TABLE OF CONTENTS

Chapter 1 Introduction to cost and management accounting

Chapter 2 Accounting for Materials

Chapter 3 Accounting for Labour

Chapter 4 Accounting for Overheads

Chapter 5 Marginal and Absorption costing

Chapter 6 Breakeven analysis or CVP Analysis

Chapter 7 Accounting for Decision Making

Chapter 8 Activity Based Costing (ABC)

Chapter 9 Budgetary Planning and Control Systems

Chapter 10 Standard costing

Chapter 11 Variance analysis

Chapter 12 Processes Costing

Chapter 13 Joint and By-products

CHAPTER ONE1

INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING

What is Accounting?

Is a process of identifying, measuring, analyzing and reporting economic or financial information to users to permit them makes informed decision. Accounting can be divided into the following branches:

a) Financial Accountingb) Taxationc) Auditingd) Management Accounting

There are many definitions of accounting. The Chartered Institute of Management Accountants (CIMA) in its Official Terminology describes accounting as:

The classification and recording of actual transactions in monetary terms, and

The presentation and interpretation of these transactions in order to assess performance over a period and the financial position at a given date.

Users of accounting information

Different people have different needs for accounting information.

Managers need information that will assist them to plan and control the activities of their organizations. They need to make decisions of say the selling price for their products, they need to understand the demand for their product, their position on the market, is their business making a profit, which of their products are more profitable etc.

Shareholders, other investors, require information on the value of their investments and the income that is yielded by their investments.

Prospective investors require information that will help them in making decisions of where and how to invest.

Lenders of capital such as banks would like to assess the reliability of a prospective borrower regarding the ability to pay back sums borrowed and to pay interest on sums borrowed.

Employees are concerned with the security of their jobs, they need to have information that will enable them make better bargains regarding their wages and other employment benefits etc.

Government requires information for computing various economic statistics that help in policy formulation; it also requires information for levying tax etc.

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The list of users can go on and on. The users are not only business organizations, but also individuals, church organizations, clubs and societies, various charities etc. The objective of accounting is to provide sufficient information to meet the needs of the various users at the lowest possible cost. It is important that the benefit derived from using information should exceed the cost of obtaining that information.

A close look at the various users of accounting information will show that there are two categories of users:

1. Internal parties within the organization such as managers.2. External parties such as shareholders, lenders of capital, prospective

investors, creditors etc.

Management accounting is concerned with providing information to people within the organization to help them make better decisions and improve the efficiency and effectiveness of existing operations. Management accounting therefore provides information required by managers for purposes such as:

1. Formulation of policy.2. Planning and controlling the activities of the organization.3. Making decisions on which course of action to take, where a number of

alternatives exist.4. Safeguarding the assets of the organization.

Such information will aid management in:

1. Long-term planning, that is making plans that are aimed at achieving the objectives of the organization.

2. Making short-term operation plans.3. Comparing plans with actual results to assess performance.4. Taking corrective actions to bring future actual transactions in line with

plans.5. Obtaining and controlling finance.6. Reviewing and reporting on systems and operations.

Financial accounting is concerned with providing information mainly to external parties to satisfy their various needs according to their interests in the reporting organization.

It is referred to as “that part of accounting which covers the classification and recording of actual transactions of an entity in monetary terms in accordance

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with established concepts, principles, accounting standards and legal requirements and presents as accurate a view as possible of the effect of those transactions over a period of time and at the end of that time.”

Management Accounting

Management accounting is a branch of accounting that measures and report financial and non-financial information to managers to help them in carrying out their managerial functions of planning, controlling and decision-making.

Therefore the purpose of management accounting is to generate and provided management information to various managerial levels.

Management Information

Management information is information that managers need to effectively carry out their managerial functions i.e. planning, controlling, organising and decision-making.

In an organisation management information is generated and is provided in the following three levels;

a) Strategic informationb) Tactical informationc) Operational information

Qualities of good information

i. Relevanceii. Understandabilityiii. Timelinessiv. Comparabilityv. Objectivityvi. Reliabilityvii. Completenessviii. Cost/benefit criterion

Comparisons between management and financial Accounting

Both management and financial accounting follow the same accounting principles and almost uses the same information and sources. But they differ in their roles and presentation. The following table illustrates their differences:

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Management and cost Accounting

Financial Accounting

Information mainly produced for

Internal use e.g. managers and employees

External use e.g. shareholders, creditors, lenders, banks , government

Purpose of information

To aid planning, controlling and decision making

To record the financial performance in a period and the financial position at the end of that period

Legal requirements

None Regulated by companies Act and others laws

Format Management decide on the information they require and the most useful way of presenting it

Format and content of financial accounts intending to give true and fair view should follow accounting standards (IASs) and company law

Nature of information

Both financial and non-financial

Mostly financial

Time period Historical and forward looking

Mainly an historical record

Generally management accounting is part of management information system (MIS) designed to assist in the efficient management of business. It provides information for internal use as opposed to financial accounting. Since management accounting and financial accounting systems have different proposes, they are often kept separate in two sets of accounts i.e. interlocking system. However it is possible to have integrated sets of accounts containing both cost and financial accounting information i.e. integrated system.

Cost Accounting

Cost accounting is a specialized form of management accounting which measures, analyzes, and reports financial and non-financial information relating to the cost of acquiring or using resources in an organization.

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Purposes of Cost and management accounting

i. To calculate cost per unit of the products produced or services provided.ii. To develop cost standardsiii. To highlight all forms of waste and analyse variations from expected

performance.iv. To provide for periodic profit and loss accounts and balance sheet by

segment.v. To reveal sources of economies in production.vi. To provide actual versus estimate cost comparisons, guideline for future

quotations and assistance in price fixing.vii. To ensure standards are kept up to date.viii. To present comparative cost data for different levels of output.ix. To provide actual information for assessment of performance of individual

units, managers, machines etc.What is costing?

Is the process of calculating a cost of a unit of a product or a service.Cost classification in a cost accounting system.

The total cost of making a product or providing a service consists of the following:

i. Material cost ii. Labour cost (wages and salaries)iii. Other expenses ( rent and rates, electricity, gas bills,

depreciation e.t.c) Costs can be classified in different ways and these includes:

a. Classification by traceability (by nature)b. Classification by functionc. Classification by behaviord. Classification by responsibility

a. Classification by traceability This involves classifying costs as direct and indirect cost.

What are direct costs? Is a cost that can be traced in full to the product, service or department

that is being costed. Examples include; raw materials costs, wages costs, wages of a foreman

supervising a single product, overtime at the request of a customer.

What is an indirect cost?

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Is a cost that cannot be traced in full to the product, service or department that is being costed.

Examples includes; production overheads, administration overheads, selling overheads, wages of a foreman supervising a variety of products, overtime as a company or management policy.NB: indirect costs are also called overheads.

The sum of direct costs (direct materials plus direct labour plus direct expenses) is called prime cost.

The sum of prime cost plus production overhead is called factory cost or full cost of production.

The sum of production costs plus other costs outside and or after production (non-production overheads) e.g. marketing costs, selling costs, e.t.c is called cost of sales or cost of goods sold.

Cost of sales plus a profit margin or profit mark up is called selling price.

A unit cost card will appear as follows:

Direct costs: K KDirect materials XXDirect labour XXDirect expenses XXPrime Cost XXProduction overheads: Indirect materials XX Indirect labour XX Indirect expenses XX XXProduction or Factory Cost XXNon-production overheads Admin, marketing, office rates etc. XXTotal Cost XXAdd profit margin or mark up XXSelling price XX

RECAP: All direct costs are variable costs but variable costs are not direct costs e.g. commission is a variable cost but not a direct cost.

b. Classification by function it involves classifying costs as production or manufacturing costs,

administration costs, marketing or selling or administration costs. Costs which do not fall under production, administration, marketing,

distribution are called general overheads or other costs.

Other definition of terms:

Production (factory) overheads:7

It includes all indirect materials, indirect labour and other indirect expenses incurred in the factory.

Administration overheads: Are all indirect material cost, indirect wages and indirect expenses

incurred in the direction, control and administration of an undertaking. E.g. depreciation, office salaries, etc.

Selling overheads: Are all indirect material cost, indirect wages and indirect expenses

nincurred in promoting sales and retaining customers e.g. advertising, sales promotion, market research, salesman salaries and commission.

Distribution overheads: Are all indirect material costs, wages and indirect expenses incurred in

making the packed products ready for dispatch and delivering to the customer.

c. Classification by behavior This involves classifying costs according to the way they are affected by

changes in the levels of activity and these includes:1. Variable costs: these are costs which changes with the levels of

activity e.g. material and labour costs.2. Fixed costs: these are costs that do not change with the volume of

activity e.g. rent of factory and salaries.3. Mixed costs or semi-variable costs or semi-fixed costs: these

are costs which are partly fixed and partly changes with the volume of activity e.g. water bills, gas bills, electricity bills.

4. Step fixed costs: these are costs which changes at different levels of activity e.g. rent as accommodation and loyalty bonus.

d. Classification by responsibility It involves classification of costs as controllable and uncontrollable costs.What are controllable costs? Are costs that can be influenced by a decision of a particular or specific

manager.

What are uncontrollable costs? Are costs that cannot be influenced or affected by a decision of a specific

manager.Other cost terminologies

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Product costs: are costs identified with goods produced or purchased for resale. Such costs are initially identified as part of the value of inventory. They becomes expenses (in the form of cost of goods sold) only when the inventory is sold.

Period costs: are costs that are deducted as expenses during the current period without ever being included in the value of inventory held, that are all non-manufacturing costs. Normal costs: are those which are expected.

Abnormal costs: are those which are unusual either by nature or size and those to which management attention should be drawn respectively.

Relevant cost: are future cash flows arising as a direct consequence of a decision made or under review.

Irrelevant costs: are costs that are not affected by management's decision.

Notional costs: are costs which does not involve the outflow of cash either now or in future e.g. notional rent, depreciation, notional interest.

Real costs: are costs that will result into outflow of cash.

Differential cost: is the difference in cost of alternative choices

Incremental cost: is the difference in cost between making the unit and not making it.Opportunity cost: is the benefit forgone by selecting one alternative in preference to the most profitable or best alternatives.

Sunk costs or past costs or committed costs: are past costs or expenditures which is not directly relevant in decision making.

They might have been charged already as a cost of sale in previous accounting periods or will be charged in future accounting period though has already been committed.

Avoidable costs: is a specific cost of an activity or sector of a business that would be avoided if the activity or sector did not exist.Allocation of costs to cost centres

Cost unit

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Is a unit of a product or service to which cost can be related or ascertained.

A cost unit is a basic control unit for costing purposes.

Examples of cost units:

Industry or area Cost unit

Hospital Patient per night, number of operations, outpatient visit, etc

Brewery industry BarrelHotel Rooms, guest per night, beds

occupied per night, meals supplied

Road haulage business Tone per mile, mileRoad passenger business Passenger per mileCanteen Meals suppliedCar production Cost per carGarment production Cost per garmentDoctor or Lawyer Cost per client

Cost centres

These are collecting places for costs before they are further analysed. Or Is a location, function, activity, or item of equipment in respect of which

costs may be related or ascertained. Examples includes a machine, a department, group of achiness, a project, overhead costs (rent, rates, electricity

Types of cost centres

There are two main types of cost centres and these are;

a. Service cost centres: these are centres that provide services to other cost centres which has no output to the external market but provides support internally. Examples are stores, maintenance, canteen, personnel department among others.

b. Production cost centres: these are centers that has output to the external market. They are involved in production of goods and not provision of services. Examples are milling, moulding, engineering, packing and assembly department among others.

Cost objects: is any activity for which a separate measurement of cost is desired.

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If users of management information wish to know the cost of something, that something is called a cost object. Examples are cost of a product, cost of a service, and cost of operating a department.

Profit centres:

Are collecting places for both costs and revenues before they are further analysed.

Revenue centres:

Are collecting places for revenues before they are further analysed.Investment centres:

Is a profit centre with an additional responsibility for capital investment and possibly financing and whose performance is measured by its return on investment.

Responsibility centres:

Is a department or organizational function whose performance is a direct responsibility of a specific manager.

NOTE: cost, revenue, profit and investment centres are all known as responsibility centres.

Cost behaviour

This refers to the way in which cost are affected by changes in the levels of activity or output.

Why is cost behavior essential?

It is useful for:

i. Budgeting and planningii. Decision makingiii. Control accounting

Levels of activity (volume of output) may refer to either of the following:

i. Number of units produced ii. Value of items sold iii. Number of items soldiv. Labour or machine hoursv. Number of invoices issuedvi. Number of units of electricity consumed, e.t.c

Cost behavior principles

The basic principle is that as the levels of activity rises the costs will usually rise and vice versa.

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NB the commonly used levels of activity are volume of output and labour or machine hours

Cost behavior patterns:

Fixed costs: are costs that do not change with the levels of activity. E.g. rent, salaries, straight line depreciation e.t.c

They are also known as period costs because they relate to a span of time.

Sketch graph

Total fixed cost

Costs (K)

Output

Variable costs: are costs which changes with levels of activity e.g. raw material costs, direct labour cost, sales commission, bonus payment.

Sketch graph

Variable cost

Cost (K)

Output

Step fixed costs: is a cost which is fixed in nature but only within certain levels of activity e.g. rent as accommodation, loyalty bonus.

Sketch graph

Step costs12

Costs (K)

Relevant range

Output

Relevant range: is a period within which fixed costs remain unchanged.

Mixed costs or semi-fixed cost or semi-variable cost: Are costs which are partly fixed and partly changes with the levels of activity e.g. electricity and gas bills, sales man salaries, cost of running a car.

Sketch graph

Total costs

Costs (K) variable cost part

Fixed cost part

Output

Assumptions about cost behavior

Within the normal or relevant range of output, costs are often assumed to be either fixed, variable, or mixed.

Departmental costs within an organization are assumed to be mixed costs Departmental costs are assumed to rise in a straight line as the volume of

activity increases. I.e. costs are said to be linear.

Determining fixed and variable elements from mixed costsThere are several ways of estimating fixed and variable costs from mixed costs and these are:

1) Scatter graph This involves preparing a scatter graph of costs in the previous periods (with costs on the y-axis and volume on the x-axis) and then drawing a line of best fit through the points as follows:

Sketch graph

Total costs13

Y-axis Estimated line of best fit (ELOBF) ₒ ₒͦ ͦ ͦ ͦ ₒ ͦ ₒ ͦ ͦ

Costs (K) ͦ ͦ ͦ Variable part

ₒ ͦ ͦ ͦ ₒ ₒ

Fixed part

Output X-axis

Fixed cost line is determined where line of best fit cuts the y- axis.

2) Statistical analysis or least square regression analysis It involves calculating a line of best fit from historic records of cost and output data and then measuring the degree of confidence in these estimates by means of correlation coefficient.

It involves formulating an equation of Y=a + bx where; Y= total cost, a= fixed cost, b= variable cost per unit and x= output or quantity.

3) High-low method or technique

This is the common method used in costing and budgetary control and involves the following steps:

Step 1: Review records of costs and output in previous periods

Select the period with highest and lowest activity levels

Determine the total cost at the highest and lowest activity levels selected above

Step 2: Calculate the variable cost per unit by calculating;

Total cost at highest levels less total cost at lowest levels / total units at highest levels less total units at lowest levels = variable cost per unit.

Step 3: Then determination of fixed costs

Total costs at highest levels less (total units at highest levels *variable cost per unit) = fixed costs. Or

Total costs at lowest levels less (total units at lowest levels *variable cost per unit) = fixed costs.

Example on high- low method or technique

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Example 1. Ignoring InflationThe costs of operating the maintenance department of a computer manufacturer, Silick and Chips Ltd, for the last four months have been as follows.

Month Cost Production volume K standard hours

1 110,000 7,0002 115,000 8,0003 111,000 7,7004 97,000 6,000

What costs should be expected in month five when output is expected to be 7,500 standard hours? Ignore inflation

SolutionVolume Total Cost(Hours) K

High output 8,000 115,000Low output 6,000 97,000 Range 2,000 18,000

Variable cost per standard hour = K18 000 2,000

= K9.00

Subtracting in either the high or low volume: High Low

K KTotal cost 115,000 97,000Variable costs (8000 x K9) 72,000 (6000 x K9) 54,000Fixed Costs 43,000 43,000

Estimating costs of 9000 standard hours of output K

Fixed costs 43,000Variable costs (9000 x K9) 81,000Total Costs 124,000

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2. With InflationR&F Ltd has recorded the following total costs during the last five years.

AverageYear Output price level

volume Total cost index %units K

2000 65,000 145,000 1002001 80,000 179,200 1122002 90,000 209,100 1232003 60,000 201,600 1442004 75,000 248,000 160

RequirementsCalculate the total cost that should be expected in 2007 if output is 85,000 units and the average price level index is 180?

SolutionAdjusting price levels to a common basis

Output Total cost Adjusted Total costunits K K

High level 90,000 209,100 x 100 170,000 123

Low level 60,000 201,600 x 100 140,000 144

Range 30,000 30,000

Variable cost per unit = K30, 000 30,000 = K1.00 per unit

Substituting into high level KTotal cost 170,000Variable costs (90000 x K1) 90,000Fixed cost 80,000

Costs in 2005 for 85,000 units will be as follows: K

Variable cost (85000 x K1) 85,000Fixed costs 80,000 Total costs 165,000

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At index 180 = 165,000 x 180 100

= K270, 000

CHAPTER TWO

ACCOUNTING FOR MATERIALS

Accounting for materials is vital for management to implement an effective inventory control system, and to be aware of major costing problems relating to pricing of material issues and inventory valuations at the end of each accounting period. Normally inventory in an organisation are classified under the following:

i. Raw materials are elements or substances which are used in the manufacturing of a particular unit.

ii. Work in progress (WIP)iii. Spare parts/Consumables (e.g. cleaning materials)iv. Finished goods.

The main stages of material control involved in inventory system cover the following;

a) Ordering of inventory.b) Purchasing of inventory.

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c) The receipts of inventory into stores.d) Storage.e) Issue of inventory into production departments.f) Accounting.

Inventory control

Is the systematic regulation of inventory levels. This is necessary in keeping the manufacturing operations of the business to go on continuously without sudden interruptions if raw materials are lacking, or a great deal of expenses can be incurred on inventory with a short shelf life.Inventory Controls

There are three main objective of inventory control: To be able to supply to production process the required level of inventory

of an appropriate quality as and when required; To have efficient and effective procedures for the ordering and storage of

materials To have appropriate inventory recording procedures.

The main stages of material control

Ordering and Receiving Materials

a) An order is initiated by a particular department or cost centre requisitioning the stores for some materials. This is made on a Material requisition.

b) A purchase requisition is made by the stores department and sent to purchasing department, authorizing order for further inventory.

c) Purchasing department place an order with a supplier through a Local Purchase order (L.P.O), copies of the purchase orders are sent to accounts department and stores.

d) The supplier delivers the consignment of materials, and the storekeeper signs a delivery note for the carrier.

e) On receipt of goods the store keeper confirm the goods and prepares a Goods receivable note (GRN) and copy will be send to accounts department to marched with an invoice before making payment.

f) All the goods are kept by storekeeper and recorded on a Bin card which will contain details of goods received and issued to production i.e. records physical movement of inventory. Inventory record card contains more information, such as order placed, and free inventory balance. Free Inventory balance represents what is really available for future use calculated by material in inventory plus materials on order form suppliers minus materials requisitioned, not yet issued. Stores ledger include

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details about the price paid for each batch of goods received and their total value. Any transfers of goods from stores department have to be authorized and the Bin card and stores ledgers have to be up dated.

Issue of Materials

Materials can only be issued against a materials requisition or stores issue note.Where materials, having been issued to one job or cost centre, are later transferred to a different job or centre, a material transfer note should be raised.Material returns must also be documented, on materials returned note. This is a reverse of a requisition note.Storage of Raw Materials

Storekeeping involves storing materials. Materials may be kept in either a central (main) store; this is a centralized storekeeping or a departmental (sub) store. Sub-stores may be necessary for the storage of high value items, inflammable and corrosive materials, part-finished goods, raw materials or tools and fixtures.Centralised storekeeping system

Advantages

There will be less duplication of physical resources, such as land, buildings, and equipment.

Fewer personnel will need to be employed. Greater supervision of staff is possible. Clerical and recording costs can be reduced. Inventory count is easier to arrange and to operate.

Disadvantages;

Transport costs may be increased. Departments that are some distance from a Centralised store may find

that delays and errors occur hence there may be stoppages to production. There is a greater risk of inventory losses if all inventories are located

centrally owing to such factors as fire and theft. There may be a loss of local knowledge and expertise.

Inventory coding

To ensure that inventory control system runs smoothly, each item held in stores must be unambiguously identified. Materials are therefore coded and classified. Some of the advantages of coding are that ambiguity is avoided; its time saving as descriptions can be length and time consuming and make computerized processing easier.

Inventory count

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Involves counting the physical inventory at a certain date and then check against the balance in the clerical records. There are two methods of inventory count:

Periodic inventory count: This is usually carried out annually and the objective is to count all items

of inventory on a specific date.Continuous inventory count:

Involves a specialist team counting and checking a number of inventory items each day, so that each item is checked at least once a year.

Inventory discrepancies

This will occur when inventory checks disclose difference between the physical amount of an item in inventory and the amount in the inventory records. The cause should be investigated and appropriate action taken to ensure that it does not happen again.

If it is due to clerical error, then the records should be rectified immediately. If it is because units of inventory appear to be missing, the lost inventory must be written off. The accounting transaction will be recorded by a store credit note if items of inventory have been lost, or a stores debit note if there is more actual inventory than the amount recorded. Then a stock adjustment account will be debited or credited depending on the situation. The balance of this account is written off directly to profit and loss account at appropriate times.Perpetual Inventory

Perpetual inventory involves the recording of every receipt and issue of inventory as it occurs on bin cards and store ledger accounts.

This means that there is a continuous clerical record of the balance of each item of inventory. The balance on the inventory ledger account therefore represents the inventory on hand and this balance is used in calculation of closing inventory in monthly and annual accounts.

In practice, physical inventory may not agree with recorded inventory and therefore continuous inventory count is necessary to ensure that the perpetual inventory system is functioning correctly and that minor inventory discrepancies are corrected.Inventory Levels and Statistical techniques

The overall objective of inventory Control is to maintain the inventory levels that minimize the combined cost made up of the following;

Holding cost (i.e. cost of storage and stores operations, interest charges, insurance costs, risk of obsolescence, deterioration and theft),

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Ordering costs (i.e. clerical and administrative costs associated with purchasing, accounting for and receiving goods, transport costs and production run costs) and

Inventory out costs (lost contribution from lost sales, loss of future sales due to disgruntled customers, loss of goodwill, cost of production stoppages, labour frustration over stoppages and extra costs of urgent, small quantity, replenishment orders)

This is to ensure that there is no inventory out: Insufficient inventory to meet production demand- which lead to loss of customers goodwill, reduced profits and on other hand no surplus inventory are carried which result in increased storage costs, which leads to reduced profits. Hence inventory must be at an optimal level.

Inventory Control Terminologies

Lead time/procurement time: The time period between ordering and replenishment.

Demand: Amount required by sales or production (usually expressed as a rate of demand per week, year etc).

Physical inventory: number of physical items in inventory at a given time.

Buffer inventory /minimum inventory/safety inventory: inventory allowance to cover errors in forecasting the lead time or demand during the lead time.

Maximum inventory: inventory level selected as a maximum desirable which is used as an indicator to show when inventory have risen too high.

Free inventory: physical inventory plus outstanding replenishment order minus unfulfilled requirement.

Free inventory = material in inventory + Ordered inventory form suppliers - inventory requisitioned, not yet issuedInventory Levels

Inventory control levels can be calculated in order to maintain inventories at the optimal levels as follows, Reorder Level

This is the level where inventory have to be replenished; the level is determined by the maximum rate of consumption and lead time, which is the time between placing an order with supplier and the inventory becoming available for use.Reorder level= maximum usage x maximum lead timeReorder Quantity

This is Quantity of inventory to be ordered when the inventory reaches reorder level. The quantity is set so that the combined cost of ordering and holding are minimized.

