M Acc Spring 2017

Management Accounting
Chapter 1
The nature and purpose of management

accounting
The nature and purpose of
management accounting
• Data and information.
• Planning, decision making and control.
• Responsibility centres.
• The role of management accounting.
Data and information
• Data and information are different.
– Data consists of numbers, letters, symbols, raw
facts, events and transactions which have been
recorded but not yet processed into a form
suitable for use.
– Information is data which has been processed in
such a way that it is meaningful to the person who
receives it (for making decisions).
Attributes of good information
The ‘ACCURATE’ acronym:
– A – Accurate
– C – Complete
– C – Cost-effective
– U – Understandable
– R – Relevant
– A – Accessible
– T – Timely
– E – Easy-to-use!
The managerial processes of decision making and control
• The main functions that management are

involved with are:
• Planning
• Decision making
• Control
Planning, decision making & control
Levels of planning: Strategic, tactical and
operational planning:
Strategic planning – senior managers formulate
long-term Objectives (goals) and plans (strategies)
for an organisation.
Tactical planning – senior managers make short-
term plans for the next year.
Operational planning – all managers (including
junior managers) are involved in making day to
day decisions about what to do next and how to
deal with problems as they arise.
Levels of planning: Strategic, tactical and
operational planning:
Control-Feedback Loop
Decision making
Responsibility Accounting & Centres
Responsibility accounting is based on identifying
individual parts of a business which are the
responsibility of a single manager.
A responsibility Centre is an individual part of a business
whose manager has personal responsibility for its
performance.
The main responsibility centres are:
• Cost Centre
• Profit Centre
• Investment Centre
• Revenue Centre.
Responsibility Centres
Cost Centre
Profit Centre Responsibility Centre Investment

Centre
Revenue Centre
Managers to plan & control areas of performance on which they are measured.
Responsibility Centres
Responsibility centres - Examples
Practice questions
1. The part of an organisation which generates revenues and for
which costs are also collected is called:
A)A cost centre
B )A revenue centre
C )A profit centre
2. A support department in an organisation, for which costs are

collected, is called:
A) A cost centre
B )A revenue centre
C )A profit centre
Financial Accounting
• Financial accounting involves classifying and

recording the financial information of an organization
and summarizing them in periodic financial
statements for external users who wish to analyze
and interpret the financial position of the
organization.
Cost Accounting
• Cost accounting is a system for recording data and
producing information about costs for the products
produced by an organization and/or the services it
provides.
• It is also used to establish costs for particular
activities or responsibility centres.
• Cost accounting is part of management accounting.
• Cost accounting provides a bank of data for the
management accountant to use.
Management Accounting
• Management accounting is used to aid

management to plan & control the
organization's activities and to help the
decision making process.
Management Accounting vs. Financial
Accounting
Management Accounting Financial Accounting
Information mainly Internal users, e.g. Managers External users e.g. Shareholders,
produced for and employees creditors, lenders, banks,
government
Purpose of To aid planning, control and To record financial performance and
information decision making position in a period
Legal requirements No Yes (limited companies)

Formats No set format – managers Limited companies must produce
decide on content & financial accounts
presentation
Nature of Financial & non-financial Mostly financial
information
Time period Historical & forward-looking Mainly an historical record

Example
Solution
Role of Management Accounting within an
organization's management information system
• The management information system of an
organisation is likely to be able to prepare the
following:
• annual statutory accounts
• budgets and forecasts
• product profitability reports
• cash flow reports
• capital investment appraisal reports
• standard cost and variance analysis reports
Relevant Costs and Revenues
INCREMENTA
L
CASH FLOWS FUTURE
Relevant
Cash
flow
Relevant Cash Flows
• Relevant costs are future costs. Cost and
revenues that are going to be incurred some
time in the future.
• Costs that have been incurred in the past are
totally irrelevant to any decision that is being
made 'now'. Such costs are past costs or sunk
costs.
Relevant Cash Flows
• Relevant costs are cash flows. Only cash flow
information is required.
• This means that costs or charges which do not
reflect additional cash spending (such as
depreciation) should be ignored for the
purpose of decision-making.
Relevant Cash Flows
• Incremental- the extra cost or revenue that is
created as a result of a decision taken.
Chapter Summary
Chapter 2
Types of cost and cost behaviour

Cost Classification
• Costs can be classified in a number of different ways.
1. Element costs are classified as materials, labour or
expenses (overheads).
2. Nature costs are classified as being direct or indirect.
3. Behaviour costs are classified as being fixed, variable,
semi-variable or stepped fixed.
4. Function costs are classified as being production or
non-production.
Slide 30 Slide 30
Classifying costs
Classification by elements
Materials
All costs of materials purchased for production or nonproduction
activities. For example, raw materials, components, cleaning
materials, maintenance materials and stationery.
Labour costs
All staff costs relating to employees on the payroll of the
organisation.
Expenses
All other costs which are not materials or labour. This includes all
bought in services, for example, rent, telephone, subcontractors
and costs such as the depreciation of equipment.
Classification by Function
Production Costs
• Production costs are costs that relate
to the manufacture of a product or
provision of a service.
• These are costs incurred when raw
materials are converted into finished
and part-finished goods and are
included in the valuation of inventory.
Production Costs
Production Costs
• Example:
• Direct material: bricks, cement
• Direct Labour: builders, plasterers
• Direct Expenses: cost of subcontracted
cranes and drivers
• Variable production Overheads: electricity
• Fixed Production Overheads: site manger
salary
Non-Production Costs
• Non-Production Costs are costs that are not
directly associated with the production of
business outputs.
• These costs are not included in the
valuation of inventory.
• These costs are charged as expense in the
income statement.
Non-Production Costs
Classification by Nature
Direct and Indirect costs
Direct costs : costs which can be directly identified with a specific unit or cost centre
Total of direct costs =

Direct Materials + Direct labour + Direct expenses =
Prime Cost
Indirect costs : costs which can not be directly identified with a specific unit or cost
centre
Indirect costs =
Indirect Materials + Indirect labour + Indirect expenses =
Overheads
Direct and indirect costs
• A direct cost is a cost that can be traced in full to
the product, service or department that is being
costed. It is also known as prime cost.
• There are three main types of direct cost:
• direct materials for example, cloth for making
shirts
• direct labour for example, the wages of the
workers stitching the cloth to make the shirts
• direct expenses for example, the cost of
maintaining the sewing machine used to make the
Slide shirts.
39 Slide 39
Direct Costs-Direct material
• Direct material is all material becoming part of
the product (unless used in negligible amounts
and/or having negligible cost).
Examples of direct material are as follows.
(a) Wood in the production of a table or fabric in
a shirt.
(b) Primary packing materials like cartons and
boxes.
Direct Costs-Direct labour
• Direct wages are all wages paid for labour (either
as basic hours or as overtime) expended on work
on the product itself.
• Workers engaged in altering the condition or
composition of the product.
• Inspectors, analysts and testers specifically
required for such production.
• Foremen, shop clerks and anyone else whose
wages are specifically identified.
Direct Costs-Direct expense
• Direct expenses are any expenses which are
incurred on a specific product other than direct
material cost and direct wages
• Direct expenses are charged to the product as
part of the prime cost.
• The hire of tools or equipment for a particular job
• Maintenance costs of tools, fixtures and so on,
Royalty on production, Import duty, Excise duty
• Total direct costs are known as prime cost
Indirect costs
• An indirect cost is a cost which cannot be
traced directly to the product, service or
department.
• Indirect costs are also known as overheads.
Indirect costs
• Indirect materials which cannot be traced in the
finished product. e.g. material used in negligible
amounts
• Indirect wages, meaning all wages not charged directly
to a product. e.g. Wages of non-productive personnel
in the production department e.g. supervisors
• Indirect expenses (other than material and labour) not
charged directly to production, e.g. Rent, rates and
insurance of a factory, depreciation, fuel, power,
maintenance of plant, machinery and buildings
Example
Suppose that a furniture maker is determining the cost
of a wooden table.
• The manufacture of the table has involved the use of timber,
screws and metal drawer handles. These items are classified
as direct materials .
• The wages paid to the machine operator, assembler and
finisher in actually making the table would be classified as
direct labour costs .
• The designer of the table may be entitled to a royalty
payment for each table made, and this would be classified
as a direct expense .
Example Cont…
Other costs incurred would be classified as indirect
costs .
• They cannot be directly attributed to a particular
cost unit, although it is clear that they have been
incurred in the production of the table. Examples of
indirect production costs are as follows:
• Cost incurred Cost classification
Lubricating oils and cleaning materials Indirect material
Salaries of supervisory labour Indirect labour
Factory rent and power Indirect expense
Classification by Behaviour
• Costs may be classified according to the way
that they behave in relation to changes in the
levels of activity.
• Cost behaviour classified costs as one of the
followings:
– Variable cost
– Fixed cost
– Semi-variable cost
– Stepped fixed cost
Slide 50 Slide 50
Fixed Costs
• A fixed cost is a cost which is incurred for an
accounting period, and which, within certain
activity levels remains constant.
• rent of a building
• business rates
• salary of a director
Slide 51 Slide 51
Cost behaviour – Fixed Costs
A cost that, within certain output and sales revenue limits, is unaffected by
changes in the level of activity.
Variable Costs
• Variable costs are costs that vary in direct
proportion with the level of activity.
– direct materials
– direct labour
– sales commission
• Costs may also be semi-fixed or semi-variable
• Such as an telephone bill which has a fixed standing charge and
a variable cost per calls made
Slide 53 Slide 53
Cost Behaviour – Variable Costs
The way in which costs vary at different levels of activity
• A cost that varies with the level of activity, e.g. Material cost
Material Cost and Quantity Discount
1. Discounts are received on additional

purchases of material above a set order
quantity and the discount only applies to the
extra units.
2. Discounts are received when total purchases
exceed a certain level and all units purchased
are invoiced at a lower cost per unit.
Semi-variable Costs
• Semi-variable costs contain both fixed and
variable cost elements and are therefore
partly effected by change in the level of
activity.
• Such as an telephone bill which has a fixed
standing charge and a variable cost per
calls made
Slide 56 Slide 56
Cost behaviour – Semi-variable Costs
A cost with a fixed and a variable element, e.g. telephone charges with fixed line
rental and charge per call
Stepped Fixed Costs
A fixed cost which is only fixed within a certain level
of activity. Once the upper level is reached, a new
level of fixed costs becomes relevant.
• Warehouse costs(as more space is required,
more warehouse must be purchased or
rented).
• Supervisors 'wages (as number of employees
increases, more supervisors are required)
• Royalties.
Cost behaviour - Stepped Fixed Costs
Example
• Classify the following items of expenditure according to their
behavior i.e. as fixed, variable, semi-variable or stepped fixed costs.
(1) Monthly rent
(2) Council tax charge
(3) Bank loan interest
(4) Petrol
(5) Electricity bill
(6) Telephone bill
(7) Annual salary
(8) Depreciation of one, two and three factory machines
(9) Raw materials
Solution
• The items of expenditure would be analysed as follows.
(1) Fixed
(2) Fixed
(3) Fixed
(4) Variable
(5) Semi-variable
(6) Semi-variable
(7) Fixed
(8) Stepped fixed
(9) Variable
• Note that the depreciation charge for the factory machines (8) is a stepped
fixed cost because as activity increases to such a level that a second and third
machine are required, the fixed cost will double and then treble.
• A fixed cost is shown in graph 4
• A variable cost is shown in graph 1
• A semi-variable cost is shown in graph 3
• Fixed cost per unit is shown in graph 6
• Variable cost per unit is shown in graph 4
• A stepped fixed cost is shown in graph 2
Cost behaviour – Hi-low method
Costs are analysed into variable & fixed elements using the hi-
low method.
Step1 :
Select high and low activity levels and their associated costs.
Step 2 :
Variable Cost per unit
=
cost at high level of activity-cost at low level of activity / High level of activity-
low level of activity
Step 3 :
Find fixed cost by substitution using either the high or low activity level
Fixed cost=Total cost at activity level– Total variable Cost

