ACCA F2 Course Notes

F2 Course notes
Chapter 1
THE NATURE AND PURPOSE OF
MANAGEMENT ACCOUNTING
1.1 ACCA SYLLABUS GUIDE OUTCOME 1
Describe the purpose and role of cost and management accounting within an
organisation.
The purpose of cost and management accounting is to provide financial information

to managers that will help them to plan the activities, control the activities for which
they are responsible and see the financial implications of any decisions they may
take. It serves management by providing information for planning, decision-making
and control. It collects, manages and reports information in demand by managers,
employees and decision makers internal to the organisation.
Management information is generally supplied in the form of reports. Reports may be

routine (monthly management accounts) or prepared for a specific purpose (e.g.
one-off decisions).
Cost accounting and management accounting are terms which are often used
interchangeably. It is not correct to do so.
Cost accounting is part of management accounting. Cost accounting is mainly

concerned with:
Preparing statements (e.g. budgets, costing)

Cost data collection
Applying costs to inventory, products and services
Therefore, management accounting goes beyond cost accounting. In general, cost

accounting information is unsuitable for decision-making.
2
1.2 ACCA SYLLABUS GUIDE OUTCOME 2:
Compare and contrast financial accounting with cost and management
accounting
Management Financial Accounting

Accounting
1. Users and decision- Internal use External use
makers management and shareholders, banks,
employees government
2. Purpose of information To aid in planning, To record the financial
decision-making and performance and position
control of the business
3. Legal requirements None Limited companies must
produce financial
statements
4. Formats Management decide the According to company
best way to present law
information
5. Nature of information Mostly monetary; but also Monetary information
nonmonetary information
6. Time period Historical and forward- Mainly historical
looking
Lecture Example 1
The following assertions relate to financial accounting and to cost accounting:
(i) The main users of financial accounting information are external to an

organisation.
(ii) Cost accounting is that part of financial accounting which records the cash
received and payments made by an organisation.
Which of the following statements are true?
A. Assertions (i) and (ii) are both correct.

B. Only assertion (i) is correct.
C. Only assertion (ii) is correct.
3
Outline the managerial processes of planning, decision making and control.
The main functions of management are: -

1. planning
2. decision-making
3. control
1.3.1 Planning
Planning involves establishing objectives and selecting appropriate strategies to

achieve these objectives. An objective is the aim or goal of an organization. A
strategy is a possible course of action that might enable an organisation to achieve
its objectives.
Planning can be either short-term (tactical and operational planning) or long-term

(strategic planning). We will be discussing these three types of planning in outcome
4.
1.3.2 Decision Making
Managers of all levels within an organisation take decisions. Decision making always
involves a choice between alternatives; e.g. decide on the selling price to charge for
a new product introduced on the market.
The first part of the decision-making process is planning. The second part is control.
1.3.3 Control
Managers use the information relating to actual results to take control measures and
to re-assess and amend their original budgets or plans. Actual performance of the
organisation is compared against detailed operational plans; e.g. check whether the
company is over or under spending on materials. Any deviations from the plans are
identified and corrective action is taken.
A management control system measures and corrects the performance of activities

of subordinates in order to make sure that the objectives of an organization are being
met and the plans devised to attain them are being carried out.
4
Explain the difference between strategic, tactical and operational planning.
LONG TERM
SHORT TERM
DAY-TO-DAY
5
1.4.1 Strategic Planning
Senior management formulate long-term (e.g. 5 to 10 years) objectives and plans for
an organization. Such plans include overall profitability, the profitability of different
segments of the business, capital equipment needs and so on.
1.4.2 Tactical Planning
Senior management make medium-term, more detailed plans for the next year, for
e.g. decide how the resources of the business should be employed, and to monitor
how they are being and have been employed. An example would be: - how many
people should be employed next year?
1.4.3 Operational Planning
All managers are involved in making day-to-day decisions. 'Front-line' managers

such as foremen or senior clerks have to ensure that specific tasks are planned and
carried out properly within a factory or office.
Operational information is derived almost entirely from internal sources. It is

prepared frequently and is highly detailed. It is mainly quantitative.
Lecture Example 2
Which of the following statements are correct?
(i) Strategic information is mainly used by senior management in an

organisation.
(ii) Productivity measurements are examples of tactical information.
(iii) Operational information is required frequently by its main users.
A. (i) and (ii) only

B. (i) and (iii) only
C. (ii) and (iii) only
D. (i), (ii) and (iii)

Distinguish between cost, profit, investment and revenue centres.
Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area. An area of responsibility may be structured as: -
6
1.5.1 Cost centre
A cost centre is a production or service location, function, activity or item of

equipment whose costs are identified and recorded; e.g. manufacturing department,
purchasing department and paint shop.
1.5.2 Revenue centre
A revenue centre is accountable for revenues only. Revenue centre managers

should normally have control over how revenues are raised; e.g. retail outlet, sales
department and airline reservation department.
1.5.3 Profit centre
A profit centre is a part of the business for which both costs and revenues are
identified; e.g. product division
1.5.4 Investment centre
An investment centre is a profit centre with additional responsibilities for capital

investment and possibly for financing, and whose performance is measured by its
return on capital employed (ROCE); e.g. subsidiary company
Cost centres, revenue centres, profit centres and investment centres are also known
as responsibility centres.

Describe the differing needs for information of cost, profit, investment and
revenue centre managers.
1.6.1 Cost centres
Cost centre managers will want information regarding cost of material, labour,
expenses and overheads. The performance of the manager is judged on the extent
to which cost targets have been achieved.
1.6.2 Revenue centres
Revenue centre managers will want information on markets and new products and
they will look closely at pricing and the sales performance of competitors in
addition to monitoring revenue figures
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1.6.3 Profit centres
Profit centre managers will want information regarding both revenues and costs.
They will be judged on the profit margin achieved by their division.
1.6.4 Investment centres
Investment centre managers will want the same information as the profit centre
manager and in addition they will require quite detailed appraisals of possible
investments and information regarding the results of investments already
undertaken.
Lecture Example 3
For which of the following is a profit centre manager responsible?
A. Costs only
B. Revenues only
C. Costs and revenues
D. Costs, revenues and investments

Distinguish between data and information.
Data is the raw material for data processing. Data relate to numbers, letters,
symbols, raw facts, events and transactions which have been recorded but not yet
processed into a form suitable to make decisions. Data on its own is meaningless.
Information is data that has been processed so that it will be meaningful to the
person who receives it. It improves the quality of decision making.
DATA PROCESS INFORMATION
It is the management accountant who is expected to provide the information to

management to assist them with their decisions.
Most organizations require the following types of information:-

1. Financial e.g. costs of heat and light, capital costs, etc.
2. Non-financial, e.g. attendance records, details of the number of meals served
each day, etc.
3. A combination of financial and non-financial information
8
While management accounting is mainly concerned with the provision of financial
information to aid planning, decision making and control, the management
accountant cannot ignore non-financial influences and should qualify the information
provided with non-financial matters as appropriate.
Lecture Example 4
Data is information that has been processed in such a way as to be meaningful to its
recipients.
Is this statement true or false?
A. True
B. False

Identify and explain the attributes of good information
Good information should be ACCURATE.
Accurate - Information should be accurate because using incorrect information could

have serious and damaging consequences.
Complete - An information user should have all the information he needs but it
should not be excessive.
Cost-effective - The benefits obtainable from the information must exceed the costs
of acquiring it. The value of information results from actions by decision makers who
use the information to improve profitability.
Understandable - Information must be clear to the user. If the user does not
understand it properly he cannot use it properly.
Relevant - Information must be relevant to the purpose for which a manager wants to
use it.
Accessible Information should be accessible via the appropriate channels of

communication and to the right people.
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Timely - Information which is not available until after a decision is made will be useful
only for comparisons and longer-term control, and may serve no purpose even then.
Information prepared too frequently can be a serious disadvantage.
Easy to Use
Lecture Example 5
The following statement refers to a quality of good information:

The cost of producing information should be greater than the value of the benefits of
that information to management.

A. True
B. False

Explain the limitations of management information in providing guidance for
managerial decision-making
Management accounting information may fail to meet its objective of assisting

management in the decision making process. Why?
1. Failure to meet the requirements of good information listed above
2. The problem of relevant costs and revenues
The figures presented to assist in management decision-making are those

that will be affected by the decision, i.e. they should be:
Future ignoring costs (and revenues) that have already been

incurred sunk costs
Incremental ignoring items such as the reapportionment of existing,

unchanging fixed costs
Cash flows ignoring book values, historical costs, depreciation

charges.
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3. Non-financial information
Managers must not only look at quantitative information. They should also
consider qualitative, behavioural, motivational, even environmental factors,
when taking decisions.
4. External information
Should we focus only on information derived internally? No, we should

consider what is happening around us, including what our competitors are
doing, any changes in legislation etc.
11
KEY NOTES
12
1. The purpose of cost and management accounting is to provide financial
information to managers that will help them to plan the activities, control the
activities for which they are responsible and see the financial implications of
any decisions they may take.
2. Cost accounting is mainly concerned with establishing inventory valuation,

cost accumulation and product costing. Management accounting is not only
concerned with historical information; it is also forward-looking, e.g. budgets
and forecasts.
3.
Management Financial Accounting
Accounting
1. Users and decision- Internal use External use
makers management and shareholders, banks,
employees government
2. Purpose of information To aid in planning, To record the financial
decision-making and performance and position
control of the business
3. Legal requirements None Limited companies must
produce financial
statements
4. Formats Management decide the According to company
best way to present law
information
5. Nature of information Mostly monetary; but also Monetary information
nonmonetary information
6. Time period Historical and forward- Mainly historical
looking
4. The main functions of management are: -

planning
decision-making
control
5. Strategic Planning
Senior management formulate long-term (e.g. 5 to 10 years) objectives and
plans for an organization.
13
6. Tactical Planning
Senior management make medium-term, more detailed plans for the next
year
7. Operational Planning
All managers are involved in making day-to-day decisions. Operational
information is derived almost entirely from internal sources. It is prepared
frequently, is highly detailed and is mainly quantitative.
8. A management control system is a system which measures and corrects the

performance of activities of subordinates in order to make sure that the
objectives of an organization are being met and the plans devised to attain
them are being carried out.
9.
Responsibility Centre Authority Level

Cost centre Control of costs
Revenue centre Control of revenues
Profit centre Control of revenues and costs
Investment centre Control of revenue, costs and certain
balance sheet items, often fixed assets
perhaps inventory levels and debtor
management
10. Data is the raw material for data processing. Information is data that has been
processed in such a way as to be meaningful to the person who receives it.
DATA PROCESS INFORMATION
11. Good information should be ACCURATE.
Accurate
Complete
Cost-effective
Understandable
Relevant
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Accessible
Timely
Easy to use
12. Limitations of Management Accounting Information
a. Failure to meet the requirements of good information listed above

b. The problem of relevant costs and revenues
c. Non-financial information
d. External information
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QUESTIONS
16
1. A strategy is the aim or goal of an organisation.
A. True
B. False
2. Higher level management take: -

A. Short-term decisions
B. Long-term decisions
C. Short-term and long-term decisions
3. Which of the following statements is not correct?

A. Financial accounting information can be used for internal reporting
purposes
B. Cost accounting can also be used to provide inventory valuations for
external reporting
C. There is no legal requirement to prepare management accounts
D. Management accounts detail the state of affairs of an organisation at
the end of that period
4. Which of the following is a characteristic of an investment centre?

A. Managers can purchase capital assets
B. Managers have control only over marketing
C. Managers are accountable for revenues only
D. Managers are accountable for costs only
5. Management accounting produces information

A. To meet internal users needs
B. To meet a users specific needs
C. Often focusing on the future
D. All of these
6. A management control system is

A. A possible course of action that might enable an organisation to
achieve its objectives
B. A collective term for the hardware and software used to drive a
database system
C. A set up that measures and corrects the performance of activities of
subordinates in order to make sure that the objectives of an
organisation are being met and their associated plans are being carried
out
D. A system that controls and maximizes the profits of an organisation
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ANSWERS
18
1. B
2. C
3. D
4. A
5. D
6. C
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Chapter 2
SOURCES OF INFORMATION
Different sources of information are available to organisations, including those
available within and outside the organisation. Such information will become the input
into an organisations decision making and management accounting systems.
Classification of data
Data can be classified as: -
1. Primary vs secondary data

2. Discrete vs continuous data
3. Sample vs population data
1. Primary data are data collected especially for a specific purpose, e.g. raw
data.
Secondary data are data which have already been collected elsewhere, for
some other purpose but which can be used or adapted for the survey being
conducted, e.g. official statistics, data obtained from financial newspapers,
trade journals, etc.
2. Discrete data are data which can only take a finite or countable number of
values within a range, e.g. you cannot have 1.25 units but 1 unit, 2 units etc.
Continuous data are data which can take on any value. They are measured
rather than counted, e.g. a person can be 1.585m tall.
3. Sample data are data arising as a result of investigating a sample. A sample

is a selection from the population.
Population data are data arising as a result of investigating the population. A
population is the group of people or objects of interest to the data collector.
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Describe sources of information from within and outside the organisation
(including government statistics, financial press, professional or trade
associations, quotations and price list.
Explain the uses and limitations of published information/data (including
information from the internet).
Data may be obtained from an internal source or an external source.
2.1.1 Internal Sources of Information
Internal information may come from various sources.
2.1.1.1 Accounting System
The accounting system provides us with loads of information relating to expenses,

income, revenues etc. It helps us to identify any increase in costs, any losses we
may be doing in any department, branch etc.
2.1.1.2 Payroll System
The payroll system provides us with important information relating to our employees,
hours of work, output, employee turnover etc.
2.1.1.3 Strategic Planning System
What information does this strategic planning system provide us with? It may
provide information about the companys targets and objectives, its capital
investment programme and any long term plans it may have. Hence, this
information can be very sensitive and may not be available to all employees within
the company but only to top management.
2.1.2 External Sources of Information
Can a business ignore the external government? No it cant if it wants to succeed.
Environmental scanning/monitoring: -
Environmental scanning is the acquisition and use of information about events,

trends, and relationships in an organization's external environment, the knowledge of
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which would assist management in planning the organization's future course of
action1
The main sources of external information are:

Government statistics
Business contacts - customers and suppliers
Professional or trade associations
The financial press
Quotations and price lists
2.1.2.1 Government Statistics
1. Provide the company with useful information about the industry, e.g. the
tourism industry. This will help both the company and the industry to decide
on the future
2. Provide information for economic planning as most information deals with the
economy as a whole
2.1.2.2 Business Contacts
Customers can provide information to the organization on such matters as:
- What they need: specifications and quality required, any specific

packaging
- Due dates for delivery
- Any feedback on the product delivered
Suppliers may be able to provide information to the organization on:
- The products they have available and their features

- Any alternative products available
- The availability of their products
1 Extracted from http://www.informationr.net/ir/7-1/paper112.html
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2.1.2.3 Professional or trade associations
Most major industries have their own trade or professional association.
E.g. The Malta Chamber of Commerce provides a central, national organization for
the representation, promotion and protection of all members interests, as well as
acting as an authoritative medium of communication between members sectors,
Government, and the EU. The Malta Chamber also aims to establish and support
initiatives which lead to the establishment of new business ventures and employment
opportunities.2
2.1.2.4 The Financial Press
In the UK, particular newspapers such as The Financial Times, the Guardian, The
Times and the Daily Telegraph provide statistics and financial reviews as well as
business economic news and commentary. In Malta, we have the Malta Business
Review and other journals which look into the local and foreign financial aspects.
Such information is now also widely available via electronic media and digital
television services (such as Bloomberg TV). There is also the internet as a widely
available source of up-to-date financial information. But the internet has its
limitations
2.1.2.5 The Internet
The internet is a global network allowing any computer with a telecommunications

link to send and receive information to and from any other computer. Information on
the internet is not necessarily good information. The reliability and reputation of the
provider is important.
Lecture Example 1
Which of the following are external sources of data.
i. Government statistics.
ii. The Financial Times.
iii. Data collected for a survey which was commissioned in order to determine
whether the company should launch a new product.
2 http://malta.usembassy.gov/com-link-trade.html
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iv. Historical records of expenditure on light and heat in order to prepare current
forecasts.
A. i and ii only
B. i, ii and iii only
C. i, ii and iv only
D. i, ii, iii and iv

Describe the impact of general economic environment on costs/revenues
The economic environment affects firms at national and international level, both in
the general level of economic activity and in particular factors, e.g. inflation, interest
rates and exchange rates.
Inflation affects the decisions taken by businesses. An increase in interest rates

affects cash flow especially for those businesses which carry a high level of debt.
Exchange rates affect the imports and exports of the company.
Even the state of the economy will influence the planning process of an organisation.
In times of boom, consumer demand and consumption increases. In times of
recession, the company has to focus on its survival through cost effectiveness and
competition.