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RQ= Maximum Inventory level-(Reorder level-minimum usage x minimum lead time)Minimum Level

It is a warning level to draw management attention to the fact that inventory are approaching a dangerous low level. It is determined by Reorder level average rate of consumption and average lead time.Minimum Level= Reorder level-(average usage x average lead time)Maximum Level

A warning to the management that inventory have reached a wasteful level, inventory level must not exceed this up most limits, it is set by considering the following factors; reorder level, quantity ordered, minimum rate of consumption and minimum lead time.Max. L=Reorder level + Reorder Quantity-(minimum usage x minimum lead time)Average InventoryAS= Minimum Inventory + ½ Reorder Quantity

ECONOMIC ORDER QUANTITY/ ECONOMIC BATCH QUANTITY

Is a reorder quantity where holding and ordering cost are at a minimum. This theory assume that cost tend to increase with the level of cost and so could be reduced by ordering smaller amounts from suppliers each time.EOQ=√2cd/h Where : c- Cost of order

h- Holding cost/ carrying costd- Annual demand

Example

The following data relate to an item of raw material used by M. The cost of raw material is K20, usage per week is 250 units, cost of ordering material is K400 and the annual cost of holding inventory as a percentage of cost is 10%. Year consist of 48 weeks and 5 days by week. Calculate the EOQ.Solution

EOQ =√2cd/h = √ 2 x 400 x (250 x 48) =√4,800,000 = 2,191 units

10% x K20 22

Example

Assume the company decides to make widgets in its own factory. Machinery has been purchased with a capacity of 250,000 widgets per annum, but the company uses 50,000 widgets. The cost of inventory is K10, ordering and handling cost K150 per order and carrying costs are 15% per annum. Determine EOQ.Solution

EOQ = √ 2 x 150 x 50,000 1.5 (1 - 50,000/250,000) = 3,536

Example

A company uses components at the rate of 500 units per month, which are bought in at a cost of K1.20 each from the supplier. It costs K20 each time to place an order, regardless of the quantity ordered.The supplier offers a 5% discount on the purchase price for order quantities of 2000 items of more. The current EOQ is 1000 units. The total holding cost is 20% per annum of the value of inventory held.Required

Should the discount be accepted?Solution

Order quantity 1000 2000K K

Order cost (6000/1000xK20) 120 (6000/2000xK20) 60Holding cost [20%xK1.20x (1000/2)] 120 [K0.24x0.95x (2000/2)]

228Purchase cost (6000xK1.20) 7200 (6000xK1.20x0.95)

6840Total annual costs 7440

7128The discount should be accepted because it saves the company K312 (K7440-K7128).Example

The following details are extracted from the accounts of EJ Investments at the end of the year;Opening inventory K2 000

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Purchases K26 000Closing inventory K5 000Calculate the inventory turnover.Solution

Inventory turnover rate = 3000 + 26000 – 5000 (3000 + 5000)/2

= 6 times per annumOn average inventory is held for two months. But note that this is an average figure. High turnover indicates efficiency in manufacturing.Alternative method uses the maximum inventory level and minimum inventory level and turnover will be calculated as follows;

Cost of materials consumed during the period ½(maximum inventory level + minimum inventory level)

Suppose the maximum level is K3000 and the minimum level is K1000 and what has been issued during the period is K10000, the turnover will be calculated as follows;

= 10000 ½(3000 + 1000) = 5 times

A more refined method uses the re-order quantity as follows;Cost of materials consumed during the period Minimum inventory level +½ Re-order quantity

Suppose the maximum inventory level is 1500 units and the minimum is 600 units. The re-order quantity is 800 units and issues during the period were 6000 units, the turnover will be;

= 6000 600 + ½(800)

= 6 timesAssumptions of EOQ

Meaningful order costs and inventory holding costs can both be calculated.

Order costs and inventory holding costs are constant. Rate of demand are known Known constant price per unit

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Orders are not received in batches. Replenishment is made instantaneously

It is clear from the assumptions that the main problem that arises from the use of the EOQ is difficulty in calculating the order and the inventory holding costs. Nevertheless, the EOQ should be used only as a guide and should not be adhered rigidly without regard of the stores manager's personal experience and knowledge of what actually happens in practice.Instantaneous replenishment

Gradual replenishment

This is where inventory is replenished over a period of time.EOQ with gradual replenishment= √ 2 x Ordering cost x Demand Carrying cost (1- Demand/production rate per annum)There are a number of important formulae related to EOQ that you should note;Average inventory held is equal to ½ of the EOQ (= EOQ/2).The number of orders in a year = Expected annual demand/EOQTotal annual holding cost = Average inventory (EOQ/2) x holding cost per unit of inventory.Total annual ordering cost = Number of orders x cost of placing an order.There is also a formula that allows us to calculate the total annual cost (TAC) i.e. the total of holding costs and ordering costs.TAC = C x D/Q + H x Q/2Where : C - ordering cost

D - Annual demandQ - Reorder quantity (EOQ)H - Holding cost

Bulk Discount

It is worthwhile taking a discount and ordering larger quantities if doing so minimises the total of material costs, ordering cost, inventory holding cost.

The total cost will be minimized at one of the following:

At the pre-discount EOQ level, so that a discount is not worthwhile.

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At the minimum order size necessary to earn the discount.To establish whether the discount should be accepted or not, the following calculations should be carried out;

i. Calculate total actual cost with discount. Andii. Compare this with the annual costs without the discount (at the EOQ

point).Inventory turnover

It is important to compare turnover of different grades and kinds of inventory as a means of detecting inventory which does not move regularly.Inventory turnover is measured in terms of the ratio of cost of materials consumed to the average inventory held during the period.

Cost of materials consumed during the period Average inventory of material during the period

Example

The following details are extracted from the accounts of EJ Investments at the end of the year;Opening inventory K2 000Purchases K26 000Closing inventory K5 000Calculate the inventory turnover.Solution

Inventory turnover rate = 3000 + 26000 - 5000 (3000 + 5000)/2 = 6 times per

annumOn average inventory is held for two months. But note that this is an average figure. High turnover indicates efficiency in manufacturing.Alternative method uses the maximum inventory level and minimum inventory level and turnover will be calculated as follows;

Cost of materials consumed during the period½(maximum inventory level + minimum inventory level)Suppose the maximum level is K3000 and the minimum level is K1000 and what has been issued during the period is K10000, the turnover will be calculated as follows;

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= 10000

½(3000 + 1000)= 5 times

A more refined method uses the re-order quantity as follows;Cost of materials consumed during the period Minimum inventory level +½ Re-order quantities

Suppose the maximum inventory level is 1500 units and the minimum is 600 units. The re-order quantity is 800 units and issues during the period were 6000 units, the turnover will be;

= 6000___600 + ½(800) = 6 times

Example

Component X is one of thousands of items kept in a store of a manufacture. Maximum inventory level set at 17000 units. Expected consumption per month for maximum is 3000 units, for minimum 1600 units and estimated delivery period maximum 4 months and minimum 2 months.Required to calculate

1. Reorder level,2. Reorder quantity,3. Minimum level,4. Average inventory held.Solution

1. Reorder level = Maximum usage x maximum delivery period= 3,000 units x 4 months= 12,000 units

2. Reorder quantity = maximum inventory - (reorder level - minimum usage in minimum delivery period)

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= 17,000 units - (12,000 units - (1,600 units x 2 months))

= 8,200 units

3. Minimum level= reorder level - (average usage x average delivery period)= 12,000 units - (2,300 units x 3 months)= 5,100 units

4. Average inventory held = minimum inventory + ½ reorder quantity= 5,100 units + 4,100 units= 9,200 units

Types of inventory revealed by inventory turnover are;

Slow moving inventory: Inventory with low turnover, they take a long time to be used up. These should be maintained at lowest level consistent with forecast demand and supply.Obsolete inventory: Items of inventory which have become out of date and are no longer required. These should be scrapped off if they have some scrap value, otherwise they are discarded.Dormant inventory: Inventory that presently has no demand, but there is a possibility that in future they may be required. Consultations should be made between purchasing manager, stores controller, production controller and cost accountant to make decision whether to retain them due to anticipated demand or scrap them to reduce storage costs.Inventory valuation

Correct pricing of issues and the valuation of inventory are important as they have a direct effect on the calculation of profit.Methods stock valuation

a) First in First out (FIFO)b) Last in First out (LIFO)c) Cumulative weighted average cost (AVCO)d) Periodic simple average (PSA)e) Periodic weighed average (PWA)f) Replacement costg) Standard cost

Inventory valuation and profitability

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Ledger entry related to materials

The cost of materials issued is recorded on a stores ledger account for raw materials and finished goods. The cost of work in progress completed is recorded in a system of production costing records. The stores ledger account also shows the value of materials or finished goods received into store, the value of materials returned, credit notes and debit notes.ExampleAt 1 July 2007, the total value of items held in store was K50 000. During July the following transactions occurred.

KMaterials purchased from suppliers, on credit 120,000Materials returned to suppliers, because they were of unsatisfactory quality

3,000Materials purchased for cash 8,000Direct materials issued to the production department 110,000Indirect materials issued as production overhead costs 25,000Value of materials written off after a discrepancy was found in a inventory check 1,000Direct materials returned to store from production 4,000

RequiredDraw up a materials account and inventory adjustment account for July 2007.

Solution Materials Account _________________________________

K KOpening inventory b/f 50,000 Returns to supplier

3,000Purchases (payables a/c) 120,000 Work in progress-issues 110,000Purchases (cash a/c) 8,000 Production o/h a/c-issues

25,000Returns from WIP 4,000 Loss of inventory-adj a/c

1,000 Closing inventory C/F 43,000182,000 182,000

Inventory Adjustment account ________________________ K K

Stores account 1,000Profit and loss account 1,000

Example

S Limited had the following transactions relating to production material AB1 for the month of April 2007:

Date Description Units Price per unit (K)29

April 1 Opening inventory 45 10April 6 Purchases 70 12April 10 Issues to production 30April 13 Purchases 15 15April 17 Issue to production 40April 20 Purchases 100 14April 22 Issue to production 90April 24 Issue to production 40April 27 Purchases 80 17Required:

1. Using the following methods of pricing the issue of materials to production, calculate the value of the closing inventory of AB1 as at 30 April 2007:

a) first in, first out (FIFO);b) last-in, first-out (LIFO)c) cumulative weighted average (CWA)d) periodic simple average (PSA)e) periodic weighted average (PWA)f) standard cost (assume that standard cost per unit is K20)

2. Assuming that the total sales revenue for completed units of AB1 for April 2007 was K4000 and the other production costs involved totaled K500, calculate S's gross profit using each of the above inventory pricing methods.

Solution

(a) First In First Out (FIFO)

_____________________________________________________________________________Date Receipts Issues InventoryApril Quantity Price Value Quantity PriceValue

Quantity Value K K K K K____ 1 45 450 6 70 12 840 115 1290 10 30 10 300 85 990 13 15 15 225 100 1215 17 40 15 @ K10 450 60 765

25 @ K12 20 100 14 1400 160 2165 22 90 45 @ K12 1185 70 980

15 @ K15 30 @ K14

24 40 14 560 30 420 27 80 17 1360 ____ 110 1780

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3825 2395

(b) Last In First Out (LIFO)____________________________________________________________________________Date Receipts Issues InventoryApril Quantity PriceValue Quantity PriceValue Quantity

Value K K K K K____ 1 45 4506 70 12 840 115 129010 30 12 360 85 93013 15 15 225 100 115517 40 15 @ K15 525 60 630

25 @ K1220 100 14 1400 160 203022 90 14 1260 70 77024 40 10 @ K14 470 30 300

15 @ K12 15 @ K10

27 80 17 1360 ____ 110 16603825 2615

(b) Cumulative Weighted Average (CWA) or Weighted Average Cost(AVCO)

_____________________________________________________________________________ Date Receipts Issues InventoryApril Quantity PriceValue Quantity PriceValue Quantity

Value K K K K K____ 1 45 4506 70 12 840 115 129010 30 K1290/115 337 85 953

= K11.2213 15 15 225 100 117817 40 K1178/100 471 60 707

= K11.7820 100 14 1400 160 210722 90 K2107/160 1185 70 922

= K13.1724 40 13.17 527 30 39527 80 17 1360 ____ 110 1755

3825 2520

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(d) Periodic simple average

Purchases K1) April 1 102) April 6 123) April 13 154) April 20 145) April 27 17

68

K68/5=13.60

Issues to production 200 (30 + 40 + 90 + 40) x K13.60 = K2720

(Opening inventory + purchases) - Issues to production = closing inventory value

= (K450 + 3825) - 2720

= K1555

(e) Periodic weighted average

Opening inventory + purchases during April Opening inventory units + units purchased during April

= K450 + 840 + 225 + 1400 + 1360 = 4275 = K13.7945 + 70 + 15 + 100 + 80 310

Issues to production = 200 x K13.79 = K2758

Closing inventory value = (opening inventory + purchases) - issues to production

= (K450 + 3825) - 2758

= K1517

(f)Standard costing method

Opening + purchases less issues to production x standard cost per unit45+70+15+100+80 – (30+40+90+40) =110 x 20

Value of closing stock is K220.00

2. Calculation of gross profit

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FIFO LIFO CWA PSA PWA K K K K K

Sales revenue 4000 4000 4000 4000 4000

Direct materials (2495) (2615) (2520)(2720) (2758)

Other costs (500) (500) (500) (500) (500)

(2995) (3115) (3020)(3220) (3258)

Gross profit 1005 885 980 780 742

Just-in time (JIT) control system

Just-in-time systems (JIT)

The just-in-time approach to manufacturing first appeared from the Japanese (called kanban in Japanese). The success of Japanese firms in international markets in the 1980s generated interest among many Western companies as to how this success was achieved. The implementation of the just-in-time methods was considered to be one of the major factors contributing to this success. Colin Drury defines a JIT approach as a philosophy of management dedicated to the elimination of non-value added activities. A non-value added activity is defined as an activity where there is an opportunity for cost reduction without reducing the customer’s perceived usefulness of a product or service. In contrast, a value-added activity is an activity that customers perceive as adding usefulness to the product or service they purchase.The CIMA Terminology defines JIT as:

‘A technique for the organization of work flows, to allow rapid, high quality, flexible production whilst minimizing manufacturing waste and stock levels.’JIT production is defined as:

‘A system which is driven by the demand for finished products whereby each component on a production line is produced only when needed for the next stage.’JIT purchasing is defined as:

‘Matching the receipt of the material closely with usage so that raw material inventory is reduced to near zero levels.’The various definitions give JIT the appearance of being merely an alternative production management system, with similar characteristics and objectives to techniques such as MRP. However, as properly defined by Colin Drury, JIT is a philosophy of management, as it encompasses a commitment to continuous

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improvement and the pursuit of excellence in the design and operation of the production management system.The JIT approach is results driven, with the aim being the elimination of all non-value added costs. It is surprising how little of what traditionally happens in manufacturing system actually adds value to the product. The lead times to produce and sell a good consists not only of processing it, but also inspecting it for quality, moving it from machine to machine, having it queue at each machine as it waits for further processing, and finally storing it as a finished good prior to sale. It will be apparent that value is only added to the product during the actual processing stages. These have been estimated to represent as little as 10% of the total manufacturing lead time in many companies, and thus up to 90% of production time adds costs but no value.The aim of JIT is to see the manufacturing lead time equal to the processing time. Although this objective is unlikely ever to be achieved in practice, it nevertheless creates the correct climate for the commitment to continuous improvement and excellence.JIT is a customer led production system, also known as a ‘pull’ system. The main aim is to produce products as they are required by the customer rather than build up inventory to cater for demand.JIT system incorporates:

JIT purchasing, requires raw material to be purchased, in such a way that receipt and usage of materials coincides.

The following are the assumptions of JIT purchasing;

suppliers will deliver on time suppliers will deliver materials of 100% quality (i.e. there will be no rejects

returns and production delays) JIT production, components or work in progress is only produced when

needed in the next stage of production. The system is driven by need for finished products. The result is minimal (or in some cases non-existent) inventories of work in progress and finished goods.

Characteristics of JIT

A move towards zero inventory Elimination of non-value added activities An emphasis on perfect quality (i.e. zero defects) It’s a demand-pull manufacturing

Aims or advantages of JIT

Minimizing warehousing and storage cost in the case of raw materials, to ensure those costs are borne by the supplier.

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Eliminating the waste by maintaining control over quality of inventory to be input to production process.

Reducing the raw material and work in progress inventory carried as working capital through more efficient production planning thus saving the financial costs.

Reducing the finishing goods inventory held as working capital.JIT has been successfully implemented in Japan and UK; however its success is hampered for the following reasons: It is costly to administer.It depends on very close relationship with supplier in terms of production scheduling and quality control.Commitment to quality and close relationship with suppliers runs counter to a business culture where price rather than quality is basis for choosing suppliers.

CHAPTER THREE

ACCOUNTING FOR LABOUR

Labour comprise wages and salaries paid to employees of the organisation. As any other costs it has a system of controlling the labour cost.

Techniques used to control labour cost includes:1. Production planning- this is the preparation of planning schedule in

advance of production runs, with supporting schedule of man-hour requirements. This is so to reduce or avoid bottlenecks due to shortage of labour and idle time payment due to stoppage in production.

2. A labour budget and use of labour standards- a standard of expected performance is required to measure productivity by comparing the actual time taken against the expected time and in making of production planning schedules and labour budgets.

3. The labour performance reports. These should be prepared periodically, to signal whether control action is needed.

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4. Wage incentive scheme. Usually employees are productive and more efficient if motivated. If the scheme is applied correctly it will reward both the company and employees by raising productivity.

5. Accounting for direct labour cost. The system should identify direct labour cost associated with product, process or jobs.

Production and Productivity

Production is the quantity or volume of output produced.

Productivity is a measure of efficiency with which output has been produced.

Production levels can be planned and controlled by manipulating overtime, number of staff or by managing productivity. Productivity if improved enables the company to achieve its production targets in fewer hours of work, and therefore at a lower cost.

Measurements of labour activities

Capacity ratio (C) = Actual hours worked (A) Budgeted hours (B)

If the ratio is above 100% then its favourable (F) and if below 100% then its adverse (A).

It is a substitute of fixed overhead capacity variance.ORCapacity ratio =efficiency ratio x volume ratioEfficiency ratio (E) =Standard hours (Expected hour to make an output) (S)

Actual hours taken (A)

Efficiency ratio is also called productivity ratio If the ratio is below 100% then its adverse (A) and if it is above 100% its

favourable (F)OREfficiency ratio = capacity ratio / volume ratioVolume ratio (V) =Standard hours (Output measured in expected hours ) (S)

Budgeted hours (B)

Volume ratio is also called production or activity ratio This compares actual output with budgeted output It is similar to production volume variance If the ratio is above 100% then its favourable (F) and if below 100% then

its adverse (A).OR

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Volume ratio = capacity ratio / efficiency ratio Standard hours = actual output * standard hours per unit (budgeted hours per unit)

NOTE: A mnemonic CABESAVSB is used to recall the above formulae.

ExampleR & F Ltd 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. Calculate the efficiency, capacity and production volume ratios.

Solutiona) Efficiency ratio

(27,000 x 4) hours x 100% = 90% 120,000

b) Capacity ratio120,000 hours x 100% = 120%100,000 hours

c) Production volume ratio(27,000 x 4) hours 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% x 120% = 108%).

Recording Labour CostSeveral departments and management groups are involved in the control and measuring of labour cost, these will include;

1. Personnel departmentThis department is responsible for engaging employees, their discharge, transfer, classification and method of remuneration, besides issuing reports to management on normal and overtime hours worked absenteeism and sickness, lateness, labour turnover and disciplinary action.

When a person is employed a personnel record card should be prepared showing full personal particulars, previous employment, medical category and wage rate among others.

2. Production planning departmentThis department schedules work, issues job orders to production departments and chases up jobs in the factory when they run late. Materials requisitions and job time tickets are issued with job orders.

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3. Timekeeping departmentTimekeeping department is responsible for accurately recording the time spent in the factory by each worker and time spent by each worker on each job or operation- attendance tine and job time respectively.

Following are records to be kept:a) Daily and weekly time sheets- show how a worker spent his time during

the day. The objective is to reconcile all the time recorded in attendance within different jobs or operations.

b) Clock cards- record the total number of hours a worker is present in a day including overtime hours.

c) Job cards- relate to a single job and contain entries relating to numerous employees.

d) Route cards- similar to job cards except that they follow the product through the works and carry details of all operations to be carried out.

Wages are calculated on the basis of the hours noted on the attendance card, whereas production costs are obtained from the time sheets. It is most important that any idle (waiting) time is booked by employees to enable total time spent to be reconciled with total time attended.

4. Wages department

This department is responsible for preparation of the payroll and payment of wages. Besides it will also do the following;a) Maintaining a record of job classification, department and wage rate of

each employee and calculating and recording each employee's earningsb) Summarising the wages costs and hours worked in each cost centre, to

enable payment and average cost centre pay rates determined for control and budget purposes.

c) Summarising deductions from pay, overtime premium, bonus payments and the employees' payments in respect of taxation and pension etc.

d) Providing an internal check on preparation and payout of wages.

Attendance cards are the basis for payroll preparation. After calculation of net pay, a pay slip is prepared showing all details of earnings and deductions.

The following are safeguards relating to the preparation of payroll and payment of wages;a) Install some time recording mechanism.b) A person made responsible for timekeeping.c) Wages sheets checked by personal officer.d) Separate payroll and payout clerks.e) Deductions prepared by another clerk.f) Control accounts maintained.

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g) Wage rate schedules maintained by personnel.h) Identify employees on receipts of wages packet.i) Unclaimed wages register maintained and wages locked up.

5. Cost accounting department Cost accounting department is responsible for the accumulation and classification of all cost data of which labour costs are part. The information is the passed to management in the form of accounting reports to enable them determine what control measures are required.

Data will be obtained from the following documents;a) Clock cards, job cards, idle time cards, A reconciliation is required on total

attendance time with time booked on job cards plus time booked as idle.b) Wages calculation sheet, rate of pay schedule, deduction charts and

schedules. Required for payroll calculation.c) Payroll. All analyses and abstracts of labour cost can be obtained from the

payroll.d) Wages analysis. An analysis of the payroll to respective cost units or cost

centre. At the end of week or month, the totals for all jobs are added and the grand total should agree with total wages paid.

An idle time report should be prepared analyzing the non-productive time and the causes.

Idle time has a cost because employees will still be paid their basic wage or salary for these unproductive hours and so there should be a record of idle time.

Idle time ratio= Idle hours x 100% Total hours

The ratio is useful because it shows the proportion of available hours which were lost as a result of idle time.

Labour TurnoverLabour turnover is a measure of number of employees leaving/ being recruited in a period of time (say one year) expressed as a percentage of the total labour force.

Labour Turnover = Replacements x 100Average no. of employees in period

The labour turnover can be caused by both unavoidable factors like retirement, death, illness, accident, marriage, pregnancy e.t.c and controllable factors which include low wages, unsafe or stressful conditions, lack of career advancement opportunity, poor relationship between management and staff etc.

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Example 1

Time RateA factory operate a 40 hour week and direct worker works for 45 hours and is paid at K40 per hour with overtime at time rate plus half. PAYE is deducted at K450 and pension contribution of K200. Employer's contribution to pension scheme is K240.

Requirements Prepare a payroll for direct worker. SolutionPayroll

Basic pay (40 x 40) 1,600Overtime (5 x 60*) 300Gross Pay 1,900Deduction

PAYE 450Pension contribution 200Net pay 1,250

*K40 + K20 (½ of K40) = K60

Cost to employerGross pay 1,900Pension contribution 240

2,140Example 2

Ten employees work as a group. A bonus is paid to each man in the group for excess production when production exceeds the standard of 200 pieces per hour and the bonus is in addition to a man's wages at hourly rate. The bonus paid is one half of the percentage of production in excess of the standard quantity. Each man is paid as a bonus this percentage of a wage rate of K52.00 per hour.

The following is one weeks' record

Day Hours worked ProductionSunday 90 24,500Monday 88 20,600Tuesday 90 24,200Wednesday 84 20,100Thursday 88 20,400Friday 40 10,200

480 120,000

Requirements

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1. Compute the rate and amount of bonus of the week2. Calculate total pay of Chrissie who worked 42 hours and was paid K30.00 per

hour basis, and Charity, who worked 44 hours and was paid K37.50 per hour basic

Solution1. Standard production for the week (480 hours x 200) = 96,000

piecesActual production for the week = 120,000

piecesExcess production = 24,000 pieces

Bonus rate = 24,000 x 50% x 52.0096,000

= K6.50 per hour= 480 hours x K6.50= K3 120

2. Chrissie Charity K K

Basic pay 42 x 30.00 1,260 44 x 37.50 1,650Bonus pay 42 x 6.50 273 44 x 6.50 286

1,533 1,936Example 3

ST Co. manufactures a single product. Its workforce consists of 10 employees, who work a 36-hour week exclusive of lunch and tea breaks. The standard time required to make one unit of the product is two hours, but the current efficiency (or productivity) ratio being achieved is 80%. No overtime is worked, and the workforce is paid K4 per attendance hour.

Because of agreements with the workforce about procedures, there is some unavoidable idle time due to bottlenecks in production, and about four hours per week per person are lost in this way.

The company can sell all the output it manufactures, and makes a cash profit of K20 per unit sold, deducting currently achievable costs of production but before deducting labour costs.

An incentive scheme is proposed whereby the workforce would be paid K5 per hour in exchange for agreeing to new work procedures that would reduce idle time per employee per week to two hours and also raise the efficiency ratio to 90%.

RequiredEvaluate the incentive scheme from the point of view of profitability.

