × 3 × Ksh 25) = Ksh 825
3. Rowan Scheme (30 Hrs × Ksh 25) + (10/40 × 10 × 25) = Ksh 812.5

e) Group Incentive Scheme/ Group Bonus Plan

I f the nature of production such that the labour is used as group and not as individual employees then the
bonuses and premiums can only be computed for the whole group.
In most manufacturing industries, the total output comes from the effort of the group and the production of
each individual cannot be determined.

REQUIRED FOR APPLICATION OF GROUP OWNERS

(i.) The group must have workers of relatively similar skills.
(ii.) The group should not be too large.
(iii.) The output should be under the control of the group, i.e., the group effort should influence the output.

SHARING OF THE GROUP BONUSES

The amount of group bonus once computed can be distributed as follows:
(i.) EQUALITY
Bonus = Total group
Number of employees

ii RATE PER HOUR

Bonus = Total group bonus

Total hours for all workers

i. PERECENTAGE OF WAGES EARNED

Bonus = Total group bonus

Total wages of employees

ii. ANY OTHER BASIS AS DETERMINED BY THE MANAGEMENT

f) Profit Sharing Co. ownership

It is a type of a group incentive scheme where employees can participate in sharing of bonus under two
methods:-

i. PROFIT-SHARING

41
The management declares a certain percentage and offers this percentage to the labourers/workers in
form of a bonus. It is distributed among them using equal basis, percentage of the wages or rate per
hour.

ii. CO.OWNERSHIP.PARTNERSHIP
It is a non-cash type of bonus where the employees are allowed to acquire shares of the organization or
company and become shareholder. This method has the weakness in that if an organization incurs a
loss, nothing is distributed to the shareholders, i.e no dividends.

42
COST ALLOCATION/ APPORTIONMENT

Objectives:
At the end of this topic, students should be able to:
o Compute cost allocation using various methods
o Compute Overhead absorption rates using different bases

Departments within an organization can be divided in to two broad classes.

i) Operating departments- includes those departments or units where the central purposes of
organization are carried out. 9E.g., production department such as milling, assembly and painting in a
manufacturing company.
ii) The service departments: - by contrast, do not engage directly on operating activities. Rather they
provide services or assistance that facilitates the activities of the operating departments. Examples of
such services include cafeteria, internal auditing, personnel etc. Although service departments do not
engage directly in the operating activities of an organizations, the costs that they incur are generally
viewed as being part of the cost of the cost of the final product or service, the same as are raw
material, labour, and overhead in a manufacturing company or medications in a hospital.

Therefore:
Costs apportionment is the allotment to two or more cost centers of proportions of the common items of cost
on the estimated basis of the benefit received. Cost of service departments are allocated to other departments
by means of some type of allocation base.
An allocation base: - is a measure of activity that acts as cost drivers for the department involved e.g. labour
hours, number of employees, square footage of floor space etc. Managers try to select allocation bases that
reflect as accurately as possible the benefits that are being received by various departments within the
company from the services involved.

The procedure for overheads appointment

i) All overheads are collected under the separate headings provided i.e. cost account numbers.
ii) Where possible allocate any overhead directly to a cost center.
iii) All the separate totals of expense in standing orders are apportioned to production and service cost
centers.
iv) The total overhead for each service cost center is then apportioned to the production cost centers
which use those services and this is repeated if necessary until all the overhead has been apportioned.
v) The final totals of overheads for the production cost centers are absorbed in a way that each works
order number, or unit of production, is charged with its share of the centers through which it passes.

METHODS OF COST ALLOCATION

1. Direct method of cost allocation.
The direct method is a very simple allocation approach in that it ignores the costs of services between service
departments and allocates all costs directly to operating departments.

43
Example
Services department Operating department
Dairy
Hosp Custodial patient
Admn services Laboratory center Total
Department cost before
allocation 360,000 90,000 261,000 689,000 1,400,000
Labour hours - 6,000 18,000 30,000 54,000
Proportion of labour hours - 1/9 3/9 5/9 9/9
Space occupied - square feet 10,000 - 5,000 45,000 60,000
Proportion of space occupied 2/12 - 1/12 9/12 12/12

Solution
Services department Operating department
Dairy
Hosp Custodial patient
Adim services Lab center Total
Department cost before 261,00 689,00
allocation 360,000 90,000 0 0 1,400,000
Allocation
Hospital administration
cost
135,00
Labour hours (3/8, 5/8) (360,000) - 0 225,000
Custodial services cost 9,00
(1/10, 9/10) - (90,000) 0 81,000
405,00
- - 0 995,000 1,400,000

Note
i) After all allocations have been made, all of the departmental costs are contained in the two
operating departments. These costs will form the basis for preparing overheads rates and for
determining the overall profitability of the operating departments in the hospital.
ii) Direct method is simple; it is highly inaccurate since it ignores interdepartmental services. This
can be a major defect in that overhead rates can be affected if the resulting errors in allocation are
significant. This can lead further to distorted product and service costs and to ineffective pricing.

2. Step method/ sequential.

Unlike the direct method, the step method provides for allocation of a service department’s costs to other
services departments as well as to operating departments in a sequential manner. The sequence typically
begins with the department that provides the greatest amount of service to other departments. After its costs
have been allocated, the process continues, step by step ending with the department that provides the least
amount of service to other service departments.
Using previous example.

Services department Operating department

44
 Hosp Custodial Daily patient
Admn services Lab center Total
Department cost
before allocation 360,000 90,000 261,000 689,000 1,400,000
Allocation
Hospital
administration 1/9, 3/9,
5
/9 (360,000) 40,000 120,000 200,000

Custodial Services
costs 1/10, 9/10, 5/10 (130,000) 13,000 117,000
-o- -o- 394,000 1,006,000 1,400,000

Note
i) The Costs of hospital administration are borne by another service department as well as the operating
department.
ii) Hospital administration costs that have been allocated to custodial services are included with custodial
services costs and that the total is allocated only to subsequent departments. After the allocation of a
service department’s costs has been completed, costs of other service departments are not reallocated
back to it.

3. Repeated distribution.
Services department Operating department
Hosp Custodial Dairy patient
Admn services Lab center Total
Department cost 360,000 90,000 261,000 689,000 1,400,000
Service dept Hosp
1
/9, 3/9, 5/9 (360,000) 40,000 120,000 200,000
Custodial Dept
2
/12, 1/12, 9/12 21,667 (133,000) 10,833 97,500
Hospital Dept
1
/9, 3/9, 5/9 (21,667) 2,407 7,222 12,037
Custodial Dept
2
/12, 1/12, 9/12 401 (2,407) 201 1,805
Hospital 1/9, 3/9, 5/9 (401) 45 134 223
0 45 399,390 1,000,565 1,400,000

Use of simultaneous equation to allocate interdependency.

A company has three production departments and two service departments and for a period the departmental
distribution summary has the following totals:

Sh”000”
Production costs center A 1600
B 1400

45
 C 100
Service cost center 1 468
2 600
5068
The expense of the service cost center is charged out on a percentage basis as follows:
A B C 1 2
Service cost center 1 20% 40% 30% - 10%
Service cost center 2 40% 20% 20% 20% -
Show the apportionment of overheads using simultaneous – equation method.

Let x be total overhead of center 1

Let y be total overhead of center 2

x = 468 + 0.2y
y = 600 + 0.1x

x – 0.2y + 468 =► 10x – 2y + 4680

y – 0.1x =600 =► -x + 10y = 6000

by elimination 10x – 2y = 4680

x – 10y = -6000
10x – 2y = 4680
10x – 100y = - 60000
98Y = 64680 y = sh 660.

Then x = 468 + 0.2 (660) = 600

Then take the total cost of services departments found in the equation and apportion them to the production
cost centers.

A B C 1 2
Cost before allocation 1600 1400 100 600 660

Total A B C
Cost Per distribution summary. 4000 1600 1400 1000
Service center 1 (600- 10% x 600) 540 120 240 180
Service center 2 (660- 20% x 660) 528 264 132 132
5068 1984 1772 1312

Matrices method
Using the equation formed above, we can form a matrix and then solve.

