Bac 404 Cost Accounting II Module Fourth Year

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BAC 404 COST Accounting II Module Fourth year
Accounting for Assets (Kenyatta University)
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KENYATTA UNIVERSITY
INSTITUTE OF OPEN DISTANCE AND E-LEARNING
IN COLLABORATION WITH
SCHOOL OF BUSINESS
DEPARTMENT OF ACCOUNTING AND FINANCE
BAC 404-COST ACCOUNTING II
WRITTEN BY: EDITED BY: A.O ONGIRI

REV.J.M THEURI
A.K THUO
E.SIMIYU
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TABLE OF CONTENTS
TABLE OF CONTENTS......................................................................................................2
COURSE OUTLINE..............................................................................................................4
LESSON ONE..............................................................................................................6
OVERVIEW OF COST ACCOUNTING.............................................................................6
1.0: INTRODUCTION..........................................................................................................6
1.1: LECTURE OBJECTIVES.................................................................................................6
1.2: DEFINITION................................................................................................................6
1.2.1: Cost Accounting vis a vis other Accounting Subjects:.........................................7
1.3: PURPOSE OF COST ACCOUNTING..............................................................................8

1.3.1: The role of a cost accounting department in an organization............................9
1.4: ROLE OF COST ACCOUNTING IN BUSINESS MANAGEMENT....................................10

1.5: COSTING TERMS AND CONCEPTS............................................................................11
1.6: ACTIVITY...................................................................................................................13
1.7: SUMMARY................................................................................................................13
1.8: FURTHER READING..................................................................................................13
1.9: SELF TEST QUESTIONS..............................................................................................14
LESSON TWO...........................................................................................................14
ADVANCED COST ESTIMATION METHODS................................................................14
2.0: INTRODUCTION........................................................................................................14
2.1: LECTURE OBJECTIVES...............................................................................................14
2.2: INTRODUCTION........................................................................................................15
2.3: MAIN METHODS......................................................................................................15
2.3.1: REGRESSION ANALYSIS......................................................................................15
2.3.1.1: Simple Regression 16
2.3.1.2: Multiple Regression 23
2.3.2: LEARNING CURVE METHOD...............................................................................27
2.3.2.1: Limitations of the Learning curve method.....................................................31
2.3.3: SIMULATION METHOD.......................................................................................31
2.4: SUMMARY................................................................................................................39
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2.5: FURTHER READING..................................................................................................39

LESSON THREE.........................................................................................................42
COSTING METHODS.................................................................................................42
3.0: INTRODUCTION........................................................................................................42
3.2: COSTING METHODS.................................................................................................42
3.3: OPERATION COSTING METHODS.............................................................................43
3.3.1: Process Costing Method....................................................................................43
3.1.1.1: Valuation of Work In Progress 44
3.1.1.2: Process Cost Report 49
3.1.1.3: Process Losses 51
3.4: OTHER COSTING METHODS............... 60

3.4.1: ACTIVITY BASED COSTING (ABC) 60
3.4.2: UNIFORM COSTING...........................................................................................64
3.5: SUMMARY................................................................................................................65
3.6: FURTHER READING..................................................................................................65
LESSON FOUR..................................................................................................................66
ALLOCATION OF JOINT COSTS.........................................................................................66
4.0: INTRODUCTION........................................................................................................66
4.2: GENERAL OVERVIEW................................................................................................66
4.3: ALLOCATION OF JOINT COSTS..................................................................................67
4.3.1: Physical Measure/Unit.......................................................................................67
4.3.2: Constant Gross Margin Rate..............................................................................67
4.3.3: NET REALIZABLE VALUE.....................................................................................67
4.3.4: Sales Value at Split Off point..............................................................................68
4.4: ACCOUNTING FOR BY-PRODUCTS............................................................................68

4.5: ACTIVITY...................................................................................................................71
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4.6: SUMMARY................................................................................................................71
4.7: FURTHER READING..................................................................................................71
LESSON FIVE............................................................................................................74
COST ACCOUNTING SYSTEMS........................................................................................74
5.0: INTRODUCTION........................................................................................................74
5.2: OVERVIEW OF COST ACCOUNTING SYSTEMS..........................................................74
5.2.1: Interlocking Cost Accounting System:...............................................................74
5.2.1.1: Reconciliation of profits in an interlocking system 77
5.2.2: THE NATURE OF INTEGRATED ACCOUNTS.........................................................82
5.3: ACTIVITY...................................................................................................................83
5.4: SUMMARY................................................................................................................83
5.5: FURTHER READING..................................................................................................83
COURSE OUTLINE
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COURSE PURPOSE
The course aims at developing the candidates understanding and application of costing concepts,
procedures and techniques to organisations.
COURSE OBJECTIVES
At the end of the course learners should;
 Be well conversant with the application of advanced methods of cost estimation and
forecasting
 Appreciate the use process costing method
 Be in a position to allocate joint costs that emanate from joint processes
 Be able to prepare and maintain costing books of accounts
Topics covered
1. Overview of cost accounting

 Definition of cost accounting
 Purpose of cost accounting
 Costing terms and concepts
2. Advanced cost estimation methods

 Linear regression method
 Learning curve method
 Simulation method
3. Costing methods
 Process costing
 Service Costing
 Activity based costing
 Uniform costing
4. Allocation of joint costs

 Introduction
 Allocation methods: Net realisable value, constant gross profit margin, physical
output, sales value
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5. Cost accounting systems

 Introduction
 Interlocking cost accounting system
 Integrated cost accounting system
REFERENCES
1. Drury, C. (2004). Management and Cost Accounting. 6th Ed, ELST.
2. Lucey, T. (2005). Costing. 6th Ed. ELST
3. Lucey, T. (2006). Management Accounting. 6th Ed. ELST
4. Saxena, V.K And Vashit,C.D. Advanced Cost and Management Accounting.
Latest Ed
5. Horngren And Foster, G. Management Accounting. Latest Ed
6. Any other Cost Accounting text
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LESSON ONE
OVERVIEW OF COST ACCOUNTING
1.0: INTRODUCTION
The main purpose of this lesson is to provide a general overview of cost accounting by highlighting
its importance to a business entity.
1.1: LECTURE OBJECTIVES
By the end of this lecture, you should be able to:

 Identify and distinguish the various branches of accounting
 Appreciate the role of a cost accounting system in an organisation
 Pinpoint the various terms applied in cost accounting
1.2: DEFINITION
Cost accounting has been defined by many accounting scholars in various forums. There is no one
watertight definition of cost accounting, but the various definitions all point to certain common
aspects about the subject. Below are some definitions by certain authorities:
“That part of management accounting which establishes budgets and standard costs and actual costs
of operations, processes, departments or products and the analysis of variances, profitability or
social use of funds” (Chartered Institute of Management Accountants - CIMA)
“That which identities, defines, measures, reports and analyses the various elements of direct and
indirect costs associated with producing and marketing goods and services. Cost accounting also
measures performance, product quality and productivity” (Letricia Gayle Rayburn)
“A systematic process of collecting, summarizing and recording data regarding the various
resources and activities in a firm so as to calculate the basis of production costs used in financial
accounting or making other relevant decisions in a firm (Horngren C.T)
Cost accounting is broad and extends beyond calculating production costs for inventory valuation,
which government-reporting requirements largely dictate. However accountants do not allow
external reporting requirements to determine how they measure and control internal organizations
activities. In fact, cost accounting focus is shifting from inventory valuation for financial reporting
to costing for decision making. The main objective of cost accounting is communicating financial
information to management for planning, evaluating and controlling performance, and also to assist
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management to make more informed decisions. Its data is used by managers to guide their
decisions.
1.2.1: COST ACCOUNTING VIS A VIS OTHER ACCOUNTING SUBJECTS:

Accounting can be described as a specialized information system that is used for purposes of
decision making by the management of the organization and other users such as tax authorities,
investors, creditors and the general public. Accounting is broadly divided into two:
i. Financial Accounting
ii. Management Accounting
Financial Accounting:
This is the analysis, classification, and recording of financial transactions and the ascertainment of
how such information will be reported to the various users. It involves the development of general-
purpose financial statements largely for external reporting. These statements are developed in
accordance with standards imposed by the public (through the professional accounting bodies such
as the Institute of Certified Public Accountants of Kenya – ICPAK and the International Accounting
Standards Board – IASB) as well as the requirements of the Companies Act Chapter 486.
Management Accounting:
This is the part of accounting that provides special-purpose statements and reports to management
and other persons inside the organization. The information generated by management accounting is
therefore for internal uses and is not guided by any standards or legal requirements. Management
Accounting, unlike financial accounting, is proactive i.e. it is future-oriented. It is required in
making decisions that affect the organization. In a nutshell, cost accounting enables businesses to
not only find out what various jobs or processes have cost, but also what they should have cost. It
indicates where losses are occurring before the work is finished and therefore corrective action can
be undertaken.
From the foregoing discussion, it is then clear that cost accounting is very closely related to other
accounting subjects especially management accounting. In fact, most people make no distinction
between management accounting and cost accounting, as the dividing line between the two is
slimmer than thin.
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1.3: PURPOSE OF COST ACCOUNTING

The main purposes of cost accounting include;
a) Cost ascertainment
The costs of producing different commodities or providing services must be ascertained accurately.
These costs consist of material cost, labour cost and overheads. The detailed information about
costs provided through cost accounting systems helps management to make some important
decisions and to evaluate the performance of the organisation.
b) Planning and Budgeting

This involves the quantification of plans for the future operations of the enterprise; such plans may
for the long or short term, for the enterprise as a whole or for the individual aspects of the
enterprise.
c) Controlling
This is the process by which management makes sure that intended and desired results are
consistently and continuously achieved. Controlling involves establishment of standards,
comparison of results against standards and correction of deviations.
d) Decision Making
Cost accounting information assists in the making of decisions about the future operations of the
enterprise; such decisions making may be assisted by the information from cost techniques and
cost-volume – profit analysis.
e) Performance evaluation
Cost accounting information is used to measure and evaluate actual performance so as to make a
decision of the degree of optimality or efficiency of resource utilization. Cost data is used to
measure the efficiency of an organisation. If there are various departments of a business enterprise
then it is important to determine the relative importance of these departments. More efficient
departments must be given greater incentives and appropriate steps must be taken to improve the
performance of less efficient departments.
f) Inventory Management
Cost accounting assists in inventory management by keeping a complete record of materials from
the time they enter into the premises till the time they are sold in the form of finished products. This
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enables stock valuation to be undertaken quickly without necessarily carrying out a physical stock
count.
1.3.1: THE ROLE OF A COST ACCOUNTING DEPARTMENT IN AN ORGANIZATION
As part of their jobs, cost accountants interpret results, report them to management and provide
analysis that assist decision-making in the following departments:
a) Manufacturing
Cost accountants work closely with production personnel to measure and report manufacturing
costs. The efficiency of the production departments in scheduling and transforming materials into
finished units is evaluated for improvements.
b) Engineering
Cost accountants and engineers translate specifications for new products into estimated costs; by
comparing estimated costs with projected sales prices, they help management decide whether
manufacturing a product will be profitable.
c) Systems design
Cost accountants are becoming more involved in designing Computer Integrated Manufacturing
(CIM) systems and databases corresponding to cost accounting needs. The idea is for cost
accountants, engineers and system designers to develop a flexible production process responding
swiftly to market needs
d) Treasury
The treasurer uses budgets and related accounting reports developed by cost accountants to forecast
cash and working capital requirements. Detailed cash reports indicate where there are excess funds
to invest or where cash deficits exist and need to be financed.
e) Financial accounting
Cost accountants work closely with financial accountants who use cost information in valuing
inventory for external reporting and income determination purposes.
f) Marketing
Marketing involves the cost accountant during the product innovation stage, the manufacturing
planning stage and the sales process. The marketing department develops sales forecast to facilitate
preparing a products manufacturing schedule. Cost estimates, competition, supply, demand,
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environmental influences and the state of technology determines the sales price that the product will
be offered and will command in the market.
g) Human resources
Human resources department administers the wage rate and pay methods used in calculating each
employees pay. This department maintains adequate labour records for legal and cost analysis
purposes.
NOTE:
Cost accounting is simply an information system designed to produce information to assist the
management of an organization in planning and controlling the organisation’s activities. It also
assists the management to make informed decisions so as to enable the organization to operate at
maximum effectiveness and efficiently.
1.4: ROLE OF COST ACCOUNTING IN BUSINESS MANAGEMENT

A system is a set of interdependent parts which together form a unitary whole that performs some
functions. A number of sub systems make up the whole. In this context of the organization, a
management information system may be seen as the overall system with a number of sub systems
including the cost and management accounting system that provide the information to management
for purposes of planning, organizing, directing and controlling the organization’s activities so as to
achieve corporate goals including profit maximization. Information must be collected, processed
and communicated in an organized manner if the objectives of the enterprise are to be efficiently
implemented and alternative strategies for their implementations examined, so as to select the best
strategy. Information may be non- mutually exclusive in nature. This means that information
gathered as part of the management information system may be used in two or more subsystems for
differing purposes. An example of this information is with regard to the amount and location of
work in progress: (work in progress refers to partly completed units of products where a product
passes through a number of operations and processes before being passed into finished goods store
or to the customer). Work in progress information may be used by:
a) Production planning department in order to monitor the progress of parts of an order
through the production process and to instigate action to speed up the completion of slow
moving parts of the order
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b) Quality control department in comparing one batch of product with another in

highlighting the incidence of process losses and their location
c) Cost management department in the quantification and valuation of actual loses as

compared to the level originally allowed for in the business plan
d) Financial accounting department in the valuation of work in progress for balance sheet
purposes and for purposes of determining the cost of sales in the income statement.
NOTE:
Business Management involves planning, organizing, staffing, directing and controlling an

organization’s activities so as to meet a specified objective, usually profit maximization. The
function of managing a business’s activities is entrusted to the managers of the business. For the
managers to maximize profits, they must minimize the entire business’s cots. They therefore need
to track all costs as they are incurred and recovered via the organization’s activities. To get this
information as it happens, they need an effective an efficient ‘information system’ referred to as
cost accounting. It will therefore be appreciated that if an organization’s cost accounting
information system fails, the managers cannot manage it efficiently and effectively.
1.5: COSTING TERMS AND CONCEPTS

a) Cost
This can be defined as the value of economic resources foregone or sacrificed to achieve a specific
objective. It can also be defined as the act of expenditure actual or assumed, notional or incurred, on
or attributable to a specific thing or activity.
b) Cost Units
It is the quantitative unit of the product, service or time in relation to which costs are ascertained or
expressed. Cost units are the things the business is set up to provide of which cost is ascertained.
Cost unit will be determined by the nature of the business enterprise. It may be
- An individual job, batch or contract
- A unit of production expressed as a relevant quantity
- A service provided to the customer
c) Cost Centre
This refers to a location, person, item, equipment or a group of these of which costs may be
ascertained for purpose of control. It can be a location such as a department or division or a person
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such as a salesman or manager. Cost centres are used for control and accountability on those
responsible for them.
d) Cost Objective
This refers to any activity for which a separate measurement of costs is desired e.g construction of a
road, treatment of patients or tuition for students.
e) Cost Accountant
This is a member of chief accounting officer’s department. He is responsible for collecting product
costs and preparing accurate and timely reports to evaluate and control company operations. Cost
accountants assemble, classify and summarize financial and economic data on the production and
pricing of goods and services
f) Cost Analysis
This is an activity that uses engineering, time and motion studies, timekeeper’s records and
planning schedules from production supervisors. Cost analysis techniques include break even
analysis, comparative cost analysis, capital expenditure analysis and budgeting techniques. After
determining what is actually happening, accountants should identify available alternatives.
Professional judgment is then needed to apply and interpret the results of each costing technique.
g) Cost benefit approach

