MA2 Study Notes 2021-22

ACCA Diploma in Financial and
Management Accounting (RQF Level 3)
MA2
Managing Costs and Finances
STUDY NOTES
2021-22
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Contents
PAGE
INTRODUCTION 1
KEEP UP TO DATE! 3
SESSION 1 – MANAGEMENT INFORMATION 5
SESSION 2 – COST CLASSIFICATION AND COST BEHAVIOUR 9
SESSION 3 – ELEMENTS OF COSTS 23
SESSION 4 – MARGINAL COSTING AND ABSORPTION COSTING 51
SESSION 5 – PRODUCT AND SERVICE COSTS 57
SESSION 6 – ESTIMATING COSTS AND REVENUES (CVP ANALYSIS) 69
SESSION 7 – CASH RECEIPTS AND PAYMENTS 103
SESSION 8 – MANAGING CASH SURPLUSES AND DEFICITS 115
SESSION 9 – INFORMATION FOR COMPARISON 121
SESSION 10 – REPORTING MANAGEMENT INFORMATION 129
ANSWERS AND MISSING SECTIONS 135
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P.4 KAPLAN PUBLISHING
Introduction
Format of the examination

Number of marks
50 objective test questions (multiple choice, number entry and multiple response) 100
Each question is worth two marks each.
Questions assess all parts of the syllabus and will include both computational and non-
computational elements.
Total time allowed: 2 hours
Examination technique
• You can take a CBE at any time during the year – you do not need to wait for June
and December exam sessions.
• Be sure you understand how to use the software before you start the exam. If in
doubt, ask the assessment centre staff to explain it to you. Questions are displayed
on the screen and answers are entered using keyboard and mouse.
• Don’t panic if you realise you’ve answered a question incorrectly – you can always go
back and change your answer.
• Read the questions carefully and work through any calculations required. If you don’t
know the answer, eliminate those options you know are incorrect and see if the answer
becomes more obvious. Remember that only one answer to a multiple-choice question
can be right!
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MA2 – MANAGING COSTS AND FINANCES
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Keep up to date!
RELEVANT ARTICLES FROM ACCA STUDENT

ACCOUNTANT
Month/Year Title
August 2015 Effective presentation and communication of information using charts
November 2012 Accounting for joint products
All articles can be found on the ACCA website at: www.accaglobal.com
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Session 1
Management information
SYLLABUS CONTENT
(a) Nature and purpose of internal reporting
(b) Management information requirements
(c) Maintaining an appropriate cost accounting system
NATURE AND PURPOSE OF INTERNAL REPORTING

Internal reporting processes will be important as a means of making plans for the future,
exercising control over an organisation, and as a means of recording performance.
The information reported to management can be either financial in nature or non-financial, both
types of information will be important for decision-making purposes and evaluating
performance.
Financial information will include information on costs, revenues and profits whereas non-
financial information will include such things as labour hours, labour efficiency, labour turnover
and normal losses.
The type of information reported to management and acted on will depend on the nature of the
responsibility centre
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Responsibility centres
Cost centre
A cost centre is where managers are accountable for the expenses that are under their control.
Profit centre
A profit centre is where divisional managers are responsible for both costs and revenues. Profit
may be measured in absolute terms (a $ figure) or in relative terms (as a percentage of
turnover). Divisional managers are held accountable for sales as well as costs. Decisions on
investments are taken at head office level.
Investment centre
An investment centre provides divisional managers with responsibility for investment as well as
costs and revenues. Divisional managers are encouraged to plan, control and make decisions
for the costs, revenues and investments with which they are entrusted. It is normal to measure
divisional performance by relating profitability to investment.
Management information requirements

Information is data that has been processed in order to give it meaning. The characteristics of
good information include:
1 Complete
2 Relevant/appropriate for the particular purpose
3 Timely
4 Objective/accurate
5 Understandable
6 Significant
7 Communicated
8 Confidence inspiring
The role of IT
It can provide a number of advantages:
• it is quicker
• it can be more accurate
• it can deal with a greater volume of information
• it can deal with more complex information
• it can be used as a database for information.
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SESSION 1 – MANAGEMENT INFORMATION
DIFFERENCES BETWEEN FINANCIAL AND MANAGEMENT

ACCOUNTING INFORMATION
Difference with regard to Cost and management Financial accounting
accounting
Purpose To aid planning for the future, to To report historic financial

ensure the business is operations performance.
are well controlled and to aid
decision making.
Who produced for Internal management and External users such as

decision makers. shareholders.
Format/presentation Can be personalised to the Is standardised for all

organisation’s needs. organisations in a prescribed
format in order to aid
comparisons between
organisations.
Legal requirements None Lots
Nature of information Forward looking Backward looking
Time scale Can be produced as often as the Typically prepared once per
organisation requires – often daily year
Costing bases
Costing bases represent the timing of providing information. In cost and management
accounting information can be:
(a) historic,
(b) standard, or
(c) budget.
Standard is a plan for a unit of output. Standards represent the building blocks upon which
budgets are based. A budget is a plan for a total number of units. E.g. Standard costs for one
chair may be $10 whereas for 10 chairs we would describe the cost as a budgeted cost of $100.
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Costing methods
Specific order Continuous operation

costing costing
Job costing Batch costing Process Service

costing costing
Specific order costing: the basic cost accounting method applicable where work consists of
separate jobs, batches or contracts.
Job costing: this is where each unit we make is separately identified and needs costing
individually (i.e. each unit is different from the next).
Batch costing: units produced are produced in batches e.g. the shoe industry where
batches of style, colour and sizes of shoes are produced. (This costing method can also
be treated as job costing if the cost of the whole batch is of interest to us.)
Continuous operation costing: the costing method applicable where goods or services result
from a sequence of continuous or repetitive operations or processes. Costs are averaged over
the units produced during the period.
Process costing: units undergo several processes e.g. food processing, papermaking,
brewing.
Service costing: relate to the service industry e.g. costing of airline seats, hospital beds.
MAINTAINING AN APPROPRIATE COST-ACCOUNTING

SYSTEM
Cost accounts are maintained for each of the key costs in a manufacturing systems such as
labour, materials, overheads and inventories (often divided by stage of production such as
work-in-progress or finished goods). On the debit (left) side of the account (usually referred to
as a ‘T’ account due to its shape) money spent or costs added get recorded, whilst any outflows
(such as transfers to other accounts) are recorded on the credit (right) side of the account.
Date Narrative $ Date Narrative $
This states
where the
double entry
is posted
T accounts are then opened for each asset/liability and for each type of expense/income.
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Session 2
Cost classification and

cost behaviour
SYLLABUS CONTENT
(a) Cost classification
(b) Cost behaviour
What is a cost?
A cost is a measurement in financial terms of the amount of a resource (materials, labour or
other expenses) consumed for a specific purpose.
Cost objective
A cost objective is any activity for which a separate measurement of costs is desired. In other
words if the user of accounting information wants to know the cost of something, this something
is called a cost objective. E.g. cost of a product; the cost of rendering a service to a bank
customer or hospital patient; the cost of running a department or sales territory. Indeed anything
for which one wants to measure the cost of resources used.
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Cost units
A cost unit is a unit of product or service (a single item, a batch, a job or contract) in relation to
which costs may be ascertained and expressed. The cost unit is the basic control unit for
costing purposes.
Examples of cost units
Business Cost unit
Brewing Barrel/hectolitre
Car manufacturer Car
Hotel and catering Room/cover
Professional services
(accountants, architects, lawyers) Chargeable hour
Education (a) Enrolled student
(b) Successful student
(c) Number of lectures
(d) School meal
Healthcare (hospitals) (a) Bed occupied
(b) Out-patient
Activity
Building service Square metre
Materials storage/handling (a) Requisition
(b) Unit issued/received
(c) Value issued/received
Personnel administration Employee
Unit issued/received (a) Number
(b) Value
Telephone service (a) Call made
(b) Extensions
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SESSION 2 – COST CLASSIFICATION AND COST BEHAVIOUR
COST CLASSIFICATION
Cost classification may be defined as: the arrangement of items in logical groupings with
reference to their nature and the purpose to be fulfilled.
Examples may be:
1 By function
2 By unit of product or service or by activity level
3 By degree of control
4 By extent of relevance
1 By function
In an organisation which manufactures and sells products the functional nature of the
business – and hence the cost classification – results from the ‘functions’ that the
business performs, such as:
• Production (making, finishing, packing)
• Services (maintenance, power)
• Administration (office tasks,)
• Selling (marketing)
• Distribution (delivering goods to customers)
Before we explain some of the costs involved in such businesses, it is important that you
understand the concept of a cost centre. A cost centre may be defined as any point at
which costs may be gathered in order to control cost, fix responsibility and enable costs
to be re-charged on an equitable basis. Each cost centre may be the responsibility of one
management member, which will have costs charged to it and will have costs re-charged
from it. The re-charging of costs may be made to products or to other cost centres.
Production costs centres

Costs from making, finishing and packing cost centres will be charged to products, which
pass through each cost centre. The basis on which such costs will be charged to the cost
centres and from there to product units will be discussed later.
Maintenance and power cost centres

Costs from the maintenance and power costs centres will be charged to other cost
centres, which make use of such services.
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Administration, selling, distribution cost centres

Costs from administration, selling, and distribution cost centres will be charged to
products as they are sold and will therefore become part of the cost of sales. They do not
normally perform a service for other cost centres and are not, therefore, charged to other
cost centres.
Within each cost centre, costs may be analysed into materials costs, labour costs and
other expenses.
Production costs
Are those incurred in converting the raw material into finished products, which are then
passed into the finished goods store before being sold to customers.
Service costs
Are those incurred in providing services, which are required in order that the production,
administration, selling, and distribution functions may be efficiently implemented.
Examples of service costs are those applicable to the operation of a maintenance
department or to the operation of a power department. The way in which service costs
are charged to the cost centres using each service is an important aspect of the control of
such costs.
Administration costs
Is the sum of costs associated with the overall management of the enterprise, which
cannot be readily identified with one of the other major functional areas.
For example the salary of the factory manager would be seen as a production cost. But
the salary of the personnel officer would be viewed as an administration cost, since the
personnel function does work for all the other functions in the enterprise.
Selling costs
The sum of costs associated with securing of orders from customers.
For example, salaries paid to the salesmen and expenditure on advertising.
Distribution costs
Is the sum of costs associated with warehousing of products and delivery to customers.
For example, wooden pallets on which products are stacked for delivery to customers,
cost of delivery using own vehicles or outside firm.
Other costs
Financial costs are those costs of financing the business such as interest payable on
loans.
Research and development costs are the costs which arise from:
• Expenditure incurred in seeking new products
• Expenditure incurred in the development of new ideas which may be implemented

into the production plan
EXERCISE 1
Cost classification
The following list of cost items has been prepared for the four-week period ended 30th June
200X
$
Raw material cost 10,400
Advertising expenditure 8,000
Packaging for delivery to customers 1,200
Cost and management accounting salary 7,500
Production workers wages 8,400
Sales people’s salaries 6,300
Service dept costs (see note 1) 2,700
Production manager’s salary 1,800
Delivery vehicle running costs 600
Sales office costs 4,100
Delivery vehicle driver’s wages 1,300
Special design costs relating to product X 500
Note 1:
Service costs are estimated to have been used in providing services to the other functions as
follows: production 60%, administration 15%, selling 10%, distribution 15%.
Required:
Prepare a cost summary for the four-week period to 30th June 200X which shows the total
costs analysis for each function and for the overall business.
EXERCISE 2
1 Material cost may be analysed into:
Direct material cost $9,000
Indirect material cost $1,400
2 Production worker wages may be analysed into:
Direct wages cost $6,500
Indirect wages cost $1,900

Required:
(a) Prepare a cost summary for the four-week period ended 30 June 200X, which takes into
account the additional analysis given above.
(b) Calculate the average unit cost for each element of cost where 100 units are produced
and comment on the accuracy of the average unit cost.
EXERCISE 3
The data from Exercise 2 has been amended to incorporate the following:
1 100 units of a single product were produced in the four-week period ended 30th June
200X.
2 No inventory of finished goods existed at the beginning of the period.
3 The company sold 80 units at a price of $650 per unit.
You are required to prepare a profit and loss account for the four-week period ended 30th June
200X.
2 By unit
In a cost and management accounting system it is important to charge production costs
to cost units for a number of reasons.
1 To give an inventory valuation for balance sheet valuation and profit measurement.
2 To assist in the estimation of a selling price quotation, which will give a reasonable
profit.
3 To assist in budgetary planning and control.
Direct costs are a cost, which can be identified with and allocated to a cost centre or
cost unit. E.g. rubber to make tyres, wood to make chairs.
Indirect costs are costs, which cannot be allocated, but which can be absorbed, by cost
centres or cost units. Indirect costs are commonly referred to as overheads.
E.g. brush used by a worker who sweeps the factory floor.
Direct material costs include materials, which may be readily identified with product
units. E.g. cost of timber used in the manufacture of a chair.
E.g. glue used to bond joints in the assembly of a chair.
Direct labour cost includes the wages paid to workers who are directly involved in the
conversion of raw materials into finished goods.
E.g. wages paid to a machine operator preparing limber pans for a chair or wages paid to
a worker assembling the chair.
Indirect labour cost refers to the wages paid to workers whose efforts cannot be readily
identified with specific product units or batches.
E.g. wages paid to a worker who sweeps the wood shavings from the factory floor.
Direct expenses. These are items other than direct material and direct wages cost which
may be readily identified with specific product units.
E.g. special design costs or royalty payment is made for the right to produce a product
under licence.
Indirect expenses are usually called overheads. All items, which have not previously
been defined as direct costs fall into this category. Indirect materials and indirect labour
may also be classified as indirect expenses or overheads.
Product costs are those, which can be identified with a product in getting it into a
condition such that it is ready for sale to a customer. Product costs include all costs
incurred up to the point where the product is transferred into the finished goods store. It
includes direct materials, direct wages, direct expenses and production overheads.
Period costs are those which are related to the operation of an enterprise for a specific
time period rather than being related to the production of the enterprise. Administration,
selling and distribution costs are seen as having been incurred in achieving sales in the
period and are therefore written off in the period in which they arise.
The total costs of a unit $

Direct materials X
Direct labour X
Direct expenses X
–––
Prime costs X
Add: Production overheads X
–––
Production costs (factory costs) X
Add: Administration X
Selling X
Distribution X
–––
Total costs X
–––
3 By degree of control
A controllable cost, may be defined as a cost that is reasonably subject to regulation by
the manager with whose responsibility that cost is being identified. If this condition does
not hold then clearly the cost should be classified as non-controllable by the manager.
E.g. labour and materials are normally controllable costs whereas costs such as factory
rent, advertising expenditure and depreciation are non-controllable. However, such non-
controllable cost will be controllable at higher management level.
4 By extent of relevance
Relevant costs are those future costs that will be changed by a decision, whereas
irrelevant costs are those that will not be affected by the decision.
E.g. you are faced with a journey either by car or public transport.
Car tax, insurance costs are irrelevant since they will remain the same whatever
alternative is chosen.
However petrol cost for the car differ depending on which alternative is chosen and this
cost will be relevant for decision-making.
E.g. do you make or buy a component.
To buy will cost $1,000 from an outside supplier.
To make we have: Direct material $200
Direct labour $300
Variable overheads $400
Fixed overheads $500
Avoidable and unavoidable costs

Avoidable costs are those costs that may be saved by not adopting a given alternative,
whereas unavoidable costs cannot be saved. Avoidable costs are relevant for decision-
making purposes.
E.g. In the previous example the fixed costs of $500 are unavoidable and are irrelevant,
but the $900 are avoidable and hence relevant.
Incremental costs/revenue (differential costs)

These are the additional costs or revenues that arise from the production or sale of a
group of additional units.
Sunk costs
These costs are the costs of resources already acquired where the total will be
unaffected by the choice between various alternatives. They are costs that have been
created by a decision in the past and which cannot be changed by any decision that will
be made in the future. Sunk costs are irrelevant for decision-making purposes.
E.g. purchase price of materials in inventory which are already in inventory represents
sunk costs. However, if needed to be replaced the replacement cost is a relevant cost.
Opportunity costs
An opportunity cost is a cost, which measures the opportunity which is lost or sacrificed
when the choice of one course of action requires an alternative course of action be given
up.
E.g. materials in inventory not used regularly.
The materials can either be sold or used in a contract.
The decision to use the materials in the contract means loss proceeds. The loss
proceeds represents the opportunity costs of using the materials.
COST BEHAVIOUR
In this section we consider how costs behave as activity level or output level increases. To
avoid confusion always make sure that you understand whether the explanation or description
applies to the total value, marginal or average value of a cost (also known as unit cost).
Marginal cost refers to the additional costs incurred from producing one more or less unit of
production and is particularly important for profit-maximising decisions by the organisation. You
may also find that you have to be able to recognise the appropriate graph for each type of cost
in a multiple choice question.
Total fixed costs

These are those costs which over certain output limits are unaffected by changes in the level of
activity. They are incurred as a consequence of the passing of time and are consequently
known as ‘period costs’. E.g. rent of the premises, rates, advertising expenditure. As a
consequence the graph will be as below:
Cost $
Activity or output
Average or unit fixed cost
Notice that this must regularly fall. This is the idea of ‘spreading your overheads’. It must fall
because the average fixed cost multiplied by the number of units must be the total fixed cost
and this must remain the same, no matter how many units of output are produced.
Cost $
Activity or output
Total variable costs
These are costs which vary or change directly with the level of activity. E.g. direct materials or
direct labour.
Cost $
Activity or output
Average or unit variable cost
Total Cost
From the previous cases, we can see that the total cost is the addition of total fixed cost and
total variable cost i.e.
Total cost = Total fixed cost + Total variable cost
For example say that a business has estimated that its total fixed costs are $25,000 per month
and that its average variable costs are $10 per unit, what are the total costs for a month in
which output is expected to be 3,000 units?
Cost $
Activity or output
Semi-variable costs
These types of costs have both a fixed and a variable element to them. This means that these
costs are partly affected by changes in activity level. There are different situations that can arise
that result in different types of graph, so be careful to read the question carefully.
EXAMPLE 1
Standing charge
Many utility providers have a standing charge to cover their fixed costs but an additional charge
is incurred based on the usage. This last element is therefore variable, rising with activity. If the
standing charge is $800 then the graph will be as below:
Cost $
Activity or output
EXAMPLE 2
Bonus payments on top of basic salary
In this case the bonus payments are not made (and therefore no variable cost element is
incurred) until after a certain level of activity is reached. For example a basic salary of $15,000
per annum is paid but after sales reach 50 units a bonus is paid for each unit sold.
Cost $
Activity or output
Stepped costs (semi-fixed costs)

We described earlier fixed costs as being unaffected by changes in activity within certain output
limits. The concept of semi-fixed costs arises if we consider what happens to costs if we
increase output beyond these limits. For example rent was used as an example of a fixed cost.
We suggested that if activity increased, the cost of rent would remain the same. However, this is
only true up to certain point. There would eventually come a point where the current premises
would be incapable of supporting the higher level of activity and additional space would be
required. This would increase the total costs to a new level but these would remain fixed until
output once again reached a point where additional space was required.
Costs that behave in this fashion are referred to as stepped (semi-fixed) costs and they
behave as below:
Cost $
Activity or output
Separating out cost elements: the high-low method

This approach uses only two items of information: the cost of the highest output and the cost
of the lowest output. Both of these outputs will include the total fixed cost which will be the
same for both. Thus if we were to subtract the total cost of one from the other we must be left
with the total variable cost for a particular number of units.
By deducting the units of output from each other we can determine the number of units. If we
then divide the total variable cost by this quantity we can identify the unit variable cost. This
information can then be used at either level of output levels to identify the total fixed cost
element. Having then identified both unit variable cost and total fixed cost it is possible to
forecast the total cost for any other level of output. In effect we are making use of the fact that
the total cost equation takes the general form:
TC = TFC + bq
Where:
q = activity level or output level
b = unit variable cost
This technique is the basis of many questions. Therefore make sure that you understand the
following example.
Worked example:
A business has recorded the following information:
Total Costs ($) Output units

Month 1 560,000 50,000
Month 2 480,000 40,000
Month 3 410,000 35,000
Required:
Estimate the costs expected for the next month where the following activity level is expected to
arise:
Month 4 55,000 units
Solution
Highest units: 50,000 Total cost: $560,000
Lowest units: 35,000 Total cost: $410,000
Difference 15,000 $150,000
Thus the variable cost per unit must be = $150,000/15,000 = $10.00
At 50,000 units re-arranging it must be true that:
Total fixed cost = Total cost – Total variable cost
= $560,000 – ($10.00 × 50,000) = $60,000
Thus:
Total cost = $60,000 + 10q where q = number of units or activity
Therefore for Month 4:
Total cost = $60,000 + ($10.00 × 55,000) = $610,000.
EXERCISE 4
A business has recorded the following information for the last six months:
Total Costs ($) Output units

January 48,100 4,200
February 49,900 4,700
March 50,500 4,800
April 54,700 5,400
May 55,400 5,100
June 48,500 4,500
July 4,400
Required:
Estimate the total costs expected for July.
Comments on technique
1 Not very reliable as it does not use all data: regression is better.
2 Be careful where extrapolation or interpolation is involved.
3 Sometimes examiners like to make life difficult and the highest output does not
correspond to the highest cost and the lowest output to the lowest cost. Remember to
use the cost of the highest and lowest output.
Session 3
Elements of costs
SYLLABUS CONTENT
(a) Materials
(b) Labour
(c) Expenses
(d) Overheads
MATERIALS
How do goods move through the organisation?
Inventory arises as both ends of the production process. In order to produce the final product
and avoid the problem of downtime in production we need to hold inventories of raw material.
But inventories of finished goods are also needed at the end of the production process if we
wish to avoid the problem of a potential stockout and a loss of customers.
There are three basic issues that can be asked about in an exam question:
(a) The documentary procedures involved in receiving and issuing inventory: for this refer to
your study text.
(b) How do we value inventory in the company?
(c) How do we control inventory levels and what is the optimal amount of inventory to re-
order?
INVENTORY VALUATION METHODS OR ISSUE PRICING

There are two problems in terms of inventory valuation:
First what costs are included in the valuation of inventory?
This is referred to as the product cost and is the cost of making or buying the inventory item.
Accounting standards require that this is the total manufacturing costs. This would therefore
include direct materials, direct labour, direct expenses (= prime cost) and variable and fixed
factory expenses (notice that we would exclude any non-manufacturing costs).
Secondly how do we deal with the problem of valuing inventory as inventory levels change over
time?
Inventory comes into a cost centre at different points in time. To illustrate the different kinds of
solutions that can be applied to this problem we use the following example:
EXAMPLE 1
A company produces bedside cabinets and examination of the bin records for June showed that
5,000 drawer runners were purchased on the following dates and in the following quantities:
4 June 1,500 runners @ $5 each
10 June 500 runners @ $6 each
22 June 3,000 runners @ $4 each
The record also showed that materials requisition orders were received on:
7 June for 1,000 runners
12 June for 500 runners
We then have to calculate the material cost of each requisition. It would be unnecessarily time
consuming to try to identify the actual items of inventory and their value that were used to make
up a particular consignment of materials to satisfy the materials requisition requirement. How
then do we value the inventory or determine the inventory (materials) issue price?
There are five different methods of valuing inventory.
• FIFO
• LIFO
• Weighted average cost
• NIFO
• Standard cost (this is not relevant to our exam)
SESSION 3 – ELEMENTS OF COSTS
FIFO
Each issue of inventory is valued at the price paid for the material first taken into inventory from
which the issue could have been drawn. In simple terms we are saying that we are using the
earliest inventory first.
Notice that we can check our work in that the sum of the value column should be the same as
the multiplication of our closing balance price and quantity. Notice that there is also a quick way
of arriving at the balance for multiple choice questions in the exam. As we are using FIFO we
must always be left with the latest or most recent inventory as our balance. Thus if we calculate
the difference between purchases and issues in total (5,000 – issues of in total 4,500 = 500
balance), then this must of the 500 latest units acquired. We then count back 500 to find the
value. This would be 500 units of the 3,000 bought at $4. Therefore closing balance is $2,000.
However, this method needs to be treated with caution where returns have occurred.
LIFO
Each issue is valued at the price paid for the material last taken into inventory from which the
issue could have been drawn. In simple terms we are using the latest inventory first.
the multiplication of our closing balance price and quantity.
Weighted average cost or price
the multiplication of our closing balance price and quantity. Notice also that in this example it
doesn’t work and the reason for this is that we have rounded the weighted average cost or
price. The value that we should use for our inventory should be based on the vertical
summation. Horizontal multiplication uses the rounded weighted average cost.
NIFO
Under this method each issue of inventory would be valued at the price which is assessed as
the cost that will be paid for the next order to replace the materials. Adjustments are then
likely to be necessary to equate the issue value with the receipt value. Differences are adjusted
in the costing ledger through an inventory adjustment account.
Standard cost
Issues to production and inventory balances are valued at their standard price or cost.
Differences between the actual price of purchases and the standard price of purchases are
accumulated in a separate variance account for action outside the stores ledger. A major
advantage of this system is that there is no need to maintain value records in the stores ledger.
MATERIALS INVENTORY ACCOUNT