Solution

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The current situation

Hours in attendance 10 x 36 360Hours spent working 10 x 32 320

Units produced, 80% efficiency 320∕2 x 80∕100 = 128 units

Cash profit before deducting labour cost (128 x K20) 2 560Less: Labour costs (K4 x 360 hours) 1 440Net profit 1 120

Incentive scheme

Hours spent working 10 x 34 340Units produced, at 90% efficiency 340 ∕ 2 x 90 ∕ 100= 153 units

Cash profits before deducting labour costs (153 x K20) 3 060Less: Labour costs (K4 x 360) 1 800Net profit 1 260

In spite of a 25% increase in labour costs, profits would rise by K140 per week. The company and the workforce would both benefit provided, of course, that management can hold the workforce to their promise of work reorganization and improved productivity.

The cost of labour turnover1. Preventive costs: cost incurred in trying to keep employees, e.g. pension

scheme providing security cost of personal administration in maintaining good relationships, medical services etc.

2. Replacement costs: costs incurred as a result of hiring new employees e.g. costs of selection and placement, training, inefficiency of new labour etc.

Replacement costs are associated with high labour turnover, whereas high preventive costs may lead to low labour turnover.

Labour turnover can be reduced by:1. Paying satisfactory wages2. Offering satisfactory hours and conditions of work.3. Creating a good informal relationship between fellow workers and between

supervisors and subordinates.4. Offering good training schemes and a well-understood career or promotion

ladder5. Improving the content of jobs to create job satisfaction6. Proper planning so as to avoid redundancies.

Direct and Indirect Labour

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Labour cost constitute of the following:

1. Basic pay of direct workers i.e. cash paid, tax and other deductions which is a direct cost to the unit, job or process.

2. Basic pay of indirect workers is an indirect cost unless the worker's time is dedicated to an order specifically asked by a customer.

3. Overtime premium paid to both direct and indirect works is an indirect cost except where the overtime is specifically requested by a customer or it is worked regularly in the normal course of operations by direct workers.

4. Bonus payments are generally an indirect cost.5. Employer’s insurance and pension contributions are normally treated

as indirect labour cost.6. Idle time is an overhead costs.7. The cost of work on capital equipment is incorporated into the capital

cost of the equipment.

Accounting for labour costsThe labour cost will be recorded in the wages control account.

Example

The following details were extracted from a weekly payroll for 750 employees at a factory.

Analysis of gross payDirect IndirectWorkers workers Total

K K KOrdinary time 36,000 22,000 58,000Overtime: basic wage 8,700 5,430 14,130

Premium 4,350 2,715 7,065Shift allowance 3,465 1,830 5,295Sick pay 950 500 1,450Idle time 3,200 - 3,200

56,665 32,475 89,140

Net wages paid to employees K45 665 K24 220 K69 825

Required

Prepare the wages control account for the week.

Solution Wages Control Account_______________________

K KBank: Net wages paid 69,825 Work in progress-direct labour 44,700Deductions Production overhead: (PAYE & Superannuation)19,315 indirect labour 27,430

Overtime Premium 7,06543

Shift allowances 5,295 Sick pay 1,450

Idle time 3,20089,140 89,140

CHAPTER FOUR

ACCOUNTING FOR OVERHEADS

Absorption costing

Is a principle whereby fixed and variable costs are allotted to cost units and total overheads are absorbed according to activity levels.

The distinguishing feature of absorption costing is that the cost of an item is calculated by adding (absorbing) a share of fixed overheads costs.

In marginal costing also known as variable costing or direct costing only variable overheads are absorbed.

Procedure for building up accost of a unit

a) Ascertain and charge the items of prime costs i.e. direct costs.b) Charge the appropriate amount of factory or production overheads.c) The sum of (a) and (b) is the factory cost or full cost of production.d) Charge the appropriate amount of selling and distribution overheads.e) Charge the appropriate amount of administration overheads.f) The sum of (c, (d) and (e) will be the total cost of sales.

Note: Absorption only goes as far as point (c) i.e. applies to production only.

Reasons for using absorption costing

a) Closing stock valuation which must be included in the balance sheet and to calculate cost of stocks used or sold in the period. i.e

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Closing stocks = opening units plus production units or purchases less sales units

b) Pricing decisions i.e. companies attempt to fix the selling prices by calculating the cost of production or sales and then adding a profit margin to get the selling prices.

c) Establishing profitability of individual products where different products are produced or manufactured.

Stages in absorption costing (costing procedure)

There are three stages of calculating the cost of overheads to be charged to manufactured output and these includes;

I. Cost allocation or overhead allocation It means charging of discrete identifiable items of cost to cost centres

or cost units. Or Is the process by which whole cost items are charged direct to a cost

centre or cost unit.

Example

The cost of a certain cottage company includes the following:

Wages of a foreman of department A K200, 000.00

Wages of a foreman of department B K150, 000.00

Indirect materials consumed in department A K50, 000.00

Rent of the factory premises shared by department A and B K300, 000.00

Requirements

Allocate the overhead costs.

II. Cost apportionment or overhead apportionment Is the process by which cost items or cost centre costs are divided

between several cost centres in a fair proportion. Or Is the division of cost amongst two or more cost centres in proportion

to the estimated benefits received using an appropriate basis.III. Overhead absorption

Is the process whereby cost centre costs are added to unit, job, or process costs.

It is a means of attributing overheads to a product or service based on for example on direct labour hours, direct labour cost, or machine hours.

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NB: Overhead absorption is of great importance when dissimilar products are made using common facilities, because overhead should reflect the load that each product places upon the production facilities.

Cost apportionment and reapportionment

In order to apportion cost amongst different departments several bases are used .the table below illustrate some of the bases of apportionment and re apportionment.

Basis of apportioning overhead costs

Overheads to which the basis relates

Basis of apportionment

Rent, rates, heating and light, repairs and depreciation of buildings

Floor area occupied by each department

Depreciation of equipment and insurance of equipment

Cost of equipment Book value of equipment Depreciation rates on cost of

equipmentPersonnel office cost, canteen, welfare costs, wages and office costs, first aid.

Number of employees Labour hours

Heating, lighting Volume of space occupied by each department

Carriage inwards Value of material issues to each department

Lighting Floor area occupied by each department

Heating Volume occupied by each department

Basis of reapportionment of service cost to other departments

Service departments Possible basis of apportionment

Stores department Number of material usage or requisitions

Value of material usage or requisition

General service department Machine or labour hoursMaintenance department Hours of maintenance and

repair work done for each department

Production planning Direct labour hours worked for each production department

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Selling and marketing Sale valueResearch and development Consumer cost i.e.

production cost minus cost of direct material

Added value i.e. sales value minus cost of bought in materials

Distribution Sales valueAdministration Consumer cost and added

value

Example

Bravo limited incurred the following overhead costs:

K’ 000

Depreciation of factory 1,000

Factory repairs and maintenance 600

Factory office costs 1,500

Depreciation of equipment 800

Insurance of equipment 200

Heating 390

Lighting 100

Canteen 900

TOTAL 5,490

Additional information relating to the service and production departments in the factory is as follows;

Production department service departments

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A B storescanteen

Allocated overheads K10, 000.00 K15, 000.00 K17, 000.00 K21, 000.00

Floor area (sq. metres) 1200 1600 800 400

Volume (cubic metres) 3000 6000 2400 1600

Number of employees 30 30 15 15

Book value of equipment K30, 000.00 K20, 000.00 K10, 000.00 K20, 000.00

Requirements

Apportion the overheads costs to the four departments

Reapportionment

Is the apportionment of the allocated and apportioned overheads from service cost centres to production cost centres.

Why is it important to reapportion service cost centre costs to production cost centres?

It is essential so as to incorporate or add service cost into production cost.

If absorption costing is used failure to do so will lead to under absorption of overheads and under valuation of finished goods stock.

Methods of reapportionment

a. Direct method or ignoring reciprocity or two step methodsa. It involves apportioning service cost to production department only on

the assumption that service cost centres do not offer services to each other but rather they offer services to production departments only.

Reciprocity

This refers to a situation where service cost centres share costs amongst other service cost centres.

Service departments e.g. stores service departments e.g. canteen

b. Specific order of closing or step down method

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It involves apportioning allocated overheads not only to production departments but also to other service departments.

Start apportioning the department that offers services to both production and other service departments and finishing with a service department that offers services to production cost centres only.

How does it work alternatively?

Start apportioning service departments which ranks first either horizontally or vertically depending on the format of a question. Or

Start apportioning a service department with the highest overheads. Or

Start apportioning a service department which shares most to other service department and finish with the least sharing service department.

c. Repeated distribution or continuous allotment or reciprocal method

This is where service cost centre costs are re apportioned repeatedly using given bases or percentages or ratios until they become insignificant and immaterial.

d. Algebraic method or simultaneous equations method This involves formulation of simultaneous equations and can be

difficult where there are more than two unknowns.NOTE: if no method is given in an exam, the method adopted depends on the kind of a question but in most cases where there is reciprocity use algebraic or continuous allotment method and the least immaterial apportioned figure should be allocated to the production department bearing a greater ratio or percentage of reapportionment. If no method is given, and you are stuck on which method to use here is a hint “start with algebraic ,if it doesn’t work, try continuous allotment, if it doesn’t work, try specific order of closing and lastly, if it doesn’t work, try direct method.( try and adopt one method that suits the question first).

Example

Hover and hover limited has two production and two service departments (stores and maintenance). The following information about the recent costing period is available:

Production department Service department

A B storesmaint

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Overhead costs: K10, 030.00 K8, 970.00 K10, 000.00K8, 000.00

Cost of material requisition K30, 000.00 K50, 000.00 -K20, 000.00

Maintenance hours needed 8,000 hrs 1,000 hrs 1,000hrs -

The following additional information has been identified to show the appropriate shares of overhead costs:

Production departments Service departments

A B storesmaint

Sores 30% 50% - 20%

Maintenance 80% 10% 10% -

Requirements

Reapportion the overhead costs using the following methods

a) Direct methodb) Specific order of closingc) Reciprocal methodd) Simultaneous method

Overhead absorption

Overheads refers to all indirect costs Overheads are also called on-cost or burden cost Overhead absorption is the process whereby overheads are added to

unit, job, or process costs. Overhead absorption is also called overhead recovery.

Overheads are usually added to unit cost using a predetermined overhead absorption rate which is calculated from budgeted figures.

Overhead absorption rate= budgeted overheads /budgeted levels of activity.

Where:

Budgeted levels of activity can be any possible basis of absorption.

Overhead absorption rate (OAR) is also called overhead recovery rate (ORR).

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Chosing the appropriate absorption basis or rate.

Different bases of absorption rates include:

a) A percentage of direct labour costb) A percentage of direct material costc) A percentage of prime costd) A rate per machine houre) A rate per labour hourf) A rate per unitg) A percentage of factory cost (for administration overhead).h) A percentage of sales or factory cost (for selling and administration

overheads).NOTE: there is no best way of choosing an overhead absorption rate or basis but its subject to judgment and common sense, but what matters is choosing a basis which reflects the characteristics of a department and prevents undue anomalies.

For example:

a) A department with more machine hours than labour hours is machine intensive hence uses machine hours as a basis.

b) A department with more labour hours than machine hours is labour intensive hence uses labour hours as a basis.

c) A rate per unit is appropriate in departments where all units produced are identical and use identical production processes.

Why are hourly bases commonly used?

Because they are likely to reflect the load on a cost centre or department hence the incidence of overheads.

Non hourly rates are seldom used because there is no relationship between them and the ways in which the overheads are incurred.

Example on overhead absorption rates

The budgeted production overheads and other budgeted data of a certain cottage company in Salima are as follows:

Production departments

A B

Overheads costs K36, 000.00K5, 000.00

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Direct material cost K32, 000.00 -

Direct labour cost K40, 000.00 -

Machine hours 10,000 hours -

Direct labour hours 18,000 hours -

Units of production - 1,000 units

Requirements

Calculate the overhead absorption rates using various bases of absorption.

Blanket vs departmental absorption rates

Blanked overhead absorption rate is a rate used throughout a factory and for all jobs and units of output irrespective of the departments in which they were produced.

Circumstances where blanket overhead absorption rate is not appropriate

Where there is more than one department or where jobs spent unequal amount of time in each department.

Why not blanket overhead absorption rates?

Some products may receive a higher charge of overheads than they could fairly bear, while others may be undercharged.

Why are departmental overhead absorption rates commonly used?

It is fair and full cost of production will represent the real amount of effort and resources put into making them

Example on departmental vs. blanket absorption rates

Old age grammar school has two production departments for which the following budgeted information is available:

Departments A B TOTAL

Budgeted overheads K360, 000.00 K200, 000.00K560, 000.00

Budgeted direct labour hours 200,000 hrs. 40,000 hrs. 240,000 hrs.

Requirements 52

a) Calculate the following rates:i. Single factory or blanket overhead absorption rateii. Separate or departmental overhead absorption rates

b) Job X has a prime cost of K100,000.00 and takes 300 hours in department A and does not involve any work in department B. job Y has a prime cost of K100,000.00 and takes 280 hours in department A and 20 hours in department B.

Requirements

Calculate the cost of each job using the rates calculated in a (i) and (ii).

Over or under absorption of overheads

Over or under absorption of overheads occurs because the predetermined rates are based on estimates.

What is over absorption?

This occurs where actual overheads incurred are less than overhead absorbed.

What is under absorption?

This occurs where actual overheads incurred are more than overheads absorbed.

NOTE: Absorbed overhead = actual activity x overhead absorption rate

How to calculate under or over absorption

Dept. A Dept. BK’000 K’000

Actual overheads (overhead incurred) XXX XXXLess: absorbed overheads XXX XXX Under or (over) absorbed overheads XXX (XXX)

Note: here is a simple rule to work out whether overheads are over or under absorbed.

Actual overheads incurred – absorbed overheads = negative (N), then overheads are over absorbed (O) i.e N.O. (Negative means Over).

Actual overheads incurred – absorbed overheads = positive (P), then overheads are under absorbed (U) i.e P.U. (Positive means Under).

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This then follows that N.O.P.U. rule should be used to identify under or over absorption of overheads

Reasons for under or over absorbed overheads

Actual overheads are different from budgeted overheads. Actual activity levels are different from the budgeted activity levels. Both actual overheads and actual activity levels are different from

budgeted overheads and budgeted activity levels. Example on under or over absorbed overheads

Franco and company has a budgeted production overheads of K50,000.00 and a budgeted activity of 25,000 direct labour hours.

Requirements

Calculate the under or over absorption of over heads and state the reasons for the under or over absorption in the following circumstances:

a. Actual overheads cost K47, 000.00 and 25,000 direct labour hours are worked.

b. Actual overheads cost K50, 000.00 and 21,500 direct labour hours are worked.

c. Actual overheads cost K47, 000.00 and 21,500 direct labour hours are worked.

Show the reasons for under or over absorption by causes or causation (show the reasons in figures) and prepare a reconciliation statement.

Ledger entries relating to overheads

Marritto motorcycles absorb production overheads at the rate of K0.50 per operating hour and administration overheads at 20% of the production cost of sales. Actual data for one month was as follows:

Administration overheads K32, 000.00

Production overheads K46, 000.00

Operating hours 90,000 hours

Production cost of sales K180, 000.00

Requirements Prepare the ledger accounts relating to overheads.

How is over or under absorption of overheads accounted for?

Over absorbed overheads is credited to the income statement or profit and loss account.

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Under absorbed overheads is debited to the income statement or profit and loss account.

Template showing under or over absorption by causes or causation This method explains the for under or over absorption

Dept. A Dept. BExpenditures K’000 K’000Budgeted overhead XXX XXXActual overhead XXX XXX Under (over) XXX (XXX)

Volume Units or Hours Units or Hours

Budgeted hours XXX XXXActual hours XXX XXXUnder or over in hours XXX XXXX Overhead absorption rate OAR OAR Under or (over) (XXX) XXX

Reconciliation statement

K’000 K’000

Volume under or over (XXX) XXXLess: Expenditures under or over XXX (XXX) Under or (over) absorption XXX (XXX) Exam style questions

Mbayifwa rice milling company has two production departments Milling and Packing and two service departments Maintenance and stores. The company’s weekly overheads cost is as follows:

Milling K90, 000.00 and Packing K75, 000.00

Direct labour hours are budgeted at 5000 hours and machine hours at 3000 hours. Costs for the service departments are allocated as follows:

Maintenance 60% to milling

30% to packing

10% to stores

Stores 30% to milling

50% to packing

20% to maintenance55

At the end of one week, actual results were tabulated as follows:

Milling K65, 000.00

Packing K45, 000.00

Maintenance K25, 000.00

Stores K20, 000.00

The milling department actually worked 2900 machine hours and the packing department worked 5200 direct labour hours.

Requirements

a. Compute the overhead to be charged o the milling and packing department for the week using the reciprocal method and simultaneous equations method.

b. Calculate the under or over absorption of overheads in the two production departments.

c. State the factors that that have caused the under or over absorption of overheads.

d. Make a reconciliation of the under or over absorption in relation to the production department with reference to the causation.

e. Prepare departmental overhead accounts to show the entries of overheads

f. Show the over or under absorption in the over or under absorption overhead account.

g. State the accounting treatment for over or under absorbed overhead.

ABC ltd has two production departments, a Machine shop and an Assembly shop, and three service departments, Stores, Engineering and General services. The Engineering service department serves the Machine shop only.

The following data has been provided:

Department : book area effective prod. Directcapacity

Value (sqm) horse labour machine

(K) Power (%) hourshours

Production:Machine shop 210, 000 11,000 85 350,000 90000Assembly shop 30, 000 8,000 5 300,000 -Service:

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Stores 12, 000 2,000 -Engineering 36, 000 2,500 10General 12, 000 1,500 -TOTAL 300, 000 25,000 100

The annual budgeted overhead costs for the year are:

Indirect wages consumable supplies

Machine shop 88, 580.00 30, 800.00Assembly shop 16, 220.00 4, 200.00Stores 8, 200.00 2,800.00Engineering 5, 340.00 4, 000.00General 7,340.00 3, 000.00TOTAL 125, 680.00 45, 200.00

Depreciation of machinery K44, 000.00Insurance of machinery K8, 000.00Insurance of buildings K3, 600.00 (note 1)Power K7, 200.00Light and heat K6, 000.00Rent and rates K14, 100 (note 2)Notes:

1. Because of certain fire risks, the machine shop is responsible for a special loading of insurance on the building. This results in a total building insurance cost for the machine shop of 50% of the annual premium.

2. The general services department is located in building owned by the company. This building is valued at K80, 000.00 and is charged into costs at a notional rental value of 6% per annum. This cost is additional to the rent and rates shown above.

3. The values of issues of material to the production departments are in the same proportions as shown above for consumable supplies.

Requirements

a. Prepare and compete an overhead analysis sheet showing the bases of any apportionments.

b. Calculate suitable overhead absorption rates for the production departments. No services department costs are to be apportioned amongst other service department.

c. The following information relates to job 149 undertaken by ABC ltd on behalf of a customer:

Direct materials K50, 000.00Direct labour K20, 000.00

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Other direct expenses K127, 000.00Direct labour hours:Machine shop 100 machine hours, 80 labour hoursAssembly shop 120 labour hours

Requirements

If ABC ltd calculates its selling price by adding a profit margin is 40%, Calculate the price of job 149.

DC Limited is an engineering company which uses job costing to attribute costs toindividual products and services provided to its customers. It has commenced thePreparation of its fixed production overhead cost budget for 2001 and has identified the following costs:

K’000Machining 600Assembly 250Finishing 150Stores 100Maintenance 80TOTAL 1 180

The stores and maintenance departments are service departments.An analysis of the services they provide indicates that their costs should beapportioned accordingly:

Machining Assembly Finishing Stores Maintenance

Stores 40% 30% 20% — 10%Maintenance 55% 20% 20% 5% —

The number of machine and labour hours budgeted for 2001 is:Machining Assembly Finishing

Machine hours 50 000 4 000 5 000Labour hours 10 000 30 000 20 000

Requirements:(a) Calculate appropriate overhead absorption rates for each production department for 2001.

(b) Prepare a quotation for job number XX34, which is to be commenced early in2001, assuming that it has:

58

Direct materials costing K2400Direct labour costing K1500And requires: Machine hours Labour hoursMachining department 45 10Assembly department 5 15Finishing department 4 12And that profit is 20% of selling price.

(c) Assume that in 2001 the actual fixed overhead cost of the assembly department totals K300 000 and that the actual machine hours were 4200 and actual labour hours were 30 700.RequirementsPrepare the fixed production overhead control account for the assemblydepartment, showing clearly the causes of any over/under-absorption.

(d) Explain how activity based costing would be used in organizations like DCLimited.

Sven Ltd has two production departments, Machining and Assembly, and two service departments, Tooling and Maintenance. The budgeted activity levels for April 2004 were thus:

Machining 400 hours K16,000Assembly 2,400 hours K9,600

The service departments are apportioned thus:Tooling 70% to Machining

20% to Assembly10% to Maintenance

Maintenance 50% to Machining30% to Assembly20% to Tooling

During April 2004 the actual results were:Machining 420 hours K12,000Assembly 2,300 hours K8,000Tooling K5,000Maintenance k3,000

Required:a) Calculate the budgeted overhead absorption rate per hour for each of the

production departments.

b) Calculate the amount of overhead to be charged to each of the production departments.

59

c) Calculate the amount of under or over absorption of overhead for each of the production departments.

d) ‘The under or over utilisation of capacity can have an effect on the fixed cost of an organisation.’ Briefly describe two ways, other than the under/over absorption calculated above, by which this effect can be measured.

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CHAPTER FIVE

MARGINAL AND ABSORPTION COSTING

What is a marginal cost?

Is the variable cost of one unit of a product which can be avoided if such a product or service is not produced or provided.

What is marginal costing?

Is a principle whereby variable costs are charged to cost units and fixed cost attributed to the relevant period is written off in full against the contribution for that period.

Marginal costing

This is an alternative method to absorption costing where only variable costs are charged as cost of sales and a contribution is calculated.

In marginal costing closing stock, work in progress or finished goods are valued at marginal (variable) production cost.

In marginal costing fixed costs are treated as period costs hence charged in full to the profit and loss of the accounting period in which they relate or incurred.

Elements of marginal cost of production of an item

Direct material Direct labour Variable production overheads

Marginal cost of sales (variable cost of sales)

It includes variable (marginal) cost of production i.e. direct material cost, direct labour cost, and variable production cost (overheads), plus variable cost of administration, selling and distribution.

Contribution

Is the difference between sales value and marginal or variable cost of sales.

It means contribution towards covering fixed overheads and making a profit.

Uses of marginal costing

For planning For decision making

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Cases or situations where marginal costing principles are used as a decision making aid.

These include:

Make or buy decisions Accepting or rejecting special orders (contracts) Shut down decisions (closing or continuation decisions) Limiting factor decision making (determining the most efficient use

of scarce resources).Uses of absorption costing.

Used for routine reporting. Used for financial accounting purposes.

Principles of marginal costing

a. Period fixed costs are the same for any volume of sales and production if the levels of activity is within the relevant range hence:

Revenue will increase by the same values of the items sold. Cost will increase by variable cost per unit. Profits will increase by the amount of contribution earned from an

extra item.b. If the volume of sales fall by one item profit also fall by the amount of

contribution earned from that one item.c. Profit measurement is based on analysis of contribution.d. When a unit of a product is made, the extra costs incurred in its

manufacture are the variable costs and fixed costs are unaffected.Application of marginal costing principles

Example1

Rain until September Company makes a product, the splash which has a variable production cost of K16 per unit and a sales price per unit K20. At the beginning of September 2013, there were no opening inventories and production during the month was 20, 000 units. Fixed costs for the month were K45, 000.00 (production, administration, sales and distribution). There were no variable marketing costs.

Requirements

Calculate the contribution and profit for September 2013, using marginal costing principles if sales were:

a. 10, 000 splashesb. 15, 000 splashesc. 20, 000 splashes

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Example 2Tom and jerry ltd makes two products, the Tom and Jerry. Information relating to each of these products for April 2011 is as follows:

Toms Jerry’s

Opening inventory nil nil

Production units 15, 000 6, 000

Sales units 10,000 5, 000

Sales price per unit K20 K30

Cost per unit: K K

Direct materials 8 14

Direct labour 4 2

Variable production overheads 2 1

Variable sales overheads 2 3

Fixed cost for the month: K

Production cost 40, 000.00

Administration cost 15, 000.00

Sales and distribution costs 25, 000.00

Requirements

a) Calculate the profit in 2011 in April using marginal costing principlesb) Calculate the profit if sales had been 15000 units of Toms and 6000 units

of Jerry’s.c) What is the contribution to sales ratio for both (a) and (b) above for Toms

and Jerry.NOTE: when using marginal costing or its principles the contribution to sales ratio is the same even if sales change.

But it does mean that contribution to sales ratio is the same when variable costs change.

Variable sales costs vary with sales units and not production units.

Variable production costs vary with production units and not sales units.

63

Marginal and absorption costing compared

Marginal costing Absorption costingClosing inventories are valued at variable costs only.

Closing inventories are valued at full production cost i.e. fixed + variable costs.