This is the primary criterion for choosing among alternative accounting approaches. In a company,
there is a direct relationship between the amount of time and the funds management is willing to
spend on cost analysis and the degree of reliability desired. If a company wants detailed records
with a high degree of accuracy, managers should provide additional time and money for compiling
and maintaining cost information. Managers should only use cost analysis and control techniques
when anticipated benefits in helping achieve management goals exceed the cost.
h) Cost accumulation
This refers to the collection of costs incurred on the production of goods or provision of services in
an organized manner through an accounting system. It involves the preparation of a cost statement
showing details of all the costs in respect of any specific product or service.
i) Costing
This simply refers to the methods of determining costs. It can also be defined as the classification,
recording and allocation of expenditure for the ascertainment of costs.
j) Costing Methods
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This refers to processes employed in ascertaining costs. The application of a given costing method
by an entity depends on the nature of its operations or the category of the industry it belongs to.
1.6: ACTIVITY
Establish the various costing methods that can be used in ascertainment of costs by business
entities and identify specific industries in which these methods are highly applicable.
1.7: SUMMARY
In this lesson we have looked at the role and importance of a cost accounting system in an
organisation as well as the basic terms applied.
1.8: FURTHER READING
 Drury, C. (2004). Management and Cost Accounting. 6th Ed, ELST.

 Lucey, T. (2005). Costing. 6th Ed. ELST
 Saxena, V.K And Vashit,C.D. Advanced Cost and Management Accounting. Latest Ed
1.9: SELF TEST QUESTIONS

i. Define the following terms
 Cost Accounting
 Financial Accounting
 Management accounting
ii. Describe the main purposes of Cost Accounting.
iii. Distinguish between Cost Accounting and Financial Accounting
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LESSON TWO
ADVANCED COST ESTIMATION METHODS
2.0: INTRODUCTION
The purpose of this lesson is to identify and analyze various advanced methods that can be used in
the process of cost estimation for purposes of formulating suitable cost budgets.

 Recognise advanced methods that can be applied in cost estimation
 Appreciate the process of cost estimation
 Identify the strengths and weaknesses of each cost estimation method
2.2: INTRODUCTION
Determining how cost will change with output or other measurable factors of activity is of vital
importance for decision making, planning and control. The preparation of budgets, the production
of performance reports, the calculation of standard costs and the provision of relevant cost for
pricing and other decisions all depend on reliable estimate of costs and distinguishing between fixed
and variable costs at different activity levels. Unfortunately costs are not easy to predict, since they
behave differently under different circumstances.
The importance of accurately estimating costs and the complexity of cost behavior means that
management accountants must use increasingly sophisticated techniques. Advances in information
technology have made it possible for more sophisticated techniques to be used for estimating costs,
even by small business. These developments have led to an increasing awareness of the important
potential of mathematical and statistical techniques for estimating costs.
2.3: MAIN METHODS

The main advanced cost estimation methods include;
 Regression
 Learning curve
 Simulation
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2.3.1: REGRESSION ANALYSIS

A regression equation identifies an estimated relationship between a dependent variable (the cost)
and one or more independent variables (the cost driver). When the equation includes only one
independent variable then it is referred to as simple regression and its form is:
Ỹ= a + bX
Where;
Ỹ- is the predicted value of Y (Cost)
a- Fixed cost
b- Variable cost per unit
X- Cost driver
When the above equation includes two or more independent variables, it is referred to as multiple
regression and is of the form:
Y = a + b 1 X1 + b2 X2 + …….bn Xn for n independent variables.
2.3.1.1: Simple Regression

Simple regression analysis determines mathematically the line of best fit (Y=a +bX) on the basis of
the assumption that the dependent variable is influenced by only one independent variable. This
line of best fit is generated by the use of the following set of normal equations;
y = na + b (x)
xy = a (x) + b (x2)
From these normal equations:
b = n xy – x y
nx 2– (x)2
a= Y - bx
n n
ILLUSTRATION
The production manager of XYZ Company, is concerned abut the apparent fluctuation in efficiency
and wants to determine how labour costs (in Sh.) are related to volume. The following data
presents results of the 12 most recent weeks.
Week No. Units Produced(X) Labour Costs(Y)
KSHS
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1 34 340
2 44 346
3 24 287
4 36 262
5 30 220
6 49 416
7 39 337
8 21 180
9 41 376
10 47 295
11 34 215
12 24 275
REQUIRED
Estimate a suitable cost function using regression analysis and project the cost of labour for week
13 and 14 if it is expected that 45 and 34 units will be produced respectively
SOLUTION
UNITS LABOUR COST

WEEK PRODUCED(X) (KSHS)(Y) X2 XY Y2
1 34 340 1156 11560 115600
2 44 346 1936 15224 119716
3 24 287 576 6888 82369
4 36 262 1296 9432 68644
5 30 220 900 6600 48400
6 49 416 2401 20384 173056
7 39 337 1521 13143 113569
8 21 180 441 3780 32400
9 41 376 1681 15416 141376
10 47 295 2209 13865 87025
11 34 215 1156 7310 46225
12 24 275 576 6600 75625
423 3549 15849 130202 1104005
∑X ∑Y ∑X2 ∑XY ∑Y2
Value of b can be calculated as follows:
b= 12(130202) - 423(3549) = 61,197 = 5.435

12(15849) - (423) 2 11,259
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a = 3549 - 5.435 (423) = 295.75- 191.58 =104. 17

12 12
Therefore the predicting function is Ŷ = 104.17 + 5.435X
.
i. If X = 45 units, then
Ŷ = 104.17 + (5.435 x 45)
= Kshs 348.745
ii. If X = 34 units, then
Ŷ = 104.17 + (5.435 x 34)
= Kshs 288.96
NOTE
The estimated function has to be tested first for reliability before it is applied in the estimation
process. The necessary tests are referred to as the tests of goodness of fit.
TESTING THE RELIABILITY OF A COST FUNCTION

The regression based cost function is formulated on the assumption that a selected cost driver such
as volume of output or direct labour hours can be used as a predictor of costs. There is a need to
check whether this selected cost driver is indeed the best determinant of costs or there is another
cost driver that can be chosen. There is a need to find out whether the cost function can be relied on
to provide accurate forecasts which can be compared with actual costs later. In checking the
reliability of the cost function the following tests are recommended;
 Test of economic plausibility
 Test of goodness of fit for the whole model
 Test of goodness of fit for the slope coefficient
 Test of goodness of fit for the intercept
Test of Economic Plausibility

This is a non quantitative test that is meant to find out whether in the practical situation there exists
a relationship between the cost being estimated and the selected cost driver(s). This test should be
carried out first before the regression process is undertaken to avoid the generation of a cost
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function that would give spurious results. The cost accountant needs to draw from practice as well
as the available costing theory to establish whether there exists a logical relationship between the
cost and the selected cost driver(s).
Test of goodness of fit for the whole model

The purpose of this test is to establish whether the developed line of best fit (cost function) is one
that can be relied upon. The test involves the following three main statistics;
i. Standard Error of Estimate (Se)
This gives an absolute measure of the vertical deviations of actual values from the predicted values.
It provides an estimate of the amount by which the predicted cost might be far from the actual cost.
Generally the lower the Se the more reliable the cost function is. Se is computed as follows;
Se = √ [(∑Y2-a∑Y-b∑XY) / (n-k)]
Where;
n- Number of observations
k- Number of constants in the function
Illustration
Using the earlier illustration compute the Se.
Solution
Se = √ [(1,104,005-(104.17*3,549)-(5.435*130,202)/ (12-2)]
= √2665.78
= 51.63
Interpretation
The actual cost value is likely to be 51.63 above or below the predicted cost.
When all the assumptions of regression analysis are met Se is sufficiently powerful to enable the
construction of confidence intervals for the estimates of the dependent variable. Se enables the
establishment of a range of values of the dependent variable within which one may have a degree of
confidence that the true value lies. This confidence interval is established as follows;
NOTE
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Confidence level = Point Estimate + (Z or t-value) *Se

Z value is applied where n ≥30 while t-statistic is used where n< 30
Illustration
Using the previous illustration construct the confidence interval for the point estimate of period 13
based on a 95% level of confidence.
Solution
Point estimate for period 13 if expected volume of output is 45 units.
If X = 45 units, then
Ŷ = 104.17 + (5.435 x 45)
= Kshs 348.745
At 95% level of confidence and 10 degrees of freedom the t-statistic is = hence the confidence
interval will be given as;
Kshs 348.745+ * 51.63 = Kshs
The actual labour cost in period 13 is likely to fall between given a 95% level of confidence.
ii. Coefficient of Determination (r2)

This indicates the percentage of dependent variable that can be explained by the independent
variable(s). It indicates the amount of variation in the dependent variable caused by the introduction
of a unit of the independent variable. In a cost function r 2 represents the extent to which the selected
cost driver influences the given cost. Generally the higher the r 2 the more reliable the cost function
is. The coefficient of determination is computed as follows;
r2 = na∑Y + nb∑XY- (∑Y)2

n∑Y2-(∑Y2)
Illustration
Using the previous illustration compute the coefficient determination and interpret.
r2 = (12*104.17*3549) +(12*5.435*130,202)- (3549)2

(12*1,104,005)- (3549)2
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= 332765.4
652,659
= 0.51
Interpretation
Only 51% of the changes in labour cost can be explained by the volume of output. The remaining
49% is explained by other cost drivers not captured in the cost function.
iii. Fisher’s Statistic (F-Test)

This is used to test the hypothesis that the relationship between the dependent variable and all the
independent variables is not significant. The hypothesis is set out as follows;
Ho: Relationship between Y and all Xs is not significant.

HA: Relationship between Y and all Xs is significant
F-Statistic is computed as follows;
F= _ r2____
(1 – r2)/n-k
The computed F-value is compared with the F-value from the tables given a certain level of degree
of confidence e.g 95%. If the computed F-value is > the F-value from the tables, then the null
hypothesis is rejected and hence the model is deemed to be appropriate
Illustration
Using the previous illustration compute the F-Statistic and establish whether the relationship is
statistically significant at 95% level of confidence.
Solution
r2 = _0.51________
(1-0.51)/(12-2)
= 10.41
Test of Goodness of fit for the Slope coefficient
There is a need to test whether the slope coefficient (b) which represents the variable cost per unit is
statistically significant such that it can be relied upon in the prediction of costs. This test requires
the computation of the Standard Error of Slope coefficient (S b). Sb is a measure of the sampling
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error that results from estimating the true coefficient that exists in the population. it is computed as
follows;
Sb= _____Se____
2 2
√[∑X -(∑X) /n]
Illustration
Using the previous illustration compute the standard error of the slope coefficient and interpret the
results.
Sb = _____________51.63____________
√ [15,849-(423)2 /n]
= 51.63/30.63
= 1.69
Interpretation
The true value of b is likely to be 1.69 above or below the estimated value of b = 5.435
Sb is then used to test the following hypothesis as to whether there exists a linear relationship
between the cost and the cost driver.
H0: There is no linear relationship i.e b = 0
HA: There is a linear relationship i.e b ≠ 0
To test this hypothesis the t-statistic is computed and then compared with a suitable t-statistic from
the tables based on a certain degree of confidence.
Computed t-statistic = _ b__ = 5.435/1.69 = 3.22

Sb
The t-statistic from the tables at 95% level of confidence and 10 degrees of freedom =
Since the computed t-statistic is greater than the one from the tables at 95% level of confidence, the
null hypothesis is rejected and it is concluded that b is statistically significant and hence a good
predictor of the variable cost.
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Test of Goodness of fit for the Intercept

There is a need to test whether the intercept which represents the fixed cost is statistically
significant such that it can be relied upon in the prediction of costs. This test requires the
computation of the Standard Error of Intercept (Sa). Sa is a measure of the sampling error that results
from estimating the true intercept that exists in the population. It is computed as follows;
Sa = Sb * √ (∑X2 /n)
Illustration
Using the previous illustration, compute the value of the standard error of intercept and interpret the
results.
Solution
Sa = 1.69 *√ (15,849/12)
= 1.69 *36.34
= 61.41
Interpretation
The true value of a is likely to be 61.41 above or below the estimated value of a = 104.17
Sa is then used to test the following hypothesis as to whether a is statistically significant and hence a
good predictor of the fixed cost.
H0: a is not a good predictor of the fixed cost
HA: a is a good predictor of the fixed cost
To test this hypothesis the t-statistic is computed and then compared with a suitable t-statistic from
the tables based on a certain degree of confidence.
Computed t-statistic = _ a__ = 104.17/61.41 = 1.69

Sa
The t-statistic from the tables at 95% level of confidence and 10 degrees of freedom =
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Since the computed t-statistic is less than the one from the tables at 95% level of confidence, the
null hypothesis is accepted and it is concluded that a is statistically insignificant and hence not a
good predictor of the fixed cost.
2.3.1.2: Multiple Regression

This is regression involving more than one independent variable (Cost drivers). The general form of
a multiple linear regression equation is as follows;
Y= a+b1X1+b2X2+b3X3+-----bnXn +ὲ
The values of a and b computed using the set of normal equations which depend on the number of
independent variables e.g for two independent variables the equations would be as follows;
y = na + b1 X1 + b2x2
X1Y = ax1 + b1X12 + b2 X1 X2
X2 Y = ax2 + b1X1X2 +b2 X22
Given the complexity of multiple linear regressions, analysis is carried out using statistical packages
such as E-Views and Stata .However the cost accountant has to be in a position to interpret the
output generated by the statistical packages. In addition the various tests of goodness of fit still have
to be carried out.
Illustration
The production manager of XYZ Company is concerned about the apparent fluctuation in efficiency
and wants to determine how labour costs (in Kshs.) are related to direct labour hours and machine
hours. The following data presents results of the 20 most recent weeks.
LABOUR Direct labour Machine Hours

WEEK COST (KSHS) Hours(X1) (X2)
1 340 34 22
2 346 44 27
3 287 24 19
4 262 36 21
5 220 30 27
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6 416 49 35
7 337 39 41
8 180 21 24
9 376 41 38
10 295 47 52
11 215 34 26
12 275 24 24
13 380 40 46
14 395 45 48
15 420 52 41
16 455 53 52
17 475 56 50
18 440 51 49
19 480 60 48
20 495 65 61
Required
Estimate a suitable cost function using regression function and interpret the output generated.
Solution (Using E-Views)
Dependent Variable: LABOUR_COST

Method: Least Squares
Date: 07/01/12 Time: 19:23
Sample: 1 20
Included observations: 20
Variable Coefficient Std. Error t-Statistic Prob.