10 -2 x = 4,680
1 -10 y -6,000

46
Inverse matrix of:

10 -2 is -10 2
1 -10 -1 10

10 -2 -10 2 x = -10 2 4680

1 -10 -1 10 y -1 10 -6000

-98 0 x = -10 2 4680

0 -98 y -1 10 -6000

-98 0 x = -58800
0 -98 y -64680

- 98 x = -58800
-98 y -64680

x = 600
y = 660

OVERHEAD ABSORPTION
Overhead absorption is the process by which overheads are included in the total cost of a product. i.e. a
means of attributing overheads to a product or a service based for example on direct labour hours, direct
labour cost or machine hours.
Overhead absorption is of great importance when dissimilar products are made which require different
production processes or for jobs which, although using identical facilities occupy the facilities for varying
lengths of time.
To be able to compute the overhead to be absorbed by a cost unit it is necessary to establish an overhead
absorption rate (OAR) which is calculated by using two factors; the overhead attributable to a given cost
center and the number of the units of the absorption base e.g. labour hours, machine hours etc that is deemed
to be suitable.

OAR = Total overheads of cost center .

Total number of units of absorption base applicable to cost center

Bases of absorption
The objective of the overhead absorption process is to include in the total cost of a product an appropriate
share of the firm’s total overheads. The following are most commonly used rates of overheads absorption.

47
 Direct labour hour OAR = Overheads .
Direct labour Hrs

 Direct wages OAR = Overheads . x100

Direct wages
 Direct Material cost = Overheads x 100
Direct material costs
 Prime cost OAR = Overheads x100
Prime costs
 Machine Hour OAR = Overheads
Machine Hours
 Cost of Unit OAR = Overheads
Number of Units

 Predetermined absorption rates

OAR is calculated prior to the accounting period, using estimated or budgeted

figures for overheads and units of the absorption base chosen.

Predetermined OAR = Budgeted Total Overhead for cost center

For cost Center Budgeted total number of units of absorption base.

Example
Two products x and y are made using similar equipment and methods. The data for the last period are.
X y
Units produced 6,000 8,000
Labour hours per unit 1 2
Machine hours per unit 4 2
Set – ups in period 15 45
Orders handled in the period 12 60

Overheads for period Sh

Relating to production setups 179,000
Relating to order handling 30,000
Relating to machine activity 55,000
264,000

Calculate the overheads to be absorbed per unit of each product based on conventional absorption costing
using labour hour absorption rate.

Solution
Labour hours
Product x = 6,000 x 1 = 6,000

48
 Product y = 8,000 x 2 = 16,000

Labour hour OAR = 246,000 = Sh 12 per hour

22,000
Overheads absorbed on labour hours
Product x Product y
Overheads absorbed 1 x Sh x 12 = 12 2 x Sh12 = 24
Total overheads 12 x 6,000 = Sh 72,000 8,000 x Sh24 = 192,000
Example 2
i) Name five different rates used for absorption of overheads
ii) The following information is available from a manufacturing company.

Sh
Total overheads 600,000
Total direct wages 480,000
Total indirect wages 16,000
Total direct material 300,000
Total indirect materials 15,000

Wage rate per hour 4

Direct material cost per Kg 5
Direct labour hours 120,000
Indirect labour hours 4,000
Machine hours 15,000
Indirect material usage 60,000
Direct material usage 3,000
Units of output 750,000

Calculate any three of the rates named in (a) above.

Solution

Direct labour hours.

O.H Absorption rate = Total overheads
Direct Labour Hours.
= 600,000 = Sh 5 per hour
120,000

Machine Hours rate = Total Overheads = 600,000 = Sh 40 per machine hour

Machine hours 15,000

Direct wages percentages

OH Absorption rate = Total overheads x 100 = 600,000 = 125%
Direct wages 15,000

49
50
 UNDER OR OVER ABSORPTION
Using predetermined rates, overheads are absorbed into the actual production thought the accounting period.
Because the predetermined rates are based on the estimated production and estimated overheads, invariably,
the overheads absorbed by this process do not agree with the actual overheads incurred for the period.

If the overheads absorbed are greater than actual overheads this is known as Over Absorption. Conversely,
if the overheads absorbed are less than actual overheads, this is known as Under Absorption.

Example,
The following data relates to a manufacturing department for a period
Budgeted data Actual data
Direct material cost 1,000,000 1,500,000
Direct labour cost 2,500,000 2,750,000
Production overhead 2,500,000 3,500,000
Direct labour hours 50,000 hours 55,000 hours

Job ZX was one of the jobs worked on during the period. Direct material costing Sh70, 000 and direct labour
(800 hours) costing sh 40,000 were incurred.

Required:
i) Calculate the production overhead absorption rate predetermined for the period based on :
a. Percentage of direct material cost
b. Direct labour hours
ii) Calculate the production overhead cost to be charged to job ZX based on the rates calculated in answer to
(i) above
iii) Assume that the direct labour rate of absorption is used calculate the under or over absorption of
production overheads for the period and state an appropriate treatment in the accounts.

Solution
i) % direct material = Budgeted overheads = 2,500,000 x 100 = 250%
Budgeted material 1,000,000

Direct labour hours = 2500000 = Sh 50 per hour

50,000

ii) Overheads for Job ZX

Using material =Sh 70,000 x 250% 175,000
Using labour hours = 800 hrs x 50 40,000

iii) Overheads incurred 3,500,000

Overhead absorbed (55,000 x 50) 2,750,000
Under absorption 750,000

This amount would be written off to the P/ L a/c either directly or via a suspense A/C

Example 2

51
A large hotel has recently re-organized its costing systems and spilt activities into four cost centers.
i) Accommodation
ii) Catering
iii) Leisure
iv) Outings.

The hotel is moving towards standardizing its services and selling a hotel package to its customers which will
include accommodation, meals, use of leisure facilities and a number of outings. There is to be
predetermined price per day for the use of each cost center by the customers.

Labour and material can be identified and allocated to the cost centers in the budget but other overheads
listed below cannot be so readily identifiable.

Accommodation Catering Leisure Outing Total

£ £ £ £ £
Labour 110,000 100,500 35,000 38,500 284,000
Material 19,000 36,000 16,000 13,000 84,000
Power 84,000
Rent and rates 72,000
Depreciation 60,000
Advertising 7 6,000
Office expenses 240,000

You are given the following information about the cost centers from the budget for the coming year:
Accommodation catering leisure outing
Floor area (Sq meters) 1,200 400 600 200
No. of employees 32 16 24 8
Machinery value £10,000 £20,000 £60,000 £30,000
Kilowatt hours 1,000 2,500 12,500 1,000
Expected customers
Usage in days 15,000 12,000 8,000 3,000

You are told that the advertising cost is to be apportioned to the cost centers on the basis of customer usage
and office expenses apportioned on the basis of total cost per cost center before the apportionment of the
office expenses.

The budget for the coming year has been based upon the strategy that the customers will have a standard
accommodation and catering package with the leisure facilities and outings package as operational. Hotel
policy for the coming years is to operate a profit margin of 30% on price.

Required
a) Prepare a cost statement for the four cost centers showing the budgeted total cost and the budgeted
cost per customer day per cost centre.
b) Calculate the price to be charged to a married couple who want to stay at the hotel for one week.
They require accommodation and catering for seven days, usage of leisure facilities for three days and
want to go on outings on three days.

52
 c) That actual results for the hotel for the year under review were as follows:

Customer days
Total cost usage
£
Accommodation 320,000 15,250
Catering 275,000 13,000
Leisure 200,000 6,800
Outings 125,000 3,200

Calculate the under or over absorption of costs per cost centre.