Explain sampling techniques (random, systematic, stratified, multistage,
cluster and quota).
Choose an appropriate sampling method in a specific situation.
2.3.1 Introduction
Sampling:
Purpose: We need to get information from a population. Hence a predetermined

number of observations will be taken from a larger population.
24
Definitions:
Population
the set of individuals, items, or data from which a statistical sample is taken
Sample
A group of items drawn from the population and used to estimate the characteristics
of the whole population.
http://tomhopper.me/2014/11/14/sample-size-matters/
2.3.2 Sampling Techniques
A probability sampling method: - A probability sampling method is any method of

sampling that utilizes some form of random selection.
Probability sampling methods are: -
1. Random
2. Systematic
3. Stratified random
4. Multi-stage
5. Cluster
Quota sampling is a non-probability sampling method, i.e. the samples are gathered
in a process that does not give all the individuals in the population equal chances of
being selected.
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2.3.2.1 Random Sampling
Every member of the population has an equal chance of being selected.
Each item in the population has to be numbered. In random sampling, we find the
sampling frame. What is this? A list of the items or people forming a population from
which a sample is taken.
For e.g. if I want to use simple random sampling to choose 10 students from my F2
class, I can put each name on the attendance sheet on a piece of paper, put the
papers in a bag and blindly select the name of 10 students.
This method has limitations when the population is large or not known. It does not
guarantee a representative sample BUT eliminates selection bias.
2.3.2.2 Systematic Sampling (quasi-random)
In systematic sampling, sample members from a larger population are selected

according to a random starting point and a fixed periodic interval.
Strictly speaking, systematic sampling is not 100% random as only the first item is
selected randomly.
In the following diagram, we have selected randomly the 2 nd person in the list, then
every 3, will be included in the sample.
http://www.snipview.com/q/Systematic_sampling
26
E.g. I would like to sample 8 houses from a long street which has 120 houses. This
means that every 15th house is chosen (120/8) after a random starting point is
chosen.
Limitations:
A systematic random sample can only be carried out if a complete list of the
population is available. Also there is the danger of bias.
2.3.2.3 Stratified Sampling
We need to divide the entire population into different subgroups or strata, then
randomly select the final subjects proportionally from the different strata. How does it
work? We can divide our population into smokers and non-smokers. A random
sample is taken from each group. But the number in each sample must be
proportional to the size of that group in the population - probability proportional to
size. Hence, a representative cross-section of the strata in the population is
obtained.
https://sites.google.com/a/whps.org/mrs-murray-s-math-site/unit-1---intro-to-statistics
Auditors use frequently this method to choose a sample to confirm receivables

balances. What happens is that they select a greater proportion of larger balances.
27
2.3.2.4 Cluster Sampling
In cluster sampling, we need to take several steps in gathering the sample

population.
For example, a researcher wants to survey academic performance of high school

students in Malta.
1. He can divide the entire Maltese population into different clusters (cities).
2. Then he selects a number of clusters using simple or systematic random
sampling.
3. Then, from the selected clusters (randomly selected cities) the researcher will
interview all the students in that cluster.
2.3.2.5 Multi-stage Sampling
Multi-stage sampling is similar to cluster sampling BUT a sample is taken from the
final group.
Advantages
It takes less time to do than cluster sampling

Normally more accurate than cluster sampling for the same size sample
Disadvantages
Not as accurate as simple random sampling

More testing is difficult to do
2.3.2.6 Quota Sampling
In quota sampling, a population is first segmented into mutually exclusive sub-

groups, just as in stratified sampling. Then judgment is used to select the subjects or
units from each segment based on a specified proportion.
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For example, an interviewer may be told to sample 200 females and 300 males
between the age of 45 and 60. This means that individuals can put a demand on
who they want to sample (targeting ).3
Lecture Example 2
Under which sampling method does every member of the target population have an
equal chance of being in the sample?
A. Stratified sampling
B. Random sampling
C. Systematic sampling
D. Cluster sampling
Lecture Example 3
A publishing company is researching the reading habits of the United Kingdoms

population. It randomly selects a number of locations from around the United
Kingdom and then interviews everyone who lives in these locations.
What is this approach to sampling known as?
A. Systematic sampling
B. Stratified sampling
C. Quota sampling
D. Cluster sampling
3 https://en.wikipedia.org/wiki/Quota_sampling
29
Lecture Example 4
Which of the following are disadvantages of systematic sampling?
i. The sample chosen might be biased

ii. Some samples have a zero chance of being selected so sampling method is
not completely random
iii. Prior knowledge of each item in the population is required
A. i and ii
B. ii and iii
C. iii only
D. ii only
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KEY NOTES
31
1. Data may be primary (collected specifically for the purpose of a survey) or
secondary (collected for some other purpose). Discrete data can only take on
a countable number of values. Continuous data can take on any value.
Sample data arises as a result of investigating a sample. Population data
arises as a result of investigating the population.
2. Internal information may come from various sources: -
a. Accounting system
b. Payroll system
c. Strategic planning system
3. External information may come from various sources: -
a. Government sources
b. Business contacts - customers and suppliers
c. Trade associations and trade journals
d. The financial and business press and other media
4. The economic environment affects firms at national and international level,

both in the general level of economic activity and in particular factors, e.g.
inflation, interest rates and exchange rates.
5. The purpose of sampling is to gain as much information as possible about the

population by observing a sample.
6. The term population is used to mean all the items under consideration in a
particular enquiry.
7. A sample is a group of items drawn from that population
8. A probability sampling method is a sampling method in which there is a known

chance of each member of the population appearing in the sample.
9. A non-probability sampling method is a sampling method in which the chance

of each member of the population appearing in the sample is not known.
10. Random Sampling

A sample taken in such a way that every member of the population has an
equal chance of being selected. The normal way of achieving this is by
numbering each item in the population sampling frame. This method has
obvious limitations when either the population is extremely large or, in fact not
known.
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11. Systematic Sampling (quasi-random)
Only the first item is selected randomly. Then, each nth item is chosen.
12. Stratified Sampling

A random sample is taken from each group in a population in proportion to the
size of the group
13. Multi-Stage Sampling

A population is split into groups and some groups are selected randomly.
Each group is then sub-divided into further groups and a selection made
randomly. The process continues until a random sample is taken from the final
groups selected.
14. Cluster Sampling

Similar to a multi-stage sample except that all items are selected from the final
groups.
15. Quota Sampling

A sample where items, usually people, are selected in given quantities and
according to pre-defined characteristics.
33
QUESTIONS
34
1. The population is divided into several groups and a sample is chosen to
represent the make-up of the population. A sample from each age group is
selected in the same proportion as the estimate of the population as a whole.
C. Quota sampling
D. Cluster sampling
2. The population is divided into smaller and smaller groups until small enough
to sample all of the people in the final group.
C. Quota sampling
D. Cluster sampling
3. Which of these statements are true?

i. If a sample is selected using random sampling, it will be free from bias
ii. A sampling frame is a numbered list of all items in a sample
iii. Cluster sampling is a non-probability sampling method
iv. In quota sampling, investigators are told to interview all the people they
meet up to a certain quota
A. all of the statements

B. i, ii and iv only
C. i and ii only
D. i and iv only
4. The essence of systematic sampling is that
A. every nth item of the population is selected

B. every element of one definable sub-section of the population is selected
C. each element of the population has an equal chance of being chosen
D. members of various strata are selected by the interviewers up to
predetermined limits
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ANSWERS
36
1. B
2. D
3. D
4. A
37
Chapter 3
COST CLASSIFICATION
Explain and illustrate production and non-production costs
For the preparation of financial statements, costs are often classified as: - production
and non-production costs.
3.1.1 Production costs
Production costs are costs identified with goods produced for resale. Production
costs are all the costs involved in the manufacture of goods, i.e. direct material,
direct labour, direct expenses, variable production overheads and fixed production
overheads.
3.1.2 Non-production costs
Non-production costs are not directly associated with production of manufactured

goods. They are taken directly to the income statement as expenses in the period in
which they are incurred; such costs consist of administrative costs, selling and
distribution expenses, and finance costs.

Describe the different elements of production cost - materials, labour and
overheads
Costs can be classified by element: materials, labour and overheads (expenses).
3.2.1 Materials
This includes all costs of materials purchased for production or non-production

activities, e.g. raw materials and components.
3.2.2 Labour
This includes all staff costs relating to employees.
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3.2.3 Overheads
Overheads include all other costs which are not materials or labour. These include
rent, telephone, and depreciation of equipment.
Production Costs
Direct Direct Direct Variable Fixed

Material Labour Expenses production production
overheads overheads

Describe the different elements of non-production costs - administrative,
selling, distribution and finance.
3.3.1 Administrative costs
These include all the costs involved in running the general administration department
of an organization.
Examples of administrative costs include: -

Depreciation of office buildings and equipment.
Office salaries, including salaries of directors, secretaries and accountants.
Rent, rates, insurance, lighting, cleaning, telephone charges and others.
3.3.2 Selling costs
Selling costs include all costs incurred in promoting sales and retaining customers.
Examples of selling costs are: -

Salaries and commission of salesmen and sales department staff.
Advertising and sales promotion, market research.
Rent, rates and insurance of sales offices and showroom.
39
3.3.3 Distribution costs
Distribution costs include all costs incurred in making the packed product ready for
dispatch and delivering it to the customer.
Examples of distribution overhead are:

Delivery costs
Wages of packers, drivers and despatch clerks.
Insurance charges, rent, rates and depreciation of warehouse.
3.3.4 Finance costs
Finance costs include all the costs that are incurred in order to finance an
organization, for e.g. loan interest.
Non-Production Costs
Administrative Selling Distribution Finance

costs costs costs costs
Total costs = Production costs + Non-Production costs
Non-production costs are taken directly to the income statement as expenses in the
period in which they are incurred.
Lecture Example 1
Indicate whether each event results in the incurrence of a production cost or a

selling, distribution, administration or finance cost.
i. Paid wages to production workers

ii. Paid advertising
iii. Purchased cars for sales staff
iv. Used general office supplies
v. Used raw materials in the manufacturing process
vi. Paid wages to factory supervisors
vii. Paid loan interest
40
Lecture Example 2
A manufacturing organisation incurs costs relating to the following:
(1) Commission payable to salespersons.

(2) Inspecting all products.
(3) Packing the products at the end of the manufacturing process prior to moving
them to the warehouse.
Which of these costs are classified as production costs?
A. (1) and (2) only

B. (1) and (3) only
C. (2) and (3) only
D. (1), (2) and (3)

Explain and illustrate with examples classifications used in the analysis of the
product/service costs including by function, direct and indirect.
Direct and Indirect Costs
Direct costs: - these are costs which can be directly identified with a specific cost
unit or cost centre. There are 3 main types of direct cost: -
Direct materials: - materials used in making and selling a product (or even
providing a service); e.g. raw material, packing material.
Direct labour: - the specific costs of the workforce used to make a product or
provide a service.
Direct expenses: - any expenses which are incurred on a specific product

other than direct material cost and direct wages, e.g. depreciation of machine
used in the production of the goods.
Direct Materials + Direct Labour + Direct Expenses = PRIME COST
Indirect costs: - these are costs which cannot be directly identified with a specific
cost unit or cost centre. These costs cannot be easily traced to a specific product.
Indirect materials: - those costs which cannot be traced in the finished

product. E.g. oil for machine in a production line.
41
Indirect labour: - all wages not charged directly to a product. These include
wages of non-productive personnel in the production department, example
supervisor.
Indirect expenses: these are costs not directly charged to production.

Examples are rent, rates and insurance of a factory, depreciation, fuel, power,
maintenance of plant, machinery and buildings.
Indirect Materials + Indirect Labour + Indirect Expenses = Overheads
Lecture Example 3
Identify whether the following costs are direct or indirect materials, labour or
expenses.
i. Wages of factory production workers

ii. Salaries of factory supervisors
iii. Rent of a factory
iv. Oil for lubricating machines
v. Packing material
Lecture Example 4
Which one of the following should be classified as indirect labour?
A. Assembly workers on a car production line

B. Bricklayers in a house building company
C. Machinists in a factory producing clothes
D. Forklift truck drivers in the stores of an engineering company.
Classification by Function
Classification by function involves classifying costs as production/manufacturing

costs, administration costs or marketing/selling and distribution costs. These costs
have been defined earlier on in this chapter. Note that expenses that do not fall into
one of these classifications might be categorized as general overheads or even
listed as a classification of their own, e.g. research and development costs.
42
Please note that research costs are the costs of searching for new or improved
products. Development costs are the costs incurred between the decision to produce
a new or improved product and the commencement of full manufacture of the
product.

Explain and illustrate the use of codes in categorising transaction4
A code is a system of symbols designed to be applied to a classified set of items to

give a brief accurate reference, facilitating entry, collation and analysis 5.
A cost coding system is therefore based on the selected cost classifications. It

provides a way of expressing the classification of each cost in a shortened
symbolized form.
To use descriptions only of the items would lead to ambiguities and difficulties in
recording and processing the information. The items need to be logically coded. For
example, 5 cm brass plates may be coded as 05677 and no other class of item
should be coded the same.
The advantages of a coding system
Some of the advantages of a well-designed coding system are:
1. It is more suitable than a description in computerised system.

2. A code reduces ambiguity.
3. A code is usually briefer than description.
The requirements for an efficient coding system
The codes will either be all numerical or all alphabetical.

The codes will be brief, have a logical structure and be of the same length- for
example, 5 digits long.
There will be no ambiguities in the codes and the system must be such that all
items can be assigned a code.
The code must be capable of expansion so that new items can be
accommodated.
The control of the coding system will be centralised to avoid the proliferation
and duplication of codes.
4 Based on Kaplan, CAT, T5, 2008

5 CIMA definition
43
3.5.1 Types of Code
1. Composite codes:
The CIMA terminology describes the use of composite symbols in codes. The first
three digits in the composite code might indicate the nature of the expense whereas
the last three digits might indicate the cost centre or the cost unit to be charged.
For example:
Symbol 892.133 means:
8 labour
9 semi-skilled
2 grade 2
These codes are showing this was semi-skilled labour
1 indirect cost
1 Factory XYZ
3 finishing department
This code shows us this labour expenditure is to be charged as indirect labour
to the finishing department in factory XYZ
2. Sequence (or progressive) codes:
A sequential code simply follows a sequence. Imagine we are drafting a register for
employees for salary purposes. We begin with the first employee being assigned
the number 00, the second employee is assigned the number 01 and so on. In this
code, we have allowed for there to be as many as 100 employees, since we have
allocated 2 digits to the code and can assign all of the numbers from 00 to 99, 100
numbers, to that number of employees:
00 Cassar 01 Farrugia 02 Vella 03 T Borg 34 S Borg

67 Abela
If a new employee were to join this group? He would become employee 68
3. Group classification codes:
Group classification (block) codes are very common in accounting circles in that they
commonly form the basis of charts of accounts, as depicted below:
44
1000 Non-current assets
2000 - Current assets (excl. inventories)
3000 - Inventories
4000 Non-current liabilities
5000 - Current liabilities
6000 - Equity
7000 - Revenues
8000 - Expenditures
The 1000 Block is allocated to non-current assets. This means that it is possible
to classify up to 1,000 different non-current assets using this block. Of course, there
may be sub blocks so that we can extend the range of non-current assets we can
have.
4. Faceted codes:
A faceted code is one that is broken down into a number of facets or fields, each of
which signifies a unit of information. We could use a chart of accounts, that is
commonly faceted; but lets work through the faceted code of a furniture
manufacturer. Well consider a code that will deal with direct materials, direct
labour, and indirect costs.
In this example, there are three facets, or fields, to the code:

Facet 1 is the department or cost centre, and is 2 digits long
Facet 2 is the cost heading, and is 2 digits long
Facet 3 is the cost item, and is 4 digits long
Facet 1: 00 Preparation
01 Carpentry
02 Assembly
03 Finishing
04 Upholstery
Facet 2: 00 Direct materials

01 Direct labour
02 Direct expenses
03 Indirect costs
Facet 3: 0000 - 0100 Direct material descriptions

0101 - 0150 Direct labour grades
0151 - 0500 Factory overhead cost items
45
Facets 1 and 2 should need little further explanation; but lets expand Facet 3.
Facet 3: 0000 Oak batten 2 cm x 4 cm

0003 Oak plank 20 cm x 4 cm
0020 Seat covering, plain
0025 Seat covering, striped
0040 Foam padding
0050 Chair brackets, metal, steel

0055 Chair brackets, metal, brass
0101 Preparation department labour grade 1

0102 Preparation department labour grade 2
0111 Carpentry department labour grade 1

0112 Carpentry department labour grade 2
0151 Factory rent

0152 Factory rates
0160 Insurance: machinery

0161 Insurance: buildings
0162 Insurance: public liability
Let's use this code shown now to determine the code for grade 2 labour costs
incurred by the carpentry department. The code is:
01 01 0112;
and the code for buildings insurance for the upholstery department is:
04 03 0161.
5. Significant digit codes:
These incorporate some digits which are part of the description of the item being
coded.
Example: 4000 = Nails
4010 = 10mm nails