Using our FIFO example (as required by SSAP 9) the raw materials ledger account would
appear as below:
Credit side represents

Debit side decreases in raw
represents raw materials. This might be
material either returns to suppliers
purchases or issues to production
(increases in raw and therefore work in
materials) progress (wip)
Raw materials
$ $
Creditor 22,500 Work in progress 20,500
Bal. c/d 2,000
––––––– –––––––
22,500 22,500
––––––– –––––––
Bal. b/d 2,000
This represents closing

stock and should be the
same as that shown on the
stores ledger card
Note: Indirect materials are not debited in the work in progress account but are recorded as a
production overhead and included in the overhead absorption process (see later).
What happens if there is a raw material return?
Period 1
Raw material
Debit Credit
Purchase 1,000 x Issue 800 x
CF 200 x
1,000 x 1,000 x
Account closed off
Period 2
A return is in effect like having more of the raw material as far as the raw material account is
concerned and is therefore a debit entry, whereas the return is like a ‘sale’ for the wip and is
therefore a credit. When the return occurs both the wip account and the raw material account
will require adjustment as below:
Raw material
Debit Credit
BF 200 x x
Return 400
x x
NB: There will be other events before the account is closed off.
WIP
Debit Credit
RM received 800 x Return 400 x
CF 200 x
1,000 x 1,000 x
Account closed off
EXERCISE 1
Timber
Examination of the bin records for June showed that 9,000 metres of timber were purchased on
the following dates and in the following quantities:
4 June 3,000 metres @ $4 metre
The record also showed that materials requisition orders were received on
7 June for 2,000 metres
On 24 June 500 metres of timber were returned from the production department.
Required:
Prepare a tabulation of the movement of inventory over the month, showing the changes in the
level of inventory, its valuation per metre, and the total value of the inventory using FIFO, LIFO
and the weighted average cost basis.
Assuming that the company uses the FIFO method construct the raw materials ledger account
for this raw material.
INVENTORY MANAGEMENT
The problem is that there is a trade off between:
• The cost of holding inventories
• Order costs
• Stock out costs
Inventory control policy can be either aggressive or conservative but needs to take into account:
• Minimising inventory costs
• Appropriate ‘service level’/stock out frequency
• Smooth running/efficient inventory management systems
• Flexible inventory management system to meet changes in demand
Two basic inventory control systems:
1 Re-order level/2-bin system: fixed quantity being ordered at varying intervals
2 Periodic review system or constant order cycle system involves a varying quantity being
ordered at fixed intervals
And
3 Mixed system (mix the above)
4 Just in time (JIT) technique to minimise inventory levels by manufacturing at exact time
and in exact quantities customers require. JIT focuses on reducing waste. JIT should
reduce amount of working capital. JIT results in low ordering costs and thus the EOQ
approach will result in ordering small quantities at frequent intervals to minimise holding
costs.
Inventory control questions can be summarised by the following diagram:
How much to re- When to re-order?

order?
When demand and When demand and/or

lead time are known lead time are not
with certainty known with certainty
Inventory control formulae

The following formulae are used to determine the answer to the following issues and can turn
up in multiple choice questions. One of the most common confusions that arises is between the
re-order level and the re-order quantity. These two terms deal with different issues:
Re-order level = When we re-order
Re-order quantity = How much we re-order
There are only three basic formulae to learn and memorise. These are:
What is the re-order level?
The re-order level is the level of inventory holding at which replenishment of inventory occurs. If
we have instantaneous supply then this would be zero. However, if on inventory outs are
allowed then the re-order level is the maximum demand in the maximum lead time. In other
word’s we must have sufficient inventory to meet this demand.
EXAMPLE 2
It is estimated that the maximum amount of timber used in a day is 100 metres and that the
maximum delay between placing an order and receiving the materials is five days. Then the re-
order level will be:
What is the minimum inventory level?
This usually corresponds to the buffer inventory and it is the level below which we would not
normally expect inventories to fall. This can be calculated as:
Re-order level – (average usage per day × average lead time (days))
EXAMPLE 3
A company re-orders paint when the levels of its inventory fall to 2,500 litres. On average it
takes five days for deliveries of paint to arrive. The company uses on average 400 litres of paint
a day. Then the minimum inventory level will be:
What is the re-order quantity?
The re-order quantity is the amount of the item of inventory to be ordered each time the re-order
level is reached. If we are operating an EOQ system then the re-order quantity is the EOQ.
Re-order quantity = (Maximum inventory – re-order level or current inventory) + usage in lead
time (minimum usage per period × minimum lead time)
The above is simply the third formula we have to memorise re-arranged.
What is the maximum inventory level?
The maximum level of inventory is the peak holding i.e. the buffer inventory plus the re-order
quantity. The maximum level is the level above which the inventory should not normally rise. It is
the same formula as above but re-arranged. It is given by:
Re-order level + EOQ – (Min usage per day × Min. lead time per day)
EXAMPLE 4
A company re-orders 10,000 metres when its inventory falls to a level of 15,000 metres of
timber. On any one day the minimum amount of timber it will use is 450 metres. Delivery of
timber takes a minimum of 20 days. What is the maximum inventory it will hold?
EXERCISE 2
Flora Ltd provides the following information with regard to an item of inventory DCP/347x:
Minimum usage 5,000 units per month
Maximum usage 8,000 units per month
Maximum lead (delivery) time 2 months
Minimum lead (delivery) time 1 month
Re-order quantity 24,000 units
Required:
Calculate for item DCP/347x:
(a) Re-order level
(b) Maximum inventory level
(c) Minimum inventory level
(d) Average inventory level
ECONOMIC ORDER QUANTITY (EOQ)

This is for a re-order level system. When our inventory level falls to a pre-determined minimum
level how much inventory do we re-order?
The answer to this question is the EOQ.
There are two costs involved:
Annual order costs
Annual inventory holding costs
The model makes two assumptions:
1 Demand for the item being stocked is steady over time.
2 Instantaneous supply.
Stock
level
Order
quantity
0
Time
The smaller the size of each order, the greater will be the number of orders placed each year
and so the greater will be the annual order costs. This can be found as below:
Annual order costs = Annual demand × Cost per order

Order quantity
Or to put in the more usual symbol form we have:
Annual order costs = D × Co

Q
The larger the order quantity, the larger will be the average inventory level held and the greater
will be the annual inventory holding costs:
Order quantity
Annual inventory holding costs = × Cost of holding an item of inventory/year
2
Or to put it in the more usual symbol form we have:
Annual inventory holding costs = D × CH

2
Notice that there is a trade-off between these two costs and the quantity. Annual order costs will
fall with quantity whereas inventory holding costs increase as the size of the order increases.
This in turn means that the total cost will fall initially but then subsequently rise. From this we
can identify the economic order quantity:
Total annual costs

$
Annual stock holding
Annual order
Q Q
Total annual costs are minimised where the annual order costs are equal to the annual
inventory holding costs:
2 × Co × D
Q=
CH
Q = Economic Order Quantity
D = Annual Demand
Co = (Fixed) cost per order
CH = Cost of holding one item of inventory for one year
EXAMPLE 5
Simple EOQ
Monthly demand = 1,250 units
Cost per order = $10
Cost of holding 1 item for 1 year = $2
What is the economic order quantity?
EXAMPLE 6
EOQ with lead time
Taking the same data as before but this time we have constant demand but non-instantaneous
supply. Supply has a one-week lead time. How frequently do we place an order? How much
inventory must the company keep on hand?
Annual demand = 15,000
EOQ = 387
EXAMPLE 7
EOQ and quantity discounts
For this case we assume as before constant demand and instantaneous supply.
Given the following information:
D = 200,000 units
This is used to calculate
Co = $50 the cost of holding stock as
CH = $100 × 0.10 = $10
Price/unit = $100
Bank overdraft interest rate = 10%
A discount of 0.5% is offered on all orders of 2,000 units or more. Should we take the
discount?
EXERCISE 3
Simple EOQ
Aircon is a supplier of air-conditioning equipment for small businesses and annual demand for
its units are known to be 5,000 units. Each unit costs $800 to buy in from a manufacturer. It is
estimated that each order costs $150 to handle. The cost of holding an air-conditioning unit in
inventory for one year is estimated to be 10% of the purchase price.
What is the economic quantity order? How many orders will be placed each year and what are
total annual costs?
EXERCISE 4
Lead time included
Using the same information as in the example above. If it takes one week for an order to be
delivered i.e. we have a lead time of one week, how frequently do we place an order? How
much inventory must the company keep on hand? If the lead time falls to three days how does
this alter the answer?
EXERCISE 5
Large order discount included
Returning to the original example we now incorporate a discount to see if this alters the EOQ. A
0.5% discount is offered on orders of at least 150 units and a 1% discount on 200 units.
LABOUR COSTS
Introduction
Labour as a topic is less important than it used to be simply because today labour costs are
likely to be a relatively small part of total product costs. However, examiners still like to set
questions on this topic. The topic is less important than it once was because of changes in the
technology of manufacturing goods.
Direct and indirect labour

Labour can be divided into two broad categories:
Direct: labour that has worked directly on producing the product
Indirect: labour that has not worked on the product
Labour that has not worked on the product would include:
Maintenance
Canteen
Accountant
Some of these labour costs can be allocated on an equitable basis e.g. maintenance and the
canteen. However, other labour costs cannot be readily allocated. In this case the costs are
treated as period costs and are written off in the profit and loss account. For example the
services of the accountant cannot be readily allocated and these would be treated as period
costs.
Treatment of idle time/down time

This is time that has to be paid for but it is non-productive. In effect this means less is produced
than was expected. This situation needs to be controlled and investigated by management.
Such down time or idle time can be divided into:
Avoidable
This is production disruption due to machine breakdown, material shortage, poor labour
supervision, poor programming/scheduling. It can also arise as a result of policy decisions by
management such as: run down of inventories, changes in product specifications, retraining
programmes.
These are costs that should not have been incurred. If they were included in the product cost
then they would overvalue the product cost and they are therefore excluded from product
costs.
Therefore avoidable costs are written off to the P/L.
Unavoidable
These include tea breaks, rest periods, a decrease in the demand for the product.
This is a realistic cost of the product and therefore should be included in the cost of the
product.
Therefore unavoidable costs are included in product costs.
Paid labour hours

Actual paid labour hours = productive time + idle time.
EXAMPLE 8
Total hours paid for = 25,000
Idle time ratio = 20%
Wage rate = $4 per hour
What is the value of productive hours?
EXAMPLE 9
Actual hours taken = 2,520 hours
Idle time ratio = 10%
Wage rate = $4 per hour
What is the budgeted labour cost?
Overtime
Direct labour
This is incurred for two reasons:
1 To make up for lost time earlier in production – avoidable: this is charged to the
overhead production control account.
2 To produce more of the product than was originally anticipated – unavoidable: this is
included in the cost of the product.
THE TREATMENT OF AVOIDABLE OVERTIME

If additional hours are spent making the product then the cost of direct labour for these hours =
basic hourly rate. Only the overtime premium is the additional unnecessary cost and is
therefore written off to the production overhead control account. The basic hours are
included in the product cost as this was still time spent making the product.
Indirect labour
In general all costs of indirect workers will be included in the product through the use of an
overhead absorption rate in the production overhead control account. The only exception to this
is when overtime is worked at the specific request of the customer. In this situation the
overtime premium paid to indirect labour is included as the part of the product cost but not
the basic pay which still counts as production overhead.
Bonuses
A bonus is generally regarded as part of ordinary production cost units.
Recording labour costs

Wages control
Debit Credit
Cash (bank) x Wip (direct) x
Deductions x Prodn OH (indirect) x
x x
EXERCISE 6
A worker spends 10 hours on a job on Monday where his normal working day is 7 hours and his
basic rate of pay is $10 per hour. Overtime is paid for at time and one-half.
Required:
Calculate the gross wages for the day.
LABOUR MEASUREMENT TERMS

Labour turnover:
This measures the percentage of people leaving an organisation:
Number of leavers who need to be replaced

= × 100
Average number of employees
To be meaningful this figure is then compared with past figures.
Labour efficiency
In order to measure labour efficiency we will need to first define a standard hour as below:
Standard Hour:
This is the number of production units which should be achieved by an experienced worker
within the period of one hour.
Efficiency ratio:
Actual output measured in standard hours

=
Actual hours
EXAMPLE 10
Standard time per unit = 30 minutes
Actual output = 860 units
Actual hours worked = 412 hours
Budgeted hours = 400 hours
Calculate the efficiency ratio.
EXPENSES
This is all types of revenue expenditure not classified as materials or labour costs.
Notice that expenditure is either classified as:
Capital expenditure = Money spent on fixed Recorded on the balance sheet.

assets
Revenue expenditure = All other expenditure Treated as an expense in the

except capital profit and loss account in the
period when the expense was
incurred.
Notice that this classification can still create problems. If we replace the tyres on a vehicle what
type of expenditure is it? Normally it would be regarded as revenue expenditure as it is simply
maintaining and not increasing the amount of the fixed asset.
We can then classify two types of expense:
Direct = Can be attributed to a particular Recorded in wip control as

product or cost unit product cost
Dr: Wip control account
Cr: Cash/Creditors account
E.g. the running cost of the machine = Direct manufacturing expense

for the product
E.g. the packaging costs for the = Direct selling expense

product
Indirect = Cannot be attributed to a particular Recorded as part of overheads

product or cost unit
Dr: Production Overhead
Control Account
Cr: Cash/Creditors account
E.g. lighting/heating for the factory = Indirect manufacturing expense
E.g. cost of running vehicles = Indirect distribution expense
DEPRECIATION
This is a measure of the wearing out or consumption of the useful life of a fixed asset. It is
therefore a revenue expense that should appear in the profit and loss account.
It represents a means by which we can charge some of the initial cost of the fixed asset to the
accounts in each period that the asset is used. There are a variety of methods for charging such
as:
• Straightline
• Reducing balance
• Machine hours
• Product units method
Straightline
An asset was purchased for $20,000 with a useful life of four years and a resale value of $2,000
in year 4. What is the annual charge for depreciation?
Reducing balance
An asset was purchased for $20,000 with a useful life of four years. The asset’s value was to be
reduced over the four years and therefore a rate of 25% was used. The asset was sold in year 4
for $5,000. Show the amounts to be charged for depreciation.
Notice that the difference of $1,328.12 between the net book value recorded for year 4 and its
actual resale value of $5,000 would then be charged to the profit and loss account as a loss on
disposal of an asset in year 4.
Machine hours
A machine was purchased for $20,000 and has an estimated residual value of $5,000. The
machine is estimated to be operational for 16,000 hours over the next four years. In the first
year the machine was used for 2,000 hours. What is the depreciation charge for the first year?
Product units method

A machine costs $160,000 to buy and can produce a total of 24,000 units during its useful
economic life, at the end of which it will be sold for $10,000. It is expected to produce 10,000
units this year. Calculate the depreciation charge for the year.
OVERHEADS
Introduction
Overheads refers to production or ‘factory’ overheads.
Some overheads can be directly allocated to particular production departments, whereas other
overheads would have to be apportioned or shared out amongst the production departments
on some equitable or fair basis.
Why is the treatment of overheads important?

Direct costs @ 5%
Indirect costs @ 95% Consider rent
–––––
Total costs 100%
Why do we need to know the total cost?

The total cost is used to for establishing the selling price:
Selling price = Total cost + Profit
Mark-up Margin
This is the
basis of job
costing
Pricing, Profit Margins and Mark-up

In establishing the selling price we will need to add on to our total cost, our profit. There are two
different ways this can be done and the terms are often used interchangeably in the everyday
world. For our purposes this is not the case and we need to be careful with regard to exam
questions.
Mark-up Margin
Mark-up Margin
Profit is based on cost Profit is based on selling price
∴cost = 100% ∴selling price = 100%
Always use the fact that
Worked examples
1 Total cost is $500
Mark-up is 20%
Find the selling price
120% 100% 20%
∴100% = $500
∴ Selling price = 120% = $500 × 120 = $600

––––
100
2 Selling price is $700
Margin is 20%
Find the total cost
100% 80% 20%
∴100% = $700
∴ Total cost = 80% = $700 × 80 = $560

––––
100
3 Cost is $800
Margin is 35%
100% 65% 35%
∴65% = $800
∴ Selling price = 100% = $800 × 100 = $1,230.77

––––
65
4 Selling price is $1,750
Mark-up is 25%
Find total cost
125% 100% 25%
∴125% = $1,750
∴ Total cost = 100% = $1,750 × 100 = $1,400

––––
125
The above issue is not particularly difficult but often turns up in exam questions and is answered
incorrectly by students. Practise with further examples until you are confident. The more
examples you do the more confident you will be that you can get them right.
EXERCISE 7
(a) Selling price is $350 and mark up is 25% what is the total cost of the product?
(b) Selling price is $350 and margin is 25% what is the total cost of the product?
(c) Total cost is $875 and mark up is 25% what is the selling price of the product?
(d) Total cost is $875 and margin is 25% what is the selling price of the product?
OVERHEAD ALLOCATION AND APPORTIONMENT

The sequence to be followed is as below it is possible that you may be examined in any one of
these steps in exam questions:
Step 1: Allocate overheads
i.e. production overheads relating to a single production department are

allocated directly to that production department.
Step 2: Apportion overheads that relate to a number of cost centres between all the
relevant cost centres.
Note: There are different bases for doing this.
Step 3: Re-apportion service cost centre costs to production cost centre costs on an
appropriate basis. There are two different situations that can arise:
Non-reciprocal services Repeated distribution
Reciprocal services Algebraic method
Overhead analysis
A typical outline for overhead analysis is given below. Notice that totals sum both horizontally
and vertically. The materials are of course indirect materials that are allocated to production
departments that are part of the production overhead control.
Total Basis P1 P2 P3 S1 S1
Allocated
Materials X X X X X X
Expenses X X X X X X
Subtotal X X X X X X
Primary apportionment
Rent X Area X X X X X
Rates X X X X X X
Heat X Vol X X X X X
Light X X X X X X
Depreciation X $xx X X X X X
Subtotal X X X X X X
Secondary apportionment
S1 0 X X X (X) X
S2 0 X X X X (X)
Budgeted overheads X X X X 0 0
EXERCISE 8
The following data relates to the four departments in a factory:
Department Machining Assembly Maintenance Stores
Area occupied (m2) 1.000 2,500 300 1,200
Plant & equipment (NBV) 30,000 15,000 5,000 –
Number of employees 10 20 10 10
Volume occupied (m3) 5,000 15,000 1,000 4,000
Machine hours 58,000 30,000 12,000 –
Labour hours 1,600 4,000 1,500 2,000
EXERCISE 8
Overhead costs incurred in May were: $
Lighting 100
Heating 500
Electricity 500
Canteen 1,000
Building depreciation 1,500
Machine depreciation 1,200
Personnel 800
–––––
5,600
–––––
Prepare an 'overhead analysis sheet' showing the basis for apportionments made.
Service department re-apportionment

We re-apportion service department overheads to production departments so that these costs
can then be absorbed into cost units.
Two different situations can then arise.
NON-RECIPROCAL SERVICE DEPARTMENT’S COSTS

In this case we apportion the service department which services the other service department
first.
Example ABC
ABC Ltd incurred the following overheads in February in two production departments and a
service and maintenance department:
P1 P2 S1 M1
$100,000 $100,000 $30,000 $50,000
The following information also applies:
P1 P2 S1 M1
Hours of maintenance work 500 500 _ _
Number of stores requisitions 40 40 20
RECIPROCAL SERVICE DEPARTMENT COSTS
STORES services MAINTENANCE
In this case there are three different ways of solving the situation:
(a) The reciprocal method uses equations and substitution
(b) The repeated distribution method
(c) The specified order method – this is a crude approximation approach and is not as
accurate as the previous two
Example BCD
BCD Ltd incurred the following overheads in February in two production departments and a
service and maintenance department:
P1 P2 S1 M1
$100,000 $100,000 $30,000 $50,000
The following information also applies:
P1 P2 S1 M1
Hours of maintenance work 500 400 100 –
Number of stores requisitions 40 40 20
For all methods:

Sort out the basis of apportionment and put this onto a percentage basis.
Reciprocal or equation method

1 Work out the totals for the two service departments.
2 State each service department costs and the extra proportion.
3 Substitute in one equation and solve.
4 Using the service costs totals apportioned to each production department in the ratios
given by the question.
Repeated distribution method

Item Basis Total P1 P2 S1 M1
Specified order method

The first step is to identify the service department performing the most work. In above example
M1 provides 20% to S1. Apportion the other service department S1 ignoring the work done for
M1.
EXERCISE 9
A company has three production departments A, B and two service departments S1 and S2.
Each service department works for each of the production departments and the other service
department in the proportions given below.
A B C S1 S2
S1 50% 20% 20% – 10%
S2 30% 25% 40% 5% –
Overheads ($) for the period were:
A 45,000
B 65,000
C 50,000
S1 10,000
S2 20,000
Required:
Reapportion the overhead service costs to the production departments.
Why are overheads a problem in accounting for costs?

The simple answer to this is: Timing!
Consider the issue of time, the problem is illustrated below:
200X
January December
 
Selling price is established We now know our
now and therefore we have overheads
to use budgeted
information
We can therefore think of each year has three ‘periods’:
200X
Before During After
  
Establish: Collection of overheads Adjustment of the difference
OAR = Overhead absorption known as recovery through between actual overheads
rate the use of the OAR incurred and overheads
collected or recovered
Before the recording period

During this period we would have to establish the OAR. There are a number of issues that arise
with regard to this that have to be considered. In particular we will need to consider:
1 The basis on which it is to be done e.g. per machine hour or labour hour.
2 Whether we use a single OAR (= blanket rate) or a multi product rate. This issue is
examined in more detail below.
Allocated to the cost centres
P1, P2, P3
Apportioned or shared out
OAR = Budgeted Overhead (BOH)
 Budgeted Level of Activity There are different bases

(BLOA)
Must say per – per machine hour
machine hour, – per labour hour
labour hour etc. – per unit
– as a % of prime cost
– as a % of direct material
cost
– as a % of direct labour
cost
How do we decide which basis to use?