Assumptions Underlying High/Low Method
• The only thing causing any change in cost is

the change in activity.
• The cost under consideration is potentially
semi-variable cost.
• The linear model of cost behavior is valid i.e.
y = a+ bx
Example : The high/low method
Output (units) Total costs ($)

200 7000
300 8000
400 9000
a) Calculate the variable cost per unit
b) Calculate the total fixed cost
c) Estimate the total cost if output is 350 units
d) Estimate the total cost if output is 600 units
Example: The high-low method
DG Co has recorded the following total costs during the last

five years.
Year Output volume Total cost
Units $
20X0 65,000 145,000
20X1 80,000 162,000
20X2 90,000 170,000
20X3 60,000 140,000
20X4 75,000 160,000
Required
Calculate the total cost that should be expected in 20X5 if
output is 85,000 units.
• High/low method with stepped fixed costs
Sometimes fixed costs are only fixed within certain level

of activity and increase in steps as activity increases.
The high/low method can still be used to estimate the fixed and
variable costs.
Simply Choose two activity levels where the fixed cost remains
unchanged
Adjustments need to be made for the fixed costs based on the
activity level under consideration.
Example: The high-low method with
stepped fixed costs
The following data relate to the overhead expenditure of
contract cleaners (for industrial cleaning) at two
activity levels.
Square meters cleaned 12,750 15,100
Overheads $73,950 $83,585
When more than 14,000 square meters are industrially
cleaned, there will be a step up in fixed costs of $4700
Required
Calculate the estimated total cost if 14,500 square meters

are to be industrially cleaned.
Solution
Before we can compare high output costs with

low output costs in the normal way, we must
eliminate the part of the high output costs
that are due to the step up in fixed costs:
Total cost for 15,100 without step up in fixed
costs = $83,585 – $4,700 = $78,885
We can now proceed in the normal way using
the revised cost above.
Solution
Sq Met $
High activity 15,100 Total cost 78,885
Low activity 12,750 Total cost 73,950
2,350 4,935
Variable cost = $4,935
2,350
= $2.10 per square metre
Solution
• Before we can calculate the total cost for 14,500 square
metres we need to find the fixed costs. As the fixed
costs for 14,500 square metres will include the step up
of $4,700 we can use the activity level of 15,100 square
metres for the fixed cost calculation:
$
Total cost (15,100 square metres)
(this includes the step up in fixed costs) 83,585
Total variable costs (15,100 x $2.10) 31,710
Total fixed costs 51,875
Solution
Estimated overhead expenditure if 14,500
square metres are to be industrially cleaned:
$
Fixed costs 51,875
Variable costs (14,500 X$2.10) 30,450
82,325
High Low method with changes in the variable cost per unit
Same data as the previous question.

Additionally, a round of wage negotiations have just
taken place which will cost an additional $1 per
square metre.
High Low method with changes in the variable cost per unit
Estimated overheads to clean 14,500 square metres.
Per square metre
$
Variable cost 2.10
Additional variable cost 1.00
Total variable cost 3.10
Cost for 14,500 square metres:

$
Fixed 51,875
Variable costs (14,500 X $3.10) 44,950
96,825
Example
An organization has the following total costs at two activity
levels:
Activity levels (units) 16,000 22,000

Total costs ($) 135,000 170,000
Variable cost per unit is constant within this range of

activity but there is a step up of $5,000 in the total fixed
costs when the activity exceeds 17,500 units.
What is the total cost at an activity of 20,000 units? ,

Example : High/low method with stepped
fixed costs
Example : The high/low method with changes in
variable cost
Advantages and Limitation of high/low
method
• Main advantage is easy to understand and use.
• Limitations
– Use historical data and assume this data can predict future
costs.
– It assumes that level of activity are the only factors affecting
costs.
– It use only two values (highest and lowest) to predict future
costs and these results may be distorted because of random
variations.
– Bulk discount may be available for purchasing resources in
large quantities.
Cost Equation
• Cost equations are derived from historical cost data.

• it can be used to estimate future costs.
• The equation of a straight line is a linear function and is
represented by the following equation:
y = a + bx
• ‘a’ is the fixed cost per period (the intercept)
• ‘b’ is the variable cost per unit (the gradient)
• ‘x’ is the activity level (the independent variable)
• ‘y’ is the total cost = fixed cost + variable cost (the
dependent variable).
Graph of linear function
Equation for the total cost function
Question 1: Total Cost Functions
If y = 8,000 + 40x
Please find the followings:

(a) Fixed cost
(b) Variable cost per unit
(c) Total cost for 200 units
If the total cost of a product is given as:
Y = 4,800 + 8x
(a) The fixed cost is ?

(b) The variable cost per unit is ?
(b) The total cost of producing 100 units is ?
Consider the linear function y = 1,488 + 20x and
answer the following questions.
(a) The line would cross the y axis at the
point
(b) The gradient of the line is
(c) The independent variable is
(d) The dependent variable is
Question 4: Total Cost Function
Fixed costs $100,000.
Variable costs per unit $5 for volumes up to
1,000 units.
Volumes above 1,000 units receive 5%
discount on all units.
Required:
Derive the two equations for the total cost
function.
Cost Units
• A unit of product or service in relation to
which costs are ascertained.
• Industry sector Cost unit
• Brick-making 1,000 bricks
• Electricity Kilowatt-hour
• Professional services Chargeable hour
• Education Enrolled student
Activity Cost unit
• Credit control Account maintained
• Selling Customer call
Cost Object
• A cost object is often a product or department for
which costs are accumulated or measured.
• For example, a product is the cost object for direct
materials, direct labor and manufacturing overhead.
• The factory maintenance department is a cost object
for the cost of the maintenance employees and the
maintenance supplies.
• A cost object can also be a customer, a machine, a
group of machines, a group of employees, etc.
Cost Card
Question
• Are the following likely to be fixed, variable or
mixed costs?
(a) Telephone bill
(b) Annual salary of the chief accountant
(c) The management accountant's annual
membership fee to CIMA (paid by the company)
(d) Cost of materials used to pack 20 units of product
X into a box
(e) Wages of warehousemen
Chapter 3
Business Mathematics
Expected Values
The weighted average of a probability distribution, used in simple decision-making
situations.
EV = ∑px
Where p = probability of outcome occurring

x = outcome.
When using Expected Values :
•Only accept projects if EV is positive
•With mutually exclusive options, accept the one with the highest EV.
Expected Values - Example
Expected Values - Limitations
Expected values :
• Use past data and estimates, which may be inaccurate
• Are not always suitable for one-off decisions as they are long-term average.
The expected value might never occur for any single result
• Do not take into account the time value of money
• Do not take into account the decision maker’s attitude to risk.

Regression
If x is the independent variable and y the dependent variable, least squares regression
finds the line of best fit through the scatter diagram.
y = a + bx
Where a is the y value when x is 0, and b is the change in y when x increases by one unit.
Regression
In the context of cost estimation :
y represents the total cost

x represents the production volume in units
a represents the total fixed costs
b represents the variable cost per unit
(Given)
Correlation Coefficient
r measures the strength of a linear relationship between two variables.
-1 < r < 1
• If r = 1 perfect positive correlation

•If r = 0, no correlation
•If r = -1, perfect negative correlation.
(Given)
Correlation does not prove cause and effect – it merely suggests it.
Coefficient of determination
r² shows how much of the variation in the dependent variable is dependent on the
variation of the independent variable.
E.g. If r = 0.95, r² = 0.90 or 90%
This means that 90% of the variation in y (costs) is explained by the variation in x
(level of output).
Chapter 4
Accounting for
Materials
Accounting procedures for ordering and
issuing inventory
• Accounting and control procedures for ordering
and issuing inventory include the following
functions:
• ordering
• purchasing
• receiving
• issuing
• storing and stocktaking.
Inventory control-Ordering, Receiving and issuing
materials
Inventory control-Ordering, Receiving and issuing
materials
Inventory control-Paperwork
Document Completed by Sent to Information
included
Purchase Requisition form Production department Purchasing department Goods required
Manager’s authorisation
Purchase order form Purchasing Department Supplier Goods required

Accounting (copy)
Goods receiving department
(copy)
Delivery note Supplier Goods Receiving Department Check of goods delivered against
order form
Goods Received Note Goods receiving department Purchasing department Verification of goods received to
enable payment
Materials requisition note Production department Stores Authorisation to release goods

Update stores record
Materials returned notes Production Department Stores Details of goods returned to stores
Update stores record
Materials Transfer notes Production Department A Production Department B Goods transferred between
departments
Update stores records
Accounting for inventory
Inventory control account
Inventory valuation
• Perpetual inventory is an inventory recording system
where the records are updated for each receipt/issue of
inventory.
– Inventory records are updated using stores ledger cards
and bin cards.
– Bin cards also show a record of receipts, issues and
balances of the quantity of an item of inventory handled
by stores.
– As with the stores ledger card, bin cards will show
materials received (from purchases and returns) and
issued (from requisitions).
Inventory valuation
• Inventory valuation is important for
• Financial reporting
– For inclusion in the financial statements of the
business
• Costing
– To calculate how much to charge for a product
based on the amount of inventory consumed.
Inventory valuation
• Inventory is valued at the lower of cost and
net realizable value.
• To charge units of inventory with an
appropriate value the business will
consistently use an appropriate basis:
– FIFO
– LIFO
– Weighted average cost.
Stocktaking
• The process of stocktaking involves checking
the physical quantity of inventory held on a
certain date and then checking this balance
against the balances on the stores ledger
(record) cards or bin cards.
• Stocktaking can be carried out on following
basis:
– periodic basis or
– a continuous basis.
Inventory levels
• Inventory is held for a number of reasons
• To ensure any unexpected demands can
be met
• To meet any future shortages
• Bulk purchasing discounts available
Slide 109 Slide 109

Chapter 5
Order Quantities and

Reorder Levels
Holding & Ordering Costs
Stock-out costs : running Holding costs: holding Ordering costs :

out of inventory inventory placing orders
Fixed costs
Loss of sales • Cost of storage Administrative costs
space, insurance
• damage &
pilferage
Loss of customers
and goodwill Delivery
Variable costs
• Interest on capital
tied up in stock
Order costs vary with
Reduced profits number of orders
placed
Minimise total of holding, ordering and stock-out costs