Solution
Accommodation Catering Leisure Outing Total
Labour 110,000 100,500 35,000 38,500 284,000
Materials 19,000 36,000 16,000 13,000 84,000
Power (kilowatt Hour) 20,000 10,000 50,000 4,000 84,000
Rent and rates (Floor space) 36,000 12,000 18,000 6,000 72,000
Depreciation (Market value) 5,000 10,000 30,000 15,000 60,000
Advertising (No of
customers days) 30,000 24,000 16,000 6,000 76,000
220,000 192,500 165,000 82,500 660,000
8 7 6 3
/24 /24 /24 /24
Office expenses 8,000 70,000 60,000 30,000 240,000
300,000 262,500 225,000 112,500 900,000
No of customer days 15,000 12,000 8,000 3,000
Cost per day £20 £21.875 £28.125 £37.50

Price per person

Cost per day Days £
Accommodation 20.000 7.000 140.000
Catering 21.875 7.000 153.125
Leisure 28.125 3.000 84.375
Outing 37.500 3.000 112.500
490
Profit (30% x 700) 210
Selling price 700

Profit is 30% on the selling price

Therefore costs = 70% of selling price and selling price 490 = 700
0.7
Under/ over
Costs absorbed Actual costs absorption.
Accommodation 20 x 15250 = 305,000 - 320,000 = (15,000)
Catering 21.875 x 13,000 = 284375 - 275,000 = 9,375
Leisure 28.125 x 6800 = 191,250 - 200,000 = (8,750)
Outing 37.500 x 3200 = 120,000 - 25,000 = (500)

53
 COSTING METHODS

Objectives:
At the end of this topic, students should be able to:
o Describe the nature of cost and various ways in which cost may be classified
o Explain various users of accounting information and their respective information needs
o Prepare a manufacturing cost statement and a profit statement.

Costing methods are designed to suit the way goods are processed or manufactured or the way that services
are provided. Thus each from will use a costing method with unique features.

There are two broad categories of product costing methods, namely specific order costing and continuous/
process costing.

Specific order costing

Apply where work consists of separate contracts or jobs and frequently and not always the jobs or contracts
are different from each other.
The main subdivision of specific order costing is
(a) Job costing
(b) Contract costing
(c) Batch costing
Continuous operation / Process costing (unit costing)
It’s a costing method applicable where goods or services result from a sequence of conditions or repetitive
operations or processes to which cost are charged before being averaged over the units produced during the
period

The divisions are shown in the figures below

Specific Order Costing Continuous Operation Costing

Job Contract Batch Process Service /

Costing Costing Costing Costing Function
Costing

Product costing service costing

Fig: Costing methods
NB: Dotted line shows there’s an overlap

Job costing

54
The main objective is to change all costs incurred to the particular job and establish the profit or loss on each
job and to provide valuation of work in progress. Its appropriate for special projects i.e. jobs that meet
customers specifications / requirements

Features of job costing

- Each job is comparatively short duration
- Work is undertaken to customers specific requirements
- Overheads are applied on a predetermined rate.

To cost a job, the following factors are necessary

- Comprehensive works documentation. Typically this includes works orders and bill of material
(material requisition)
- An appropriate time booking system using either time sheets or piece work tickets
- A well organized basis to the costing system with clearly defined cost centers, good labour
analysis, appropriate overhead absorption rates and a relevant materials issuing pricing system.

CONTRACT COSTING
- A contract is an agreement between two or more persons (contractor and contractee) which is legally
binding and enforceable by the law. The contract involves construction of a building, roads, dams,
bridges etc.
Features of Contract Costing
i) The contract is long term
ii) The contract is constructional in nature
iii) The contracts are site based
iv) The contract involves significant uncertainty (risk) due to their long-term nature
v) Usually, the contracts are large in size
vi) Separate account is prepared for each account
vii) Payments by the contractee are made in various stages

Objectives of Contract Costing

i) To ascertain the total cost incurred in construction
ii) To ascertain the amount to charge on completion of the contract
iii) To ascertain the profit and loss from each contract.

Types of contracts
1. Fixed price contract
This is a contract where the contract price is fixed as agreed between the contractor and contractee. Some
of the contracts may contain a cost escalation clause which is meant to provide for any future changes in
the contract price due to increase in price of materials, labour and overheads.
2. Cost plus contracts
These are contracts that involve reimbursement of cost of construction to the contractor by the contractee
plus a percentage of the cost which acts a the profit of the contractor.
3. Cost contracts
This is a contract where the contractor is refunded the cost incurred. Such contracts are common amongst
government ministries

55
 Contract costs
1. Direct materials
2. Direct labour- wages and salaries paid to workers at the site.
3. Direct expenses e.g. cost of hiring machinery. Cost of specialized labour among others
4. Contract overheads – Expenses incurred at the site e.g. depreciation of machinery at site, rent at site,
subcontractors fees etc.
5. Institutional expenses these are costs incurred as a result of the existence of a contractor and are
incurred even when there is no control. Such costs are not charged to the contract eg head office rent
and rates.
Terms
i) Work certified
This is the amount of work that according to the architect hired by the contractor is complete. Based on
the work certified the contractor will ask for progress payment
ii) Retention money
This is the percentage of the value of the work certified retained by the contractee and will only be paid
to the contractor upon full completion of the contract as per the specifications give y the contractee.
iii) Value of work not certified
This is the cost of work that has been completed by the contractor but has not been inspected by the
architects . the contractor shall estimate the value of the work not certified.
iv) Notional profit
This is the total estimated profit of the contract
Notional profit = value of work + value of work – cost incurred to date
Certified not certified
According to the prudence concept, the total profit should not be recognized in the profit and loss
because the concept requires that only revenues received and be recognized in the accounts
v) Attributable Profit (AP)
This is the portion of the notional profit that is included I the profit and loss account in any year of
income.

Rules applied in estimated AP

a) If the contract is in its early stages (less than i/3 complete) no profits should be recognized
b) If the contract is 1/3 complete: AP = 1/3 x notional profit x cash received
Work certified
c) If the contact is 2/3 complete: AP = 2/3 x Notional Profit x Cash received
Work certified
d) If the contract is nearing completion: AP = Notional profit x value of work certified
Contract Price
e) Profit provision. This is the difference between notional profits and attributable profit
Profit provision = notional profit – attributable profit

FORMAT OF CONTRACT ACCOUNT

CONTRACT A/C
FOR THE YEAR ENDED……
Opening balance Materials xxx Materials returned to the store xxx
Plant xxx Materials at site xxx
Loose Tools xxx Plant balance c/d xxx

56
Purchases materials xxx Materials returned to supplier xxx
Plant xxx Materials sold (cost) xxx
Labour cost(paid + accrued) xxx
Site expenses xxx
Materials delivered from other sites xxx
Overheads charged against other contracts xxx
Any other contract expenses xxx Cost incurred to date c/d xxx
xxx (balance figure) xxx
Cost incurred to date c/d xxx Cost of work certified xxx
Notional profit c/d xxx Cost of work not certified xxx
(balance figure) xxx xxx
Attribute profits xxx Notional profit b/d xxx
Profit provision xxx
xxx xxx
Opening balances Materials xxx
Plant xxx
Loose tools xxx

Valuation of work in progress (W.I.P)

Cost incurred to date xxx
Add attributable profit xxx
Less cash received (xxx)
W.I.P. xxx

Contractee account / clients account

Work certified xxx Cash received xxx

Bal c/d (retention money) xxx
xxx xxx

architecht’s certificate account

Attributable Profit xxx Work certified xxx
Profit provision xxx
Balance c/d xxx
xxx xxx

Illustration
Kirinyaga construction ltd is currently engaged in construction of a bridge at a price of shs 900,000,000. it
has been agreed that the retention money is 10% of the work certified. It is the company’s policy to transfer
2/3 of notional profit to the profit & loss account. The contract commenced on 1 st November 2005. The
following information relates to the contract 1st year of operation to 3ist October 2006.
Details shs ‘000’
Plant (1st Nov. 2005) 90,000
Direct materials received at site 115,200
Direct wages paid 59,400
Direct expenses paid 10,800

57
Site expenses 16,650
Plant (31st Oct 2005) 67,500
Direct materials returned from site 1,125
Direct wages accrued 1,350
Direct expenses accrued 450
Allocated overheads 8,100
Direct material cost from site to other projects 1,350
Direct materials on site 15,975
Cash received in respect of work certified 202,500
Cost of work completed but not certified 31,500
Required
a) Contract account for the year ended 31/10/2006
b) Valuation of work in progress
c) Contractee account
d) Architect’s certificate account