The following flow chart will assist in making the decision:
Is a specific
basis required Use the
by the Yes specific basis
question? required
No
Is the cost centre a

Yes Use machine
machining cost
hours basis
centre?
No
Are machine hours

greater than labour Yes
hours?
During the recording period

Recovery occurs and this is calculated as:
OHs recovered = Actual Level of Activity (ALOA) × OAR
After the recording period

There will now be a difference or discrepancy between the overheads we have actually incurred
and the overheads that we have been able to recover using our OAR. This will either mean our
costs are overstated (over absorption) or understated (under absorption) and therefore profit is
understated or overstated. This needs to be allowed for and over- or under- absorption is then
treated as a debit or credit entry in the profit and loss account as shown below:
Over/under-absorption = OHs recovered – OHs incurred
A positive figure above would imply we have over-absorption and a negative figure under-
absorption.
This is then recorded as below:
Production overhead control account
$ $
OHs incurred X OHs recovered X
Over-absorption X Under-absorption X
X X
Notice that the over- or under-absorption figure will bring about the reconciliation in the account
and that at any given point we will have either one or the other. The over-or under-absorption
will then be matched as a credit or debit entry in the profit or loss account.
Session 4
Marginal costing and

absorption costing
SYLLABUS CONTENT
(a) Marginal costing
(b) Absorption costing
(c) Marginal versus absorption costing for profit reporting purposes
THE BASIC PRINCIPLES OF A MARGINAL COSTING

SYSTEM
1 Inventories and production are valued at the variable production costs per unit.
Direct materials x
Direct labour x
Variable overheads x
––––
x
––––
2 Fixed overheads (both production and non-production) are treated as period costs and
are therefore written off in the p/l for the time period.
3 Contribution is highlighted:
Selling price x
– Variable costs x
––––
Contribution x
––––
Pro-forma of profit statement using marginal costing approach

Sales x
Less variable production cost of goods sold calculated as below (x)
Opening inventory (qty × var. production cost per unit) x
+ Production (qty × var. production cost per unit) x
– closing inventory (qty × var. production cost per unit) (x)
–––– ––––
Gross contribution x
Less non-production variable cost (sales commission etc.) (x)
Contribution x
Less fixed cost
Production x
Non-production x (x)
–––– ––––
Profit/(loss) x/(x)
–––– ––––
THE BASIC PRINCIPLES OF AN ABSORPTION COSTING

SYSTEM
Remember this approach has to be used to produce financial statements in accordance with
SSAP 9.
1 Inventories and production are valued at full production cost per unit
Direct materials x
Direct labour x Based on the
budgeted level of
Variable overheads x
activity
Fixed production overheads x
––––
Full production cost per unit x
––––
2 Fixed non-production overheads are treated as period costs
3 Gross profit is highlighted
SESSION 4 – MARGINAL COSTING AND ABSORPTION COSTING
Proforma of profit statement using absorption costing approach

Sales x
Less full production cost of goods sold calculated as below (x)
Opening inventory (qty × full production cost per unit) x
+ Production (qty × full production cost per unit) x
– closing inventory (qty × full production cost per unit) (x)
–––– ––––
Gross profit x
Over-absorption x
Under-absorption (x)
Less
Variable sales and distribution (sales commission etc.) (x)
Fixed non-production (x)
––––
Profit/(loss) x/(x)
––––
Reconciliation of the two approaches

If the two approaches are compared, then any discrepancy or difference between the two
approaches will be with regard to the treatment of inventories. In both cases the physical
quantity of inventories will be the same. However, how these inventories are valued will be
different depending on whether we use an absorption costing approach or a marginal costing
approach. This also has implications for the reported profits under the two systems.
If inventory is increasing (closing inventory exceeds opening inventory) absorption costing profit
will be higher and if it is decreasing marginal increasing (opening inventory exceeds closing
inventory) costing profit will be higher.
Profit/loss per marginal costing ×
Difference $×
Profit/loss per absorption costing ×
Reconciled
Opening inventory per marginal costing ×
Difference $××
Opening inventory per absorption costing ×
Difference $×
Closing inventory per marginal costing ×
Difference $××
Closing inventory per absorption costing ×
EXERCISE 1
Product X
X Limited commenced business on 1 March making one product only, the budgeted cost of
which is as follows:
$
Direct labour 5
Direct material 8
Variable production overhead 2
Fixed production overhead 5
––––
Total production cost 20
––––
The fixed production overhead figure has been calculated on the basis of a budgeted normal
output of 36,000 units per annum.
You are to assume that all the budgeted fixed expenses are incurred evenly over the year and
that actual expenditure was in line with budget. March and April are to be taken as equal period
months.
Selling, distribution and administration expenses are:
Fixed $120,000 per annum
Variable 15% of the sales value
The selling price per unit is $35 and the number of units produced and sold was:
March April
units units
Production 2,000 3,200
Sales 1,500 3,400
Required:
Prepare profit statements for each of the months of March and April using:
(a) marginal costing
(b) absorption costing.
SESSION 4 – MARGINAL COSTING AND ABSORPTION COSTING
COMPARISON OF THE METHODS

Advantages of marginal costing
1 Most fixed cost relates to time (e.g. depreciation, insurance, rent and rates) and is not
dependent upon the level of activity. These costs should be charged to the time period in
which they are incurred rather than to products.
2 Marginal costing is prudent because it ensures that all fixed costs are charged to the
Profit and Loss account immediately (i.e. in the period in which they are incurred). This
avoids the danger in absorption costing of carrying forward fixed costs in inventory, which
may be unsaleable.
3 Useful for decision-making, because fixed and variable costs are kept separate and the
contribution approach is adopted towards decision-making.
Advantages of absorption costing

1 The fixed production costs are considered to be real cost of production. Whilst not
directly related to the level of production they nevertheless provide the capacity
(resources) to enable production to take place in a particular accounting period. These
should be absorbed into the costs units.
2 It complies with international accounting standards regarding inventory valuation i.e. an

element of fixed production costs is included in the inventory valuation.
3 It is ideally suited for long-run pricing i.e. the selling price is set to recover the full cost of
production.
MARGINAL AND ABSORPTION COSTING: A COMPARISON

OF THEIR IMPACT ON PROFIT
(i) When inventory levels are increasing (closing inventory is greater than opening
inventory), the absorption costing profits will be higher than marginal costing profits.
This is because some of the fixed overhead is carried forward in inventory instead of
being written off against sales for the period.
(ii) When inventory levels are falling (opening inventory is greater than closing inventory),
profits will be higher under marginal costing than absorption costing. This is because the
fixed overhead, which had been carried forward in inventory with absorption costing, is
now being released to be charged against sales for the period.
(iii) If there are no changes in inventory level (production equals sales) then profit will be the
same under both techniques.
EXERCISE 2
A company, who uses an absorption costing system, made a profit in the last year of $64,000.
This was calculated after deducting fixed production overheads of $120,000.
During the year budgeted and actual production was 12,000 units, but sales were only 10,000
units.
What would have been the profit if a marginal costing system had been used?
A $88,000
B $84,000
C $44,000
D $40,000
Session 5
Product and service costs
SYLLABUS CONTENT
(a) Specific order costing: job and batch costing
(b) Process costing
(c) Service costing
SPECIFIC ORDER COSTING

Introduction
Specific order costing systems arise in organisations where cost units are separately identifiable
from each other. There are three types of situation:
Job costing
Batch costing
Contract costing (not part of our syllabus)
This applies where work is undertaken according to specific orders from customers to meet their
own special requirements. Each order takes a relatively short period of time (within the
accounting period of the organisation). The job is also usually undertaken on the supplier’s
premises.
Job costing
This is a situation where we have a ‘one off’ product or service such as car servicing, dentistry,
etc. The main feature of a job costing system is the use of a cost or job card. This card is used
to collect the costs of each job. In practice this is often a separate file in a computer system,
however, each job is given a specific number that enables it to be readily identified. Costs are
then allocated to this job number as they arise. As the sales value of the job can be separately
identified it is also possible to determine the profit and loss on each job.
What costs are collected?

Direct labour
The correct analysis of labour costs and their allocation to specific jobs depends on the
existence of an efficient time recording and booking system. For example time sheets can be
used to record how each employee’s time was spent using job numbers where appropriate to
indicate the time spent on each job. This allows wage costs to be charged to specific job
numbers) or to overhead costs if an employee was engaged on indirect activities).
Direct material
All the documentation used to record the movement of materials within the organisation will
indicate the job number to which it relates. For example a materials requisition note will have a
space to record the number of the job for which the material is being requisitioned. Similarly if
any of the material is later returned to stores then the material returned note will also record the
original job from which the material is being returned. This job would then be credited with the
returned material.
Direct expenses
These are not as common as direct material and direct labour. However, it is again important
that they are charged against the correct job number. If a machine has to be hired to complete a
particular job then the cost of this machine is a direct expense of the job and must be recorded.
The purchase invoice should be coded properly to ensure that it is charged to the job.
Production overhead costs
The successful attribution of production overhead costs to specific cost units depends on the
existence of well-defined cost centres and an appropriate basis for the absorption of overhead
costs by each cost centre. It must be possible to accurately record the units used as the basis
for absorption costing in order to accurately assign overheads to jobs. For example if the basis
used is machine hours, then the number of machine hours spent on each job must be recorded
on the cost card. This would then allow the relevant cost centre absorption rate to be applied in
order to produce a fair overhead charge for the job.
Non-production overheads
The level of accuracy achieved in attributing overhead costs such as selling, distribution and
administration will depend on the level of cost analysis used by the organisation. Many
organisations will use a predetermined percentage (based on estimated activity levels for the
next period of time) to absorb these types of costs.
SESSION 5 – PRODUCT AND SERVICE COSTS
Typical layout for job costing:
Job ABC $
Direct materials (quantity × price) x
Direct labour
Dept 1 (labour hours × rate) x
––––
Prime cost x
+ Overheads
Dept 1 (ALOA × OAR) x
––––
Production cost x
+ Non-production cost x
––––
Total cost x
––––
EXAMPLE 1
Direct materials used in job 3421 were 1000 litres @ $2/litre. The direct labour used in
department 1 was 40 hrs @ $4.50/hr. The budgeted level of activity in department 1 was
40,000 units and budgeted overheads are $80,000. The actual level of activity for job 3421 was
200 units. Non-production costs incurred on job 3421 were $500. In department 2 direct labour
used was 20 hours@ $3.75/hr and the budgeted overheads were $50,000 with a budgeted level
of activity of 20,000 units. The actual level of activity for job 3421 in department 2 was 100 units.
What is the total cost of job 3421?
Solution 1
BATCH COSTING
A batch is a cost unit, which consists of a separate readily identifiable group of units, which
maintains its separate identity throughout the production process.
Costs are collected for the entire batch of production (unlike job costing which is one unit)
because it is more convenient and then an average cost is calculated per unit.
SERVICE COSTING
This is cost accounting for a specific service or function such as canteen, maintenance or the
personnel department. These can be referred to as service centres departments or functions.
This service may be provided for sale such as public transport, hotel accommodation,
restaurants, utility services or they may be provided within the organisation such as stores,
canteen and maintenance.
The cost unit used in service costing varies but might be as below:
Service Possible cost unit
Transport Tonne mile, passenger mile, miles travelled
Hospitals Patient days, number of operations
Electricity Kilowatt hours
Hotels Occupied bed nights
Restaurants Meals served
Colleges Full-time equivalent student, course or subject

enrolment
We calculate the cost per service unit in the usual fashion as below:
Total costs during the period

Cost per service unit =
Number of service units supplied during the period
EXERCISE 1
Information has been collected about two hospitals over the last year as shown in the table
below:
Loamshire General Brownton Central
Number of beds 780 500
Number of in-patients 23,472 8,165
Average stay 7.5 days *
Number of out- patients 216,500 63,920
*This was not recorded for this hospital but the bed occupancy rate was known to be 85%.
Information with regard to costs for the two hospitals has also been given:
Loamshire General Brownton Central
In-patients Out-patients In-patients Out-patients
$ $ $ $
Direct patient care
Supplies, drugs etc. 1,821,520 693,600 1,551,350 285,450
Medical staff 8,729,100 3,308,950 6,832,700 1,975,050
Support services 2,210,500 2,563,700 1,845,380 1,591,620
Indirect costs
General services 3,524,470 1,721,800 1,937,410 635,600
––––––––– ––––––––– ––––––––– –––––––––
Totals 16,285,590 8,288,050 12,166,840 4,487,720
Required:
Calculate
(a) Average length of stay in Brownton Central
(b) Bed occupancy rate or percentage in Loamshire General
(c) Cost per in-patient day for both hospitals
(d) Cost per out-patient attendance for both hospitals
PROCESS COSTING
What is process costing?
Process 1 Process 2 Process 3
Cost → DM1 Output  DM1 →
Cost → DM2 DM2
Cost → DM3 DL
Cost → DL
OAR → OH OH
This is a method of costing used where units pass through stages known as processes e.g.
chemicals, cement, oil, paint and the textile industries. These processes are continuous and the
output from one process becomes the input for the next process.
Key problems
Losses Normal
Abnormal losses/gains
Joint products/By products
SIMPLE PROCESS ACCOUNT

Procedure
A control account is established for each process. It is then debited with material costs, labour
costs and overheads. The account is credited with the transfer to the next process or finished
goods inventory. As production moves from one process to another so too do the costs,
consequently costs become cumulative as production proceeds until total costs are established.
In the following example a system of absorption costing is used, however, process accounts
can be prepared under both absorption and marginal costing. The account is debited with direct
costs and absorbed overheads. The total process costs incurred less the scrap value of any
normal loss is used to value the output which is credited to the account (it is then debited to
inventories or the next process account).
EXAMPLE 2
During a period three chemicals were input into process 1:
150 litres of A at a cost of $300
40 litres of B at a cost of $80
60 litres of C at a cost of $180
Labour cost was $400 and fixed overhead was $150. Production was then transferred to
process 2 where 150 litres of materials costing $1,000, labour costing $500 and fixed overheads
of $200 were incurred. The product was then transferred to finished goods. There are no losses
in the processes.
Required:
Construct the process accounts for the period.
Losses
Many chemical processes result in a loss of volume/weight when output is compared to input.
As this is what is normally expected it is described as a normal loss. It is regarded as
unavoidable. The cost of producing this loss is really a cost of producing the finished product
and therefore the cost of this loss is shared by the good units produced. This means that normal
losses are included in the calculation of the cost per unit.
Process cost incurred – scrap value of normal loss *

CPU =
Expected output units (Input – Normal loss)
*If there is a disposal cost rather than a normal loss then we would add this on rather than
subtract it
EXAMPLE 3
Production costs are $1,440
Input: 300 kg of raw materials
Expected loss: 10% of input
The loss has a scrap value of $3/kg
What is the expected output and the production cost per unit? Prepare the process account.
Abnormal losses and gains

Losses which are greater than expected are referred to as an abnormal loss. If the actual loss
is less than the normal loss we have an abnormal gain. The abnormal items are valued as
though they were good units and then such values are transferred to the profit and loss account
so that management can see clearly the cost of these abnormal items. The cost of producing
the abnormal loss less any scrap value is transferred to the profit/loss account. The value
attributed to an abnormal gain less the scrap value foregone on the units is transferred to the
profit/loss account.
Both of these need to be identified for management action.
EXERCISE 2
Input quantity 1,000 kg
Normal loss 10% of input
Process costs $15,020
Actual output 880 kg
Losses are sold for $8/kg
Required:
Construct the process account and the loss accounts for the period.
EXERCISE 3
Input quantity 1000 kg
Required:
Construct the process account and the loss account for the period.
EXERCISE 4
Input quantity 1000 kg
Required:
Construct the process account and the loss account for the period.
MULTI PRODUCT (JOINT) PROCESSES

Split off point
DM1 → Process 1  Joint product A → Further

processing
DM2 →
Lab →  Joint product B
OAR →
 By-product C
A distinction is made between:
• Joint product: this has a significant sales value.
• By-product is a saleable item with an insignificant sales value.
Thus judgment is needed
By-products are usually accounted for in the same way as a normal loss. That is the by-product
value (sales proceeds – any further processing costs) used to reduce the cost of the process.
The cost of the process is then allocated to the joint products.
The costs incurred up to the split-off point are apportioned between the joint products on the
basis of one of the following:
1 Physical measurement such as weight/volume/units
2 Market value at the split-off
3 Net realisable value
Worked example:
Common costs are $10,100.
Output:
Product A 1,000kgs and is sold for $5
Product B 1,500kgs and is sold for $6
Product C 200kgs and is sold for $0.5
Required:
Calculate the profit on the process output if common costs are apportioned on the basis of:
(a) Physical volume
(b) Market value
Solution:
Step 1 Notice that product C is a by-product with little significant value and therefore it is used to
reduce the common costs to be apportioned to the other processes.
The common costs are = $10,100 – (200 × $0.5)
= $10,000
By volume
Product Volume Proportion Share of costs Per kg.

A 1,000 2/5 $4,000 $4
B 1,500 3/5 $6,000 $4
––––––– –––––––
2,500 $10,000
Profit statement per kg.
Product A B
Sales value $5 $6
Share of common costs ($4) ($4)
––––––– –––––––
Profit/loss $1 $2
––––––– –––––––
× 1,000 × 1,500 Total profit
$1,000 $3,000 $4,000
By market value
Product Market value Proportion Share of costs Per kg.

A $5,000 5/14 $3,571 $3.57
B $9,000 9/14 $6,429 $4.29
––––––– –––––––
$14,000 $10,000
Product A B
Sales value $5 $6
Share of common costs ($3.57) ($4.29)
––––––– –––––––
Profit/loss $1.43 $1.71
––––––– –––––––
× 1,000 × 1,500 Total profit
1,430 2,565 = $3,995*
* Difference is due to rounding error. The total profit should remain $4,000 as before.
EXERCISE 5
Common costs are $6,400
Output
Product W 500 kgs and is sold for $6/kg.
Product X 800 kgs and is sold for $5 or after further processing which costs $2,000 could
be sold for $8/kg
Product Y 600 kgs and is sold for $4/kg.
Product Z 600 kgs and is sold for $0.20/kg.
Required:
Calculate the profit on the process output if common costs are apportioned on the basis of:
(a) Physical volume
(b) Market value at the split-off point
(c) Final market value
Session 6
Estimating costs and revenues

(CVP analysis)
SYLLABUS CONTENT
(a) CVP analysis
(b) Decision-making
(c) Discounted cash-flow techniques
INTRODUCTION
This set of ideas looks at how costs and profits change due to a change in the volume or level
of activity.
CVP analysis is based on:
Contribution/unit (assumed to be constant)
Never on profit/unit as this will change every time more or fewer units are made.
CVP analysis can be used to calculate
Break-even = sales revenue = total cost
Profit = difference between contribution and fixed cost i.e. contribution – fixed cost
KEY CONCEPTS
Unit contribution = Selling price per unit – variable cost per unit
Total contribution = Volume (selling price – variable cost per unit)
Contribution target = Fixed costs + profit target
Volume target = Contribution target
Unit contribution
Fixed cost + profit target
Selling price per unit – variable cost per unit
Worked example:
Information
Selling price = $5/unit
Variable cost = raw material = $1/unit
Fixed cost = factory rent = $1,000 per annum
1 How many units must be sold to break even?
Check
SESSION 6 – ESTIMATING COSTS AND REVENUES (CVP ANALYSIS)
2 If rent rises by 20% and the aim is to make $500 p.a. profit what output is needed?
3 Assuming that total fixed cost is $1,000 p.a. and that unit variable cost is $1 per unit, if
maximum output is 500 units p.a. what would the selling price have to be to achieve a
profit target of $500 p.a.?
Notice
1 Any change in the selling price or variable cost will alter unit contribution.
2 Changes in fixed cost or profit required affect the contribution target.
Margin of safety
This is the difference between the budgeted sales volume and the break-even point.
Information:
Budgeted sales 80,000 units
Selling price $8
Variable cost $4/unit
Fixed cost $200,000 p.a.
Required:
Identify the break-even point. What is the margin of safety expressed as a percentage?
EXERCISE 1
ABC Ltd manufactures calculators, which have a variable cost of $2 per unit and a selling price
of $6 per unit. Fixed costs are budgeted at $40,000.
Required:
(a) How many calculators must be sold in order to break even?
(b) What is the break-even point in sales value?
(c) How many calculators are required to be sold, to generate a profit of $50,000?
EXERCISE 2
A company manufactures and sells a single product which has the following cost and selling
price structure:
$/unit $/unit
Selling price 60
Direct material 11
Direct labour 18
Variable overhead 7
––––
Fixed overhead 6 42
––––
Profit per unit 18
––––
The fixed overhead absorption rate is based on the normal capacity of 2,000 units per month.
Assume that the same amount is spent each month on fixed overheads. Budgeted sales for
next month are 2,100 units.
You are required to calculate:
(i) the break-even point, in sales units per month,
(ii) the margin of safety for next month,
(iii) the budgeted profit for next month,
(iv) the sales required to achieve a profit of $48,000 in a month.
EXERCISE 3
If the selling price per unit of a product is $4 and with the following information below:
Levels Low High
Total costs ($) 28,990 37,700
Profit/(Loss) ($) (990) 3,300
Required:
(a) Calculate the variable cost per unit and the fixed cost.
(b) Calculate the contribution to sales ratio.
(c) Calculate the sales revenue needed to make a profit of $6,270.
EXERCISE 4
Below are the summary results for two trading periods:
Period 1 Period 2
($000) ($000)
Sales 500 750
Variable costs 300 555
–––––– ––––––
Contribution 200 195
Fixed costs 150 175
–––––– ––––––
Net profit 50 20
–––––– ––––––
Required:
Calculate the sales required in Period 2 to achieve the same net profit as in Period 1.
EXERCISE 5
Homework
Below are the summary results for two trading periods:
Period 1 Period 2
($000) ($000)
Sales 900 1000
Variable costs 400 500
––––– –––––
Contribution 500 500
Fixed costs 350 300
––––– –––––
Net profit 150 200
––––– –––––
Required:
Calculate the sales required in Period 2 to achieve the same net profit as in Period 1.
MULTI PRODUCT FIRMS

Where we have a multi product firm it is not very useful to look at the total volume in terms of
units – instead we would tend to use the contribution to sales ratio. This is found as below:
Contribution in $
Contribution to sales ratio
Sales in $
It is necessary to calculate total sales and total contribution for the organisation.
The BEP volume in sales value is found by dividing the total fixed cost by the contribution to
sales ratio for the business as a whole. (Provided that the proportions of each product sold
remain the same or that the same ratio of contribution to sales applies to each product.) This
will give a break-even point in terms of sales value (revenue) from all its products for the
business as a whole, rather than as a target number of units for one product.
EXERCISE 6
Excel Products Ltd manufactures and sells two products: X and Y. Forecast data for 20X2 are:
Product X Product Y
Sales (units) 8,000 2,000
Sales price (per unit) $12 $8
Variable cost (per unit) $8 $3
Annual fixed cost are estimated at $27,300
Required:
What is the break-even point in the current sales mix?
BREAK-EVEN CHARTS
Assumptions
1 Linear variable cost. This is in contrast to economics.
2 Linear total revenue function. This is based on an assumption that the firm is a price-taker
which in turn implies that the market is one of perfect competition.
Uses
1 Comparing products/time periods/actual versus planned outcomes.
2 Showing the effects of changes in circumstances or plans.
3 Giving a broad picture of the company’s position.
Sales
$ revenue
Total
cost
Total
variable
cost
Total fixed cost
BEP Margin of Budgeted or Output

safety actual sales
Contribution break-even charts

For these graphs we exclude the horizontal total fixed cost line in order to highlight the
contribution. If the total cost line is also plotted it is possible to identify the break-even point and
whether the company is making a profit or loss. This graph is shown below:
Sales
$ revenue
Total
Profit
cost
Total
Variable
Cost
Los
BE Margin of Budgeted Outp

safety or actual
Contribution
Profit volume charts
Profit
Sales volume
Break-even output
Loss
Loss equal to fixed cost
RELEVANT COSTING
Introduction
Decisions involve choices or alternatives. For example, management typically have to decide
whether to launch a new product, what type of machine to buy, whether to invest in one location
or another, or maybe even which unit or division to close down.
These choices will involve different costs. We have to consider which costs remain the same
regardless of the decision (these are irrelevant costs) and those which alter with the decision.
Any costs which alter with the decision are relevant costs.
Relevant costs are also known as incremental costs. Relevant costs may include opportunity
costs. The opportunity cost is the value of any benefit sacrificed in favour of an alternative
course of action.
The only costs and revenues which should be considered in decision-making are those which
will be different as a result of the decision.
In general terms it is reasonable to assume that the variable costs are relevant whereas fixed
costs are not (unless the decision affects the cost structure of the organisation). Thus
information for decision-making should always be based on marginal costing principles. As a
result the objective is usually to maximise contribution.
Which costs are relevant?

To be relevant to a decision a cost must satisfy three criteria:
• It must occur in the future
• It must change because of the decision being considered
• It must impact on cash flows
NON-RELEVANT COSTS
Costs, which are not usually relevant in management decisions, include the following:
Cost Why it isn’t relevant

Historic costs Sunk or past costs, which is money already spent which cannot now be
recovered. Common examples of a sunk cost are expenditure which has
been incurred in developing a new product or money already spent in
buying materials. The money cannot be recovered even if a decision is
taken to abandon further development of the new product. The cost is
therefore not relevant to future decisions concerning the product.
Absorbed fixed These will not increase or decrease as a result of the decision being
overheads taken. The amount of overhead to be absorbed by a particular cost unit
might alter because of the decision. However this is a result of the
company's cost accounting procedures for overheads. If the actual
amount of overhead incurred by the company will not alter, then the
overhead is not a relevant cost.
Committed costs This is expenditure which will be incurred in the future, but as a result of
decisions taken in the past which cannot now be changed. They can
sometimes cause confusion because they are future costs. However, a
committed cost will be incurred regardless of the decision being taken
and therefore it is not relevant. An example of this type of cost could be
expenditure on special packaging for a new product, where the
packaging has been ordered and delivered but not yet paid for. The
company is obliged to pay for the packaging even if they decide not to
proceed with the product; therefore it is not a relevant cost.
Accounting Historical cost depreciation, which has been calculated in the
adjustments such conventional manner. Such depreciation calculations do not result in
as depreciation any future cash flows. They are merely the book entries, which are
designed to spread the original cost of an asset over its useful life.
Notional costs Notional costs such as notional rent and notional interest. These are
only relevant if they represent an identified lost opportunity to use the
premises or the finance for some alternative purpose. In these
circumstances, the notional costs would be opportunity costs.
Relevant cost of material
Buy the materials

Are the materials in stock? No
therefore relevant cost is
the purchase cost
Yes
Are the materials regularly Do the materials have a

used? No scrap value?
Yes Yes No
Replace the stock on the Relevant cost is the loss Do materials have an
contract therefore of the scrap value alternative use?
relevant cost is (opportunity cost)
replacement cost
Yes No
Relevant cost is the loss Zero relevant cost

of savings if used in
alternative use
If the materials have an alternative use and a scrap value the relevant cost will then be the
higher of the two.
Relevant cost of labour

1 If the staff are being paid on a time basis and have idle time then there will be no relevant
cost.
2 If staff have no spare capacity and no additional labour is available the relevant cost is
the loss in contribution per labour hour that they would have earned?
3 If staff have no spare capacity and additional staff are employed the relevant cost is the
cost of the new staff.
Relevant cost of overheads

1 Variable overheads are always relevant as they represent incremental cost.
2 Overheads absorbed are never relevant as they are fixed overheads. The only time fixed
overheads become relevant is when they become incremental i.e. a step-fixed cost.
HOW DO WE TACKLE A QUESTION?