4020 = 20 mm nails
4030 = 30 mm nails
46
6. Hierarchical codes:
The coding systems used by libraries are examples of hierarchical codes. The
major advantage of such systems is that they are, in theory at least, infinitely
expandable: they can be extended for ever; but in a logical, structured, way.
If we assume that code 657 is the library classification number for accounting, then
we can develop the code hierarchically:
657 Accounting
657.01 Financial accounting

657.02 Financial management
657.03 Management accounting
657.03.001 Management accounting, standard costing
657.03.001.01 Management accounting, standard

costing, setting standards
657.03.001.02 Management accounting, standard
costing, variance analysis
and so on ...
The drawback of infinite expandability is that it would need an infinitely large storage
device to store an infinitely large code!
47
KEY NOTES
48
1. Production vs. Non-production costs
Production costs are costs identified with goods produced for resale. Non-
production costs are not directly associated with production of manufactured goods.
2. Production costs Material, labour and overheads
Materials - all costs of materials purchased for production or non-production activities
Labour - all staff costs relating to employees.
Overheads - all other costs which are not materials or labour
3. Non-Production costs administrative, selling, distribution and finance
Administrative costs - all the costs involved in running the general administration
department of an organization.
Selling costs - all costs incurred in promoting sales and retaining customers.
Distribution costs - all costs incurred in making the packed product ready for dispatch
and delivering it to the customer.
Finance costs - all the costs that are incurred in order to finance an organization.
4. Direct and Indirect Costs
Direct costs costs which can be directly identified with a specific cost unit or cost
centre. There are 3 main types of direct cost: - direct materials, direct labour and
direct expenses.
Direct Materials + Direct Labour + Direct Expenses = PRIME COST
Indirect costs costs which cannot be directly identified with a specific cost unit or
cost centre. These include indirect materials, indirect labour and indirect expenses.
Indirect Materials + Indirect Labour + Indirect Expenses = Overheads
5. Classification by function involves classifying costs as production/manufacturing

costs, administration costs or marketing/selling and distribution costs.
49
QUESTIONS
50
1. In an organisation, manufacturing a number of different products in one large
factory, the rent of that factory is an example of a direct expense when costing
a product.
A. True
B. False
2. Specify whether the following expenses are production costs, selling and
distribution costs, administration costs and research and development costs.
i. Depreciation of factory plant and equipment

ii. Commission paid to sales representatives
iii. Salary of scientist in a lab
iv. Salary of factory supervisor
v. Insurance of the companys premises
51
ANSWERS
52
1. B indirect expense
2. i. production cost
ii. selling cost
iii. research and development cost
iv. production cost
v. administration cost
53
Chapter 4
COST BEHAVIOUR
Describe and illustrate, graphically, different types of cost behaviour.
Costs can be classified according to the way that they behave within different levels
of activity. Cost behaviour tends to classify costs as: -
Variable cost
Fixed cost
Stepped fixed cost
Semi-variable cost
4.1.1 Variable cost
A variable cost is a cost which tends to vary directly with the volume of output. As
total costs increase with activity levels, the variable cost per unit remains constant.
By their nature, direct costs will be variable costs. Examples of variable costs include
raw materials and direct labour.
Graph 1: - Total variable costs
Variable costs in total change in direct proportion to the level of activity.
54
Graph 2: - Variable cost per unit
The cost per unit of variable costs remains constant.
4.1.2 Fixed Costs
A fixed cost is a cost which is incurred for an accounting period, and which, within
certain activity levels remains constant.
Examples of fixed costs include the salary of the managing director, the rent of a
building and straight line depreciation of machinery.
Graph 3: - Total Fixed Costs
Total fixed costs remain constant over a given level of activity.
55
Graph 4: - Fixed cost per unit
The fixed cost per unit falls as the level of activity increases but never reaches zero.
4.1.3 Stepped Fixed Costs
A stepped fixed cost is only fixed within certain levels of activity. The depreciation of
a machine may be fixed if production remains below 1,000 units per month. If
production exceeds 1,000 units, a second machine may be required, and the cost of
depreciation (on two machines) would go up a step.
Other stepped fixed costs include rent of warehouse (more space required if activity
increases) and supervisors wages (more supervisors required if number of
employees increase).
Graph 5: - Stepped fixed costs
Fixed costs increase in steps as activity level increases beyond a certain limit.
56
4.1.4 Semi-variable Costs (semi-fixed/mixed)
Semi-variable costs contain both fixed and variable components and are therefore
partly affected by changes in the level of activity.
Examples of semi-variable costs includes

Electricity and gas bills - Fixed cost = standing charge
Variable cost = charge per unit of electricity used
Salesman's salary - Fixed cost = basic salary

Variable cost = commission on sales made
ORWARD
Costs of running a car Fixed cost = road tax, insurance
Variable costs = petrol, oil, repairs
Graph 6: - Total semi-variable costs
Graph 7: - Semi-variable costs per unit
57
Lecture Example 1
Classify the following items of expenditure as fixed, variable, semi-variable or

stepped fixed costs:-
i. Electricity bill
ii. Raw materials
iii. Rent of factory
iv. Supervisors wages (more supervisors required as the number of
employees increases)
Graph 8: - Other cost behaviour patterns
This graph represents a cost which is variable with output, subject to a minimum
(fixed) charge.

Use high/low analysis to separate the fixed and variable elements of total
costs including situations involving semi-variable, stepped fixed costs and
changes in the variable cost per unit.
There are two main methods which analyse semi-variable costs into their fixed and
variable elements: -
High/low method
Least squares regression (covered in later chapters)
58
4.2.1 High-low method
The main steps are: -
1. Review records of costs in previous periods.
Select the period with the highest activity level.

Select the period with the lowest activity level.
2. Find the variable cost per unit
Total cost at high activity level - total cost at low activity level
Total units at high activity level - total units at low activity level
3. Find the fixed costs
Total cost at high activity level (Total units at high activity level Variable
cost per unit)
Advantages of the High-Low Method
1. Easy to use
2. Easy to understand
Limitations of the High-Low Method
1. It relies on historical cost data predictions of future costs may not be reliable
2. It assumes that the activity level is the only factor affecting costs
3. It uses only two values to predict costs
4. Bulk discounts may be available at large quantities
Lecture Example 2
The total costs of a business for differing levels of output are as follows:
Output Total Costs

units $000
500 70
200 30
300 50
800 90
1000 110
59
What are the fixed and variable elements of the total cost using the High-Low
method?
Lecture Example 3
MVP Steel has the following total costs at two activity levels:
Activity level (units) 16,000 22,000
Total costs ($) 135,000 170,000
Variable cost per unit is constant within this range of activity but there is a step up of
$5,000 in the total fixed costs when the activity exceeds 17,500 units.
What is the total cost at an activity of 20,000 units?
A. $155,000
B. $158,000
C. $160,000
D. $163,000

Explain the structure of linear functions and equations
4.3.1 Equation of a straight line: y = a + bx
60
The equation of a straight line is y = a + bx
a the intercept, i.e. the value of y when x = 0

b the gradient of the line y = a +bx (the change in y when x increases by one unit)
x - the independent variable
y the dependent variable
Lecture Example 4
Consider the linear function y = 2,000 + 40x.
i. The line would cross the y axis at the point _______.
ii. The gradient of the line is ______.
4.3.2 Cost Equations
a is the fixed cost per period

b is the variable cost per unit
x is the activity level
y is the total cost = fixed cost + variable cost
61
Lecture Example 5
If the total cost of a product is given as: -
Y = 5,000 + 6x
i. The fixed cost is $_______
ii. The variable cost per unit is $_________
iii. The total cost of producing 500 units is $____________
4.3.3 Cost objects, cost units and cost centres
4.3.3.1 Cost Objects
A cost object is any activity for which a separate measurement of cost is undertaken.
E.g. cost of a product, cost of a service, cost of a particular department.
4.3.3.2 Cost Units
A cost unit is a unit of product or service in relation to which costs are ascertained.
E.g. a hotel room, a course, one litre of paint.
Lecture Example 6
Suggest appropriate cost units for the following businesses: -
Car Manufacturer ___________________________
Cigarette Manufacturer _________________________
Audit firm _____________________
4.3.3.3 Cost Centres
A cost center is a production or service location, function, activity or item of

equipment for which costs can be ascertained. E.g. a department, a project, a
machine.
62
4.3.3.4 Cost Cards
A cost card lists out all the costs involved in making one unit of a product.
Cost Card: -
$
Direct Materials X
Direct Labour X
Direct Expenses X
Prime Cost XX
Variable Production Overheads X
Marginal Production Cost XX
Fixed Production Overheads X
Total Production Cost XX
Non-production overheads:
Administration X
Selling X
Distribution X
Total Cost XX
Profit X
Sales Price XXX
63
KEY NOTES
64
1. Different types of cost behaviour
Variable cost tends to vary directly with the volume of output
Fixed cost a cost which, within certain activity level, remains constant
Stepped fixed cost a cost which is fixed up to a certain level of volume, and then it
increases to an even higher level of fixed cost to a certain level of volume
Semi-variable cost it contains both a fixed and variable element and therefore is
partly affected by a change in the activity level
2. The High-Low method
This method analyses semi-variable costs into their fixed and variable elements.
Always select the period with the highest activity level and the period with the lowest
activity level.
The variable cost per unit =
The fixed costs =
Total cost at high activity level (Total units at high activity level Variable
cost per unit)
3. Linear functions and equations
Equation of a straight line
y = a + bx
a the intercept, i.e. the value of y when x = 0

b the gradient of the line y = a + bx (the change in y when x increases by one
unit)
x - the independent variable
y the dependent variable
65
Cost Equation
y = a + bx

x is the activity level
4. Cost objects, cost units and cost centres
Cost object - an activity for which a separate measurement of cost is undertaken.

E.g. cost of product, cost of a service, cost of a particular department
Cost unit - a unit of product or service in relation to which costs are ascertained. E.g.
a hotel room, a course, one litre of paint
Cost centres - a production or service location, function, activity or item of equipment

for which costs can be ascertained. E.g. a department, a project, a machine
Cost cards - lists out all the costs involved in making one unit of a product.
66
QUESTIONS
67
1. A semi-variable cost is one that, in the short term, remains the same over a
given range of activity but beyond that increases and then remains constant at
the higher level of activity.
A. True
B. False
2. A cost centre is
A. A unit of product or service in relation to which costs are

ascertained
B. An amount of expenditure attributable to an activity
C. A production or service location, function, activity or item of
equipment for which costs are accumulated
D. A centre for which an individual budget is drawn up
3. RCA has recorded the following costs over the last six months:
Month Total cost Units produced

000 000
1 74.00 3.00
2 72.75 1.75
3 73.25 2.00
4 75.00 2.50
5 69.50 1.50
6 72.75 2.00
Using the high low method what would be the total cost equation?
A. Total cost = 61,250 + 5.5 x Quantity

B. Total cost = 65,000 + 3 x Quantity
C. Total cost = 70,250 + 1.25 x Quantity
D. Total cost = 71,000 + 1 x Quantity
4. The following information relates to the manufacture of product AB in 20X7: -

Units Total cost ($)
200 7,000
300 8,000
400 8,600
68
For output above 350 units, the variable cost per unit falls by 10%. This fall
applies to all units, not just the units above the 350 threshold.
Required: Estimate the cost of producing 450 units in 20X8.
5. Electricity costs for the first 6 months of the year are as follows:
Units produced Costs ($)

January 340 2,260
February 300 2,160
March 380 2,320
April 420 2,400
May 400 2,300
June 360 2,266
Calculate the fixed and variable costs using the high-low method.
6. The three major cost components of manufacturing a product are:
A. direct materials, direct labour and factory overhead
B. period costs, product costs and sunk costs
C. variable costs, fixed costs and period costs
D. indirect labour, indirect materials and fixed expenses
7. A company has the following data for a semi-variable cost
Output 20,000 units 60,000 units

Total cost $85,000 $253,000
The fixed element of total cost increases by $8,000 at output levels in excess of
30,000 units.
What is the variable cost per unit?

A. $4.00
B. $4.20
C. $4.22
D. $4.25
69
ANSWERS
70
1. B - stepped fixed cost
2. C
3. B
4. $9050
Units $
300 8000
200 7000
100 1000
VC/unit = $1000 = $10

10
TC (300) = FC + VC
8000 = FC + (300 x 10)
FC = 5000
TC (450) = 5000 + (450 x [10 x 0.9])

TC = $9050
5. Variable cost per unit = $2

Fixed costs = $1560
Units $
420 2400
300 2160
120 240
VC/unit = $240 = $2
120
TC = FC + VC
2400 = FC + (420 x 2)
FC = 1560
71
6. A
7. A
Units Cost
60,000 (253,000 8,000) 245,000

20,000 85,000
40,000 160,000
VC/unit = $160,000 / 40,000 = $4
72
Chapter 5
PRESENTING INFORMATION
Prepare written reports representing management information in suitable
formats according to purpose
When producing written reports, the management accountant needs to carry out four
steps: -
a. Prepare: determine the type of document required and establish
the user of the information
b. Plan: select the relevant date: summarise, analyse, illustrate to turn
the raw data into useful information
c. Write
d. Review what has been written
5.1.1 The Structure of a Report
A typical report structure will be as follows:
Title
At the top of your report show who the report is to, who it is from, the date and
a heading.
Introduction
Showing what information was requested, the work done and where results
and conclusions can be found.
Analysis
Presenting the information required in a series of sub-sections. Use an

underlined heading for each sub section.
Conclusion
Including, where appropriate, recommendations. Keep this brief. Never

introduce new material into a conclusion.
73
Appendices
Containing detailed calculations, tables of underlying data, etc. If you use

appendices refer to them in your report.
Numbered headings and cross referencing between sections make reports easier to
follow (or navigate).

Present information using tables, charts and graphs (bar charts, line graphs,
pie charts and scatter graphs)
In this section, we will be looking at different ways how information can be presented
through the use of tables, charts and graphs. Scatter graphs will be described in
detail when discussing forecasting methods later on in the course notes.
5.2.1 Tables
Tabulation is the process of presenting data in the form of a table an arrangement

of rows and columns.
The purpose of tabulation is to summarise the information and present it in a more

understandable way.
5.2.1.1 Rules of Tabulation
a) Title: the table must have a clear and self-explanatory title.
b) Source: the source of the material used in drawing up the table should be stated
(usually by way of a footnote).
c) Units: the units of measurement that have been used must be stated.
d) Headings: all column and row headings should be clear and concise.
e) Totals: these should be shown where appropriate, and also any subtotals that
may be applicable to the calculations.
f) Percentages and ratios: these are sometimes called derived statistics and
should be shown, if meaningful, with an indication of how they were calculated.
74
g) Column layout: for ease of comparison columns containing related information
should be adjacent and derived figures should be adjacent to the column to
which they refer.
h) Simplicity: the table should be as concise as possible.
i) Layout: wherever possible ensure that the table is set up so that there is no
need to turn the page. This will affect the choice of columns and rows.
Illustration 1 Tables
Dept A
2011 2010 % change
$ $ $
Raw Material 120,000 100,000 20%
Labour 56,000 50,000 12%
Overheads 24,000 20,000 20%
5.2.2 Charts and Graphs
Clarity of presentation of information can be further improved if data is presented in

the form of charts or graphs (diagrams).
The following are the principal types of diagrams:
Bar charts
Line graphs
Pie charts
Scatter graphs
5.2.2.1 Bar Charts
A bar chart is a widely used method of illustrating quantitative data. Quantities are
shown in the form of bars on a chart, the length of the bars being proportional to the
quantities.
75
1. Simple bar charts
A simple bar chart consists of one or more bars, in which the length of each bar
indicates the size of the corresponding information.
ABC Ltd: Sales figures
A ($) B ($) C ($) Total ($)

2009 300,000 400,000 500,000 1,200,000
2010 400,000 500,000 600,000 1,500,000
2011 300,000 600,000 400,000 1,300,000
2. Component bar chart
A component bar chart is used when each total figure in the data is made up of a
number of different components and it is important that these component elements
are shown as well as the total figure.
A ($) B ($) C ($) Total ($)

2009 300,000 400,000 500,000 1,200,000
2010 400,000 500,000 600,000 1,500,000
2011 300,000 600,000 400,000 1,300,000
76
3. Percentage component bar chart
Division A Division B Division C Total

2009 $300,000 25% $400,000 33.33% $500,000 41.67% $1,200,000
2010 $400,000 27% $500,000 33% $600,000 40% $1,500,000
2011 $300,000 23% $600,000 46% $400,000 31% $1,300,000
77
4. Compound (multiple) bar charts
Compound bar charts are sometimes termed multiple bar charts. A compound bar
chart is one where there is more than one bar for each sub-division of the chart. For
example if the sales per product for each year are given then for each year there
could be a separate bar for each product.
This has obvious similarities to a component bar chart where each component of the
total was shown as part of the total bar. However the difference here is that each
component has its own bar and is not stacked. It is a suitable format if the total of
each component of the bar chart has no significance.
A ($) B ($) C ($) Total ($)

2009 300,000 400,000 500,000 1,200,000
2010 400,000 500,000 600,000 1,500,000
2011 300,000 600,000 400,000 1,300,000
ABC Ltd Divisional Sales