KIRINYAGA CONSTRUCTION LTD

CONTRACT ACCOUNT
FOR THE YEAR ENDED 31ST OCTOBER, 2006
‘000’ ‘000’
Plant balance c/d 90,000 Plant balance c/d 67,500
Materials required 115,200 Direct materials returned 1,125
Direct wages paid 59,400 Direct materials from site
Accrued 1,350 60,750 to other projects 1,350
Direct expenses paid 10,800 Direct materials on site (c/d) 15,975
Accrued 450 11,250
Site expenses 16,650
Allocated overheads 8,100 Cost incurred to date c/d 216,000
301,950 301,950
Cost incurred to date b/d 216,000 Cost of work certified 225,000
Notional profit c/d 40,500 Cost of work not certified 31,500
256,500 256,500
Attributable profit 24,300 Notional profit c/d 40,500
Profit provision 16,200
40,500 40,500
Opening balance Plant 67,500
Materials 15,975
Valuation of w.i.p workings
Cost incurred to date 216,000 Work certified 202500x100= 225,000
Add attributable profits 24,300 90
Less cash received (202,500)
W.I.P. 37,800

CONTRACTEE A/C
Work certified 225,000 Cash received 202,500
Bal. C/d retention money 22,500

58
 225,000 225,000

ARCHITECTS CERTIFICATE A/C

Attributable profits 24,300 Work certified 225,000
Profit provision 16,200
Balance c/d 184,500
225,000 225,000
Review Questions
Question one
The following information relates to item P003 stocked by 2000 products Ltd. For the month of April 2000
Date Receipts (units) Issues (units) Unit cost (sh)
April 3 2400 18
4 3200
6 2600 20
12 2700
14 3000 22
18 2800 21
20 2200
22 2600 23
25 3800
26 3100 24
27 2500 25
28 3200 25
29 6900

The closing balance for March 2000 was a batch of 3000 units received at a unit price kof sh 19
Required
c) Stores perpetual inventory record for item P003 for May 2000 under LIFO system of stores issues
(14mks)
d) Closing stock valuation (6mks)

Question two
d) Explain the advantages of centralized system of maintaining stores (5mks)
e) Explain the assumptions behind the Economic Order Quantity (EOQ) (5mks)
f) The following information is given for material Y-20
Consumption
Annual 360,000 units
Maximum 1,200 units/day
Minimum 800 units /day
Normal 900 units/day
Re-order period 12-24 days
Re-oder quantity 32,000 units

Required
d) Reorder level (3mks)
e) Minimum stock level (3mks)

59
f) Maximum stock level (3mks)

60
PROCESS COSTING

Objectives:
At the end of this topic, students should be able to:
o Describe the nature of cost and various ways in which cost may be classified
o Explain various users of accounting information and their respective information needs
o Prepare a manufacturing cost statement and a profit statement.

It is a costing method that is applicable where products resulting from a sequence of continuous repetitive
operations or processes are produced. Cost of different material, labour and overheads are recorded in each
process account. Costs are averaged over the products produced during a period. Usually, the basic input
material enters the production line at the end and after a number of processes and conversions emerges at the
other end of the finalized products. Therefore, the finished product of one stage becomes input of the next
stage of production
Thus, cost per unit = Total process cost for the period
The number of expected productions

Process losses
They are losses that are experienced during the production process caused by a certain amount of material
being lost or deteriorated due to ash, evaporation, leakage, off cuts, trimming or spoilage. Types of process
losses. Certain losses are inherent in production and can not be eliminated e.g. liquid may evaporate, part of
the cloth required to make suit maybe lost, losses occur in cutting wood to make furniture
(i) Normal loss
It’s the loss of the output experienced during the normal production condition. These loses occur
under efficient operating conditions and are unavoidable. Through experience based on repetitive
production the firm will determine the level of normal loss.
(ii) Abnormal losses
They are the losses that are experienced during the production process and they result when actual
loss is greater than normal loss.
(iii) Waste
These are losses that have no value
(iv) Scrap
These are losses that can be sold at some throw away price to produce some supplementary
revenue
(v) Abnormal gain
Is experienced when actual losses are less than normal losses. It represents savings on cost.
Book keeping for process losses
 Abnormal loss
Dr: Abnormal loss account
Cr: Process account with the cost of the losses
 Scrap abnormal loss
Dr: cash/ scrap debtor (sales) account
Cr: Abnormal loss account with the scrap value of the losses
 Abnormal gain (represent a saving on cost)

61
 Dr: Process account
Cr: Abnormal gain account
 Scrap abnormal gain
Dr: Abnormal gain etc with scrap value of losses
Cr: Scrap debtors account with scrap value of losses
NB: Scraping the losses, reduces the process costs
When losses are scrapped,
Cost/unit of good production = Total process cost – Scrap value of Normal loss
The expected production

Illustration
Production of product x passes through three processes A,B and C . During January, 3000 units of material
were issued to process A at shs 25/=/ unit. Direct materials cost in the three processes were 15000/=,
36000/= and 54000/= respectively. Other costs were:
A B C

Direct labour 90000/= 60000/= 30000/=

Direct expenses 8400/= 15600/= 6000/=
Total overheads amounted to shs 270000/= for the period. The firm uses direct labour cost to apply
overheads at a rate of 150% in each department
Required
Show process account and finished goods inventory account

COMPANY
Process A
Unit @ amt Unit @ amt
Input material 3000 25/= 75000 Transfer to department B 3000 107.8/= 323400
Introduced material 15000
Direct labour 90000
Direct expenses 8400
Manufacturing overheads 135000
3000 323400 3000 323400

Process B account
Unit @ Amt Unit @ Amt
Transfers from Process A 3000 107.8 323400 Transfer to process C 3000 175 525000
Direct material 36000
Direct labour 60000
Direct expenses 15600
Manufacturing overheads 90000
3000 525000 3000 525000

Process C account

62
 Units @ Amt Unit @ Amt
Transfers from Process B 3000 175 525000 Transfer to finished 3000 220 660000
Direct material 54000 goods inventory
Direct labour 30000
Direct expenses 6000
Manufacturing overheads 45000
3000 660000 3000 660000

Process A
Cost/ unit = 323400 = 107.8
3000

63
Finished goods inventory account
Units @ Amt Unit @ Amt
Transfer from process 3 3000 220 660000 balance c/d 3000 220 660000

Illustration
In manufacturing of product A. 6000kg of material at a cost of 5/= per kg were issued to process 1. direct
material = 9000/= overhead in the department 6900/= 5250kg of the output were produced. Normal loss 10%
of good production
Required
Show process 1 account
Abnormal loss account

Process 1 account

Unit @ Amt Unit @ Amt

Input material 6000 5 30000 Normal loss 600
Direct labour 9000 Abnormal loss 150 8.50 1275
Overheads 6900 Transfer to finished 5250 8.50 44625
To finished goods
6000 45900 6000 45900

Cost/ unit of good production = 45900 = 8.50 shs

5400
Normal loss = 10% of 6000 = 600kgs
Therefore, expected production = 6000 – 600kgs = 5400
Actual production = 5250
Abnormal loss is therefore 150
NB: Abnormal losses and abnormal gains are costed same as good production

Illustration 3
Assuming that the losses in example 2 above will be scrapped at sh 2.10 per kg. Show the process account
and abnormal loss account
Solution
Scrap value of net loss = 600kg x 2.10 = sh 1260
Expected production = 5400kg

Process Account

Units @ Amt Unit @ Amt

Direct Material 6000 5 30000 Normal Loss 600 2.10 1260
Direct Labour 9000 Actual Loss 150 8.2667 1240
Direct overheads 6900 Transfer Finished goods 5250 43400
6000 45900 6000 45900
Cost/ unit of good production = 8.2667
th
NB Estimate at least to the 4 decimal point

64
 Abnormal Loss Account
Units @ Amt Unit @ Amt
Process I 150 8.2667 1240 Scrap debtors A/c 150 2.10 315
P & L Account 925
150 1240 150 1240

Scrap Debtor
Units @ Amt Unit @ Amt
Normal Loss 600 2.10 1260 Balance C/d 1575
Allowed Loss 150 2.10 315
750 1575 1575

This is a supplementary revenue to be credited = P& L Account (miscellaneous revenue)

Illustration 4
Suppose the actual production in example 2 was 5490kgs and losses will be scrapped at shs 2.10
Required
Show the necessary accounts

Workings
Normal loss = 10% of input (6000) = 600kg
Expected production = 5400
Actual production = 5490
Abnormal gain 90

Progress 1 account
Kg @ Amt Kg @ Amt
Input material 6000 5 30000 Normal Loss 600 2.10 1260
Direct Labour 9000 Transfer to finished 5490 45384
Abnormal gain 90 8.2667 744 goods inventory
6090 46644 6090 46644

Cost/ unit of goods production = Total cost of production – Scrap value

Expected production

= 45900 – 1260 = sh 8.26667

5400
Abnormal Gain Account
Kg @ Amt Kg @ Amt
Scrap debtor 90 2.10 189 Process 1 Account 90 8.2667 744
Profit & Loss Account 555
90 744 90 744

65
Scrap Debtors
Kg @ Amt Kg @ Amt
Normal Loss 510 2.1 1071 Abnormal gain 90 2.10 189
Balance c/d 420 2.10 882
510 1071 510 1071

Balance C/d 420 2.10 882

This credit to scrap Abnormal Gain is necessary so that the scrap debtor account shows a balance of sh 882
as the units we’ve owned i.e. (510-90)

Illustration 5
Orion Ltd produces a single product which undergoes three processes. The following details relate to one
period.