Economic Order Quantity
The EOQ minimises the total of holding, ordering & stock-out costs
EOQ =
√ 2C0D
Ch
Where :
D = demand p.a.
C0 = Cost of placing one order
Ch = cost of holding one unit per year
Total Annual Cost = PD + (Co X D/Q)+ (Ch X Q/2)
EOQ assumptions
• Demand and lead time are constant and

known.
• Purchase price is constant.
• No buffer inventory is held.
Economic Order Quantity
• A company uses components at the rate of 500

units per month, which are bought at a cost of
$1.20 each from the supplier. It cost $20 each time
to place an order, regardless of the quantity order.
• The total holding cost is 20% per annum of
purchase price.
Required:
How many components company should order and
what will be the total annual cost ?
EOQ with discount
• A company uses components at the rate of 500 units per

month, which are bought at a cost of $1.20 each from the
supplier. It cost $20 each time to place an order, regardless
of the quantity border.
• The supplier offers a 5% discount on the purchase price for
order quantities of 2000 units. The current EOQ is 1000
units.
• The total holding cost is 20% per annum of purchase price.
Required:
Should the discount be accepted?
Question
• Watton Ltd is a retailer of beer barrels. The company

has an annual demand of 36,750 barrels. The barrels
cost $12 each.
• Ordering costs and the cost of carriage inwards are
$200 per order. The annual cost of holding one barrel
in stock is estimated to be $1.20.
• The economic order quantity has been calculated to
be 3,500 barrels. The suppliers introduce a quantity
discount of 2% on orders of at least 5,000 barrels and
2.5% on orders of at least 7,500 barrels.
Required: Determine whether the least cost order
quantity is still the EOQ of 3,500 barrels.
Economic Batch Quantity
The EBQ is primarily concerned with determining the number of items that should be
produced in a batch.
EBQ =
√ 2C0D
Ch(1-D/R)
Where :
Q= Batch size
D = demand p.a.
R=Annual production rate
C0 = Cost of setting up a batch ready to be produced
Ch = cost of holding one unit per year
Question
The following is relevant to item X:

• Production at a rate of 500 units per week.
• Demand is 10,000 units per annum, evenly spread
over 50 working weeks.
• Set up cost is $2,700 per batch.
• Storage cost is $2.50 per unit for a year.
Required:
Calculate the economic batch quantity (EBQ) for
item X.
Solution
• Annual production rate, R=500 x 50 =25,000 units

• Annual demand rate = 10,000 units
• Cost per setup Co = $2,700
• Cost of holding one item in inventory per year, Ch =
$2.50
EBQ = √ 2 x 2,700 x 10,000
2.5 (1-10,000/25,000)
EBQ = 6,000 units
Inventory control levels
• Inventory control levels can be calculated in

order to maintain inventories at the optimum
level.
• The three critical control levels are:
• reorder level,
• minimum level
• and maximum level.
Reorder level
• When inventories reach this level, an order should be

placed to replenish inventories. The reorder level is
determined by consideration of the following.
• The maximum rate of consumption
• The maximum lead time
The maximum lead time is the time between placing
an order with a supplier, and the inventory becoming
available for use
Reorder level = maximum usage x maximum lead time
Minimum level/Buffer Level

This is a warning level to draw management attention to the
fact that inventories are approaching a dangerously low level
and that stock outs are possible.
Minimum level = reorder level – (avg usage x avg lead time)
Maximum level
This also acts as a warning level to signal to management that
inventories are reaching a potentially wasteful level.
Maximum level = reorder level + reorder quantity –
(minimum usage x minimum lead time)
Reorder quantity
• This is the quantity of inventory which is to be
ordered when inventory reaches the reorder
level.
• If it is set so as to minimize the total costs
associated with holding and ordering
inventory, then it is known as the economic
order quantity
Question- Maximum inventory level
A large retailer with multiple outlets maintains a central

warehouse from which the outlets are supplied.
The following information is available for Part Number SF525.
Average usage 350 per day
Minimum usage 180 per day
Maximum usage 420 per day
Lead time for replenishment 11-15 days
Re-order quantity 6,500 units
a) Based on the data above, what is the re-order level and maximum
level of inventory?
b) Based on the data above, what is the approximate number of Part
Number SF525 carried as buffer inventory?
Answer
Maximum inventory level = reorder level + reorder quantity

– (min usage x min lead time)
=6,300 + 6,500 – (180 x 11)
=10,820units
Buffer inventory = minimum level

Minimum level = reorder level – (average usage x average
lead time)
= 6,300 – (350 x 13)
= 1,750units
Chapter 6
Accounting for Labour

Direct or Indirect Costs?
‘Type’ of worker
Indirect workers (Maintenance

directly involved in making products staff, supervisors, Canteen
Direct Labour cost Indirect Labour cost

Make up part of General O/T premiums
prime cost of a • Bonus payments
Indirect Labour cost
product, • Idle time
Basic Pay • Sick pay
• Overtime Premium
• Time spent on indirect
jobs
ALL COSTS
‘on specific job’, ‘at
customer’s request’
Overtime and overtime premiums
• When employees work overtime, they receive

a basic pay element and an overtime premiu
• For example, if Fred is paid $8 per hour and
overtime is paid at time and a half, when Fred
works overtime, he will receive $12 per hour
($8 + $4 (50% x $8)).
• It is important that his pay is analyzed into
direct and indirect labour costs.
• Overtime premiums are treated as direct labour

costs, if at the specific request of a customer
because they want a job to be finished as soon as
possible.
• Employees who work night shifts, or other antisocial
hours may be entitled to a shift allowance or shift
premium.
• Shift premiums are similar to overtime premiums
where the extra amount paid above the basic rate is
treated as an indirect labour cost.
Direct and Indirect Labour
Vienna is a direct labour employee who works a standard 35

hours per week and is paid a basic rate of $12 per hour.
Overtime is paid at time and a third. In week 8 she worked 42
hours and received a $50 bonus.
• Please find Basic pay for standard hours (DLC)
• Basic pay for overtime hours (DLC)
• Overtime premium (IDLC)
• Bonus (IDLC)
Example
• A company operates a factory which employed 40 direct
workers throughout the four-week period just ended.
Direct employees were paid at $4 per hour for 38 hours
per week.
• The total hours of the direct workers in the four- week
period were 6,528. Overtime, which is paid at premium
of 35%, is worked in order to meet production
requirements.
• Employees deduction total 30% of gross wages. 188
hours of direct workers time were registered as idle.
Calculate: Gross Wages, deductions, net wages, direct
labour cost and indirect labour cost for the four-week
period.
Solution
Solution
Calculating labour in products and services
• Determining time spent doing jobs

• Methods can include:
• time sheets
• time cards
• job sheets.
Payroll department
• The payroll department is involved in carrying out

functions that relate input labour costs to the work
done.
• Preparation of the payroll involves calculating gross
wages from time and activity records.
• The payroll department also calculates net wages
after deductions from payroll (PAYE, Employer’s
National Insurance Contributions and Employee’s
National Insurance Contributions).
• The payroll department also carries out an analysis of
direct wages, indirect wages, and cash required for
payment.
Remuneration Methods
• Time Based Schemes
•Total Wages = (hours worked * basic pay/hour) + (o/t
hrs worked * o/t premium/hour)
• Higher quality if workers are happy to spend longer on

units to get them right; However, no incentive to improve
productivity.
• Other Schemes e.g. Flat salary + bonus
• Bonus Schemes (individuals or groups)

Remuneration Methods
• Piecework Schemes
Total Wages = Number of units completed * agreed rate
per unit.
•May involve a guaranteed minimum wage;
•May use a higher rate per unit once productivity target
achieved
•Higher productivity at the expense of quality?
Type of piecework systems
• Straight piecework systems
• Differential piecework systems
Piecework Schemes
• A company operates a piecework system of remuneration,
but also guarantees its employees 75% of a time-based rate
of pay which is based on $19 per hour for an eight hour
working day.
• Three minutes is the standard time allowed per unit of
output. Piecework is paid at the rate of $ 18 per standard
hour.
• If an employee produces 200 units in eight hour on a
particular day.
• What is the employee guaranteed wages and gross pay for
that day?
Incentive schemes
• They should be closely related to the effort
expended by employees.
• They should be agreed by employers/employees
before being implemented.
• They should be easy to understand and simple to
operate.
• They must be beneficial to all of those employees
taking part in the scheme.
Incentive schemes
• Halsey – the employee receives 50% of the time
saved
Incentive schemes
• Rowan – the proportion paid to the employee is
based on the ratio of time taken to time
allowed.
Incentive schemes
• Measured day work – the concept of this
approach is to pay a high time rate, but this
rate is based on an analysis of past
performance.
• Share of production – Any gains in value
added – whether by improved production
performance or cost savings, are shared by
employees in this ratio.
Example
The following data relate to Job A.
Employee’s basic rate = $4.80 per hour
Allowed time for Job A = 1 hour
Time taken for Job A = 36 minutes
• The employee is paid the basic rate for the allowed time
for the job and then the bonus based on any time saved.
Required.
a) Halsey scheme – Total payment for Job A = ?
b) Rowan scheme – Total payment for Job A = ?
Solution
Solution
Example
• A company operates a premium bonus scheme for its
employees of 50% of the time saved compared with the
standard time allowance for a job, at the normal hourly
rate.
• The data relating to job completed by an employee is as
follows:
Allowed time for the job - 12 hours
Time taken to complete job – 10hours
Normal hourly rate of pay is $15.
• What is the total pay of the employee for job for 10
hours spent on job?

Remuneration methods - examples
Question Weekly pay
• Penny Pincher is paid 50c for each towel she
weaves, but she is guaranteed a minimum wage
of $60 for a 40 hour week for any number of
towels produced. In a series of four weeks, she
makes 100, 120, 140 and 160 towels.
Required
• Calculate her pay each week, and the conversion
cost per towel if production overhead is added
at the rate of $2.50 per direct labour hour.
Solution
Labour Turnover
Labour Turnover
At 1st January a company employed 3,641
employees and at 31 December employees
numbers were 3,735. During the year 624
employees choose to leave the company.
What was the labour turnover rate for the

year?
Causes of labour turnover
• Avoidable:
– Poor remuneration
– Poor working conditions
– Lack of training opportunities
– Lack of promotion prospects
– Bullying in the workplace
Causes of labour turnover
• Unavoidable:
– Retirement
– Illness/death
– Family reasons
– Relocation.
Costs of labour turnover
• Advertising cost
• Cost of selection
• Training new employees
• Reduce efficiency until the new employee
reaches the required skills.
Preventive costs of labour turnover
• Pay competitive wages and salaries
• Improve working conditions
• Offer good training opportunities
• Make sure promotion prospect arises as
necessary
• Stamp out bullying in the workplace
• Investigate high labour turnover rates
objectively.
Labour Related Ratios
• Labour Efficiency Ratio
Expected hours to make actual output
Actual hours taken
• Labour Capacity Ratio
Actual hours worked
Hours budgeted
• Labour Production Volume Ratio
Expected hours to make actual output
Hours Budgeted
Example: Labour activity ratios
• Rush and Fluster Co budgets to make 25,000
standard units of output (in four hours each)
during a budget period of 100,000 hours.
• Actual output during the period was 27,000
units which took 120,000 hours to make.
Required
• Calculate the efficiency, capacity and
production volume ratios.
Solution
• Efficiency ratio
= (27,000u x 4h) 108,000 x 100 = 90%
120,000h
• Capacity ratio
= 120,000 hours x 100 = 120%
100,000hours
Solution
• Production volume ratio
= (27,000u x 4h) 108,000h x 100 = 108%
100,000
The production volume ratio of 108% (more
output than budgeted) is explained by the
120% capacity working, offset to a certain
extent by the poor efficiency (90% x120% =
108%).
Labour Related Ratios
Chapter 7
Accounting for Overheads