(a) Decide the basis of the decision: for example do relevant revenues exceed relevant
costs?
(b) Identify the alternatives
(c) Decide which costs are relevant.
EXAMPLE 1
Identify which of the following costs are relevant or non-relevant:
(a) The salary to be paid to a market researcher who will oversee the development of a new
product. This is a new post to be created especially for the new product but the $12,000
salary will be a fixed cost. Is this cost relevant to the decision to proceed with the
development of the product?
(b) The $2,500 additional monthly running costs of a new machine to be purchased to
manufacture an established product. Since the new machine will save on labour time, the
fixed overhead to be absorbed by the product will reduce by $100 per month. Are these
costs relevant to the decision to purchase the new machine?
(c) Office cleaning expenses of $125 for next month. The office is cleaned by contractors
and the contract can be cancelled by giving one month's notice. Is this cost relevant to a
decision to close the office?
(d) Expenses of $75 paid to the marketing manager. This was to reimburse the manager for
the cost of travelling to meet a client with whom the company is currently negotiating a
major contract. Is this cost relevant to the decision to continue negotiations?
Opportunity costs
Opportunity costs are concerned with identifying the value of any benefit forgone as the result of
choosing one course of action in preference to another.
Examples of opportunity costs

(a) A company has some obsolete material in inventory, which it is considering using for a
special contract. If the material is not used on the contract it can either be sold back to
the supplier for $2 per tonne or it can be used on another contract in place of a different
material which would usually cost $2.20 per tonne.
The opportunity cost of using the material on the special contract is $2.20 per tonne. This
is the value of the next best alternative use for the material, or the benefit forgone by not
using it for the other contract.
(b) Chris is deciding whether or not to take a skiing holiday this year. The travel agent is
quoting an all-inclusive holiday cost of $675 for a week. Chris will lose the chance to earn
$200 for a part-time job during the week that the holiday would be taken.
The relevant cost of taking the holiday is $875. This is made up of the out-of-pocket cost
of $675, plus the $200 opportunity cost which is the part-time wages forgone.
AVOIDABLE, INCREMENTAL COSTS AND INCREMENTAL

REVENUES
Avoidable costs
If a company is considering shutting down a department, then the avoidable costs are those
which would be saved as a result of the shutdown. Such costs might include the labour costs of
those employed in the department and the rental cost of the space occupied by the department.
The latter is an example of an attributable or specific fixed cost. Costs such as apportioned
head office costs, which would not be saved as a result of the shutdown, are unavoidable costs.
They are not relevant to the decision.
Incremental costs
Incremental costs can be useful if the cost accountant wishes to highlight the consequences of
taking sequential steps in a decision. For example, the accountant might be providing cost
information for a decision about whether to increase the number of employees in a department.
Instead of quoting several different total cost figures, it might be more useful to say ‘the
incremental cost per five employees will be $5,800 per month'. Differential costs are cost
differences between two levels of activity: they are therefore the same idea as incremental
costs.
Remember that only relevant costs should be used in the calculations.
Incremental revenues
Just as incremental costs are the differences in cost between alternatives, so incremental
revenues are the differences in revenues between the alternatives. Matching the incremental
costs against the incremental revenues will produce a figure for the incremental gain or loss
between the alternatives.
EXERCISE 7
ABC Limited is deciding whether or not to proceed with a special order. Use the details below to
determine the relevant cost of the order.
(a) Materials P and Q will be used for the contract. 100 tonnes of material P will be needed
and sufficient material is in inventory because the material is in common use in the
company. The original cost of the material in inventory is $1 per tonne but it would cost
$1.20 per tonne to replace if it is used for this contract. The material Q required is in
inventory as a result of previous over-purchasing. This material originally cost $500 but it
has no other use. The material is toxic and if it is not used on this contract, then ABC
must pay $280 to have it disposed of.
(b) The contract requires 200 hours of labour at $5 per hour. Employees possessing the
necessary skills are currently employed by the company but they are idle at present due
to a lull in the company's normal business.
(c) Overhead will be absorbed by the contract at a rate of $10 per labour hour, which
consists of $7 for fixed overhead and $3 for variable.
(d) The contract will require the use of a storage unit for three months. ABC is committed to
rent the unit for one year at a rental of $50 per month. The unit is not in use at present. A
neighbouring business has recently approached ABC offering to rent the unit from them
for $70 per month.
Total fixed overheads are not expected to increase as a result of the contract.
EXERCISE 8
Homework
A one-year contract has been offered which will utilise an existing machine that is only suitable
for such contract work. The machine cost $25,000 five years ago and has been depreciated
$4,000 per year on a straight line basis and thus has a book value of $5,000. The machine
could be sold now for $8,000 or in one year's time for $1,000. Three types of material would be
needed for the contract as follows:
Material Units in Required for Purchase Current Current resale
inventory contract price of buying-in price per unit
inventory price per unit
$ $ $
W 1,200 300 1.80 1.50 1.20
X 200 1,100 0.75 2.80 2.10
Y 3,000 600 0.50 0.80 0.60
W is in regular use within the firm. X could be sold if not used for the contract and there are no
other uses for Y, which has been deemed to be obsolete.
What are the relevant costs in connection with the contract?
Minimum price quotations for special orders

EXERCISE 9
A company produces a range of products and absorbs production overhead using a rate of
200% on direct wages. This rate was calculated from the following budgeted information.
$
Variable production costs 64,000
Fixed production costs 96,000
Direct labour costs 80,000
The normal selling price of product X is $22 and production cost for one unit is:
$
Raw materials 8
Direct labour 4
Production overhead 8
–––
20
There is a possibility of supplying a special order for 2,000 units of product X at $16 each. If the
order were accepted the normal budgeted sales would not be affected and the company has the
necessary capacity to produce the additional units.
The cost of making component Q which forms part of product Y, is stated below:
$
Raw materials 4
Direct labour 8
Production overhead 16
–––
28
Component Q could be brought from an outside supplier for $20.
Required:
Assuming that fixed production costs will not be changed:
State whether the company should:
(i) Accept the special order.
(ii) Continue making component Q or buy it from outside.
DECISION-MAKING
Limiting factors
A limiting factor is a resource that limits an organisations ability to fully meet demand for its
products. For example, a manufacturer may not have enough materials to produce all the
products that a customer wants to buy, or a firm of accountants may not have enough staff to
work on all potential new clients.
All resources are scarce but not all limit what we can do. In a question the first task is to identify
the limiting factor. In order to maximise profits
Aim: maximise profits Method: maximise contribution per usage of the limiting factor
In calculations, the steps to take are:
1 Identify the limiting factor.
2 Calculate the contribution per unit of each product.
3 Divide this by the usage of the limiting factor per unit for each product.
4 Rank the products in the order of highest to lowest based on step 3.
5 Continue to produce in the ranking order until all of the resource is used. This will
determine the optimum production plan.
EXAMPLE 2
A company produces three products K, M and P which all use skilled labour. Skilled labour will
be limited for the next period to 6,100 hours. (Notice that in this case we know that labour is our
limiting factor. In other questions this may need to be determined from the information given.)
K M P
Labour hours per unit 1 3 1.5
Contribution per unit $30 $45 $30
Maximum sales demand 2,500 units 1,000 units 2,000 units
How much of each product should the company produce in order to maximise profit?
EXERCISE 10
A company produces three products K, M and P which all use skilled labour. Skilled labour will
be limited for the next period to 25,000 hours and machine hours will be limited to 34,000 hours.
K M P
Contribution per unit $60 $45 $30
Labour hours per unit 5 3 1
Machine hours per unit 9 4.5 4
Maximum sales demand 3,000 units 1,000 units 2,000 units
How much of each product should the company produce in order to maximise profit?
EXERCISE 11
Homework
ABC Limited makes three products, all of which use the same machine, which is available for
50,000 hours per period.
The standard costs of the product, per unit, are:
Product A Product B Product C

$ $ $
Direct materials 70 40 80
Direct labour:
Machinist ($8/hour) 48 32 56
Assemblers ($6/hour) 36 40 42
––––– ––––– –––––
Total variable cost 154 112 178
––––– ––––– –––––
Selling price per unit 200 158 224

Maximum demand (units) 3,000 2,500 5,000
Fixed costs are $300,000 per period.
ABC Limited could buy-in similar quality products at the following unit prices:
A $175
B $140
C $200
Required:
(a) Calculate the deficiency in machine hours for the next period.
(b) Determine which product(s) and quantities (if any) should be bought out.
(c) Calculate the profit for the next period based on your recommendations in (b).
METHODS OF APPRAISING CAPITAL PROJECTS

There are three basic methods employed with some variations on the basic techniques
involved. They are:
1 Return on capital employed also referred to as the accounting rate of return (ARR).
2 Payback.
3 Discounted cash flow.
Notice that all these appraisal methods concentrate on return but it is also necessary to
consider Risk. This means that comparisons between projects can be meaningless if they have
different risks unless risk has already been taken specifically into account.
TECHNIQUE 1: RETURN ON CAPITAL EMPLOYED (ROCE)

This is also known as the accounting rate of return (ARR).
It is found as below:
Average annual (post dep.) profit before interest/tax (EBIT)

ROCE = × 100
Initial capital costs
There are variations of this that are used in practice (and therefore could turn up in exam
questions) such as:
Initial capital costs  average book value of asset over its lifetime
Average annual EAIT  first year’s profit
 total profit over whole investment life
EXAMPLE 3
A company purchases a photocopier costing $250,000. It will generate cash flows of $60,000
for five years starting in Year 1. The photocopier will be sold at the end of five years and have a
resale value of $50,000. Depreciation is on a straight line basis. What is the ROCE or ARR?
Variation 1: Using the average book value of the investment
Using the data from the previous example. We have already calculated the average annual
profit as $20,000. The average book value of assets is found as below:
Notice that we have an increased ROCE because any scrap or second hand resale value will
increase the average book value of the asset.
EXERCISE 12
A garden centre purchases a hydroponics system costing $300,000. It will generate cash flows
of $90,000 for four years starting in year 1. The hydroponics system will be sold at the end of
four years and have a resale value of $60,000. Depreciation is on a straight line basis.
What is the ROCE or ARR?
Variation 2: Differing cash inflows
In our previous example the cash inflow was uniform throughout the period. In practice this is
very unlikely to be the case. In the example below the purchase of a machine again costs
$250,000 and it then generates net cash inflows as below:
Year 1 2 3 4 5 6
Cash inflows ($000) 40 80 120 120 80 40
At the end of Year 6 the machine will be sold for $40,000.
You are required to:
Calculate ROCE using:
(a) Initial capital invested.
(b) Average capital invested
EXERCISE 13
The purchase of a computer system costs $400,000 and it then generates net cash inflows as
below:
Year 1 2 3 4 5
Cash inflows ($000) 50 100 120 130 100
At the end of Year 5 the system can be sold for $100,000.
Required:
Calculate ROCE using:
(a) Initial capital invested.
(b) Average capital invested.
Merits of the technique

1 Simplicity: the technique is based on widely reported measures of returns and asset
values. It is therefore easily calculated and understood.
2 Links with other accounting measures: annual ROCE calculated to assess business
sector. ROCE is a widely used measure and is familiar.
Limitations/drawbacks/criticisms of the technique

1 It ignores project life and timing of cash flows. It ignores the time value of money.
2 As a measure it will vary with the specific accounting policies followed. A different ROCE
would be obtained for different depreciation methods. A different ROCE for different
methods is used to capitalise project costs.
3 It tends to ignore any working capital requirements and focuses on fixed asset
requirements only.
4 It is not a measure of absolute gain in wealth. (This is true of any rate of return measure).
5 It does not easily provide an appropriate investment signal. It is not clear what the target
cut-off ROCE actually is.
TECHNIQUE 2: PAYBACK METHOD

This simply involves the idea that at the end of the payback period cash inflows must equal
cash outflows. This is the payback point measured in years.
As a measure it gives a rough measure of liquidity but not of profitability i.e. investments with
short paybacks are more liquid than those with longer paybacks.
The payback method is often used as a first screening device.
Version 1: Equal annual cash flows

This is the simplest of all calculations:
Initial payment
Payback period =
Annual cash inflow
Example
An investment involves spending $4m to earn $1m p.a. for 8 years
$4m Please see p236 for

Payback period = = 4 years
$1m the answer to this.
Version 2: Uneven annual cash flows

In these circumstances the payback period has to be calculated by working out the cumulative
cashflow over the life of the investment.
Year Cashflow ($,000)

0 (4000)
1 800
2 1,000
3 1,000
4 1,200
5 600
6 400
Payback period for this investment =
LIMITATIONS OF THE PAYBACK TECHNIQUE

The limitations of the payback technique become readily apparent when comparisons between
projects are made as in the example below.
Year\Project A B C D E F
0 (200) (200) (200) (200) (200) (200)
1 20 20 80 80 80 100
2 40 40 60 60 (40) 100
3 60 60 40 40 80 80
4 80 80 20 20 40 20
5 Nil 20 20 80 40 40
6 Nil 80 80 20 20 (80)
Payback period 4 years 4 years 4 years 4 years 4 or 5 2 years

years
Comments/analysis
The first 4 projects all have exactly the same payback period but a closer examination of their
cash flows reveals that they are far from similar.
• Taking A and B cash flows exactly match for the first 4 years but then terminate in the
case of A, whereas in the case of B they continue. On this basis B would be preferable to
A but payback does not take this into consideration.
• Similarly if we compare B and C the payback period is the same and they both have the
same cash flow pattern after the end of the payback period. However, in the case of C
the larger funds arrive earlier and this would be picked up by NPV but is not picked up by
using payback.
• Looking at C and D although earlier cash flows prior to payback are identical, the cash
flows following payback would be superior in the case of D. This again would be picked
out by using NPV.
• Again there are further problems where negative cash flows arise either during the
payback period or after the payback period as in the case of E.
• Finally all these projects involved the same initial cash outflow and again we could have a
project where the payback period was the same but the initial cash flows were
substantially larger. This would again be incorporated in NPV calculations but is not
handled by payback methods
Advantages and disadvantages of the technique

Advantages Disadvantages
Simple It needs a subjective target
Suitable to environments which change Cash flows after the payback period are
quickly ignored
Useful when cash is limited Does not link to shareholder wealth
Uses cash (rather than profit) Ignores the time value of money
Takes account of risk
EXERCISE 14
A project generates the same annual cash sum of $50,000 per annum and will do so for the
next 10 years. In order to generate these cash sums the company initially will have to invest
$250,000. What is the payback period?
EXERCISE 15
Given that a project costing $450,000 will generate the cashflows shown below what is its
payback period? At the end of Year 8 the project will be terminated.
Year Cashflow
1 60,000
2 80,000
3 120,000
4 140,000
5 150,000
6 130,000
7 120,000
8 60,000
Other variations on the payback technique

1 Discounted payback. This involves determining how long it takes to recoup the initial
capital investment from the present value of cash inflows.
2 Payback reciprocal. This involves using the reciprocal of the payback period and is often
expressed as a percentage. Under some circumstances this can approximate to IRR.
3 Multiple payback. This involves calculating the time taken to recover the initial outlay not
just once but at a number of times.
TECHNIQUE 3: DISCOUNTED CASH-FLOW METHOD

Introduction
There are two discounted cash-flow methods to consider:
Net present value (NPV) this is the theoretically more sound approach.
Internal rate of return (IRR) this tends to be the more popular.
Both approaches recognise the importance of the time value of money. Money has a time value
because:
Consumption preference money arriving now can be spent.
Risk preference risk is removed once money has been received.
Investment preference money received can be invested.
Compounding
The basis of the idea derives from the principle of compound interest. This is expressed as
below:
FV = PV (1 + r)n
where
FV = future value
PV = present value
r =the cost of capital
n = the number of time periods
EXAMPLE 4
How much would $100 be worth in three years time if it was invested today in an account that
pays interest at 10% per annum?
Discounting
The compound interest expression can then be re-arranged mathematically to arrive at the
present value of a future sum of money as below:
This is known as the discount
1 for different values of interest
PV = FV ×
(1 + r)n rates (r) and years (n) and will
provided in examination
questions
This can be further written as:
PV = FV × Discount factor
EXAMPLE 5
How much would you have to place on deposit today to be able to buy a machine costing
$50,000 in 3 years’ time, when interest rates are 5%? The relevant discount factor is 0.864.
The result can be expressed an alternative way. An individual would be indifferent between
having $43,191.88 today and $50,000 in 3 years’ time (given that interest rates are 5%). In this
example we have used interest rates, more usually we use the investor’s required rate of return.
Finding the Net Present Value (NPV) of cash flows

1 Determine whether the particular item is a relevant cash flow or not. For example
depreciation may be included a s a cost but this is not a cash flow item and should be
excluded.
2 Put the cash flows into the relevant time period.
3 Multiply the cash flow by its discount factor. (Tuition note: In the exam you are given the
relevant discount factors and do not have to use tables.)
4 Sum the discounted cash flows to find the NPV. If the NPV is positive the project adds to
present wealth and is worthwhile, if the NPV is negative it reduces present wealth and is
not worthwhile.
EXAMPLE 6
A project costing $450,000 will generate the cash flows shown below. At the end of Year 5 the
project will be terminated and the machine sold for $20,000. Is the project worthwhile if the cost
of capital is 10% which provides the discount factors in the final column?
Year Cash flow Discount Factor

1 60,000 1.000
2 80,000 0.909
3 120,000 0.826
4 140,000 0.751
5 150,000 0.683
EXERCISE 16
Using the same information provided above in the worked example now establish what the NPV
would be if interest rates fell to 5% and conclude as to whether the project is now worthwhile or
not. The 5% discount factors are as follows:
Year Discount factor

0 1.000
1 0.952
2 0.907
3 0.864
4 0.823
5 0.784
EXERCISE 17
A machine was purchased for $20,000 and has a useful life of 4 years and a resale value in
Year 4 of $2,000. Depreciation is charged on a straight line basis. Profits generated by the
machine (after allowing for depreciation) are $2,000 p.a. Is the purchase of the machine
worthwhile if the company’s cost of capital is 10%? (use the discount factors provided in
example 6)
Annuities
An annuity refers to a stream of cash flows which have the same value each year. To calculate
the present value of an annuity the formula is:
PV = $annual amount × annuity factor
Annuity factors are the addition of the relevant discount factors for the number of years
involved.
EXAMPLE 7
Calculate the present value of $100 received each year for three years, with the first cash flow
arising in one year’s time.
Take the standard 3-year annuity shown below. This is effectively the present value of $100
received in 1 year’s time plus the present value of a $100 in 2 years’ time plus the present
value of $100 in 3 years’ time. This can be done using discount factors as below:
PV of standard 3-year annuity = ($100 × 0.909) + ($100 × 0.826) + ($100 × 0.751)
But this could be rewritten as $100 × (0.909 + 0.826 + 0.751) Or $100 × 2.486
This is the 3-year annuity

factor.
Annuity patterns
Using as an example 3-year $100 annuities, there are a number of different types:
End of 0 1 2 3 4 5
year or now
Standard
$100 $100 $100
annuity
Deferred
$100 $100 $100
annuity
Deferred
$100 $100 $100
annuity
Annuity
$100 $100 $100
due
STANDARD ANNUITY
The characteristic of this annuity is that the first cash flow is at the end of Year 1. This was
examined in Example 7.
DEFERRED ANNUITIES
The characteristic of these annuities is that the first cash flow is after the end of Year 1. There
are different ways that examiners can describe this situation, the two most common are given
below
e.g. $100 3-year annuity deferred by one year or it can be described as an annuity that
commences in two years or in Year 2.
e.g. $100 3-year annuity deferred by two years or it commences in three years or in Year three.
In these cases there will be two steps involved in the calculation. The second step involves
discounting the gathered term back into present value terms. To calculate the present value we
have to use both the annuity factor and the discount factor.
Deferred annuity by one year

0 1 2 3 4
• $100 $100 $100
using $100 × A3 10%

does this
So if we use the ‘standard’ three year annuity factor we will have the present value at year 1.
We always want the present value at year 0, and therefore we need to discount our answer by
one more year. The full calculation is explained in the next example.
EXAMPLE 8
Calculate the present value of a three year annuity of $100 where the first cash flow arises in
2 years time. The cost of capital is 10% p.a. and the three year annuity factor is 2.487. The
discount factors at 10% are 0.909 for one year and 0.826 for two years.
Deferred annuity by two years

Exactly the same technique is then used for any other case. The first step to deciding what to
do is to draw a diagram as above. Using the annuity formula gathers the terms back to one year
before. To obtain the present value we have to then discount by two years (using the
appropriate value from the discount tables).
EXERCISE 18
Calculate the present value of a three year annuity of $100 where the first cash flow arises in
3 years time. The cost of capital is 10% p.a. and the three year annuity factor is 2.487. The
discount factors at 10% are 0.909 for one year and 0.826 for two years.
ANNUITY DUE
The characteristic of this annuity is that the first cash flow arises immediately.
Visualising the cash flows helps to decide what to do. You will notice below that the first $100 is
immediate. It therefore is already in present value terms. This leaves two years’ worth of
payments that need to be gathered back to the present value. To do this we use the annuity
formula but for a two year annuity.
0 1 2 3
$100 $100 $100
Already
paid
EXAMPLE 9
Calculate the present value of a three year annuity of $100 where the first cash flow arises
today. The cost of capital is 10% p.a. The two year annuity factor is 1.736 and the three year
annuity factor is 2.487.
Perpetuity
This is a special type of annuity that lasts forever. As with annuities it is possible to have both
standard and deferred annuities.
Standard
0 1 2 3 4 …..
$100 $100 $100 $100 ….. Standard
$100 $100 $100 ….. Deferred
$100 $100 Deferred
The present value of a standard perpetuity is given by:
Annual cash flow ÷ discount rate
= $100 ÷ 0.1 = $1000
I.e. $100 in perpetuity is equivalent to having $1,000 now. As before by using this arithmetic we
are gathering it all to one year before the cash flows commence.
DEFERRED
EXAMPLE 10
Calculate the present value of $100 received in perpetuity, where the first cash flow arises in
three years time. The cost of capital is 10% p.a. The two year annuity factor is 1.736 and the
three year annuity factor is 2.487. The discount factors at 10% are 0.909 for one year, 0.826 for
two years and 0.751 for three years.
This will involve two elements to the calculation. We use the standard perpetuity expression to
gather all the data to the year before and then using discounting to bring this sum back into
present value terms. Once again a diagram helps to make this clear:
0 1 2 3 4 5 ….
• $100 $100 $100 ….
EXERCISE 19
A company is offered a $10,000 lease for five years, payable in advance. What is the cost of the
lease if interest rates are 8%? How much cheaper would the lease be if the lease did not
commence until Year 2 but still lasted for five years, assuming that the interest rate remains the
same?
Discount factors and annuity factors at 8%

Year DF AF
1 0.926 0.926
2 0.857 1.783
3 0.794 2.577
4 0.735 3.312
5 0.681 3.993
INTERNAL RATE OF RETURN

Say a project has cash flows of:
0 1 2 3
($1,000) $600 $500 $400
And the discount rate is 10%. Then the NPV @ 10% would be
$600 $500 $400

= ($1,000) + + +
(1 + 0.1) (1 + 0.1) 2 (1 + 0.1)3
= ($1,000) $545.45 $413.22 $300.52
= $259.20
To find the IRR we need to find the discount rate where NPV = 0 and therefore in this situation
we would have to try a higher rate say 12%. This would give:
$600 $500 $400
= ($1,000 ) + + +
(1+ 0.12) (1+ 0.12)2 (1+ 0.12)3
= ($1,000) $535.11 $398.60 $284.70
= $219
This is getting closer but we are still a long way from the solution. In order to get closer to the
true IRR we use the linear interpolation formula:
1 00 KAPLAN PUBLISHING
Memorise
$600
IRR = LR + × (HR – LR )
NPVLR – NPVHR
Where:
LR = Lower discount rate
HR = Higher discount rate
NPVLR = NPV at the lower discount rate
NPVHR = NPV at the higher discount rate
Using this expression and plugging in the appropriate values we get:
259
= 10% + × (12% – 10%)
259 – 219
= 10% + 6.5 2%
= 23%
Notes:
1 The closer the two chosen rates are to the actual IRR the more accurate the result will
be.
2 A quick way (but not necessarily that accurate) is to use as the other discount rate 0% as
this would not require any discounting of cash flows!
3 There is a short cut that can be used in exam questions where there is only one cash
flow that arises in the next year. This helps to minimise the arithmetic involved in the
calculation of the IRR. It is based on the fact that the IRR is the discount rate that gives a
zero NPV of the cash flows. If this is to be true then this situation corresponds to where
cash inflow must be equal to cash outflow. A simple example illustrates the point. Say an
investment costs $100 immediately and subsequently it yields a single return in Year 1 of
$10, what is its IRR?
KAPLAN PUBLISHING 1 01
Solution:
Cash outflow in present value terms = $100
Cash inflow in present value terms = $10 × 1/ (1 + r)
We then set these equal to each other (this would give a present value of the cash flows of zero
as one value is negative (the cash outflow) and the other positive (the cash inflow). This gives
the following:
$10
$100 =
(1+ r )
This can be re-arranged and solved for ‘r’, the IRR. Notice this technique does not readily work
for longer than one year in the future, because the solution would involve solving quadratic
expressions i.e. finding square roots, cube roots etc. If we do this in the current case, we obtain
a value for ‘r’ of 10% (r = 0.1).
Session 7
Cash receipts and payments
SYLLABUS CONTENT
• Types of receipts and payments
• Cash budgets and forecasts
• Accounting for cash
TYPES OF RECEIPTS AND PAYMENTS
Cash Payment by a trade Trade Rights issue

debtor payables
Employees Loans
Investment
Tax
authorities
Expenses
Receipts Payments Receipts Payments
Revenue Capital
Cash
Exceptional items Disbursements Drawings/Dividends
Receipts Payments
Interim Final
Interest on loans
Cash Damages
grants
Corporation taxation
Redundancy
SESSION 7 – CASH RECEIPTS AND PAYMENTS
CASH BUDGETS
This is a detailed forecast of cash inflows and outflows for future time periods. A cash budget is
a forecast adopted as a formal plan or target. The purpose of a budget is to:
• Anticipate cash shortages and surpluses to make plans for dealing with them.
• Provide a basis against which actual cash flows are monitored.
The format of cash budgets:
Expected cash receipts
Less: Expected cash payments
Equals: Net cash flow for the period
Add: Opening cash balance
Equals: Closing cash balance
[Note: Closing balance (this period) = opening balance (next period)]
We now consider some of these items in more detail.
Receipts from sales