66
C 63.17392 36.91893 1.711153 0.1052
MACHINE_HRS 0.436226 1.503363 0.290167 0.7752
DIRECT_LABOUR_
HRS 6.506409 1.582875 4.110501 0.0007
R-squared 0.798399 Mean dependent var 354.4500

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Adjusted R-squared 0.774682 S.D. dependent var 94.53736

S.E. of regression 44.87471 Akaike info criterion 10.58311
Sum squared resid 34233.57 Schwarz criterion 10.73247
Log likelihood -102.8311 F-statistic 33.66259
Durbin-Watson stat 1.868983 Prob(F-statistic) 0.000001
Interpretation of the output

b2 = 0.44
b1 = 6.51
a = 63.17
The cost function estimated is as follows;
Y = 63.17 + 6.51X 1 + 0.44X2
Tests of Reliability
i. Test of Economic Plausibility
From both a theoretical and practical perspective there exists a logical relationship between labour
cost and labour hours as well as machine hours.
ii. Test of goodness of fit for the whole model

 Standard Error of Estimate (Se) = 44.87
 Coefficient of Determination (r2) = 0.77
 F-Statistic = 33.66
iii. Test of goodness of fit for the slope coefficient

Sb1 = 1.58
Sb2 = 1.50
Computed t-statistic;
For b1 = 4.11
For b2 = 0.29
iv. Test of goodness of fit for the intercept

Sa = 36.91
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Computed t-statistic = 1.71
2.3.2: LEARNING CURVE METHOD

On many repetitive projects such as the manufacturing of aircraft, computers and spacecrafts the
amount of labour time required to produce succeeding units decreases substantially. The apparent
reason is that as people gain experience with the particular project they can produce each unit more
efficiently than the preceding unit. Thus for instance a worker would keep on consulting the
blueprint for virtually every part to be installed when producing the first unit. On the second unit
he/she may at least know which parts of the blueprint to look at in order to find out how to install a
part. Eventually he/she will remember where and how to install. This phenomenon is known as the
learning curve effect. It is also referred to as improvement curve theory. It occurs when new
production methods are introduced, new products (either goods or services) are made or when new
employees are hired. It is based on the proposition that as workers gain experience in a task, they need
less time to complete the job and productivity increases.
The learning curve theory affects not only direct labour costs but also impacts direct labour related
costs such as supervision, and direct material costs due to reduced spoilage and waste as experience is
gained. The time to perform many operations begins slowly and speeds up as employees become more
skilled as depicted in the productivity graph below;
Constant productivity
state (steady state)
Productivity
(Units/hour)
Cumulative quantity
When the average time taken per cumulative quantity is graphed, it leads to a negative exponential
curve as depicted in the graph below;
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Average Time/
Unit of cumulative
Production Y1
Steady state
Y2
X1 X2 Cumulative output (units)
As cumulative production rises average time taken per cumulative unit reduces e.g
Unit Time taken (Minutes) Average time/unit (Minutes)

1st 40 40
2nd 30 35 (70/2)
3rd 20 30 (90/3)
Mathematically negative exponential curve is of the form Y = aXb; where b is a negative exponent
The general form Y = aXb can be interpreted as;
Y = Average time taken/cumulative unit

a = Time taken to produce the 1st unit
X = Cumulative output (units)
b = Coefficient of learning = log r/log 2; where r – Learning improvement rate
Additional research undertaken indicated that at double cumulative production levels average time
taken tends to reduce at a constant rate e.g
Output Time Taken (mins) Cumulative Time Taken AverageTimeTaken/unit

(mins)
1st 40 40 40
2nd 36 76 38 38/40 =0.95
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3rd 35 111 37
4th 33.4 144.4 36.1 36.1/38 =0.95
In this case 0.95 is the learning improvement rate-r
Interpretation:
Every time cumulative output doubles, average time declines to 95 percent of the previous amount.
Recall
Y =aXb
Y1 = aX1b --------- eqn 1

Y2 = aX2b --------- eqn 2
But;
X2 = 2X1
Hence; Y2 = a(2X1)b ---------- eqn 3
But;
Y2 = r* Y1 hence; rY1 = a(2X1)b ------eqn 4
Y1 = aX1b-----------------------------eqn i
rY1 = a(2X1)b ------------------------ eqn ii
Solve the two equations simultaneously by dividing
1/r = 1/2b
r = 2b
Log r = b Log 2
b = Log r/ Log 2
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The basic learning curve model can be extended to be in a position to calculate total time taken
rather than average time taken.
Total Time Taken= average Time Taken * volume of output
= aXb * X
= aXb+1
Illustration One
A certain manufacturing process has experienced an 80% learning curve effect. The first unit
required 2000 minutes to make. Determine
i. Total labour time required to produce the first 32 units
ii. Total labour time required to produce the 32nd unit
iii. Total labour time required to produce the last 16 units in a batch of 32 units
Solution
i. YT32 units = aXb+1
b = Log r/ Log 2
= Log 0.8/Log 2
= -0.3219
YT 32 units = 2000*32-0.3219+1
= 2000 * 10.487
= 20,974 mins
ii Y32nd unit = Y T33 units – Y T32 units

= 2000* 33 -0.3219+1 – 20,974mins
= 21,416 mins- 20,974 mins
= 442 mins
iii Y T Last 16 units = Y T 32units- Y T 16units

= 20,974 mins- 2000* 16 -0.3219 +1
= 20,974 – 13,108
= 7,866 mins
Illustration Two
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Ziwani Limited has designed a new product, the “Vebster XL” to add to the existing range of
computer peripherals. Each unit of the product will be sold for Kshs 62 in a highly competitive
market. The initial estimated unit costs of the product are as follows;
Kshs
Direct materials 28
Variable processing cost;
18 minutes @ Kshs 25 per hour 7.50
35.50
There are also annual product specific costs of Kshs 240,000. These are to be incurred at a constant
rate throughout the year. No units of the product have yet been made. The company plans to make
and sell 1000 units each month during the year commencing 1/1/2012. A 90% learning curve effect
is expected to apply.
Required
a) Calculate the standard cost of production of the product for January 2012
b) Calculate the standard cost of production for June 2012 given that output in every
month will be in accordance with the budgeted output of 1000 unit per month.
Solution
a) Total time taken in January = YT 1000units = aXb+1
b = Log 0.90/ Log 2 = - 0.1520
YT 1000units = 18 * 1000 -0.1520+1
= 18 * 1000 0.8480
= 18 * 349.9452
= 6,299 mins
= 104.98 hours
The standard cost for January 2012 will be as follows;

Kshs
Direct materials (28*1000) 28,000
Variable processing cost (104.98*25) 2,624.5
Product specific costs (240,000/12) 20,000
Total standard cost 50,624.5
b) Total time taken in June 2012 for 1000 units = Total time taken for 6000 units- Total time
taken for 5,000 units
YT 1000 units = YT 6000 units – YT 5000 units
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= 18* 6000 0.8480 – 18*5000 0.8480

= 28,784 – 24,660
= 4, 124 mins
= 68.7 hours
The standard cost for June 2012 will be as follows;

Kshs
Direct Materials (28*1000) 28,000
Variable processing cost (68.7*25) 1,717.5
Product specific cost (240,000/12) 20,000
Total standard cost 49,717.5
2.3.2.1: Limitations of the Learning curve method
i. It is only applicable in industries that apply labour intensive methods. If an industry

is highly automated the effect of labour will be negligible and no learning effect will be
observed
ii. Assumes that employees are motivated enough to learn effectively on the job
iii. Assumes no labour turnover will take place
iv. May lead to the setting of inappropriate standards which may have a negative
motivational impact on the employees.
2.3.3: SIMULATION METHOD

Simulation is a method of analyzing a system by experimentally duplicating its behavior.
Management accountants can be able to make meaningful inferences concerning the operation of
some real-world system by constructing a model of the system and then experimenting with the
model. If the model is an adequate representation of the real system, a study of the responses of the
model to various decisions will give considerable insight into the effects of implementing such
decisions in the real system. Simulation is used where analytical techniques are not available or
would be very complex. e.g. in inventory control problems, production planning problems,
corporate planning, queuing problems etc.
Types of Simulation
A) Operational Games Method
This refers to those situations involving conflict of interest among players or decision makers within
the framework of a simulated environment. The two most widely used forms of operational games
are;
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Military games
This is essentially a training device for military leaders, enabling them to test alternative strategies
under simulated war conditions.
Business management games

This is a training technique used to help company executives to develop their ability in making
difficult interdependent decisions in a simulated environment. The primary use of business games is
to help the participants be they executive in the industry or students in business develop their ability
to;
 Make difficult interdependent business decisions
 Conceptualise and evaluate new ideas
 Introduce new techniques of decision making, (all in a simulated environment)
B) Monte Carlo Method
In Monte Carlo simulation the behavior of at least some components of the model are
probabilistically determined. It can be used to solve several different classes of problems. The first
are problems that involve some kind of stochastic process while the second are deterministic
methods. To carry out a realistic simulation involving probabilistic elements, it is necessary to avoid
bias in the selection of the values which vary. This is done by selecting randomly using one of the
following methods.
 Random numbers generated by computers
 Random number tables
Model Construction
The success of a simulation exercise is related to the predictive quality of the underlying model, so
that considerable care should be taken with model construction. Important factors in model
development are:
 Object oriented: The model should be constructed with some definite purpose and the model
results must be directly related to this purpose.
 Critical variables and relationships: Model building is an iterative, creative process with the
aim of identifying those variables and relationships which must be included in the model.
 Simplicity: The best model is the simplest that has adequate predictive qualities.
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 Management involvement: To construct good models these must be a thorough

understanding of actual operations. Only management here these knowledge so that they must
be involved.
Steps involved in constructing the Simulation Model

 Identify the objectives of the simulation
 Identify the input variables. Distinguish between controlled and non-controlled variables.
 Determine the probability distribution of the uncertain variables
 Identify any parameters and status variables
 Identify the output variable
 Determine the logic of the model
 Run the model and evaluate the results
Variables in the simulation model

Controlled variables
Variables that are certain since they can be controlled by management
Non controlled variables

Variables that are uncertain since management cannot control them. Require probability distribution
Parameters
Input variables which for a given simulation have a constant value.
Status Variables
May be used to specify the days and seasons to be used in a simulation e.g. demand may be affected
by the day of the week
Output Variables
These are the results of the simulation. They arise from the calculations and tests performed in the
model.
Random number range

This is the range of distributing the random numbers. It depends on the number of decimal places
pertaining to the probabilities of uncertain variables. Its generated based on concept of cumulative
probability as follows;
Outcome Prob Cum prob. Random no.range
2 0.3 0.3 0-2
4 0.5 0.8 3-7
6 0.2 1.0 8-9
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Illustration
Githurai Ltd has set the re-ordering point at 15 units and order quantity at 20 units. The holding
cost has been computed to be Shs 10 per unit per week, and the cost of placing an order is Shs 250.
The stock-out cost is Shs 100 per unit short. However the demand and lead time are uncertain and
can only be estimated using the following probabilities;
Demand (units) Probability

0 0.02
1 0.08
2 0.22
3 0.34
4 0.18
5 0.09
6 0.07
Lead time (weeks) Prob

1 0.23
2 0.45
3 0.17
4 0.09
5 0.06
Required
Simulate the problem for 12 weeks, and determine the average weekly stock cost using the
following random numbers. Assume the opening inventory in the first week is 20 units.
68 52 50 90 59 08 72 44 95 85 81 93 28 89 15 60 03
Solution
i. Identify the objective of the simulation- To determine the average weekly stock cost
for the next weeks
ii. Identify the input variables- Lead time, demand, ordering cost, holding cost, stock
out cost. Controlled variables- Ordering cost, holding cost and stock out cost. Non
controlled variables- Lead time and demand
iii. Determine probability distribution of the non controlled (uncertain variables)
Demand
Demand (units) Probability Cumulative Probability Random number range
0 0.02 0.02 00-01
1 0.08 0.10 02-09
2 0.22 0.32 10-31
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3 0.34 0.66 32-65

4 0.18 0.84 66-83
5 0.09 0.93 84-92
6 0.07 1.00 93-99
Lead time
Lead time (weeks) Probability Cumulative Probability Random number range
1 0.23 0.23 00-22
2 0.45 0.68 23-67
3 0.17 0.85 68-84
4 0.09 0.94 85-93
5 0.06 1.00 94-99
iv. Identify Parameter variables- Cost per order, holding cost per unit and stock out cost
per unit
v. Determine the output variable- Total stock cost
vi. Determine the logic of the model
Total stock cost = Total ordering cost + Total holding cost + Total stock out cost
Total ordering cost = Cost per order * Number of orders
Total holding cost = Average stock * Holding cost per unit where average stock = (opening
stock + closing stock)/2
Total stock out cost = Stock out (units) * stock out cost per unit
vii. Run the model

W O/S UR UA RN DD C/S Order RN LT OC HC Stock Total
K out stock
Yes/no
cost cost
Units Units Units Units Units Wks Kshs Kshs
Kshs Kshs
1 20 - 20 68 4 16 No - - - 180 - 180
2 16 - 16 52 3 13 Yes 50 2 250 145 - 395
3 13 - 13 90 5 8 No - - - 105 - 105
4 8 20 28 59 3 25 No - - - 165 - 165
5 25 - 25 08 1 24 No - - - 245 - 245
6 24 - 24 72 4 20 No - - - 220 - 220
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7 20- - 20 44 3 17 No - - - 185 - 185

8 17 - 17 95 6 11 Yes 85 4 250 140 - 390
9 11 - 11 81 4 7 No - - - 90 - 90
10 7 - 7 93 6 1 No - - - 40 - 40
11 1 - 1 28 2 -1 No - - - - 100 100
12 - 20 20 89 5 15 Yes 15 1 250 75 - 325
750 1,590 100 2,440
Average stock cost per week = 2,440/12 = Kshs 203.3
NOTE
It’s assumed that the ordering and subsequent receipt of the items occurs at the beginning of the
week. The notation used in the table is as follows;
UR- Units received, UA- Units available, O/S- Opening stock, C/S- Closing Stock, HC- Holding
cost, OC- Ordering cost, DD- Demand, LT- Lead time, RN- Random number
Advantages of Simulation
 It can be used in areas where analytical techniques are not available or would be too
complex.
 Constructing the model inevitably must involve management and this may enable a deeper
insight to be obtained into a problem.
 A well-constructed model enables the results of various policies and decisions to be
examined without any irreversible commitments being made.
 Simulation is a cheaper and less risky than altering the real system.
 Can be used for training decision makers.
Disadvantages of Simulation
 Although all models are simplification of reality, they may still be complex and require a
substantial amount of managerial and technical time.
 Practical simulation inevitably involves the use of computers which may be a handicap to
firms without computer facilities or easy access to a computer.
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 Simulation does not produce optimal results. The manager makes the decision after testing
a no. of alternative policies. There is always the possibility that the optimum policy is not
selected.
 Simulation can be expensive in terms of design personnel, facilities e.g computers.
 Each simulation model is unique and therefore cannot be generalized to other environments.
2.4: SUMMARY
In this lesson we have looked at the three main advanced cost estimation methods i.e regression
analysis, learning curve and simulation. We have specifically focused on the major principles
underlying each method as well as the basic procedures.
 Drury, C. (2004). Management and Cost Accounting. 6th Ed, ELST.