Absorption costing
Step1 : O/H allocated or
apportioned to cost
centres using suitable OVERHEADS
bases
Step 2 : Service cost

centres reapportioned to
production cost centres
Production Production Service Service
Department Department Department Department
Step 3 : Overheads
absorbed into units of A B C D
production
Cost Unit x
Overheads
• Overhead is the cost incurred in the course of making
a product, providing a service or running a
department, but which cannot be traced directly and
in full to the product, service or department.
• Overhead is actually the total of the following
- Indirect materials
- Indirect expenses
- Indirect labour
Overheads
• The total of these indirect costs is usually split
into the following categories.
• Production
• Selling and distribution
• Administration
Overheads
• In cost accounting there are two schools of thought
as to the correct method of dealing with overheads.
- Absorption costing
- Marginal costing
Absorption costing: an introduction
The objective of absorption costing is

• to include in the total cost of a product an appropriate
share of the organization's total overhead.
• An appropriate share is generally taken to mean an
amount which reflects the amount of time and effort that
has gone into producing a unit or completing a job.
• An organisation with one production department that
produces identical units will divide the total overheads
among the total units produced.
• Absorption costing is a method for sharing overheads
between different products on a fair basis.
Absorption costing
A business needs to know
• the cost per unit of goods and services
- to value stock
- to fix a selling price
- to analyze profitability
Absorption costing
• In principle, the unit cost of material and labour should
not be a problem, because they can be measured.
Problem?
• It is overheads that present the real difficulty-in
particular fixed overheads.
• e.g. If the factory cost $100,000 p.a. to rent, then how
much should be included in the cost of each unit?
Absorption costing
• Allocation
Allocation involves charging overheads directly to
specific departments(production and service).
• Apportionment
Apportionment is a procedure whereby indirect costs
are spread fairly between cost centers.
• Overhead absorption
Overhead absorption is the process whereby overhead
costs allocated and apportioned to production cost
centers are added to unit, job or batch costs. Overhead
absorption is sometimes called overhead recovery.
Example: Overheads allocation
• Consider the following costs of a company.

Wages of the foreman of department A $200
Wages of the foreman of department B $150
Indirect materials consumed in department A $50
• The cost accounting system might include three overhead cost
centers.
Code Cost centre:
101 Department A
102 Department B
Overhead costs would be allocated directly to each cost centre:
101 Department A ( $200 + $50) $250
102 Department B $150
Absorption costing-Absorption of overheads
Example 1 (One product in a factory)
X Plc produce desks.
Each desk uses 3kg of wood at a cost of $4 per kg,
and takes 4 hours to produce.
Labour is paid at the rate of $2 per hour.
Fixed costs of production are estimated to be
$700,000 p.a..
The company expects to produce 50,000 desks
P.a.
Calculate the cost per desk.`
Absorption costing-Absorption of overheads
Example 2(more than one product)
X plc produce desk and chairs in the same factory.
Each desk uses 3 kg of wood at a cost of $4 per kg and takes
4 hours to produce.
Each chair uses 2 kg of wood at a cost of $4 per kg, and
takes 1 hour to produce.
Labour is paid at the rate of $2 per hour.
Fixed cost of production are estimated to be $700,000 p.a..
The company expects to produce 30,000 desks and 20,000
chairs p.a..
Overheads are absorbed on labour hours basis
• Calculate cost per unit of desks and chairs
Blanket absorption rates and
departmental absorption rates
• A blanket overhead absorption rate is an absorption
rate used throughout a factory and for all jobs and
units of output irrespective of the department in
which they were produced.
• Example, if total overheads were $500,000 and there
were 250,000 direct machine hours during the
period, the blanket overhead rate would be $2 per
direct machine hour and all jobs passing through the
factory would be charged at that rate.
• Blanket overhead rates are not appropriate in
the following circumstances.
• There is more than one department.
• Jobs do not spend an equal amount of time in
each department.
• If a single factory overhead absorption rate is used,
some products will receive a higher overhead
charge than they ought 'fairly' to bear, whereas
other products will be under-charged.
• If a separate absorption rate is used for each
department, charging of overheads will be fair
and the full cost of production of items will
represent the amount of the effort and resources
put into making them.
Example: Blanket absorption rates and
The Old Grammar School has two production departments, for
which the following budgeted information is available.
Departments A B Total
Budgeted overheads $360,000 $200,000 $560,000
Budgeted direct labour hours 200,000 hrs 40,000 hrs 240,000 hrs
Required:
Find a single factory overhead absorption rate and departmental
overhead absorption rate?
Solution
• If a single factory overhead absorption rate is applied,
the blanket rate/factory rate is:
• $560,000/240,000h = $2.33 per direct labour hour
• If separate departmental rates are applied,

Dep A=$360,000/200,000h =$1.80 per direct labour hour
Dep B =$200,000/40,000h = $5 per direct labour hour
(Department B has a higher overhead rate of cost per
hour
worked than department A)
Example-Cont…
Now let us consider two separate jobs.
• Job X has a prime cost of $100, takes 30 hours in department
B and does not involve any work in department A.
• Job Y has a prime cost of $100, takes 28 hours in department

A and 2 hours in department B.
What would be the factory cost of each job, using the
following rates of overhead recovery?
• A single factory rate of overhead recovery
• Separate departmental rates of overhead recovery
Example-Cont…
Single factory rate
Job X Job Y
$ $
Prime cost 100 100
Factory overhead (30 x$2.33) 70 70
Factory cost 170 170
Example-Cont…
Separate departmental rates
Job X Job Y
$ $
Prime cost 100 100
Factory overhead: department A 0 (28x$1.80) 50.40
department B (30 x$5) 150 (2x$5) 10.00
Factory cost 250 160.40
Example-Cont…
• Using a single factory overhead absorption rate, both jobs would
cost the same. However, since job X is done entirely within
department B where overhead costs are relatively higher,
whereas job Y is done mostly within department A, where
overhead costs are relatively lower, it is arguable that job X
should cost more than job Y. This will occur if separate
departmental overhead recovery rates are used to reflect the
work done on each job in each department separately.
• If all jobs do not spend approximately the same time in each
department then, to ensure that all jobs are charged with their
fair share of overheads, it is necessary to establish separate
overhead rates for each department.
More than one department in the factory
• In this situation we need first to allocate and

apportion overheads between each
department. We can then absorb the
overheads in each department separately.
Example 3 (more than one department)
X plc produces desk and chairs. The factory has two
departments, assembly and finishing.
Each desk take 3kg of wood at $4 per kg and takes 4 hours to
produce-3 hours in assembly and 1 hour in finishing.
Each chair uses 2kg of wood at $4 per kg and takes 1 hour to
produce-1/2 hour in assembly and ½ in finishing,
All labor is paid at the rate of $2 per hour.
Fixed cost of production are estimated to be $700,000 pa, of
this total , $100,000 is the salary of the supervisors-$60,000 to
assembly supervisor and $40,000 to finishing supervisor.
The remaining overheads are to be split 40% to assembly and
60% to finishing.
The company expect to produce 30,000 desks and 20,000
chairs. Overheads are absorbed on labour hour basis.
Calculate the cost per unit for desks and for chairs?
Basis of apportionment
Overheads Basis
Rent, rates, heating and Floor area occupied by each
light, repairs and cost center
depreciation of buildings
Depreciation, insurance of Cost or book value of

equipment equipment
Personnel office, canteen, Number of employees, or
welfare, wages and cost labour hours worked in each
offices, first aid cost centre
Overheads Allocation and Apportionment
Example 4
X plc, production overheads costs for the period
$
Factory rent 20,000
Factory heat 5,000
Processing Dep-Supervisor 15,000
Packing Dep-Supervisor 10,000
Depreciation of equipment 7,000
Factory Canteen expense 18,000
Welfare cost of factory employees 5,000
There is also direct labour cost of $20,000.

Processing Dep Packing Dep Canteen
Cubic space (m) 50,000 25,000 5,000
NBV equipment $300,000 $300,000 $100,000
No. of employees 50 40 10
Allocate and apportion production overheads costs amongst the
three departments using a suitable basis.
Reapportionment of service cost centre
overheads
Example 5
Reapportion the canteen cost in example 4
to the production cost centers.
Question- Apportioning service
department overheads
Spaced Out Co has two production departments (F and G) and two
service departments (Canteen and Maintenance). Total allocated and
apportioned general overheads for each department are as follows.
F G Canteen Maintenance
$1,25000 $80,000 $20,000 $40,000
Canteen and Maintenance perform services for both production
departments and Canteen also provides services for Maintenance in
the following proportions.
F G Canteen Maintenance
% of Canteen to 60 25 - 15
% of Maintenance to 65 35 - -
Required:
What would be the total overheads for production department G
once the service department costs have been apportioned?
Fast Inc has two production departments (A and B) and two service departments
(maintenance and stores). Details of next year’s budgeted overheads are shown
below.
Total ($)
Central Heating 19,200
Direct labour 8,000
General Repair costs 9,600
Machinery Depreciation 54,000
Rent and rates 38,400
Canteen 9,000
Machinery insurance 25,000
Direct Material 20,000
Details of each department are as follows.
A B Maintenance Stores Total
Floor area (m2) 6,000 4,000 3,000 2,000 15,000
Machinery book value ($000) 48 20 8 4 80
Number of employees 50 40 20 10 120
Allocated overheads ($000) 15 20 12 5 52

.
.Service departments’ services were used as follows

A B Maintenance Stores Total
Maintenance hours worked 5,000 4,000 ---- 1,000 10,000
Number of stores requisitions 3,000 1,000 ---- ---- 4,000

Required
a) Allocate and apportion production overheads costs amongst the four
departments using a suitable basis and reapportion the service department cost
to production departments and finds the total overheads of production
.departments
B) In FAST incorporation there are two production departments A and B. Both
departments are machine intensive. Department A use 10,000 machine hours and
department B uses 12,000 machine hours. Find OAR for department A and B?
Example: The basis of absorption
Athena Co makes two products, the Greek and the
Roman. Greeks take 2 labour hours each to make and
Romans take 5 labour hours. Athena Co estimates
that the total overhead will be $50,000. Athena Co
estimates that a total of 100,000 direct labour hours
will be worked
Required:
What is the overhead cost per unit for Greeks and
Romans respectively if overheads are absorbed on
the basis of labour hours?
Absorption costing
• Cost pu is normally calculated in advance using
budgeted figures. This is for several reasons.
• We need an estimate of the cost before we can fix a
selling price.
• the estimated cost per unit provides a benchmark for
control purposes.
• The Management Accountant can check regularly
whether or not units are costing more or less than
estimated and attempt to take corrective action if
necessary.
• Management Accountant’s Profit Statement takes a
different form than that of the Financial
Accountant’s.
Absorption costing
• The statement is usually prepared monthly, and its
objective is to show whether the profit is higher or lower
than that expected, and to list the reasons for any
differences.
• The statement starts with the profit that should have
been made if all the costs had been the same as on the
standard cost card.
• It then lists all the reasons for any differences in profit (or
variances) to end with the actual profit.
• However, in calculating the budgeted profit for individual
months, absorption costing causes a problem when the
expected production in a month differs from that used to
absorb fixed overheads for the cost card.
Over and under absorption of overheads
• The rate of overhead absorption is based on

estimates (of both numerator and denominator) and
it is a quite likely that either one or both of the
estimates will not agree with what actually occurs.
Reasons of under-/over absorbed
overheads
The overhead absorption rate is predetermined from
budgeted estimates of overhead cost and the expected
volume of activity. Under or over recovery of overhead will
occur in the following circumstances
• Actual overhead costs are different from budgeted
overheads.
• The actual activity level is different from the budgeted
activity level.
• Both actual overhead costs and actual activity level are
different from budget.
Hourly absorption rate
Y plc budgets on working 80,000 hours per month and having
fixed overheads of $320, 000. During April, the actual hours
worked are 78,000 and the actual fixed overheads are
$315,000.
Calculate:
a) the overhead absorption rate per hour.
b) the amount of any over or under absorption of fixed
overheads in April.
Solution
Example 7
X plc produces one product-desk. Each desk is budgeted to require 4
kg of wood at $3 per kg, 4 hours of labour at $2 per hour, and
variable production overheads of $5 per unit.
Fixed production overheads are budgeted at $20,000 per month and
average production is estimated to be 10,000 units per month. The
fixed production overheads incurred in January and February was
$20,000.
The selling price is fixed at $35 per unit.
There is also a variable selling cost of $1 per unit and fixed selling cost
of $2000 per month.
During the first two months X plc expects the following level of
activity
January February
Production 11,000 units 9,500 units
Sales 9,000 units 11,500 units
a) Prepare a cost card using absorption costing?