Fixed costs are period costs Fixed costs are absorbed into unit costs.

Costs of sales does not include a share of fixed costs (overheads)

Costs of sales does include a share of fixed production costs (overheads)

Marginal vs. absorption costing

Example 1

Ross ltd budgeted to commence production of product X in month one. The standard variable production cost per unit of product X is:

K

Material 70

Labour 40

Production overhead 30

Budgeted monthly fixed production overhead is K72, 000.00

Production is budgeted a 6000 units per month which will be used to calculate a predetermined fixed overhead absorption rate if absorption costing is used.

The budgeted selling price of X is K180 per unit.

The actual production and sales for the first three months were:

Month 1 Month 2 Month 3

Production 5500 units 6200 units 5900 units

Sales 5000 units 6300 units 6200 units

Requirements

a) Calculate both the standard contribution and profit for one unit.b) Prepare profit statements for month 2 and month 3 only using

i. Marginal costing ii. Absorption costing

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c) Prepare a statement to reconcile the profits obtained using both methods for month 2 and month 3.

d) Mention two advantages and disadvantages of using marginal costing.Example 2

Rowland Company makes and sells one product, the standard cost of which is as follows for one unit:

K

Direct material 28

Direct labour 18

Production overhead: variable 3

Fixed 20

Standard production cost 69

Normal output is 16000 units per annum and this figure is used for the fixed production overhead calculation. Costs relating to selling, distribution and administration are:

Variable 20% of sales value

Fixed K180, 000.00 per annum

The only variance is a fixed production overhead volume variance. There are no units in finished stock at 1 October, 2013. The fixed overhead expenditure is spread evenly throughout the year. The selling price per unit is K140.

For the six monthly period detailed below, the number of units to be produced and sold are budgeted as:

October to March 2013 April to September 2013

Production units 8500 7000

Sales units 7000 8000

Requirements

a) Prepare to management statements showing sales, costs and profits using:

i. Marginal costingii. Absorption costing

b) Reconcile the profits reported under both methods for each period.65

Reconciliation procedure

K’000

Profit as per marginal costing statement XXXAdjustments on fixed OAR XXXAdd: closing stock * fixed OAR XXXLess: opening stock * fixed OAR (XXX) Profit as per absorption costing statement XXX

What causes the difference in profits under the two methods.

Stocks are valued on total production cost in absorption costing whilst in marginal costing are valued on variable production costs only.

If stock levels increases between the beginning and end of period absorption costing reports higher profits because some of the fixed production overheads incurred during the period will be carried forward in closing stocks to be set against sales revenues in the following period instead of being set off in full against the profits in the concerned period.

If stock levels decreases between the beginning and end of period absorption costing reports lower profits because both fixed production overheads incurred during the period and which had been carried forward in opening stock is released and included in cost of sales.

Advantages of marginal costing

It is simple to understand and apply. It concentrates on the controllable aspects of the business by

separating fixed from variable costs. It is a useful short term survival technique in a competitive

environment or where recession is experienced.Disadvantages of marginal costing

It uses historical data whilst management decisions relate to the future

It is difficult to classify fixed and variable costs from mixed costs It is not suitable for pricing decisions in the long run as it ignores fixed

costsArguments in favour of absorption costing

It sounds realistic to charge all output with a share of fixed production costs which are incurred in order to make output.

It is in line with SAAP 9 for closing stock valuation.

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It does not distort profits through stock valuation where stock building is necessary or activity is seasonal.

Profitability of various products can be established since fixed costs are already charged to each product.

Reasons for marginal costing

Under or over absorption of overheads is avoided. It is simple to operate No arbitrary apportionment of fixed costs It sounds realistic to value stock at variable production cost since it is

directly attributable. For management better information about expected profits is obtained

from the use of variable cost and contribution.

CHAPTER SIX

67

BREAKEVEN ANALYSIS OR COST VOLUME PROFIT ANLYSIS(CVP ANALYSIS)

Break even analysis or CVP analysis

Is the study of the interrelationships between costs, volume, and profit at various levels of activity.

What is breakeven point (break even sales)?

Is a point where no profits nor losses occur Is the amount by which actual sales can fall below anticipated sales

without a loss being incurred.

Formula for breakeven sales (point)

Breakeven point in units = total fixed cost/ contribution per unit OR

Breakeven point in revenue = total fixed cost/contribution to sales ratio (C/S ratio)

Example 1 on breakeven point

Nugget Company has provided with you the following information:

Expected sales 10000 units at K8 per unit = K80, 000.00

Variable cost K5 per unit

Fixed cost K21, 000.00

Requirements

Calculate the breakeven sales point.

Breakeven analysis and the C/S ratio (contribution to sales ratio)

The C/S ratio is also called contribution margin ratio (CM ratio) or profit volume ratio (P/V ratio) or contribution ratio.

Contribution to sales ratio is a measure of how much contribution is earned from each K1 of sales. E.g. if the C/S ratio is 20% it means for every K1 of sales the contribution is K0.20

Formula approach to breakeven point

If sales = variable cost + fixed cost the answer is breakeven point or profit is zero.

Therefore making fixed costs subject of the formula in the above equation it will be:

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Fixed cost = sales – variable cost

So if sales less variable cost is contribution then contribution is equal to fixed cost

Now the formula for breakeven point can be as follows:

Breakeven point in units = required contribution (total fixed cost) / contribution per unit

Breakeven point in revenue = required contribution (total fixed cost) / contribution to sales ratio (C/S ratio)

Example 2 on breakeven point

Francis and sons ltd makes a product which has a variable cost of K7 per unit. If fixed costs are K63, 000.00 per annum.

Requirements

What must the selling price per unit be if the company wishes to breakeven and sell 12000 units of the products?

Target profits or required profits or expected profits

Since: if sales (S) = variable cost (V) + fixed cost (F) = breakeven (BEP)

Then: sales (S) = variable cost (V) + fixed cost (F) + target profit (P) = target profit (P)

S = V +F +P

S – V = F + P

Therefore total required contribution (S – V) = Fixed cost (F) + required profit (P), then the formula for required sales becomes:

Required sales in units = Total required contribution (fixed cost + profits) / contribution per unit

Required sales in revenue = total required contribution (fixed cost + profits) / contribution to sales ratio (C/S ratio)

Example 1 on target profit

Riding breaches ltd makes and sells a single product for which the variable costs are: K

69

Direct material 10

Direct labour 8

Variable production overhead 4

Variable sales overhead 2

TOTAL 24

the sales price is K30 per unit and fixed costs per annum are K68, 000.00 . the company wishes to make a profit of K16,000.00 per annum.

Requirements Calculate the amount of sales required to achieve this profits.

Example 2 on target profit

Seven league boots ltd wishes to sell 14000 units of its product which has a variable cost of K15 to make and sell. Fixed costs are K47, 000.00 and the required profit is K23, 000.00

Requirements: What should the selling price be?

Example 3 on required profit

Tripod stand ltd makes and sells three products X, Y and Z. the sales price per unit and costs are as follows:

X Y Z

Selling price per unit K80 K50 K70

Variable cost per unit K50 K10 K20

Fixed cost per month is K160, 000.00

The maximum sales demand per month is 2000 units of each product and the minimum sales demand is 1000 units of each.

Requirements

a) Comment on the potential profitability of the company.b) Suppose that there is fixed demand for X and Y of 1500 units per month,

which will not be exceeded, but for which firm order have been receivedRequirements

How many units of Z would have to be sold to achieve a profit of atleast K25, 000.00 per month?

Margin of safety (MOS)70

Is a measure by which the budgeted volume of sales is compared with the volume of sales required to breakeven.

Formulae

Margin of safety = budgeted sales less breakeven sales OR

Margin of safety = budgeted sales less breakeven sales / budgeted sales * 100 OR

Margin of safety in revenue = profits / contribution to sales ratio (C/S ratio) OR

Margin of safety in units = profits / contribution per unit.

Example on margin of safety

Mal de mere ltd makes and sales a single product which has a variable cost of K30 and which sells for K40. Budgeted fixed costs are K70, 000.00 and budgeted sales are 8000 units.

Requirements

Calculate the breakeven sales in units and kwacha

Calculate the margin of safety in units and kwacha

Purposes or uses of CVP or breakeven analysis

Provides information to management about cost behavior for routine planning and one off decision making.

To determine what volume of sales is needed at any given budgeted sales price in order to breakeven.

To calculate the effect on profits of changes in variable costs, contribution to sales ratio, sales price and volume, product mix.

It is a useful technique for mangers as it can provide simple and quick estimates.

Breakeven chart provides a geographical representation of breakeven arithmetic.

Breakeven charts and profit volume charts

Is a chart which shows approximate levels of profit or loss at different sales volume levels within a limited range.

How to construct a breakeven chart

The vertical axis shows the sales revenues and costs whilst the horizontal axis shows sales or output (in value or units).

The sales line starts at the origin and ends at the point signifying expected sales.

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Fixed cost line runs parallel to the horizontal axis and meets the vertical axis at a point which represents total fixed costs.

The total cost line starts where fixed cost line meets the vertical axis and ends at a point which represents anticipated sales on the horizontal axis and total cost of anticipated sales on vertical axis.

The breakeven point is the intersection of sales line and total cost line. The distance between the breakeven point and expected or budgeted

sales in units indicates the margin of safety.

See the figure below:

Revenue Budgeted profits

or Costs (K) Breakeven point Profits

Total costs budgeted variable costs

Fixed costs

Loss Margin of safety Budgeted fixed costs

Output units

Example on breakeven chart

Budgeted annual output of a factory is 120000 units. Fixed overheads amount to K40000 and the variable cost are k0.50 per unit. The sales price is K1 per unit.

Requirements

Construct a breakeven chart showing the current breakeven point and profit earned up to the present maximum capacity.

The value or use of breakeven charts

To plan production of the company’s products To market company’s products To give a visual display of breakeven arithmetic

Contribution chart

See figure below:72

Breakeven point sales revenue

Revenue profits contribution

Or costs (K) Total costs

Variable costs margin of safety fixed cost

Advantages of a contribution chart

It shows clearly the contribution for different levels of production.

Profit/volume chart (P/V chart)

Is a variation of the breakeven chart which illustrates the relationship of costs and profits of sales and the margin of safety.

How to construct a P/V chart

The vertical axis shows the profits and contribution extending above and below the horizontal axis which intersect with the vertical axis at point zero.

The negative section below the horizontal axis represents fixed cost. This means that at zero production, the firm is incurring a loss equal to the fixed cost.

Volume is on the horizontal axis and comprises volume of sales or revenue.

The profit is a straight line drawn with its starting point at zero production at the intercept on the Y axis representing the level of fixed cost and with a gradient of contribution per unit.

The P/V line cuts the horizontal axis at breakeven point of sales volume.

Any point on the P/V above the horizontal axis represents the profits to the firm.

See the figure below:

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Profits 100

Budgeted profits

Breakeven0 Sales Volume (units)

Budgeted Contribution

Loss -100

Advantages of profit / volume chart

Is the clearest way of presenting information. It shows clearly the effect on profit and breakeven point on any

changes in selling prices, variable costs, fixed costs and or sales demand.

Limitation of CVP analysis )(breakeven analysis)

It can only apply to a single product or a single mix of a group of products.

Breakeven charts may be difficult to construct and interpret It ignores uncertainty in the estimates of fixed costs and variable cost

per unit It is difficult to forecast with reasonable accuracy the volume of sales

mix which would maximize profits. It is only correct if input prices and selling prices remain constant. It assumes that the changes of opening and closing stocks are

insignificant though they may be significant. It assumes that variable costs are the same per unit at all levels of

output It assumes that fixed costs are constant at all levels of output. It assumes that variable costs vary with production only. It assumes that selling prices remains constant at all levels. It assumes that technology and efficiency remains constant but in

reality may vary leading to wrong results. Assumptions of CVP analysis (breakeven analysis) and why they may not be correct

It assumes that all costs can be separated into fixed and variable elements but in reality most costs tend to be of semi fixed nature.

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Fixed costs will remain constant and variable costs will vary with activity but fixed costs may be incremental and some variable costs vary with sales and not production.

Technology and efficiency remains constant but in practice efficiency may vary.

Production and sales are the same but in reality there may be production specifically made for stock.

Selling prices remain constant at all levels but discounts may be given to increase sales.

Labour costs remain constant at all levels of activity but bonuses may be paid to increase production.

Material costs remain constant but bulk buying may give rise to cheaper material due to discounts.

Exam style questions

Jingle Bells Company manufactures two products A and B. The following incomplete management report has been prepared in respect of these two products:

Product A Product B

Sales K600, 000.00 (vi)

Variable costs (i) (vii)

Contribution (ii) (viii)

Fixed cost (iii) (ix)

Profits (iv) K240, 000.00

Contribution to sales ratio 40% 50%

Breakeven point in revenue (v) K320, 000.00

Margin of safety in revenue K350, 000.00 (x)

Requirements

a) Copy the above table into your answer book and complete the missing figures.

b) Discuss five assumptions on which breakeven calculations are based.c) State three situations where marginal costing can be used as a decision

making aid.

Bully limited budgets its cost and revenue for product A for the next financial year as follows:

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K

Sales price 40

Direct material 8

Direct labour 6

Variable overheads 3

For the period concerned the budgeted fixed overhead is K100, 000.00 and budgeted sales are 12, 000 units.

Requirements

a) Calculate the budgeted profit for the year.b) Calculate and explain the significance of :

i. Breakeven point in units and kwacha.ii. Margin of safety in units and kwacha.

c) Show by means of a statement, the effect on the budgeted profit of each of the following independent courses of action and calculate the breakeven point for each of the three courses of action:

i. Reduce the selling price to K35 per unit, this will increase sales by 2000 units with an increase in fixed cost of K10, 000.

ii. Increase the selling price to K45 per unit, it will reduce sales by 4000 units and increase direct material cost by K2 per unit of all units, fixed cost being unchanged.

iii. Reduce the selling price to K30 per unit, this will increase sales by 5000 units, increase fixed overheads by K12, 000.00 and decrease direct material cost by K3 per unit for all units.

d) Which of the above courses of action is the best and give a reason for your answer?

The following details relate to Chasowa’s shop which currently sells 40000 pairs if shoes annually.

K

Selling price per pair 60

Buying price per pair 40

Total annual fixed costs:

Salaries and wages 200, 000.00

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Rent and rates 60, 000.00

Other fixed costs 300, 000.00

Requirements

a) Calculate both in number of units sold and sales value, the:i. Breakeven pointii. Margin of safety

Note: required parts (b) to (d) are considered individually and are not related to each other.

b) Calculate the shops profit or loss if 26000 pairs of shoes were sold during the year.

c) Calculate how many pairs of shoes would need to be sold if a sales commission of K2 per pair of shoes was paid in addition to other costs and the required a net profit of K240, 100.00

d) Calculate how many pairs of shoes would need to be sold to breakeven if an advertising campaign costing K20, 000.00 was undertaken while at the same time selling prices were increased by 15%.

e) Explain what is meant by each of the following terms and give one example of each:

i. Fixed costii. Variable cost

CHAPTER SEVEN

ACCONTING FOR DECISION MAKING

It implies that there is a choice to be made between different possible options i.e.

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a) The selection of the optimal budget from the many different choices about product mix, sales mix, output volume and sales prices.

b) The selection of the best mutually exclusive options i.e. should option A or b or C be chosen.

c) A decision as to whether a particular activity should be carried out or not.

NOTE: accounting for decision making in budgeting makes most the use of marginal costing principles.

Types of decisions

i. A chosing the best budget when there is a limiting factor restricting production.

ii. The make or buy decision in budgetingiii. Decision about whether to accept or reject and orderiv. Shut down decisionsv. Joint product further processing decisionsvi. Pricing decisionsvii. Extra shift decisionsDecision making terminologies

Relevant cost: is a future cash flow arising as a direct consequence of the decision made or under review.

Avoidable costs: is a specific cost of an activity or sector of a business that would be avoided if the activity or sector did not exist.

Differential cost: is the difference in cost of alternative choices.

Incremental cost: is the difference in cost between making the unit and not making it.

Opportunity cost: is the benefit forgone by selecting one alternative in preference to the most profitable (best) alternative.

Sunk or past or committed costs: are past costs which are not directly relevant in decision making.

These are past expenditures which have either:

i. Been charged already as a cost of sale in the previous accounting period. Or

ii. Will be charged in future accounting period, though has already been committed.

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Notional costs: is a cost that does not involve the outflow of cash whether now or in future e.g. absorbed overheads, notional rent, notional interest. OR

Imputed or Notional costs: is a hypothetical accounting cost to reflect the use of a benefit for which no actual cash expense is incurred. This is aimed at dovetailing accounting to economic reality.

General fixed overheads: are those fixed overheads which would be unaffected by decisions to increase or decrease the scale of operations for example an apportioned share of head office charges.

NOTE: The golden rule underlying decision making is that “BYGONES ARE BYGONES” i.e. what has happened in the past is done and cannot be undone hence it’s irrelevant in your current decision.

Examples of relevant costs

i. Future cash flowsii. Opportunity costsiii. Incremental costsiv. Differential costsv. Incremental fixed costsvi. Overheads incurredvii. Directly attributable fixed costsviii. Avoidable costsExamples of irrelevant costs

i. Past costs, or money already spent i.e. committed costsii. Future spending already committed by separate previous decisionsiii. Costs which are not of cash nature e.g. depreciation, notional rent,

notional interest, overhead absorbed.iv. Fixed overheadsv. General fixed overheads or other fixed costs

Limiting budget factors

What is a limiting factor?

Is a factor which at any time or over a period of time may limit the activity of an entity, often one where there is a shortage or difficulty of supply.

A limiting factor is also called a key budget factor or a principal budget factor or a scarce resource.

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Limiting factor decision making

Examples of limiting factors

i. Sales I.e. there is a limit to sales demandii. Labour : i.e. there is insufficient labour to produce enough to satisfy sales

demandiii. Materials: i.e. there is insufficient materials available to produce enough

units to satisfy sales demandiv. Manufacturing capacity i.e. there is not sufficient machine capacity to

produce enoughv. Financial resources i.e. there is not enough cash to pay for enough

productionNOTE: if sales demand is a factor restricting greater production profit will be maximized by making exactly the amount required for sales.

Other factors which are not scarce resources but restricts production

i. A contract to supply a certain number of products to a customer which cannot be cancelled.

ii. Production or sales of a minimum quantity of one or more products to provide a complete range and or to maintain customer goodwill.

iii. Maintenance of a certain market share of one or more products.NOTE: If an organization has to produce more of a particular product or products than the level established by ranking according to contribution per unit of limiting factor, the products should be ranked in the normal way but the optimum production plan must first take into account the minimum production requirements. The remaining resources then be allocated according to the ranking.

Marginal costing principles in limiting factor situations

It is assumed that profit will be maximized when contribution is maximized:

i. Contribution will be maximized by earning the biggest possible contribution per unit of a scarce resource.

ii. The limiting factor decision involves the determination of the contribution earned by each product per limiting factor or scarce resource.

iii. In limiting factor decisions we assume that fixed costs are the same whatever production mix is selected and so only variable costs are relevant.

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Limiting factor decision making examplesDesperate Dan ltd makes two products, the biff and the snoot. The information relating to the two products are as follows:

Biff Snoot

Unit variable costs are: K K

Direct materials 1 3

Direct labour (K3 per hour) 6 3

Variable overhead 1 1

TOTAL 8 7

The sales price per unit is K14 per biff and K11 per snoot. During July 2013 the available direct labour is limited to 8000 hours. Sales demand in July is expected to be; biff 3000 units and snoot 5000 units.

Requirements

a) What production budget will maximize profits assuming fixed costs are K20, 000.00 per month and there are no opening stocks.

b) Calculate the increase in profits that will arise, if a further 400 hours becomes available.

c) State ways in which the shortfall in labour can be overcomed in the short term.

Providential sparrow ltd makes four products P, Q, R and S from the same materials. The sales prices and variable costs per unit are as follows:

P Q R S

K K K K

Material A 6 4 3 8

Material B 4 8 10 2

Direct labour 5 10 10 8

Variable overhead 2 2 3 2

Sales prices 25 23 31 32

Sales demand (units) 4000 5000 8000 6000

Most production resources are in sufficient supply, but there will only be 6500kgs of material A available in the period. Material A costs K12 per kg.

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Requirements

a) Calculate the production quantities of each product which will maximize profits in the period.

b) What other factors should management consider before finalizing the budget

Harvey ltd is currently preparing its budget for the year ending 30 September 2012. The company manufactures and sells three products; beta, delta, and gamma.

The unit selling price and cost structure of each product is budgeted as follows:

Beta Delta Gamma

K K K

Selling price 100 124 32

Variable costs:

Labour 24 48 6

Materials 26 7 8

Overhead 10 5 6

Total 60 60 20

The labour rate is budgeted at K6 per hour, and fixed costs at K1, 300, 000.00 per annum. The company has a maximum production capacity of 228000 labour hours.

A meeting of the board of directors has been convened to discuss the budget and to resolve the problem as to the quantity of each product which should be made and sold. The sales director presented the results of a recent market survey which revealed that market demand for the company’s products will be as follows:

Products units

Beta 24000

Delta 12000

Gamma 60000

The production director proposes that since the gamma only contributes K12 per unit, the product should no longer be produced, and the surplus capacity

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transferred to produce additional quantities of beta and delta. The sales director does not agree with the proposal. Gamma is considered to complement the product range and to maintain customer goodwill. If gamma is not offered, the sales director believes that sales of beta and delta will be seriously affected. After further discussion the board decided that a minimum of 10000 units of each product be produced. The remaining production capacity would then be allocated so as to achieve the maximum profit possible.

Requirements

a) Prepare a budget statement which clearly shows the maximum profit which could be achieved in the year ending 30 September 2012.

b) Mention any three factors that limit production other than a scarce resource.

Recognizing a limiting factor situation

Always there will be a hint with the wording of the question e.g.

a) It is possible that the main raw materials used in manufacturing the products will be difficult to obtain next year.

b) The company employs a fixed number of employees who work a minimum overtime of say 8 hours. The company has also agreed that no more staff will be recruited next year.

How to deal with limiting factor questions

a) Calculate the amount of the scarce resource needed to meet potential demand.

b) Calculate the amount of the scarce resource available.c) Compare the two figures and see if there is a shortfall or surplus of

the limited resource.d) If there is a shortfall then that resource is a limiting factor.

Make or buy decisions

A product is either manufactured in house or bought in if there will be savings in costs.

Examples

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Buster ltd makes four components W, X, Y and Z for which the costs in the forthcoming period are expected to be:

W X Y Z

Production units 1000 2000 4000 3000

Unit marginal costs: K K K K

Direct material costs 4 5 2 4

Direct labour cost 8 9 4 6

Variable overheads 2 3 1 2

Total 14 17 7 12

Total fixed cost per annum: K

Incurred as a direct consequence of making W 1, 000.00

Incurred as a direct consequence of making X 5, 000.00

Incurred as a direct consequence of making Y 6, 000.00

Incurred as a direct consequence of making Z 8, 000.00

Other committed fixed costs 30, 000.00

Total 50, 000.00

A subcontractor has offered to supply units of W, X, Y and Z for K12, K21, K10 and K14 respectively.

Requirements

a) Should buster limited make-In or buy-in the componentsb) What other factors should buster consider?

SolutionThe relevant costs are the differential costs between making and buying. They consist of differences in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some savings on fixed cost.

W X Y ZK K K K

Variable cost for buying 12 21 10 14Variable cost of making 14 17 7 12 Extra cost of buying (2) 4 3 2Annual requirement (units) x 1000 x 2000 x 4000

x 300084

Extra cost of buying (2000) 8000 12000 6000Fixed cost savings (1000) (5000) (6000) (8000)Extra total cost of buying (3000) 3000 6000 (2000)

The company would save K3000 (K2000 in variable costs and K1000 in fixed costs) per annum by subcontracting component W and would save K2000 in fixed costs per annum by subcontracting Z.

Therefore buster should: Buy- in W and ZMake - in X and Y

Further consideration would be as follows:a) If components W and Z are subcontracted, the company will have spare

capacity. How should that spare capacity be profitably used? Are there hidden benefits to be obtained from subcontracting? Would the company workforce resent the loss to an outside subcontractor, and might such decision cause an industrial dispute?

b) Would the subcontractor be reliable with delivery times and would he supply components of the same quality as those manufactured internally?

c) Does the company wish to be flexible and maintain better control over operations by making itself?

d) Are the estimates of fixed cost savings reliable? In the case of product W, buying is clearly cheaper than making in-house. In case of product Z, the decision to buy rather than make would only be financially beneficial if the fixed cost saving of K8000 could really be delivered by management.

Note: the make option would give management more direct control over the work, but the buy option often has the benefit that the external organisation has a specialist skill and expertise in the work. Make or buy decisions should certainly not be based exclusively on cost consideration.

Make or buy decisions and limiting factors

Green limited manufactures three components A, B and C using the same machines for each. The budget for the next year calls for the production and assembly of 4000 of each component. The following information is available.