 Lucey, T. (2005). Costing. 6th Ed. ELST
 Lucey, T. (2006). Management Accounting. 6th Ed. ELST
 Saxena, V.K And Vashit,C.D. Advanced Cost and Management Accounting. Latest Ed
 Horngren and Foster, G. Management Accounting. Latest Ed
QUESTION ONE
Malindi Marines limited is a company involved in the manufacturing of boats for leisure activities.
Earlier this year the company accepted an order for 15 specialized “crest” boats at a fixed price of
Kshs. 100,000 each. The contract allows four months for building and delivery of all the boats and
stipulates a penalty of Kshs. 10,000 for each boat delivered late. The boats are built using purchased
components and internally manufactured parts, all of which are readily available. However there is
only a small team of specialized technicians and boat yard space is limited so that only one boat can
be built at a time. Four boats have now been completed and as the company has no previous
learning experience of this particular boat the building times have been carefully monitored as
follows:
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Boat Number Completion (days)

1 10
2 8.06
3 7.4
4 7.14
The company has 23 normal working days in every month and the first four boats have been
completed with normal working. Management is now concerned about completing the contract on
time. The management accountant’s estimate of direct costs per boat, excluding labour cost is as
follows:
Kshs 000
Purchased components 40
Manufactured Parts 15
Other direct expenses 5
Direct labour costs are Kshs. 2,500 per day for the normal 23 working days per month. Additional
weekend working days at double the normal pay rates can be arranged up to a maximum of 7 days
per month (making 30 possible working days per month in total). Overheads will be allocated to the
contract at a rate of Kshs. 3,000 per normal working day and no overheads will be allocated for
overtime working.
Required
Determine whether it would be preferable for the company to continue normal working or to avoid
penalties by working weekends in order to complete the contract.
NB: Assume payment can be made for part days.
QUESTION TWO
Solai Ltd. is a manufacturing company that requires component XLA40 in one of its production
lines. The components are bought from outside suppliers. From past experience, the company has
determined that the demand for the component can be approximated by a normal distribution with a
mean of 500 and a standard deviation of 10, over the range 470 to 530. The unit is an initial stock of
2000 components and the company has decided to order in batches of 2500 whenever the stock
level falls below 1500 components. Again, past experience indicates that the time between the
order being placed and delivery varies as follows:
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Lead time distribution

Lead time (weeks) 1 2 3 4
Probability 0.02 0.50 0.25 005
The unit cost of holding stock is Sh.5 per week applied to the total stock held at the end of each
week. The cost associated with placing an order is Sh.500 and the unit cost of being out of stock is
Sh.200 per week. The company does all its accounting at the end of the week and all ordering and
delivery occur at the beginning of a week.
Required:
Using 15 runs Estimate the average cost per week of the above policy, using simulation analysis
and the following random numbers:
For Demand: 034 743 738 636 964 736 614 698 637
162 332 616 804 560 111 410 959 774
For 95 73 10 76 51 74
Lead-
time:
LESSON THREE
COSTING METHODS
3.0: INTRODUCTION
The purpose of this lesson is to examine some of the costing processes applied by business entities
in establishing the cost of their products and activities.

 Appreciate the basic principles underlying process costing
 Apply process costing to establish the cost of products
 Identify the basic principle underlying activity based costing
 Use activity based costing in the absorption of overheads
 Appreciate what it would take to have uniformity in costing procedures
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3.2: COSTING METHODS

These are the processes employed by businesses in ascertaining the cost of the goods produced or
services provided. The application of a given costing method by a business depends on the nature of
its operations or the category of the industry it belongs to. In general costing methods are broadly
classified into two;
a) Specific order costing methods
This is a broad costing system, which is applicable where work jobs consist of separate jobs,
batches or contracts. Each job, batch or contract is a cost unit and in most cases, it is different from
another. Each order made can be identified separately and the system is designed to find the cost of
each order. Specific order costing is subdivided into;
i. Job order Costing
This is a costing method which is applied when a job/cost unit is relatively of small size, is
undertaken to fit the customer’s specifications and is of comparatively short duration: Each job
moves through the operations continuously as an identifiable unit. The method is usually adopted
by businesses, which receives orders for work peculiar to the needs of individual customers.
ii. Batch Costing
This is a type of job costing that is used when production consists of limited repetitive work and
definite number of item manufactured in one batch. A batch is defined as a cost unit consisting of a
group of identical items. The total cost incurred in production is spread on the number of units made
when the batch is completed.
iii. Contract Costing
This is a form of specific order costing that is applied to relatively large cost units, which normally
take a considerable length of time to complete e.g. building or construction works. Contract jobs
are undertaken in accordance with specific requirements of contractee/Customer.
NOTE
The specific order costing methods are dealt with at length in the first part of the cost accounting
syllabus undertaken as Cost Accounting I
b) Operating costing methods
These are costing methods applied where the cost units are standardized and homogeneous. The
main operating costing methods include;
i. Process costing
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This is a method used where cost units are passed through a series of clearly defined processes
before the final product is completed.
ii. Service Costing
This is a method applied where standardized services are provided e.g public transport and hotel
accommodation.
3.3: OPERATION COSTING METHODS
3.3.1: PROCESS COSTING METHOD

This is a costing method that is applied where there are standard operations with continuous
production of homogeneous as identical units. Hence the output is the final product of a sequence
of operations. In this type of costing, costs are accumulated on the basis of process, and the cost per
unit is arrived at by dividing the total process costs by the number of input of the next process and
further materials can be added at each stage production. Therefore cost per unit for the second and
subsequent processes is a cumulative cost for example; the cost per unit for the output transferred
from process 2 is the cost of production for both process 1 and 2 and not for process 2 above. The
fact that the output for the first process becomes the input for the next process means that the
process costing procedure strives to maintain the cost of each process product and charge that with
the first process. The aim is to transfer the cost accumulated in the first process to the next process.
This is illustrated below:
Process 1
Kshs Kshs
Direct Material: 10,000 Transferred to
Direct Labour 50,000 Process 2: 175,000
Overheads 25,000
175,000 175,000
Process 2
Kshs Kshs
Transfer from Transfer to
Process 1: 175,000 Finished Goods: 240,000
Direct material 15,000
Direct labour 20,000
Overheads 30,000 ____
240,000 240,0000
Process Costing Procedure

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1. The production factory is divided into a number of processes.

2. An account is opened and maintained for each process.
3. Each process account is debited with materials, labor, direct expenses and overheads
apportioned to the process.
4. The output of a process is transferred to the next process input of that process.
5. The finished output of the last process is transferred to the finished goods account.
3.1.1.1: Valuation of Work In Progress
The concept of Equivalent units

This is a notional quantity of completed goods in the production process. It is a collection of work
application (direct materials, direct labor and overheads) necessary to produce one complete unit of
output. They are the number of units that would have been produced during a period of all the
departments’ efforts had resulted into completed units. The concept is used for purposes of
translating the partially completed production into its completed units equivalent. This enables cost
accountants to value the work-in-progress in an objective, consistent, reliable manner.
Illustration 1
Suppose there are 8,000 units of a product in ending inventory out of which 60% are fully complete
whereas the remaining are 70% complete. What are the equivalent units of the product?
Solution: 60% x 8,000 = 4,800 units fully complete.
40% x 8,000*70% = 2,240 units –Equivalent units.

Total Equivalent units = 7,040 units
Assume the total process costs was Kshs.28, 160 then each unit would cost Kshs.28,
160/7,040=Kshs 4
NOTE
In calculating the equivalent units it is important to separate each cost component due to
differences in the degree of completion i.e the units may be at different stages of completion in
respect of materials, labour and overheads.
Illustration 2
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Material X is added at the beginning of a production process. Labour and overheads are added
continuously during the production process. At the end of the process, 20,000 units were complete
and 4,000 units were 60% complete as per labour and overheads. The cost of raw materials used
during the period amounted to shs.480, 000, labour shs.300, 000 and overheads shs.148, 000. There
was no opening inventory.
Required
Determine the cost per unit of both the completed units, and the units in the ending inventory.
Solution:
Physical Units Materials Conversion Cost

Completed 20,000 20,000 20,000
Ending Inventory 4,000 4,000 2, 400
24,000 ______ _______
Equivalent Units 24,000 22,400
Cost for the Period 480,000 448,000
Cost per Equivalent Unit: 480,000/24000=sh20

448,000/11,200=sh20
Total Cost/Equivalent Unit =20 +20= Kshs 40
Where Conversion cost = labour cost plus overheads
The above computations do not incorporate any opening work in progress. Where opening WIP
exists then the following two methods have to be used.
 Weighted Average Method
 First in First Out (FIFO) Method.
Using these methods enables the cost of the opening work in progress to be appropriately assigned
to the finished goods and the closing work in process.
Weighted Average
Under this method all costs of production are considered in assigning costs to inventory. The
method puts together opening work in progress inventory costs and cost of production. It mixes the
costs of previous period with those of current period in determining costs per unit. No
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distinguishing of the “units started and completed in the current period” from the `units completed
and transferred ` and the `Ending working period` is done under this method. Under this method,
equivalent units are calculated as follows:
Equivalent Units = Units completed and Transferred + Ending work in progress inventory
(equivalent units)
Cost per E/Unit = Cost of opening WIP +Current costs

Number of Equivalent units
First In First Out (FIFO)
This method considers only those costs incurred during the current period. It ddistinguishes the
“units started and completed in the current period” from the units completed and transferred. Under
this method the equivalent units are computed as follows;
Equivalent Units= Units completed and transferred + E/units of closing WIP- E/units of
opening WIP
Cost/Equivalent Unit = Current Costs

Equivalent Units
Illustration
The following work in progress account relates to the Process X of Ruiru Limited, a soft-drinks
company for the month of June 2012. Raw materials were introduced at the start of the process
while labour and overheads were incurred through-out the process.
Process 2 Account
Particulars Kshs Particulars Ksh

s
Opening WIP 10,000L 130,00 Completed and transferred out: -
0 58,000L
Raw materials added 250,00 EndingW.I.P -
(60,000L) 0 12,000L
Direct Labour 290,00
0
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Factor Overheads 402,00

0
Additional Information
i. The opening WIP is 80% complete and consists of the following costs
Kshs
Raw materials 30,000
Direct Labor 40,000
Factory Overheads 60,000
ii. The closing WIP is 2/3 complete
Required
Calculate cost/equivalent units using:
a) Weighted average
b) FIFO
Weighted Average
Total Materials Conversion
Physical Units
Completed &Transferred Out 58,000 58,000 58,000
Ending W.I.P 12,000 12,000 8,000 (2/3 *12000)
______ ______ ________
70,000 70,000 66,000
Process Costs: Opening WIP 30,000 80,000

Current Costs: 250,000 692,000
280,000 782,000
Cost per equivalent Unit: Kshs.280,000 Kshs.782,000

70,000 66,000
= Kshs.4 Kshs.12
Total Cost per equivalent Unit: 4 + 12 = Kshs.16
FIFO
Total Physical Units Materials Conversion

Completed & transferred out 58,000 58,000 58,000
Closing WIP 12,000 12,000 8,000(2/3*12000)
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Less E/Units of Opening WIP (10,000) (8,000)(0.8*10000)

70,000 60,000 58,000
Current Costs Kshs 250,000 Kshs 792,000

Cost/Equivalent Unit 250,000 792,000
60,000 58,000
Total Cost Per E/unit : Kshs 16.10 = Kshs 4.20 Kshs.11.90
3.1.1.2: Process Cost Report

This is a commonly used statement which traces the flow of units produced and costs incurred in
the production process. The report is prepared for each process and it provides a reconciliation of
the physical flow of units and the total costs for the period. Assuming no spoilage or losses, the
following relationships will always hold:
1. Physical Units:
Opening W.I.P + Units started during (Units to account for the period) = Units completed and
transferred + Closing WIP (Units accounted for)
2. Costs:
Cost of Opening W.I.P. + Current costs incurred (Cost to account for) = Costs of units
completed and transferred + Cost of Closing WIP (Cost accounted for)
Ilustration
Assume that the opening work in progress in Mandera Company Ltd in the month of July 2012 was
10,000 units which were 100% complete in terms of materials and 75% complete as to conversion.
Raw materials costs relating to opening work in progress amounted to Kshs.18, 000 and conversion
was Kshs.6, 000. 100,000 units were completed during the period and transferred to finished goods
stock account. 20,000 units were still in process and were 100% complete in relation to materials
and 50% complete in relation to conversion costs. Costs incurred during the period were raw
materials Kshs.198, 000, conversion Kshs.258, 000;
Required
Prepare the process cost report for the month of July 2012 using both the weighted average and
FIFO methods
MANDERA COMPANY LIMITED.
PROCESS COST REPORT
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For the month of July 2012
(Weighted Average Method)
Physical Units
Opening W.I.P 10,000
Units started in the 110,000 (100,000 + 20,000 – 10,000)
period
Units to account for: 120,000
Equivalent Units
Total Materials Conversion
Units Costs
Units completed during the period: 100,000 100,000 100,000
Ending W.I.P 20,000 20,000 10,000
Units accounted for 120,000 120,000 110,000
Cost Determination
Total Material Cost Conversion
Cost Costs
Opening WIP 24,000 18,000 6,000
Current costs 456,000 198,000 258,000
Cost to account for: 480,000 216,000 264,000