2009 - 2011
700,000
600,000
500,000
$ Sales
400,000
300,000 A
200,000 B
100,000 C
0
2009 2010 2011
Years
ABC Ltd Divisional Sales

2009 - 2011
C
Division
B 2011
2010
A
2009
0 100,000200,000300,000400,000500,000600,000700,000
$ Sales
78
5.2.2.2 Graphs
1. Simple line graphs
In many instances data can be more clearly and understandably presented in the
form of a line graph. The x axis would represent the independent variable whereas
the y axis represent the dependent variable.
Lecture Example 1
The total cost of production at various levels of production for an organisation is

shown below:
Production Level Total Cost of Production

($)
500 units 3,000
1,000 units 5,000
1,500 units 7,000
2,000 units 9,000
2,500 units 12,000
Required: Draw a graph to illustrate this information
2. Multiple line graphs
You may be required to plot more than one set of variables on the same graph.
If more than one line is to appear on a graph then they must also be drawn to the
same scale and the different line should be clearly indicated by use of a key (e.g.
continuous line, broken line, dotted line) or different colour.
79
The y axis must
be labelled - here
it represents the The subject of the graph
value of sales is explained in the title
The legend or
key identifies
each line
The x axis must be

labelled here it
represents time periods
5.2.2.3 Pie Charts
A pie chart is a circular chart divided into sectors, illustrating proportion. In a pie
chart, the arc length of each sector (and consequently its central angle and area),
is proportional to the quantity it represents. Together, the sectors create a full disk.
80
ABC Ltd
Divisional Sales 2011
26%
42% A
B
C
32%
ABC Ltd Divisional Sales 2011
Division A Division B Division C Total

2011 $400,000 26% $500,000 44% $650,000 30% $1,550,000
To calculate segment angle:
Value of segment x 360

Value of total
Division A: 400,000 x 360 = 92.9

1,550,000
Division B: 500,000 x 360 = 116.1

1,550,000
Division C: 650,000 x 360 = 151

1,550,000
Pie charts can be an effective way of displaying information in some cases,

especially if the aim is to compare the size of a slice with the whole pie. They work
particularly well when the slices represent 25 to 50% of the data, but in general,
other charts such as the bar chart or non-graphical methods such as tables, may be
more adapted for representing certain information. In fact, it may be difficult to
compare different sections of a given pie chart, or to compare data across pie charts.
81
Lecture Example 2
Last year, MV Quads made the following sales in each of its four stores which it has
in different areas of the country.
$
Store 1 30,000
Store 2 25,000
Store 3 70,000
Store 4 75,000
Total 200,000
Using a pie chart to represent the proportion of sales which each store has
made last year, what would be the angle of the section to represent the sales
from store 3? ___________________
5.2.2.4 Frequency Histogram
A histogram is a representation of a frequency distribution. It is constructed from a

frequency table. The intervals from the table are placed on the x-axis and the values
needed for the frequencies are represented on the y-axis. The rectangles represent
class intervals and their areas are proportional to the corresponding frequencies.
Example: - Number of students and the marks they obtained in each class
Marks: f Cum f Cum %
90-99 0 50 100
80-89 2 50 100
70-79 6 48 96
60-69 9 42 84
50-59 12 33 66
40-49 10 21 42
30-39 7 11 22
20-29 3 4 8
10-19 1 1 2
0-9 0 0 0
82
83
KEY NOTES
84
1. When preparing reports, the management accountant should use the correct
structure including introduction, analysis, conclusion and any appendices.
2. Information can also be presented through the use of tables, charts and graphs.
3. Tabulation is the process of presenting data or in the form of a table an

arrangement of rows and columns.
4. A simple bar chart shows not only the actual amount of the data which can be
read off from the vertical axis but also the relationship between the data.
5. A component bar chart is used when each total figure in the data is made up of a
number of different components.
6. A percentage component bar chart is one where the percentage of the total for
each component is shown.
7. A compound bar chart is one where there is more than one bar for each sub-
division of the chart.
8. In many instances data can be more clearly and understandably presented in the
form of a line graph.
9. A pie chart is a circular chart divided into sectors, illustrating proportion. In a pie
chart, the arc length of each sector (and consequently its central angle and area),
is proportional to the quantity it represents.
85
QUESTIONS
86
1. Identify the correct formula for calculating the segment angles in a pie chart: -
A. The total value divided by the segment value multiplied by 100

B. The total value divided by the segment value multiplied by 360
C. The segment value divided by the total value multiplied by 360
D. The segment value divided by the total value multiplied by 100
2. Which of these are types of bar chart?
i. Component bar chart

ii. Composite bar chart
iii. Percentage component bar chart
iv. Simple bar chart
A. (i) and (ii)

B. (ii) and (iii)
C. (i) and (iii)
D. (i), (iii) and (iv)
3. Which one of the following statements is true?
A. The independent variable is shown on the y axis

B. The dependent variable is shown on the y axis
C. The x axis is the vertical axis
D. The y axis is the horizontal axis
4. What is the independent variable?
A. A fixed point of measurement not affected by another variable

B. A fixed point of measurement that depends upon another variable
C. Sales value
D. A cost
5. Product B is made up as follows: -
Material W: $2,000
Material X: $1,000
Material Y: $4,000
Material Z: $2,000
If the material proportions were displayed on a pie chart, how many degrees
would Material Y represent? ____________
87
ANSWERS
88
1. C
2. D
3. B
4. A
5. 4,000 / 9000 x 360 = 160 degrees
89
Chapter 6
ORDERING AND ACCOUNTING FOR
INVENTORY

Describe the different procedures and documents necessary for the ordering,
receiving and issuing of materials from inventory
Every movement of a material in a business should be documented using the

following as appropriate: -
Purchase requisition; purchase order; GRN; materials requisition note; materials
transfer note and materials returned note.
6.1.1 Procedures for ordering, purchasing and receiving materials
The procedures for ordering, purchasing and receiving materials include: -
90
Department requires new Ordering and
materials Purchasing
Purchase requisition
Purchasing
department
Purchase order form Copy Copy

Supplier Accounts Goods receiving
department department (stores)
Supplier
Goods with delivery note
Goods receiving
Receipt
department (stores)
Goods received note
Purchasing department
Proper records must be kept of the physical procedures for ordering and receiving a
consignment of materials to ensure that: -
enough inventory is held

there is no duplication of ordering
quality is maintained
there is adequate record keeping for accounts purposes
6.1.2 Documents for ordering, purchasing and receiving materials
6.1.2.1 Purchase requisition
Current inventories run down to the level where a reorder is required. The stores
department issues a purchase requisition which is sent to the purchasing
department, authorising the department to order further inventory.
91
6.1.2.2 Purchase order
The purchasing department draws up a purchase order which is sent to the supplier.
Copies of the purchase order must be sent to the accounts department and the
storekeeper (or goods receiving department).
6.1.2.3 Quotation
The purchasing department may have to obtain a number of quotations if a new

inventory line is required, the existing supplier's costs are too high or the existing
supplier no longer stocks the goods needed.
6.1.2.4 Delivery note
The supplier delivers the consignment of materials, and the storekeeper signs a
delivery note for the carrier. The packages must then be checked against the copy of
the purchase order, to ensure that the supplier has delivered the types and quantities
of materials which were ordered.
6.1.2.5 Goods received note
If the delivery is acceptable, the storekeeper prepares a goods received note (GRN).
A copy of the GRN is sent to the accounts department, where it is matched with the
copy of the purchase order. The supplier's invoice is checked against the purchase
order and GRN, and the necessary steps are taken to pay the supplier.
6.1.3 Documents for issuing inventory
6.1.3.1 Materials requisition note

Materials can only be issued to production departments against a materials
requisition. This document must record not only the quantity of goods issued, but
also the cost centre or the job number for which the requisition is being made. The
materials requisition note may also have a column, to be filled in by the cost
department, for recording the cost or value of the materials issued to the cost centre
or job.
6.1.3.2 Materials returned note

This is used to record any unused materials which are returned to stores.
6.1.3.3 Materials transfer note

This document is used to transfer materials from one production department to
another.
92
Lecture Example 1
Which documentation could be used to transfer materials from one production

department to another?
A. Materials transfer note
B. Materials returned note
C. Materials requisition note

Interpret the entries and balances in the material inventory account.
6.2.1 Material Inventory Account
Materials held in store are asset and are therefore recorded in the statement of
financial position of a company.
Transactions relating to materials are recorded in the material inventory account.
Material Inventory A/c

Materials purchased 100 Issues to production WIP A/c 94
Materials returned to stores 5 Materials returned to suppliers 3
Materials write-off I/S 1
Production overhead account
indirect material 5
Closing Inventory c/d 2
105 105
Closing Inventory b/d 2
Lecture Example 2
The following represent the materials transactions for a company for a year: -
$000
Material purchases 240
Issued to production 215
Materials written off 12
Returned to stores 6
Returned to suppliers 2
93
The material stock at 1 January 20x8 was $25,000.
What was the closing balance of materials stock at 31 December 20x8?
__________.

Describe the control procedures used to monitor physical and book inventory
and to minimise discrepancies and losses.
6.3.1 Perpetual Inventory
Perpetual inventory is the recording as they occur of receipts, issues and the
resulting balances of individual items of inventory in both quantity and value. These
inventory records are updated using stores ledger cards and bin cards.
Bin Card
Commodity :
Package size
Date Receipt / issue Received Issued Balance

voucher no.
94
6.3.2 Stocktaking
The process of stocktaking involves checking the physical quantity of inventory held
on a certain data with the balance on the stores ledger cards or bin cards.
Stocktaking can be carried out either on a periodic basis or continuous basis.
6.3.2.1 Periodic stocktaking
Periodic stocktaking involves checking the balance of every item in inventory at a set
point in time, usually at the end of an accounting year.
6.3.2.2 Continuous stocktaking
This involves counting and valuing selected items of inventory on a rotating basis.
Each item is checked at least once a year.
6.3.3 Control procedures to minimize discrepancies and losses
Inventories cost a considerable amount of money and therefore, control procedures

must be in place.
Such control procedures would include:
1. physical security procedures, regular stocktaking and recording of all issues to

eliminate unnecessary losses from inventory;
2. separation of ordering and purchasing activities to eliminate fictitious purchases;
3. quotation for special order to reduce the probability of ordering goods at inflated
prices.
Inventory losses arising from theft, pilferage or damage must be written off against
profits as soon as they occur.

Calculate the value of closing inventory and material issues using LIFO, FIFO
and average methods.
In management accounting, there are various methods to value closing inventory

and issues from stores.
The three main inventory valuation methods are: -
95
i. FIFO materials are issued out of stock in the order in which they were delivered
into inventory, i.e. issues are priced at the cost of the earliest delivery remaining
in inventory. This is a logical pricing method but can be cumbersome to operate
since each batch of material has to be identified separately.
ii. LIFO the last items of material received are the first items to be issued. LIFO is
not accepted for financial accounting purposes (IAS 2). The items remaining in
inventory are the first which were produced or purchased.
iii. Cumulative Weighted average cost AVCO calculates a weighted average price
for all units in inventory. Issues are priced at this average cost, and the balance
of inventory remaining would have the same unit valuation.
A new weighted average price is calculated whenever a new delivery of materials

into store is received. Hence, fluctuations in prices are smoothed out, making it
easier to use the data for decision making.
Lecture Example 3
Boomerang Co had 200 units in inventory at 30 November 20X1 valued at $800.

During December it made the following purchases and sales.
2/12 Purchased 1,000 @ $5 each

5/12 Sold 700 @ $7.50 each
12/12 Purchased 800 @ $6.20 each
15/12 Purchased 300 @ $6.60 each
21/12 Sold 400 @ $8.00 each
28/12 Sold 500 @ $8.20 each
Calculate the value of material issued and closing inventory using FIFO, LIFO and
AVCO.
How do we calculate the PERIODIC weighted average cost?
This method is only used if specifically mentioned in the exam question. Otherwise,
the cumulative weighted average method should be used.
Periodic weighted average = cost of opening inventory + total costs of receipts

units of opening inventory + total units received
96
Lecture Example 4
Using the information in lecture example 3, calculate the value of closing inventory at
the end of December using the periodic weighted average.
97
KEY NOTES
98
1. Procedures for ordering, purchasing and receiving materials
Department requires new Ordering and

materials Purchasing
Purchase requisition
Purchasing
department
Purchase order form Copy Copy

Supplier Accounts Goods receiving
department department (stores)
Supplier
Goods with delivery note
Goods receiving
Receipt
department (stores)
Goods received note
Purchasing department
2. Documents for ordering, purchasing and receiving materials
i. Purchase requisition
ii. Purchase order
iii. Quotation
iv. Delivery note
v. Goods received note
99
3. Documents for issuing inventory
i. Materials requisition note
ii. Materials returned note
iii. Materials transfer note
4. Material Inventory Account

Materials purchased 100 Issues to production WIP A/c 94
Materials returned to stores 5 Materials returned to suppliers 3
Materials write-off I/S 1
Production overhead account
indirect material 5
Closing Inventory c/d 2
105 105
Closing Inventory b/d 2
5. Perpetual Inventory
Perpetual inventory is the recording as they occur of receipts, issues and the
resulting balances of individual items of inventory in both quantity and value.
6. Stocktaking
i. Periodic stocktaking
Periodic stocktaking involves checking the balance of every item in inventory on the
same date, usually at the end of an accounting year.
ii. Continuous stocktaking
This involves counting and valuing selected items of inventory on a rotating basis.
Each item is checked at least once a year.
100
7. Inventory Valuation Methods
i. FIFO materials are issued out of stock in the order in which they were
delivered.
ii. LIFO the last items of material received are the first items to be issued.
iii. Cumulative weighted average cost AVCO values all items of inventory and
issues at an average price, which is calculated after each receipt of goods.
iv. Periodic weighted average =
cost of opening inventory + total costs of receipts

units of opening inventory + total units received
101
QUESTIONS
102
1. The following data represents the stores ledger control account for a
manufacturing company: -
$000
Opening inventory 1.1.x8 18.5
Closing inventory 31.12.x8 16.1
Deliveries from suppliers 142.0
Returns to suppliers 2.3
Cost of indirect materials issued 25.2
How would the issue of direct materials be recorded in the cost accounts?
A. Debit Stores ledger control account $119,200

Credit Work in progress account $119,200
B. Debit Work in progress account $119,200

Credit Stores ledger control account $119,200
C. Debit Stores ledger control account $116,900

Credit Work in progress account $116,900
D. Debit Work in progress account $116,900

Credit Stores ledger control account $116,900
2. Continuous stocktaking is the process of checking the balance of every item of

inventory on the same date, usually at the end of an accounting period.
A. True
B. False
3. Which of the following are true?
i. With LIFO, units are issued at a price close to the current market value
ii. With FIFO, inventory value will be very close to replacement cost
iii. Decision making can be difficult with both FIFO and LIFO because of the
variations in price
iv. A disadvantage of the weighted average method of inventory valuation is that
the resulting issue price is rarely an actual price that has been paid and it may
be calculated to several decimal places
A. i and ii only
B. i, ii and iii only
C. i and iii only
D. all of the above statements
103
ANSWERS
104
1. D

WIP 116.9
Opening Stock 18.5 Return 2.3
Deliveries 142 Indirect Mat. 25.2
Closing Inventory 16.1
160.5 160.5
2. B False as it refers to periodic stocktaking
3. D - all of the statements are correct
105
Chapter 7:
ORDER QUANTITIES AND REORDER
LEVELS
Identify and explain the costs of ordering and holding inventory (including
buffer inventory)
7.1.1 Holding Costs
A business holds inventory so that customer demands are met as soon as they
arise. Buffer (safety) inventory is the minimum inventory level required to prevent
stock-outs from occurring.
Advantages and Disadvantages of Holding Stock6
There are advantages and disadvantages of holding stock (of buying stock in large
or small quantities). The advantages include:
the need to meet customer demand
taking advantage of bulk discounts
reducing total annual re-ordering cost
The disadvantages include:

storage costs
cost of capital tied up in stock
deterioration, obsolescence, and theft
Stock-out costs occur when the business runs out of inventory and these include:
i. Loss of sales
ii. Loss of customers
iii. Loss of reputation
iv. Reduced profits
6 Article Stock Control by Tony Mock, May 2007, http://www.accaglobal.com/en/student/qualification-

resources/acca-qualification/acca-exams/f2-exams/exams-f13/stock-control.html
106
Holding Cost =
Cost of holding 1 unit for 1 year x average inventory through the year
= Ch x Q
2
7.1.2 Ordering Costs
An order cost is incurred every time an order is placed to purchase materials.

Therefore, an increase in the number of orders will cause a corresponding increase
in ordering costs.
Ordering costs =
Cost per order x no of orders pa
= C0 x D
Q
Where: -
Q is the quantity per order.
Lecture Example 1
XYZ Ltd uses components at the rate of 10,000 units per annum, which are bought
in at $1.50 each. It orders 1,000 units each time it places an order. The average
inventory held is 500 units. It costs $50 each time to place an order, regardless of
the quantity ordered.
The total holding cost is 20% per annum of the average inventory held.
Required:-
i. The annual holding cost

ii. The annual ordering cost
Lecture Example 2
A manufacturing company uses 25,000 components at an even rate during a year.