The variable production cost per unit of the final product the gamma is as follows:

Machine hours variable cost (K)

1 unit of A 3 20

85

1 unit of B 2 36

1 unit of C 4 24

Assembly 20

TOTAL 100

Only 24000 hours of machine time will be available during the year and a subcontractor has quoted the following unit prices for supplying components: A at K29, B at K40 and C at K34.

Requirements: Advise green limited

Accepting or rejecting orders

An order is accepted if it increases contribution and profits and rejected if it reduces profits.

Example with opportunity cost

Belt and Braces limited makes a single product which sells for K20, and for which there is great demand. It has a variable cost of K12, made up as follows:

K

Direct materials 4

Direct labour (2 hours per unit) 6

Variable overheads 2

The labour force is currently working at full capacity and no extra time can be made available. A customer has approached the company with a request for the manufacture of a special order for which he is willing to pay K5, 500.00

The costs of the order will be K2, 000.00 for direct materials and 500 labour hours will be required.

Requirements

Should the order be accepted?

Solution

Relevant cost statement K K

Revenue 5 500Relevant costs:

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Direct materials 2 000Direct labour (500 x K3) 1 500Variable overhead (500 x K1) 500**Opportunity cost (500 x K4)2 000 6000

Loss (500)

The order should not be accepted.

Working for opportunity cost:Since the labour force is working at full capacity to undertake this order there will be a benefit lost (opportunity cost) by not producing their product which is currently on high demand.Opportunity cost per hour = the contribution per hour.Opportunity cost = (sales per unit – variable cost per unit) ÷ labour hours per unit

= (K20 – K12) ÷ 2 hours per unit= K4 per hour

**Therefore total opportunity cost = 500 hours x K4 per hour

Other factors may influence special-order pricing decisions. These may be,

a) Effect on regular customers: If regular customers are paying more, they may demand price deductions or stop buying from the company.

b) Special order customers turning regular customers: Another problem is that special order customers may decide to become regular customers, and changes in the price may become necessary.

Example without opportunity cost

Big banshee ltd produces a range of products and absorbs production overheads into cots at the rate of 300% of direct labour costs. This rate was calculated from the following budgeted cost.

K

Variable production overheads 144, 000.00

Fixed production overheads 216, 000.00

TOTAL 360, 000.00

Direct labour costs is K120, 000.00

One of the company products the Totem, has a normal selling price of K35 and a unit production cost of:

K

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Direct materials 12

Direct labour 4

Total production overheads 12

Factory costs 28

A customer has offered to buy 3000 units of Totem at a price of K22 each. If the order is accepted normal sales would be un affected and the company has the existing capacity to make extra units.

Requirements

Should the order be accepted?

Shut down decisions

Examples

Noddy ltd produces four products A, B, C and D. the budget for the forthcoming year shows the following results.

A B C D TOTAL

K’000 K’000 K’000 K’000 K’000

Sales 700 400 250 340 1690

Materials 210 60 30 40 340

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Labour 100 200 200 200 700

Variable overhead 90 60 50 50 250

Fixed overhead 20 40 40 40 140

Profit or (loss) 280 40 (40) 10 260

Sales units 140 20 25 20

The directors are worried about C and the loss that it appears to make. The following suggestions have been put forward to improve the situation:

i. To cease production and sales of Cii. To increase the selling price of C by 20%, this would decrease the sales

volume by 10%iii. To decrease the selling price of C by 10%, this would increase the sales

volume by 10%iv. To reduce the labour cost of C by K100, 000.00. By purchasing a new

machine which would cost K350, 000.00 and have a life span of five years and no residual value. The selling price and other variable costs per unit would remain the same.

Requirements

a) Evaluate each or the four proposals individually, by calculating the effect on the budgeted profit of implementing the suggestions.

b) Suggested the best course of action for the company to follow.

Sunshine ltd makes five products V, W, X, Y and Z. the initial profit forecast for the year beginning July 2006 is as follows:

V W X Y Z TOTAL

K’000 K’000 K’000 K’000K’000 K’000

Sales 200 300 200 400 350 1,450

Materials 50 90 80 80 80 380

Labour 70 70 60 100 100 400

Variable o/h50 30 40 100 80 300

Fixed o/h 40 40 80 80 60 300

Profit/(loss) (10) 70 (60) 40 30 7089

The fixed overheads are general fixed overheads and apportioned to the products on arbitrary basis. Because of the disappointing forecasts for products V and X the following proposals have been made:

i. That both products be abandoned as they result in a lossii. That all products be upgraded by using a superior material which would

result in the sales volumes increased by 100%. Materials costs will increase by 50% and the unit labour and variable overhead costs of the upgrade would be negligible. The fixed overhead costs would be unaffected by the upgrade.

Requirements

a) Evaluate with supporting figures, the two proposals outlined above and make recommendations as to which if either should be followed:

b) The figures in the original budget for V and X represent 10000 and 8000 units respectively. A large customer has offered to take the whole of the periods output of either V or X subject to a further manufacturing process.

The process would increase all unit costs for the product by 20% and would result in a loss of 10% of units processed. The fixed overhead would be un affected.

The selling prices of the processed units would be:

V at K25 per unit

X at K29 per unit.

Requirements

Advise management of sunshine ltd as to whether they should accept the customers offer and if so which product. Give reasons for your answer.

Extra shift decisions

This decision should be taken on the basis of whether the costs of the shift arte exceeded by the benefits to be obtained.

Example

Secker and shift ltd currently operates a single production shift which incurs the costs and earns the revenues stated below per annum.

K K

Sales (10000 units) 360000

Direct materials 120000

90

Direct labour 100000

Variable overhead 20000 (240000)

Contribution 120000

Fixed overhead (90000)

Profits 30000

Sales demand exists for an extra 6000 units at the existing sales price which could be made in a second shift.

The labour costs in the second shift be the same as in the first shift plus a second shift premium. The second shift is paid at a time-and-a-quarter. Additional fixed overheads of K10, 000.00 would be incurred, but a bulk purchase discount of 5% would be obtained on all quantities of material bought.

Requirements

Should the second shift be opened up?

Relevant cost decision making

A relevant cost is a future cash flow arising as a direct consequence of a decision made or under review.

Relevant costs for material

Are materials already in stock?

NOPurchase price is relevant

YES

Will they be replaced? Or further processed to make them usable? YES

Replacement or further process cost is relevant

NO

Will they be used for an alternative use? Or be scrapped?

NONet realizable value is a relevant cost

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YES

Contribution from alternative use or opportunity cost of alternative use is a relevant cost

Relevant costs of labour

Does spare capacity of labour exist? YES

Relevant cost is nil unless more labour force is hired with cash outlay

NO

Will more labour be hired? NO

Lost contribution from the abandoned work to create capacity is relevant

NO YESCost of hiring is relevant

Will staff be shifted from another job? YES

Extra cost paid as a result of the shift or normal pay rate is a relevant cost

NOWill substitute staff be recruited for existing staff?

YES Future labour rate is a relevant cost.(future labour cost)

Relevant cost for variable production overheads

All variable overheads are relevant except where they are absorbed on a basis that is itself irrelevant.

All absorbed overheads are irrelevant.

Relevant costs for fixed production costs

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General, departmental, and absorbed or charged overheads are irrelevant.

Only incremental fixed overheads and directly attributable fixed overheads are relevant.

NOTE: Remember to choose the lower of the relevant costs ascertained.

Examples on relevant cost decision making

ExampleA company has been making a machine to order for a customer, but the customer has gone into liquidation and there is no prospect that any money will be obtained from the winding up of the company. Cost incurred to date in manufacturing the machine were K50 000 of progress payment of K15 000 has been received from the customer prior to liquidation. Sales department has found another customer willing to pay K34 000 once completed. To complete the work the following costs would be incurred;a) Materials – those have been bought at a cost of K6 000. They have no other

use and if the machine is not finished would be sold for scrap K2 000.b) Further labour cost would be K8 000. Labour is in short of supply and if the

machine is not finished the workforce would be switched to another job which would earn K30 000 in revenue and incur direct cost of K12 000 and absorb (fixed) overhead of K8 000.

c) Consultancy fees is K4 000, if work is not completed the consultants contract would be cancelled at a cost of K1 500.

d) General overhead of K8 000 would be added to the cost of additional work.

Requirements Should the new customers offer be accepted.

Solution

Analysis of relevant and irrelevant cost for their inclusion and exclusion

Cost incurred to date of K 50, 000 is a past or sunk cost hence irrelevant Progress payment of K15, 000 received is a past or sunk cost hence

irrelevant Revenue of K34, 000 from completed work is a future cash inflow hence

relevantMaterials:

Material cost of K6000 is a sunk or past cost hence irrelevant Material scrap cost of K 2000 is a future cost hence relevant

Labour: Future labour cost of K8000 is a future cost hence relevant

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Since labour is in short supply. The revenue to be generated from switching to another job (30, 000 – 12, 000) is an opportunity cost hence relevant

Fixed overheads: Fixed absorbed overheads of K8 000 is a notional cost hence irrelevant

Other costs: Consultancy fees of (4 000 – 1 500) is an incremental cost hence relevant General overheads of K8 000 is irrelevant for decision making

Relevant cost statement K KRevenue from completed work 34 000Relevant costs:Materials: opportunity cost 2 000Labour: Basic pay 8 000

Opportunity cost (30000-12000) 18 000Incremental cost of consultancy (4000-1500) 2 500 30 500Extra profit 3 500

Therefore the customers offer should be accepted as it gives an extra profit of K3500

Roger ltd has been asked to quote for a one-off-order. The costs for the order have been calculated as follows:

K

Material A 4000kgs 8000

Material B 3000kgs 11000

Direct labour:

Department X 40 hours for 4 weeks at K5 800

Department Z 40 hours for 4 weeks at K8 1280

Supervision 1040

Variable overhead K4.50 per hour 1440

Machine depreciation K300 per department 600

Allocated fixed overhead 950

Total cost 25110

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You have ascertained that:

i. Material A is in stock at a cost of K8000. There is no use for this material other than this order. It would cost K4000 to dispose of this material.

ii. There are 2000kgs of B in stock, which cost k3 per kg. B is in continuous use in the company and the replacement cost is K5 per kg.

iii. Department X has a normal working week of 40 hours, and is currently working at 40% capacity. However, the workforce has a guaranteed wage based on 40 hours.

iv. Department Z is currently working at full capacity. To undertake this order the labour would be taken from another job. Which currently earns a contribution of K12 per hour.

v. Supervision has been charged at 50% of direct labour.vi. Machine depreciation has been charged in both departments on a straight

line basis.vii. Fixed overhead has been allocated at 5% of direct material cost.The Managing Director informs you that the customer will pay up to k24000.00 for the order, and feels that Roger Ltd should not tender as this would make a loss for the company.

Requirements

a) Calculate the minimum tender price that Roger Ltd should submit.b) State what you understand by the following

i. Variable Cost ii. Relevant Cost iii. Opportunity Cost iv. Avoidable Cost

Solution

Analysis of relevant and irrelevant costs

Materials

CHAPTER EIGHT

ACTIVITY BASED COSTING (ABC)

ABC is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final output.

Ideas behind activity based costing

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Activities cause costs and activities includes: ordering, material handling, machining, assembly, production scheduling and dispatching.

Producing products creates demand for activities Costs are assigned to a product on the basis of the products consumption

or use of the activities.How does an ABC system work?

Steps or procedures in an ABC system

i. Identifying major activities of an organisationii. Ensure that costs are collected by activity rather than cost centresiii. Identify the cost driversiv. Establish the volume of each cost driverv. Calculate the cost driver rates by dividing the activities cost by the

volume of its cost driver.vi. Establish the volume of each cost driver required by each product.vii. Calculate the overheads attributable to each product by multiplying the

cost driver rate by the cost driver volume for each product.Major steps in an ABC system

Step 1: Identify an Organizations major activities

Step 2: identify the factors which determine the size of the costs of an activity (cause costs of an activity) i.e cost drivers.

What is a cost driver?

Is a factor influencing the level of cost e.g. number of purchase orders, number of set-up e.t.c

Examples of costs and their cost drivers

Cost cost driver

Ordering costs number of orders

Material handling costs material usage or requisition

Production scheduling cost number of production runs

Dispatching costs number of dispatches

Machinery costs machine hours

Short run variable costs labour or machine hours

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Note: For those costs that vary with production levels in the short run or term, ABC uses volume related cost drivers such as labour or machine hours e.g. short run variable costs e.t.c

Step 3: Collect the cost associated with each cost driver into what are known as cost pools or cost centres.

What is a cost pool?

Is a grouping of costs relating to a particular activity in an ABC system.

Step 4: charge the cost of each cost pool to products on their basis of the activity using cost driver rates.

Cost driver rate =total cost in cost pool / number of cost drivers

Activity Based Costing (ABC) Vs Traditional or Conventional or Absorption costing

Examples

Cooplan manufactures four products W, X, Y and Z. Output and cost data for the period just ended are as follows:

Products output No of Material Direct labour Machine hours

Units Production cost/unit cost/unit per unit

Runs (K)

W 10 2 20 1 1X 10 2 80 3 3Y 100 5 20 1 1Z 100 5 80 3 3Direct labour cost per hour is K5 K

Overheads cost: Short run variable cost 3080Set up costs 10920Expediting and scheduling costs 9100Material handling costs 7700

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Total overheads 30800

Requirements

Prepare unit costs for each product using conventional costing method and ABC.Solution

Conventional costing method

W X Y Z

K K K K

Direct material 200 800 2000 8000Direct labour 50 150 500 1500Prime cost 250 950 2500 9500

Overheads (W) 700 2100 7000 21000Total costs 950 3050 9500

30500

Cost per unit 95 305 95 305Workings

Machine hours: W (1 x 10) 10X (3 x 10) 30Y (1 x 100) 100Z (3 x 100) 300

Total hours machine hours 440 Overhead absorption rate = total overhead costs ÷ total machine hours

= K30800 ÷ 440 machine hours=K70 per hour

Activity Based Costing (ABC) method

W X Y Z

K K K K

Direct material 200 800 2000 800098

Direct labour 50 150 500 1500Prime cost 250 950 2500 9500

Overheads (W):Short run variable costs 70 210 700 2100Set-up costs 1560 1560 39003900Expediting costs 1300 1300 3250 3250Material handling costs 1100 1100 2750 2750

Total costs 4280 5120 13100 21500

Cost per unit 428 512 131 215Workings (W)

Calculation of cost driver rate:Short run variable costs = 3080 ÷ 440 hours = K7 per hourSet up costs = 10920 ÷ 14 production runs = K780 per runExpediting and scheduling cost = 9100 ÷ 14 production runs = K650 per runMaterial handling costs = 7700 ÷ 14 production runs = K550 per runExample 2

Having passed costing and budgetary control subject, you have been assigned to experiment by applying the principles of ABC and absorption costing to the four products currently made and sold by your company. Details of the four products and relevant information are given below for one period.

Product A B C DOutput in units 120 100 80 120Costs per unit K K K KDirect materials 40 50 30 60Direct labour 28 21 14 21Machine hours (per unit) 4 3 2 3

The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 units.

99

The production overhead is currently absorbed by using a machine hour rate, and the total of the production overhead for the period has been analysed as follows.

KMachine department costs (rent, business rates, e.t.c) 10,430Set-up costs 5,250Stores receiving 3,600Inspection/quantity control 2,100Materials handling and dispatch 4,620 Total 26,000You have ascertained that the 'cost drivers' to be used are as listed below for the overhead costs shown.

Cost Cost driverSet-up costs Number of production runsStores receiving Requisitions raisedInspection/quality control Number of production runsMaterials handling and dispatch Orders executed

The number of requisitions raised on the stores was 20 for each product and the number of orders executed was 42, each order being for a batch of 10 of a product.

RequiredCalculate the total costs and unit cost for each product using conventional costing method and activity based costing.

SolutionConventional costing method

A B C D K K K K

Direct material 4,800 5,000 2,400 7,200Direct labour 3,360 2,100 1,120 2,520Prime cost 8,160 7,100 3,520

9,720Production overhead (W): 9,600 6,000 3,200 7,200Total costs 17,760 13,100 6,720

16,920

Cost per unit 148 131 84 141 Workings (w)Machine hours = A (4 x 120) = 480

B (3 x 100) = 300C (2 x 80) = 160D (3 x 120) = 360

Total machine hours 1300

Overhead Absorption Rate (OAR) = total overheads ÷ machine hours

100

= K26000 ÷ 1300 = K20 per machine hour

Activity based costing method A B C D

K K K KDirect material 4,800 5,000 2,400 7,200Direct labour 3,360 2,100 1,120 2,520Prime cost 8,160 7,100 3,520

9,720Production overhead (W):Machine department costs 3,851 2,407 1,284 2,888 Set-up costs 1,500 1,250 1,000 1,500 Stores receiving 900 900 900 900 Inspection/quality control 600 500 400 600 Material handling and dispatch 1,320 1,100 880

1,320 Total cost 16,331 13,257 7,984 16,928

Cost per unit 136.09 132.57 99.80 141.07

WorkingOverhead costs will be divided in the following ratios, depending upon the number of production runs, requisitions or orders per product.

A B C D TotalProduction runs 6 5 4 6 21Requisitions raised 20 20 20 20 80Orders executed 12 10 8 12 42

Cost driver rates:Machine department costs will be absorbed on a machine hour basis: Overhead Absorption Rate (OAR) = total overheads ÷ machine hours

= K10430 ÷ 1300 = K8.023 per machine hourSet- up costs = K5250 ÷ 21 runs = k250 per run

Stores receiving = K3600 ÷ 80 = 45 per requisition

Inspection and quality control = 2100 ÷ 21 runs = 100 per run

Material handling costs = 4620 ÷ 42 =110 per order

Activity based costing and allocation of overheads

ABC establishes separate cost pools for support activities such as dispatching

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As costs of these activities are assigned directly to products through cost driver rates, reapportionments of service costs is avoided.

Differences between absorption costing and ABC

Absorption costing most commonly uses labour hours and or machine hours to charge overheads to products whilst ABC uses multiple cost drivers as absorption bases .e.g. number of orders, number of dispatches, e.t.c

In an ABC system reapportionment of service costs is avoided whilst in absorption costing system there is reapportionment of service costs.

In absorption costing there is under or over absorption of overheads whilst in an ABC there is no under or over absorption

Features of an organisation that can use ABC

The product range is wide and diverse The amount of overheads resources used by the products varies Volume is not the only primary driver of overheads consumption Production overheads are a high proportion of total production costs

Why an ABC system is most suitable in a modern business environment

It may encourage reductions in throughput (processing) time and inventory and quality improvements

It traces overheads to product lines in more logical and less arbitrary manner through use of multiple cost drivers.

It helps to measure and improve efficiency and effectiveness of support departments

Advantages of Activity Based Costing

It recognizes the complexity of production process hence uses multiple cost drivers to allocate overheads costs

ABC takes cost accounting beyond its traditional factory flow boundaries ABC gives valuable insights into product design, product mix, processing

methods, administration and pricing ABC gives a meaningful analysis of costs which should provide basis for

product performance measurement in a modern competitive environment It is effective in identifying customers who are unprofitable to services

and products which are unprofitable to produceDisadvantages or criticisms of Activity Based Costing

It should not be introduced unless it can provide additional information for management to use in planning and control decisions.

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It does not solve the problems of allocating general manufacturing overheads where decisions and processes which cause these overheads are unknown

Some measures of cost apportionment may still be required at the cost pooling stage for such items like rent, rates e.t.c

It is costly and complex to set up Ability of a single cost driver to fully explain the cost behavior of all items

in its associated pool is questionable

Exam style questions:A company manufactures several products, two of which are Epson and Gamma. The following data relates to these two products and the overall production totals:

Epson Gamma Total

Units produced 40, 000 2, 000Material cost per unit K 1.25 K1.50Direct labour minutes per unit 30 minutes 20 minutesMachine time per unit 1 hour 1 hourNumber of set ups per annum 30 4

500Number of purchase orders for materials 36 6 2, 800Number of times materials handled 250 20 1, 200Direct labour costs per hour K 6.00 K6.00

Overhead costs allocated to cost pools:K

Set up 180, 000Purchasing 105, 000Material handling 180, 000Machining 600, 000

1, 065, 000

Total machine hours 400, 000RequiredCalculate, to two decimal places, a unit cost for each of Epson and Gamma using activity based costing. (20 marks)SolutionActivity based costing (ABC)

Epson GammaK K

Material costs (40000 x 1.25) 50000 (2000 x 1.50)3000

Labour costs (30/60 x 40000 x K6.00) 120000 (20/60 x 2000 x K6)4000

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Prime cost 170000 7000Overheads (W):

Set up costs (30 x 360) 10800 (4 x 360)1440Purchasing (36 x 37.5) 1350 (6 x 37.5) 225Material handling (250 x 150) 37500 (20 x 150)3000Machining (40,000 x 1.50) 60000 (2000 x 1.5)3000

Total costs 279650 14665

Cost per unit (171650 ÷ 40000 units) 7.00 (14665 ÷ 2000 units)7.33

Workings for cost driver rates (W):Set-up costs = K180, 000 ÷500 set ups = k360 per set upPurchasing = k105, 000 ÷2800 = K37.5 per purchase orderMaterial handling = K180, 000 ÷ 1200 times of handling = K150 per time of handle Machining = K600, 000 ÷ 400, 000 machine hours = K1.50 per machine hour

Workings for machine hours:Epson = 40, 000 x 1 hour per unit = 40, 000 hoursGamma = 2000 x 1 hour per unit = 2, 000 hours

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CHAPTER NINE

BADGETARY PLANNING AND CONTROL SYSTEMS

Definition of budgetary control

Is the methodical control of organisation operations through establishment of standards and targets of income and expenditures, accompanied by continuous monitoring and adjustment of performance against them.

Definition of a budget

Is a quantified plan of action or expenditure for the forthcoming accounting period.

Objectives of budgeting

To ensure the achievement of the organisations objectives To compel planning To communicate ideas and plans To coordinate activities To provide a framework for responsibility accounting To establish a system of control To motivate employees to improve their performance

CIMA terminologies

Budget period

Is the period for which a budget is prepared and used which may then be subdivided into control periods

Budget manual

Is the collection of instructions governing the responsibilities of persons and the procedures, forms and records relating to the preparation and use of budget data.

Contents of a budget manual105

Explanations of the objectives of the budgeting process Organizational structures Outline of the principle budget Procedural matters

Budget committee

Is a coordinating body in the preparation and administration of a budget.

Functions of a budget committee

Coordination of budget preparation including the use of the budget manual

Issuing of time tables for the preparation of functional budget Allocation of time tables for the preparation of functional budget Provision of information to assist in the preparation of budgets Communication of final budget to appropriate mangers Comparison of actual results with the budgets and the investigation of

variance Continuous assessment of the budgeting and planning process

Benefits or advantages of using budgetary control systems

It provides clear guidelines for mangers and supervision and is the way in which the company objectives are translated into specific tasks and objectives related to individual managers

Enables communication to individual, the objects, strategies and plans of the business and indicates the role of the individual in their achievement.

Coordination of various activities of the business Participation of staff and management encourages goal congruence

and increased motivation. Better control of current activities Management time can be directed to areas of most concern through

use of management by exception.Departmental or functional budgets

Are budgets of income and or expenditure applicable to a particular function.

Example

Giles ltd is preparing its budget for the year ending 30 June 2008, using a four-monthly accounting period to take account of seasonal nature of its sales. The company manufactures and sells one product at a standard selling price of K50 per unit. The forecast sales for the year are: July to October 7000 units

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November to February 5000 unitsMarch to June 6000 unitsIt is a company policy to carry a finished stock of 10% of the next four month period’s sales.

Sales for July to October 2008 are expected to be 8000 units. The standard cost of one unit of finished product is:

Component X 3 at K5 eachDepartment G 2 hours at K4 per hourDepartment H 4 hours at k5 per hourNo stocks of components are heldRequirements

Prepare the following budgets for each of the four month periods for the year ending 30 June 2008.

a) Sales budgetb) Production budgetc) Material usage budget in kwachas and number of componentsd) Labour usage (utilisation) budget for each of the departments G and H

in hours and kwachasFixed and flexible budgets

Fixed budget

Is a budget set prior to the control period and not frequently change in response to changes in activity or cost or revenues.

Uses of fixed budgets

It saves as a benchmark for performance evaluationFlexible budgets

Is a budget which by recognizing different cost behavior patterns is designed to change as volume of activity change.

Uses of flexible budgets

Used at the planning stage

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Used to compare actual results received with what should have been hence aid in control purposes

Examples

Grace limited manufactures kitchen appliances but uses fixed cost approach to budget reporting. The following report was prepared for the month ended 30 November 2014.