To prepare a cash budget we will need to know:
EXERCISE 1
A business has estimated that 20% of sales are cash sales and the remainder will be credit
sales. It has also been estimated that 45% of receivables pay in the month following sales, 35%
of receivables two months following sales, 16% of receivables three months following sales and
4% of credit sales are bad debts.
Total sales figures are as follows:
$
October 120,000
November 110,000
December 90,000
January 125,000
February 130,000
March 155,000
Required:
Prepare a month-by-month budget of cash receipts for sales for the months January to March.
Payments for overhead expenses

Overhead expenses can be fixed or variable in nature.
Fixed overheads are usually assumed to be an equal amount every time period.
Depreciation is an overhead expense but not a cash-flow item. Thus if there are any
depreciation charges in overhead costs these must first be stripped out to obtain a cash
expenses figure for overheads.
EXERCISE 2
A manufacturing company makes a product for which the variable overhead cost is $4 per unit.
Fixed costs are budgeted at $650,000 per year, of which $200,000 are depreciation charges.
The remaining fixed costs are incurred at a constant rate every month, with the exception of
factory rental costs, which are $150,000 per year, payable 60% in December and 40% in June.
With the exception of rental costs, 20% of overhead expenses are paid for in month they occur
and the remaining 80% are paid in the following month. Budgeted sales are:
Units
September 40,000
October 60,000
November 50,000
December 30,000
Opening inventory in September will be 10,000 units
Closing inventory is to be 20% of sales in the current period
Required:
Prepare the overhead cash budget for October, November and December
EXERCISE 3: BEGONIA
The following data and estimates are available for Begonia Ltd.
June July August
$ $ $
Sales 65,000 90,000 70,000
Wages 24,000 28,000 23,000
Overheads 20,000 20,500 19,000
June July August September
$ $ $ $
Opening inventory 6,000 4,000 5,000 6,000
Material usage 12,000 16,000 14,000
Further information:
1 20% of sales are for cash, the balance is received the following month. The amount
received in June for May’s sales is $36,000.
2 Wages are paid in the month they are incurred.
3 Overheads include $4,000 per month for depreciation. Overheads are settled in the
following month. $17,500 is to be paid in June for May’s overheads.
4 Purchases of direct materials are paid for in the month purchased.
5 The opening cash balance in June is $5,500.
6 A tax bill of $30,000 is to be paid in July.
Required:
Prepare the cash budget for the three months June, July and August.
Dealing with seasonality in cash budgets

Seasonality refers to times of the year when sales may be abnormally higher or lower than
average. For example, a company selling academic text books are likely to find that sales are
very high at the start of the academic year and very low at the end of the academic year.
Time series analysis
This is a technique for dealing with seasonality in cash flows. Time series analysis aims to
account for this by calculating two key numbers:
• The trend in sales. This is the average sales (or costs), typically calculated on a quarterly
basis. The average is ‘moved’ forward each quarter to reflect that there may be an
upward or downward trend in average sales over time.
• The seasonality for the sales. This compares actual sales each quarter to the calculated
trend. The difference from the trend will tell us whether the period is above or below
average.
These can then be used to forecast sales for future periods.
EXAMPLE 1
A company has calculated average sales for their first quarter of year 4 are expected to be 400
units. This average is expected to increase by 5 units per quarter for the foreseeable future.
The actual sales for the year 4 were as follows:

Year 4 Actual sales Trend Seasonality
Quarter 1 380 400 -20
Quarter 2 440 405 +35
Quarter 3 420 410 +10
Quarter 4 390 415 -25
Forecast sales for the first quarter of year 5.
It can be seen that the trend (average sales) is increasing at a rate of 5 units per quarter. The
seasonality is calculated as the difference between the actual sales and the trend. So Quarter 1,
for example, can be seen to be 20 units (-20) below trend, whereas Quarter 2 is 35 units above
trend.
For year 5 quarter 1 the trend will be expected to increase again by 5 units to 420 units. If
quarter 1 seasonality is expected to stay the same as in year 4 (20 units below the average)
then the forecast sales for year 5 quarter 1 will be = 420 – 20 = 400 units.
The multiplicative model
Seasonality may alternatively be expressed as a percentage rather than as an absolute value.

For example, if say we are told that seasonality for a business in quarter 3 of a year was +115%
and the expected trend for that quarter was to have sales of $20,000. The forecast sales would
be calculated as:
= $20,000 × 115% = $23,000
Cleared funds cash budgets

A similar concept to a cash budget is the idea of cleared funds budgets and forecasts. Such a
budget is likely to be for a relatively limited number of days (the more usual cash budgets are for
weeks, months or possibly years). The issue that is involved in such budgets is that there will
always be delays in receiving cash into a bank account due to a number of factors such as:
1 Delay between sending and receiving a payment (through the postal system).
2 Delay between when a payment is received and when it is actually paid into that
business’s bank account.
3 Delay within the clearing system of the bank. (Once a cheque has been paid in it typically
takes a minimum of three days to clear. Only after the cheque has cleared does the
company have access to the funds.)
The advantage of electronic payments is that they are only subject to clearing system delays.
The time at which the funds become cleared funds can therefore be anticipated with much more
accuracy.
An accurate cleared funds forecast is particularly important where a company has to stay within
agreed overdraft limits and is currently very close to the agreed limits.
Cash accounting versus accruals accounting

Accruals accounting
In this case revenues and costs are reported in the period where the sale occurs (even if the
cash flow for sales and costs occur in different periods. Notice that this is the basis behind the
use of absorption costing techniques.)
Revenues and costs are accrued (recognised as they are earned or incurred, not as money is
received or paid) and dealt with in the income statement of the period in which they relate.
Cash accounting
This is not generally regarded as good practice. This is because businesses enter into
contracts/transactions that are legally binding prior to the exchange of cash.
However, cash-flow management is vital. Businesses will need to:
• Forecast future cash flows to ensure that they do have adequate liquidity to meet their
liabilities as they fall due. This is the basis of cash budgeting.
• Monitor actual cash to ensure that it is sufficient to meet the budgeted cash needs of the
business.
Cash flow and profit
• Cash flow varies from business to business.
• Different businesses have different cash needs.
• To survive in the long run a business needs to make a profit.
• However, in the short run cash is more important than profit.
• In the short run businesses can make a loss but still have enough cash to survive.
• Businesses can make a profit but still run out of cash and therefore into difficulties.
Why are profits and cash affected differently? –Timing!
This can best be seen with regard to the purchase, use and sale of a fixed asset such as capital
plant and machinery. The following diagram shows the difference between the profit recording
process and the cash situation of the business.
Event Asset Asset

bought Asset used through working life: sold
Through different accounting
periods
Cash Cash paid Cash paid
out The only cash flows are from in
other revenues and costs
Cost of the asset is spread

Profit/Loss No impact over accounting periods P/L on
through depreciation and disposal
shared out to the P/L account
using a specific method
Balance sheet Recorded B/S adjusted for depreciation: Recorded
Recorded
Some items of cash spending and receipt such as capital receipts and payments do not directly
affect profits. It is only using the capital asset purchased or sold that subsequently generates
cash payments and receipts.
Profits are calculated after deducting a notional depreciation charge on fixed assets. This
depreciation does not affect cash flow (remember the cash flow associated with the asset has
already been allowed for at its purchase date. Similarly cash released by the sale of the asset
will arise later).
Cash flow is affected by the need to invest in operating working capital (inventory, work in
progress and receivables less inventory).
Growth of a business will require more working capital and consequently greater cash flow.
Asset disposals and cash flow

When an asset is disposed of there will usually be either be a profit or loss on disposal. This has
a consequence for the profit for the period but we will also need to consider the cash flow
consequences as well. There are three aspects to the problem that we need to consider
1 First, any capital gain or loss made on a disposal should not be included as cash
although it may have been allowed for in the calculation of the profits. This is because we
are only interested in the cash that arises from transactions and events. We will record
the cash consequences of the disposal as cash received from the sale of the asset (or
possibly cash paid out if the asset has cost us to actually dispose of it. This might be the
case if the asset had asbestos or other contaminant products within it). This means that if
the profit figure has already included the loss made on disposal we will need to add it
back to the profit figure that we have for the year. (Or if it were a gain on disposal we
would need to deduct it from the profit figure for the year.) Don’t forget that in either case
we will be allowing for the actual cash that arises from the transaction in terms of the cash
received or paid out on disposal. If we had included the notional profit or loss we would
have double counted the cash.
EXERCISE 4
A company has made a profit of $3,000 for the previous trading period. This profit includes a
loss made on the disposal of a fixed asset of $500.
Required:
What would be the cash position of the company? Ignore depreciation.
EXERCISE 5
A company has made a profit of $6,000 for the previous trading period. This figure includes any
profit or loss made on disposal of fixed assets during the period. During the period two fixed
assets were sold off. One asset had a book value of $5,000 and was sold for $2,000. The other
asset had a book value of $2,000 but has just been sold for $3,000.
Required:
What would be the cash position of the company? Ignore depreciation.
2 Secondly there is the issue of depreciation. This again is not a cash flow item. Thus
depreciation should be added back to profits to arrive at the cash position.
EXERCISE 6
A company has made a profit of $6,000 for the previous trading period. Depreciation for the
trading year was $500.
Required:
What would be the cash position of the company?
3 Thirdly there is the problem of the depreciation associated with the asset itself which
would now be lost as a result of its disposal. The problem in this case is that as a result of
the disposal there would have been a charge for depreciation made against the asset that
has now been lost. Thus the annual depreciation charge for the period would have been
higher. However, depreciation is not a cash-flow item. If we were therefore to add
back all of the loss made on disposal (or deduct all of the profit made on disposal of an
asset) this would overstate or understate the cash situation. We therefore have to remove
the depreciation associated with the asset from the loss that has been included in the
period profit. (In the case of a profit on disposal we would need to reduce the operating
profit by the amount of the profit on disposal less the amount of depreciation associated
with the asset.)
EXERCISE 7
A company has made a profit of $4,000 for the previous trading period. This profit includes a
loss made on the disposal of a fixed asset of $500. The reduction in depreciation for the year
as a result of the disposal of this fixed asset was $120.
Required:
What would be the cash position of the company?
In summary:
Cash position = Operating profit + Depreciation charge for the year* + Losses on
disposal – Gains on disposal + Cash receipts from sale – Cash payments
from purchase
Note: Items in bold and italics take us back to the cash profits of the business.
* This figure has to be reduced by any lost depreciation from the disposal of an asset.
CASH FLOW AND WORKING CAPITAL MANAGEMENT

Net cash flow = Profit – increase in working capital (a decrease would be added to profit)
Not the amount of

working capital.
This relationship must exist because profit is the difference between our income (from which
cash inflows arise) and expenditure (from which cash outflows arise). The only other source of
cash outflow during a particular period would then be if we acquired additional working capital
such as purchasing additional inventories. These inventories have not yet generated any cash
inflow from their sale, but have generated a cash outflow from their production. In a similar
fashion if we used up some of our inventories this period (so that there was a decrease in
working capital), because these inventories have already been paid for in cash terms we would
have a reduced cash flow need this period. Thus our net cash flow would be higher. Some
sample cases may make the relationship clearer (to make full sense of this point make up your
own examples and think about what is happening).
EXERCISE 8
Homework
The following transaction details relate to a contract for October, November and December
20X3 and January 20X4. Wages are paid during the month and materials are paid for one
month after receipt of the goods from the supplier. However, payment from sales will be two
months after the invoice date.
October November December January

$ $ $ $
Wages cost 400 500 700 1,000
Materials cost 600 800 1,000 1,200
Sales invoices 1,840 2,370 3,150 4,000
Required:
(a) Show whether the contract is profitable.
(b) Show the net cash flow arising from the contract.
(c) Reconcile the cash flow with the profit.
CASH AND LIQUIDITY

Liquidity is the ease of conversion into immediate spending power with little risk of capital loss.
Provided that assets are liquid a business will have less need for cash.
Liquid items will include:
Liquidity can be boosted by an unused overdraft facility.
TREASURY FUNCTION
This has four main elements to it:
• Funding management
• Liquidity management
• Investment management
• Risk management
Funding management
Liquidity management
Investment management
Risk management
Session 8
Managing cash surpluses

and deficits
SYLLABUS CONTENT
• Review of economic environment
• Sources of finance
• Calculations for relative gearing of EPS under different financial structures
THE INSTITUTIONS AND MARKETS INVOLVED IN THE

PROVISION OF FINANCE
Who are the financial institutions?
These can be divided into
1 Deposit takers. This is the biggest group and it in turn can be sub divided into:
(a) The retail banks, high street banks or clearing banks. These include HSBC,
Lloyds TSB etc. These provide loans, deposit facilities, money transmission
services. They also provide hire purchase and leasing facilities. These are different
kinds of lending similar to rental. They also provide insurance facilities.
(b) Merchant banks, investment banks. "Merchant bank" tends to be the term used
in UK, e.g. Rothschild, while "investment bank" is much more American in origin,
e.g. Chase Manhattan, USB. They give help and advice on raising finance (but for
companies). They also deal with mergers and acquisitions, portfolio management
or pension fund management. They will also advise on other advisers (e.g. legal
action, auditors). They may specialise in the provision of foreign exchange or
project finance i.e. raising sums for specific projects.
(c) Issuing houses. There are not many of these. They are a very specialist type of
merchant bank. They specialise in raising equity finance on the stock market.
(d) Finance houses. These are large specialist institutions that provide credit. They
are involved in providing hire purchase, leases and factoring. Factoring involves
the company selling the product on credit terms. An invoice is then sent to the
company buying the goods. The company sending the invoice then takes a copy of
the invoice to a finance house and asks if it will lend against the invoice.
(e) Discount houses. These are a specialist institution that raise deposits in the
wholesale money markets and use the funds raised to buy (and sell) bills of
exchange at a profit. They have the unique privilege of being able to borrow from
the Bank of England (known as discount window borrowing) and provide a central
mechanism for the transmission of interest rate changes to the economy.
(f) Building societies. These traditionally were specialist savings and lending
institutions. They specialised in providing loans for property purchase. Again many
of these have turned themselves into retail banks as a result of increasing
competition in the financial services sector of the economy.
2 Contractual savings institutions
(a) Pension funds
(b) Life assurance companies
3 Investment funds
(a) Unit trusts (in USA known as mutual funds or open-ended funds). This is
open-ended because more people can join. It has an unlimited size. The more
people who provide their savings the bigger the fund becomes.
Both types of institution parcel funds and invest on the stock market to buy shares.
It is probably not that important to know the difference between them for the exam.
(b) Investment trusts (in USA known as close-ended fund). This is of a fixed size
and generally these are not so well-known.
SURPLUS FUNDS
Surplus funds comprise liquid balances held by a business, which are neither needed to finance
current business operations nor held permanently for short-term investment.
How surplus funds may arise
SESSION 8 – MANAGING CASH SURPLUSES AND DEFICITS
External influences on cash balances
Factors to consider when investing cash surpluses
Note: Interest Rates and the Economy
The central bank (in the UK this is the Bank of England) plays a major part in influencing the
level of interest rates. The Bank of England has a major influence on interest rates as it is one of
the largest providers of cash to the economic system. It follows goals set by the government –
mainly expressed as inflation targets. There is an understanding that changing interest rates
can affect peoples’ spending power (e.g. by influencing mortgage payments and investment
returns) and therefore inflation.
Note: The monthly meeting of the Monetary Policy Committee widely reported in the financial
press is to discuss the level of this repo rate. This rate effectively determines the cost of
cash being supplied by the central bank to the economy.
KEY INVESTMENT OPTIONS

If a surplus of funds is thought to be permanent or long-term, then it should either be invested in
growing the business permanently (e.g. by launching new products or entering new markets), or
else the surplus cash should be returned to the business owners (in the form of dividends or
drawings).
Organisations with short-term surplus funds will have a number of avenues open to them for
investing these short-term surpluses.
Deposit accounts
These are normally managed by banks and have the following features:
Money market deposits can also be arranged. These are arranged via the stock exchange and
give slightly better returns than bank deposits. However they are only available in large amounts
(typically $50,000 or more).
Marketable securities
These are typically arranged on the bond market and they are called marketable securities
because there is an active second-hand market in them. This means that they can be sold to
someone else before the actual repayment date.
They have the following features:
Examples of marketable securities are:
• Certificates of Deposit – a financial instrument issued by a bank, certifying that the holder
has the right to a fixed-term deposit of funds earning a specified interest rate.
• Gilt-edged securities (Gilts) a financial instrument issued by the British Government.
• Local Authority stock a financial instrument issued by local government authorities.
Each of these has different risks (for example, banks are more risky than governments) and
therefore pay slightly different returns.
CASH DEFICITS
A cash deficit arises when there is an excess of expenditures over revenues during a certain
period due to
The most common way to solve cash deficit problems is through the use of bank loans and
overdrafts.
SESSION 8 – MANAGING CASH SURPLUSES AND DEFICITS
Sources of short-term finance

Bank overdraft
Short-term loan
BANK LENDING DECISIONS

Before a bank makes a loan to either an individual or business it will need to take into
consideration some of the following factors:
Charges on assets
Banks will often ask for security to be provided (in the form of assets) before lending to
businesses. These assets are said to have a ‘charge’ n them. There are two types of charges
on assets:
Fixed charge
• security in the form of a specified asset
• on default, the lender can take the secured asset
• the borrower cannot sell off the secured asset until the loan is repaid
Floating charge
• security in the form of assets such as its inventory and receivables
• the borrower can continue to trade in these assets
• on default, the floating charge will 'crystallise', and the bank will acquire the rights over
the categories of assets that are subject to the floating charge that the business owns at
that time.
• Floating charges are only available to companies (they are not available to individuals or
partnerships).
Session 9
Information for comparison
SYLLABUS CONTENT
• The purpose and bases of making comparisons.
• The budgeting process
• Flexible budgets.
• Calculation and cause of variances
• Investigating variances
PURPOSE OF MAKING COMPARISONS

The purpose of management information is to help management:
• make decisions about the future of the business and about the day-to-day running of the
business
• plan the strategy of the business and its operations
• control the operations, costs and income of the business.
Comparisons are typically made against:
• Previous periods – the previous month or previous year
• Corresponding periods – the period for the same time last year
• Forecast or budgeted data – the target for the period
Example
Although comparison with previous periods can help to identify trends it can be misleading if the
company’s activity is subject to seasonal fluctuations. Think about a company in the northern
hemisphere that sells ice creams. The following results show the sales revenue generated
during the latest two quarters.
$000
July to September 20X5 98
October to December 20X5 29
This comparison shows an apparently alarming reduction in sales between the two quarters.
However the sales of ice cream in this situation will be subject to seasonal fluctuation therefore
this comparison is not particularly effective. Either the effect of the seasonal variation should be
removed from the data, or a comparison should be made with a corresponding period to obtain
more useful information. A comparison with the results for the corresponding periods in the
preceding year might be as follows:
20X4 20X5 %
$000 $000 increase
July to September 75 98 31
October to December 22 29 32
Now managers can see that there has been a significant increase in sales revenue when a
comparison is made between corresponding periods.
SESSION 9 – INFORMATION FOR COMPARISON
INTRODUCTION TO BUDGETING
Budgets are plans set in financial and quantitative terms for either the whole of a business or for
the various parts of a business for a specified period of time in the future. Budgets are prepared
within the framework of objectives and policies that have been determined by senior
management.
Reasons for budgeting

There are two key reasons for budgeting:
• planning to plan for future events and to build expectations for future
performance (as illustrated with cash budgets previously)
• control to set a target against which actual performance can be assessed.
Budgetary control – the need for flexed budgets

Budgetary control is focused on calculating and assessing variances from target. In order to
calculate variances, you need to be able to produce flexed budgets.
It is unfair to compare performance against the original budget (often called the fixed budget)
that was set at the start of the year. The reason for this is that the budget may have been based
on a level of activity (i.e. production or sales) that is no longer relevant. For example, it would be
unfair to compare the budgeted cost of making 1,000 units with the actual cost of producing
5,000 units.
A flexed budget is an adjusted budget reflecting what budgeted revenues and costs would have
been if set at the actual level of activity. So if the actual production was 5,000 units then the
flexed budget would go back and adjust the original budget on the assumption of a production
level of 5,000 units.
EXERCISE 1
1,000 units of product B are budgeted to be produced and sold. The budgeted cost is $7,000
for direct materials and is $4,000 for direct labour. The budgeted revenue is $25,000.
Required:
If actual production and sales is only 800 units, calculate:
(a) the flexed direct material budget.
(b) the flexed direct labour budget.
(c) the flexed revenue budget.
INTRODUCTION TO VARIANCES
The difference between what you expected to happen and what actually did happen is a
variance.
A variance can either be good (better than you expected) or bad (worse than you expected).
Good variances are called favourable and bad variances are called adverse.
For your examination, you have to be able to calculate a number of variances. The variances
that you need to calculate fall into two categories – cost variances and revenue variances.
Cost Variances – Materials

A material variance arises when the cost of direct materials used in production differs from the
budgeted cost of material.
Example
Actual direct material cost = $39,000
Budgeted cost = $30,000
We can see that there is an adverse variance of $9,000 but we do not know what it has been
caused by.
The total direct material cost variance, as it is known, can be sub-divided into:
• a material activity (volume) variance, and
• a material variance due to changes in the purchase price and/or efficiency of usage.
You may have to calculate any of these variances in the exam.

The calculation of materials variances is best explained by means of an example.
EXERCISE 2
The fixed budget (i.e. the original budget) for the period shows a budgeted production level of
10,000 units and a budgeted direct material cost of $3.20 per unit and $32,000 in total.
Actual production is 11,000 units and the actual material cost is $33,000.
Required:
Calculate:
(a) the total direct material cost variance.
(b) the material activity (volume) variance.
(c) the material variance due to changes in purchase price and/or efficiency of usage.
Possible reasons for materials variances

• Actual production is higher/lower than budgeted production.
• Higher/lower quality of material used.
• Losing/gaining bulk discounts by buying smaller/larger quantities.
• Changing to a new and cheaper/more expensive supplier.
• Change in the design or quality of the product since the budget was set. This will result in
more or less material being required.
• A different amount of wastage than expected, e.g. due to a higher/ lower quality material
being used.
• Higher/lower grade of labour.
• Incorrect budgeting.
EXERCISE 3
An organisation has always paid $2 per kg for a particular type of direct material. This is the
budgeted price. For this month the supplier has given a 3% discount due to the large quantity
of material purchased.
Required:
Will the total direct material cost variance be adverse or favourable?
Cost variances – labour

A labour variance arises when the cost of labour used in production differs from the budgeted
cost of labour.
Example
Actual direct material cost = $25,000
Budgeted cost = $29,000
We can see that there is a favourable variance of $4,000 but we do not know what it has been
caused by.
The total labour cost variance, as it is known, can be sub-divided into:
• a labour activity (volume) variance and
• a labour variance due to changes in the rate paid and/or efficiency of workers.
The calculation of labour variances is best explained by means of an example.
EXERCISE 4
The fixed budget (i.e. the original budget) for the period shows a budgeted production level of
10,000 units and a budgeted labour cost of $8 per unit and $80,000 in total.
Actual production is 11,000 units and the actual material cost is $99,000.
Required:
Calculate:
(a) the total labour cost variance.
(b) the labour activity (volume) variance.
(c) the labour variance due to changes in the rate and/or the efficiency of workers.
Possible reasons for labour variances

• Actual production is higher/ lower than budgeted production.
• Higher/ lower grade of labour.
• There is an unexpected increase or decrease in the wage rate.
• Payment of unplanned overtime or a bonus.
• More or less efficient working due to changes in employee’s motivation.
• Higher/ lower grade of material to work with.
EXERCISE 5
The wage rate for a particular grade of labour is $9.20 per hour. An increase in demand has
resulted in labour having to work overtime. This has increased the average cost per hour to
$13.
Required:
Will the total labour cost variance be adverse or favourable?
Revenue variances
A revenue variance arises when the actual revenue differs from the budgeted revenue.
For example:
Actual revenue = $120,000
Budgeted revenue = $116,000
We can see that there is a favourable variance of $4,000 but we do not know what it has been
caused by.
The total revenue (sales) variance, as it is known, can be sub-divided into two sub-variances:
• A sales activity (volume) variance – this shows the effect on profit of selling a different
volume from that budgeted.
• A selling price variance – this shows the effect on profit of selling at a different price from
the budgeted price.
Once again, let’s look at an example.
EXERCISE 6
A company sells a single product. The sales budget for the period comprised the sale of 9,000
units at a selling price of $5.60 per unit. 10,100 units were actually sold in the period and the
revenue totalled $52,520.
Required:
Calculate:
(a) the total revenue (sales) variance.
(b) the sales activity (volume) variance.
(c) the selling price variance.
Possible reasons for revenue variances

Price charged is higher/ lower than expected.
• Higher/ lower sales due to the actions of competitors.
• Higher/ lower sales due to a change in the amount spent on advertising.
EXERCISE 7
The selling price budgeted for sales of 20,000 units of product A was $10 per unit. Actual sales
were $180,000.
Required:
Will the total revenue (sales) variance be adverse or favourable?
INTERDEPENDENCE OF VARIANCES
It is possible that one event may be the cause of more than one variance. This is known as
interdependence of variances.
For example, an increase in the selling price per unit may result in an adverse sales activity
(volume) variance (demand falls due to the increase in price) but a favourable selling price
variance.
SHOULD A VARIANCE BE INVESTIGATED?