Each order placed with the supplier of the components is for 2,000 components,
107
which is the economic order quantity. The company holds a buffer inventory of 500
components. The annual cost of holding one component in inventory is $2.
What is the total annual cost of holding inventory of the component?

A. $2,000
B. $2,500
C. $3,000
D. $4,000

Calculate and interpret optimal reorder quantities
7.2.1 Reorder quantity
This is the quantity of inventory which is to be ordered when inventory reaches the
reorder level. If the re-order quantity is set so as to minimise the total costs
associated with holding and ordering inventory, then it is known as the economic
order quantity.
7.2.2 Economic order quantity (EOQ)
When determining how much to order at a time, an organisation will recognise that:
as order quantity rises, average stock rises and the total annual cost of holding
stock rises
as order quantity rises, the number of orders decreases and the total annual re-
order costs decrease.
The economic order quantity (EOQ) is the order quantity which minimises the total
costs associated with holding and ordering stock. At this quantity, holding costs are
equal to ordering costs.
108
7.2.2.1 EOQ formula
The formula for the EOQ will be provided in your examination.
Q = EOQ =
Where:
Ch = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
D = demand during the time period
Q = the reorder quantity (EOQ)
7.2.2.2 EOQ The assumptions made:
The EOQ formula is based on certain assumptions, including:

constant purchase price
constant demand and constant lead-time
holding-cost dependent on average stock
order costs independent of order quantity
Total Annual Costs
Total Annual Costs (TAC) = purchasing costs + holding costs + ordering costs
TAC =
DP + C0 D + Ch Q
Q 2
Where: -
D= demand during the time period
P = purchase price per unit
C0 = cost of ordering a consignment from a supplier
Q = the reorder quantity (EOQ)
109
This formula is not given in the exam.
Lecture Example 3
The purchase price of a stock item is $25 per unit. In each three month period the
usage of the item is 20,000 units.
The annual holding costs associated with one unit equate to 6% of its purchase
price. The cost of placing an order for the item is $20.
What is the Economic Order Quantity (EOQ) for the stock item to the nearest
whole unit?
A. 730
B. 894
C. 1,461
D. 1,633

Calculate and interpret optimal reorder quantities when discounts apply
When bulk orders are placed, it is often possible to negotiate a quantity discount on
the purchase price. Although the purchase price and annual ordering cost will
decrease, the annual holding cost will increase.
Should the discount be accepted?
7.3.1 Steps involved in calculating the EOQ when discounts are available
1. Calculate EOQ - ignore all discounts.

2. If the EOQ is smaller than the minimum purchase quantity to obtain a bulk
discount, calculate the total cost for the EOQ.
3. Recalculate the annual total annual costs for a purchase order size that is only
just large enough to qualify for the bulk discount.
4. Compare the costs derived from steps (2) and (3). Select the minimum cost
alternative.
5. If there is a further discount available for an even larger order size, repeat the
same calculations for the higher discount level.
110
Example
Epsy Limited uses 15,000 units of its main raw material per month. The material
costs $10 per unit to buy, suppliers delivery costs are $25 per order and internal
ordering costs are $5 per order. Total annual holding costs are $4 per unit. The,
supplier has offered a discount of 1% if 4,000 units of the material are bought at a
time.
Required:
1. Establish the economic order quantity (EOQ) ignoring the discount

opportunities to the nearest unit.
2. Determine if the discount offer should be accepted.
1. EOQ = 2C0D
Ch
= 2(30)(180,000)
4
= 1,643 units
$
Purchase costs 180,000 units x $10 1,800,000
Holding costs $4 x 1,643/2 3,286
Ordering costs $30 x 180,000/1,643 ____3,286
1,806,572
111
2.
$
Purchase costs 180,000 units x $9.90 1,782,000
Holding costs $4 x 4,000/2 8,000
Ordering costs $30 x 180,000/4,000 ____1,350
1,791,350
Total savings = $15,222
Lecture Example 4
A company uses components at the rate of 500 units per month, which are bought in
at a cost of $1.20 each from the supplier. It costs $20 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 2,000
items or more. The current EOQ is 1,000 units. The total holding cost is 20% per
annum of the value of stock held.
Should the discount be accepted?

Produce calculations to minimise inventory costs when inventory is gradually
replenished
7.4.1 Economic Batch Quantity
Some organizations replenish inventory levels gradually by manufacturing their own

products internally. They need to decide whether to produce large batches at long
intervals or produce small batches at short intervals.
In order to decide which course of action to take, an Economic Batch Quantity (EBQ)
model is used. The maximum inventory level will never be as great as the batch
size, because some of the batch will be used up while the remainder is being
produced.
Whereas in the EOQ calculation, we were interested in determining the size of an

order, in EBQ, we are concerned with determining the number of items to be
produced in a batch.
112
EBQ =
Where: -
Q = the batch size

D= demand during the time period
C0 = cost of setting up a batch ready to be produced
R = annual replenishment rate
The formula for the EBQ will be provided in your examination.
However, this formula is not given: -
Average inventory = EBQ 1-D

2 R
Lecture Example 5
A company has demand for 50,000 units p.a. They produce their own units at a cost
of $30 per unit, and are capable of producing at rate of 500,000 units p.a.
Machine set-up costs are $200 for each batch. Stock holding costs are 10% p.a. of
stock value.
1. Calculate the Economic Batch Quantity.

2. Calculate the costs involved p.a. for that quantity.

Describe and apply appropriate methods for establishing reorder levels where
demand in the lead time is constant
7.5.1 Reorder level
When inventories reach the reorder level, an order should be placed to replenish
inventories. The reorder level is determined by consideration of the following.
113
The maximum rate of consumption
The maximum lead time
The maximum lead time is the time between placing an order with a supplier, and
that order arriving.
When the reorder level is reached, the quantity of inventory to be ordered is known
at the reorder quantity (EOQ).
When demand in the lead time is constant,
Reorder level = maximum usage maximum lead time
Extracted from: Article Stock Control by Tony Mock, May 2007,

http://www.accaglobal.com/en/student/qualification-resources/acca-
qualification/acca-exams/f2-exams/exams-f13/stock-control.html
7.5.2 Minimum level
This is a warning level to draw managements attention to the fact that inventories
are approaching a dangerously low level and that stock outs are possible.
Minimum level = reorder level (average usage average lead time)
7.5.3 Maximum level
This also acts as a warning level to signal to management that inventories are
reaching a potentially wasteful level.
Maximum level = reorder level + reorder quantity (minimum usage minimum

lead time)
114
7.5.4 Average inventory
The average inventory formula assumes that inventory levels fluctuate evenly
between the minimum (or safety) inventory level and the highest possible inventory
level, i.e. the amount of inventory immediately after an order is received (safety
inventory + reorder quantity).
Average inventory = safety inventory + reorder quantity
Lecture Example 6
A company stocks item AZX for which the following information is available: -
Average usage 140 units per day

Minimum usage 90 units per day
Maximum usage 175 units per day
Lead time 10 to 16 days
Reorder quantity 3,000 units
What is the maximum level of inventory possible?
_____________
115
KEY NOTES
116
1. Holding Cost
Holding Cost =
Cost of holding 1 unit for 1 year x average inventory through the year
= Ch x Q
2
2. Ordering Cost
Ordering costs =
Cost per order x no of orders pa
= C0 x D
Q
3. The Economic Order Quantity
The economic order quantity (EOQ) is the order quantity which minimises the total
costs associated with holding and ordering stock. At this quantity, holding costs are
equal to ordering costs.
Q = EOQ =
4. Economic Batch Quantity
Some organizations replenish inventory levels gradually by manufacturing their own

products internally. They need to decide whether to produce large batches at long
intervals or produce small batches at short intervals.
EBQ =
117
5. Reorder Level
Reorder level = maximum usage maximum lead time
6. Minimum level
Minimum level = reorder level (average usage average lead time)
7. Maximum level
Maximum level = reorder level + reorder quantity (minimum usage minimum

lead time)
8. Average inventory
Average inventory = safety inventory + reorder quantity
118
QUESTIONS
119
1. A manufacturing company uses 25,000 components at an even rate during a
year. Each order placed with the supplier of the components is for 2,000
components, which is the economic order quantity. The company holds a buffer
inventory of 500 components. The annual cost of holding one component in
inventory is $2.
What is the total annual cost of holding inventory of the component?
A. $2,000
B. $2,500
C. $3,000
D. $4,000
2. The purchase price of a stock item is $25 per unit. In each three month period the
usage of the item is 20,000 units.
The annual holding costs associated with one unit equate to 6% of its purchase
price. The cost of placing an order for the item is $20.
What is the Economic Order Quantity (EOQ) for the stock item to the nearest
whole unit?
A. 730
B. 894
C. 1,461
D. 1,633
3. A company always determines its order quantity for a raw material by using the
Economic Order Quantity (EOQ) model.
What would be the effects on the EOQ and the total annual holding cost of a
decrease in the cost of ordering a batch of raw material?
EOQ Annual holding cost

A. Higher Lower
B. Higher Higher
C. Lower Higher
D. Lower Lower
120
4. Sky Limited wishes to minimise its stock costs. At the moment its reorder
quantity is 1,000 units. Order costs are $10 per order and holding costs are
$0.10 per unit per annum. Sky Limited estimates annual demand to be 15,000
units.
What is the optimal reorder quantity (to the nearest 100 units)?
A. 500 units
B. 1,000 units
C. 1,200 units
D. 1,700 units
5. A company uses 9,000 units of a component per annum. The component has a
purchase price of $40 per unit and the cost of placing an order is $160. The
annual holding cost of one component is equal to 8% of its purchase price.
What is the Economic Order Quantity (to the nearest unit) of the component?
A. 530
B. 671
C. 949
D. 1,342
6. A company determines its order quantity for a component using the Economic
Order Quantity (EOQ) model.
What would be the effects on the EOQ and the total annual ordering cost of an
increase in the annual cost of holding one unit of the component in stock?
EOQ Total annual ordering cost

A. Lower Higher
B. Higher Lower
C. Lower No effect
D. Higher No effect
7. The demand for a product is 12,500 units for a three month period. Each unit of
product has a purchase price of $15 and ordering costs are $20 per order placed.
The annual holding cost of one unit of product is 10% of its purchase price.
What is the Economic Order Quantity (to the nearest unit)?
A. 577
B. 1,816
C. 1,866
D. 1,155
121
ANSWERS
122
1. C = $2 x (2000/2 +500)
2. C = 1,461 units
EOQ = 2 (20) (80,000) = 3,200,000 = 1461 units

(6 % x 25) 1.5
3. D a fall in ordering costs reduce the EOQ and therefore the holding costs.
4. D = 1,732 units = 1,700 units
EOQ = 2 (10) (15,000) = 300,000 = 1732 units

(0.10) 0.10
5. C
EOQ = 2 (160) (9,000) = 2,880,000 = 949 units

(8 % x 40) 3.2
6. A EOQ falls and therefore more orders must be done
7. D
EOQ = 2 (20) (50,000) = 2,000,000 = 1155 units

(10 % x 15) 1.5
123
Chapter 8
ACCOUNTING FOR LABOUR
Calculate direct and indirect costs of labour
8.1.1 Direct Labour Costs
Direct labour costs include the basic pay of direct workers. Direct workers are those
employees who are directly involved in making the products. Therefore, they are part
of the prime cost of a product.
8.1.2 Indirect Labour Costs
Indirect labour costs include the basic pay of indirect workers, i.e. those employees
who are not directly involved in making the product, e.g. factory supervisor,
maintenance staff. These costs are part of the overhead cost.
Indirect labour costs also include: -

1. bonus payments
2. employers NI contributions
3. idle time it occurs when employees cannot get on with their work, through no
fault of their own, e.g. machines break down or there is shortage of work
4. sick pay
5. time spent by direct workers doing indirect jobs e.g. cleaning the offices or
repairing machines.
NORMAL HOURS
Direct workers Indirect workers
direct expense indirect expense
124
8.1.3 Overtime and overtime premiums
When employees work overtime, they will receive a basic pay + an overtime
premium.
Is the overtime premium a direct or indirect cost?
OVERTIME PREMIUM
General production Specific order General Non production
Basic & Premium Pay Basic & Premium Pay

Basic Pay Premium Pay
Direct Indirect
Worker Worker
Direct Indirect Indirect Direct Indirect

Expense Expense Expense Expense Expense
Shift allowances or shift premiums are similar to overtime premiums and are treated
as an indirect labour cost.
Lecture Example 1
A company employs 100 direct workers in the factory, who are paid a basic rate of
$5 per hour for a 35 hour week. In addition to working their normal hours last month,
each worker was asked to work an additional 5 hours overtime per week to meet
general production requirements. All overtime hours are paid at time and a half. As
a result of some faulty material, 150 hours of direct labour time were registered as
idle. Employee deductions total 30% of gross wages.
For the four-week period just ended, calculate; -
i. Gross wages
ii. Deductions
iii. Net wages
iv. Direct labour cost
v. Indirect labour cost
125
Explain the methods used to relate input labour costs to work done
Different methods can be used to determine the time spent doing jobs. These
include time sheets (activity time records), time cards (clock cards) and job sheets.
These methods are required to determine the costs to be charged to specific jobs.
The payroll department carries out functions that relate input labour costs to the work
done. It calculates the gross wages from time and activity records and makes the
required deductions, e.g. NI contributions and PAYE.

Prepare the journal and ledger entries to record labour cost inputs and
outputs. Interpret the entries in the labour account.
Accounting transactions relating to labour are recorded in the labour account.
Labour A/c
Bank (gross paid) x WIP (direct labour) x
Production overheads:
Indirect labour x
Overtime premium x
Shift premium X
Sick pay x
Training x
Idle time x
x x
Therefore,
1. When gross wages are paid (gross = net pay + National Insurance + PAYE) to
employees, they are accounted for as
Dr Labour A/c Cr Bank A/c
2. When labour is used within a particular production process, the direct labour
costs are transferred from the labour account using
Dr Work in progress A/c Cr Labour A/c
126
3. Indirect labour costs are transferred from the labour account to be grouped with
other indirect costs using
Dr Production overhead A/c Cr Labour A/c
Lecture Example 2
Using the information given, complete the labour account.
Direct workers Indirect workers Total

$ $ $
Basic pay for basic hours 45,000 15,000 60,000
Overtime basic pay 12,000 6,000 18,000
Overtime premium 4,000 2,500 6,500
Training 3,000 2,000 5,000
Sick pay 1,000 750 1,750
Idle time 2,000 0 2,000
8.3.1 Idle time ratio
The idle time ratio shows the proportion of available hours which were lost as a
result of idle time
Idle time ratio = Idle hours x 100 %

Total hours

Describe different remuneration methods: time based systems, piecework
systems and individual and group incentive schemes
Labour remuneration methods have an effect on: -
1. The cost of finished products and services.