Budget Actualvariance

Sales and production units 10, 000 11, 000 1, 000K’ 000 K’ 000

K’ 000Sales revenue 2, 000 2, 156

156 (A)

Less expenses:Direct material 500 572 72(A)Direct labour 300 352 52(A)Other manufacturing costs 600 606 6(A)Company fixed overheads 400 380 20(F)Total expenses 1800 1910 110(A)

Profits 200 24646(F)

Note: (F)= favourable variance and (A)= adverse variance

The new Finance Director has decided to institute a flexed budgeting system and has established the following:

a) Budgeted selling price is K200 per unit. Actual selling price in November was K196

b) Direct material is a variable cost.c) Budgeted direct labour cost has a fixed cost of K100 000 per month. The

balance is variable.d) Other manufacturing costs are semi-variable. budgeted output and cost

for September and October 2014 were:September October

Output (units) 8000 6000Costs (K’000) 420 340

e) The fixed cost element of other manufacturing costs increases by K70, 000 for volume in excess of 9000 units

Requirements

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Prepare the flexed budget for Grace Limited for November 2014 and calculate the budget variances.

Hardy limited prepared the following budgeted figures for the first two periods of its financial year.

Period 1 Period 2

Production units 20, 000 22, 000Sales units 20, 000 21, 000Costs: K KDirect materials 60, 000 66, 000Direct labour 100, 000 110, 000Production overheads 160, 000 166, 000Depreciation 50, 000 50, 000Sales overheads 110, 000 113, 000Distribution overheads 70, 000 72, 000Overheads comprise of fixed costs and proportionately variable costs. The variable elements of sales overheads and distribution overheads vary with sales units, all other variable costs vary with production units.For period 2 the actual figures were:Production units 21, 900Sales units 20, 500Costs: KDirect materials 68, 000Direct labour 103, 000Production overheads 170, 000Depreciation 50, 000

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Sales overheads 115, 000Distribution 70,000Requirements

a) Prepare a revised budget for period 2 based on the actual activity for the period.

b) Calculate the cost variances for period 2 arising from the revised budget in (a) above.

c) If finished stock is valued on standard variable production cost basis in the company’s management accounts, calculate the increase in the value of finished stock that would have arisen in the value of finished stock that would have arisen as a result of the actual production and sales in period 2.

Mushroom Limited manufactures a single product and has produced the following flexed budget for the year.

Levels of activity

70% 80% 90%Costs: K K K

Direct materials 17780 2032022860

Direct labour 44800 5120057600

Production overheads 30500 3200033500

Administration 17000 1700017000

Total costs 110000 120000130960

Requirements

Prepare a budget flexed at 45% level of activity

APM Limited has prepared the following profit forecast for the year to 31 December 2009:Level of activity 70% 80% 100%

K`000 K`000K`000

110

Sales revenue 1,050 1,200 1,350

Less: expensesDirect material 350 400 450Direct labour 70 80 90Production overhead 170 190 210Administrative overhead 75 80 85Selling and distribution overhead 90 100 110Total costs 755 850

945

Profit 295 350 405Trading conditions turned out to be very bad, and the company only managed to sell 6500 units (equivalent to an activity level of 65%). The actual results were as follows:

K`000Sales revenue 910

Less: expensesDirect material 390Direct labour 60Production overhead 200Administrative overhead 80Selling and distribution overhead 75Total costs 805

Profit 105Additional information:

1. The budgeted selling price was K150 per unit.2. All production is sold.3. The fixed element of the budgeted costs is likely to remain unchanged at all levels of production.

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Required:

Prepare a flexible budget for APM Limited for the year to 31 December 2007 at the actual level of activity.

Solution

Flexed ActualVariance

Budget at

65% level

K`000 K`000K`000

Sales revenue (1) 975 910 (65)

Less: expensesDirect material (2) 325 390

(65)Direct labour (3) 65 60 5Production overhead (4) 160 200

(40)Administrative overhead (5) 73 80 (7)Selling and distribution overhead (6) 85 75 10

708 805 97

Profit 267 105 (162)Flexible budget workings at 65% level of activity

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1. No fixed element. The sales revenue moves in steps of K150,000 for each 10% increase in activity (K1050/70 x 65).

2. No fixed costs: the direct material costs rise in bands of K50 000 for each 10% increase in activity (K350/70 x 65).

3. No fixed costs: the direct labour cost rises in bands of K10 000 for each increase in activity (K70/70 x 65).

4. A rise of K20 000 for each 10% increase in activity = K140 000 at 70% level of activity, but given as K170 000. Fixed cost, therefore, = K30 000. At 65% level of activity variable cost = K130 000 (6.5 x K120 000) + fixed cost of K30 000. Total = K160 000.

5. A rise of K5000 for each 10% increase in activity level = K35 000 at 70%, but given as K75 000. Fixed cost therefore = K40 000. At 65% level of activity variable cost = K32 500 (6.5 x K5000) + fixed cost of K40 000, a total of K72 500.

6. Arise of K10 000 for each 10% increase in activity level = K70 000 at 70%, but given as K90 000. Fixed costs, therefore, = K20 000. At 65% level of activity, variable costs = K65 000 (6.5 x K10 000) + fixed costs of K20 000, a total of K85 000.

Cash budget

Is a detailed budget of estimated cash inflows and outflows incorporating both revenues and capital items.

Usefulness of a cash budget

It shows whether there are insufficient cash resources to finance the planned operations.

It gives to management an indication of potential problems that could arise and allow them the opportunity to take action to avoid such problems.

Acts as a financial control aid. Assists in financial planning for capital projects. Directs attention to the management of cash resources Provides projected revenues and expenses estimates necessary to

prepare financial statements. Provides an opportunity to evaluate borrowing and repayment plans.

Problems encountered with shortage of cash

Costs of inability to meet bills as they fall due Cost of lost opportunities for special offer purchases. Costs of borrowing cash to meet unexpected demands Loss of goodwill among suppliers

Problems encountered with excess cash

Los of interest if cash were not invested Loss of purchasing power in times of high inflation Security costs and Insurance costs

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Cash position Appropriate management action

Short term surplus Pay suppliers early to obtain discount

Attempt to increase sales by increasing receivables and inventory

Make short term investmentsShort term deficit Increase payables

Reduce receivables Arrange an overdraft

Long term surplus Make long term investments Expand, diversify, replace or

update non-current assetsLong term deficit Raise long term finance e.g.

issue of shares. Consider shutdown or

disinvestment

Sources of cash in a cash budget

Cash sales. Payment by customers for credit sales. Sale of property, plant and equipment. Issue of new shares or loan inventory. Receipts of interests and dividends from investments outside the

business.Reasons for paying cash

Purchase of inventories Purchase of capital items Payroll costs or other expenses Payment of interests, dividends or taxation

Items which should not be included in a cash budget

All none cash items should not be included e.g.a) Depreciationb) Bad debtsc) Doubtful debts may not be received so need to be

adjustedd) Notional costs e.g. notional rent, notional interest e.t.c

Differences between cash flow and profits

Cash flows is simply the money which flows into and out of a business

114

Profits is the difference between income and expenses (expenses includes both cash and non-cash items)

Some incomes and expenses will be affected by timing differences It is possible for a business to make a profit but still have insufficient cash

Differences between cash budget and cash flow statements

Cash budget Cash flow statement Plans for the future Reports on the past Is not a legal requirements Is a legal requirement Is broken down into shorter

periods hence enabling corrective action

Is a summary of an entire periods of operations covering the financial year

Differences between funds flow statements and cash budgets

Fund flow statement Cash budget Based on historic data Based on future plans Cannot be legally manipulated May be adjusted to reflect

management policy Is a legal requirement For internal use, not legally

required Does not give rise to principal

budget factor Give rise to principal budget

factor

Comparing cash flow with profit and loss statements

Cash budget Income statement Does not include depreciation

charges Includes depreciation charges

Does not include accrued amount if they have not been incurred in that period unless they have been incurred

Includes accrued amounts

Purchase of non-current asset will be shown when the asset is paid for

Purchase of a non-current asset will be shown even when not paid for

The golden rule in cash budget

An item is shown when it is paid for or received All non-cash items should not be included

Possible courses of action to management when there is cash deficit

Activities could be curtailed Payments could be delayed Inventory holding policy should be reviewed

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Efforts to increase the speed of debt collection could be made Dividend payments could be postponed Other sources of cash could be explored e.g. long term loan to finance the

capital expenditure Extra staff might be taken to reduce the amount of overtime paid

Examples

FMP Limited manufactures and sells a single product. The following budget details are available:

Cost per unit K KSelling price 150Less: Material 60

Labour 30 (90) Contribution 60

Additional information:1. Budgeted sales units are as follows:

January February March April5000 2000 2500 6000

2. Opening stock of finished goods at the start of January will be 1000 units. Closing stock of finished goods at the end of each month is budgeted at 10% of sales volume for that month.

3. FMP Limited operates a Just-In-Time ordering system. The stock of raw materials is therefore always zero.

4. Raw material purchases are paid for in the month of purchase and labour costs are paid for in the month of production.

5. All goods are sold on credit. Sales revenue is received 60% in the month of sale and 35% during the following month. The remaining 5% is treated as being irrecoverable.

6. Fixed overheads are K80, 000 per month. This figure includes depreciation of K20, 000.

7. Fixed overheads are paid for in the month in which they are incurred.8. Machinery costing K200, 000 is due to be installed in February and paid

for in March.9. Taxation of K150, 000 and proposed dividends of K75, 000 are due for

payment in April.10. At the beginning of January, trade debtors will total K130, 000 and

the usual collectible amount will be received during January.

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11. Overdraft interest of 1% per month will be paid in respect of the closing bank balance at the previous month end.

12. The opening bank balance of FMP Limited in January will be K200, 000 overdrawn.

Requirements

a. Prepare a production budget, in units, for each of the four months, January to April.

b. Prepare in columnar form, a cash budget for each month. The cash balance at the end of each month must be clearly shown.

c. Comment on the cash budget prepared in (b) and the implications for the company

Stavely Plc has provided with you the following information:i. The company’s only product, a leather vest, sells at K40 and has a

variable cost of K26 made up as follows:Material K20; Labour K4; Overheads K2

ii. Fixed costs of K6000 per month are paid on the 28th of each month.iii. Quantities sold or to be sold on credit are:

May June July August

September

October November

December

1000

1200 1400

1600 1800 2000 2200 2600

iv. Production quantities:

May June July August

September

October November

December

1200

1400 1600

2000 2400 2600 2400 2200

v. Cash sales at a discount of 5% are expected to average 100 units a month.

vi. Customers are expected to settle their accounts by the end of the second month following the month of sales.

vii. Suppliers of materials are paid two months after materials is used in production.

viii. Wages are paid in the same month as they are incurred.ix. 70% of the variable overheads is paid in the month of production the

remainder in the following month.x. Corporation tax of K18000 is to be paid in October.xi. A new delivery vehicle was bought in June, the cost of which K8000 is to

be paid in August. The old vehicle was sold for K600, the buyer undertaking to pay in July.

xii. The company is expected to be K3000 overdrawn at the bank at 30 June, 2007.

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xiii. The opening and closing stock of raw materials, work in progress and finished goods are budgeted to be the same.

Requirements

a. Prepare a month by month cash budget for 1July to December 2007.b. Add brief comments that you consider might be helpful to Stavely’s

management.Master budgets

Is a budget which consolidates all subsidiary budgets and is normally comprised of the budgeted profit and loss account, balance sheet, and cash flow statement.

Zero based budgeting (ZBB)

Is a method of budgeting which requires each cost element to be specifically identified as though the activities to which the budget relates were undertaken for the first time.

The budget allowance is zeroThree step approach to ZBB

Define decision packages:i. Mutually exclusive packages contain alternative methods of

getting the same job doneii. Incremental packages divide one aspect of an activity into

different levels of effort e.g. the base package Evaluate and rank the packages on the basis of benefits to the

organisation Allocate resources according to the funds available and the evaluation

and ranking of the competing packages.Advantages of ZBB

It increases motivation It challenges the status quo( the current state of affairs) It results into more efficient allocation of resources It provides an in depth appraisal of an organisation operations It enforces employees to avoid wasteful expenditures It is possible to identify and remove inefficient or obsolete operations

Disadvantages of ZBB

Volume of extra paperwork is created Emphasis on short term benefits and detriments long term benefits It may be a call for management both in constructing decision packages

and in ranking process. Information systems may not be capable of providing suitable information Ranking process could be difficult It requires a lot of management time and paperwork

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Activity based budgeting

Is a method of budgeting based on an activity framework and utilizing cost driver data in the budget setting and variance feedback processes.

Discretionary costs

Is a cost whose amount within a time period is determined by a decision taken by the appropriate budget holder.

Examples of discretionary costs are; marketing costs, training costs, research costs, e.t.c

Rolling or continuous budgets

Is a budget continuously updated by adding a further period e.g. a month, a quarter, and deducting the earliest periods.

Advantages of rolling or continuous budgets

They reduce the element of uncertainty in budget They force managers to reassess the budget regularly and to produce

updated budgets There is always a budget which extends for several months ahead Planning and control will be based on recent plan instead of an annual

budget that might have been made many months ago and which is no longer realistic.

Disadvantages of rolling or continuous budgets

It involves more time , effort and money in budget preparation Frequent budgeting might have an off-putting effect on managers who

doubt the value of preparing one budget after another at regular intervals.

Characteristics of a good budget

It is practical to implement It is expressed in quantitative or monetary terms Many people are involved in drawing up a budget It is prepared on the basis of cost and revenues It spells out the objects and the policies to be pursued in order to achieve

the objectives of the organisation It should be flexible enough to allow changes in the changing

environment It is prepared for a fixed period of time and is prepared before the period

in which it concerns It is prepared on the basis of budget report performance of the

organisation and is constantly monitoredLarger example

119

Ntchindi Company manufactures two products, known as super and deluxe. Super is produced in department 1 and deluxe in department 2. The following information is available for 200X.

Standard material and labour costs: K

Material X 7.20 per unitMaterial Y 16.00 per unitDirect labour 12.00 per unitOverhead is recovered on a direct labour hour basis.

Standard material and labour usage for each product is as follows:

Model super Model deluxe Material X 10 units 8 unitsMaterial Y 5 units 9 unitsDirect labour 10 hours 15 hours

The Balance sheet for the previous year end 200X was as follows:

K K KFixed assets:

Land 170,000Buildings and equipment 1,292,000Less depreciation 255,000 1,037,000 1,207,000

Current assets:Inventory, Finished goods 99,076Raw materials 189,200Receivables 289,000Cash 34,000

611,276Less current liabilitiesPayables 248,800 362,467Net assets 1,569,476Represented by shareholder's interest:1,200,000 ordinary shares of K1 each 1,200,000Reserves 369,476

1,569,476

Other relevant data is as follows for the year 200X:

Finished goodsModel super Model deluxe

Forecast sales (units) 8 500 1 600Selling price per unit K400 K560Ending inventory required (units) 1,870 90Beginning inventory (units) 170 85

Raw materials

Material X Material YBeginning inventory (units) 8 500 8 000Ending inventory required (units) 10 200 1 700

Department1 Department 2 K K_____ Budgeted variable overhead rates (per direct labour hour):

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Indirect materials 1.20 0.80Indirect labour 1.20 1.20Power (variable portion) 0.60 0.40Maintenance (variable portion) 0.20 0.40

Budgeted fixed overheadsDepreciation 100,000 80,000Supervision 100,000 40,000Power (fixed portion) 40,000 2,000Maintenance (fixed portion) 45,000 3,196

KEstimated non-manufacturing overheads:Stationery etc. (Administration) 4,000Salaries

Sales 74,000Office 28,000

Commissions 60,000Car expenses (sales) 22,000Advertising 80,000Miscellaneous 8,000

267,000

Budgeted cash flows are as follows:

Quarter 1 Quarter 2 Quarter 3 Quarter 4 K K K K

Receipts from customers 1,000,000 1,200,000 1,120,000 985,000Payments: Materials 400,000 480,000 440,000 547,984 Payments for wages 400,000 440,000 480,000 646,188 Other costs and expenses 120,000 100,000 72,016 13,642

You are required to prepare a master budget for the year 200X and the following budgets:1. sales budget;2. production budget;3. direct material usage budget;4. direct material purchase budget;5. direct labour budget;6. factory overhead budget;7. selling and administration budget;8. cash budget

Solution

1. Sales budget Units sold Selling price Total__

Super 8,500 400 3,400,000Deluxe 1,600 560 896,000

10,100 4,296,000

Sales budget is the numeric representation of the marketing department plans for the coming year. sales forecast deals with the number of units to be sold

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2. Production budget Super Deluxe

Units to be sold 8,500 1,600Closing Inventory 1,870 90

10,370 1,690Less: Opening Inventory 170 85Units to be produced 10,200 1,605

Once the sales forecast is established, it is the task of the budget committee to prepare plans for making the product available for sale. Production budget deals with the products that are to be produced/ manufactured.

In the case of a service company, the sales plan must be converted to service capability requirements; for a retail or wholesale enterprise, the sales plan must be translated into merchandise purchases requirements; and in the case of a manufacturing enterprise, the sales plan must be converted to production (manufacturing) requirements.

The general equation which deals with flow of goods is: Beginning inventory + Production – Sales = Ending inventory. This can also be expressed as: Production = Sales + Change in Inventory. Where change in inventory is equal to Ending Inventory – Beginning Inventory.

3. Direct material usage budget Super Deluxe Total Cost/ Total Cost/

Material unit Total Cost Material unit Total Cost

X (10200x10) 102,000 7.20 734,400 (1605x8) 12,840 7.20 92,448Y 10200x5) 51,000 10.00 163,200 (1605x9) 14,445 16.00 231,120

153,000 897,600 27,295 323,560

4. Direct material purchase budget Material X Material Y

Material needed 114,840* 65,445** Planned closing inventory 10,200 1,700

125,040 67,145Less: Opening inventory 8,500 8,000Materials to be Purchased 116,540 59,145Cost per unit 7.20 16.00Total Purchase 839,088 946,320

*102,000+12,840=114,840**51,000+14,445=65,445

A direct materials budget indicates the expected amount of direct materials required to produce the budgeted units of finished goods. This budget specifies the cost of direct materials used and the cost of the direct materials purchased.

The direct materials budget is useful in the following ways: a) It helps the purchasing department to prepare a schedule to ensure delivery of materials

when needed. b) It helps in fixing minimum and maximum levels of inventories in the stores department.

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c) It helps the finance manager to determine the financial requirements to meet production targets.

5. Direct labour budget Total hours Cost/unit Total Cost

Super (10200x10hrs) 102,000 12.00 1,224,000Deluxe (1605x15hrs) 24,075 12.00 288,900Total 126,075 1,512,900

Direct labor budget represents the direct labor requirements necessary to produce the types and quantities of outputs planned in the production budget.

6. Factory overhead budget Rate Overhead

Controllable Dept. 1 Dept. 2 Dept. 1Dept. 2Indirect Materials 1.20 0.80 122,400 19,260Labour 1.20 1.20 122,400 28,890Power 0.60 0.40 61,200 9,630Maintenance 0.20 0.40 20,400 9,630

326,400 67,410UncontrollableDepreciation 100,000 80,000Supervision 100,000 40,000Power 40,000 2,000Maintenance 45,600 3,196

285,600 125,196Total Overheads 612,000 192,606Overhead Rate (Overhead/Hours) K6.00 K8.00

The factory overhead budget estimates the requirements and costs of the above overheads for the production of the budgeted units. It requires that expenses should be classified by departments since expenses are incurred by various departments. In this way departmental heads should be held accountable for expenses incurred by their departments.

Cost per UnitSuper Deluxe

D/ material X (10x7.20) 72 (8x7.20) 57.60Y (5x16.00) 80 (9x16) 144.00

D/labour (10x12) 120 (15x12) 180.00O/H (10x6) 60 (15x8) 120.00

332 501.60

7. Inventory budget

An inventory budget can be prepared to find out the values of direct materials and finished goods inventory.

8. Selling and administration budgetSelling K KSalaries 74,000Commissions 60,000Car expenses 22,000Advertising 80,000 236,000Administration

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Stationery 4,000Salaries 28,000Miscellaneous 8,000 40,000Total budget 276,000

9. Cash budget Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4

Opening Balance 34,000 114,000 294,000 421,984Receipts 1,000,000 1,200,000 1,120,000 985,000

1,034,000 1,314,000 1,414,000 1,406,984Payment:Materials 400,000 480,000 440,000 547,984Payments for labour 400,000 440,000 480,000 646,188Other costs & expenses 120,000 100,000 72,016 13,642

920,000 1,020,000 992,016 1,207,814Closing Balance 114,000 294,000 421,984 199,170

Budgeted Profit and Loss account K K

Sales 4,296,000Opening inventory- Raw materials 189,200Purchases 1,785,408

1,974,608Less: Closing inventory- Raw materials 100,640Cost of Materials consumed 1,873,968Direct Labour 1,512,900Factory overheads 804,606Total manufacturing cost 4,191,474Add: Opening inventory- Finished goods 99,076Less: Closing inventory- Finished goods 665,984 3,624,566Gross Profit 671,434Less: Selling and Distribution expenses 276,000Budgeted Profit 395,434

Budgeted Balance sheetFixed Assets K KLand 170,000Building 1,292,000Less: Depreciation (255,000+180,000) 435,000 857,000

1,027,000Current AssetsRaw materials 100,640Finished goods 665,984Receivables 280,000*Cash 199,170

1,245,794Less: Current liabilitiesPayables 307,884** 937,910

1,964,910Financed By:1,200,000 Ordinary shares of K1 each 1,200,000Reserves 369,476Profit and Loss account 395,434

1,964,910

Working *Receivables a/c_______________________

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Balance b/d 289,000 Cash 4,305,000Sales 4,296,000 Balance c/d 280,000

4,585,000 4,585,000

**Payables/c______________________ Cash 1,867,984 Balance b/d 248,800Balance c/d 307,884 Purchase 1,927,068

2,175,868 2,175,868

Exam style question

Bradman ltd has the following budgeted unit sales figures for six months from July 2005:July 800August 600September 700October 900November 1000December 900The company makes and sells one product only, the unit costs and selling price of which are: K

Selling price 70Material A 2kg at K5 10Material B 1.5kg at 6 9Labour 2 hours at K10 20Variable overheads K8 per hour 16The following information is also available:

Customers are allowed one month credit Production takes place in the month of sale Closing stocks of finished products are equal to 10% of the next month

sales Materials are purchased in the month of before use and are paid for two

months after purchases. Wages and variable overheads are paid for in the month of production Fixed overheads is K3000 per month (including depreciation of K500)

payable in the month incurred The opening cash balance at 31 August is expected to be K20, 000.00 in

handRequirements

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a) Prepare for September only the following:i. Sales budget (in units and kwachas)ii. Production budget in units onlyiii. Raw material purchases budget for both material A and B (in

kilos and kwachas)b) Prepare the cash budget for the months of September and October

only

CHAPTER TEN

STANDARD COSTINGStandard cost

Is an estimate unit cost, prepared in advance and calculated from management expectations. OR

Is a predetermined calculation of how much costs should be under specified working conditions.

Uses of standard cost

To provide basis for control through variance analysis Valuation of stock and work in progress For fixing selling prices

Standard

Is a predetermined measurable quantity set in defined conditions against which actual performance can be compared. OR

Is a predetermined unit of cost for inventory valuation, budgeting amd control.

Standard costing

Is a technique which uses standards for costs and revenues for the purpose of control through variance analysis. OR

Is a control technique that reports variances by comparing actual costs to pre-set standards so facilitating action through management by exception (MBE). OR

Is the preparation of standard cost to be used in the following circumstances:

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a. To assist in setting budget and evaluating managerial performance.

b. To act as a control device by establishing standards and highlighting activities that do not conform to plan via variance analysis.

c. To enable the principle of management by exception to be practiced.

Management by exception

Is the practice of focusing on activities which requires attention and ignore those which appear to be conforming to expectations.

Situations where standard costing is used

In mass and batch production Process manufacture Job manufacture Service manufacture

Standard hour

Is the amount of work achievable at standard efficiency level in an hour or minute.

It is a measure of work content and not a measure of time.Setting standards for manufacturing

Standard cost card

Is a document or digital record detailing, for each product, the standard inputs required for production as well as the standard selling price.

Example of a standard cost cardCost per unit (K)

Direct material A 6 kg at K2/kg 12B 2kg at K3/kg 6

Direct labour 3 hours at K4/kg 12 Standard prime cost 30Variable production overhead 3 hours at K2/hour 6 Standard variable production cost 36Fixed production overheads 6 Factory cost or full cost of production 42Sales and administration cost 5 Standard cost of sales 47Standard profit 10 Standard sales price 57

Setting standards for material costsThis will be estimated by the purchasing department through:

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Purchase contracts already agreed Pricing discussions with regular suppliers Quotations and estimates from potential suppliers The forecasts movements of prices in the markets The availability of bulk purchase discounts Material quantity required

Setting standards for labour

Direct labour will be set by discussions with the personnel department and by reference to the payroll and to any agreements on pay rise.

Setting standards for material usage and labour efficiency

Performance standards

These are used to set efficiency standards and includes; ideal, attainable, current and basic standards.

a. Ideal standards

These are based on perfect operating conditions; no wastage, no spoilage, no inefficiencies, no idle time, no breakdowns etc.Advantages

It pinpoints areas which are not performing thus allowing management by exception.