216000/120,000 264000/110000
Cost/ E.unit 4.20 1.80 2.40
Cost assignment Kshs Kshs

Units completed and transferred out = 100,000* 4.20 420,000
Closing WIP:
Materials = 20,000*1.80 36,000
Conversion= 10,000 * 2.40 24,000 60,000
Cost accounted for 480,000
MANDERA COMPANY LIMITED.
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PROCESS COST REPORT
For the month of July 2012
(FIFO Method)
Physical units
Total
Opening WIP 10,000
Units started in the period 110,000
Units to account for 120,000
Equivalent units Physical Materials Conversion

Units completed 100,000 100,000 100,000
Closing WIP 20,000 20,000 10,000
Less E/Units of opening WIP (10,000) (7,500)
Units accounted for 120,000 110,000 102,500
Cost Determination Total Materials Conversion

Opening WIP 24,000 - -
Current costs 456,000 198,000 258,000
Cost to account for 460,000
Cost per E. Unit 198,000/110,000 258,000/102,500
4.32 1.80 2.52
Cost Assignment
Kshs Kshs Kshs
Units completed & transferred out:
Units started & completed (100,000-10,000)*4.32 388,800
Opening WIP:
Previous period cost 24,000
Conversion (2,500*2.52) 6,300 419,100
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Closing WIP:
Conversion (10,000*2.52) 25,200
Materials (20,000*1.80) 36,000 61,200
Cost accounted for 480,300*
*- Kshs 300 is rounding off error
3.1.1.3: Process Losses

Most manufacturing processes result in some portion of the raw materials used not being converted
into a reliable half hence losses. These losses may take the form of waste, scrap, rework, and spoilt
units.
 Waste: are materials lost in the process, which are irrecoverable or have no recoverable
value.
 Scrap: Material held after a productive process, which are irrecoverable or have no
recoverable value.
 Rework: These are finished goods that do not meet quality standards but which with some
additional work can be sold.
 Spoilage: Refers to finished or partially finished units, which cannot be reworked or used
for their intended purpose. They may be discarded or sold for minimal value. There are two
types of spoilage;
- Normal Spoilage: This is loss expected and unavoidable even under the most efficient
systems of production. Normal spoilage cost is normally included in product cost.
- Abnormal Spoilage: This is loss that is avoidable with efficient operating conditions. The
cost is regarded as controllable and can be eradicated if due diligence and supervision are
exercised. The cost is normally treated as a loss and charged to profit and loss account.
Accounting Treatment of Spoilage Costs
Normal Spoilage Costs

These costs are assigned to the good output using two approaches:
Omission Approach
Under this approach, the normally spoilt units are not included in the calculation of equivalent units.
This means that the cost of the normally spoilt units will automatically be distributed to the good
output. By excluding the normal spoilage in the computation to the good output, a lower figure will
be derived. The weaknesses of this method are;
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 The cost of normal spoilage is spread equally into the finished goods and the ending W.I.P
regardless of whether the ending W.I.P. has passed the inspection stage or not.
 It does not allow the manager to see the costs of spoilage because these costs are not
computed.
Recognition and Re-Assignment Approach
In this approach, the normal spoilage is included in the equivalent units computation, further, the
normally spoilt units will be assigned costs just like any other unit. The spoilage costs will then be
reallocated to these good units that have passed the inspection point. The steps to follow under this
method are:
 Compute equivalent units including normal spoilage.
 Assign costs to all units including normal spoilage.
 Reassign normal spoilage costs to good output.
Abnormal Spoilage Costs
These costs do not add any production benefit to the company and are treated as accounting losses.
The costs are written off directly as losses for the period in which they occur.
Illustration
Lamu Limited manufactures a product through two processes. The following is the data in respect
of process 2 for the month of July 2012
Opening W.I.P. (25% complete as to conversion): 10,000 units

Costs for Opening W.I.P:
Transferred in Kshs.82,900
Conversion costs Kshs.42,000
Units started in the current period. 70,000 units
Current costs: Transferred in Kshs.645,100
Conversion Kshs.612,500
Additional Kshs 651,000
Materials*
Units completed and transferred: 50,000 units
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Units in ending W.I.P (95% complete as to conversion) 20,000 units

Spoilt Units 10,000 units
1. Normal spoilage is 10% of all good units that pass inspection
2. Inspection occurs when production is 80% complete.
3. Conversion costs are incurred evenly through-out the process.
4. The additional Material is added when the process is 90% complete
Required
Prepare a process cost report using
(a) Weighted Average
(b) FIFO
Apply both the recognition re-assignment and omission approach in dealing with the spoilage.
Solution
Lamu Limited.
Process 2 Cost Report
Weighted Average Approach
Recognition and reassignment
Physical Units Total

Opening W.I.P. 10,000
Units started in the period 70,000
Units to Account for 80,000
Equivalent Units: Physical Transfer in Additional Conversion

Material
Finished Goods: 50,000 50,000 50,000 50,000
Closing W.I.P 20,000 20,000 20,000 19,000
Normal spoilage 7,000 7,000 - 5,600(0.8*70
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00)
Abnormal spoilage 3,000 3,000 - 2,400
(0.8*3000)
Units accounted for 80,000 80,000 70,000 77,000
Cost Determination Total Transfer Additiona Conversion

Cost In l Material
Opening W.I.P 124,900 82,900 - 42,000
Current Costs 1,908,60 645,100 651,000 612,500
0
Costs to Account for: 2,033,50 728,000 651,000 654,500
0
Divided by Equivalent 80,000 70,000 77,000
Units
Cost per equivalent Unit Shs.26.9 Shs.9.10 Shs.9.30 Shs.8.50
0
Cost Assignment
Kshs Kshs
Normal spoilage cost:
Transfer in (7000*9.10) 63,700
Additional material (0*9.30) 0
Conversion (5600*8.50) 47,600
Total 111,300
Reassignment of normal spoilage cost
Finished output = 50000/70000 * 111,300 = Kshs 79,500
Closing WIP = 20,000/70,000 * 111,300 = Kshs 31,800
Kshs Kshs
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Finished output:
Normal cost (50,000*26.90) 1,345,000
Normal spoilage cost 79,500 1,424,500
Closing WIP:
Transfer in (20,000*9.10) 182,000
Additional Material (20,000*9.30) 186,000
Conversion (19,000*8.50) 161,500
Normal spoilage cost 31,800 561,300
Abnormal spoilage:
Transfer in (3,000*9.10) 27,300
Additional material (0*9.30) 0
Conversion (2,400*8.50) 20,400 47,700
Cost accounted for 2,033,500
Lamu Limited
Process 2 Cost Report
FIFO Method
(Omission Approval)
Physical Units: Total

Opening 10,000
W.I.P
Units started 70,000
in the period
Units to 80,000
account for
Equivalent
Units
Physical Transfer in Additional Conversion
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Material
Finished 50,000 50,000 50,000 50,000

Goods
Closing 20,000 20,000 20,000 19,000
W.I.P
Normal 6,000 - - -
Spoilage
Abnormal 4,000 4,000 3,200
Spoilage
Units 80,000
Accounted
for
Less (10,000) 0 (2,500)
equivalent
units of 64,000 70,000 69,700
Opening
WIP
Cost Determination Total Transfer In Additional Conversion

Cost Material
Opening W.I.P 124,900
Current Costs 1,908,600 645,100 651,000 612,500
Costs to Account for: 2,033,500 645,100 651,000 612,500
Divided by Equivalent 64,000 70,000 69,700
Units
Cost per equivalent Unit Shs.28.16 Shs.10.07 Shs.9.30 Shs.8.79
Cost Assignment
Kshs Kshs
Finished goods:
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Units started & completed in the period (50,000-10000)*28.16 1,126,400

Opening WIP:
Previous period cost 124,900
Current period cost;
Material (10,000*9.30) 93,000
Conversion (7,500 *8.79)
65,925
283,825
1,410,225
Closing WIP:
Transfer in (20,000*10.07) 201,400
Additional material (20,000*9.30) 186,000
Conversion (19,000*8.79) 167,010 554,410
Abnormal spoilage:
Transfer in (4,000*10.07) 40,280
Additional Material (0*9.30) 0
Conversion (3,200*8.79) 28,128 68,408
Cost accounted for 2,033,0431*
*- Difference due to rounding off
Accounting for Shrinkage

Shrinkage refers to loss or disappearance of material inputs used during the production process. It
occurs mainly through the evaporation. This is unlike spoilage in which the units still exist only
that they will be of a lower value than the good units. Shrinking is common in chemical mixtures
which produce or use liquid gases as material inputs. The problem associated with shrinking is the
reconciliation of the beginning and ending inventory. This problem is resolved by expressing the
various layers of production in terms of what its weights or volume would be either at the beginning
or end of the process.
Illustration
Assume that a chemical company, which is processing one of its products through one of its
processes, must start with 100kg of a certain chemical for its 80kg of finished products. Assume
that all the chemical is added at the beginning of the process and 20% of the evaporation takes place
gradually through-out the process. The actual weights through measurement were as follows:
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Beginning W.I.P Inventory (75%complete as to 21,250kg.

conversion)
Units started 110,000kg.
Finished Goods Transferred 80,000kg.
Ending W.I.P (25% complete as to conversion) 33,250kg.
Costs:
Beginning W.I.P: 100,000
Current Conversion Costs: 252,000
Current Material Costs: 220,000
Prepare a cost report:
Using the FIFO method
(i) Based on ending weight
(ii) Based beginning weights
Solution
For beginning W.I.P: Actual weight = 21250kg (75% complete as to conversion). Only
20%x75%=15% evaporation will have incurred. Therefore beginning weight (without evaporation)
=
100
21250 x
85
= 25,000 kgs
For ending W.I.P., Actual weight = 33,250kg actual weight (25% complete as to conversion). Only
20%*25% = 5% evaporation has occurred. Therefore beginning weight (without evaporation)
= 33,250 *100
95
= 35,000 kgs
PROCESS COST REPORT
FIFO Method: Assuming Beginning weights

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Physical Units
Beginning W.I.P. 25,000
Units started 110,000
Units to account for 135,000
Materials Conversion
Beginning W.I.P 25,000 6,250(25%*25,000)
Units started & 75,000 75,000 75,000
completed
Ending W.I.P 35,000 35,000 8,750 (25%x35,000)
135,000 110,000 90,000
Cost
Determination Total Costs Materials Costs Conversion costs
Beginning W.I.P 100,000 - -
Current Costs 472,000 220,000 252,000
Costs to A/c for 572,000 220,000 252,000
Costs per unit Kshs.4.80 Kshs.2 Kshs.2.80
Cost
Assignment
Units started and completed: (75,000x4.80) = 360,000
Ending work in process:
Material: 35,000 x 2 = 70,000

Conversion (8,750 x 2) = 24,500 94,500
Beginning W.I.P: Previous period cost 100,000
Conversion (6,250x2.80) = 17,500 117,500
Costs Accounted for 572,000
Using the Ending Weights
Start End
Beginning W.I.P. 25,000kg 80% 20,000kg
Units Started 110,000kg 80% 88,000kg
Finished goods 100,000kg 80% 80,000kg
Closing W.I.P 28,000kg
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Physical Units
Beginning W.I.P 20,000
Units Started: 88,000

108,000
Equivalent units
Physical Materials Conversion
Finished Goods: 80,000 80,000 80,000

Ending W.I.P. 28,000 28,000 7,000(25% x 28,000)
Units accounted 108,000
for
Less E/Units of opening WIP (20,000) (15,000) (75% x 20,000)
88,000 72,000
Cost Determination
Total Cost Materials Conversion
Beginning W.I.P. 100,000 - -
Add Current Costs: 472,000 220,000 252,000
Costs to account for: 572,000 220,000 252,000
Divide by equivalent 88,000 72,000
units
Cost/Equiv Units Shs.6 Shs.2.50 Shs.3.50
Cost Assignment
Units started and completed: (60,000 x6.00) = 360,000
Ending work in process:
Material: 28,000 x 2.50 70,000

=
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Conversion (7,000 x 3.50) 24,500 94,500

=
Beginning W.I.P: Previous period cost 100,000
Conversion (5,000x3.50) = 17,500 117,500
Costs Accounted for 572,000
3.4: OTHER COSTING METHODS
3.5.1: ACTIVITY BASED COSTING (ABC)

Absorption Costing appears to be relatively straightforward way of adding overhead costs to units
of production using, more often than not, a volume-related absorption basis (Such as direct labour
hours or direct machine hours). The assumption that all overheads are related primarily to
production volume is implied in this system. Absorption costing was developed at a time when
most organizations produced only a narrow range of products and when overhead costs were only a
very small fraction of total costs, direct labour and direct material costs accounting for the largest
proportion of the costs. Errors made in adding overheads to products were therefore not too
significant.
Nowadays, however, with the advent of advanced manufacturing technology, overheads are
likely to be far more important and in fact direct labour may account for as little as 5% of a
product’s cost. Moreover, there has been an increase in the costs of non-volume related support
activities, such as setting-up, production scheduling, inspection and data processing, which assist
the efficient manufacture of a wide range of products. These overheads are not, in general affected
by changes in production volume. They tend to vary in the long term according to the range and
complexity of products manufactured rather than the volume of output.
Because traditional absorption costing methods tend to allocate too great a proportion of overheads
to high-volume products (which cause relatively little diversity), and too small a proportion of
overheads to low-volume products (which cause greater diversity and therefore use more support
services), alternative methods of costing have been developed. Activity-based costing (ABC) is
one such development. The major ideas behind activity-based costing are as follows:
 Activities cause costs; activities include ordering, materials handling, machining,

assembly, production scheduling and dispatching,
 Products create demand for the activities
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 Costs are assigned to products on the basis of a product’s consumption of the

activities.
Absorption rates under ABC should therefore be more closely linked to the cause of overhead costs
and hence product costs should therefore be more realistic especially where support overheads are
high.
OUTLINE OF AN ABC SYSTEM