Process

1£ 2£ 3£
Raw material (60,000 units) 80,000
Material introduced 23,500 18,750 22,100
Direct wages 15,600 12,000 13,400
Overheads allotted to processes 3,800 4,600 3,200
Other overheads to the £27,000

Units Units Units

Output in units 55,200 53,800 49,600

Abnormal loss of 5% of the input to each process is anticipated.

Units lost have the following scrap values
After process 1 Nil
After process 2 £1
After process 3 £1.80

There was no opening or closing or closing W-I-P

Prepare ledger accounts for the period.

Process 1 Account

DR CR
Units CPU Amount Units CPU Amounts
Raw 60,000 80,000 Normal 3,000 - -
materials loss
Material Abnormal
introduced 23,500 loss 1,800 2.336 4,205
Direct Process 2

66
wages 15,600 a/c 55,200 2.336 128,968
Overheads
allocated to 3,800
process
Other
overheads 10,273
applied on
wages
6,000 133,173 6,000 133,173

Process 2 Account

DR CR
Units CPU Amount Units CPU Amounts
Process 1 Process 3
A/C 55,200 2.336 128,968 a/c 53,800 3.2215 173,855
Material Normal
introduced 18,750 loss 2,760 1 2,760
Direct
wages 12,000
Overheads
allocated 4,600
Other
overheads 7,902
Abnormal
gain 1,360 3.2319 4,395
56,560 176,615 56,560 176,615

Process (R) = 169,460 = 3.2319

52,440

Process 3

DR CR
Units CPU Amount Units CPU Amounts
Process 3 55,800 3.2315 173,855 Finished
good a/c 49,600 4.2367 210,141
Allocated Normal
costs 3,200 loss 2,690 1.8 4,842
Direct Abnormal
wages 13,400 loss a/c 1,510 4.2367 6,397
Other
overheads 8,824
Introduced
material 22,100

67
 58,800 221,379 53,800 221,380

216,537 = 4.2367
51,110
DR Abnormal gain/loss CR

Process 1 A/C 4,205 Process 2 A/C 4,395

Process 2 A/C 6,397 Scrap sale (III) (1.8 x 1,510) 2,718
Scrap Sales (II) (1.0 x 1,360) 1,360

DR Scrap Sales A/C CR

Abnormal losses a/c 2,718 Abnormal gains a/c 1,360

Normal loss a/c Process (II) 2,760
Normal loss Process (III) 4,842

Process i
Input 60,000 units
Normal loss (5% x 60,000) (3,000) 133,173 = 2.336
Notional output 57,000 57,000
Actual output 55,200
Abnormal loss 1,800

Process ii
Input 55,200
Normal loss (5% x 55,000) (2,760)
Expected output 52,440
Actual output (53,800)
Abnormal gain 1,360

Process iii
Input 53,800
Normal loss (5% x 53,800) 2,690
Expected output 51,110
Actual output (49,600
Abnormal loss 1,510

Work in Progress
In the previous examples we assumed all the units in each processing department were fully completed and
transferred in the entirety to the finished goods store / warehouse. This is practically possible but its also

68
possible that some units will remain incomplete in some processing department. The units in the work in
progress (beginning and ending) needs to be costed and their cost added to that of the finished output
This is achieved through the concept of equivalent

Input material and materials introduced.

The raw materials introduced in the first process is transferred to the second process after processing. The
output of process 1 becomes the input of process 2 and so on. The full cot of the completed unit transferred
from the previous process forms the input material is 100% complete. Materials introduced in the current
process is extra material needed in the process and should always be shown separately from input material.
Sometimes input material is referred as material 1 and material introduced as material 2.

Equivalent unit
It’s the number of units that would have been produced during the period if all departmental efforts had
resulted in complete units of production. It’s the equivalent fully complete units which the partly complete
units (W.I.P) represent.

The concept uses the percent completion method to convert the partially completed units into equivalent fully
complete units
Equivalent Units in Work In Progress = % complete x Number of units in Work In Progress

Normally, the management will supply the information with respect to degree of completion (stage)

An average cost per element needs to be computed to determine the cost to be used in valuing finished
production, work in progress inventory and even losses (abnormal losses & gain)

The units in work in progress, ending or beginning in abnormal loss or gain are usually a 100% complete
with respect to input material (material 1)

Valuation of Work in Progress

Method 1: FIFO (First In First Out) Method

- Its assumed the 1st works to be done is the completion of units in the beginning work in progress
inventory therefore, the beginning work in progress maintains its identity in the valuation.
- This means the work to be done this period is :
1. Complete beginning work in progress
2. Started and completed units
3. Started units and remain incomplete (WIP, End)
- Units to be transferred to the next process include
 Work in Progress beginning
 Completed units during the period
- Therefore full consideration must be given to the work done to finish the beginning work in progress
inventory, units started and completed and the work done to bring units in work in progress ending to
their unfinished stage.

Illustration using FIFO method

The following information relates to XYZ’s process B

69
 % Completed
Material Labour Overhead
WIP beginning 800 units had a cost of 25600/= 80% 50% 50%
Units transferred from Process A
12000 units @ 354400/=
Units transferred to Process C
10000 units
Current production costs : Material 85,760/=
Labour 106,160/=
Overheads 75,072/=
WIP ending
Material Labour Overheads
1600 units 80% 60% 40%
Units scrapped 1200 units @ sh 25 100% 70% 70%
Normal losses - 10% of good production
Scrapped at sh 25/=
Required
Prepare processing department B’s account Abnormal loss account

Solution
Stage 1: Determine if there’s Abnormal loss or gain
Beginning Work in Progress 800 units
Transfer from process A 12000
Work In Progress End (1600)
Production this period 11200
This normal loss = 10% of 11200 =1120 units
But units scrapped were 1200 units
Therefore Abnormal loss was 80 units

Step 2; Compute /determine total equivalent units and cost per equivalent unit
Under FIFO total equivalent units = Completed production
Plus Equivalent units - Equivalent Unit in + Equivalent unit in – Equivalent Unit in
in abnormal loss abnormal gain WIP end WIP beginning

There are two types of material

1. Input Material (Material 1)
2. Introduced Material (Material 2)
NB WIP beginning and end , abnormal loss and abnormal gain are always 100% complete with respect to
input material (M1)

Cost Elements M1 M2 Labour Overheads

Completed units 10000 10000 0000 10000
Add: Equivalent unit in abnormal loss 80 80 56 56
Less: Equivalent unit in abnormal gain 0 0 0 0
Add: Equivalent units in WIP end 1600 1280 960 640
Less: Equivalent units in WIP beginning (800) (640) (400) (400)

70
Total costs 10880 10720 10616 10296
Transfer from Process A Sh 354,400
Less scrap value of normal loss
(1120 x sh 25) (sh28,000)
Net cost of M1 236,400

Production cost 326400 85760 106160 72072

Cost / E.U = Total production cost 326400 85760 106160 72072

Total E.U. 10880 10720 10616 10296

= sh 30 sh 8 sh 10 sh 7

Total cost / equivalent units = Sh( 30+ 8+10+7) =sh 55/=

Step 3: Valuation of inventories

a) Completed production
Units transferred to process C 10000
Less: WIP beginning 800
Units started and completed 9200