b) Set out budgeted profit statement for the month of Jan and Feb?
Marginal Costing
• Variable production costs are included in
cost per unit(i.e. treated as a product cost).
Many businesses only want to know the variable cost of the
units they make, as fixed costs treated as period cost.
The variable cost is the extra cost each time a unit is made,
fixed cost being effectively incurred before any production is
started.
Fixed costs are deducted as a period cost in the profit
statement
Marginal Costing
• Variable production cost of a unit is made up
of
$
Direct material X
Direct Labour X
Variable production OH X
Marginal Cost of a Unit X
Contribution
• It is the difference between selling price and
all variable costs (marginal cost), including
non-production variable costs.
• It may be defiend as profit before the recovery
of fixed cost. Thus contribution goes towards
recovery of fixed costs and profit and is equal
to:
• Contribution = FC + Profit
Example 8
X plc produces one product-desk. Each desk is budgeted to require 4 kg
of wood at $3 per kg, 4 hours of labour at $2 per hour, and variable
production overheads of $5 per unit.
Fixed production overheads are budgeted at $20,000 per month and
average production is estimated to be 10,000 units per month. The
fixed production overheads incurred in January and February was $20,000.
The selling price is fixed at $35 per unit.
There is also a variable selling cost of $1 per unit and fixed selling cost
of $2000 per month.
During the first two months X plc expects the following level of
activity
January February
Production 11,000 units 9,500 units
Sales 9,000 units 11,500 units
a) Prepare a cost card using marginal costing?

b) Set out profit statement for the month of Jan and Feb?
A company commenced business on 1st March making one product
only, the cost card of which is as follows
$
Direct labour 5
Direct material 8
Variable production overheads 2
Fixed production overheads 5
20
Fixed production overheads figure has been calculated on the basis of a
budgeted normal output of 36,000 units per annum. The fixed
production overhead incurred in March was $15,000 each month.
Selling, distribution and admin expenses are
Fixed $10,000 per month
Variable 15% of the sales value
The selling price per unit is $35 and units produced and sold were:
Production in March 2000 units
Sales in March 1500 units
Prepare the absorption costing and marginal costing income
statement for March.
Example: Marginal and absorption costing compared
Big Woof Co manufactures a single product, the Bark, details of which are as follows.
Per unit $
Selling price 180.00
Direct materials 40.00
Direct labour 16.00
Variable overheads 10.00
Annual fixed production overheads are budgeted to be $1.6 million and Big Woof
expects to produce 1,280,000 units of the Bark each year. Overheads are absorbed on
a per unit basis. Actual overheads are $1.6 million for the year.
Budgeted fixed selling costs are $320,000 per quarter.
Actual sales and production units for the first quarter of 20X8 are given below.
January – March
Sales 240,000
Production 280,000
There is no opening inventory at the beginning of January.
Prepare income statements for the quarter, using
(a) Marginal costing
(b) Absorption costing
Absorption costing
Step1 : Allocation is the charging of overheads directly to specific departments where they can be
identified directly with a cost centre or cost unit.
Apportionment is the sharing of overheads which relate to one department between those
departments on a fair basis.
Step 2 : Service department costs need to be reapportioned to the production departments, using a
suitable basis linked to usage of the service.
Step 3 : Costs within production cost centres are charged to a cost unit, using Overhead absorption
rates (OAR) based on :
• Labour or machine hours
• % of direct labour cost
• ....
OAR
=
Budgeted overheads / Budgeted level of activity
Re-apportionment
Over- or under-absorption of overheads
Overheads Absorbed
=
Actual labour hours * OAR per labour hour
Actual Overheads Incurred
Overhead under- or over-absorbed
Actual overheads Actual activity level

different from budget different from budget
Ledger Accounting
●
In Production
●
Debited to one
of the non-
Overheads production OH
Account accounts
Indirect Non-
Production production
Costs Overheads
Over- or
Absorbed
under-
Production
absorption
Overheads
overheads
●
Transferred to ●
Credited to the
income production
statement at the overheads
end of the period account
Chapter 8
Marginal and Total Absorption Cost

Contribution
Absorption & marginal costing and profits
ABSORPTION COSTING MARGINAL COSTING
Valuing units Total production cost Marginal (variable)
production cost
Valuing inventory Opening and closing stock valued at total OS and CS valued at marginal
production cost cost
Fixed production Carried forward from one period to the FC charged in full against
overheads next as part of the closing / opening profit in the period in which
stock valuation. Only hit profit when they are incurred
units are sold.
Adjusting for over- or Yes – in the income statement None needed
under-absorption
Impact of increase in Gives higher profit Gives lower profit
inventory levels
Impact of decrease in Gives lower profit Gives higher profit
inventory levels
Inventory level constant Same profit under both systems
Profit Statements
* *
*
*
Reconciliation
MARGINAL COSTING PROFIT
Increase in inventory * Fixed OAR
ASORPTION COSTING PROFIT

Absorption Vs Marginal
CVP Analysis :CVP analysis makes use of the
contribution concept in order to assess the
following measures for a single product.
Price
per
Price
Contribution per
ratio
B.E.P.
Selling
Contribution
ratio
B.E.P.
Fixed Costs
Selling
C/S
Fixed Costs
Contribution per unit
C/S
Contribution per unit

unit
unit
CVP Analysis
profit)
(Fixed
profit)
Targ
(Fixed
Contribution
Budget ed Sal es %
Target
Costs
et profit
(Budgeted – BEP sales)
Contribution
unitunit
Budget ed Sal es %
Budg Sal es – B.E.P Sales
Costs
(Budgeted – BEP sales)
Margin of Safety
Budg Sal es – B.E.P Sales
profit
+ Req
Margin of Safety
+ Req
perper
Breakeven or CVP Analysis
• Cost-volume-profit(CVP)/Breakeven analysis is
study of the effects on future profit of changes
in fixed cost, variable cost, sales price, quantity
and mix .
• CVP analysis is a particular example of ‘what if?’
analysis. A business sets a budget based upon
various assumptions about revenues, costs,
product mixes and overall volumes.
•
Breakeven Point
The breakeven point which is the activity level
at which neither profit nor loss.
Breakeven Point = Total Fixed Cost

(in terms of number of units sold) Contribution per unit
Breakeven Point = Total Fixed Cost

(in terms of sales revenue) C/S Ratio
Example
The following information relates to product X
$
Selling price per unit 20
Variable cost per unit 12
Fixed cost 100,000
Required:
a) Calculate the breakeven point in terms of number

of units sold
b) Calculate the breakeven point in terms of sales
revenue.
C/S ratio/PV ratio/Contribution margin ratio
C/S ratio= Contribution PU = Total Contribution

Selling price PU Total sales revenue
Example
The following information relate to product B.
$
Fixed cost 100,000
Calculate the contribution to sales ratio.

Margin of safety
Margin of safety = Budgeted Sales – Breakeven point
sales
(in terms of no. of units)
Margin of safety = Budgeted Sales – Breakeven sales

Budgeted Sales
(as a % of budgeted sales)
Example
The following information relates to product X
$
Fixed cost 100,000
Budgeted sales for the period are 16,000 units.
Required:
a) Calculate the margin of safety in terms of units.
b) Calculate the margin of safety as a % of budgeted

sales.
Target profits
Sometime an organization might wish to know
how many units of a product it needs to sell in
order to earn a certain level of profit or target
profit.
Sales volume to = (fixed cost + required profit)

achieve a target profit contribution per unit
Example
Arrow ltd manufactures product A and wishes to
achieve a profit of $20,000, the following information
relate to product A
$
Fixed cost 100,000
Budgeted sales for the period are 16,000 units.
Required:
Calculate the sales volume required to achieve a profit
of $20,000.
Example
the following information relate to product A
$
Fixed cost 220,000
Budgeted sales are 7,500 units.
Required:
a)Calculate the C/S ratio.
b) Calculate the breakeven point in terms of units sold.
c) Calculate the breakeven point in terms of sales revenue.
d) Calculate the unit sales required to achieve the target profit of
$550,000.
e) Calculate the margin of safety (expressed as a percentage of
budgeted sales).
Breakeven Chart
The Breakeven point can also be determined graphically using a
breakeven chart.
The breakeven chart plots total costs and total revenues at

different levels of output.
A breakeven chart has the following axis

A horizontal axis showing the budgeted/actual sales/output (in
terms of units)
A vertical axis showing $ for sales revenues and costs
Drawing a breakeven chart
The breakeven chart is constructed as follows
1) Plot the fixed cost line as a straight line parallel to the
horizontal axis.
2) Plot the sales revenue line from the origin.
3) the total cost line is represented by fixed cost plus variable
costs.
4) Note the point at which the breakeven point and margin of
safety occurs.
5) Breakeven point is the point where sales revenue is equal to
the total costs.
6) Margin of safety is the difference between the breakeven
point and the budgeted or actual sales.
Example
A restaurant selling 600 meals at $24. The meals

cost $8 each to prepare.
The restaurant also pays fixed cost such as rent of
$8500 a week.
Draw a breakeven chart?
Quantity Fixed Cost Variable cost Total cost Revenue $24