2. The morale and efficiency of employees.
There are two basic methods: -
1. Time-based systems
2. Piecework systems
127
8.4.1 Time-based systems
Employees are paid a basic rate per hour, day, week or month.
Total Wages = (hours worked x basic rate of pay per hour) +

(overtime hours worked x overtime premium per hour)
Basic time-based systems do not provide an incentive for employees to improve

productivity / efficiency. Therefore, close supervision is necessary.
8.4.2 Piecework systems
A piecework system pays a fixed amount per unit produced.
Total wages = units produced x rate of pay per unit
There are two main piecework systems:
1. Straight piecework systems these are almost extinct. Today, it is normal for
pieceworkers to be offered a guaranteed minimum wage, so that they do not
suffer loss of earnings when production is low through no fault of their own.
2. Differential piecework systems these systems involve different piece rates for
different levels of production. They offer an incentive to employees to increase
their output by paying higher rates for increased levels of production. For
example:
up to 80 units per week, rate of pay per unit = $1.00

80 to 90 units per week, rate of pay per unit = $1.20
above 90 units per week, rate of pay per unit = $1.30
If an employee makes several different types of product, it may not be possible to

add up the units for payment purposes. Instead, a standard time allowance is given
for each unit to arrive at a total of piecework hours for payment.
Incentive (bonus) schemes can also be in place which pay a basic time rate, plus a
portion of the time saved as compared to some agreed allowed time.
The characteristics of such schemes are as follows: -
i. Employees are paid more for their efficiency.

ii. The profits arising from productivity improvements are shared between
employer and employee.
128
iii. Morale of employees is likely to improve since they are seen to receive extra
reward for extra effort.
There are two schemes: -
1. Halsey the employee receives 50% of the time saved
Bonus = Time allowed Time taken x Time rate

2
2. Rowan the proportion paid to the employee is based on the ratio of time
taken to time allowed
Bonus = Time taken x Time rate x Time saved

Time allowed
Lecture Example 3
Pride currently pays its direct production workers on a time basis, at a rate of $8.20
an hour. In an effort to improve productivity, Pride is introducing a bonus based on
(time taken /time allowed) x time saved x rate per hour.
The standard time allowed for a worker in the assembly department to perform this
particular operation once has been agreed at 45 minutes. In the first week of
operation, Paul worked for a total 45 hours and performed 99 operations.
The gross wages Paul should receive for this first week, to 2 decimal places is:
$__________
Lecture Example 4
In a manufacturing company,
Normal working day 8 hours

Basic rate of pay $6 per hour
Standard time allowed to produce 1 unit 2 minutes
Premium bonus 75% of time saved at basic rate
If 350 units are made in one particular day, what will be the labour cost?
129
8.4.3 Individual vs. group bonus schemes
An individual bonus scheme is a remuneration scheme whereby individual

employees qualify for a bonus on top of their basic wage, with each persons bonus
being calculated separately. Hence, the bonus is unique to the individual and it gets
higher if efficiency is improved.
A group bonus scheme is related to the output performance of an entire group of

workers, a department or even the whole factory. It increases co-operation between
team members and is easier to administer.
8.4.4 Profit sharing schemes
A profit sharing scheme is a scheme in which employees receive a certain proportion

of their companys year-end profits (the size of their bonus being related to their
position in the company and the length of their employment to date).
8.4.5 Value added incentive schemes
These incentive schemes exclude any bought-in costs and are affected only by costs
incurred internally such as labour.
Value added = sales cost of bought-in materials and services.
For example, valued added should be treble the payroll costs and one third of any
excess earned would be paid as a bonus.
Payroll costs $50,000

Value added target (x3) $150,000
Value added achieved $180,000
Excess value added $30,000
Employees share $10,000

Calculate the level, and analyse the costs and causes of labour turnover
8.5.1 Level of Labour Turnover
Labour turnover is the rate at which employees leave a company relative to the
average number of people employed. This rate should be kept as low as possible.
130
Labour turnover =
Number of leavers who require replacement x 100%
Average number of employees
8.5.2 Causes of Labour Turnover
Some employees will leave their job and go to work for another company or
organisation. Sometimes the reasons are unavoidable.
Illness or accidents
A family move away from the locality
Marriage, pregnancy or difficulties with child care provision
Retirement or death
However, some other causes can be avoidable. Example: -
Poor remuneration
Poor working conditions
Lack of promotion prospects
Bullying at the workplace
8.5.3 Costs of Labour Turnover
The costs of labour turnover can be large and management should attempt to keep
labour turnover as low as possible so as to minimise these costs.
The cost of labour turnover may be divided into the following.
Preventative costs
Replacement costs
Replacement costs
These are the costs incurred as a result of hiring new employees. These include: -
Cost of selection and placement

Inefficiency of new labour; productivity will be lower
Costs of training
Loss of output due to delay in new labour becoming available
Increased wastage and spoilage due to lack of expertise among new staff
The possibility of more frequent accidents at work
Cost of tool and machine breakage
131
Preventative costs
These are costs incurred in order to prevent employees leaving and they include:
Cost of personnel administration incurred in maintaining good relationships

and eliminating bullying in the workplace
Cost of medical services including check-ups, nursing staff and so on
Cost of welfare services, including sports facilities and canteen meals
Pension schemes providing security to employees
Investigate high labour turnover rates objectively
How can high labour turnover be reduced?
Paying satisfactory wages

Offering satisfactory hours and conditions of work
Creating a good informal relationship between employees
Offering good training schemes and career or promotion ladder
Improving the content of jobs to create job satisfaction
Proper planning so as to avoid redundancies
Investigating the cause of an apparently high labour turnover
Lecture Example 5
Claps had a staff of 2,000 at the beginning of 20x8. Owing to a series of

redundancies, it had a staff of 1,000 at the end of the year. 1,500 members of staff
took voluntary redundancy. The company had planned that only 1,000 members
would leave. Hence, it immediately replaced the excess redundancies with new
joiners.
Calculate the labour turnover rate.

Explain and calculate labour efficiency, capacity and production volume ratios
8.6.1 Labour Efficiency Ratio
The labour efficiency ratio measures the performance of the workforce by comparing
the actual time taken to do a job with the expected time.
Labour Efficiency Ratio =

Expected hours to produce output x 100%
Actual hours to produce output
132
8.6.2 Labour Capacity Ratio
The labour capacity ratio measures the number of hours spent actively working as a
percentage of the total hours available for work.
Labour Capacity Ratio =

Number of hours actively spent working x 100%
Total hours available
8.6.3 Labour Production Volume Ratio
The labour production volume ratio compares the number of hours expected to be
worked to produce actual output with the total hours available for work.
Labour Production Volume Ratio =

Expected hours to produce actual output x 100%
Efficiency ratio x Capacity ratio = Production volume ratio
Expected hours to produce Expected hours to produce

actual output x Actual hours worked = actual output
Actual hours taken Total hours available Total hours available
Lecture Example 6
A company budgets to make 25,000 standard units of output in 100,000 hours (each
unit is budgeted to take four hours each).
Actual output during the period was 27,000 units which took 120,000 hours to make.
Required: -
Calculate the efficiency, capacity and production volume ratios.
133
KEY NOTES
134
1. Direct Labour Costs
Direct labour costs include the basic pay of direct workers. Direct workers are
those employees who are directly involved in making the products.
2. Indirect Labour Costs
Indirect labour costs include the basic pay of indirect workers, i.e. those
employees who are not directly involved in making the product, e.g. factory
supervisor, maintenance staff.
Indirect labour costs also include: -

a. bonus payments
b. employers NI contributions
c. idle time
d. sick pay
e. time spent by direct workers doing indirect jobs
NORMAL HOURS
Direct workers Indirect workers
direct expense indirect expense
3. Overtime and overtime premiums
OVERTIME PREMIUM
General production Specific order General Non production
Basic & Premium Pay Basic & Premium Pay

Basic Pay Premium Pay
Direct Indirect
Worker Worker
Direct Indirect Indirect Direct Indirect

Expense Expense Expense Expense Expense
135
4. The Labour Account
Labour A/c
Bank x WIP (direct labour) x
Indirect labour x
Overtime premium x
Shift premium X
Sick pay x
Training x
Idle time x
x x
5. Idle Time Ratio
Idle time ratio = Idle hours x 100 %

Total hours
6. Labour Remuneration Methods
There are two basic methods: -
1. Time-based systems
2. Piecework systems
Time-based systems
Employees are paid a basic rate per hour, day, week or month.
Total Wages = (hours worked x basic rate of pay per hour) +

(overtime hours worked x overtime premium per hour)
Piecework systems
A piecework system pays a fixed amount per unit produced.
Total wages = units produced x rate of pay per unit
136
Incentive (bonus) schemes can also be in place, which pay a basic time rate,
plus a portion of the time saved as compared to some agreed allowed time.
7. Labour Turnover
Labour turnover is the rate at which employees leave a company relative to the
average number of people employed.
Labour turnover =
Number of leavers who require replacement
Average number of employees
8. Labour Efficiency, Capacity and Production Volume Ratios
Labour Efficiency Ratio =

Labour Capacity Ratio =

Labour Production Volume Ratio =

Efficiency ratio x Capacity ratio = Production volume ratio

output x Actual hours worked = actual output
137
QUESTIONS
138
1. Using the information given, complete the labour account.
Direct workers Indirect Total

workers
$ $ $
Basic pay for basic 36,000 22,000 58,000
hours
Overtime basic pay 8,700 5,430 14,130
Overtime premium 4,350 2,715 7,065
Shift allowance 3,465 1,830 5,295
Sick pay 950 500 1,450
Idle time 3,200 0 3,200
2. In a manufacturing company, skilled workers are paid $10 per hour and unskilled
workers are paid $5 per hour.
In a particular week, the direct skilled workers have worked 20 hours overtime,
12 hours worked on specific orders whereas the other 8 hours worked on
general duties. Overtime is paid at a rate of time and a quarter.
The direct unskilled workers have worked 30 hours overtime. 20 hours were
spent on specific orders requested by a customer and the rest were spent on
general production overtime. Overtime is also paid at a rate of time and a
quarter.
What would be the total overtime pay which will be considered a direct cost?
_________
3. At 31 March 20X7, an organisation had 5,400 employees. During the previous

year, 750 employees had left the organisation although the management had
decided that only 600 needed replacing and had recruited accordingly.
What was the labour turnover rate?
A. 11.11%
B. 10.96%
C. 13.89%
D. 11.27%
139
4. A company operates a differential piecework system and the following weekly
rates have been determined: -
Weekly production Rate of pay per unit

$
1 to 500 units 0.20
501 to 600 units 0.25
601 units and above 0.55
Each employee is guaranteed a minimum wage of $130 per week.
How much would be paid to: -

a. Matthew who achieved an output of 570 units
b. Simon whose output was 800 units
5. Overtime premiums are treated as direct labour costs, if at the specific request of
a customer.
A. True
B. False
6. Employees who work night shifts may be entitled to a shift allowance or shift
premium. The extra amount paid above the basic rate is treated as an indirect
labour cost.
A. True
B. False
140
ANSWERS
141
1.
Labour A/c
Bank 89,140 WIP (direct labour) 44,700
Indirect labour 27,430
Overtime premium 7,065
Shift allowance 5,295
Sick pay 1,450
Idle time 3,200
89,140 89,140
2. $405
Skilled 12hrs x $10 x 1.25 = 150

8 hrs x $10 = 80
Unskilled 20hrs x $5 x 1.25 = 125

10hrs x 5 = 50
405
3. B
Average No. of Employes = 5400 + [5400 600 + 750]

2
= 5475
600 x 100 = 10.96%

5475
4. a. $130 = guaranteed minimum
Matthew 500 x 0.20 = 100

70 x 0.25 = 17.50
117.50
Therefore Matthew will take the guaranteed minimum of $130
b. $235
142
Simon 500 x 0.20 = 100
100 x 0.25 = 25
200 x 0.55 = 110
235
5. True
6. True
143
Chapter 9
ACCOUNTING FOR OVERHEADS
Explain the different treatment of direct and indirect expenses
As we have seen in Chapter 3, direct expenses are expenses that can be directly
identified with a specific cost unit or cost centre, e.g. the hire of tools and equipment
used directly in producing a particular product. Direct expenses are part of the prime
cost of a product.
Overheads are indirect expenses which cannot be directly identified with a specific
cost unit or cost centre, e.g. factory rent, factory light and heat.
Production overheads = indirect materials + indirect labour + indirect

expenses
The total of these indirect costs is usually split into the following.
Production overhead
Administration overhead
Selling and distribution overhead
Organisations recover their fixed production overheads by absorbing a fixed amount

into each product that they make and sell.
Lecture Example 1
Quad Ltd produces a particular product Quadro, which has the following cost card: -
$
Direct Materials 2 kg at $4/kg 8
Direct Labour 4 hrs at $10/hr 40
Direct Expenses 5
Prime Cost 53
The company produces and sells 1,000 Quadros per month.
144
Based on past experience, Quads monthly overheads are: -
Heating and Lighting $14,000

Rent $16,000
Maintenance $10,000
$40,000
Calculate: -
i. The overhead cost allocated to each unit of Quadro
ii. The cost per unit of Quadro

Allocate and apportion production overheads to cost centres using an
appropriate basis
Absorption costing is a method used to recover production overheads by

absorbing them into the cost of a product. Therefore, the objective of absorption
costing is to include in the total cost of a product an appropriate share of the
organisation's total overhead, i.e. an amount which reflects the amount of time and
effort that has gone into producing a unit or completing a job.
Absorption costing involves 3 stages: -

1. allocation and apportionment of overheads
2. reapportionment of service (non-production) cost centre overheads to
production cost centres
3. absorption of overheads
Stage 1: - Allocation and apportionment of overheads
Allocation means charging overheads directly to specific departments (both

production and service). If the overheads relate to more than one department, then
they must be apportioned / shared between these departments using a fair basis.
Overheads are allocated and apportioned in an overhead analysis sheet.
Possible bases of apportionment include: -
1. floor area for rent, rates, heat and light overheads

2. cost or net book value of non-current assets for depreciation and insurance
of machinery
3. number of employees or labour hours worked in each cost centre for
canteen costs; personnel office, welfare, wages, first aid
145
Lecture Example 2
STL Co has two production departments (Processing and Packing) and two service
departments (Maintenance and Canteen).
The following are budgeted production overhead costs for next period: -
$
Factory rent 20,000
Factory heat 5,000
Processing Dept supervisor 15,000
Packing Dept supervisor 10,000
Depreciation of equipment 7,000
Factory canteen expenses 18,000
Welfare costs of factory employees 5,000
80,000
Processing Packing Maint Canteen

Cubic space 50,000m3 25,000m3 20,000m3 5,000m3
NBV equipment $200,000 $200,000 $200,000 $100,000
No. of employees 40 30 20 10
Required: -
Allocate and apportion production overhead costs between the four departments
using a suitable basis.
Stage 2: - Reapportionment of service cost centre overheads to production

cost centres
Since service cost centres/departments are not directly involved in making the
products, the fixed production overheads of these service cost centres must be
shared out between the production departments. Examples of service cost centres
include: - stores, canteen, maintenance and payroll departments.
Two methods are used to reapportion service cost centre costs to production cost
centres: -
1. Basic method when one service department does work of another service
department but not vice-versa
2. Reciprocal method when both service departments do work for each other
146
Lecture Example 3
Following on from Lecture Example 2
A suitable basis for sharing out the maintenance costs is the time spent servicing
equipment. The amount of time spent by the maintenance department servicing
equipment in both production departments was: -
Processing 60%
Packing 40%
The canteen departments overheads are to be reapportioned on the number of

employees in the other three departments.
Required: -
Reapportion the costs incurred by the two service cost centres to the two production
cost centres.

Reapportion service cost centre costs to production cost centres (using the
reciprocal method where service cost centres work for each other).
As described in the previous section, reciprocal reapportionment is used where

service cost centres do work for each other.
Many reapportionments are carried out until all of the service departments
overheads have been reapportioned to the production departments repeated
distribution method.
The results of the reciprocal method of apportionment may also be obtained using
algebra and simultaneous equations.
Regardless of the method used, the total overheads for production departments will
be the same.
147
Lecture Example 4
Following on from Lecture Example 2
A suitable basis for sharing out the maintenance costs is the time spent servicing
equipment. The amount of time spent by the maintenance department servicing
equipment in both production and canteen departments was: -
Processing 50%
Packing 40%
Canteen 10%
The canteen departments overheads are to be reapportioned on the number of

employees in the other three departments.
Required: -
Reapportion the costs incurred by the two service cost centres to the two production
cost centres, using reciprocal reapportionment:-
a) repeated distribution
b) algebraic method

Select, apply and discuss appropriate bases for absorption rates
9.4.1 Stage 3:- Absorption of Overheads
Overhead absorption (overhead recovery) is the process whereby overhead costs

allocated and apportioned to production cost centres are added to unit, job or batch
costs.
Having allocated and/or apportioned all overheads, the next stage in the costing
treatment of overheads is to absorb them into cost units using an overhead
absorption rate.
9.4.2 How do we calculate overhead absorption rates?
1. Estimate the overhead likely to be incurred during the coming period.

2. Estimate the activity level for the period. This could be total hours, units, or
direct costs or whatever it is upon which the overhead absorption rates are to
be based.
3. Divide the estimated overhead by the budgeted activity level. This produces
the overhead absorption rate.
148
4. Absorb the overhead into the cost unit by applying the calculated absorption
rate.
9.4.3 Bases of Absorption
Overheads can be absorbed into cost units using the following bases of absorption
(or 'overhead recovery rates'): -
A rate per machine hour (for machine intensive departments)

Most
A rate per direct labour hour (for labour intensive departments) commonly
A rate per unit (when production includes identical units) used
A percentage of direct materials cost
A percentage of direct labour cost
A percentage of prime cost
A percentage of factory cost (for administration overhead)
A percentage of sales or factory cost (for selling and distribution overhead)
9.4.4 The Overhead Absorption Rate (OAR)
OAR = Total production overhead

Total of absorption basis
This OAR is calculated for each department. Each product which passes through this
department will be charged this overhead rate.
Usually, this OAR is calculated at the beginning of an accounting period in order to

determine the OAR for products before they are sold to customers. Therefore,
budgeted figures will be used for both production overheads and activity levels.
OAR = Budgeted overheads

Budgeted level of activity
Sometimes a blanket OAR (single factory-wide OAR) is calculated. Only one

absorption rate is calculated for the entire factory regardless of the departments
involved in production.
149
Illustration 1
If budgeted output (activity) for the year was 1,000 units and budgeted fixed
production overhead is $10,000, what is the fixed production overhead absorption
rate (FOAR)?
Budgeted fixed production overhead = $10,000 = $10 per unit

Budgeted units 1,000
If each unit takes two labour hours to be produced, what is the FOAR/ labour hour?
$10 / 2 = $5 per labour hour
Lecture Example 5
Following on from lecture example 4.
Processing Packing
Labour hours 20,000 40,000
Machine hours 50,000 15,000
Calculate the OAR for each of the two production departments (to two decimal
figures).