The following factors should be considered when deciding whether or not to investigate a
variance:
• Controllability of the variance some variances are caused by

uncontrollable factors, e.g. a change in the
price of material on the world market. These
variances are generally not worth
investigating.
• Cost of investigation investigation is only worthwhile if the cost of

investigation is less than the benefit gained
from investigation.
• Size of variance small variations are to be expected and it

may not be worthwhile investigating these
variances.
• Inter-relationships between variances if there is an obvious inter-relationship

between variances, investigation will not be
worthwhile.
• Trend a variance that forms part of steadily

worsening trend may be worth investigating.
EXCEPTION REPORTING
This is the principle of highlighting for management attention only those variances which exceed
a certain limit.
The limit might be expressed as an absolute amount, e.g. investigate all variances above
$5,000, or a percentage, e.g. investigate all variances that exceed 5% of the budgeted amount.
EXERCISE 8
A company produces a variance report detailing those variances which, when compared with
the budget are more than 5% adverse or 10% favourable.
The following information is available:

Actual Budget Variance
$ $ $
Material 47,600 44,020 3,580 adverse
Labour 26,400 25,200 1,200 adverse
Sales 101,000 90,000 11,000 favourable
Calculate the percentage variance based on budget and state which variances should be
investigated.
Session 10
Reporting management
information
SYLLABUS CONTENT
• Identifying suitable formats for the presentation of management information according to
purpose
• Describing methods of analysing, presenting and communicating information
• Interpreting information presented in management reports.
PRESENTATION OF DATA
The two main methods of presenting data are to present it in the form of a table or some form of
diagrammatic presentation.
Tables
Very often raw data is in a form that is not easy to understand or form a clear opinion on. Often,
presenting the data in a table shows the information much more clearly.
Key advantage Key disadvantage Suitability
Graphs and charts

However, charts, diagrams and graphs are more popular ways of displaying data simply. Such
visual representation of facts plays an important part in everyday life since diagrams can be
seen daily in newspapers, advertisements and on television.
Type Key advantage Key disadvantage Suitability
Bar/column
Pie
Scatter graphs
Line graphs
Area chart
SESSION 10 – REPORTING MANAGEMENT INFORMATION
METHODS OF REPORTING
Methods of comparing information were considered earlier. A comparison of information will
normally be requested in a particular format. This can range from an informal note through to a
formal report. We will consider each of the different methods of reporting.
Choosing a suitable format for communicating information

A number of factors need to be taken into account when deciding on the appropriate format for
communicating management information. Some of the factors conflict with each other and it is
up to the person who prepared the information to weigh up the various considerations to select
the most appropriate communication medium.
The factors to be considered include the following:
• Speed and timing
• The need for a written record
• Confidentiality
• Cost
• Distance
• Complexity
A Note
Probably the most simple and informal method of reporting information to another person in the
organisation is by way of a note.
There is no set format for a note although obviously it must be addressed to the appropriate
person, be dated, be headed up correctly so that the recipient knows what it is about. Make
sure you include your name so that the recipient knows who the note is from.
A Letter
A slightly more formal method of communicating information is in the form of a letter. A letter is
most likely to be used when communicating with someone outside the organisation. It would be
quite unusual to communicate with another person in the same organisation in this way
although a letter may be appropriate if the person to whom you are sending the information
works in a separate location.
A letter should always have a letter heading showing the organisation’s name, address,
telephone number, etc. Most organisations will have pre-printed letterheads for you to use. The
letter must also be dated and the name and address of the recipient be included before the
contents of the letter are written.
The method of signing a letter will depend upon the formality of how the letter begins.
If a letter is started as ‘Dear Sir’ then the appropriate way to sign off the letter is ‘Yours
faithfully’. However if the letter is started ‘Dear Mr Smith’ then the appropriate way to sign off the
letter is ‘Yours sincerely’.
Electronic Mail (‘Email’)

Most organisations are now fully computerised and most individuals within an organisation can
communicate with each other via electronic mail or email.
An email must be addressed to the person to whom it is being sent using their email address. It
should also be given a title so that the recipient can see at a glance who it is from and what it is
about.
In terms of format of the content of the email there are no rules other than any organisational
procedures that should be followed.
Memoranda
A memorandum serves a similar purpose to a letter. However the main difference is that letters
are usually sent to persons outside the organisation, whereas memoranda or memos are for
communication within the organisation itself. Memos can range from brief handwritten notes, to
typed sets of instructions to a junior, to a more formal report to a superior.
Many organisations will have pre-printed memo forms. In smaller organisations each individual
may draft his own memoranda. However there are a number of key elements in any
memorandum.
Memorandum
To:
From:
Date:
Ref:
Subject:
Body of memorandum
Signature:
cc:
Enc:
Whatever the precise style and content of the memo some general rules apply:
• There should be a heading to give an indication of the subject matter.
• There should be an introductory paragraph setting the scene.
• The main paragraphs of the memo should follow in a logical order, so that the recipient
clearly understands the arguments being put forward.
• There should be a summary of the main points.
SESSION 10 – REPORTING MANAGEMENT INFORMATION
Reports
The following guidelines for report writing should be observed:
(a) Recipient
The writer should consider the position of the recipient and design the report accordingly.
Some recipients will require detailed calculations; others will have little time to study a
lengthy report and should therefore be given one of minimum length consistent with
providing the required information.
(b) Heading
Each report should be headed to show who it is from and who it is being sent to, the
subject and the date.
(c) Paragraph point system – each paragraph should make a point; each point should
have a paragraph
This simple rule should always be observed. Important points may be underlined.
(d) Jargon and technical terms
The use of jargon should be avoided at all times. If it is necessary to use technical terms,
these should be fully explained.
(e) Conclusion
A report should always reach a conclusion. This should be clearly stated at the end of the
report, not in the middle.
(f) Figures
All detailed figures and calculations should be relegated to appendices.
Answers and
missing sections
SESSION 2
Exercise 1
Cost summary: Four-week period ended 30th June 200X
$ $
Raw material cost 10,400
Production workers’ wages 8,400
Production manager's salary 1,800
Product design costs 500
Service cost (60% of $2,700) 1,620
––––––
Production cost 22,720
––––––
Administration cost $ $
Cost and management accounting salaries 7,500
Service cost (15% of $2,700) 405
––––––
7,905
Selling cost
Advertising cost 8,000
Sales people's salaries 6,300
Sales office costs 4,100
Service cost (10% of $2,700) 270
––––––
18,670
Distribution cost
Packing 1,200
Delivery vehicle running costs 600
Delivery vehicle driver's wages 1,300
Service cost (15% of $ 2,700) 405
––––––
3,505
––––––
Total cost 52,800
––––––
ANSWERS AND MISSING SECTIONS
Exercise 2
(a) Cost summary
Four-week period ended 30 June 200X
Total Per unit

$ $ $ $
Direct material 9,000 90
Direct labour cost 6,500 65
Direct expenses 500 5
–––––– ––––––
Prime cost 16,000 160
Add Production overhead cost:
Indirect material cost 1,400 14
Indirect wages cost 1,900 19
Production manager salary 1,800 18
Service costs 1,620 6,720 16.20 67.20
–––––– –––––– –––––– ––––––
Add Administration cost (total) 7,905 79.05
Selling cost (total) 18,670 186.70
Distribution cost (total) 3,505 30,080 35.05 300.80
–––––– –––––– –––––– ––––––
Total cost 52,800 528.00
–––––– ––––––
(b) The average cost unit is acceptable if the 100 units are all the same product size and
type. If they are not different procedures will be required.
Exercise 3
Profit and loss account four-week period ended 30 June 200X
$ $
Sales (80 units @ $650) 52,000
Less: Production cost of sales
Opening inventory –
add: Production cost 22,720
less: Closing inventory (20 units @ $227.20) (4,544) (18,176)
–––––––
Gross profit (Production margin) 33,824
Less: Administration cost 7,905
Selling cost 18,670
Distribution cost 3,505 (30,080)
–––––––
Net profit 3,744
–––––––
Notes
1 The average product cost per unit is calculated as $22,720/100 = $227.20. This cost is
used for inventory valuation purposes and does not include administration, selling and
distribution costs, which are deemed period costs. Such period costs are written off in the
period in which they are incurred
2 The term production margin is often used in cost and management accounting
statements to denote the difference between sales revenue and production cost of sales.
It is similar to gross profit.
3 The closing inventory at the end of the period is 20 units which is valued at 22 × $227.20
= $4,544. This amount is then deducted from production cost in arriving at the production
cost of sales.
Answer: It all depends on the fixed overheads, if to buy or make fixed overheads stay the same
(do not change) therefore this cost is irrelevant whatever decision is made and must not be
included.
Therefore the relevant cost of producing the component is $900. Compared with $1,000 to buy
and therefore we should make.
Answer:
$25,000 + (3000 × $10) = $55,000
Exercise 4
Highest units: 5,400 Total cost: $54,700
Lowest units: 4,200 Total cost: $48,100
Difference 1,200 $6,600
Thus the variable cost per unit must be = $6,600/1,200 = $5.50
At 4,200 units re-arranging it must be true that:
Total fixed cost = Total cost – Total variable cost
= $48,100 – (5.50 × 4,200) = $25,000
Thus:
Total cost = $25,000 + 5.50q where q = number of units or activity.
Therefore for July:
Total cost = $25,000 + (5.50 × 4,400) = $49,200.
SESSION 3
Example 1
Drawer runners
Receipts (issues) Balance quantity
Date Quantity Price Value ($) @ $4 @ $5 @ $6
4/6 1,500 $5 7,500 1,500
7/6 (1,000) $5 ($5,000) (1,000)
10/6 500 $6 3,000 500
12/6 (500) $5 ($2,500) (500)
22/6 3,000 $4 $12,000 3,000
23/6 (2,000) ($4.5) ($9,000) (1,500) (500)
27/6 (1,000) $4 ($4,000) (1,000)
30/6 (bal.) 500 $4 $2,000 500 nil nil
Drawer runners
Receipts (issues) Balance (quantity)
4/6 1,500 $5 7,500 1,500
7/6 (1,000) $5 ($5,000) (1,000)
10/6 500 $6 3,000 500
12/6 (500) $6 ($3,000) (500)
22/6 3,000 $4 $12,000 3000
23/6 (2,000) $4 ($8,000) (2,000)
27/6 (1,000) $4 ($4,000) (1,000)
30/6 (bal.) 500 $5 $2,500 nil 500 nil
Drawer runners
Receipts (Issues) Weighted
average cost or
Date Quantity Price Value ($) price
4/6 1,500 $5 7,500
7/6 (1,000) $5 ($5,000)
10/6 500 $6 3,000
Balance 1,000 5,500 $5.50
12/6 (500) $5.50 ($2,750)
22/6 3,000 $4 12,000
Balance 3,500 14,750 $4.21
23/6 (2,000) $4.21 (8,420)
27/6 (1,000) $4.21 (4,210)
30/6 (bal.) 500 $4.21 $2,120
Exercise 1
FIFO
Timber
Receipts (Issues) Balance (quantity)
4/6 3,000 $4 $12,000 3,000
7/6 (2,000) $4 ($8,000) (2,000)
10/6 3,000 $5 $15,000 3,000
12/6 (1,500) $5 ($6,500) (1,000) (500)
–––––––
22/6 3,000 $6 $18,000 3,000
23/6 (1,000) $5 ($5,000) (1,000)
24/6 500 $5 $2,500 500
27/6 (1,000) $5 ($5,000) (1,000)
30/6 (bal.) 4,000 $ $22,000 1,000 3,000
LIFO
Timber
Receipts (Issues) Balance (quantity)
4/6 3,000 $4 $12,000 3,000
7/6 (2,000) $4 ($8,000) (2,000)
10/6 3,000 $5 $15,000 3,000
12/6 (1,500) $5 ($7,500) (1,500)
22/6 3,000 $6 $18,000 3,000
23/6 (1,000) $6 ($6,000) (1,000)
24/6 500 $6 3,000 500
27/6 (1,000) $6 ($6,000) (1,000)
30/6 (bal.) 4,000 $5.50 $20,500 1,000 1,500 1,500
WEIGHTED AVERAGE COST OR PRICE

Timber
Receipts (issues) Weighted
average cost or
Date Quantity Price Value ($) price
4/6 3,000 $4 $12,000
7/6 (2,000) $4 ($8,000)
10/6 3,000 $5 $15,000
Balance 4,000 $19,000 $4.75
12/6 (1,500) $4.75 ($7,125)
22/6 3,000 $6 18,000
Balance 5,500 29,875 $5.43
23/6 (1,000) $5.43 ($5,430)
24/6 500 $5.43 $2,715
Balance 5,000 $27,160 $5.43
4,000
$19,000
$4.75
27/6 (1,000) $5.43 ($5,430)
30/6 (bal.) 4,000 $5.43 $21,730
Raw material
Debit Credit
BF 0 $0 ×
Purchases 9 000 $45,000 Issues 5,500 $27,500
Return 500 $3,000 CF 4,000 $20,500
9,500 $48,000 9,500 $48,000
Example 2
100 metres × 5 days = 500 metres
Example 3
2,500 litres – (400 × 5) = 500 litres
Example 4
15,000 + 10,000 – (450 × 20) = 16,000
Exercise 2
(a) Re-order level = Maximum usage × Maximum lead time
= 8,000 × 2 = 16,000
(b) Maximum inventory level = Re-order level + re-order quantity – (minimum usage ×
minimum lead time)
= 16,000 + 24,000 – (5,000 × 1) = 35,000 units
(c) Minimum inventory level = Re-order quantity – (average usage × average lead time)
= 16,000 – ((5,000 + 8,000)/2) × ((2 + 1)/2)) = 6,250 units
(d) It would be tempting here to take the average of the maximum and minimum inventory
levels. But this would not be correct because the maximum will not always be attained.
However, by definition inventory cannot fall below the minimum. Thus what we need to
take is the minimum of 6,250 and add to this the re-order quantity of 24,000 units but
divided by two (because on average this is the amount of inventory we will have plus the
minimum or buffer inventory). This gives an average inventory of 18,250. Visualising the
process of inventory depletion under EOQ will help to make sense of the answer.
Example 5
12 × $10 × 15,000 $300,000
Q= =
$2 $2
= 387.29 units
This result is based on the assumptions of a constant level of demand and an instantaneous
supply of inventory. Therefore the firm should place an order of 387 units whenever the
inventory level falls to zero.
The annual order costs

D
= × Co
Q
15,000
= × $10
387
= $387 / yr
The inventory holding costs

D
= × CH
2
387
= × $2
2
= $387 / yr
Therefore the total annual costs are $387 + $387 = $774/year
We can check out the validity of our answer by taking two points on either side of our answer.
To do this suppose:
Q = 500
Then ordering costs would be:

15,000
= × $10
500
= $500 / yr
And stockholding costs would be:

500
= × $2
2
= $500 / yr
Q = 300
Then ordering costs would be:

1500
= × $10
300
= $500/yr
And stockholding costs would be:

300
= × $2
2
= $300/yr
This can be shown in the diagram below:
Total annual costs

$
costs
$800
$774
Annual order
300 387 500 Q
Example 6
To make sense of the calculation below imagine that the EOQ was 15,000. Then we would only
need to order once every 365 days. On the other hand had the EOQ been 7,500, we would
have to re-order twice in a year and therefore we take the EOQ and divide by the annual
demand multiplying by the number of days in the year as below:
387
= × 365 = 9.4 days
15,000
Lead time demand is then found as below:
Lead time
= × Annual demand
One year
Putting in the values for a one-week lead time we have:
1 week
= × 15,000 = 288 units/week
52 weeks
EOQ = 387 (as before)
From our calculation above when the inventory levels fall to 288 units, we have to re-order 387
units and this would need to be done every 9.4 days.
Units
9.4 days
387
288
0
Time
1 week
Re-order point
Example 7
Then the calculation of EOQ is as before:
2 × $50 × 200,000
Q= = 1,414 units (EOQ)
$10
The annual order costs

D
= × Co
Q
200,000
= × $50
1,414
= $7,072/yr

D
= × CH
2
1414
= × $10
2
= $7,070/yr
The annual cost of items will be: 200,000 × $100 = $20 million.
The supplier then offers a discount of 0.5% on any order of 2,500 units or more each time we
order. Taking a situation where we then order the minimum amount required to obtain the
discount i.e. 2,500 units. Then the annual order costs are:
D
= × CO
Q
200,000
= × $50
2,500
= $4,000 /yr

D
= × CH
Q
2,500
= × $9,95
2
= $12,437.50 /yr
Notice how in this case the annual order cost has fallen. (This is because we would now be
making fewer orders). The stockholding costs have increased, because we now hold larger
inventories in order to obtain the discount.
The annual cost of items (with discount) will be: 200,000 × $99.50 = $19.9 million.
We can now compare the total costs with and without the discount as below:
Total without discount = $20,014,140
Total with discount = $19,916,437.50
Therefore take the discount!
Total annual costs

$
costs
Total annual costs
with discount
Annual order
1,414 2,50 Q
Exercise 3
This is a simple EOQ question and the solution is as below:
2 × CO × D
Q=
CH
Q = Economic order quantity
D = Annual demand
Co = (Fixed) cost per order
CH = Cost of holding one item of inventory for one year
2 × 150 × 5,000
Q=
80
Q = 136.9 or 137 units
Total annual costs for Aircon will comprise holding costs plus re-ordering costs = (average
inventory × holding cost per inventory unit per year) + (number of re-orders per year × fixed cost
per order):
(137/2) × $80 + ((5,000/137) × $150)
= $5,480 + 5,474 = 10,954
Notice the above are not equal as we rounded to the nearest whole unit. Un-rounded values
come out closer.
Exercise 4
Annual demand = 5,000 and EOQ = 137
Thus the company places order 137/5,000 × 365 = 10 days
In other words the company would have to re-order every 10 days.
The company must have sufficient inventory in hand when it places an order to last the one-
week lead time mentioned in the question. It therefore has to place an order when there is a
one-week lead time. This corresponds to:
= 1/52 × 5,000 = 96 units in inventory.
If the lead time where to falls to three days, this would decrease the amount that would have to
be left in inventory to:
= 3/365 × 5,000 = 41 units in inventory.
Exercise 5
Sequence
1 Calculate EOQ ignoring discounts.
2 If this is below level for discounts, calculate total annual inventory costs.
3 Recalculate total annual inventory costs and item costs using order size to just obtain the
discount.
4 Compare costs of step 2 and 3 with the saving from the discount and select minimum
cost alternative.
5 Repeat this process for all levels of discount.
We have already calculated total annual costs for EOQ of 137 units as $11,954 (inventory costs
plus item costs of 5000 × $800 = $4,000,000 or a total of $4,011,954).
At order quantity 100 units total costs are as follows:
150 5,000
× $79.6 + × $150 = $10.970
2 150
Plus cost of items after discount 0.995 × $800 × 5,000 = $3,980,000
––––––––––
New total $3,990,970
Thus it is worth taking the discount for 100 units.
At order quantity 200 units total costs are as follows:
200 5,000
× $79.2 + × $150 = $11.670
2 200
Plus cost of items after discount 0.99 × $800 × 5,000 = $3,960,000
––––––––––
New total $3,971,670
Again, it is worth taking the discount for 200 units as although there are extra costs involved in
increasing the size of the order the discount on the purchase of items more than outweighs this
increase in costs.
Example 8
Idle time
Idle time ratio × 100 = 20%
Total time
Idle time
= 20
25,000
20
Idle time = 25,000 ×
100
Idle time = 5,000 hours
Thus productive time will be:
Total time less idle time = 25,000 – 5,000 = 20,000 hours.
And the value will be = 20,000 × $4 = $80,000
Example 9
The actual hours of 2,520 represents only 90% of the total budgeted hours because these
budgeted hours would also have to include the 10% of idle time.
0.9 Budgeted total = 2,520 hours
Thus Budgeted total = 2,520/0.9 = 2,800 hours
Thus our budgeted labour cost would be 2,800 × $4 = $11,200
Exercise 6
Method 1: $
Basic pay (7 hours @ $10 per hour) 70
Overtime pay (3 hours @ $15) 45
––––
Gross wages 115
Method 2: $
Basic earnings (10 hours @ $10 per hour) 100
Overtime premium pay (3 hours @ $5) 15
––––
Gross wages 115
Example 10
30
860 × = 430 Units in a standard hour
60
430
Efficiency ratio = × 100 = 104.4%
412
Missing sections
Straight line
Cost = $20,000
$2,000
Resale value =
$18,000
Reducing balance
Annual depreciation charge = $18,000/4 = $4,500 p.a.
Cost = $20,000
Year 1 dep. = $5,000
(20,000 × 25%)
Net Book Value $15,000
––––––––
Year 2 dep. = $3,750
(15,000 × 25%)
Net Book Value $11,250
––––––––
Year 3 dep. = $2,821.50
(11,250 × 25%)
Net Book Value $8,437.50
––––––––
Year 4 dep. = $2,109.38
(20,000 × 25%)
Net Book Value $6,328.12
––––––––
Machine hours
Total depreciation = $20,000 Purchase

= $5,000 Residual
––––––––
$15,000
Dep. charge for year 1 2,000

–––––––– × $15,000 = $1,875
16,000
Product units
Total depreciation = $160,000 Purchase

= $10,000 Residual
––––––––
$150,000
Dep. charge for year 1 10,000

–––––––– × $150,000 = $62,500
24,000
Answer
Item Basis Total P1 P2 S1 M1

Overheads 280,000 100,000 100,000 30,000 50,000
Re-apportion S1 (reqs) 12,000 12,000 (30,000) (6,000)
Re-apportion M1 (hrs) 28,000 28,000 (56,000)
–––––––– –––––––– –––––––– –––––––– ––––––––
280,000 140,000 140,000 0 0
Exercise 7
(a) Selling price is $350
Mark-up is 25%
125% 100% 25%
∴ 125% = $350
∴ Total cost = 100% = $350 × 100
–––– = $280
125
(b) Selling price is $350
Margin is 25%
100% 75% 25%
∴ 100% = $350
∴ Total cost = 75% = $350 × 75
–––– = $262.50
100
(c) Total cost is $875
Mark-up is 25%
125% 100% 25%
∴ 100% = $875
∴ selling price = 125% = $875 × 125
–––– = $1,093.75
100
(d) Total cost is $875
Margin is 25%
100% 75% 25%
∴ 75% = $875
∴ Selling price = 100% = $875 × 100
–––– = $1,166.67
75
Exercise 8
This question is asking us to allocate the overheads to the production and service departments.
Machining and Assembly = production department
Maintenance and Stores = service department
Overhead analysis sheet
Cost items Basis of apportionment Machine Assembly Maintenance Stores
Lighting Area occupied 20 50 6 24
Heating Volume occupied 100 300 20 80
Electricity Machine hrs 290 150 60 0
Canteen No of employees 200 400 200 200
Bldg dept Area occupied 300 750 90 360
Machine dept NBV 720 360 120 0
Personnel No. of employees 160 320 160 160
–––– –––– –––– ––––
Total 1,790 2,330 656 824
–––– –––– –––– ––––
Workings
Lighting
Total overhead lighting cost = $100
Area occupied in total = 5,000
Shared between departments:
Machining 1,000/5,000 × $100 $20

Assembly 2,500/5,000 × $100 $50
Maintenance 300/5,000 × $100 $6
Stores 1,200/5,000 × $100 $24
––––
Total $100
––––
Heating
Total overhead heating cost = $500
Volume occupied = 25,000
Machining $100
Assembly $300
Maintenance $20
Stores $80
––––
Total $500
––––
Electricity
Total overhead electricity cost = $500
Total machine hours = 100,000
Machining $290
Assembly $150
Maintenance $60
Stores $0
––––
Total $500
––––
Canteen
Total overhead canteen cost = $1,000
Total number of employees = 50
Machining $200
Assembly $400
Maintenance $200
Stores $200
––––––
Total $1,000
––––––
Building depreciation
Total overhead depreciation cost = $1,500
Total area occupied = 5,000
Machining $300
Assembly $750
Maintenance $90
Stores $360
––––––
Total $1,500
––––––
Machine depreciation
Total overhead depreciation cost = $1,200
Plant and equipment NBV = $50,000
Machining $720
Assembly $360
Maintenance $120
Stores $0
––––––
Total $1,200
––––––
Personnel
The same method as above is used.
Total overhead personnel cost = $800
Total number of employees = 50