Helps in pinpointing areas where close examination may result in large savings

Disadvantages

It demotivates employees Employees will often feel that the goals are un unattainable and so not

work so hard Nobody can achieve the planned output Can only be used in highly automated processb. Attainable standards

These are based on the hope that a standard amount o0f work will be carried out efficiently, machines properly operated or materials properly used.This can be achieved under efficient working conditionsSome allowances is made for wastage and inefficiency.Advantages

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They are attainable or achievable They provide a useful psychological incentive by giving employees a

realistc but challenging target of efficiency. The consent and cooperation of employees involved in improving the

standards is requiredc. Current standards

These are based on current working conditions. i.e current wastage, current inefficiencies.Advantages

They encourage the status quo Speeds up budget preparation

Disadvantages

No real incentive to improve upon standards They do not attempt to improve on current levels of efficiency d. Basic standards

These are kept unaltered over a long period of time and may be out of date.Advantages

Trends can be easily spotted i.e used to show changes in efficiency or performance over a long period of time.

Disadvantages

May be out of date Lack of flexibility Demotivates employees

Capacity levels (measures of capacity)

These are used for budgeting and include the following;a. Full capacity It is a theoretical capacity assuming continuous production without any

stoppages due to factors such as machine breakdown, supply shortages or labour shortages.

It is output achievable if sales orders, supplies and workforces are available.

It is associated with ideal standardsb. Practical capacity This acknowledges that some stoppages are un avoidable such as

maintenance time for machines and resetting time between jobs, some machines breakdowns etc.

It means full capacity less an allowance for known unavoidable volume losses

It is below full capacity and is associated with attainable standards.c. Budgeted capacity

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Is standard hours planned for the budget period, taking account of, for example budgeted sales, workforce and expected efficiency.

Is the capacity needed to produce the budgeted output and is associated with current standards.

d. Idle capacity Is the difference between practical capacity and budgeted capacity

measured in standard hours of output.Problems encounterd when setting labour standards

Inaccurate supply of information from individual departments Work measurement may be required which is costly and time saving May be difficult to establish and maintain the chosen labour grades.

Setting selling price standards and margin or contribution

Factors to consider in setting standards selling prices

Anticipated market demand Competing products and competitors action Manufacturing or production costs Inflation estimates

Standard sales margin or contribution

Is the difference between standard selling price and standard variable costs.

Problems of setting standards

Difficult in deciding how to incorporate inflation into planned unit costs Agreeing labour efficiency standards Deciding on the quality of materials to be used The cost of setting up and maintaining a system of establishing standards Difficult to establish a measurable cost unit for some services Deciding on the appropriate mix of component materials where some

change in the mix is possible Estimating material prices where seasonal price variations or bulk

purchase discounts may be significant.Solution to the problems

Establishing a measurable cost unit Attempt to reduce the heterogeneity of services Reduce the element of human influence

Advantages of standard costing

Motivation when targets are achieved It is cost consciousness (saving)

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It acts as an aid to more accurate budgeting It assists in evaluating managerial performance It provides a basis for stock valuation It provides guidance on improvements of efficiency and minimization of

wastes It enables the principle of management by exception to be operated It provides a valuable aid to management in determining prices and

formulation of prices Standard costs simplify the process of bookkeeping in cost accounting Standard times simplify the process of production scheduling

Labour productivity ratios or standard costing ratios

These includes; efficiency (productivity) ratio, capacity ratio and volume or activity or production ratio.Capacity ratio (C) = Actual hours worked (A)

Budgeted hours (B)

If the ratio is above 100% then its favourable (F) and if below 100% then its adverse (A).

It is a substitute of fixed overhead capacity variance.ORCapacity ratio =efficiency ratio x volume ratioEfficiency ratio (E) =Standard hours (Expected hour to make an output) (S)

Actual hours taken (A)

Efficiency ratio is also called productivity ratio If the ratio is below 100% then its adverse (A) and if it is above 100% its

favourable (F) OR Efficiency ratio = capacity ratio / volume ratioVolume ratio (V) =Standard hours (Output measured in expected hours) (S)

Budgeted hours (B)

Volume ratio is also called production or activity ratio This compares actual output with budgeted output It is similar to production volume variance If the ratio is above 100% then its favourable (F) and if below 100% then

it’s adverse (A). OR

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Volume ratio = capacity ratio / efficiency ratio Standard hours = actual output x standard hours per unit (budgeted hours per unit)NOTE: A mnemonic CABESAVSB is used to recall the above formulae.

Examples

Woodall ltd has two production departments X and Y. for month 2, the company budgets its overhead costs as:

X Y

Variable overheads k23, 000 K42, 000Fixed overhead K18, 000 K18, 000The absorption rate is based on labour hours in each department. The budgeted hours in each department are 5000 for X and 8000 for Y.At the end of month 2, department X had actually worked 4900 hours and department Y worked 8200 hours and the standard hours produced were 5200 and 8100 in department Y.The actual expenditure on overhead for the month was: Department X K42500 Department Y K59500Requirements

a. Calculate the under or over absorption of overheads in both departmentsb. State the factors that give rise to the under or over absorption of

overheadsc. Analyse your answer to (a) above under the headings stated in (b) aboved. State what is meant by the term standard houre. For each department X and Y calculate the following; capacity ratio,

efficiency ratio and activity ratio

Price ltd has two departments A and B. Both departments absorbs fixed overheads using a direct labour hour rate.The following figures relate to a recent period

A BBudgeted fixed overhead K60, 000 K50, 000Budgeted direct labour hours (i) 5000Budgeted overhead absorption rate K6/hour (v)Budgeted production units 5000 1000Actual hours worked 8000 (vi)Actual production units 3900 1120Fixed overheads absorbed (ii) K55, 000

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Actual fixed overheads (iii) K52, 000Under or over absorbed overheads K8000 under

(vii)Standard hours produced (iv) (viii)Requirements

a. Calculate the figures (i) to (viii) inclusiveb. For both departments calculate:

i. Activity ratioii. Capacity ratioiii. Efficiency ratio

CHAPTER ELEVENVARIANCE ANALYSIS

Variance: Is the difference between planned, budgeted or standard cost and actual costs incurred. Variance analysis:

Is the analysis of the difference (variance) between what was planned (Budget) using standard costing system, and what actually happened (Actual).

The ultimate objective is to describe the difference between the actual profit and planned profit. OR

Is the process by which the total difference between standard and actual results is analysed. OR

Is the evaluation of performance by means of variances, whose timely reporting should maximize the opportunity for managerial action.

NOTE: Favourable (F) occurs when actual results are better than expected results.

Adverse (A) occurs when actual results are worse than expected results.Analysis of variances helps the firm in the following ways.

a. Budgets are expectations of the future, or plans of what should be done. Therefore, if what is achieved is different from the plan then it would be useful to find out whether the firm is planning realistically.

b. Allows the firm to plan better so that it incorporates the differences between the earlier plan and the actual into plans

Planning and operational variances

Planning (uncontrollable) variances

These compares original cost with revised standard costs Managers cannot be held responsible for such variances.

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Operational (controllable) variances

These compares actual costs with revised standard costs Managers can be held responsible for such variances.

Benefits of separating variances into planning and operational variances

An operating statement is supposed to take into account any changes so as to make the standard cost data relevant. The separation makes variances to be more useful. Planning variances are uncontrollable whereas operational variances are controllable hence the need for separation. Separating variances will aid managers to be responsible for only operational variances rather than planning variances. Planning variances indicates where investigating variances may result into improvements in planning and budgeting process.Main groups of variances:

i. Variable cost variances: Direct material Direct labour Variable production overhead

ii. Fixed production overhead variancesiii. Sales variances

Direct material variances

Total Material variance:

Is the difference between what the output actually cost and what is should have cost in terms of materials. OR

Is a measurement of the difference between the standard material cost of the output produced and the actual cost incurred.

(Actual quantity x actual cost) – (standard quantity for actual production x standard cost)Sub-divisions of material total variances

a. Direct material price which is the difference between what the material did cost and what should have cost. OR

Is the difference between the actual price paid for purchased materials and their standard cost

(Actual cost per unit – standard cost per unit) x actual quantityb. Direct material usage is the difference between the standard cost of

materials that should have been used and the standard cost of the materials that were used. OR

This measures efficiency in the use of materials by comparing the standard material usage for actual production with actual material used, the difference valued at a standard cost.

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(Actual quantity – standard quantity for actual production) x standard cost

ExampleProduct X has a standard direct material cost as follows:

10kg at K10 per kg = K100 per unitDuring period 4, 1000 units of X were manufactured using 11, 700 kg of materials which cost K98, 600.RequirementsCalculate the following:

a. Direct material total varianceb. Direct material price variancec. Direct material usage variance

Solution

a. Direct material total variance K1000 units should have cost (1000 x K100) 100, 000

But did cost 98, 600 Direct material total variance 1400 F

b. Direct material price variance K11700 kg should have cost (11700 x K10) 117, 000

But did cost 98, 600 Direct material price variance 18, 400 F

c. Direct material usage variance Kg1000 units should have used (1000 x 10Kg) 10, 000

But did use 11, 700 Material usage variance in kg 1, 700 AStandard cost per kg x K10 Material usage variance in (k) 17, 000 A

Direct labour variancesDirect labour total variance: is the difference between what the output should have cost and what it did cost in terms of labour. OR

Is the difference between the standard labour cost of the output which has been produced and actual direct labour incurred.

(Actual hours x actual hourly rate) – (standard hours for actual production x standard hourly rate)Sub-divisions of labour total variances

a. Direct labour rate- difference between what labour did cost and what it should have cost. OR

Indicates the actual cost of any change from the standard labour rate of remuneration.

Actual hours x (actual hourly rate – standard hourly rate)135

b. Direct labour efficiency: Is the difference between standard cost of the hours that should have been worked and the standard cost of the hours that were worked. OR

Indicates the standard labour costs of any change from the standard level of labour efficiency.

(Actual hours – standard hours for actual production) x standard hourly rate.c. Direct labour idle time: The number of hours of idle time valued at

standard rate per hour. This occurs when hours paid exceed the hours worked and there is an

exact cost caused by this idle time.(hours paid –hours worked) x standard direct labour rate per hour

ExampleProduct X has a standard direct labour cost as follows:

2 hours at K5 per hour = K10 per unitDuring period 4, 1000 units of X were manufactured and the direct labour cost was K8, 900 for 2300 hours.RequirementsCalculate the following:

a. Direct labour total varianceb. Direct labour rate variancec. Direct labour efficiency variance

Solutiona. Direct labour total variance K1000 units should have cost (1000 x K10) 10, 000

But did cost 8, 900Direct labour total variance 1, 100 Fb. Direct labour rate variance K2300 hours should have cost (2300 x K5 per hour) 11, 500

But did cost 8, 900Direct labour rate variance 2, 600 F

c. Direct labour efficiency variance hours1000 units should have taken (1000 x 2 hours) 2, 000

But did take 2, 300 Direct labour efficiency variance in hours 300 AStandard cost per hour x K5 Direct labour efficiency variance in (k) 1, 500 A

Example 2Product X has a standard direct labour cost as follows:

2 hours at K5 per hour = K10 per unitDuring period 5, 1500 units of X were manufactured and the direct labour cost was K17, 500 for 3080 hours. During the period however, there was a shortage of customer orders and 100 hours were recorded as idle time.

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RequirementsCalculate the following:

a. Direct labour total varianceb. Direct labour rate variancec. Idle time varianced. Direct labour efficiency variance

Solutiona. Direct labour total variance K1500 units should have cost (1000 x K10) 15, 000

But did cost 17, 500Direct labour total variance 2, 500 Ab. Direct labour rate variance K3080 hours should have cost (3080 x K5 per hour) 15, 400

But did cost 17, 500Direct labour rate variance 2, 100 A

c. Idle time variance = 100 hours x K5 per hour = K500 Ad. Direct labour efficiency variance hours1500 units should have taken (1500 x 2 hours) 3, 000

But did take (3080-100) 2, 980 Direct labour efficiency variance in hours 20 FStandard cost per hour x K5 Direct labour efficiency variance in (k) 100 F

Variable production overhead variances

Variable production overhead total variance: is the difference between what the output should have cost and what it did cost in terms of variable production overhead. OR

Is the sum of variable overhead expenditure variance and variable overhead efficiency variance.

Actual variable production overhead – (standard hours for actual production x variable production overhead rate)Sub-divisions of variable production overhead total variances

a. Variable production overhead expenditure variance: Is the difference between the amount of variable production overhead that should have been incurred in the actual hours actively worked and the actual amount of variable production overhead incurred. OR

Actual variable production overhead – (actual hours worked x V.OAR)

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b. Variable production overhead efficiency variance: Is the difference between standard cost of the hours that should have been worked for the number of units actual produced and the standard cost of the actual number of hours worked. OR

Is the same as the direct labour efficiency variance but priced at the variable overhead rate per hour

(Actual hours – standard hours for actual production) x V.OAR

ExampleProduct X has a standard variable production overhead cost as follows:

2 hours at K1.50 per hour = K3 per unitDuring period 6, 400 units of X were manufactured and the labour force worked 820 hours of which 60 hours were recorded as idle time. The variable overhead cost was K1, 230.

RequirementsCalculate the following:

a. Variable overhead total varianceb. Variable overhead expenditure variancec. Variable overhead efficiency variance

Solution

a. Variable overhead total variance K

400 units of product X should have cost (400 x K3)1200But did cost 1230

Variable production overhead total variance 30 A b. Variable overhead expenditure variance K

(820 – 60) hours of variable overhead should have cost (760 x K1.50)1140But did cost 1230

Variable production overhead expenditure total variance 90 A c. Variable overhead efficiency variance

hours

400 units should have taken (400 x 2 hours) 800

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But did take (820 – 60 hours) active hours760

Variable production overhead efficiency variance in hours 40 FStandard variable overhead rate per hour x K1.5 Variable overhead efficiency variance in (K) 60 F Fixed production overhead variancesFixed production overhead total variance: is the difference between fixed production overhead incurred and fixed production overhead absorbed (the under or over absorbed overhead). Actual fixed overhead – (actual hours worked x F.OAR*)

*fixed overhead absorption rate, i.e. budgeted fixed overhead/total budgeted hours of productionSub-divisions of fixed production overhead total variances

a. Fixed production overhead expenditure variance is the difference between the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure.

Actual fixed overhead – budgeted fixed overheadb. Fixed production overhead volume variance- difference between

actual and budgeted production or volume multiplied by the standard absorption rate per unit.

(Actual hours – standard hours for actual production) x F.OAR

Fixed production overhead volume variance can further be split into:a. Volume efficiency variance: is the difference between standard hours

that should have been worked and the actual hour worked, indicates a failure to utilize capacity efficiently,(Actual hours worked – standard hours of actual production) x F.OA

b. Volume capacity variance: this is the difference between the budgeted hours of work and the actual active hours of work (excluding idle time), indicates a failure to utilize capacity at all

Budgeted fixed overhead – (actual hours worked x F.OAR)

ExampleThe company budgets to produce 1000 units of product E during August. The expected time to produce a unit of E is 5 hours and budgeted fixed overhead is K20, 000. The standard cost per unit is as follows:

5 hours at K4 = K20 per unit

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Actual fixed overhead expenditure in August turns out to be K20, 450. The labour force manages to produce 1100 units of E in 5400 hours of work.RequirementsCalculate the following:

a. Fixed overhead total varianceb. Fixed overhead expenditure variancec. Fixed overhead volume varianced. Fixed overhead volume efficiency variancee. Fixed overhead volume capacity variance

Solution

a. Fixed production overhead total variance K

Actual fixed overhead 20450Fixed overhead absorbed - (1100 x K20 per unit) 22000 Fixed overhead total variance(under or (over) absorbed overhead) 1550 F

b. Fixed overhead expenditure variance K

Budgeted fixed overhead expenditure 20000Actual fixed overhead expenditure 20450 Fixed overhead expenditure variance 450 A

c. Fixed overhead volume variance units

Actual production 1100Budgeted production 1000 Fixed overhead volume variance in units 100 FStandard fixed overhead absorption rate per unit x 20 Fixed overhead volume variance in (K) 2000 F

Subdivisions of fixed overhead volume variance:

d. Fixed overhead volume efficiency variance hours

Actual hours worked 5400Budgeted hours (1100 x 5) 5500

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Fixed overhead efficiency variance in hours 100 F Standard fixed overhead rate per hour x K4 Fixed overhead efficiency variance in (K) 400 F

e. Fixed overhead volume capacity variance K

Budgeted fixed overhead 20000Absorbed fixed overhead (5400 x K4) 21600 Fixed overhead volume capacity variance in (K) 1600 F

Sales variancesa. Sales price variance: is the difference between what sales revenue should have been for the actual quantity sold and the actual revenue.

(Actual selling price per unit – Standard selling price per unit) x actual sales quantityc. Sales volume variance: This measures the increase, decrease in

expected profit because of the sales volume being high, or lower than budget. OR

Is the difference between actual units sold and the budgeted quantity.(Actual quantity – budgeted quantity) x standard profit per unit

ExampleJasper has the following budget and actual figures for year 4

Budget ActualSales units 600 620Selling price per unit K30 K29Standard full cost of production is K28 per unitStandard variable cost of production is K19 per unitRequirementsCalculate the following sales variances:

a. Selling price varianceb. Sales volume profit variancec. Sales volume contribution varianced. Sales volume revenue variance

Solution

a. Sales price variance

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Revenue from 620 units should have been (620 x 30) 18600But was (620 x 29 ) 17980

Sales price variance 620 A b. Sales volume profit variance

Budgeted sales volume 600Actual sales volume 620 Sales volume variance in units 20 FStandard profit per unit (30 – 28) x 2 Sales volume profit variance 40 F

c. Sales volume contribution variance

Sales volume contribution variance = sales volume variance x standard contribution per unit = 20 F x K (30 – 19) = K220 F

d. Sales volume revenue variance

Sales revenue variance = sales volume variance units x standard selling price

= 20 F x K30= K600 F

Operating Statement

An operating statement is a report, usually to senior management, at the end of a control period, reconciling budgeted profit for the period to actual profit. OR

Is a report for management, normally prepared on a regular basis showing actual costs and revenues, usually comparing actual with budget showing variances.

Usually an operating statement is produced to report all variances to the management at the end of control period.

Investigation of variancesVariance analysis is not the end, but a means to an end. Adverse variances are merely important signs of a problem indicating a need for control. Once variances have been extracted it must be decided which (if any) variances are to be investigated.

Methods for selecting which area to investigate

There are three main method used and includes:142

i. Instinct: Managers use their experience and judgment in determining whether it is necessary to examine a particular variance.

ii. Tolerance levels: In order to avoid arbitrary and sometimes irrational decisions, some companies set tolerance levels. For instance if a variance is within plus or minus 10% of the standard, the variance will not be investigated.

iii. Statistical models: A standard cost is an average figure representing the mid-point between a range of variables. It is to be expected, therefore, that the actual results will occur somewhere within that range. This would be classed as a random or chance result and it would not be investigated. One of the techniques used include make control charts.

Management by ExceptionManagement by exception entails that manager's attention and effort should be drawn on significant deviations from the expected results only. Therefore, by following the principles of reporting by exception only significant variances from the expected will be reported for corrective action. This saves managerial time.

When reporting the following should be considered when deciding whether to investigate further:

a. Materiality: Small variations in a single period are bound to occur and are unlikely to be significant. Obtaining an explanation is likely to be time-consuming and irritating for the manager concerned. The explanation will often be chance which is not particularly helpful.

b. Size: if the company has a policy on what are the tolerable variances it can investigate any variance that is contrary to the tolerable errors.

c. Controllability: Is the issue controllable, if for example there is a general worldwide price increase in the price of an important raw material there is nothing that can be done internally to control the effect of this.

d. Variance trend: If the same variance keeps on occurring despite correct actions, the trend indicates that the process is in control and the standard has been wrongly set.

e. Historic pattern of the variance: unusual variances considered for investigation to identify the cause of such variance than usual ones.

f. Cost vs. benefit: The likely cost of an investigation needs to be weighed against the cost to the organisation of allowing the variance to continue in future periods.

g. Interrelationship of variances: Individual variances should not be looked in isolation. One variance might be inter-related with another, and much of it might have occurred only because the other, inter-related, variance occurred too.

h. Adverse or favorable: adverse variances are subject to investigation than favourable ones because adverse variances show where the budget was slack.

i. Reliability and quality of data: if the quality of measuring and recording systems is not as high as it was supposed to be, there may be uncertainty about the benefits from investigation of variances.

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General causes of variances

i. Incorrect standards which may be because of faulty or incorrect planning, perhaps standards were carelessly put together, or perhaps of quite unpredictable circumstances.

ii. Out of date standards usually standard cost are not prepared on frequent basis, because preparation is expensive and time consuming.

iii. Measurement it is possible that some errors will have occurred in setting the standards, in compiling the actual results, and in calculating the variances.

iv. Interdependence of variances often occurs because they are dependent upon other variances.

Cost Accounting EntriesAll cost variances are recorded in the accounts where they arise with appropriate double entry. The following are the basic principles;

i. Material price variance is recorded in the stores control account.ii. The labour rate variance is recorded in the wages control account.iii. Material usage, idle time, labour efficiency, variable and fixed production

overhead efficiency variances may be recorded in work in progress control account.

iv. Variable production overhead expenditure variance will be recorded in the variable production overhead account.

v. Sales variances (price and volume) do not appear in the books of accounts. Sales are recorded in the sales account at the actual value.

vi. Balance of variances in the variance accounts at the end of the period are written off to profit and loss account.

Control Ratios

Any management accounting report that involves budgets and variances should incorporate control ratios in for of efficiency, capacity and production volume.

Capacity ratios measure the extent to which planned utilisation has been achieved and compares actual hours worked and budgeted hours. The formula is as follows:

Capacity Ratio = Actual hours worked x 100 Standard hours worked for budgeted production

The capacity ratio links with the fixed production overhead capacity ratio. Hence if the ratio is less than 100%, the variance will be adverse.

Production volumes (activity ratio) measure the number of standard hour equivalent to actual work produced and actual hours. The formula is:

Production Ratio = Standard hours for actual production x 100 Standard hours for budgeted production

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Efficiency ratio measure efficiency of labour force by comparing equivalent standard hours for work produced and actual hours worked.

Efficiency Ratio = Standard hours for actual production x 100 Actual hours worked

If the ratio is more than 100%, we have been more efficient that we had expected to be in producing the work we did.

Reasons for various variancesThe following table shows the subdivision of the forms of variances and their causative reasons of both a favourable and adverse variance:Variance Favourable Adverse

Material price

Unforeseen discount Proper purchasing

procedures Change in material

standard

Market price increases Careless purchasing

Material Usage

Material used of higher quality

More effective use of materials/high quality machine

Defective materials Excessive waste Pilferage

Labour rate of pay

Use of apprentices or other low quality workers at lower rate than standard

Wage rate increase

Idle time Machine breakdown Non-availability of

materials Illness or injury to workers

Labour efficiency

Output produced more quickly than expected due to motivation, better equipment or materials

Output lower than standard because of deliberate restrictions, lack of training or lower quality materials used

Overhead expenditure

More economical use of services

Increase in cost of services used

Excessive use of services Changes in types of

services usedOverhead efficiency

Same as labour efficiency

Same as labour efficiency

Overhead capacity

Excess of actual time over budget

Excessive idle time Shortage of plant capacity

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Sales volume

High demand Improved quality Low sales prices or

discounts Sales promotions

Low demand Poor or low quality High sales prices

Sales price High quality High demand Low competition Sales promotions

Low demand Low quality High competition No sales promotions

Larger example

Francis Ltd manufactures one product, and the entire product is sold as soon as it is produced. There is no opening or closing inventory and work in progress is negligible. The company operates a standard costing system and analysis of variances is made every month. The standard cost card for the product, a boomerang, is as follows.

Standard cost card-boomerang K

Direct materials 0.5 kilos at K4 per kilo 2.00Direct wages 2hours at K2.00 per hour 4.00Variable overheads 2 hours at K0.30 per hour 0.60Fixed overhead 2hours at K3.70 per hour 7.40Standard cost 14.00

Standard profit 6.00

Standard selling price 20.00

Selling and administration expenses are not included in the standard cost, and are deducted from profit as a period charge.Budgeted output for the month of June 20X7 was 5,100 units. Actual results for June 20X7 were as follows:Production of 4,850 units was sold for K95, 600Materials consumed in production amounted to 2,300 kilos at a total cost of K9, 800Labour hours paid for amounted to 8,500 hours at a cost of K16, 800Actual operating hours amounted to 8,000 hoursVariable overheads amounted to K2, 600Fixed overheads amounted to K42, 300Selling and administration expenses amounted to K18, 000

RequirementsCalculate all variances and prepare an operating statement for the month ended June 20X7.

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Solution

Absorption costing

Sales variances1) Sales price variance is the difference between what sales revenue should

have been for the actual quantity sold and what is was.