Calculate and explain the under- and over- absorption of overheads
Over and under absorption of overheads occurs because the predetermined

overhead absorption rates are based on estimates (both numerator and
denominator) and it is quite likely that either one or both of the estimates will not
agree with what actually occurs.
At the end of an accounting period, the overheads absorbed will be calculated as
follows: -
Overheads absorbed = predetermined OAR x actual level of activity
i. Over-absorption (over-recovery) means that the overheads absorbed are

greater than the overheads actually incurred.
ii. Under-absorption (under-recovery) means that the overheads absorbed are
less than the actual overheads.
150
Under or over-recovery of overhead will occur in the following circumstances: -
1. Actual overhead costs are different from budgeted overheads

2. The actual activity level is different from the budgeted activity level
3. Actual overhead costs and actual activity level differ from the budgeted costs
and level
Illustration 27
Assume a company budgeted to work 10,000 direct labour hours in the coming year.
If budgeted fixed production overhead was $50,000 the FOAR would be:
Budgeted overhead $50,000

Budgeted activity 10,000 = $5 per hour
If in the year actual overhead was $60,000 and actual direct labour hours were 9,000
the following under absorption would occur:
Absorbed overhead = Actual hours x FOAR =

9,000 x $5 per unit = $45,000
Actual overhead = $60,000
Under-absorbed overhead ($15,000)
Lecture Example 6
The following data relate to RCA Ltd for the year 20x8: -
Budget Actual
Overheads $100,000 $120,000
Labour hours worked 20,000 25,000
Calculate the over/under-absorption of overheads for 20x8.___________

7 Overhead Absorption, April 2016,
151
Lecture Example 7
A business absorbs its fixed overheads on the basis of direct labour hours. During
the month of January, there were the following figures: -
Budgeted fixed overheads $100,000

Budgeted labour hours 50,000
Actual fixed overheads $105,000
Over-absorption of overheads $4,000
How many direct labour hours were worked in January? ___________

Apply methods of relating non-production overheads to cost units
Non-manufacturing overheads, i.e. administration, distribution and selling overheads

and finance costs, may be allocated by choosing a basis for the overhead absorption
rate which most closely matches the non-production overhead, or on the basis of a
product's ability to bear the costs.
Lecture Example 8
Woody manufactures Woody Pecker, a product which has a production cost of $40
per unit. The company has budgeted production costs of $500,000 and budgeted
non-production overheads of $100,000 associated with the production of Product
Woody Pecker.
Required: -
Find the total cost of one unit of Woody Pecker if non-production overheads are
apportioned on the basis of a proportion of production costs incurred by the Woody
Pecker.
152
Prepare journal and ledger entries for manufacturing overheads incurred and
absorbed
The direct costs of production (materials, labour and expenses) are debited in the
work-in-progress (WIP) account.
Indirect production costs are debited in the production overheads account.

Absorbed production overheads are credited to the production overheads account
and debited in WIP account.
Any over- or under- absorption should be transferred to the income statement at the
end of the accounting period.
Production Overheads A/c

Labour x WIP (prod oheads absorbed) x
Expenses x Under-absorption x
Material inventory x
x x
Under-absorption of overheads
Production overheads x Income statement x
x x
Lecture Example 9
Polar Co absorbs production overheads at the rate of $0.50 per direct labour hour.
Actual data for one month was as follows: -
Indirect materials issued from stores $26,500

Indirect wages $15,000
Indirect expenses paid in cash $ 5,000
Direct labour hours 90,000
What entries need to be made for overheads in the ledger accounts?
153
Further Questions8
Question 1
A companys overheads have been allocated and apportioned to its four cost centres
as shown below.
Production Production Service Service Service

cost centre cost centre cost centre cost centre cost centre
A B C D E
Apportioned
and allocated
overheads ($) 80,000 100,000 10,000 20,000 4,000
Usage of service cost centres is as follows:
Cost centre A B
Use of Cs services 40% 60%
Use of Ds services 75% 25%
Use of Es services 30% 70%
Required:
Reapportion the costs incurred by the service cost centres to the production
cost centres.
Question 2
as shown below.

A B C D E
Apportioned
and allocated
overheads ($) 80,000 100,000 10,000 20,000 4,000
8 Article Re-apportionment of service cost centre costs by Steve Jay, F2/FMA examiner, Student Accountant
August 2012, http://www.accaglobal.com/content/dam/acca/global/PDF-
students/2012s/sa_aug12_f2fma_reapportionment.pdf
154
Cost centre A B C D E
Use of Cs services 40% 50% NIL 8% 2%
Use of Ds services 75% 20% NIL NIL 5%
Use of Es services 30% 70% NIL NIL NIL
Required:
cost centres.
Question 3
as shown below.

A B C D E
Apportioned
and allocated
overheads ($) 80,000 100,000 10,000 20,000 4,000
Use of Cs services 40% 50% NIL 10% NIL
Use of Ds services 75% 20% 5% NIL NIL
Required:
cost centres using the repeated distribution method.
155
Question 4
as shown below.

A B C D E
Apportioned
and allocated
overheads ($) 80,000 100,000 10,000 20,000 4,000
Use of Cs services 40% 50% NIL 10% NIL
Use of Ds services 75% 20% 5% NIL NIL
Required:
cost centres using the algebraic method.
Question 5
A company has two production cost centres (V and W) and two service cost centres
(X and Y). The following overheads have been apportioned and allocated to the four
cost centres.
Cost centre V W X Y
Apportioned
and allocated 6,000 8,000 4,000 10,000
overheads ($)
The company has calculated the following usage of X and Ys services:
Cost centre V W X Y
Use of Xs services 60% 30% NIL 10%
Use of Ys services 80% 20% NIL NIL
156
Required:
How much would cost centre Vs total overhead cost be if the company used
the step-down approach to re-apportion service cost centre overhead?
A. $10,400
B. $10,720
C. $16,400
D. $16,720
157
KEY NOTES
158
1. Direct vs. Indirect Costs
Direct expenses are expenses that can be directly identified with a specific cost unit
or cost centre, e.g. the hire of tools and equipment used directly in producing a
particular product.
Overheads are indirect expenses which cannot be directly identified with a specific
cost unit or cost centre, e.g. factory rent, factory light and heat.
2. Absorption Costing
Absorption costing is a method used to recover production overheads by absorbing

them into the cost of a product.
Absorption costing involves 3 stages: -

1. allocation and apportionment of overheads
2. reapportionment of service (non-production) cost centre overheads to
production cost centres
3. absorption of overheads
3. Reapportionment of Service Cost Centre Costs
Reciprocal reapportionment (or the repeated distribution method) is used where

service cost centres do work for each other.
4. Bases for Absorption
Overheads can be absorbed into cost units using different bases of absorption (or
'overhead recovery rates'), the most common are: -
A rate per machine hour (for machine intensive departments)

A rate per direct labour hour (for labour intensive departments)
A rate per unit (when production includes identical units)
5. The Overhead Absorption Rate (OAR)
OAR = Budgeted overheads

Budgeted level of activity
Sometimes a blanket OAR (single factory-wide OAR) is calculated. Only one

absorption rate is calculated for the entire factory regardless of the departments
involved in production.
159
6. Under- and Over- Absorption of Overheads
At the end of an accounting period, the overheads absorbed are calculated as

follows: -
Overheads absorbed = predetermined OAR x actual level of activity
i. Over-absorption (over-recovery) means that the overheads absorbed are

greater than the overheads actually incurred.
ii. Under-absorption (under-recovery) means that the overheads absorbed are
less than the actual overheads.
Under or over-recovery of overhead will occur in the following circumstances: -
i. Actual overhead costs are different from budgeted overheads

ii. The actual activity level is different from the budgeted activity level
iii. Actual overhead costs and actual activity level differ from the budgeted costs
and level
7. Apportioning Non-Production Overheads
A number of non-production overheads can be classified as direct costs. The

majority of non-production overheads, however, cannot be directly allocated to
particular units of output.
Two possible methods of allocating such non-production overheads are: -
Method 1: Choose a basis for the overhead absorption rate which most closely
matches the non-production overhead such as direct labour hours, direct machine
hours.
Method 2: Allocate non-production overheads on the ability of the products to bear

such costs.
8. The Production Overheads Account
The direct costs of production (materials, labour and expenses) are debited in the
work-in-progress (WIP) account.
Indirect production costs are debited in the production overheads account.
Absorbed production overheads are credited to the production overheads account

and debited in WIP account.
160
Any over- or under- absorption should be transferred to the income statement at the
end of the accounting period.
Production Overheads A/c

Labour x WIP (prod oheads absorbed) x
Expenses x Under-absorption x
Material inventory x
x x
Under-absorption of overheads
Production overheads x Income statement x
x x
161
QUESTIONS
162
1. A factory consists of two production cost centres (A and B) and two service cost
centres (X and Y). The total allocated and apportioned overhead for each is as
follows:
A B X Y
$95,000 $82,000 $46,000 $30,000
It has been estimated that each service cost centre does work for other cost
centres in the following proportions:
A B X Y
Percentage of service cost centre X to 50 50 _ _
Percentage of service cost centre Y to 30 60 10 _
The reapportionment of service cost centre costs to other cost centers fully
reflects the above proportions.
After the reapportionment of service cost centre costs has been carried out, what
is the total overhead for production cost centre A?
A. $124,500
B. $126,100
C. $127,000
D. $128,500
2. The process of cost apportionment is carried out so that
A. Costs may be controlled

B. Cost units gather overheads as they pass through cost centres
C. Whole items of cost can be charged to cost centres
D. Common costs are shared among cost centres
3. A company manufacturers two products L and M in a factory divided into two cost
centres, X and Y. The following budgeted data are available:
Cost centre
X Y
Allocated and apportioned fixed
overhead costs $84000 $93000
163
Direct labour minutes per unit: -
Product L 36 25
Product M 30 40
Budgeted output is 9,000 units of L and 6,000 units of M. Fixed overhead costs
are absorbed on a direct labour hour basis.
What is the budgeted fixed overhead cost per unit for Product L?
A. $10
B. $11
C. $12
D. $13
4. The management accountant of Warsaw Limited has already allocated and

apportioned the fixed overheads for the period although she has yet to
reapportion the service centre costs. Information for the period is as follows:
Production Service departments Totals

departments
1 2 Stores Maintenance
Allocated and apportioned $17,500 $32,750 $6,300 $8,450 $65,000

Work done by:
Stores 60% 30% - 10%
Maintenance 75% 20% 5% -
What are the total overheads including in production department 1 if the

reciprocal method is used to reapportion service centre costs?
A. $27,618
B. $28,171
C. $28,398
D. $28,453
164
5. Production Depts Service Centres
X Y Stores Maintenance
$ $ $ $
Allocated and apportioned 70,000 30,000 20,000 15,000
overheads
Estimated work done by the

service centres for other
departments:
Stores 50% 30% - 20%
Maintenance 45% 40% 15% -
Reapportion service department costs to departments using the repeated

distribution method
6. A company uses an overhead absorption rate of $3.50 per machine hour, based
on 32,000 budgeted machine hours for the period. During the same period the
actual total overhead expenditure amounted to $108,875 and 30,000 machine
hours were recorded on actual production.
By how much was the total overhead under or over absorbed for the period?
A. Under absorbed by $3,875
B. Under absorbed by $7,000
C. Over absorbed by $3,875
D. Over absorbed by $7,000
7. A company absorbs overheads based on labour hours. Data for the latest period
are as follows: -
Budgeted fixed overheads $148,750

Budgeted labour hours 8,500
Actual fixed overheads $146,200
Actual labour hours 7,928
i. What is the labour hour overhead absorption rate?

ii. What is the amount of under-/over-absorbed overhead?
165
ANSWERS
166
1. D
A X Y
95,000 46,000 30,000

9,000 3,000 -30,000
49,000 --
24,500 -49,000 --
128,500 0 0
2. B
3. B
X Y
$84,000 $93,000
Labour hours
L (9,000 x 36 /
60) 5,400 (9,000 x 25 / 60) 3,750
M (6,000 x 30 /
60) 3,000 (6,000 x 40 / 60) 4,000
84,000 7,750
= $84,000 = $93,000
8,400 7,750
= $10 / hr = $12 / hr
Production L = x36 / 60 = x 25 / 60
= $6 + = $5 = $11
167
4. C - $28,398
Dept 1 Stores Maint
Maint. 17,500 6,300 8,450

6,338 422 -8,450
6,722 0
Stores 4,033 -6,722 672
0 672
Maint. 504 34 -672
34 0
Stores 20 -34 3
0 3
Maint. 3 0 -3
28,398 0 0
5. Dept X - $90,283; Dept Y - $44,717
X Y Stores Maint
70,000 30,000 20,000 15,000

-
Maint. 6,750 6,000 2,250 15,000
22,250 0
Stores 11,125 6,675 -22,250 4,450
0 4,450
Maint. 2,003 1,780 667 -4,450
667 0
Stores 334 200 -667 133
0 133
Maint. 60 53 20 -133
20 0
Stores 10 6 -20 4
0 4
Maint. 2 2 -4
90,284 44,716 0 0
168
6. A
Overhead absorbed (30,000 x 3.50) = 105,000

Overhead incurred = 108,875
Under absorbed = 3,875 .
7. i) $17.50/labour hour
$148,750 = $17.50
8,500
ii) Under-absorbed $7,460
Overhead absorbed (7,928 x 17.50) = 138,740

Overhead incurred = 146,200
Under absorbed = 7,460 .
169
Chapter 10
MARGINAL AND ABSORPTION
COSTING
Explain the importance of, and apply, the concept of contribution
10.1.1 Marginal Costing
Marginal costing is an alternative method of costing to absorption costing. In

marginal costing, only variable costs are charged as a cost of sale. Therefore, the
cost of a unit =
Direct materials + direct labour + variable production overheads
Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.
10.1.2 Contribution
How do we calculate contribution?
Contribution = Sales price variable costs
Contribution is of fundamental importance in marginal costing, and the term

'contribution' is really short for 'contribution towards covering fixed overheads and
making a profit'.
Total contribution = contribution per unit x sales volume
Profit = Total contribution Fixed overheads
170
Lecture Example 1
A company commenced business on 1 January making one product only, the cost
card of which is: -
$
Direct material 5
Direct labour 8
Variable production overhead 2
Fixed production overhead 5
Variable selling and distribution cost 3
The selling price of one unit is $35. Sales during the period were 5,000.
The fixed production overhead figure has been calculated on the basis of a budgeted
normal output of 3,600 units per annum. The actual fixed production overheads were
$15,000.
Calculate: -
i. The total contribution earned during the period
ii. The total profit or loss for the period

Demonstrate and discuss the effect of absorption and marginal costing on
inventory valuation and profit determination.
Marginal costing values inventory at the total variable production cost of a

product. Absorption costing values inventory at the full production cost (including
fixed production overheads) of a product.
Inventory values using absorption costing are therefore greater than those calculated
using marginal costing.
Since inventory values are different, profits reported in the income statement will also
be different.
171
Calculate profit or loss under absorption and marginal costing
In marginal costing, fixed production costs are treated as period costs and are
written off as they are incurred.
In absorption costing, fixed production costs are absorbed into the cost of units and
are carried forward in inventory to be charged against sales for the next period.
In the long run, total profit for a company will be the same whether marginal costing
or absorption costing is used. Different accounting conventions merely affect the
profit of individual accounting periods.
Marginal costing Income Statement
$ $
Sales X
Less: Variable cost of sales:
Opening inventory X
Production Costs:
Variable costs X
X
Less : closing inventory (X)
(X)
X
Variable selling, distribution and
Less: administration costs (X)
CONTRIBUTION X
Less: Fixed costs (actually incurred): -
Production X
Selling & distribution X
Administration X
(X)
NET PROFIT X
Note that inventories are valued at variable production costs only.
172
Absorption costing Income Statement
$ $
Sales X
Less: Cost of Sales:
Opening inventory X
Production Costs:
Variable costs X
Fixed overhead absorbed X
X
Less : closing inventory (X) (X)
X
Fixed overhead (under)/over absorbed X/(X)
GROSS PROFIT X
Less : Selling & administration etc costs (non
production) (X)
NET PROFIT X
Note that inventories are valued at full production cost
Marginal costing Absorption costing

Closing inventories are valued at Closing inventories are valued at full
marginal production cost production cost
Fixed costs are period costs Fixed costs are absorbed into unit costs
Cost of sales does not include a share Cost of sales does include a share of fixed
of fixed overheads overheads
Lecture Example 2
X plc produces one product desks.
Each desk is budgeted to require 4kg of wood at $3 per kg, 4 hours of labour at $2
per hour, and variable production overheads of $5 per unit. Fixed production
overheads are budgeted at $20,000 per month and average production is estimated
to be 10,000 units per month. Fixed production overheads incurred were $22,000 in
January and $18,000 in February.
The selling price is fixed at $35 per unit.
173
There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per
month.
During the first two months, X plc expects the following levels of activity:
January February
Production 11,000 units 9,500 units
Sales 9,000 units 11,500 units
All other results were as budgeted.
Required:-
i. Prepare a cost card using marginal costing

ii. Set out an income Statement of Profit /Loss based on marginal costing
principles for the months of January and February.
iii. Set out an income Statement of Profit/Loss based on absorption costing
principles for the months of January and February.