An ABC costing system operates as follows:
Step 1
Identify an organization’s major activities.
Step 2
Identify the factors which determine the size of the costs of an activity/cause of the costs of an
activity. These are known as cost drivers e.g.
Activity Possible cost driver

Ordering Number of orders
Materials handling Number of production runs
Production scheduling Number of production runs
Dispatching Number of dispatches
For those costs that vary with production levels in the short term, ABC uses volume-related cost
drivers such as labour or machine hours. For instance the cost of oil used as a lubricant on the
machines would therefore be added to products on the basis of the number of machine hours since
oil would have to be used for each hour the machine ran.
Step 3
Collect the costs of each activity into what are known as cost pools (equivalent to cost centres under
more traditional costing methods).
Step 4
Charge support overheads to products on the basis of their usage of the activity. A product’s usage
of an activity is measured by the number of the activity’s cost driver it generates.
NOTE
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Absorption costing and ABC are similar in many respects. In both systems, direct costs go
straight to the product and overheads are allocated to production cost centres/cost pools. The
difference lies in the manner in which overheads are absorbed into products. Absorption costing
most commonly uses two absorption bases (labour hours and /or machine hours) to charge
overheads to products ABC uses many cost drivers as absorption bases (number of orders, number
of dispatches and so on).
Advantages of ABC
i. It is flexible enough to trace costs to processes, customers, areas of managerial
responsibility as well as product costs.
ii. It provides a reliable indication of long run variable product cost which is relevant to
strategic decision making
iii. Focuses attention on the real nature of cost behavior and helps in reducing costs and
identifying activities which do not add value to the product.
iv. Recognizes that it is activities which cause costs not products. However it is products
which consume activities
v. Recognizes the complexity and diversity of modern production by the use of
multiple cost drivers many of which are transaction based rather than based solely on
production volume.
Disadvantages of ABC
i. A full ABC system with numerous cost pools and multiple cost drivers is undeniably
more complex than traditional systems and will thus be more expensive to administer.
ii. Many practical problems are unresolved e.g. common costs, cost driver selection,
non linearity of cost driver rates etc.
ILLUSTRATION
ABC Lt. Is a manufacturing company that makes only three products P, Q, and R. Data for the
period ended last month are as follows:
P Q R
Units produced and sold 12,000 16,000 8,000
Sh. Sh. Sh.

Sales price per unit 50 70 60
Direct material cost per unit 16 24 20
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Direct labour cost per unit 8 12 8
Production overheads costs

Total Cost drivers
Sh.
Machining costs 102,000
Production scheduling 84,000 Machine hours
Set-up costs 54,000
Machine hours
Number of production runs
Quality control 49,200 Number of production runs
Receiving materials 64,800 Number of components receipts
Packing materials 36,000 Number of customer orders
390,000
Information on the cost drier is given as follows:
P Q R
Direct labour hours per unit 1 1½ 1
Machine hours per unit ½ 1 1½
Number of components per unit 3 5 8
Number of component receipts 18 80 64
Number of customer orders 6 20 10
Number of production runs 6 16 8
Required:
Using activity based costing (ABC) show the cost and gross profit per unit for each product during
the period.
SOLUTION
Overhead costs (Activities) P(Shs) Q(Shs) R(Shs) TOTAL(SHS)
Machinery cost 18,000 48,000 36,000 102,000
Production scheduling 16,800 44,800 22,400 84,000
Set up cost 10,800 28,800 14,400 54,000
Quality control 9,848 26,240 13,120 49,200
Receiving materials 7,200 32,000 25,600 64,800
Packing materials 6,000 16,000 8,000 36,000
Total overhead cost 68,640 199,840 121,520 390,000
Units produced 12,000 16,000 8,000
Overhead cost/unit Shs.5.72 Shs.12.49 Shs.15.19
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Workings for Recovery Rates

(i) Machining cost = Budgeted machining cost = 102,000
Budgeted machine hours 34,000
= Kshs.3/machine hour
{Budgeted machine hours = ½ (12,0000 + (16,000) + 1½(8,000) = 34,000}
ii. Production scheduling = Budgetedd production scheduling cost = 84,000

No. of production runs 30
= Kshs.2,800/production run
iii. Set up costs = Budgeted Set Up Cost = 54,000 = Kshs.1,800/production run

iv. Quality control = Budgeted Quality Control Cost = 49,200 = Kshs1,640/production run
vi. Receiving materials = Budgeted Receiving Materials cost = 64,800 = Kshs

400/component Receipt
No. of components Receipts 162
vi. Packing Materials = Packing Material’s cost = 36,000 = Kshs1,000/Customer order

No. of customers orders 36
Total cost statement and profit (shillings per unit)
P Q R
Direct materials 16.00 24.00 20.00
Direct labour 8.00 12.00 8.00
Overhead cost (as above) 5.72 12.49 15.19
Total production cost 29.72 12.49 15.19
Sales price 50.00 70.00 60.00
Gross profit per unit 20.28 21.51 16.81
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3.5.2: UNIFORM COSTING

This is a common system using agreed concepts, principles and standard accounting practices
adopted by different entities in the same industry to ensure that they all deal with accounting
information in a similar manner so as to facilitate inter-firm comparison. The objectives of uniform
costing are:
 To promote uniformity of costing methods, so that valid costs comparisons can be made
between similar organization
 To eliminate inefficiencies and promote good practice revealed by the cost comparison.
 Serve as a basis for government subsidies or grants which weed similar costing systems to
ensure equitable distribution.
 Serve as a basis for competitive bidding.

Requirements of Uniform Costing
Uniform costing systems should process the following features:
1. Cost statements and reports should be organized and laid out in a similar format so that each
element of cost and revenue can be compared quite easily.
2. Accounting periods must be the same in all firms in the industry.
3. The methods of valuing stocks and work in progress must be the same.
4. The basis of valuing fixed assets must be the same.
5. The method and actual rates of depreciation for each type of asset must be the same.
6. The basis of cost or overhead apportionment and absorption must be similar.
7. Cost classification systems must be the same in all the firms in the industry so that similar
items are classified in the same names.
Advantages of Uniform Costing
a) It enables costs to be compared easily
b) It makes it easier to computerize the accounting system of various organizations in the

industry.
c) It leads to easier cost transferability between organizations.
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Disadvantages
1. It may not be appropriate or suitable to an individual organization in the industry if there is a

difference in size and structure.
2. It is slow to adopt to changing conditions and demands.
3.6: SUMMARY
In this lesson we have looked at process costing as a method of establishing the cost of products
that go through a number of production stages. We have also addressed the use of activity based
costing in the absorption of overheads as well as the essential requirements for the establishment
of standardized procedures in cost accounting.
Drury, C. (2004). Management and Cost Accounting. 6th Ed, ELST.

Lucey, T. (2005). Costing. 6th Ed. ELST
Lucey, T. (2006). Management Accounting. 6th Ed. ELST
Saxena, V.K And Vashit,C.D. Advanced Cost and Management Accounting. Latest Ed
Horngren And Foster, G. Management Accounting. Latest Ed
QUESTION ONE
During the last 20 years Lodwar Enterprise’s manufacturing operation has become increasingly
automated with computer controlled robots replacing operatives. The company currently
manufactures over 100 products of varying levels of design complexity. A single plant wide
overhead absorption rate based on direct labour hours is used to absorb overhead costs. In the
quarter ended march 2012, the company’s manufacturing overhead costs were;
Kshs 000
Equipment operation expenses 125
Equipment maintenance expenses 25
Wages paid to technicians 85
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Wages paid to store men 35

Wages paid to dispatch staff 40
310
During the quarter Excel management consultants were engaged to conduct a review of the
company’s cost accounting systems. Excel report includes the following;
“In Lodwar Enterprise’s circumstances, absorbing overhead costs in individual products on a labour
hour absorption basis is meaningless. Overhead costs should be attributed to products using an
activity based costing system. We have identified the following as being the most significant
activities;
i. Receiving component consignments from suppliers
ii. Setting up equipment for production runs
iii. Quality inspections
iv. Dispatching goods orders to customers
Our research has indicated that in the short term, Lodwar Enterprise’s overheads are 40% fixed and
60% variable. Approximately half of the variable overheads vary in relation to direct labour hours
worked and half vary in relation to the number of quality inspections. This model applies only to
relatively small changes in the level of output during a period of two years or less”
i. Equipment operation and maintenance expenses are apportioned as follows;
Component stores- 15%
Manufacturing – 70%
Goods dispatch- 15%
ii. Technician wages are apportioned as follows;
Equipment maintenance- 30%
Setting up equipment for production run- 40%
Quality inspection- 30%
iii. During the quarter;
 A total of 2000 direct labour hours were worked (paid at Kshs 12/hour)
 980 component consignments were received from suppliers
 1,020 production runs were set up
 640 quality inspections were carried out
 420 goods orders were dispatched
iv. The company’s production during the quarter included components R, S and T. The
following information is available;
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R S T
Direct labour hours worked 25 480 50
Direct material cost (Kshs) 1,200 2,900 1,800
Production runs 16 18 12
Quality Inspections 10 8 18
Goods orders dispatched 22 85 46
Quantity produced (Units) 560 12,800 2,400
Component consignments received 42 24 28
v. In April 2012 a potential customer asked the company to quote for the supply of a new
component Z to a given specification. 1,000 units of Z are to be supplied each quarter for a two
year period. They will be paid for in equal instalments on the last day of each quarter. The job
will involve an initial design cost of Kshs 40,000 and production will involve 80 direct labour
hours, Kshs 2,000 materials, 20 component consignments, 15 production runs, 30 quality
inspections and 4 dispatches per quarter. The company’s sales director made the following
comment in regard to this order “Now we have a modern ABC system, we can quote selling
prices with confidence. The quarterly charge we quote should be the forecast ABC production
cost of the units plus the design cost of Z depreciated on a straight-line basis over the two years
of the job- to which we should add 25% mark up profit. We can base our forecast on costs
experienced in the quarter ended March 2012”
Required
a) Calculate the unit cost of components R, S and T using the company’s existing accounting
system
b) Calculate the unit cost of components R, S and T using the ABC system
c) Calculate the charge per quarter that should be quoted for supply of component Z in a
manner consistent with the sales Director’s comments.
QUESTION TWO
a) Explain which features of large scale service organisations encourage the application of
activity based approaches to the analysis of cost information
b) Explain which features of service organisations may create problems for the application of
activity based costing
c) Explain the uses for activity based cost information in service industries
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QUESTION THREE
Kaloleni Limited is a warehousing and distribution company which receives products from
customers, stores the products and then repacks them for distribution as required. There are three
customers for whom the service is provided; Fafi Limited, Ijara Limited and Mwingi Limited. The
products from all three customers are similar in nature but of varying degrees of fragility. Basic
budget information has been gathered for the year to 31st December and is shown in the following
table;
Products handled (Cubic metres)
Fafi Limited 15,000
Ijara Limited 22,500
Mwingi Limited 12,500
Costs (Kshs 000)

Packaging materials 3,900
Labour:
Basic 700
Overtime 60
Occupancy 1,000
Administration 120
Packaging materials are used in repacking each cubic metre of product for Mwingi, Ijara and Fafi in
the ratio 6:4:2 respectively. This ratio is linked to the relative fragility of the goods for each
customer. Additional information has been obtained in order to enable unit costs to be prepared for
each of the three customers using an activity based costing approach. The additional information for
the year to 31st December has been estimated as follows;
i. Labour and overhead costs have been identified as attributable to each of the three
work centres; receipt and inspection, storage and packing as follows;\
Cost Allocation Proportions
Receipt and inspection Storage Packing

% % %
Labour:
Basic 20 20 60
Overtime 60 20 20
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Occupancy 30 50 20
Administration 50 20 30
ii. Studies have revealed that the fragility of different goods affects the receipt and
inspection time needed for the products for each customer. Storage required is related to the
average size of the basic incoming product units from each customer. The repacking of
goods for distribution is related to the complexity of packaging required by each customer.
The relevant requirements per cubic metre of product for each customer have been
evaluated as follows;
Fafi Ltd Ijara Ltd Mwingi Ltd
Receipt & Inspection (Minutes) 10 18 30
Storage (Square metres) 0.6 0.6 0.4
Packing (Minutes) 72 90 120
Required
Calculate the budgeted average cost per cubic metre of packaged products for each customer using
the following two circumstances;
a) Where only the basic budget information is used
b) Where the additional information enables an activity based costing approach to be applied
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LESSON FOUR
ALLOCATION OF JOINT COSTS
4.0: INTRODUCTION
The main purpose of this lesson is introducing the concept of joint processes that generate joint
products as well as incur joint costs. In addition the lesson identifies and discusses the methods that
can be used to allocate these costs to the respective products.