$8 each each
0 $8500 0 $8500 0
600 $8500 $4800 $13,300 $14,400
Breakeven Chart
Example
The budgeted annual output of a factory is 120,000 units.
The fixed overheads amounts to $40,000 and the variable
costs are 50c per unit.
The sales price is $1 per unit.
Required
Construct a breakeven chart showing the current
breakeven point and profit earned up to the present
maximum capacity.
Contribution Breakeven Chart
A variation on the traditional breakeven chart is the
contribution breakeven chart. The main difference
between the two charts are as follows,
a) The tradition breakeven chart shows the fixed cost
line whereas the contribution chart shows the variable
cost line.
b) Contribution can be read more easily from the
contribution breakeven chart than the traditional
breakeven chart.
Contribution Breakeven Chart
P/ V Chart
Chapter 9
Relevant Costs
Relevant Costs
Relevant
Cash flow
FUTURE
INCREME
NTAL CASH
Relevant Cash Flows
• Relevant costs are future costs. A decision is about
the future and it cannot alter what has been done
already. Costs that have been incurred in the past
are totally irrelevant to any decision that is being
made 'now'. Such costs are past costs or sunk costs.
• Costs that have been incurred include not only costs
that have already been paid, but also costs that have
been committed. A committed cost is a future cash
flow that will be incurred anyway, regardless of the
decision taken now.
Relevant Cash Flows
• Relevant costs are cash flows. Only cash flow
information is required. This means that costs
or charges which do not reflect additional
cash spending (such as depreciation and
notional costs) should be ignored for the
purpose of decision-making.
Relevant Cash Flows
• The cost associated with one additional unit of
production. also called marginal cost.
• Incremental cost is the overall change that a
company experiences by producing one
additional unit of good.
Differential costs and opportunity costs
• Relevant costs are also differential costs and
opportunity costs.
• Differential cost is the difference in total cost
between alternatives.
• An opportunity cost is the value of the benefit
sacrificed when one course of action is chosen in
preference to an alternative.
• For example, if decision option A costs $300 and
decision option B costs $360, the differential cost is
$60.
Example: Differential costs and opportunity costs
• Suppose for example that there are three options, A, B and C,
only one of which can be chosen. The net profit from each
would be $80, $100 and $70 respectively.
• Since only one option can be selected option B would be
chosen because it offers the biggest benefit.
Profit from option B
100
Less opportunity cost (ie the benefit from the most profitable
alternative, A) 80
Differential benefit of option B
20
• The decision to choose option B would not be taken simply
because it offers a profit of $100, but because it offers a
differential profit of $20 in excess of the next best alternative.
Relevant Cash Flows-Sunk costs
-
• A sunk cost is a past cost which is not directly relevant in decision
making.
Example:
• An example of a sunk cost is development costs which have already
been incurred. Suppose that a company has spent $250,000 in
developing a new service for customers, but the marketing
department‘s most recent findings are that the service might not
gain customer acceptance and could be a commercial failure.
• The decision whether or not to abandon the development of the
new service would have to be taken, but the $250,000 spent so far
should be ignored by the decision makers because it is a sunk cost.
Relevant Cash Flows
• Committed cost
A cost which has not yet been paid, but an
agreement, such as a purchase order or contract,
has been made that the cost will be incurred.
• Discretionary fixed costs, for example, advertising
and research and development costs can be thought
of as being controllable because they are incurred as
a result of decisions made by management and can
be raised or lowered at fairly short notice.
Relevant Cash Flows
Relevant Cash Flows - Materials
Relevant Cash Flows - Labour
Relevant Cash Flows - Labour
Other Relevant Costs
•The Relevant cost of overheads is only that which varies as a direct result of the
decision taken.
•Fixed Assets
• Relevant costs are treated as if related to materials
• If P+M is to be replaced, then relevant cost = current replacement cost
• If P+M not to be replaced, then relevant cost is higher of :
• Sales proceeds (if sold)
• Net cash inflows arising from use of the asset (if not sold).
Chapter 10
Dealing with Limiting Factors

Single Limiting factor
A limiting factor is a factor that
prevents a company achieving the
level of activity it would like to.
Scarce resources are where

one or more of the
manufacturing inputs
needed to make a product
are in short supply.
Multiple Limiting factor
Linear Programming is
the technique used to
establish an optimum
product mix when
there are two more
resource constraints.
Finding the solution – Method 1
Draw an example contribution
Find the last point
To solve
line
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Finding the solution – Method 2
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Chapter 11
Job. Batch and Process Costing

job
Job Costing
que
Produce a
cost card
for each
job.
PROFIT can be a mark-up
Use the same on cost, or a margin (%).
principles of
costing
atch
ent,
Batch Costing
ms
cal.
Determine
total cost
of batch.
Cost per unit : PROFIT can be a mark-up
Total Cost of on cost, or a margin (%).
batch / Number
of units in a
batch.
Introduction to process costing
Process costing
It is a costing method used where it is not possible to identify
separate units of production, or jobs, usually because of the
continuous nature of the production processes involved.
It is common to identify process costing with continuous
production such as the following.
• Oil refining
• Foods and drinks
• Paper
• Chemicals
Process costing may also be associated with the continuous
production of large volumes of low-cost items, such as cans or
tins.
Features of process costing
• The output of one process becomes the input to
the next until the finished product is made in the
final process.
• The continuous nature of production in many
processes means that there will usually be closing
work in progress which must be valued.
• In process costing it is not possible to build up
cost records of the cost per unit of output or the
cost per unit of closing inventory because
production in progress is an indistinguishable
homogeneous mass.
Features of process costing
• There is often a loss in process due to spoilage,
wastage, evaporation and so on.
• Output from production may be a single product,
but there may also be a by-product (or
byproducts) and/or joint products.
Framework for dealing with process costing
Process costing is centered around four key
steps.
• Step 1 Determine output and losses
• Step 2 Calculate cost per unit of output,
losses and WIP
• Step 3 Calculate total cost of output, losses
and WIP
• Step 4 Complete accounts
Step 1
Determine output and losses. This step
involves the following.
• Determining expected output
• Calculating normal loss and abnormal loss and
gain
• Calculating equivalent units if there is closing
or opening work in progress
Step 2
• Calculate cost per unit of output, losses and
WIP. This step involves calculating cost per
unit or cost per equivalent unit.
Step 3
• Calculate total cost of output, losses and WIP.
In some examples this will be straightforward;
however in cases where there is closing
and/or opening work-in-progress a statement
of evaluation will have to be prepared.
Step 4
• Complete accounts. This step involves the
following.
• Completing the process account
• Writing up the other accounts required by the
question
Losses in process costing
Introduction
• Losses may occur in process. If a certain level
of loss is expected, this is known as normal
loss. If losses are greater than expected, the
extra loss is abnormal loss. If losses are less
than expected, the difference is known as
abnormal gain.
• Normal loss is the loss expected during a

process. It is not given a cost.
• Abnormal loss is the extra loss resulting when
actual loss is greater than normal or expected
loss, and it is given a cost.
• Abnormal gain is the gain resulting when
actual loss is less than the normal or expected
loss, and it is given a 'negative cost'.
• Since normal loss is not given a cost, the cost of

producing these units is borne by the 'good'
units of output.
• Abnormal loss and gain units are valued at the
same unit rate as 'good' units.
• Abnormal events do not therefore affect the
cost of good production. Their costs are
analyzed separately in an abnormal loss or
abnormal gain account.
Example: abnormal losses and gains
• Suppose that input to a process is 1,000 units

at a cost of $4,500. Normal loss is 10% and
there are no opening or closing stocks.
Determine the accounting entries for the cost
of output and the cost of the loss
• if actual output were as follows.
(a) 860 units (so that actual loss is 140 units)
(b) 920 units (so that actual loss is 80 units)
Solution
Step 1 Determine output and losses
If actual output is 860 units and the actual loss is 140 units:
Units
Actual loss 140
Normal loss (10% of 1,000) 100
Abnormal loss 40
Step 2 Calculate cost per unit of output and losses
The cost per unit of output and the cost per unit of abnormal
loss are based on expected output.
Cost incurred = $4,500 = $ 5 pu
Expected output 900 units
Solution
Step 3 Calculate total cost of output and losses
Normal loss is not assigned any cost.
$
Cost of output (860 x$5) 4,300
Normal loss 0
Abnormal loss (40 x $5) 200
4,500
Solution
Step 4 Complete accounts
PROCESS ACCOUNT
Units $ Units $
Cost incurred 1,000 4,500 Normal loss 100 0
Output (finished
goods a/c) 860 ($5) 4,300
Abnormal loss 40 ($5) 200
1,000 4,500 1,000

4,500
Solution
ABNORMAL LOSS ACCOUNT
Units $ Units $
Process account 40 200 Income statement 40 200
40 200 40 200
Example: Abnormal losses and gains again
During a four-week period, period 3, costs of input to a
process were $29,070. Input was 1,000 units, output
was 850 units and normal loss is 10%.
During the next period, period 4, costs of input were
again $29,070. Input was again 1,000 units, but output
was 950 units.
There were no units of opening or closing inventory.
Required
Prepare the process account and abnormal loss or gain
account for each period.
Solution

Period 3
Units
Actual output 850
Normal loss (10% x 1000) 100
Abnormal loss 50
Input 1,000
Solution
Period 4
Units
Actual output 950
Normal loss (10% x 1000) 100
Abnormal gain (50)
Input 1,000
Solution
Step 2 Calculate cost per unit of output and
losses
• For each period the cost per unit is based on
expected output.
= Cost of input
Expected units of output
= $29,070/ 900 units = $32.30pu
Solution
Period 3
$
Cost of output (850 x $32.30) 27,455
Normal loss 0
Abnormal loss (50 x $32.30) 1,615
29,070
Period 4
Cost of output (950 x$32.30) 30,685

Normal loss 0
Abnormal gain (50 x $32.30) 1,615
29,070
Solution
PROCESS ACCOUNT
Period 3
Units $ Units $
Output (finished
goods a/c
@$32.30) 850 27,455
Ab Loss @$32.30 50 16,15
1,000 29,070 1,000 29,070

Solution
PROCESS ACCOUNT
Period 4
Units $ Units $
Abnormal gain a/c Output (finished
@$32.30 50 1,615 goods a/c
@$32.30) 950 30,685
Ab Loss @$32.30
1,050 30,685 1,050 30,685
Solution
ABNORMAL LOSS ACCOUNT
Units $ Units $
Period 3 Period 4
Abnormal loss 50 1,615 Abnormal gain in 50 1,615
in process A/c process A/C

.
50 1,615 50 1,615
Solution
• A nil balance on this account will be carried
forward into period 5.
• If there is a closing balance in the abnormal loss
or gain account when the profit for the period is
calculated, this balance is taken to the income
statement.
• an abnormal gain will be a credit to the income
statement and an abnormal loss will be a debit
to the income statement.
Losses with scrap value
• Scrap is 'Discarded material having some
value.'
• Loss or spoilage may have scrap value.
• The scrap value of normal loss is usually
deducted from the cost of materials.
• The scrap value of abnormal loss (or abnormal
gain) is usually set off against its cost, in an
abnormal loss (abnormal gain) account.
• As the questions that follow will show, the three steps
to remember are these.
Step 1 Separate the scrap value of normal loss from the
scrap value of abnormal loss or gain.
Step 2 In effect, subtract the scrap value of normal loss
from the cost of the process, by crediting it to the
process account (as a 'value' for normal loss).
Step 3 Either subtract the value of abnormal loss scrap
from the cost of abnormal loss, by crediting the
abnormal loss account.
3,000 units of material are input to a process.
Process costs are as follows.
• Material $11,700
• Conversion costs $6,300
• Output is 2,000 units. Normal loss is 20% of input.
• The units of loss could be sold for $1 each.
Required:
Prepare appropriate accounts.
Input 3,000 units
Normal loss (20% of 3,000) 600 units
Expected output 2,400 units
Actual output 2,000 units
Abnormal loss 400 units
Step 2 Calculate cost per unit of output and losses
$
Scrap value of normal loss 600
Scrap value of abnormal loss 400
Total scrap (1,000 units x $1) 1,000
Cost per expected unit = $(11,700-600)+ $6,300
2,400
= $7.25
$
Output (2,000 x $7.25) 14,500
Normal loss (600 x$1) 600
Abnormal loss (400 x $7.25) 2,900
18,000
Solution
PROCESS ACCOUNT
Period 3
Units $ Units $
Output (finished
goods a/c
@$32.30) 850 27,455
Ab Loss @$32.30 50 16,15
1,000 29,070 1,000 29,070