Machining $160
Assembly $320
Maintenance $160
Stores $160
––––––
Total $800
––––––
Exercise 9
Specified order method

This method is only a crude approximation and is not as accurate as either of the following
methods. This is apparent when the answer is compared with the other methods. The other two
methods give very similar answers. The first step is to identify the service department
performing the most work. In above example S1 provides 10% to S2. Apportion the other service
department S2 ignoring the work done for S1.
A B C S1 S2
Costs $,000 45,000 65,000 50,000 10,000 20,000
Apportion S1 5,000 2,000 2,000 (10,000) 1,000
–––––– –––––– –––––– –––––– ––––––
50,000 67,000 52,000 nil 21,000
–––––– –––––– –––––– –––––– ––––––
Apportion S2 6,632 5,526 8,842 nil (21,000) Done on the basis
of 95ths i.e. 30/95,
–––––– –––––– –––––– –––––– ––––––
25/95, 40/95
56,632 72,526 60,842 nil nil
–––––– –––––– –––––– –––––– ––––––
Repeated distribution or continuous apportionment method

This is where you continually apportion the costs of the service departments until such time as
they have all been apportioned out.
A B C S1 S2
Costs 45,000 65,000 50,000 10,000 20,000
AppS1 5,000 2,000 2,000 (10,000) 1,000
–––––– –––––– –––––– –––––– ––––––
50,000 67,000 52,000 nil 21,000
AppS2 6,300 5,250 8,400 1,050 (21,000)
–––––– –––––– –––––– –––––– ––––––
56,300 72,250 60,400 1,050 nil
AppS1 525 210 210 (1,050) 105
–––––– –––––– –––––– –––––– ––––––
56,825 72,460 60,610 nil 105
AppS2 31.5 26.25 42 5.25 (105)
–––––– –––––– –––––– –––––– ––––––
56,856.5 72,486.25 60,652 5.25 nil
AppS1 2.63 1.05 1.05 (5.25) .52
–––––– –––––– –––––– –––––– ––––––
56,859.13 72,487.30 60,653.05 nil .52
AppS2 16 .14 22 - --> (.52)
–––––– –––––– –––––– –––––– ––––––
56,859.29 72,487.44 60,653.27 nil nil
–––––– –––––– –––––– –––––– ––––––
Simultaneous equation method

Using this approach it is essential to ensure that you get the equations correct initially and then
it is just simple algebra.
Let S1 = Total overheads cost + transferred from S2
Let S2 = Total overheads cost + transferred from S1
S1 = 10,000 + 0.05 S2
S2 = 20,000 + 0.01 S1
S1 = 10,000 + .05 (20,000 + 0.10 S1)
S1 = 10,000 + 1,000 + 0. 005 S1
S1 = 11,000 + 0.005 S1
S1 – 0.005 S1 = 11,000
0.995 S1 = 11,000
21,000
S1 = 0.995
S1 = $11,055
Therefore
S2 = 20,000 + 0.10 (11,055)
S2 = 20,000 + 1,106
S2 = $21, l06
If you commenced with S2 then the following would be the calculation:
S2 = 20,000 + 0.10 (10,000 + 0.05 S2)
S2 = 20,000 + 1,000 + 0.005 S2
S2 = 21,000 + 0.005 S2
S2 – 0.005S2 = 21,000
0.995 S2 = 21,000
21,000
S2 =
0.995
S2 = $21,106
We then apportion service centre costs according to the values found above by inserting the
cost value found commencing with the S1 value
A B C S1 S2
Costs 45,000 65,000 50,000 10,000 20,000
AppS1 5,527 2,211 2,211 (11,055) 1,106
–––––– –––––– –––––– –––––– ––––––
50,527 67,211 52,211 (1,055) 21,106
AppS2 6,332 5,277 8,442 1,055 (21,106)
–––––– –––––– –––––– –––––– ––––––
SESSION 4
Exercise 1
Product X
Workings
W1
March April
Opening inventory nil 500
Production 2,000 3,200
–––––– ––––––
2,000 3,700
Sales (1,500) (3,400)
–––––– ––––––
Closing inventory 500 300
–––––– ––––––
March: Increase in inventory level by 500 units
April: Decrease in inventory level by 200 units
W2 Monthly output: 36,000 units/12 = = 3,000 units
W3 Budgeted fixed monthly production overhead = $5 × 3,000 = $15,000
W4 Fixed selling, distribution and administration $120,000 /12 = $10,000 per month
expenses
W5 Variable production cost per unit: = $5 + $8 + $2 = $15
Total (Full) production cost per unit = $20
W6
March Overhead absorbed (2,000 × $5) = $10,000

Overhead incurred = $15,000
––––––
Under-absorbed $5,000
April Overhead absorbed (3,200 × $5) = $16,000
Overhead incurred $15,000
= ––––––
Over-absorbed $1,000
(a) Marginal costing profit statement
March April
$ $ $ $
Sales revenue 52,500 119,000
Less variable production cost of sales

Opening inventory – 7,500
+ Variable production cost 30,000 48,000
– Closing inventory (7,500) (4,500)
–––––– ––––––
Variable production cost of sales (22,500) (51,000)

–––––– ––––––
Gross contribution 30,000 68,000
Less variable non-production overhead
Selling/distribution/admin – (7,875) (17,850)
––––––
Net contribution 22,125 50,150
Less fixed costs
Fixed production overhead 15,000 15,000
Fixed selling/distribution/admin 10,000 (25,000) 10,000 (25,000)
–––––– –––––– –––––– ––––––
Net profit (2,875) 25,150
–––––– ––––––
(b) Absorption costing profit statement
March April
$ $ $ $
Sales revenue 52,500 119,000
Less full production cost of sales

Opening inventory – 10,000
+ Variable production cost 40,000 64,000
– Closing inventory (10,000) (6,000)
–––––– ––––––
Full production cost of sales (30,000) (68,000)
–––––– ––––––
Gross profit 22,500 51,000
Over/(under)-absorption of fixed
(5,000) 1,000
production OHs
–––––– ––––––
17,500 52,000
Less Non-production overhead
Selling/distribution/admin 10,000 10,000
Variable selling/distribution/admin 7,875 17,850
–––––– ––––––
(17,875) (27,850)
––––––
Net profit (375) 24,150
–––––– ––––––
Exercise 2
$
Absorption costing profit 64,000
Adjust for fixed overhead in inventory
Inventory increase 2,000 units × $10 per unit (20,000)
––––––
Marginal costing profit 44,000
Overhead recovery rate = $120,000/12,000 budgeted units = $10/unit
SESSION 5
Example 1
Job ABC $
Direct materials (1,000 × $2) 2,000
Direct labour
Dept 1 (40 × $4.50) 180
Dept 2 (20 × $3.75) 75
–––––
Prime cost 2,255
+ Overheads
Dept 1 (200 × $8/4) 400
Dept 2 (100 × $5/2) 250
–––––
Production cost 2,905
+ Non-production cost 500
–––––
Total cost 3,405
–––––
Exercise 1
(a) To calculate the average stay in Brownton Central:
Potential in-patient days in a year = 500 × 365 = 182,500 bed days
At 85% occupancy = 0.85 × 182,500 = 155,125
Average stay = 155,125/8,165 = 19 days
(b) To calculate the bed occupancy rate or percentage in Loamshire General:
First we need to calculate the potential in-patient days = 780 × 365 = 284,700 bed days. If
we then take the actual in-patient days (found by multiplying the number of in-patients by
the average stay) and divide this by the potential in-patient days, we can find the
percentage occupancy by multiplying by a hundred.
Actual in - patient days

Bed occupancy =
Potential in - patient days
(23,472 × 7.2)
= × 100
284,700
= 62%
(c) To calculate the cost per in-patient day we need the total cost for an in-patient and the
number of in-patient days:
Total costs for in - patient

Cost per in - patient day =
No. of in - patient days
16,285,590
Loamshire General =
23,472 × 7.5
= $92.51
12,166,840
Browntown Central =
155,125
= $78.43
(d) The cost per out-patient attendance is calculated in a similar fashion:
Total costs for out - patient

Cost per in - patient day =
No. of out - patients
8,288,050
Loanshire General =
216,500
= $38,28
4,487,720
Brownton Central =
63,920
= $70,21
Example 2
Process Account 1
Units $/unit Value Units $/unit Value
A 150 $300 Output to 250 $4.44 $1,110

process 2
B 40 $80
C 60 $180
Labour $400
Fixed OH $150
250 $1,110 250 $1,110
Process Account 2
From 250 $1,100 Output to 400 $7 $2,800

process 2 fin. gds
Materials 150 $1,000
Labour $500
Fixed OH $200
400 $2,800 400 $2,800
Note:
If a marginal costing system had been used then the cost per unit in process 1 would be:
$1,110 – $150/250 = $3.84
And in process 2:
($2,800 – $150 – $200)/400 = $6.125
Expected output = Input – expected loss
= 300 – (0.1 × 300kg) = 270kg
$1,440 – $90 $1,350

CPU = = = $5
300 – 30 270
Example 3
Preparation of the process account
Materials 300 $1,440 Output to 270 $5 $1350

and process 2
conversion
Normal 30 $3 $90
loss
300 $1,440 1,000 $1,440
Exercise 2
Physical flows calculation
Owip + Input = Output + Normal + Abnormal + cwip

loss loss
0 + 1,000 = 880 + 100 + 20 + 0
The normal loss is given as 10% of the input of 1,000 and this makes it 100 units. From this
information we are then able to work out the size of the abnormal loss.
Abnormal loss = Input – output – normal loss – cwip = 20 units
Cost per unit calculation
Process cost incurred – scrap value of normal loss

CPU =
Expected output units
$15,020 – (100 × $8)

CPU = = $15.8/kg
1,000 × (1 – 0.1)
Note: Cost per unit figures have been shown as rounded values. However, in calculating the
value of output, normal loss and cwip, the actual CPU figure has been used. This avoids some
of the rounding problems that will otherwise occur in preparing the process account later.
Process account
Owip Nil Nil Output to 880 $15.8 $13,904

process 2
Materials 1,000 $15,020 Normal 100 $8 $800

and loss
conversion
Abnormal 20 $15.8 $316

loss
1,000 $15,020 1,000 $15,020
Normal loss account
Process 100 $8 $800 Cash/bank 120 $8 $960

account
Abnormal 20 $8 $160
loss
120 $960 120 $960
Notice that there is really very little point in the preparation of the normal loss account if there is
no scrap value involved and therefore in the exam we need not bother unless requested to do
so (but do state the reason for not doing so).
Abnormal loss account
Process 20 $15.8 $316 Normal 20 $8 $160

account loss
P/L $7.8* $156

account
20 $316 20 $316
* calculated as $15.8 – $8 (the scrap value).
A credit here becomes a debit in the P/L account i.e. $156 less profit due
to the abnormal loss of 20 units (total loss looks to be $316 but we
gained $8/unit or $160. thus the net loss is $156).
Exercise 3

loss loss
0 + 1,000 = 920 + 100 + – 20 + 0
Abnormal loss = Input – output – normal loss – cwip = – 20 units. As the loss is negative it is an
abnormal gain
This is the same as before.
Process account
Owip Nil Nil Output to 920 $15.8 $14,536

process 2
Materials 1,000 $15.8 $15,020 Normal 100 $8 $800

and loss
conversion
Abnormal 20 $15.8 $316

gain
1,020 $15,336 1,020 $15,336
Notice that the abnormal gain is debited to the process account. To make sense of this it can
be thought of as extra input into the production process.
Normal loss account
Process 100 $8 $800 Cash/bank 80 $8 $640

account
Abnormal 20 $8 $160
gain
100 $800 100 $800
Notice that $160 of the $800 that would normally arise from the normal loss units is due to the
abnormal gain of 20 units. This is credited to the normal loss account but debited from the
abnormal gain account.
Abnormal gain account
Normal 20 $8 $160 Process 20 $15.8 $316

loss account
account
P/L $7.8* $156

account
20 $316 20 $316
* calculated as $15.8 – $8 (the scrap value).
A debit here becomes a credit in the P/L account i.e.

$156 more profit due to the abnormal gain of 20 units
(total gain looks to be $316 but we sacrificed $8/unit or
$160 of normal loss, thus the net gain is $156).
Exercise 4

loss loss
0 + 1,000 = 880 + 100 + 20 + 0
Abnormal loss = Input – output – normal loss – cwip = 20 units.
Process cost incurred – scrap value of normal loss

CPU =
Expected output units
$14,400 – (100 × $0)

CPU = = $16/kg
1000 × (1 – 0.1)
Process account
Opening Nil Nil Output to 880 $16 $14,080

WIP process 2
Materials 1,000 $16 $14,400 Normal 100 $0 nil

and loss
conversion
Abnormal 20 $16 $320

loss
1,000 $14,400 1000 $14,400
Notice that the abnormal loss is credited to the process account.
Normal loss account
Process 100 $0 Nil Cash/bank 120 $0 Nil

account
Abnormal 20 $0 Nil
loss
120 $0 120 $0
Notice that in practice this account would not be prepared as it is not really very informative!
Abnormal loss account
Normal 20 $16 $320 Process 20 $0 $0

loss account
account
P/L $16* $320

account
20 $320 20 $320
* calculated as $16 – $0 (the scrap value).
A credit here becomes a debit in the P/L account i.e.

$320 less profit due to the abnormal loss of 20 units
(total losses looks to be $320 but we sacrificed $0/unit
or $0 of normal loss, thus the net loss is $320).
Exercise 5
Step 1 Notice that product Z is a by-product with little significant value and therefore it is used to
reduce the common costs to be apportioned to the other processes.
The common costs are = $6,400 – (600 × $0.2)
= $6,280
By physical volume
Product Volume Proportion Share of costs Per kg.

W 500 5/19 $1,653 $3.3
X 800 8/19 $2,644 $3.3
Y 600 6/19 $1,983 $3.3
–––––– ––––––
1,900 $6,280
Profit statement per kg.
*Note that we use $8 not $5 for product X’s sale value. This is because it costs $2.50 to
increase the value from $5 to $8 i.e. the additional benefit of $3 exceeds the additional cost of
$2.50 and therefore further processing is worthwhile.
Product W X Y
Sales value $6 $8* $4
Share of common costs ($3.3) ($3.3) ($3.3)
Post-separation costs i.e. any other costs – ($2.5) –
–––––– –––––– ––––––
Profit/loss $2.7 $2.2 $0.7
By market value at the split off point

W $3,000 30/94 $2,004 $4
X $4,000* 40/94 $2,672 $3.3
Y $2,400 24/94 $1,603 $2.7
–––––– ––––––
$9,400 $6,280
Product W X Y
Share of common costs ($4) ($3.3) ($2.7)
––––– ––––– –––––
Profit/loss $2 $2.2 $1.3
By final market value

W $3,000 300/118 $1,596 $3.19
X $6,400 64/118 $3,406 $4.26
Y $2,400 24/118 $1,277 $2.13
–––––– ––––––
$11,800 $6,280
Product W X Y
Share of common costs ($.19) ($4.26) ($2.13)
–––––– –––––– ––––––
Profit/loss $2.81 $1.24 $1.87
–––––– –––––– ––––––
SESSION 6
Key concepts: worked examples
1 Volume target = Contribution target
= $1,000 + $0
$5 – $1
= 50 units
Check
Sales = 250 × $5 = $1,250
Var. costs = 250 × $1 = $250
Contribution $1,000
(Fixed cost) $1,000
Profit/Loss $0
2 Volume target = Contribution target
= $1,000 (× 120/100) + $500
$5 – $1
= 425 units
3 Volume target = Fixed cost + Profit target = total contribution target
500 = $1,200 + $500
SP – $1
= 50 units
Total contribution = Volume (selling price – variable cost per unit)
1,700 = 500(SP – $1)
1,700 = 500SP – $500
500SP = $1,700 + $500
SP = $2,200
500
= $4.40
Sales = 500 × $4.40 = $2,200
Var. costs = 500 × $1 = ($500)
Contribution $1,700
(Fixed cost) ($1,200)
Profit/Loss $500
Margin of safety
BEP = Fixed cost
500 = $200,000
$8 – $4
= 50,000 units
Margin of safety
= 80,000 – 50,000 = 30,000 units
or 30,000/80,000 × 100 = 37.5%
Exercise 1
(a) Contribution per unit = Selling price per unit – variable cost per unit
= $6 – $2
= $4
Fixed cost $40,000
Break - even point = =
Contribution per unit $4
= 10,000 units
(b) Break-even point in sales value = 10,000 × $6 = $60,000
(c) Required contribution = fixed cost + desired profit = $40,000 + $50,000 = $90,000
Number of units = $90 ,000/$4 = 22,500 units
Exercise 2
(i) Contribution per unit = Selling price per unit – variable cost per unit
= $60 – ($11 + $18 + $7)
= $60 – $36
= $24
Budgeted fixed cost = 2,000 × $6
= $12,000
Breakeven point in units = $12,000/$24
= 500 units
(ii) Margin of safety (MOS) (2,100 – 500)
= × 100 = 76%
2,100
(iii) Total contribution = (2,100 × $24) = $50,400

Less fixed cost = ($12,000)
Budgeted profit = $38.400
(iv) Required contribution = Fixed cost + desired profit
= $12,000 + $48,000
= $60,000
Number of units = $60,000/$24
= 2,500 units
Sales revenue at 2,500 = 2,500 × $60 = $150,000
units
Exercise 3
(a) To calculate the variable cost per unit we make use of the fact that:
Total profit = total revenue – total costs
By plugging in the information given in the question we can work out the output levels (q)
to which the total cost information applies as below:
($990) = $4q – $28,990
$4q = $28,990 – $990
$4q = $28,000
q = $28,000/$4
q = 7,000 units
We use the same technique to find the output associated with the other level of costs as
below:
$3,300 = $4q – $37,700
$4q = $37,770 + $3,300
$4q = $41,000
q = $41,000/$4
q = 10,250 units
As we now have the two output levels it is possible to use the high/low technique to find
the variable cost as below:
Output Total cost

10,250 $37,700
7,000 $28,990
–––––– ––––––
3,250 8,710
Thus unit variable cost will be $8,710/3,250 = $2.68
This value can be substituted in either the high total cost figure or the low figure to find
the total fixed cost. Below the low figure has been used:
$28,990 = TFC + ($2.68 × 7,000)
TFC = $28,990 – $18,760
TFC = $10,230
(b) Unit contribution is $4 – $2.68 = $1.32.
Taking sales of 7,000 units the total contribution is $1.32 × 7,000 = $9,240
Whilst sales revenue is $4 × 7,000 = $28,000.
This gives a contribution to sales ratio of 33%
(c) Using the fact that:
profit target + total fixed cost

Sales revenue target =
Contribution to sales ratio
$6,270 + $10,230
Sales revenue target =
33% (as a decimal)
= $50,000 of sales revenue
Exercise 4
Sales required to maintain profits
50 + 175
= = $865,684.6 2
195 / 750
Exercise 5
Sales required to maintain profits
150 + 300
= = $900,000.0 0
500 / 1000
Exercise 6
Product X Product Y Total
Sales (units) 8,000 2,000
Sales price × $12 × $8
––––––– ––––––– –––––––
Sales revenue $96,000 $16,000 $112,000
Less variable costs $64,000 $6,000 $70,000
––––––– ––––––– –––––––
Contribution $32,000 $10,000 $42,000
Less fixed costs $27,300
–––––––
Profit $14,700
$42,000
CS ratio = = 37.5%
$112,000
$27,300
BEP = = $72,800 worth of sales
0.375
Example 1
(a) The salary is a relevant cost of $12,000. Do not be fooled by the mention of the fact that it
is a fixed cost. The cost may be fixed in total but it is definitely a cost, which is relevant to
the decision to proceed with the future development of the new product. This is an
example of a directly-attributable fixed cost.
A directly-attributable cost may also be called a product-specific fixed cost.
(b) The $2,500 additional running costs are relevant to the decision to purchase the new
machine. The saving in overhead absorption is not relevant since we are not told that the
total overhead expenditure will be altered. The saving in labour cost would be relevant but
we assume that this has been accounted for in determining the additional monthly
running costs.
(c) This is not a relevant cost for next month since it will be incurred even if the contract is
cancelled today. If a decision is being made to close the office, this cost cannot be
included as a saving to be made next month. However it will be saved in the months after
that so it will become a relevant cost saving from month two onwards.
(d) This is not a relevant cost of the decision to continue with the contract. The $75 is sunk
and cannot be recovered even if the company does not proceed with the negotiations.
Exercise 7
(a) The relevant cost of a material, which is used regularly, is its replacement cost. This will
ensure that the business profits are unaffected by the use of the material for this contract.
The relevant cost of material P is therefore $1.20 per tonne.
Material Q has a ‘negative’ cost or benefit if used for the contract. This is the saving which
will be made through not having to pay the disposal cost of $280.
(b) The relevant cost of labour is zero. The labour cost is being paid anyway and no extra
cost will be incurred as a result of this contract.
(c) The fixed overhead is not relevant because we are told that fixed overheads are not
expected to increase. The relevant variable overhead cost is $3 per hour × 200 hours =
$600.
Even if you are not specifically told that fixed overheads will remain unaltered, it is usual
to assume that they will not increase, stating the assumption clearly.
(d) The rental cost of $50 per month is not relevant because it will not be affected by the
contract. The relevant cost of using the storage unit is the foregone rental income of $70
per month.
Summary of relevant costs

$
(i) Material P 120
Material Q (280)
(ii) Labour –
(iii) Variable overhead 600
(iv) Rent foregone 210
––––
Total relevant cost 650
––––
Exercise 8
Machine costs
The historic cost is sunk cost and is not relevant. The depreciation details given relate to
accounting conventions and are not relevant.
The relevant cost is the opportunity cost caused by the reduction in resale value over the one-
year duration of the contract, i.e. $8,000 – $1,000 = $7,000
Material costs
Material W
Although there is sufficient in inventory the use of 300 units for the contract would necessitate
the need for replenishment at the current market price.
Relevant cost = 300 × $1.50 = $450
Material X
If the contract were accepted 200 units of X could not be sold for scrap at $2.10 per unit. The
balance of 900 units required would be bought – at the current buying-in price of $2.80.
∴ Relevant cost = 200 × $2.10 = $420

= 900 × $2.90 = $2,520
–––––
$2,940
–––––
Material Y
If the 600 units were used on the contract they could not be sold so the opportunity cost is the
current resale price of $0.60 per unit.
∴ Relevant cost = 600 × $0.60 = $360
Exercise 9
(i) Note: Since the question states that fixed production costs will not change, these are not
relevant to either decision. The first step is therefore to determine the proportion of the
production overhead that is variable.
$64,000
Using the data, the variable proportion is = × 100 = 40%
$64,000 + $96,000
The variable cost of producing one unit of Product X is:
$
Raw material 8.00
Direct labour 4.00
Variable production overhead ($8 × 40%) 3.20
–––––
15.20
–––––
Since this is less than the $16 price being offered, the special order should be accepted.
(ii) Variable cost of making component Q is
$
Raw material 4.00
Direct labour 8.00
Variable production overhead ($16 × 40%) 6.40
–––––
18.40
–––––
Since this is less than the external buying price of $20, component Q should continue to
be made by the company.
Example 2
K M P
Labour hours per unit 1 3 1.5
Contribution per unit of the limiting factor $30/1 = $30 $45/3 = $15 $30/1.5 = $20
Ranking order 1st 3rd 2nd
Hours taken to meet demand 2,500 × 1 = 2,500 2,000 × 1.5 = 3,000
Total hours taken on K and P = 5,500 from a total of 6,100. This leaves 6,100 – 5,500 = 600
hours to produce M.
This will allow 600/3 = 200 units of the product M to be produced.
Exercise 10
The first step is to identify the limiting factor. We can do this by working out the maximum
amount of each resource that would be needed to meet demand for the product of the firm.
K M P Total Available Shortfall?
Labour hours 3,000 × 5 = 1,000 × 3 = 2,000 × 1 20,000 25,000 No

needed to meet 15,000 3,000 = 2,000
demand
Machine hours 3,000 × 9 = 1,000 × 4.5 2,000 × 4 39,500 34,000 5,500

needed to meet 27,000 = 4,500 = 8,000
demand
From this information we can identify that machine hours are the limiting factor.
We then aim to maximise the contribution per unit of this limiting factor.
K M P
Machine hours per unit 9 4.5 4
Contribution per unit of the $60/9 = $6.67 $45/4.5 = $10 $30/4 = $7.5
limiting factor
Ranking order 3rd 1st 2nd
Hours taken to meet demand 1,000 × 4.5 = 4,500 2000 × 4 = 8,000
Total hours taken on M and P = 12,500 from a total of 34,000. This leaves 34,000 – 12,500 =
21,500 hours to produce K.
This will allow 21,500/9 = 2,389 units of the product M to be produced.
Exercise 11
(a)
Product A Product B Product C Total