Establish the meaning of joint costs
Identify the methods that can be used in the allocation of the joint costs
Apply the different methods of allocating joint costs
4.2: GENERAL OVERVIEW

When two or more products of relatively high value emerge simultaneously from a single process,
they are referred to as joint products. Joint products are described as two or more products separated
in the course of processing each having a sufficiently high saleable value to merit recognition as a
main product. The process that gives rise to these products is called a joint process and the costs
involved are referred to as joint product costs. Joint products are not separately identifiable as
individual products until their split off point. Split-off point is the point at which joint products
become separate entities or are individually identifiable. Allocation of joint costs involves assigning
the costs of the joint process to the products emerging at the split off point. Any costs beyond the
split off point are referred to as separable costs.
Labour and Product

overheads Joint costs
A
Joint
Process Product Separable costs
B
Raw
Materials Product
C
Split off point
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4.3: ALLOCATION OF JOINT COSTS

If all the production for a particular period was sold, the problem of allocating joint costs to
products would not exist. Inventory valuations’ would not be necessary and the calculation of profit
would merely require the deduction of total cost from total sales. However if inventories are in
existence at the end of the period, cost allocation to products are necessary. As any such allocations
are bound to be subjective and arbitrary, this area will the cost accountant in making decisions
which are among the most difficult to defend. All one can do is to attempt to choose an allocation
method that seems to provide a rational and reasonable basis of cost distribution. The most
frequently used methods in allocation of joint costs include;
4.3.1: PHYSICAL MEASURE/UNIT

Using this method, the cost allocation is a simple allocation of joint costs in proportion to volume.
Each product is assumed to receive similar benefits from the joint cost and is therefore charged with
its proportionate share of the total cost.
4.3.2: CONSTANT GROSS MARGIN RATE

This method assumes that each product contributes an equal percentage of gross profit for every
shilling of sales. It works back from gross margin to the joint costs allocation. It involves the
following steps:
(i) Calculate the overall rate of gross margin for al the products
(ii) Multiply the computed overall rate by the sales of every product to obtain the
gross margin of the product.
(iii) Deduct the gross margin from the sales value of the product to determine the
total costs for each product.
(iv) Deduct separable costs from the total costs to obtain joint costs allocated.
4.3.3: NET REALIZABLE VALUE

In practice it is likely that joint products will be processed individually beyond the split off point
and market values may not exist for the products at this stage. To estimate the sales value at the split
off point, it is therefore necessary to use the estimated sales value at the point of sale and work
backwards. The difference between the ultimate sales value and the cost of further processing is the
Net realisable value i.e;
Net Realizable Value = Ultimate Sales Value – Separable Costs.
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4.3.4: SALES VALUE AT SPLIT OFF POINT

Under this method joint costs are allocated to the joint products in proportion to the estimated sales
value of production. The method assumes that higher selling prices indicate higher costs. To a
certain extent, this method could better be described as a means of apportioning profits or losses
according to sales value rather than a method of allocating joint costs.
4.4: ACCOUNTING FOR BY-PRODUCTS

A by- product is a supplementary or secondary product arising as the result of a process whose
value is small relative to that of the principal product. It’s a product which is recovered incidentally
from the material used in the manufacture of recognised main products. As the major objective of
the company is to produce the joint products, it can justifiably be argued that the joint costs should
be allocated only to the joint products and that the by-products should not be allocated with any
portion of the joint costs that are incurred before the split off point. Any costs that are incurred in
producing by-products after the split off point can justifiably be charged to the by-product since
such costs are incurred for the benefit of the by-product only. By-product revenue or net revenue in
case of further processing should be deducted from the joint cost before it is allocated to the main
products. If the by-product has no sales value, then it should not be considered in the allocation
process.
Illustration
During the month of June 2012 Bidco Company processes a basic raw material through a
manufacturing process that yields three products; X, Y and Z. The process also generates a by-
product A. There were no opening inventories and the products are sold either at split off point or
after further processing. Details of the production process and sales revenues are given below;
Product Output (Kgs) Sales value at Cost of Further Sales value

split off point processing after further
(Kshs/Kg) (Kshs) processing
(Kshs/Kg)
X 40,000 75 800,000 100

Y 20,000 250 1,000,000 300
Z 60,000 34 200,000 100
A 2,000 5 10,000 30
The total cost incurred in the processing of the basis raw material was Kshs 5,550,000.
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Required
Allocate the joint cost incurred in the month of June 2012 to the products using the Four methods.
SOLUTION
Net revenue from Product A = (30*2,000)- 10,000 = Kshs 50,000
Joint cost to be allocated = Kshs 5,550,000- Kshs 50,000 = Kshs 5,500,000
a) Physical output Method
Product Output (Kgs) Proportion Joint cost

allocated (Kshs)
X 40,000 40,000/120,000=1/3 1,833,333
Y 20,000 20,000/120,000=1/6 916,667
Z 60,000 60,000/120,000=1/2 2,750,000
TOTAL 120,000 1.00 5,500,000
b) Net realisable Value Method
Product Ultimate sales Cost of Net Proportion Joint cost

Value Further realisable allocated
processing value
(Kshs) (Kshs) (Kshs) (Kshs)

X 40,000*100= 800,000 3,200,000 0.23 1,265,000
4,000,000
Y 20,000*300= 1,000,000 5,000,000 0.36 1,980,000
6,000,000
Z 60,000*100= 200,000 5,800,000 0.41 2,255,000
6,000,000
16,000,000 2,000,000 14,000,000 1.00 5,500,000
c) Sales value at split off point method

Product Sales Value at split off Proportion Joint cost Allocated
point (Kshs) (Kshs)
X 40,000*75 =3,000,000 0.30 1,650,000
Y 20,000*250 =5,000,000 0.50 2,750,000
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Z 60,000*34 = 2,040,0000 0.20 1,100,000

10,040,000 1.00 5,500,000
d) Constant Gross Margin method

Kshs Kshs
Sales:
X 4,000,000
Y 6,000,000
Z 6,000,000 16,000,000
Less Costs:
Joint cost 5,500,000
Separable cost;
X 800,000
Y 1,000,000
Z 200,0000 7,500,000
Gross Margin 8,500,000
NOTE
Overall gross margin = Gross margin / Total sales *100

Overall gross margin = 8,500,000/16,000,000 *100 = 53.1%
Product X Product Y Product Z Total

(Kshs) (Kshs) (Kshs) (Kshs)
Sales 4,000,000 6,000,000 6,000,000 16,000,000
Gross profit 2,124,000 3,186,000 3,186,000 8,496,000
(53%)
Cost of sales 1,876,000 2,814,000 2,814 ,000 7,504,000
Separable cost 800,000 1,000,000 200,000 2,000,000
Joint cost 1,076,000 1,814,000 2,614,000 5,504,000*
allocated (Rounding off)
4.5: ACTIVITY
Identify processes which in practice are joint processes. Establish the main products as well any
by-products that normally emerge from these processes.
4.6: SUMMARY
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In this reason we have looked at the general meaning of joint costs as well as the main methods
applied in the allocation of these costs to the main products that emerge from the joint process.
We have also addressed the treatment of any by-products that may arise from the joint process.

Lucey, T. (2006). Management Accounting. 6th Ed. ELST
Horngren And Foster, G. Management Accounting. Latest Ed
QUESTION ONE
A company produces three products, A, B, and C in the same process. The data below reflects
average monthly results:
A B C
Monthly output (kg) 40,000 20,000 20,000
Sales Value at split off (shs.) 0 30,000 105,000
Sales Value after Split off (Shs) 45,000 100,000 155,000
Costs of further processing 20,000 40,000 65,000
(Shs)
The joint costs were Shs.200, 000
Required
Allocate the joint cost to the three products using the three methods used to allocate joint costs.
QUESTION TWO
Malindi Quarries limited crushes and refines mineral ore into three products in a joint operation. For
the year to 31st May 2012, the cost and production figures of the company were as follows;
Department A
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Initial joint costs- Kshs 4.2M

Production;
Deluxe- 300,000 Kgs
Classic – 100,000 Kgs
Standard – 500,000 Kgs
Department B
Process classic further at a cost of Kshs 2m
Department C
Process deluxe further at a cost of Kshs 3m
The results achieved for the year under reference were;
Classic: 100,000 Kgs completed; 95,000kgs sold for Kshs 200 per kg
Deluxe: 300,000 Kgs completed; 295,000 Kgs sold for Kshs 50 per kg
Standard: 500,000 Kgs completed: 495,000kgs sold for Kshs 20 per kg. It required no further
processing
Required
Allocate the joint costs to the three products using the four methods
QUESTION THREE
A process costing Kshs 1M produces three products; R, T and S. Output details are as follows;
Product Output (Litres)
R 12,000
S 10,000
T 20,000
Each product may be sold at the completion of the process as follows;

Product Sales Value at the end of first process (Kshs/Litre)
R 100
S 40
T 100
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Alternatively further processing of each individual product can be undertaken to produce an

enhanced product. Additional cost and subsequent sales value is as follows;
Product Subsequent Sales value

Processing cost after final process
Kshs Kshs
R 140 200
S 20 80
T 60 160
Required
Allocate the joint process cost to the three products using the four methods of allocation
LESSON FIVE
COST ACCOUNTING SYSTEMS
5.0: INTRODUCTION
The main purpose of this lesson is to identify and discuss the different accounting systems that an
entity can employ in preparing and maintaining its cost accounting books

 Apply the interlocking cost accounting system to prepare and maintain costing
records
 Identify the reasons why financial accounting profit will not be the same as costing
profit in an interlocking system
 Reconcile the profit as per financial books with that as per costing books
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 Apply the integrated cost accounting system to prepare and maintain costing
records
5.2: OVERVIEW OF COST ACCOUNTING SYSTEMS

In cost account accounts, extensive use is made of control accounts which are based in the same
principles as those used in financial accounts. Two basis accounting systems are normally used:
 Interlocking Cost Accounting System
 Integrated Cost Accounting System.
5.2.1: INTERLOCKING COST ACCOUNTING SYSTEM:

Under this system, separate cost accounting and financial accounting books are maintained although
both use the same basic accounting data. The financial accounting books have the normal and credit
entries within themselves. In addition, a memorandum account also known as Cost Ledger Control
accounts is maintained and all the items to be transferred to the cost accounts are posted in this
account.
Cost accounting books on the other hand contain impersonal accounts necessary for costing
purposes in addition to a Financial Ledger Control Account, also known as Cost Ledger Control
Account which enables the financial and Cost Ledger to be interlocked. The interlocking cost
accounting system, costing and financial profit differ and have therefore to be reconciled at the end
of the financial year.
Required Ledgers
a) General Ledger Adjustment Account:

It is sometimes called the cost ledger account. All the items extracted from the financial account
are recorded in this account. The balance in this account represents the total of all the balances of
the impersonal accounts extracted from the financial books. It completes the double entry in the
cost accounts.
b) Stores Ledger Control Account
This account shows all the transaction of materials e.g. purchases, issuance of materials, returns to
suppliers etc. The balance of this account represents in total the detailed balance of the stores
account.
c) Work in Progress Ledger Control Account
It shows the total work in progress at any particular time.
d) Finished Goods Ledger Control Account
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Receipts from production and transfer to distribution department are entered in this account and the
balance of this account shows the total value of finished goods in stock.
e) Production Overheads Control Account
This is recorded with amount of overheads incurred in the production process
f) Wages Control Account
This is recorded with the amount of wages incurred both direct and indirect
g) Selling and Distribution Overheads Control Account
This is recorded with the amount of selling and distribution overheads incurred
h) Administrative Overheads Control Accounts
This is recorded with the amount of administrative overheads incurred in the organisation
Journal Entries
i. Purchase of materials whether direct or indirect
Dr. Stores ledger control A/c
Cr. General Ledger Adjustment A/c
ii. Return of materials to suppliers
Dr. General Ledger Adjustment A/c
Cr. Stores Ledger Control A/c
iii. Issue of direct materials for production
Dr. Work in Progress Control A/c
iv. Return of direct Materials to the store
Dr. Stores Ledger control A/c
Cr. Work in progress Control A/c
v. Issue of indirect Materials from the store
Dr. Production overheads control A/c
vi. Return of indirect materials to the store
Cr. Production Overheads control A/c

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vii. Incurrence of wages
a. Direct wages
Dr. WIP control A/c
Cr. Wages control A/c
b. Indirect wages
Dr. Production Overheads control A/c
Cr. Wages Control A/c
c. Administrative wages
Dr. Administrative Overheads control A/c
d. Selling and distribution wages
Dr. Selling & distribution overheads control A/c
viii. Payment of wages
Dr. Wages control A/c
Cr. General Ledger adjustment A/c
ix. Absorption of production overheads
Dr. WIP control A/c
x. Actual production overheads incurred
xi. Over absorption of production overheads
Cr. Costing Income Statement
xii. Under absorption of production overheads
Dr. Costing Income Statement
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xiii. Absorption of Administrative overheads
Dr. Finished goods control A/c
Cr. Administrative Overheads control A/c
xiv. Actual Administrative overheads incurred
xv. Over absorption of Administrative overheads
Dr. Administrative overheads control A/c
xvi. Under absorption of Administrative overheads
xvii. Absorption of Selling & distribution overheads
Dr. Cost of sales control A/c
Cr. Selling & distribution Overheads control A/c
xviii. Actual Selling overheads incurred
Dr. Selling & distribution Overheads control A/c
xix. Over absorption of Selling and distribution overheads
xx. Under absorption of Selling and distribution overheads
xxi. Cost of finished goods transferred from production
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Cr. WIP control A/c
xxii. Cost of finished goods sold
Cr. Finished Goods control A/c
At the end of the costing period;
Dr. Costing Income statement
Cr. Cost of sales control A/c
xxiii. Sale of goods
Dr. General Ledger Adjustment A/c
Cr. Sales A/c
Dr. Sales A/c
Cr. Costing income statement.
xxiv. For the profit made
Dr. Costing income statement
Treatment of peculiar items
i. Carriage inwards on materials
Cr. General Ledger adjustment A/c
ii. Capital orders
This involves the incurrence of capital expenditure on the improvement of assets.
Dr. Capital order A/c
Cr. WIP control A/c
When the capital expenditure is capitalised;
Dr. General Ledger adjustment A/c
Cr. Capital order A/c
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iii. Special repair orders
Production may receive special repair orders from the other departments
a. When the repairs are complete;
Dr. Special repairs order A/c
Cr. WIP Ledger control A/c
b. Cost charged to respective department;
Dr. Respective Overhead control A/c
Cr. Special repair orders A/c
5.2.1.1: Reconciliation of profits disclosed in an interlocking system

When interlocking cost accounting system is applied, there will always be differences between the
profit shown in the financial accounts and that shown in the financial accounts even if there are no
errors in either accounts. This disparity in profits is caused by the different ways of recording
accounting entries in the cost books and the financial books. For this reason, the two profit figures
in the set of the two accounts should be periodically reconciled if they are to be meaningful. This
reconciliation is done using an account known as the Memorandum Reconciliation Account.
Differences between the profit figures in the cost books and the financial books are caused by
factors such as;
1. Items Shown only by one set of Accounts i.e. Items appearing in the financial accounts and
not in the cost books and vice versa.
(a) Item shown only in the financial books e.g
 Losses on disposal of assets

 Stamp duty and other expenses on issues and transfers of capital stock (shares,
bonds, debentures etc)
 Losses on investment
 Interest on bank loans
 Discounts on bonds and debentures.
 Dividends received
 Profits arising from sale of fixed asset
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 Dividends paid
 Rent receivable but excluding that portion receivable from sub-letting part of the
business premises if it has been included in the cost accounts.
(b) Items shown only in the cost books: These are normally notional charges therefore not real.
They include:
- Interest on capital employed in production
- Notional rental charges of premises owned
The above two notional costs represents the opportunity cost of employing the capital in the
business rather than investing it outside the business.
2. Different bases of Stock Valuation
Stocks are valued differently, in cost accounts and financial accounts; the financial stock is valued
at the lower of cost and net realizable value (mark value). The valuation of stocks in cost accounts
is either based on LIFO, FIFO or weighted average. This use of different bases in valuing stocks
will affect the profit/losses shown in the financial or cost accounts hence the need for reconciliation
of the two.
3. Different Treatment of Overheads
In cost accounts, indirect expenses are recovered as overheads based on estimated expenditure and
aligned with the estimated level of production. This results in under or over-absorption of
overheads and this must be taken into account when reconciling the profits of the two sets of
accounts. In the financial accounts, however, indirect expenses are recorded at the actual cost and
charged to the production account. Profit as per costing books is reconciled with that as per
financial books as follows;
Kshs
Profit as costing books xxxx
Add items not credited in costing books xxxx
Less items not debited in costing books (xxxx)
Profit as per financial books xxxx