Solution
PROCESS ACCOUNT
Period 4
Units $ Units $
Abnormal gain a/c Output (finished
@$32.30 50 1,615 goods a/c
@$32.30) 950 30,685
Ab Loss @$32.30
1,050 30,685 1,050 30,685
Process Costing - Features
Production is continuous.
Difficult to identify units of production.
Output of one By- products
process =
Closing WIP Period 1 Part-finished
input of next
process
=
Opening WIP Period 2 Losses units
& joint
products
FIND A COST PER UNIT VALUE CLOSING STOCK

EXPECTED to occur
Process Costing – Losses & Gains Actual Losses > Normal losses Actual Losses < Normal losses
Pickup a share of process costs
Abnormal gains debit the process account
Do not pick up a share of process costs
Valued like a unit of good output
Benefit credits the income statement

Normal Abnorm Ab
Losses al losses al
Written off in income statement
Sometimes sold for scrap – credit process account.
Remember to Credit the scrap account
Cost reduced by scrap proceeds

Steps for answering questions
Draw process
Value Good output
& Abnormal Loss oraccount
Gain
Enter inputs
and value(£)
Calculate
Average Cost
per unit
Enter Normal
Loss units &
scrap value
Balance ‘units’
column with
Abnormal Loss or
Gain Enter Good
Output – Units
only
WIP – Equivalent Units
If incomplete units at the beginning or the end of

the period, the concept of Equivalent Units (EU) is
used.
100 half Process costs

Material Conversio WIP valued
completed = can be spread
evenly between Cost spread n costs Weighted
50 completed &
completed over all spread average or
part-completed
EUs units. units over Eus FIFO
WIP – Equivalent Units
AVCO 2 Methods FIFO
Opening Inventory Values Opening WIP Units are

are added to current completed first.
costs to provide overall
average cost per unit
Process Costs in the

period allocated
between :
• Opening WIP units
• Units started &
completed in period
• Closing WIP Units
Losses part way through production
Joint and by-products
Joint and by-products
Accounting
Treatment
Chapter 12
Service and Operation Costing

HETEROGE
HETEROGE
NEITY
Service & operation costing

INTANGIBILI
NEITY
INTANGIBILI
TY
TY
Output service
industries is different
from product of
manufacturing.
CONSUMPTION
PRODUCTION
SIMULTANEOUS
CONSUMPTION
PRODUCTION
SIMULTANEOUS
ITY
ITY
PERISHABIL
PERISHABIL
&&
Suitable Cost Units
Based on their May be More than
relevance to necessary to
the service use composite one type
provided cost units of cost unit
Service Possible Cost Unit
Hotel Cost per guest per night
Transport Cost per passenger mile
College Cost per student
Hospital Cost per patient day / cost per procedure

Service Cost Analysis
Labour may be the only OH likely to be absorbed

direct cost using labour hours
Chapter 13
Budgeting
Budgets and Budgeting
• A quantitative expression of a plan of action
prepared in advance. It sets out the costs and
revenues that are expected in future periods.
• Budgeting is a process to construct a quantitative
model of how our business might perform
financially if certain strategies, events and plans are
carried out.
Purpose
Communication of targets
Co-ordinating Activities
Planning for the future
Purpose
Purpose of
of
Budgeting
Budgeting Controlling Costs
Motivation
Performance
Evaluation
Authorisation of expenditure
Components of the Budget
Planning for The Future
• It can provide the basis for detailed sales targets.
• It can provide staffing plans.
• It can be a document to buy and maintain
inventory levels
• it can be use to set production Plans
• It can be used for cash investment/borrowing,
capital expenditures (for plant assets, etc.), and
on and on
Performance Evaluation
• Budgets provide benchmarks against which to
compare actual results and develop corrective
measures.
Controlling Costs
• It can be used to control costs because standards
are set in advance for each expenditure and
managers are aware about the limits.
Authorization of Expenditure
• Budgets give managers “ pre approval " for
execution of spending plans.
Communication of Targets
• A budget document is a best way to
communicate targets to the departments of
organization
• Like: sales, Purchase, Finance, manufacturing,
Store and so on
Co-ordinating
Activities
• A comprehensive budget usually involves all
segments of a business. As a result,
representatives from each unit are typically
included throughout the process.
Motivation
• It gives a forward looking guidance to

managers and employees
• Budgets don't guarantee success, but they
certainly help to avoid failure.
• Without a budget, an organization will be
highly inefficient and ineffective.
Functions of a budget 1
• A budget has two main roles – to compel planning and to
establish a system of control
Planning
• Force management to look ahead
• Establish formal system of communicating plans and ideas
usually
• Co-ordinate activities
• Quantify an organisation’s objectives
Slide 318
Functions of a budget 2
Control
• Compare with actual results
• Provide a framework for responsibility accounting
• Motivate employees to improve their performance
Slide 319
Computers and budgeting 1
• Computers are used in budgeting to process large amounts of
data and recalculate changes in key variables
• They can also be used to evaluate different options and carry
out ‘what if’ analysis
• Spreadsheets and programs are used
Slide 320
Spreadsheets
Advantages
• Forecasting – different projections can be input
• Tax – the tax associated with various options can be easily
calculated
• Profit projections – figures can be changed to deal with a variety
of options and their associated profit
• Easy to use – Excel can be learnt quickly and is easy to share
with others in the organisation
Slide 321
Spreadsheets
Disadvantages
• Danger of corruption of data or variables
• Cannot incorporate qualitative factors
• Minor errors can creep in – the output is only as good as the
input
Slide 322
Flexible budgets 1
• Fixed budgets are budgets which are set for a single activity
level.
• Master budgets are fixed budgets
• Flexible budgets are budgets which, by recognising different
cost behaviours patterns, change as activity levels change
Slide 323
Flexible budgets 2
To prepare a flexible budget:
• Decide whether costs are fixed, variable or semi-variable
• Split semi-variable costs using the high/low method
• Calculate the budget cost allowance for each item = budgeted
fixed cost* + (number of units × variable cost per unit)**
• * nil for variable cost ** nil for fixed cost
Slide 324
Behavioural effects of budgets/motivation 1
Budgets as targets
• Can standards and budgets, as targets, motivate managers to
achieve a high level of performance?
• There are a number of ways in which standards can be set:
• Ideal standards are de-motivating because adverse efficiency
variances are always reported.
• Low standards are de-motivating because there is no sense of
achievement in attainment, no impetus to try harder.
Slide 325
Behavioural effects of budgeting/motivation
2
• A target must fulfil certain conditions if it is to motivate
employees to work towards it:
• Sufficiently difficult to be challenging
• Not so difficult that it is not achievable
• Accepted by employees as their personal goal
Slide 326
3
Decision making
• Organisational goals = employees’ goals
• Goal congruence
• If manager’s goals ≠ organisational goals leads to dysfunctional
decision making
• A well-designed control system can help to ensure goal
congruence
• continuous feedback prompting appropriate control action
should steer the organisation in the right direction
Slide 327
4
There tend to be three budget setting styles:

• Imposed (from the top down)
• Participative (from the bottom up)
• Negotiated
Slide 328
5
Imposed approach
Advantages
• Enhance co-ordination between strategic plans and divisional
objectives
• Less time-consuming
Disadvantages
• Imposed so can be de-motivational
• Lower-level initiatives may be stifled
• Does not suit some employees
Slide 329
6
Participative approach
Advantages
• More realistic budgets
• Co-ordination, morale and motivation improved
• Increased management commitment to objectives
Disadvantages
• More time-consuming
• Budgetary slack may be introduced
• Does not suit some employees
Slide 330
Behavioural aspects of budgeting/motivation
7
• In practice final budgets are likely to lie between what top
management would really like and what junior managers
believe is feasible
Slide 331
8
• An important source of motivation to perform well (to achieve
budget targets, to eliminate adverse variances) is being kept
informed
• This will mean being kept informed about how actual results are
progressing compared with target.
• The information feedback about actual results should have the
qualities of good information.
• Clear and comprehensive reports
• Significant variances highlighted for investigation
• Timely reports
Slide 332
9
Example
• A production manager may be encouraged to achieve and
maintain high production levels and to reduce costs
• Particularly if a bonus is linked to these factors.
• Such a manager is likely to be highly motivated.
• The effect on the organisation, with the need to maintain high
production levels, could lead to slow-moving inventory
• This could result in an adverse effect on cash flow
Slide 333
Principal Budget Factor
• The first thing is to decide where to start. For most
companies starting point will be a sales budget.
Once it has been decided how many units the
company expects to sell it is then possible to produce
a production budget and so on.
• However this will not always the starting point.
Suppose a company produce desks for which wood is
the main material.
• Suppose also that in the coming year there will be
limited supply of wood. In this case starting point will
be to budget the amount of wood available, then
production budget and then sales budget.
Principal Budget Factor
• In general terms, the first budget to be prepared
should be whatever factor it is that limit the growth
of the company. It may be level of demand or may be
availability of raw material.
• This factor that limits the company is known as the
principal budget factor.
• The management accountant needs to identify the
principal budget factor and it is this factor that will
be budget first.
Preparing Budgets
Define long-term objectives of the business
Form budget committee to communicate budget policy, set and approve budgets.
Produce budget manual
Identify principal budget factor
Produce budget for principal budget factor
Produce and approve other budgets based on budget for limiting factor
Review variances
Different types of budgets
• The Master Budget includes the budgeted income statement,
the cash budget and budgeted statement of financial position
(Balance Sheet).
• A continuous budget is prepared for a year (or budget period)
ahead, and is updated regularly by adding a further accounting
period (month, quarter) when the first accounting period has
expired ( Rolling Budgets).
Functional budgets
Functiona
l Budgets
Overhead
s Budget
Labour Sales
Budget Budget
Raw Material
Purchases
Productio
budget n Budget
Raw Material
Usage Budget
Functional budgets
Functional budgets
Example
The XYZ company produces X, Y, Z. For the coming accounting
period budgets are to be prepared using the following information.
Budgeted Sales of Product X 2000 Units at $100 , Product Y 4000
units at $130 and Product Z 3000 units at $150
Usage: X use 5kg (pu) of wood, 2liters (pu) of varnish, Y use 3kg (pu)
of wood, 2 liters(pu) and Z 2kg (pu) of wood and 1liter (pu) of
Varnish. Standard cost of wood is $8/kg and Varnish is $4 per liter
Inventories of finished goods
X Y Z
Opening 500u 800u 700u
Closing 600u 1000u 800u
Inventories of raw material Wood (kg) Varnish (liters)
Opening 21,000 10,000
Closing 18,000 9,000
Labour is paid at the rate of $3 per hour. X, Y and Z takes 4, 6 and
8 hours respectively.
Example
Prepare the following budgets
1) Sales Budget (quantity and value)
2) Production Budget (units)
3) Material Usage Budget(quantities)
4) Material Purchase Budget(quantities and values)
5) Labour budget(hours and values)
Example 2
A ltd manufactures three products. The expected sales of each
product are shown below.
Product 1 Product 2 Product 3
Sales in units 3000 4500 3000
Opening inventory is expected to be
Product 1 500u
Product 2 700u
Product 3 500u
Management have stated their desire to reduce inventory level
and closing inventor is budgeted as
Product 1 200u
Product 2 300u
Product 3 300u
Prepare the budget for the number of units to be produced of
.Product 1, 2 and 3
Example 3
C ltd manufactures three products. The expected production of
each product is shown below.
Budgeted production in units 2700 4100 2800
The three type of material are used in varying amount in the
manufacture of the three products. Material requirement are
shown below
Material M1 (kg) 2 3 4
The opening inventory of material is expected to be
Material M1 (kg) 4300