Completed production (to be transferred):

-Opening W.I.P.
WIP beginning 800 units at a cost of sh 25600
160units complete w.r.t. M2 @ 8/= = 1,280
400units complete w.r.t. L @ 10/= = 4,000
400 units complete w.r.t. O.H @ 7/= = 2,800
33,680
-Units started and completed
9200 units @ sh 55/= 506,000
Therefore total cost of fully completed units 539680

b) Units in abnormal loss:

80 units complete w.r.t. M1 @ 30 2400
80 units complete w.r.t. M2 @ 8 640
56 units complete w.r.t. L @ 10 560
56 units complete w.r.t. O.H.@ 7 392
3992
Equivalent units in WIP, end
16 units complete w.r.t. M1 @ 30 48000
1280 units complete w.r.t. M2 @ 8 10240
960 units complete w.r.t @ 10 9600
640 units complete w.r.t. @ 7 4480
72320
Step 4 : Draw process 4 accounts

71
Process B account
Units @ Amt Units @ Amt
WIP, beginning b/d 800 25 25600 Abnormal Loss 1120 25 28000
Transfer from Pr A 12000 354400 Abnormal Loss 80 3992
Current production cost Transfer to process C 10000 539680
M1 85760 WIP ending 1600 72320
L 106160
O.H 72072
12800 643992 12800 643992

Abnormal Loss account

Process B 80 3992 Scrap debtors 80 2000

P & L account 1992
80 3992 80 3992
Scrap Debtors account
Abnormal losses 80 25 2000 Balance c/d 30000
Normal Loss 1120 25 28000
30000
Balance b/d 30000

VALUATION OF INVENTORIES
Method 2: WEIGHTED AVERAGE COST METHOD (W.A.C)
Whereas FIFO assumes production is done on first method, WAC assumes that the beginning WIP were
actually started and completed this period.
Therefore WIP beginning loses its identity. The method calculates ana average cost of producing an
equivalent plus current period cost. The same average cost is used to value completed production and
uncompleted WIP ending

Illustration
Information regarding to process B for ABC
% completion
M1 M2 L O.H
WIP beginning 300 units 100% 70% 60% 40%
Cost WIP{ beginning) M1 sh 7200
M2 sh 2400
L sh 2700
OH sh 3600
Units transferred from process A were 6000 units @ 241,900/=
Period cost (current) M Sh 82650/=
L Sh 52960/=
OH Sh 79140/=
Units transferred to C 4950 units

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WIP , end 5000 units with
% completion 90% M2, 80% L 70% OH
Units Scrapped were 850 @ 35/=
% completion 100% M2, 80% L, 80% O.H
Required
Show - Process B account
Abnormal loss account
Solution
Step 1
Determine whether there’s an abnormal gain / loss
WIP beginning 300 units
Add: Transfer from A 6000 units
Less: WIP end (500)
Production this period 5800 units
Normal loss = 10% of 5500 = 580 units
Units scrapped (actual losses) 850 units
Abnormal Loss 270 units
Step 2
Total equivalent units and cost / equivalent units
Total units = completed + Equivalent units in + Equivalent units in + Equivalent units in
Units A.L. A.G. WIP end

Cost elements
M1 M2 L OH
Completed Units 4950 4950 4950 4950
Add: E.U in abnormal Loss 270 270 216 216
Less: E.U in abnormal gain
Add: E.U. in WIP ending 500 450 400 350
Total equivalent units 5720 5670 5566 5516

Net cost of transfer from Process A 241900

Scrap value of N.L. 580 @ 35 20300
Total cost of m1 221600
Add: Wip beginning M1 7200
Period production cost shs 228800 shs 85050 shs 55660 shs 82740
Cost / equivalent units= Total cost 228800 85050 55660 82740
Total E.U 5720 5670 5566 5516
= 40 15 10 15
Step 3: Valuation of inventories
Completed Units
4950 units complete w.r.t. M1 @ 40 = 198000
4950 units complete w.r.t. M2 @ 15 = 74250
4950 units complete w.r.t. L @ 10 = 49500
4950 units complete w.r.t. OH @ 15 = 74250
396000
Abnormal Losses

73
270 units complete w.r.t. M1 @ 40 = 10800
270 units complete w.r.t. M2 @ 15 = 4050
216 units complete w.r.t. L @ 10 = 2160
216 units complete w.r.t. OH @ 15 = 3240
20250

WIP ending
500 units complete w.r.t. M1 @ 40 = 20000
450 units complete w.r.t. M2 @ 15 = 6750
400units complete w.r.t. L @ 10 = 4000
350 units complete w.r.t. OH @ 15 = 5250
36000

Process B account

Unit @ Amt Unit @ Amt

WIP beginning 300 15900 Normal Loss 580 35 20300
Transfers from Process A 6000 241900 Transfer to C 4950 396000
Current Manuf. OH M 82650 Abnormal Loss 270 20250
L 52960 WIP ending 500 36000
OH 79140
6300 472550 6300 472550

Abnormal Loss account

Process B 270 20250 Scrap debtor a/c 270 35 9450

P&L a/c 10800
20250 20250

Scrap Sales A/c

Process B. normal loss 80 35 20300 Balance c/d 29750
Abnormal loss 270 35 9450
29750 29750

Illustration 6
The following data relate to process 2 for one accounting period. Process 2 receives units from process 1 and
after processing transfers them to process 3.

Opening w-i-p 600 units

Value (£) Percentage complete

Input material 720 100
Material introduced 500 60
Labour 340 50
Overheads 270 40

74
Transfers from process 1: 4,100 units valued at £5,200.
Transfers to process 3: 3,500 units
£
Materials 2,956
Labour 2,200
Overheads 1,900

Closing stock 800 units at the following stage of completion

Input material 100% complete
Material introduced 60% complete
Labour 50% complete
Overheads 40% complete

400 units were scrap at the following stage of completion

Input material 100% complete
Material introduced 100% complete
Labour 40% complete
Overheads 30% complete

The normal loss is 10% of the production and scrapped units realized 40 each.
It is required to prepare the process account for process 2 using
(i) FIFO
(ii) The average cost method

FIFO
Production for the period

Opening w-i-p 600

+ transfers from process I 4,100
4,700
Closing w-i-p 800
Production 3,900 units

Therefore, loss 3,900 x 10% = 390

Actual loss 400
Abnormal loss 10

Calculation of effective units and cost per unit

Cost element Completed units + equivalent units in closing w-i-p Costs Cost per
+ equivalent units in abn. Loss – equivalent units in unit
opening w-i-p = Total effective production
Input material 3,500 + 800 + 10 – 600 = 3,710 5,200 1.402
Material

75
introduced 3,500 + 480 + 10 – 360 = 3,630 2,800* 0.771
Labour 3,500 + 400 + 4 – 300 = 3,604 2,200 0.610
Overheads 3,500 + 320 + 3 – 240 = 3,583 1,900 0.530

*2,800 = 2,956 – 390 x 40p = 2,800*

Valuation of closing W-I-P

Input material 800 units @ 1.402 = 1,121.29

Material introduced 480 equiv. @ 0.771 = 370.25
Labour 400 equivalent @ 0.610 = 244.17
Overheads 320 equivalent @ 0.530 = 169.69
1,905.40

 1,905

Abnormal loss valuation

Input material 10 E.U. units x 1.402 = 14.02
Materials introduced 10 E.U. units x 0.771 = 7.71
Labour 4 E.U. units x 0.610 = 2.44
Overheads 3 E.U. units x 0.530 = 1.59
£ 25.75

 £26

Process 2 a/c (FIFO)

DR CR
Units CPU Amount Units CPU Amounts
Opening w- Normal loss
i-p 600 1,830 390 0.4 156
Transfers
from Abnormal
process I 4,100 5,200 loss 10 26
Material Transfer to
introduced 2,956 process 3 3,500 11,999
Labour 2,200 w-i-p 800 1,909
Overheads 1,900