NOTE
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Notional rent and Interest on capital not included in the reconciliation
Illustration
Maisha Ltd. operates separate cost and financial accounting systems. The following balances from
the final accounts of the company for both systems are available to you as the Company’s Financial
and Management Accountant.
Shs ‘000’
Net profits as per financial accounts 95,670
Net profits as per cost accounts 100,140
Dividends paid 1,800
Shs ‘000’
Loss due to theft and pilferage charged in financial accounts 1,290
Stock depreciation charged to financial accounts 630
Stores adjustment credited in financial accounts 345
Bank interest credited in financial accounts 900
Interest received, not included in cost accounts 675
Depreciation recovered in cost accounts 5,925
Depreciation charge in financial accounts 5,490
Excess administration cost recovered 6,375
Factory cost under-recovered in cost accounts 8,550
Required
A reconciliation of the company’s cost and financial accounts.
Solution
Maisha Ltd
Reconciliation Statement
Kshs Kshs
‘000’ ‘000’
Profit as per financial accounts 95,670
Deduct items increasing financial profit

Stores adjustment 630
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Bank interest 345

Interest received 675 (1,650)
Add items decreasing financial profit

Dividend paid 1,800
Loss due to theft 390
Stock depreciation 1,290
Tax premium 900
Depreciation charge 5,490 9,870
Deduct items tending to increase Costing profit

Depreciation 5,925
Excess administration costs 6,375 (12,300)
Add: Items in cost books tending to reduce cost profit

Factory cost under covered 8,550 8,550
100, 140
5.2.2: THE NATURE OF INTEGRATED ACCOUNTS

An integrated account, ledger system has a number of features which may be viewed as preferable
to the interlocking ledger system. In recent decade there has in fact been a move towards greater
integration of accounting information requirements in a single unified systems (an integrated ledger
system), such an integrated ledger system liars the following advantages:
i. There is only one set of accounting records which is kept with sufficient analysis to
enable the preparation of financial and cost accounting statements and to facilitate the
control mechanisms undertaken by financial and management accountants.
ii. There is only one profit and loss account. This removes the possibility of Senior
management confusion and frustration from the production of two seemingly different profit
figures.
iii. There is no requirement to reconcile cost and financial accounting records.
iv. There is a removal of the duplication of effort and cost which arises when separate
ledger are maintained.
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v. The integrated ledger system fits in with the use of computer based information
systems and a database approach to information availability and use.
Entries in the Integrated Ledger System
The integrated ledger system contains most of the entries in the interlocking ledger system. The
financial ledger control account is no longer in use. The range of asset and liability accounts
required for financial control purposes and for the preparation of financial accounting statements
will incorporate the entries which would have appeared in the financial ledger control account.
Journal Entries
a) Purchase of materials whether direct or indirect
Dr. Stores ledger control A/c
Cr. Creditors/cash/bank A/c
b) Return of materials to suppliers
Dr. Creditors A/c
c) Issue of direct materials for production
Dr. Work in Progress Control A/c
d) Return of direct Materials to the store
Cr. Work in progress Control A/c
e) Issue of indirect Materials from the store
f) Return of indirect materials to the store
g) Incurrence of wages
Direct wages
Dr. WIP control A/c
Indirect wages
Cr. Wages Control A/c
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Administrative wages
Selling and distribution wages
h) Payment of wages
Dr. Wages control A/c
Cr. Bank/cash A/c
i) Absorption of production overheads
Dr. WIP A/c
j) Actual production overheads incurred
Cr. Bank/cash A/c
k) Over absorption of production overheads
l) Under absorption of production overheads
m) Absorption of Administrative overheads
n) Actual Administrative overheads incurred
Cr. Bank/cash A/c
o) Over absorption of Administrative overheads
Dr. Administrative overheads control A/c
p) Under absorption of Administrative overheads
q) Absorption of Selling & distribution overheads
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r) Actual Selling & distribution overheads incurred
Dr. Selling & distribution Overheads control A/c
Cr. Bank/cash A/c
Xix. Over absorption of Selling & distribution overheads
s) Under absorption of Selling & distribution overheads
t) Cost of finished goods transferred from production
Cr. WIP control A/c
u) Cost of finished goods sold
Cr. Finished Goods control A/c
Dr. Costing Income statement
Cr. Cost of sales control A/c
v) Sale of goods
Dr. Bank/cash/debtors A/c
Cr. Sales A/c
5.3: ACTIVITY
Work out the illustration on Maisha Limited by starting with the profit as per costing books and
reconcile it to the financial accounting profit.
5.4: SUMMARY
In this lesson we have looked at the accounting systems that are applicable in the preparation and
maintenance of cost accounting books. We have also addressed the reasons as to why the net
income as generated in financial accounting books will not be the same as that generated in the
cost accounting books. In addition we have addresses the process of reconciling the two income
figures.
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Horngren And Foster, G. Cost Accounting. Latest Ed
QUESTION ONE
The following balances appeared in the cost ledger of Githurai Limited a manufacturing enterprise
as at 1/1/2011.
Kshs Kshs
General ledger adjustment 385,000
Stores ledger control 105,000
WIP ledger control 150,000
Finished goods ledger control 130,000
385,000 385,000
During the year to 31/12/2011 the following transactions took place;

Kshs Kshs
Material purchases 578,500
Materials issued;
To production 489,800
To special repair order 5,200
To capital order 24,800 519,800
Indirect materials 13,500
Materials lost through theft 6,300
Carriage inwards 13,200
Total wages paid;
Labour incurred on products 235,400
Labour on special order 2,400
Labour on capital order 4,300
Office salaries 45,000
Selling & distribution salaries63,500
Indirect production wages 32,700 383,300
Production expenses 39,700
Administration expenses 32,600
Selling & distribution expenses 46,400
Sales 1,250,000
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At the end of the year, the following balances were obtained;

Kshs
Stores ledger control account 142,000
WIP Ledger control account 162,000
Finished Goods ledger control account 123,000
Production overheads recovered 100,000
Administration overheads absorbed 80,000
Selling & distribution overheads charged 120,000
Production overhead charged to the capital order was Kshs 3,400 and to special repairs order Kshs
2,200. Special repairs order is to be charged to selling and distribution department.
Required
i. Enter the above transactions in the necessary accounts in the cost ledger
ii. Costing income statement.
QUESTION TWO
The cost accounting profit of Kitui Limited for the year ending 31/12/2011 was Kshs 92,000
whereas the financial profit for the same period was Kshs 60,000. A more detailed scrutiny of the
books of accounts reveals the following;
a) The cost accounting records indicate;
i. The opening stock as 1/1/2011 was Kshs 230,000 while the closing stock on
31/12/2011 was Kshs 308,000
ii. Production overheads recovered amounted to Kshs 136,000
iii. Administrative overheads were absorbed at the rate of 5% of sales
iv. Selling and distribution overheads were recovered at 7.5% of sales
v. Notional rent and interest on capital amounted to Kshs 16,000 and Kshs 12,000
respectively
b) The financial income statement for the year ending 31/12/2011 was as follows;
Kshs Kshs
Sales 2,000,000
Less cost of sales
Opening stock 280,000
Add purchases of materials 1,120,000
1,400,000
Less closing stock 320,000
Cost of materials consumed 1,080,000
Direct wages 480,000
Production overheads 140,000
Factory cost 1,700,000
Gross profit 300,000
Add other incomes
Discount received 30,000
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Dividends received 36,000

Interest received 24,000
390,000
Less expenses
Discount allowed 16,000
Administrative expenses 110,000
Debenture interest 10,000
Selling & distribution expenses 134,000 270,000
Net profit 120,000
Required
Reconcile the costing profit with the financial profit
QUESTION THREE
A manufacturing enterprise operates an integrated accounting system and had the following
opening balances as 1/1/2011;
Kshs Kshs
Issued share capital 1,600,000
Reserves 320,000
Creditors 170,000
Factory Buildings (Cost) 800,000
Plant and Machinery (cost) 600,000
Provision for depreciation:
Factory Building 160,000
Plant and Machinery 150,000
Debtors 200,000
Balance at Bank 300,000
Stocks:
Raw materials 160,000
Work in progress 190,000
Finished goods 150,000
2,400,000 2,400,000
The following information is provided regarding the transactions made during the year to
31/12/2011;
Kshs Kshs
Purchase of raw materials 1,360,000
Wages and salaries:
Direct wages (Including Kshs 20,000 accrued) 440,000
Indirect wages 70,000
Administrative salaries 120,000
Selling & distribution salaries 174,000 804,000
Production expenses 67,000
Administrative expenses 45,400
Selling & distribution expenses 77,000
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Cash payments;
Creditors 1,400,000
Wages and salaries 764,000
Cash receipts:
Debtors 2,900,000
Discount allowed 50,000
Overheads recovered:
Production 250,000
Administration 170,000
Selling & distribution 240,000
Provisions:
Depreciation on buildings 16,000
Depreciation on plant 30,000
Bad debts 10,000
Factory cost of completed goods 1,960,000
Factory cost of goods sold 1,990,000
Sales 3,000,000
Material issues;
Production 1,320,000
Works maintenance 80,000
Required
i. Enter the above data in the necessary ledger accounts
ii. Income statement for the year ending 31/12/2011
iii. Statement of financial position as at 31/12/2011
QUESTION FOUR
More Ltd. is a medium size manufacturing company and it maintains separate cost and financial
accounting books. The financial accountant provided the following statement for the year ended 31
March 2012.
More Ltd
Manufacturing, Income Statement
for the year ended 31 March 2012
Kshs. Kshs.
Direct materials
Add: purchases 1,800,000
1,950,000
Less: closing stock 200,000
Direct materials cost 1,750,000
Add: direct wages 250,000
Prime cost 2,000,000
Add: factory overheads 300,000
2,300,000
Add: opening work-in-progress 125,000
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2,425,000
Production cost carried forward 2,295,000
Sales 4,500,000
Less cost of goods sold
Production cost brought forward 2,295,000
2,535,000
2,280,000
Gross profit 2,220,000
Other incomes
Income from investment 1,094,000
1,139,000
3,359,000
Expenses
Depreciation 280,000
Interest on loan 36,000
Debenture interest 25,000
Administration expenses 600,000
941,000
Net profit 2,418,000
The records from cost accounts showed the following:

1. Stock valuation as at 31 March were as follows:
2011 2012
Sh. Sh.
Raw materials 160,000 196,000
Work-in-progress 121,000 125,000
Finished goods 258,000 260,000
2. Factory overheads were absorbed at 15% of direct material costs.

3. Other costs included:
Sh.
Interest on capital 140,000
Notional rent 420,000
Administration expenses
over absorbed 32,000
Selling & distribution expenses
over absorbed 25,000
Depreciation 242,000
4. Profit as per costing books was Kshs 2,328,400
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Required:
Prepare a profit reconciliation statement for the year ended 31 March 2012
96

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BAC 404 COST Accounting II Module Fourth year

Accounting for Assets (Kenyatta University)

Studocu is not sponsored or endorsed by any college or university

INSTITUTE OF OPEN DISTANCE AND E-LEARNING

DEPARTMENT OF ACCOUNTING AND FINANCE

BAC 404-COST ACCOUNTING II

WRITTEN BY: EDITED BY: A.O ONGIRI

1.3: PURPOSE OF COST ACCOUNTING..............................................................................8

1.4: ROLE OF COST ACCOUNTING IN BUSINESS MANAGEMENT....................................10

2.3.1.1: Simple Regression 16

2.3.1.2: Multiple Regression 23

2.3.2: LEARNING CURVE METHOD...............................................................................27

2.3.2.1: Limitations of the Learning curve method.....................................................31

2.3.3: SIMULATION METHOD.......................................................................................31

2.5: FURTHER READING..................................................................................................39

3.1.1.1: Valuation of Work In Progress 44

3.1.1.2: Process Cost Report 49

3.1.1.3: Process Losses 51

3.4: OTHER COSTING METHODS............... 60

3.4.2: UNIFORM COSTING...........................................................................................64

4.3.2: Constant Gross Margin Rate..............................................................................67

4.3.3: NET REALIZABLE VALUE.....................................................................................67

4.3.4: Sales Value at Split Off point..............................................................................68

4.4: ACCOUNTING FOR BY-PRODUCTS............................................................................68

5.2.1.1: Reconciliation of profits in an interlocking system 77

5.2.2: THE NATURE OF INTEGRATED ACCOUNTS.........................................................82

1. Overview of cost accounting

2. Advanced cost estimation methods

4. Allocation of joint costs

5. Cost accounting systems

1.1: LECTURE OBJECTIVES

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

1.2.1: COST ACCOUNTING VIS A VIS OTHER ACCOUNTING SUBJECTS:

ii. Management Accounting

1.3: PURPOSE OF COST ACCOUNTING

b) Planning and Budgeting

1.4: ROLE OF COST ACCOUNTING IN BUSINESS MANAGEMENT

b) Quality control department in comparing one batch of product with another in

c) Cost management department in the quantification and valuation of actual loses as

Business Management involves planning, organizing, staffing, directing and controlling an

1.5: COSTING TERMS AND CONCEPTS

g) Cost benefit approach

1.8: FURTHER READING

 Drury, C. (2004). Management and Cost Accounting. 6th Ed, ELST.

1.9: SELF TEST QUESTIONS

ii. Describe the main purposes of Cost Accounting.

iii. Distinguish between Cost Accounting and Financial Accounting

2.1: LECTURE OBJECTIVES

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

2.3: MAIN METHODS

2.3.1: REGRESSION ANALYSIS

Y = a + b 1 X1 + b2 X2 + …….bn Xn for n independent variables.

2.3.1.1: Simple Regression

UNITS LABOUR COST

b= 12(130202) - 423(3549) = 61,197 = 5.435

a = 3549 - 5.435 (423) = 295.75- 191.58 =104. 17

TESTING THE RELIABILITY OF A COST FUNCTION

Test of Economic Plausibility

Test of goodness of fit for the whole model

Confidence level = Point Estimate + (Z or t-value) *Se

ii. Coefficient of Determination (r2)

r2 = na∑Y + nb∑XY- (∑Y)2

r2 = (12*104.17*3549) +(12*5.435*130,202)- (3549)2

r2 = (12104.173549) +(125.435130,202)- (3549)2