(Actual selling price per unit – Standard selling price per unit) x actual sales quantity

2) Sales volume variance This measures the increase, decrease in expected profit because of the sales volume being high, or lower than budget.

(Actual quantity – budgeted quantity) x standard profit per unit

Sales price variance KBudgeted sales revenue (4850 x 20) 97 000

Actual sales revenue 95 600Sales price variance in (K) 1 400 (A)

Sales volume variance unitsBudgeted sales volume 5 100

Actual volume 4 850Sales volume variance in units 250Standard profit margin x 6Sales volume variance in (K) 1 500 (A)

Marginal costingStandard cost variances using marginal costing principle are calculated very similarly to those when absorption costing is used, but there are two important differences:

a. The sales variances use a contribution approach instead of profit.b. Fixed overheads are not absorbed into individual units or processes.

1) Sales price variance is the difference between what sales revenue should have been for the actual quantity sold and what is was.

(Actual selling price per unit – Standard selling price per unit) x actual sales quantity

2) Sales volume contribution variance measures the increase, decrease in expected contribution because of the sales volume being high, or lower than budget.

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(Actual quantity – budgeted quantity) x standard contribution per unit

Sales price variance KBudgeted sales revenue (4850 x 20) 97 000

Actual sales revenue 95 600Sales price variance 1 400 (A)

Sales volume variance KBudgeted sales volume 5 100

Actual volume 4 850Sale volume variance in units 250Standard contribution margin(20-6.6) 13.4 Sales volume variance in (K) 3 350(A)

Material VariancesTotal Material variance is the difference between what the output actually cost and what is should have cost in terms of materials.

(Actual quantity x actual cost) – (standard quantity for actual production x standard cost)

It is divided into two sub-variances:1) Material price is the difference between what the material did cost and

what should have cost.

(Actual cost per unit – standard cost per unit) x actual quantity

2) Material usage is the difference between the standard cost of materials that should have been used and the standard cost of the materials that were used.

(Actual quantity – standard quantity for actual production) x standard cost

Total Material variance K4850 units should have cost (4850 x 2) 9,700

Actual cost 9,800Total material variance 100 (A)

Material Price variance K2300kgs should have cost (2300 x 4) 9,200

Actual cost 9,800Material price variance 600(A)

Material Usage variance K4850 units should have used (4850 x 0.5) 2,425kgs

Actual usage 2,300kgsMaterial usage variance in kg 125kgs

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Standard cost 4Material usage variance in (K) 500 (F)

Labour Variances

Total Labour variance is the difference between what the output should have cost and what it did cost in terms of labour.

(Actual hours x actual hourly rate) – (standard hours for actual production x standard hourly rate)

Divided into two variances;

1) Labour rate- difference between what labour did cost and what it should have cost.

Actual hours x (actual hourly rate – standard hourly rate)

2) Labour efficiency- difference between standard cost of the hours that should have been worked and the standard cost of the hours that were worked.

(Actual hours – standard hours for actual production) x standard hourly rate

3) Idle time- the number of hours that labour were idle valued at standard rate per hour.

Total Labour Variance K4850 units should have cost (4850 x 4) 19,400

Actual cost 16,800Total labour variance 2,600 (F)

Labour Rate variance K8500 hours should have cost (8500 x 2) 17,000

Actual cost 16,800 Labour rate variance 200 (F)

Labour Efficiency variance hours4850 units should have taken (4850 x 2) 9,700

Actual hours 8,000Labour efficiency variance in hours 1,700Standard cost 2Labour efficiency variance in (K) 3,400 (F)

Idle time varianceIdle hours (500 x 2) 1,000 (A)

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Variable production overhead variancesTotal Variable production overhead variance is the difference between what the output should have cost and what it did cost in terms of variable production overhead.

Actual variable production overhead – (standard hours for actual production x variable production overhead rate)

Divided into two variances1. Variable production overhead expenditure variance- difference

between the amount of variable production overhead that should have been incurred in the actual hours actively worked and the actual amount of variable production overhead incurred.

Actual variable production overhead – (actual hours worked x V.OAR)

2. Variable production overhead efficiency variance- difference between standard cost of the hours that should have been worked for the number of units actual produced and the standard cost of the actual number of hours worked.

(Actual hours – standard hours for actual production) x V.OAR

Total Variance production overhead variance k4850 units should have cost (4850 x 0.60) 2,910

Actual cost 2,600Total variable production overhead variance 310 (F)

Variable production overhead expenditure variance k8000 hours should have cost (8000 x 0.30) 2,400

Actual expenditure 2,600Variable production overhead expenditure variance 200 (A)

Variable production overhead efficiency variance hours4850 units should have used (4850 x 2) 9,700

Actual hours 8,000Variable production overhead efficiency variance in hours 1,700Standard cost 0.30Variable production overhead efficiency variance in (K) 510 (F)Fixed production overhead variances

Absorption costing

Total Fixed production overhead variance is difference between fixed production overhead incurred and fixed production overhead absorbed.

Actual fixed overhead – (actual hours worked x F.OAR*)

150

*fixed overhead absorption rate, i.e. budgeted fixed overhead/total budgeted hours of production

Divided into1. Fixed production overhead expenditure variance is the difference

between the budgeted fixed production overhead expenditure and actual fixed production expenditure.

Actual fixed overhead – budgeted fixed overhead

2. Fixed production overhead volume variance- difference between actual and budgeted production or volume multiplied by the standard absorption rate per unit.

(Actual hours – standard hours for actual production) x F.OAR

Fixed production overhead total variance k Fixed overhead absorbed (4850 x 7.40) 35,890

Fixed overhead incurred 42,300Fixed production overhead total variance 6,410 (A)

Fixed production overhead expenditure variance kBudgeted expenditure (5100 x 7.40) 37,740

Actual expenditure 42,300Fixed production overhead expenditure variance 4,560 (A)

Fixed production overhead volume variance unitsBudgeted volume 5,100

Actual volume 4,850Fixed overhead volume variance in units 250Absorption rate 7.4Fixed production overhead volume variance in (K) 1,850(A)

Fixed production overhead volume variance can be further be split into:

1. Volume efficiency variance is the difference between standard hours that should have been worked and the actual hour worked, indicates a failure to utilize capacity efficiently,

(Actual hours worked – standard hours of actual production) x F.OAR

2. Volume capacity variance this is the difference between the budgeted hours of work and the actual active hours of work (excluding idle time), indicates a failure to utilize capacity at all

Budgeted fixed overhead – (actual hours worked x F.OAR)

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Fixed production overhead volume efficiency varianceunits

4850 units should have taken (x2) 9,700Actual hours 8,000

Fixed production overhead volume efficiency variance (units) 1,700Fixed absorption rate per hour 3.7Fixed production overhead volume efficiency variance in (K) 6,290 (F)

Fixed production overhead volume Capacity variance kBudgeted hours of work (5100 x 2) 10,200

Actual hours 8,000Fixed production overhead volume capacity variance 2,200Fixed absorption rate per hour 3.7Fixed production overhead volume capacity variance in (K) 8,140 (A)

Capacity variance + Efficiency variance = Volume variance6,290 - 8,140 = 1,850 (A)

Marginal costingIn marginal costing only a fixed production overhead expenditure variance is calculated because the assumption would be that fixed costs do not change as activity change, and hence total fixed costs variance would be the fixed overhead expenditure variance.

Operating Statement

An operating statement is a report, usually to senior management, at the end of a control period, reconciling budgeted profit for the period to actual profit. OR

Is a report for management, normally prepared on a regular basis showing actual costs and revenues, usually comparing actual with budget showing variances.

Usually an operating statement is produced to report all variances to the management at the end of control period.

Operating Statement Budgeted Profit XXXVariances

-Favourable XXX-Adverse (XXX)

Actual Profit XXX Standard absorption costing Operating Statement

K K K

Budgeted sales (5100 x 20) 102 000

Budgeted cost of sales (5100 x 14) 71400

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Budgeted profit (5100 x 6) 30,600

Sales Price variance 1,400 (A)Sales Volume variance 1,500 (A)

2,900(A)Budgeted profit from actual sales 27

700 Favourable Adverse

Direct Material Price 600 Direct material Usage 500 Direct Labour Rate 200 Direct labour Efficiency 3,400 Idle time variance 1,000 Variable production o/h expenditure 200Variable production o/h Efficiency 510 Fixed production o/h Expenditure 4,560Fixed production o/h Volume capacity 8140 Fixed production o/h Volume Efficiency 6290 -

10900 14500 3,600

Actual Profit 24,100

Standard marginal costing operating statementK K K

Budgeted sales (5100x20) 102 000Budgeted variable cost of sales (5100 x 6.6) 33 660Budgeted contribution 68 340Sales price variance 1 400 (A)Sales volume contribution variance 3 350 (A) 4 750 (A)Budgeted contribution from actual sales 63 590

Favourable AdverseDirect Material Price 600 Direct material Usage 500 Direct Labour Rate 200 Direct labour Efficiency 3,400 Idle time variance 1,000 Variable production o/h expenditure 200Variable production o/h Efficiency 510 -

4 610 1 800 2 810 Actual contribution 66 400

Budget VarianceFixed production overhead 37 740 4 560 42 300Actual profit 24 100

Working backwardThe standard cost card for the trough, one of the products made by Pig Limited is as follows: K

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Direct materials 16 kg at K6 per kg 96Direct labour 6 hours at K12 per hour 72Fixed production overhead 6 hours at K14 per hour 84 252Pig reported the following variances in control period 13 in relation to the trough.

Cost variances (K) Favourable (F) Adverse (A)Direct material 18840 Direct material usage 480Direct labour rate 10598Direct labour efficiency 8478Fixed production overhead expenditure 14192Fixed production overhead volume 11592

Actual fixed production overhead cost K200, 000 and direct wages K171, 320. Pig paid K5.50 for each Kg of direct material. There was no opening or closing inventories of materials.

RequirementsCalculate the following:

a. Budgeted output.b. Actual output.c. Actual hours worked.d. Average actual wage rate per hour.e. Actual number of kg purchased and used.

Solution

a. Let budgeted output be QFixed production overhead expenditure variance = budgeted o/h – actual o/h

= K(84 Q - 200,000) = K14192 (A)Therefore 84Q- 200,000 = k1419484Q= -14192 + 200,000Q= K185, 808 ÷ 84Q= 2212 unitsTherefore the budgeted output is 2212 units

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K

b. Total direct wages cost 171320Adjustment for variances:Labour rate 10598 ALabour efficiency 8478 FStandard direct wages cost 169200

Therefore actual output = total standard cost ÷ unit standard cost= K169, 200 ÷ k72= 2350 units

c. Actual hours worked K

Total direct wages cost 171230Less labour rate variance 10598 AStandard rate for actual hours 160722÷ Standard rate per hour K12

13393.5 hoursTherefore actual hours worked is 13393.5

d. Average actual wage rate per hour = actual wages cost ÷ actual hours= K171320 ÷ 13393.5 hours= K12.79 per hour

e. Let the number of kg purchased and used be XK

X kg should have cost (X x K6) 6XBut did cost(X x K5.5) 5.5X

Direct material price variance 0.5XTherefore K0.5X = K18840X = 37680 kgTherefore the number of kilograms purchased is 37680

CHAPTER TWELVE155

PROCESS COSTING

Definition:

Is a costing method used where there is a continuous nature of production and where it is not possible to distinguish or identify specific products (units) until the point of separation (split off point).

Features of process costing

The continuous nature of production in many processes means that there will usually be opening and closing WIP (work in progress) which must be valued.

There is often a loss in process due to spoilage, wastage, evaporation, pilfering etc.

Output from the production may be a single product but there may also be a by-product and or joint products.

Products are homogeneous and are only distinguished at the split off point (separation point).

Output from one process becomes the input to the next process.Key steps in process costing

STEP1. Determine output and losses

Determine expected output Calculate normal loss and abnormal loss or gain Calculate equivalent units if there are closing work in progress

STEP2. Calculate cost per unit of output, losses, and WIP

Calculate cost per unit or cost per equivalent unitSTEP3. Calculate total cost of output, losses and WIP

In some examples this will be straight forward If there is closing and or opening WIP, a statement of equivalent units will

have to be prepared.STEP4. Complete accounts

Complete the process accounts Write up other accounts required such as abnormal loss or gain accounts

and scrap accounts.Losses in process

Losses during processes can happen through evaporation of liquids, wastage, rejected units or leakages or pilfering.

Ways of accounting for losses156

Cost per unit should be based on actual units produced (output), so any lost units have no cost at all.

Lost units have a cost, which should be charged to the income statement whenever they occur. Cost per unit would be based on units of input rather than units of output.

If some loss is to be expected it should not be given a cost. If there is some loss that shouldn’t happen it ought to be given a cost.

Normal loss and abnormal loss or gain

Normal loss or expected loss is a loss expected in the normal course of operations for unavoidable reasons.

Abnormal loss is any loss in excess of the normal loss allowance. Abnormal gain is the gain resulting when actual loss is less than the

normal or expected loss.Treatment for losses in process accounts

Normal loss or expected loss is not given any cost but if scraped its revenues are used to reduce material cost or production costs, and is credited to the process account.

Abnormal loss is given a cost as normal output units ,it is credited to the process accounts.

Abnormal gain is a cost which is debited rather than credited to the process cost accounts, it is given a negative cost and so an item of gain.

Example 1

3000 units of material are input to a process. process costs are as follows:

K

Materials 11700

Conversion cost 6300

Output is 2000 units. Normal loss is 20% of input.

Required

What value will abnormal loss and normal loss have in process account? Hints prepare the necessary accounts.

Conversion costs are costs incurred in making raw materials into finished output.

Scrap

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Scrap is a discarded material having some valueTreatment of scrap costs or revenues

Scrap value of normal losses usually deducted from the cost of materials Scrap value of abnormal loss (or abnormal gain) is usually set off against

its cost, in an abnormal loss or gain account.

SCRAP VALUE

NORMAL LOSS OR GAIN

ABNORMAL LOSS OR GAIN

Deduct scrap value from cost

deduct scrap value from cost of

of process i.e. credit process a/c

abnormal loss i.e. credit abnormal loss a/c

with scrap value of normal lossor gain

deduct scrap value from value of abnormal gaini.e. debit abnormal gain a/c

Equivalent units are notional whole units representing uncompleted work

Methods of valuing opening work in progress (WIP)

These are partly complete at the beginning of the period and are value.

1. FIFO Method (First in First out) Under this method the values of opening WIP are valued at the remaining

percentages, and closing using the percentages given It assumes that uncompleted opening stocks should be processed first

before the added materialsExample

158

The following information relates to process three of a three stage production process for the month of January 19X4

Opening stock:

300 units, complete as to:

Materials from process 2 100% costing K4,400

Added materials 90% costing K1,150

Labour 80% costing K540

Production overhead 80% costing K810

In January 19X4, a further 1800 units were transferred from process 2 at a valuation of K27, 000. Added materials amounted to K6,600 and direct labour to K3,270. Production overhead is absorbed at the rate of 150% of direct labour cost. Closing stock at 31 January 19X4 amounted to 450 units complete as to:

Process 2 materials 100%

Added materials 60%

Labour and overheads 50%

Requirements

Prepare the process 3 account for January 19X4 using FIFO valuation method.

NOTE

Fully worked units are units started and finished in the same process.

Finished goods (units) are opening stocks completed plus fully worked units

2. Weighted average cost of valuation (AVCO Method) Under this method the cost of opening stock is added to the cost incurred

during the period and, completed units of opening stocks are each given a value of one full equivalent units of production.

Opening stock count as full equivalent units of production when this method is used.

ExampleMagpie limited produces an item which is manufactured in 2 consecutive processes. Information relating to process 2 during September 19X3 is as follows:

Opening stock units 800 units

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Degree of completion: K

Process 1 materials 100% costing 4,700

Added materials 40% costing 600

Conversion costs 30% costing 1,000

During September 19X3, 3000 units were transferred from process 1 at a valuation of K18,100, added materials cost K9,600 and conversion cost were K11,800.

Closing stock at 30 September 19X3 amounted to 1000 units which were 100% complete with respect to process 1 materials, 60% with respect to added materials and conversion cost work was 40% complete.

Magpie uses a weighted average cost system for the valuation of output and closing stock.

Requirements Prepare the process 2 account for September 10X3.

Accounting for both changes in stock levels and losses

Example 1 where loss has no scrap value

Francis company has given you the following details for his company during the year 2013.

Opening stock none

Input units 2800 units

Cost of inputs K16,695

Normal loss 10% ;nil scrap value

Output to finished goods 2000 units

Closing stocks 450 units, 70% complete

Total loss 350 units

Requirements

Prepare the process account for the period

Changes in stock levels, loss and scrap value

Example1

160

The following information relates to process 2 of a three stage production process for an accounting period, period 8

Materials input from process 1 5000 units @ K1.85 per unit

Materials added K2,245

Direct labour K4,320

Overheads K3,090

Number of units scrapped 800 units

Opening stock was 600 units , complete as to: K

Materials from process 1 100% costing 945

Added materials 60% costing 180

Labour 30% costing 405

Overheads 30% costing 135

Work progress at period end (closing WIP): 1000 units complete as to:

Materials from process 100%

Materials added 75%

Labour 40%

Overhead 20%

Normal loss is taken at 10% of input during the period. Scrap value of any loss is K0.50 per unit.

Requirements

Prepare the process account and the abnormal loss account and scrap account

ASSIGNMENT: prepare the process account using AVCO method using above example.

Example 2

161

Coffen splatter ltd manufactures processed goods and the following information relates to process 2 during September 19X2

Work in progress: opening stock 300 units, cost K2,000 and closing stocks 400 units

The degree of completion of both opening and closing stocks was as follows:

Process 1 costs 100%

Added materials in process 2 60%

Conversion cost 30%

During the month, 2000 units were input were transferred from process 1 at a valuation of K10,000. Other costs in process were:

Added materials K4,650

Labour and overheads K3,580

Units are inspected in process 2 when added materials are 50% complete and conversion cost 30% complete. No losses are normally expected but during September 19X2, actual loss at the inspection stage was 200 units which were sold as scrap for K2 each.

The company uses a FIFO method of stock valuation

Requirements

Prepare the process 2 account and abnormal loss account for September 19X2.

Example 3

You are required to prepare the process account, abnormal loss or gain account and scrap account for a single process for the current period, given the following information:

Opening WIP of 1000 units, valued at K 1595 and complete as

Materials input from previous process 100%

Materials added 75%

Labour 40%

Overhead 20%

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Costs during the period were:

Materials input 8000 units at K0.94375 per unit

Materials added K3,870

Direct labour K2,640

Overheads K1,980

The number of units scrapped 500 units

Closing WIP 2000 units Complete as to:

Materials input 100%

Materials added 50%

Labour 40%

Overheads 30%

Normal loss is taken of 10% of production. Scrap value of any loss is K0.4375 per unit.

CHAPTER THIRTEEN

JOINT PRODUCTS AND BY-PRODUCTS

Joint products: are two or more products which are output from the same operation, but are indistinguishable from each other up to the split-off point.

Joint products often require further processing before they are ready for sale.

By-products: is a product which is similarly produced at the same time and from the same process as the main product or joint products.

Differences between joint products and by-products

joint products are regarded as important saleable items and so it should be costed whilst by-products are not costed for whatever revenues received from their sales

joint products profitability are assessed in the cost accounts while by-products are taken as bonus for the company

Joint products have a relatively high sales value while a by-products sales value is relatively low.

Methods of costing joint products

Physical measurement method or unit basis method

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Sales value apportionment methods at split off point Sales value less further process costs Weighted average method Gross profit percentage method

Examples

Physical measurement method or unit basis method

When using this method, the cost allocation of joint costs to joint product is in proportion to the volume of each product. Each product is assumed to receive similar benefits from the joint costs and is therefore charged with its proportionate share of the total cost.

Formula = volumeof untsTotalnumber of units produced × joint costs

The method assumes constant unit costs for each product regardless of its selling price.

Products 1 and 2 incur joint costs to the point of separation of K3000 and the output of each product is 600 tons and 1200 tons respectively.

joint product 1process A cost K2000

process B cost K1000 600 tons

joint product 21200 tons

Product 1 sales for K4 per ton and product 2 for K2 per ton.

Requirements

Calculate the cost of joint products using physical measurement methods and their profit statements.

When to use Physical Measurement

Physical measurement method of allocating joint costs to joint products can only be used when the products consume the same amounts of joint costs per unit

This method is also applicable when the joint products are measurable by the same unit of measurement such as liters

Limitations164

The method does not take into account the relative income earning potentials of the individual products with the result that one product might appear very profitable and another appear to be incurring losses.

Sales values method

This method allocates joint costs to joint products proportionate to their estimated sales values at cut-off point. This is on the basis that higher selling prices indicate higher production costs.

Example 1

Products 1 and 2 incur joint costs to the point of separation of K3000 and the output of each product is 600 tons and 1200 tons respectively.

joint product 1process A cost K2000

process B cost K1000 600 tons

joint product 21200 tons

Product 1 sales for K4 per ton and product 2 for K2 per ton.

Requirements

Calculate the cost of joint products using physical measurement methods and their profit statements.

When To Use Sales Value Method

The sales value method is used when the joint costs are directly related to the selling price, that’s when the selling prices are determined by prior production costs.

Limitations165

The method assumes that selling prices or the sales value are dependent on prior joint costs which is inaccurate.

It raises problems when allocating joint costs at split-off point when the selling prices are not readily available or are fluctuating.

Sales value less further process cost method ( net realisable value)

Sometimes the products which emerge from the split-off point are not saleable without further processing. It follows therefore that at the split-off point sales values are not known so that joint costs cannot be apportioned until the net realizable value of the joint costs at the split-off point is found.

The net realizable value is found by deducting subsequent processing costs from the final sales value.

Example

John telly made ltd has a factory where four products are originated in a common process. During period 4, the costs of common process were K16,000. Output was:

Units made units sold sales value per unit

Products P1 600 - -

Product Q1 400 - -

Product R 500 400 K7

Product S 600 450 K10

Product P1 and Q1 are further processed, separately to make end-products P2 and Q2.

Units units sold cost of sales value processed further process

per unit

Products P1/P2 600 600 K1000 P2, K10

Products Q1/Q2 400 300 K2500 Q2, K20

Requirements

What were the costs of each joint product and what was the profit from each in period 4. There were no opening stocks.

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When To Use Net Realizable Method

This method is used when the products are sold only after further processing and is also used when selling prices are certain so that you can calculate sales value at split-off point.

Weighted average method

It is a development of physical measurement method. Since units of joint product may not be comparable in physical resemblance of physical weight units of each joint product may be multiplied by a weighting factor and weighted units would provide a basis for apportioning the common costs.

Example

Margas limited manufactures four products which emerge from a joint processing operation in April 2016 the cost of the joint production process were as follows:

K

Direct materials 24, 000.00Direct labour 2, 000.00 Total 26000.00

Production overheads are added using an absorption rate of 400% direct labour cost.

Output from the process during April 2016 was as follows:

Joint product output

D 600 litres

E 400 litres

F 400 kg

G 500 kg

For the purposes of apportioning joint costs, units of output of D, E, F, and G are given a weighing of 3, 5, 8 and 3 respectively.

Total costs are 26, 000 for direct costs plus K8, 000 overheads.

Requirements

Apportion the joint costs using the weighted average method

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Gross profit percentage method

Normally gross profit percentages are different after split–off point for each product when the net realizable method is used. Some accountants argue that since the different products arise from a single productive process, they must earn identical gross profit percentage. This method allocates joint costs so that overall gross profit percentage is identical for each individual product.

Products Units produced

Weight attached to each unit

Selling price per unit at cut-off point

Selling price after further processing

Further processing costs per unit

F 70 3 K400 K600 K50G 60 4 K300 K450 K70H 40 7 K200 K400 K60I 30 9 K200 K500 K40

If total joint costs were K50, 000

Requirements

Apportion the joint costs using the gross profit percentage method

Solution

Total productioncost=¿ Joint costs + futher processing costs

¿50,000+11,300

= 61,300

sales value after further processing – total productioncost=K 100,000−K 61,300

¿K 38,700

∴gross profit%= 38,700100,000

×100%

¿38.7%

Product F G H I

Sales Value(K)

42,000 27,000 16,000 15,000

Less Gross Profit(K)

(16,254) (10,449) (6,192) (5,805)

Cost of goods sold(K)

25,746 16,551 9,808 9,195

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Less further processing costs(K)

(3,500) (4,200) (2,400) (1,200)

Joint costs allocated(K)

22,246 12,351 7,408 7,995

When to Use Gross Profit Percentage Method

This method is applicable when there is a uniform relationship of cost and sales value for each individual product.

Limitations

The method has a shortfall of assuming identical gross profit percentages for individual products in multi-product firms that do not involve joint costs.

Methods of costing by products

Income from sales of by-products taken as other sources of income Income from sales of by-products added to sales of the main product Income from sales of by-product deducted from cost of production Net realizable value of the by-products deducted from cost of production

169