4,700 14,086 4,700 14,086

Value of complete unit (1.402 + 0.771 + 0.610 + 0.53)
= 3.313

Using average cost method

Cost element Equivalent units in closing + Opening w-i-p costs + Cost per unit

76
 equivalent units in abnormal loss + period costs = Total
complete units = Effective units cost
Input 800 + 10 + 3,500 = 4,310 720 + 5,200 = 5,920 1.35
material
Introduced 480 + 10 + 3,500 = 3,990 500 + 2,800 = 3,300 0.827
material
Labour 400 + 4 + 3,500 = 3,904 340 + 2,200 = 2,540 0.651
Overheads 320 + 3 + 3,500 = 3,823 270 + 1,900 = 2,170 0.568

Valuation of closing w-i-p

Equivalent units Cost

800 x 1.35 = 1,098.83
480 x 0.827 = 396.99
400 x 0.651 = 260.24
320 x 0.568 = 181.64
1,937.70

 1,919

Completed Production

3,500 x 1.35 = 4,807.42

3,500 x 0.827 = 2,894.74
3,500 x 0.651 = 2,277.15
3,500 x 0.568 = 1,986.97
11,965.97

 11,966

Abnormal Loss
10 x 1.35 = 13.73
10 x 0.827 = 8.27
4 x 0.691 = 2.60
3 x 0.568 = 1.704
26.304

 £26

Process 2 Account (Average cost)

DR CR
Units CPU Amount Units CPU Amounts

77
w-i-p 600 1,830 Normal loss 390 156
Transfers
from Abnormal loss
process I 4,100 5,200 Transfer to 10 26
process 3
Material 2,956 Closing w-i-p 3,500 11,886
Labour 2,200
Overheads 1,900 800 1,938

4,700 14,086 4,700 14,086

If instead of the abnormal loss, there had been an abnormal gain, the treatment would be to deduct
equivalents units in abnormal gain from the total effective units for both FIFO and average cost.

When to use FIFO & WAC method

- When the value of WIP beginning is given as an aggregate (in lump sum) amount and the degree of
completion also provided, then only FIFO method is applicable
- When the value of WIP beginning is given in terms of material, labour and overheads but the degree
of completion is not given then only weighted average method is applicable
- When the value and the degree of completion of WIP beginning is given in terms of material, labour,
overheads then any method is applicable

Question One
a) Briefly explain the following terms as used in process costing
(i) Normal loss (2 marks)
(ii) Abnormal loss (2 marks)
(iii) Joint products (2 marks)
b) Timau ltd produces a detergent which passes through two process namely mixing and refining to
completion. The following data relate to the refining process for the month of June 2000.
Cost of opening stock Shs.
Materials 100,000
Labour 25,000
Overheads 60,000
During the month 20,000 units were passed from mixing to the refining process. Costs incurred
during the month were:
Shs
Labour 125,000
Overheads 108,100
Other materials 45,300
At the end of the month 21,000 units had been completed and passed to finish goods while 4,000 were
still in process having reached the following stages:
Materials - 100%
Labour - 40%

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Overheads - 60%
Required
Refining Process Account (14 marks) (Total 20 marks)

79
BUDGETS

Objectives:
At the end of this topic, students should be able to:
o Explain the meaning and need for budgets
o Prepare different kinds of budgets for an organisation

- A budget is a quantitative expression of a plan of action in advance of the period to which it relates.
- Budgets may be prepared for the business as a whole for departments, for functions such as sales and
production, or for financial and resource item such as cash, capital exp, man power, purchases etc.
Benefits of Budgeting
Planning and Coordination
Budgeting forces planning to take place. The budgeting process provides for the coordination of
activities and departments of the organization so that each facet of the operation contributes towards
the overall plan.
Clarification of authority and responsibility
A budget provides clear guidelines for managers and supervisors and is the major way in which
organizational objectives are translated into specific tasks and objectives related to individual
managers. The budgeting process makes it necessary to classify the responsibilities of each manager
who has a budget.
Communication
A budget communicates the agreed plans to all the staff involved - both vertically and horizontally to
ensure that coordination is achieved e.g. there must be full liaison between the sales and production
functions to ensure that coordinated budgets are developed.
Control
Deviations of actual results from planned result are noted so that corrective action may be taken.
Because of ‘exceptional principle’ which is at the least of budgetary control management time can be
saved and attention directed to areas of most concern.

Motivation
The involvement of lower and middle management in budget preparation and establishment of clear
targets one motivating factors. Provided there is proper participation, goal congruence is encouraged
& motivation increased.
Better Liquidity
The integration of budgets makes possible better cash and working capital management

Principal Budget Factor/Limiting/Key Factor

This is a factor which at any given time effectively limits the activities of an organization. It may be
customers demand, production capacity, labor shortage, materials, space or finance.
Since such a constraint will have a persuasive effect on all plans and budgets. The limiting factor must be
identified and its effect on each of the budgets carefully considered during the budget preparation process.

Fixed and Flexible Budgets

- A fixed budget is a budget which is designed to remain unchanged irrespective of the volume of
output or turnover attained.

80
 - A flexible budget is a budget which is designed to adjust the budgeted cost levels to suit the level of
activity actually attained. This is done by analyzing cost into fixed and variable elements so that the
budgets may be ‘flexed’ according to the actual activity.
- For control purpose its vital that flexible budgeting is used. Only by comparing what the costs should
have been with the expenditure incurred at the actual activity level can any control be exercised.
- The major purpose of a fixed budget is at planning stage when it serves to define the broad objective
of the organization. It’s unlikely to be of any real value for control purposes except if the level of
activity turned out to be exactly as planned.
- A formal definition of flexible budget is:
‘A budget which, by recognizing different cost behavior patterns, is designed to change as the volume
of output changes.’
- The results obtained from flexing a budget are only accurate if the costs behave in the ways predicted.
Illustration i
After study of planned activities, forecast cost levels and the pattern of cost behavior the following budget
has been prepared based on anticipated activity level of 8,000 labour hours.
Nature of expense Budgeted cost Cost Cost
For 8000 labour hrs Classifications (x=activity level)
Direct wages 55,500 Linear Semi-Var 3,500+6.5x
Direct materials 84,000 Linear Variables 10.5x
Salaries 22,000 Fixed 22,000+0x
Depreciation 9,500 Fixed 9,500+0x
Other overheads 19,200 Curvi-linear variable 0.0003x2
Based on the above data it is required to prepare budgets for activity levels of 7,800 and 8,400 labour hours

Solution
Expenses Cost Budgets for Budgets for
Activity of 7,800hrs activity of 8,400hrs
Direct wages 3,500+0.3x 54,200 58,100
Direct materials 10.5x 81,900 88,200
Salaries 22,000+0x 22,000 22,000
Depreciation 9,500 9,500
Other overheads 18,252 21,168

NB:
(a) Using a flexible budget the planned expenses level for the actual activity ac n be compared with the
actual expense so highlighting discrepancies.
(b) A budget analyzed to fixed and variable elements can be flexed to provide realistic budgeted expense
for any given activity level, eve n where the activity change month by month.
Illustration ii
AB Company makes a single product and has an average production of 5,000 units a month although this
varies widely. The following extract from the overhead statement for the extrusion department shows the
make-up of the budget and a month’s actual results.

Budget for Actual Results for

Average production of January Production of
5,000 units 4,650 units

81
 Shs. Shs. Shs.
Indirect Labour Fixed 300,000
Variable Shs. 100/unit 500,000 800,000 790,000
Consumables (all variable) 1,500,000 1,425,000
Variable Overheads 2,000,000 1,820,000
Fixed Overheads 1,250,000 1,250,000
Shs. 5,550,000 Shs. 5,285,000

Show two budgetary control statements for January, one based on the fixed budget for 5,000 units and one
based on flexible budget for the actual level of production.

Fixed Budget (Actual Results)

Expense type Fixed Budget Actual Results Budget Variance

Favourable (Adv.)
Shs. Shs. Shs.
Indirect Labor 100,000 790,000 10,000
Consumables 1,500,000 1,425,000 75,000
Variable Overheads 2,000,000 1,820,000 180,000
Fixed Overheads 1,250,000 1,250,000 -
Shs 5,550,000 Shs. 5,285,000 Shs. 265,000

NOTE: The variances are the differences between budget and actual. They are favorable when actual costs
are BELOW budget and adverse when above.