Maximum demand (units) 3,000 2,500 5,000
Machine hours per unit 6 4 7
(48/8) (32/8) (56/8)
Total machine hours required to 18,000 10,000 35,000 63,000
meet demand
Machine hours available 50,000
–––––
Deficiency of machine hours 13,000
–––––
(b) Note: Since the variable cost of making each product is less than the buying-in price, the
company should make each product rather than buy-in.
Product A Product B Product C

$ $ $
Selling price per unit 200 158 224
Variable cost per unit (154) (112) (178)
––––– ––––– –––––
Contribution per unit 46 46 46
––––– ––––– –––––
Machine hour per unit 6 4 7
Contribution per machine 7.67 11.50 6.57
Order of production 2 1 3
Therefore, make
Production plan: Machine hours

2,500 units of product B 10,000
(4 hours × 2,500)
3,000 units of product A 18,000
(6 hours × 3,000)
–––––
Total for A & B 28,000
Machine hours left to make product C 22,000
–––––
Total 50,000
–––––
Conclusion:
Therefore make 3,142 units of product C (22,000/7). The company should buy out
1,858 units (5,000 – 3142) of product C in the period.
(c)
Product A Product B Product C Total

$ $ $ $
Contribution 138,000 115,000 144,532 397,532
($46 × 3,000) ($46 × 2,500) ($46 × 3,142)
C bought-in* 44,592 44,592
––––––––
($24 × 1,858)* 442,124
Less Fixed costs (300,000)
––––––––
Profit for the period 142,124
––––––––
*Note: Contribution from item bought in:
Selling price $224

Variable cost $200
––––
Contribution $24
Example 3
Total depreciation = Cost of investment – scrap/resale value
= $250,000 – $50,000
= $200,000
Average annual depreciation = $200,000 ÷ 5
= $40,000
Average annual profit = $60,000 – $40,000
= $20,000
Thus our new ROCE is
Average annual (post dep.) profit before interest/tax (EBIT)

ROCE = × 100
Initial capital costs
£20,000
ROCE = × 100
£250,000
= 8%
Initial capital cost + final scrap or resale value

Average book value of assets =
2
£20,000
ROCE = × 100
£250,000
= $150,000
$20,000
ROCE = × 100
$150,000
= 13.33%
Exercise 12
(a) Initial capital invested basis:
Total annual cash inflows = $480,000
Average annual inflows = $480,000 ÷ 6
= $80,000
Average annual depreciation = ($250,000 – $40,000) ÷ 6
= $35,000
Average annual profit = $80,000 – $35,000
= $45,000
Initial capital invested basis:

$45,000
ROCE = × 100
$250,000
= 18%
(b) Average capital invested basis:
Firstly we need to calculate the average book value of assets:

$250,000 + $40,000
=
2
= $145,000
This value is then used to calculate:

$45,000
ROCE = × 100
$145,000
= 31%
This is the simplest of all calculations:
Payback period = Initial payment
Annual cash inflow
Exercise 13 This is net

cash
An investment involves spending $4m to earn $1m p.a. for 8 years earnings
Payback period = $4m = 4 years

$1m
Year Cashflow ($000) Cumulative cashflow ($000)
0 (4000) (4000)
1 800 (3,200)
2 1,000 (2,200)
3 1,000 (1,200)
Payback
4 1,200 0
5 600 600
6 400 1000
Payback period for this investment = 4 years.
Exercise 14
Initial payment
Payback period =
Annual cash inflow
$250,000
Payback period = = 5 years
$50,000
Exercise 15
In these circumstances the payback period has to be calculated by working out the cumulative
cash flow over the life of the investment.
Year Annual cash flow Cumulative cash flow

0 (450,000) (450,000)
1 60,000 (390,000)
2 80,000 (310,000)
3 120,000 (190,000)
4 140,000 (50,000)
5 150,000 100,000
6 130,000 230,000
7 120,000 350,000
8 60,000 410,000
Payback period for this investment is between 4 and 5 years but we can be a little more
accurate. Payback occurs when cumulative cash flow is $0. The total cash flow in year 5 is
$150,000 and at the beginning of the year we had a total negative cumulative cash flow of
$50,000. If cash flow were spread evenly throughout the year then this would be eliminated
50,000/150,000ths into the year or a third of the year. This corresponds to 4 months or
122 days.
PV = FV
(1 + r) n
PV = $50,000
(1 + 0.05) 3
PV = $50,000
(1.05) 3
PV = $43,191.88
Example 4 Interest
$100 × (1 + 0.1)3
Capital
= $100 × 1.13
= $100 × 1.331
= $133.10 at the end of three years
Example 5
PV = FV × discount factor
PV = $50,000 × 0.864
PV = $43,200
Example 6
Notice that in year 5 as well as the $150,000 mentioned in the table there is also the $20,000
from the sale of the machine so that total cash flow in the year is $170,000.
Year Cashflow Discount factor Present value
0 ($450,000) 1.000 ($450,000)
1 60,000 0.909 54,540
2 80,000 0.826 66,080
3 120,000 0.751 90,120
4 140,000 0.683 95,620
5 170,000 0.621 105,570
–––––––
NPV (38,070)
–––––––
As the net present value is negative, the investment would not be worthwhile.
Exercise 16
Year Cashflow Discount factor Present value
0 ($450,000) 1.000 ($450,000)
1 60,000 0.952 57,120
2 80,000 0.907 72,560
3 120,000 0.864 103,680
4 140,000 0.823 115,220
5 170,000 0.784 133,280
–––––––
NPV 31,860
–––––––
As the NPV is positive in present value terms we would have again in wealth and therefore the
project is worthwhile. This answer highlights the importance of interest rates and their effect on
our decision.
Exercise 17
The first step is to work out the annual depreciation charge made, as this amount has to be
added back to the profit figure to find the annual cash flow:
Cost = $20,000
Resale value = $2,000
–––––––
$18,000
Annual depreciation charge = $18,000/4 = $4,500 p.a.
Do not forget to also add in the resale value of the machine in Year 4 as well, as this is a cash
item.
Year Cash flow Discount factor Present value

0 ($20,000) 1.000 ($20,000)
1 2,000 + 4,500 0.909 5,908.5
2 2,000 + 4,500 0.826 5,369.0
3 2,000 + 4,500 0.751 4,881.5
4 2,000 + 4,500 + 2000 0.683 5,805.5
–––––––
NPV 1,964.5
–––––––
As the NPV is positive it is worthwhile acquiring the machine.
Example 7
PV = $100 × 2.486
= $248.6
Example 8
PV = $100 × A3 10% × 1.10 -1
PV = $100 × 2.487 × 0.909
= $226.07
Exercise 18
PV = $100 × A3 10% × 1.10 -2
PV = $100 × 2.487 × 0.826
= $205.43
Example 9
PV = $100 + ($100 × A2 10%)
= $100 + ($100 × 1.736)
=$273.60
Example 10
The present value of this perpetuity is given by:
i.e. bringing the value
back a further 2 years the
Annual cash flow ÷ discount rate = $100 ÷ 0.1 = $1000 × 1.10 -2
numerical value is 0.826
= $826 present value
Exercise 19
Notice that in this question the lease involves an advance payment and therefore this annuity
reverts from a standard five-year annuity to a five-year annuity due. This means it can be
thought of as an immediate payment plus a standard four-year annuity (drawing a picture of the
cash flows helps). This explains why the annuity factor is written as 1 + 3.312 and the value of
the lease payments in current terms is 4.312 × $10,000 = $43,120.
On the other hand if the lease does not have to be paid until the end of Year 2, the lease
payments become a standard annuity deferred by one year. This means that using the
standard 5-year annuity figure we will then have to discount back by one year (again a diagram
helps to make it clearer what is happening). The value of the lease is thus (3.993 × 0.926) ×
$10,000 = $36,975. The saving the company makes in present value terms is the difference
between the two: $6,337.
SESSION 7
Information needed to prepare a cash budget from sales
• When receivables will pay
• The level of bad debts
Exercise 1
Workings Cash
Oct Nov Dec Jan Feb Mar
$ $ $ $ $ $
October 24,000 43,200 33,600 15,360
November 22,000 39,600 30,800 14,080
December 18,000 32,400 25,200 11,520
January 25,000 45,000 35,000
February 26,000 46,800
March 31,000
Cash received in the month 103,560 110,280 124,320
Exercise 2
$
Annual fixed overheads 650,000
Deduct depreciation 200,000
–––––––
Cash expenses 450,000
Deduct Annual factory rental (150,000)
–––––––
Regular cash expenses for year 300,000
Regular cash expenses per month 25,000
Expenses paid 5,000 in month they occur
20,000 in the following month
Workings
Fixed overheads
October November December

$ $ $
September 25,000 20,000
October 25,000 5,000 20,000
November 25,000 5,000 20,000
December 25,000 5,000
–––––– –––––– ––––––
25,000 25,000 25,000
Variable overheads
Production plan September October November December

Sales 40,000 60,000 50,000 30,000
- Opening inventory 10,000 8,000 12,000 10,000
+ Closing inventory 8,000 12,000 10,000 6,000
Production 38,000 64,000 48,000 26,000
Units Variable October November December

overhead
cost
$ $ $ $
September 38,000 152,000 121,600
October 64,000 256,000 51,200 204,800
November 48,000 192,000 38,400 153,600
December 26,000 104,000 20,800
––––––– ––––––– –––––––
172,800 243,200 174,400
Overhead cash payment budget

October November December
$ $ $
Variable overheads 172,800 243,200 174,400
Fixed overheads 25,000 25,000 25,000
Factory rental 90,000
––––––– ––––––– –––––––
Total overhead payments 197,800 268,200 289,400
Exercise 3: Begonia
June July August
$ $ $
Sales 65,000 90,000 70,000
–––––– –––––– ––––––
Material usage 12,000 16,000 14,000
Plus Closing inventory 4,000 5,000 6,000
–––––– ––––– ––––––
16,000 21,000 20,000
6,000 4,000 5,000
Less Opening inventory –––––– –––––– ––––––
Purchases 10,000 17,000 15,000
Receipts of cash:
Cash sales 13,000 18,000 14,000
Credit sales 36,000 52,000 72,000
–––––– –––––– ––––––
49,000 70,000 86,000
–––––– –––––– ––––––
Cash payments:
Wages 24,000 28,000 23,000
Overheads 17,500 16,000 16,500
Direct materials 10,000 17,000 15,000
Taxation 30,000
–––––– –––––– ––––––
51,500 91,000 54,500
–––––– –––––– ––––––
Surplus/(deficit) for month (2,500) (21,000) 31,500
Opening balance 5,500 3,000 (18,000)
–––––– –––––– ––––––
Closing balance 3,000 (18,000) 13,500
–––––– –––––– ––––––
To forecast cash position from the balance sheet we need to know

• Changes to fixed assets (acquisitions and disposals).
• Future inventory levels.
• Future debtor levels.
• Future payables levels.
• Changes to share capital and other long-term funding (e.g. bank loans, debenture issue).
• Changes to retained profits.
Example 1
The expected trend will be 415 + 5 =420
Seasonality for quarter 1 = -20
Forecast sales = 420 – 20 = 400
Exercise 4
Cash position = stated profit add back the loss = $3,000 + $500 = $3,500
Exercise 5
Cash position = Stated profit, add back the loss and deduct the gain made on disposal
= $6,000 + ($5,000 – $2,000) – ($3,000 – $2,000)

= $6,000 + $3,000 – $1,000
= $8,000
Exercise 6
Cash position = Stated profit, add back the depreciation
= $6,000 + $500
= $6,500
Exercise 7
Cash position = Stated profit, add back the loss deduct but deduct from this the reduction in
depreciation on the asset
= $4,000 + $500 – $120
= $4,380
Exercise 8
(a) Profits October November December January
$ $ $
Sales invoices 1,840 2,370 3,150 4,000
Costs:
Wages 400 500 700 1,000
Materials 600 800 1,000 1,200
Total costs 1,000 1,300 1,700 2,200
––––– ––––– ––––– –––––
Profit 840 1,070 1,450 1,800
––––– ––––– ––––– –––––
(b) Cash flow

$ $ $ $
Receipts:
Paid sales invoices 0 0 1,840 2,370
Payments:
Wages 400 500 700 1,000
Materials 0 600 800 1,000
––––– ––––– ––––– –––––
Total payments 400 1,100 1500 2,000
––––– ––––– ––––– –––––
Cash surplus/deficit for the month (400) (1,100) 340 370
––––– ––––– ––––– –––––
Opening cash balance 0 (400) (1,500) (1,160)
Closing cash balance (400) (1,500) (1,160) (790)
(c) Reconciliation through working capital
End of End of End of End of

$ $ $ $
Receivables
Unpaid sales in October 1,840 1,840
Unpaid sales in November 2,370 2,370
Unpaid sales in December 3,150 3,150
Unpaid sales in January 4,000
Unpaid sales in February
Unpaid sales in March
––––– ––––– ––––– –––––
Total receivables 1,840 4,210 5,520 7,150
Payables for materials 600 800 1,000 1,200
––––– ––––– ––––– –––––
Working capital 1,240 3,410 4,520 5,950
––––– ––––– ––––– –––––
Increase/(decrease) in working
capital in the month 1,240 2,170 1,110 1,430
Reconciliation
Profit in the month 840 1,070 1,450 1,800
Increase/(decrease) in working 1,240 2,170 1,110 1,430
capital in the month
––––– ––––– ––––– –––––
Net cash flow in month (400) (1100) 340 370
––––– ––––– ––––– –––––
Remember:
Net cash flow = Profit – increase in working capital (a decrease would be a negative
value.
Not the amount of
working capital.
Liquid items will include

• Cash
• Deposits
• Investments short dated
• Trade receivables
• Inventories (possibly)
Funding management
This is primarily concerned with ensuring that there is sufficient finance for the company's
planned activities.
This would involve ensuring that the company has sufficient funds to meet its needs.
It also entails considering the cost of finance.
And the appropriateness of the debt/equity mix that is acceptable.
Liquidity management
Ensuring that the company has sufficient short-term liquidity.
This involves ensuring that the business has sufficient cash.
Cash management and cash forecasting.
Investment management
Responsibility for the investment of the company's surplus cash resources.
This involves considering the investment portfolio of share in other companies. Companies need
a pool of liquid resources and therefore hold shares in other companies. They may also include
in their portfolio potential take-over targets.
It is also likely that the treasury department oversees the company pension fund.
Risk management
Management of the company's risks exposure.
This involves considering the risk attitude of management. How will risks be managed how are
risks identified and measured? E.g. in the case of Honda management is very risk averse.
SESSION 8
How surplus funds might arise
• unexpectedly large amounts of cash that have been generated from operations; this could
be higher income from sales due to an increase in sales revenue
• lower costs maybe because of improved productivity or a cost-cutting exercise
• improvements in working capital management
• sales of non-current assets
• seasonal factors – surpluses generated in good months are used to cover shortfalls later.
External influences on cash

• Economic cycles
• Inflation and exchange rates
• There may also be trends in the financial environment (e.g. a ‘credit crunch’)
• Government policies or incentives
• Interest rates
• Markets trends
Factors to consider when investing cash surpluses

• The return from the investment
• The length of the investment
• The variability in the capital value of the investment
• The investor’s attitudes to risk and the risk of the investment
• The liquidity of the investment
• The ability for (and penalty clauses for) early redemption
Features of deposit accounts
• There is a lot of choice (due to the number of banks that exist)
• Generally low risk (though banks can go bust!)
• But also low returns
• The longer the agreed notice period the higher the return
• Penalties are imposed for a breach of the notice period
Features of marketable securities
• There is a lot of choice in the amount that can be invested
• They are more liquid than deposit accounts as no notice has to be given for converting
them into cash by selling them on the second-hand market
• The capital value can vary wildly until they reach maturity (it is affected by interest rates in
the economy)
• They pay better interest than deposit accounts in most instances
Reasons for cash deficits

• Poor trading performance
• Poor control
• Poor planning
• Poor working capital management
• Unexpected expenditure.
Sources of short-term finance

Bank overdraft
• Flexible
• Only pay interest on the amount drawn down
• Minimum documentation
• Floating/variable interest rate
• There may be an arrangement fee
• Security might be required
• Technically repayable on demand (the bank could foreclose if your business started
running into difficulties)
Short-term loan
• Given for a fixed term and the Bank cannot demand repayment before the end of the
term.
• Fixed repayment schedule
• Usually at fixed rates of interest
• Security may be required
• An arrangement fee may be required
• Interest is paid on the total amount of the loan
• Interest rate charged is usually less than the overdraft rate (e.g. about 13% on overdraft
and about 9 –10% on short term loan).
Bank lending decisions

• Purpose of the loan i.e. is this a revenue generating investment?
• Amount
• Duration; the shorter the term the more relaxed the bank is likely to be as you have less
time to get yourself into a mess!
• Security: some assets offer better security than others. The key issue is the ease of
selling the asset in an emergency and how good is the asset at maintaining its value. It
is for this reason that land and buildings are seen as the best type of asset.
• Credit rating/worthiness: there are agencies that will assess credit worthiness for the
bank
• Re-payment schedule proposed: banks are generally nervous with a ‘bullet’ schedule
i.e. when all the repayment is at the end of the period
• Capital gearing/interest rate cover: if the company has a high interest rate cover the
bank will be happier than if it is lower.
• Seasonality of your cash flows: for example lending to ice cream salesman is risky for
the Bank in the sense that two bad summers and the business is likely to be in
difficulties.
• ‘Z score’ test: this is a combination of ratios that can predict company failure. A low Z
score would make a bank very nervous in lending.
SESSION 9
Exercise 1
(a) Budgeted direct material cost per unit = $7,000 ÷ 1,000 units = $7 per unit
Flexed direct material budget = 800 units × $7 = $5,600
(b) Budgeted direct labour cost per unit = $4,000 ÷ 1,000 units = $4 per unit
Flexed direct labour budget = 800 units × $4 = $3,200
(c) Budgeted revenue per unit = $25,000 ÷ 1,000 units = $25 per unit
Flexed direct revenue budget = 800 units × $25 = $20,000
Exercise 2
(a)
Original budgeted (fixed budgeted) direct material cost $32,000

Actual cost of materials = $33,000
––––––––––––
Total material cost variance = $1,000 adverse
––––––––––––
The variance is adverse because more has been spent on materials than budgeted.
(b)
Original budgeted (fixed budgeted) direct material cost = $32,000

The flexed budget for direct material cost = 11,000 × $3.20 = $35,200
–––––––––––––
The material activity (volume) variance = $3,200 adverse
–––––––––––––
The variance is adverse because more units were produced compared with the original
budget.
This means that more direct material cost was incurred.
(c) The difference between the flexed budget and the actual cost incurred is the variance due
to changes in the purchase price and/or efficiency of usage of the direct materials
compared with the budget:
$35,200 – $33,000 = $2,200 favourable
The variance is favourable because the direct material cost incurred in the production of
11,000 units was less than the flexed budget allowance for that level of activity.
The actual cost of $3 per unit ($33,000 ÷ 11,000 units) is $0.20 lower than the budgeted
unit cost.
Exercise 3
The budgeted price of material is $2 per kg and the actual price is $1.94 per kg ($2 × 97%).
This will result in a favourable total direct material variance because less will be spent on the
material than expected.
Exercise 4
(a)
Original budgeted (fixed budgeted) direct labour cost $80,000
Actual cost of labour = $99,000
––––––––––––
The labour cost variance = $19,000 adverse
––––––––––––
The variance is adverse because more has been spent on labour than budgeted.
(b)
Original budgeted (fixed budgeted) direct labour cost = $80,000
The flexed budget for labour cost = 11,000 × $8 = $88,000
––––––––––––
Total labour activity (volume) variance = $8,000 adverse
––––––––––––
The variance is adverse because more units were produced compared with the original
budget. This means that more labour cost was incurred.
(c) The difference between the flexed budget and the actual cost incurred is the variance
due to changes in the rate paid and/or efficiency of labour compared with the budget:
$88,000 – $99,000 = $11,000 adverse
The variance is adverse because the labour cost incurred in the production of
11,000 units was more than the flexed budget allowance for that level of activity.
The actual cost of $9 per unit ($99,000 ÷ 11,000 units) is $1 higher than the budgeted unit
cost.
Exercise 5
The actual labour cost per hour is higher than expected causing an adverse total labour cost
variance.
Exercise 6
(a)
Original budgeted (fixed budgeted) revenue = 9,000 × $5.60 $50,400
Actual revenue = $52,520
––––––––––––––
Total revenue variance = $2,120 favourable
––––––––––––––
The variance is favourable because more revenue was made than originally expected.
(b)
Original budgeted (fixed budgeted) revenue = $50,400

The flexed budget calculates the revised sales revenue expected,
based on the actual sales volume at the budgeted selling price =
$56,560
10,100 units × $5.60 =
––––––––––––––
Sales activity (volume) variance = $6,160 favourable
––––––––––––––
The activity (volume) variance is favourable because more units were sold than originally
budgeted.
(c) A comparison between the flexed budget and the actual sales yields the selling price
variance:
$56,560 – $52,520 = $4,040 adverse
The variance is adverse because the actual sales revenue of $5.20 per unit ($52,520 ÷
10,100) is $0.40 below the budgeted selling price of $5.60 per unit.
Exercise 7
The total revenue variance will be adverse because the actual sales of $180,000 is lower than
the budgeted revenue of $200,000 (20,000 units × $10 per unit).
Exercise 8
Actual Budget Variance Variance as a
percentage of
$ $ $
budget
Material 47,600 44,020 3,580 adverse 8.1% adverse
Labour 26,400 25,200 1,200 adverse 4.8% adverse
Sales 101,000 90,000 11,000 favourable 12.2% favourable
Management attention will be directed to areas where control action might be necessary, i.e.
materials and sales.
As a result, managers will not be overwhelmed with information about areas of the business that
are operating according to the budget and where control action is not necessary, i.e. labour.
SESSION 10
Tables
Key advantage Key disadvantage Suitability
Information can be easily Further analysis is required to Where there are more than 5
navigated to explain the data categories of data
Graphs and charts

Type Key advantage Key disadvantage Suitability
Bar/column Can be broken into Totals and accuracy Comparing
components can be lost components over
time
Pie Good for assessing May be too simple Showing relative size
relative importance of each component
Scatter graphs Can cope with a wide Limited to two Illustrating a random
range of data variables relationship
Line graphs Illustrates trends and Complicated if lines Identifying trends
seasonality intersect
Area chart Can illustrate both the Limited to one overall An alternative to bar
total and the total charts when the total
components is important

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ACCA Diploma in Financial and

Management Accounting (RQF Level 3)

Managing Costs and Finances

P.2 KAPLAN PUBLISHING

SESSION 1 – MANAGEMENT INFORMATION 5

SESSION 2 – COST CLASSIFICATION AND COST BEHAVIOUR 9

SESSION 3 – ELEMENTS OF COSTS 23

SESSION 4 – MARGINAL COSTING AND ABSORPTION COSTING 51

SESSION 5 – PRODUCT AND SERVICE COSTS 57

SESSION 6 – ESTIMATING COSTS AND REVENUES (CVP ANALYSIS) 69

SESSION 7 – CASH RECEIPTS AND PAYMENTS 103

SESSION 8 – MANAGING CASH SURPLUSES AND DEFICITS 115

SESSION 9 – INFORMATION FOR COMPARISON 121

SESSION 10 – REPORTING MANAGEMENT INFORMATION 129

ANSWERS AND MISSING SECTIONS 135

KAPLAN PUBLISHING P.3

Format of the examination

Each question is worth two marks each.

Total time allowed: 2 hours

RELEVANT ARTICLES FROM ACCA STUDENT

August 2015 Effective presentation and communication of information using charts

November 2012 Accounting for joint products

All articles can be found on the ACCA website at: www.accaglobal.com

(b) Management information requirements

(c) Maintaining an appropriate cost accounting system

NATURE AND PURPOSE OF INTERNAL REPORTING

Management information requirements

2 Relevant/appropriate for the particular purpose

DIFFERENCES BETWEEN FINANCIAL AND MANAGEMENT

Purpose To aid planning for the future, to To report historic financial

Who produced for Internal management and External users such as

Format/presentation Can be personalised to the Is standardised for all

Legal requirements None Lots

Nature of information Forward looking Backward looking

Specific order Continuous operation

Job costing Batch costing Process Service

MAINTAINING AN APPROPRIATE COST-ACCOUNTING

Date Narrative $ Date Narrative $

Cost classification and

(b) Cost behaviour

Examples of cost units

Business Cost unit

Car manufacturer Car

Hotel and catering Room/cover

(accountants, architects, lawyers) Chargeable hour

Education (a) Enrolled student

(b) Successful student

(c) Number of lectures

(d) School meal

Healthcare (hospitals) (a) Bed occupied

Building service Square metre

Materials storage/handling (a) Requisition

(b) Unit issued/received

(c) Value issued/received

Personnel administration Employee

Unit issued/received (a) Number

Telephone service (a) Call made

Examples may be:

2 By unit of product or service or by activity level

• Production (making, finishing, packing)

• Services (maintenance, power)

• Administration (office tasks,)

• Distribution (delivering goods to customers)

Production costs centres