The closing inventory of material is expected to be
Material prices are expected to be 10% higher than this year and
current prices are $1.10/kg for material M1, $3.00/kg for
material M2 and $2.50/kg fort material M3
Prepare a budget of material usage, material purchase and

value of M1, M2 and M3.
Example
Example - continued
Fixed budgets
• Fixed budgets remain unchanged regardless of the
level of activity.
• A fixed budget is a budget which is normally set prior
to the start of an accounting period, and which is not
changed in response to changes in activity or
costs/revenues.
Flexible budgets
• A flexible budget is a budget which is designed to
change as volume of activity changes.
• Flexible budgets are prepared using marginal costing
and so mixed costs must be split into their fixed and
variable components (possibly using the high/low
method).
Fixed and flexible budget
• Comparison of a fixed budget with the actual results
for a different level of activity is of little use for
budgetary control purposes.
• Flexible budgets should be used to show what cost
and revenues should have been for the actual level
of activity.
• Differences between the flexible budget figures and
actual results are variances.
Fixed and flexed budget
• The simplest form of budget report compares
the original budget against actual results and is
known as a fixed budget.
• Any differences arising between the original
budget and actual results are known as variances.
• Variances may be either adverse or favorable.
Adverse variances (Adv) or (A) decrease profits.
Favourable variances (Fav) or (F) increase profits.
Example
A ltd manufacture one product and when operating at 100%
capacity can produce 5,000 units per period. But in last few
periods operating below capacity.
Below is the flexible budget prepared at the start of the last
period for three activity levels
Level of activity 70% 80% 90%
$ $ $
Direct material 7000 8000 9000
Direct labour 28000 32000 36000
Production overheads 34000 36000 38000
Admin and selling Overheads 15000 15000 15000
Total cost 84000 91000 98000
In the event, last period turned out to be even worse
than expected with 2500 units production only. The
following cost incurred
Direct material 4500
Direct labour 22000
Production overheads 28000
Admin Expense 16500
Total cost 71000
Required
Use the information given above to prepare the
following
a)A flexed budget for 2,500 units.
b) A budgetary control statement.
Chapter 14
Standard Costing
The purpose of standard costing
Standard Costing is a control tool for

management.
Standard Costs are collected on a

standard cost card. They may be based on
Absorption Costing or Marginal Costing.
Advantages & Disadvantages of Standard
Costing
Types of standard
Ideal
What would be expected under perfect operating conditions
Attainable
What would be expected Basic
under normal operating A standard left
Types of Standards unchanged from period
conditions
to period
Current
A standard adjusted for specific issues relating to the current period
Variance
• A variance is the difference between a planned,
budgeted, or standard cost and the actual cost
incurred.
• The same comparisons may be made for revenues.
• The process by which the total difference between
standard and actual results is analysed is known as
variance analysis.
Variance
• Variances can be divided into three main
groups.
1. Sales variances
2. Variable cost variances
3. Fixed production overhead variances
Variance Calculations
Are we working with a marginal or absorption costing system?
Marginal Costing Absorption Costing

Sales (Budgeted Sales – Actual Sales) x (Budgeted Sales – Actual Sales) x standard
Volume standard contribution/unit profit / unit
Variance
Standard Selling Price is not used. When volume changes, so do production costs, and the purpose of
the variance is to show the impact on profit or on contribution
Fixed MC does not relate fixed o/h to cost Fixed o/h are related to cost units by using
overhead units – fixed overhead is a period cost. absorption rates.
variances No fixed overheads volume variance.
The Fixed overhead total variance is equal to
The fixed overhead expenditure the over- or under-absorption of overheads.
variance is the difference between
actual expenditure & budgeted The FO Volume variance can be further
expenditure. It is the total variance. subdivided into efficiency & capacity
variances.
Sales Price Variance
Sales Price Variance
(Budgeted Sales Price – Actual Sales Price)

X
Actual Quantity sold
Sales Variance
Sales Volume Variance
(Budgeted Sales – Actual Sales)

X
Standard profit
Sales Variance
The following data relate to 2008
Actual sales 1000 units @ $650 each
Budgeted output and sales for the year 900 units
Standard selling price $700 per unit
Budgeted contribution per unit $245
Budgeted profit per unit $205
Calculate
sales volume variance (under marginal and
absorption costing) and the sales price variance.
Direct Material Variances
Direct Material Price Variance
• It is the difference between the actual cost of direct
material and the standard cost of quantity purchased
or consumed.
Direct Material Usage Variance
• It is the measure of difference between the actual
quantity of material utilized during a period and the
standard consumption of material for the level of
output achieved.
Direct Material Cost Variances
Product X has a standard direct material cost as follows.
10 kilograms of material Yellow at $10 per kilogram = $100
per unit of X.
During period four 1,000 units of X were manufactured,
using 11,700 kilograms of material Yellow which cost $98,600
Required
Calculate the following variances.
a) The direct material price variance
b) The direct material usage variance
c) The direct material total variance
Direct Labour Cost Variances
Direct Labor Rate Variance
• It is the measure of difference between the actual
cost of direct labor and the standard cost of direct
labor utilized during a period.
Direct Labor Efficiency Variance
• It is the measure of difference between the standard
cost of actual number of direct labor hours utilized
during a period and the standard hours of direct
labor for the level of output achieved.
Direct Labour Cost Variances
The standard direct labour cost of product X is as follows.
2 hours of grade Z labour at $5 per hour = $10 per unit of
product X.
During period four 1,000 units of product X were made, and
the direct labour cost of grade Z labour was $8,900 for
2,300 hours of work.
Required
a) The direct labour rate variance
b) The direct labour efficiency (productivity) variance
c) The direct labour total variance
Idle time variances
• It occurs when labour is available for production but
is not engaged in active production. e.g. shortage of
work or material.
• The cost of this can be highlighted separately in an
idle time variance, so that:
 it is not hidden in an adverse labour efficiency
variance.
 & management attention can be directed towards
the cost of idle time.
Example Idle time variance
Of the 8,722 hours of direct labour paid for, 500 hours
were idle because of a shortage of material supplies.
Labour is paid at $6 per hour.
An idle time variance could be calculated as follows:
Idle time variance= Idle hours X standard labour rate per hour
= 500hors X $6
= $3,000 (A)
Variable Overhead variances
Variable overhead expenditure variance
• It reveals how much of the variable overhead total
variance was caused by paying a different hourly rate
of overhead for the hours worked.
Variable overhead efficiency variance
• The variable overhead efficiency variance reveals how
much of the variable overhead total variance was
caused by using a different number of hours of labour,
compared with the standard allowance for the
production achieved.
Variable Overhead expenditure Variance
Actual o/h cost incurred –(actual hrs worked X variable OAR per hour)
Variable overhead efficiency Variance
(Actual hours worked X variable OAR)

-
(Actual production in standard hrs X variable OAR per hour)
Suppose that the variable production overhead cost of
Product X is as follows.
2 hours at $1.50 = $3 per unit
During period 6, only 400 units of product X were made. The
labour force worked 760 hours. The variable overhead cost
was $1,230.

a) The variable production overhead expenditure variance
b) The variable production overhead efficiency variance
c) The variable overhead total variance
Solution
Fixed Overhead Variances
Absorption Costing
Fixed
Fixed Production
Production Overheads
Overheads Total
Total Variance
Variance
Expenditure
Expenditure Volume
Volume
Variance
Variance Variance
Variance
Efficiency
Efficiency Capacity
Capacity
Variance
Variance Variance
Variance
Absorption Costing
Under-
Under- or
or over-absorption
over-absorption of
of overheads
overheads
Budgeted
Budgeted FOH
FOH (Actual
(Actual Production
Production in
in units
units
–– xx OAR)
OAR) –– Budgeted
Budgeted FOH
FOH
Actual
Actual FOH
FOH
(Actual
(Actual hours
hours taken
taken (Actual
(Actual Hours
Hours
–– standard
standard hours
hours worked
worked –– budgeted
budgeted
for
for output
output hours
hours worked)
worked) xx
achieved)
achieved) xx OAR
OAR OAR
OAR
Example: Fixed overhead variances
Suppose that a company plans to produce 1,000 units of product E
during August 20X3. The expected time to produce a unit of E is 5
hours, and the budgeted fixed overhead is $20,000. The standard
fixed overhead cost per unit of product E will therefore be as follows.
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be
$20,450. The labour force manages to produce 1,100 units of
product E in 5,400 hours of work.
(a) The fixed overhead total variance
(b) The fixed overhead expenditure variance
(c) The fixed overhead volume variance
(d)The fixed overhead volume efficiency & capacity variance
Solution
Solution
Solution
Solution
Marginal Costing
Fixed
Fixed Production
Production Overheads
Overheads Total
Total Variance
Variance
Expenditure
Expenditure
Variance
Variance
Causes of Variances
Causes of Variances

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Management Accounting

The nature and purpose of management

• The main functions that management are

Profit Centre Responsibility Centre Investment

2. A support department in an organisation, for which costs are

• Financial accounting involves classifying and

• Management accounting is used to aid

Legal requirements No Yes (limited companies)

Time period Historical & forward-looking Mainly an historical record

CASH FLOWS FUTURE

Types of cost and cost behaviour

Total of direct costs =

1. Discounts are received on additional

Fixed cost=Total cost at activity level– Total variable Cost

• The only thing causing any change in cost is

Output (units) Total costs ($)

DG Co has recorded the following total costs during the last

Sometimes fixed costs are only fixed within certain level

Calculate the estimated total cost if 14,500 square meters

Before we can compare high output costs with

Same data as the previous question.

Cost for 14,500 square metres:

Activity levels (units) 16,000 22,000

Variable cost per unit is constant within this range of

What is the total cost at an activity of 20,000 units? ,

• Cost equations are derived from historical cost data.

Please find the followings:

(a) The fixed cost is ?

Where p = probability of outcome occurring

When using Expected Values :

•Only accept projects if EV is positive

• Use past data and estimates, which may be inaccurate

• Do not take into account the time value of money

• Do not take into account the decision maker’s attitude to risk.

y represents the total cost

• If r = 1 perfect positive correlation

E.g. If r = 0.95, r² = 0.90 or 90%

Purchase order form Purchasing Department Supplier Goods required

Materials requisition note Production department Stores Authorisation to release goods

Slide 109 Slide 109

Order Quantities and

Stock-out costs : running Holding costs: holding Ordering costs :

Minimise total of holding, ordering and stock-out costs

• Demand and lead time are constant and

• A company uses components at the rate of 500

• A company uses components at the rate of 500 units per

• Watton Ltd is a retailer of beer barrels. The company

The following is relevant to item X:

• Annual production rate, R=500 x 50 =25,000 units

• Inventory control levels can be calculated in

• When inventories reach this level, an order should be

Minimum level/Buffer Level

A large retailer with multiple outlets maintains a central

Maximum inventory level = reorder level + reorder quantity

Buffer inventory = minimum level

Accounting for Labour

Indirect workers (Maintenance

Direct Labour cost Indirect Labour cost

• When employees work overtime, they receive

• Overtime premiums are treated as direct labour

Vienna is a direct labour employee who works a standard 35

• Determining time spent doing jobs

• The payroll department is involved in carrying out