FLEXIBLE BUDGET (Actual Results)

Expense type Flexible Budget Actual Budgeted

For 4.650 units results variance
Indirect labor
Fixed 300,000
Variable 465,000 765,000 790,000 (250,000)
Consumables
1,500,000 = Sh. 300/unit 1,395,000 1,425,000 (300,000)
5,000
Variable
Overheads Sh. 400/unit 1,860,000 1,820,000 40,000
Fixed Overheads 1,250,000 1,250,000 -
5,270,000 5,285,000 (15,000)

82
MASTER BUDGET
It contains various subsidiary or functional budgets. It’s a summary of all other budgets and includes also a
budgeted profit and loss account and a balance sheet.
It shows the overall picture of the budgeted targets for the next period. It helps to coordinate the activities
of a big enterprise.
A functional budget is one which relates to any of the functions of an enterprise. The various functional
budgets or parts of the master budget are:
i. Sales budget: shows the number of units of different products which a firm wants to sell i.e. Next one
period
ii. Production budget: gives details of goods to be produced in a specific period.
iii. Purchases budget: shows the various raw materials and other items to be purchased in order to meet
production demand.
iv. Production cost budget: Gives information on various elements of production cost e.g. Direct
material, Direct labour, production overheads
v. Cash budget: Comprises the details of expected cash receipts and payments in the next few months or
one year period.
vi. Budgeted profit and loss account: is prepared to find out budgeted profit
vii. Budgeted Balance Sheet: gives details of assets and liabilities at the end of the budgeted period.

Illustration 1

Ideal products limited manufactures two products A and B. for the financial year ended 30 June 2004, the
following information was assembled for preparation of the budget.
Standard data per unit
Direct materials Standard price per Kg Product A Product B
Sh Sh Sh
M1 10 10 4
M2 20 4 6
Direct Standard rate Product A Product B
Labour Per hour Hours Hours
L1 30 8 10
L2 20 12 5
The following additional information was available
a) Fixed production overhead costs were recovered on a direct labour basis
b) Administration, selling and distribution costs were absorbed at the rate of 20% of production
cost
c) Profit was estimated at the rate of 25% of cost of making and selling the products
d) Expected sales Product A Product B
Sh ‘000’ Sh ‘000’
13,494 18,816
e) Finished goods stock valued at standard production cost was as follows:
Product A Product B
Sh ‘000’ Sh ‘000’
1 July 2003 1,730 1,176
30 June 2004 1,038 1,568
f) Direct materials stock valued at standard prices was as follows:

83
 Material M1 Sh ‘000’ Material M2 Sh ‘000”
1 July 2003 640 600
30 June 2004 360 800

g) For the year ended 30 June 2004, ‘fixed overheads had been budgeted at Sh 5,760,000 and
direct labour hours budgeted at 3,600,000 110hours
h) It is management’s expectations that there will be no opening and closing work in progress
Required
a) Production budget in units (8 marks)
b) Direct material cost budget (3 marks)
c) Purchases budget (6 marks)
d) Direct labour cost budget (3 marks)
(Total 20 marks)
Solution
(a) Products
A B
Sh Sh
Material 1 100.0 40.0
Material 2 80.0 120.0
180.0 160.0
Direct labour L1 240.0 300.0
L2 240.0 100.0
660.0 560.0
Production overheads @ 1.60 32.0 24.0
692.0 584.0
Selling & distribution 20% 138.4 116.8
830.4 700.8
Profit margin 25% 207.6 175.2
Selling price per unit 1038.0 876.0

Units to be sold
A B
13,494,000 18,816,000
1038 876
13,000 21,479
Opening stock finished goods in units
A B
1,730,000 1,176,000
692 584
2,500 2,014

Closing stock finished goods in units

A B
1,038,000 1,568,000
692 584
1,500 2,685

84
Ideal products Ltd
Production budget in units
A B Total
Sales in units 13,000 21,479 34,479
Closing Stock 1,500 2,685 4,185
14,500 24,164 38,664
Less: Opening stock (2,500) (2,014) (4,514)
Production in units 12,000 22,150 34,150
(8 marks)
(b) Direct materials cost budget
M1 M2 Totals
Sh Sh Sh
Product A 1,200,000 960,000 2,160,000
Product B 886,000 2,658,000 3,544,000
2,086,000 3,618,000 5,704,000
( 3 marks)
(c) Purchases budget
M1 M2 Totals
Sh Sh Sh
Material Cost 2,086,000 3,618,000 5,704,000
Closing stock 360,000 800,000 1,160,000
2,446,000 4,418,000 6,864,000
Opening stock (640,000) (600,000) (1,240,000)
Material purchases in Sh 1,806,000 3,818,000 5,624,000
Material purchases in kg 180,600 190,900 381,800
( 6 marks)
(d) Direct labour cost budget
L1 L2 Totals
Sh Sh Sh
Product A 2,880,000 2,880,000 5,760,000
Product B 6,645,000 2,215,000 8,860,000
9,525,000 5,095,000 8,860,000
(3 marks)
(e) Material usage budget
M1 M2
Production A: 12000 units X10kg = 120,000kg X4kg = 48,000kg
B: 22151 units Xkg = 88604kg X6kg = 132,906kg
208,604kg 180,906kg
Cost per unit X sh. 10 X sh. 20
Sh 2,086,040 Sh 3,618,120
(Total 20 marks)

Example
A manufacturing company produces two products namely Q and P. Two types of material X and Y are used
in manufacture of these products. The following information is provided by the company for the year 2006.

85
 (a) Budgeted Sales
Product Qty Price
Q 18,000 65
P 20,000 80

(b) Material used

Material X Y
Unit cost Shs. 6 Shs. 3
Qty used
Q 3 6
P 5 4

There were the following stocks: -

Product Opening Closing
Q 3,000 1,500
P 2,000 2,500

Material
X 5,000 6,000
Y 2,000 3,000

Required
Prepare the following budgets: -
(i) Sales budget
(ii) Production budget
(iii) Material usage in quantities budget
(iv) Material purchases in quantity and value

Sales Budget
Product Quantity Selling price Sales volume
Q 18,000 65 1,170,000
P 20,000 80 1,600,000
2,770,000

Production Budget
Q P
Production for the year Closing 1,500 2,500
Sales for the year 18,000 20,000
Less Opening stock (3,000) (2,000)
Production 16,500 20,500

86
Material usage in quantities budget
Qty per product Q P Total
X (3 x 16,500) (5 x 20,500)
Y

X Y
Q (3 x 16,500) = 49,500 16,500 x 6 = 990,000
P 5 x 20,500 = 102,500 20,500 x 4 = 82,000
152,000 units 181,000 units

Material Purchases
X Y
Closing stock 6,000 3,000
Opening stock (5,000) (4,000)
Quantity 152,000 181,000
153,000 units 180,000 units
Cost per unit Shs. 6 Shs. 3

;;]’=[ Shs. 918,000 Shs. 540,000

CASH BUDGET
- It shows the expected cash receipts and expected cash payments during the budgeted period.
Liquidity and cash flow management are key factors in successful operations and of any
organizations. Its with good reason that the cash budget should receive close attention from
accountants and managers
- It shows the effects of budgeted activities – selling, buying, paying wages, investing in capital
equipments etc the cash flow of the organization.
- Its prepared to ensure that there will be just sufficient cash in hand to cope adequately with budgeted
activities. the cash budget may show that there’s likely to be a deficiency of each in some future
period in which case overdrafts or loans have to be arranged or activities curtailed – or alternatively
the budget may show that there is likely to be a cash surplus in which case appropriate investment or
use for the surplus can be planned rather than merely leaving the cash idle in a current account.

- The main functions of a cash account

i. To ensure that the cash is available for revenue expenditure
ii. To indicate when, where and how much cash will be needed and whether this is permanent or
temporary.
iii. Preserve liquidity throughout the year
iv. Reveal surplus cash for investment or expansion of facilities
v. Guide management on financing capital expenses internally or externally.
Illustration
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

87
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 lends 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 31st 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.

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

88
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
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
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

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 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

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 2001Sh. 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

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  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)
(Total 20 marks)

Question Two
A company prepares the following main budgets:
Sales budget
Manufacturing budget
Purchasing budget
Selling and administration overheads budget
Budgeted balance sheet
Required
Describe the relationship between these budgets and the contents of each
(Total 20 marks)

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