Reconcile the profits or losses calculated under absorption and marginal
costing
Reported profit figures using marginal costing or absorption costing will differ if there
is any change in the level of inventories in the period. If production is equal to sales,
there will be no difference in calculated profits using the costing methods.
If inventory levels increase between the beginning and end of a period, absorption
costing will report the higher profit. This is because some of the fixed production
overhead incurred during the period will be carried forward in closing inventory
(which reduces cost of sales) to be set against sales revenue in the following period
instead of being written off in full against profit in the period concerned.
If inventory levels decrease, absorption costing will report the lower profit because as
well as the fixed overhead incurred, fixed production overhead which had been
carried forward in opening inventory is released and is also included in cost of sales.
Therefore,
If inventory levels increase, absorption costing gives the higher profit

If inventory levels decrease, marginal costing gives the higher profit
If inventory levels are constant, both methods give the same profit
174
Profits generated using absorption & marginal costing can also be reconciled as
follows:
Difference in the profit = change in inventory in units x OAR per unit
Lecture Example 3
Following from Lecture example 2 ..
Prepare a reconciliation of absorption and marginal costing profits
January February
$ $
Absorption costing
Marginal costing
Difference
Lecture Example 4
The following budgeted information relates to a manufacturing company for next

period:
Units $
Production 14,000 Fixed production costs 63,000
Sales 12,000 Fixed selling costs 12,000
The normal level of activity is 14,000 units per period.
Using absorption costing the profit for next period has been calculated as $36,000.
What would the profit for next period be using marginal costing?
A. $25,000
B. $27,000
C. $45,000
D. $47,000
175
Describe the advantages and disadvantages of absorption and marginal
costing
Advantages of Absorption Costing Advantages of Marginal Costing

1. complies with IAS 2 1. contribution per unit is constant
Inventories over different sales volumes
2. better cost control due to 2. no over- or under- absorption
analyzing under-/over- 3. highlights contribution so
absorption appropriate for decision-
3. recognizes that selling price making
must cover all costs 4. profit depends on sales and
efficiency not on production
levels
5. simple to operate
Disadvantages of Absorption Disadvantages of Marginal

Costing Costing
1. profits can be manipulated by 1. contribution may not cover
changing production levels fixed costs
2. it is based on the assumption 2. does not comply with IAS 2
that overheads are volume- 3. fixed production overheads
related are not shared between units
of production but written off in
full
176
KEY NOTES
177
1. Marginal Costing
In marginal costing, only variable costs are charged as a cost of sale. Therefore, the
cost of a unit =
Direct materials + direct labour + variable production overheads
Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.
2. Contribution
Contribution = Sales price variable costs
Total contribution = contribution per unit x sales volume
Profit = Total contribution Fixed overheads
3. Inventory Valuation
Marginal costing values inventory at the total variable production cost of a

product. Absorption costing values inventory at the full production cost (including
fixed production overheads) of a product.
4. Profit Valuation
In marginal costing, fixed production costs are treated as period costs and are
written off as they are incurred.
In absorption costing, fixed production costs are absorbed into the cost of units and
are carried forward in inventory to be charged against sales for the next period.
In the long run, total profit for a company will be the same whether marginal costing
or absorption costing is used.
178
Marginal costing Absorption costing
Closing inventories are valued at Closing inventories are valued at full
marginal production cost production cost
Fixed costs are period costs Fixed costs are absorbed into unit costs
Cost of sales does not include a share Cost of sales does include a share of fixed
of fixed overheads overheads
5. Reconciliation of Profits/Losses
If inventory levels increase, absorption costing gives the higher profit

If inventory levels decrease, marginal costing gives the higher profit
If inventory levels are constant, both methods give the same profit
Profits generated using absorption and marginal costing can also be reconciled as
follows:
Difference in the profit = change in inventory in units x OAR per unit
6. Advantages and disadvantages of Absorption and Marginal Costing
Advantages of Absorption Costing Advantages of Marginal Costing

1. complies with IAS 2 1. contribution per unit is constant
Inventories over different sales volumes
2. better cost control due to 2. no over- or under- absorption
analyzing under-/over- 3. highlights contribution so
absorption appropriate for decision-
3. recognizes that selling price making
must cover all costs 4. profit depends on sales and
efficiency not on production
levels
5. simple to operate
Disadvantages of Absorption Disadvantages of Marginal Costing

Costing
1. profits can be manipulated by 1. contribution may not cover
changing production levels fixed costs
2. it is based on the assumption 2. does not comply with IAS 2
that overheads are volume- 3. fixed production overheads are
related not shared between units of
production but written off in full
179
QUESTIONS
180
1. A company manufacturers and sells a single product. In two consecutive months
the following levels of production and sales (in units) occurred:
Month 1 Month 2
Sales 3,800 4,400
Production 3,900 4,200
The opening inventory for Month 1 was 400 units. Profits or losses have been
calculated for each month using both absorption and marginal costing principles.
Which of the following combination of profits and losses for the two months is
consistent with the above data?
Absorption costing profit/(loss) Marginal costing profit/(loss)

Month 1 Month 2 Month 1 Month 2
$ $ $ $
A 200 4,400 (400) 3,200

B (400) 4,400 200 3,200
C 200 3,200 (400) 4,400
D (400) 3,200 200 4,400
2. Glossop Limited reported an annual profit of $47,500 for the year ended 31
March 2000. The company uses absorption costing. One product is
manufactured, the Rover, which has the following standard cost per unit.
$
Direct material (2kg at $5/kg) 10
Direct labour (4 hours at $6.50/hour) 26
Variable overheads (4 hours at $1/hour) 4
Fixed overheads (4 hours at $3/hour) 12
52
The normal level of activity is 10,000 units although actual production was
11,500 units. Fixed costs were as budgeted.
Inventory levels at 1 April 1999 were 400 units and at the end of the year were
600 units.
What would be the profit under marginal costing?
A. $44,300
B. $45,100
C. $49,900
D. $50,700
181
3. A company produces a single product for which cost and selling price details are
as follows.
$ per unit $ per unit
Selling price 28
Direct material 10
Direct labour 4
Variable overhead 2
Fixed overhead 5
21
Profit per unit 7
Last period, 8,000 units were produced and 8,500 units were sold. The opening
inventory was 3,000 units and profits reported using marginal costing were
$60,000. The profits reported using an absorption costing system would be
A. $47,500
B. $57,500
C. $59,500
D. $62,500
4. A company made 17,500 units at a total cost of $16 each. Three quarters of the
costs were variable and one quarter fixed. 15,000 units were sold at $25 each.
There were no opening inventories.
By how much will the profit calculated using absorption costing principles differ
from the profit if marginal costing principles had been used?
A. The absorption costing profit would be $10,000 less

B. The absorption costing profit would be $10,000 greater
C. The absorption costing profit would be $30,000 greater
D. The absorption costing profit would be $40,000 greater
182
ANSWERS
183
1. C
Month 1 Month 2
Prod > Sales Sales > Prod
Abs. Costing is Marg. Costing is

higher higher
2. B
Difference in P = in Inv x FOAR

= (600 - 400) x 12
= 2,400
Inv , AC profit
AC Profit 47,500
Diff in profits 2,400
MC profit 45,100
3. B

= (8,500 8,000) x 5
= 2,500
Sales > Prod , MC profit
MC Profit 60,000
Diff in profits 2,500
MC profit 57,500
184
4. B

FOAR = 16 x = $4
= (17,500 - 15,000) x 4
= 10,000
Inv , AC profit $10,000
185
Chapter 11
JOB, BATCH AND PROCESS COSTING
Describe the characteristics of job and batch costing
11.1.1 Job costing
Job costing is a costing method applied where work is undertaken to customers'

special requirements and each order is of comparatively short duration.
In job costing, production is usually carried out in accordance with the special
requirements of each customer. Therefore, it is usual for each job to differ in one or
more respects from another job.
The main aim of job costing is to identify the costs associated with completing the
order. Individual jobs are given a unique job number and the selling prices of jobs
are calculated by adding a certain amount of profit to the cost of the job.
11.1.2 Batch costing
Batch costing is similar to job costing in that each batch of similar articles is
separately identifiable. A batch is a group of similar articles which maintains its
identity during one or more stages of production and is treated as a cost unit.
The cost per unit manufactured in a batch is the total batch cost divided by the
number of units in the batch.
Cost per unit in batch = Total production cost of batch

Number of units in batch
The selling prices of batches are calculated by adding a profit to the cost of the
batch, i.e. very similar to job costing.

Describe the situations where the use of job or batch costing would be
appropriate
Job costing may be used by: plumbers, electricians, builders, engineering

companies, architectures, tile layers etc.
186
Batch costing is used by manufacturing companies with manufacture products that
are too small to identify the cost per unit; for example, engineering component
industry, footwear and clothing manufacturing industries.

Prepare cost records and accounts in job and batch costing situations
The usual method of fixing prices in a jobbing concern is cost plus pricing. Cost plus
pricing means that a desired profit margin is added to total costs to arrive at the
selling price.
Mark-up profit is calculated as a percentage of the total costs of the job, e.g. 20%
mark-up: -
%
Selling price 120
Total cost (100)
Profit 20
Margin profit is calculated as a percentage of the selling price of the job, e.g. 20%
margin: -
%
Selling price 100
Total cost (80)
Profit 20
Job Cost Card

Job ABC
$
Direct Material X
Direct Labour X
Prime Cost X
Variable overheads X
Fixed overheads X
Total Cost X
Profit X
Selling Price of Job X
187
Lecture Example 1
Country Ltd carried out the following job to meet a customers specific order: -
Department X Department Y
Direct materials used $5,000 $3,000
Direct labour hours 400 hours 200 hours
Direct labour rate per hour $4 $5
Production overhead per direct labour hour $4 $4
Administration overheads 20% of full production cost
Profit margin 25% of sales price
Calculate the selling price of the job.
Lecture Example 2
Ringo Ltd manufactures iron rings to order. It has the following budgeted overheads
for the year: -
Production Departments Budgeted Overheads Budgeted Activity

$
X 12,000 3,000 labour hours
Y 20,000 2,000 labour hours
Selling and administrative overheads are 25% of factory cost.
188
Calculate the cost of one batch of 500 rings if the following costs will also be
incurred: -
Materials $30,000
Labour 200 hours in Department X at $5 per hour
400 hours in Department Y at $10 per hour
11.3.1 Work in progress
Sometimes, jobs may not be 100% complete at year end. The value of work in
progress is simply the sum of the costs incurred on incomplete jobs.
Lecture Example 3
A firm uses job costing and recovers overheads on direct labour.
Three jobs were worked on during the month of July, the details of which are as
follows:
Job A Job B Job C
Opening work in progress 0 10,000 25,000

Material 29,000 35,000 0
Labour 25,000 14,000 15,000
The overheads for the period were equal to budgeted overheads at $189,000.
Jobs A and C were not completed by the end of July.
What was the value of closing work in progress? _______________

Describe the characteristics of process costing
Process costing is a costing method used where it is not possible to identify separate
units of production, or jobs, usually because of the continuous nature of the
production processes involved. All the products in the process are identical and
indistinguishable from each other.
The essence of process costing involves the averaging of the total costs of each
process over the total output of the process.
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Average cost per unit = Costs of production
Expected or normal output
The output of one process forms the material input of the next process. Also, closing
work-in-progress (WIP) at the end of one period forms the opening WIP at the
beginning of the next period.

Describe the situations where the use of process costing would be
appropriate
It is common to identify process costing with continuous production such as the

following: -
Oil refining
Paper
Foods and drinks
Chemicals
Process costing may also be associated with the continuous production of large
volumes of low-cost items, such as cans or tins.
190
Explain the concepts of normal and abnormal losses and abnormal gains
It is normal that the total of the input units may differ from the total of the output units.
This usually happens when there are losses or gains in the process.
Normal loss is the loss that is expected in a process and is often expressed as a
percentage of the materials input to the process.
Average cost per unit = Total cost of inputs

Units input Normal loss
If normal loss is sold as scrap, the revenue is used to reduce the input costs of the
process. If normal loss does not have a scrap value, it is valued in the process
account as $Nil.
Average cost per unit = Total cost of inputs Scrap value of normal loss
Normal gain is the expected gain in a process. If the loss or the gain in a process is
different to what we are expecting, then we have an abnormal loss or an abnormal
gain in the process. If losses are greater than expected, the extra loss is abnormal
loss. If losses are less than expected, the difference is known as abnormal gain.
1. The costs of abnormal gains and losses are not absorbed into the cost of
good output but are shown as losses and gains in the process account
2. Abnormal loss and gain units are valued at the same cost as units of good
output.
Lecture Example 4
During February the following costs were incurred in a process:
Materials $20,000
Labour $10,000
Overheads $ 8,000
2,000 units were produced.
Calculate the cost per unit.
191
Calculate the cost per unit of process outputs
The following steps should be followed when answering questions which include
normal loss, abnormal loss or abnormal gain: -
1. Draw the process account, and enter the inputs, i.e. units and values.
2. Enter the normal loss units and scrap value if any.
3. Enter the good output units only.
4. Balance the units. The balancing figure is either abnormal loss or gain.
5. Calculate the average cost per unit: -
6. Value the good output and abnormal loss or gain at this average cost per unit.

Prepare process accounts involving normal and abnormal losses and
abnormal gains.
Process A/c
Units $ Units $
Input cost Raw Material x x Output x x
Labour x Normal Loss x x
Overheads x
Abnormal Gain x x Abnormal loss x x
x x x x
Scrap A/c
Units $ Units $
Normal loss x x Cash Received x x
Abnormal Loss x x Abnormal Gain x x
x x x x
If no scrap value is given, no scrap account can be drawn up and value of normal
loss in process account will be nil.
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Abnormal Loss/Gain A/c
Units $ Units $
Process x x Scrap x x
Income Statement Income Statement -
Gain x Loss x
x x x x
Lecture Example 5
During March the following costs were incurred in a process:
Materials (1000kg) $12,000

Labour $7,000
Overheads $8,000
A normal loss of 10% was expected. The actual output was 900kg.
Calculate the cost per kg, and prepare a Process Account.
Lecture Example 6
During April, the following costs were incurred in a process:

Labour $12,000
Overheads $10,800
A normal loss of 10% was expected. The actual output was 2,700kg.
Losses have a scrap value of $5 per kg.
Calculate the cost per kg and prepare a Process Account and a Scrap
Account.
Lecture Example 7
During May, the following costs were incurred in a process:

Labour $18,000
Overheads $13,500
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A normal loss of 10% of input was expected.
Actual output was 850kg.
Losses are sold as scrap for $9 per kg.
Calculate the cost per kg and prepare a Process Account, a Scrap Account
and an Abnormal Loss/Gain Account.
Lecture Example 8
During June the following costs were incurred in a process:

Labour $36,000
Overheads $27,000
A normal loss of 10% of input was expected.

Actual output was 1840kg.
Losses are sold as scrap for $9 per kg.
Calculate the cost per kg and prepare a Process Account, a Scrap Account
and an Abnormal Loss/Gain Account.

Calculate and explain the concept of equivalent units
11.9.1 Equivalent Units
When units are partly completed at the end of a period (and hence there is closing
work in progress), it is necessary to calculate the equivalent units of production in
order to determine the cost of a completed unit. It would be unfair to allocate a full
unit cost to part-process units so we need to use the concept of equivalent units.
Equivalent units are notional whole units which represent incomplete work, and
which are used to apportion costs between work in process and completed output.
Closing work in progress units become opening work in progress units in the next
accounting period.
11.9.2 Different degrees of completion
Since material is input at the start of the process, it is only the addition of labour and
overheads that will be incomplete at the end of the period. This means that material
194
cost should be spread over all units but conversion costs should be spread over the
equivalent units.
Lecture Example 9
During January the following costs were incurred in a process:
Materials (1000 units) $5,000

Labour $2,760
Overheads $3,440
During the month, 800 units were finished and transferred to the next process.
The remaining 200 units were WIP and were complete as follows:
Materials 100%
Labour 60%
Overheads 30%
Required: -
i. calculate the cost per unit
ii. value the finished output and the WIP;
iii. prepare a Process Account.

Apportion process costs between work remaining in process and transfers out
of a process using the weighted average and FIFO methods
Work remaining in process (WIP) and fully-completed units can be valued using
either weighted average method or the FIFO method.
11.10.1 Weighted average costing of production
In the weighted average method, opening inventory values are added to current
costs to provide an overall average cost per unit. The cost of opening inventory is
added to the costs incurred during the period, and completed units of opening
inventory are each given a value of one full equivalent unit of production. Therefore,
no distinction is made between units in process at the start of a period and those
added during the period.
195
Lecture Example 10
During July, the following costs were incurred
Materials (30,000 units) $24,900

Labour and overheads $20,075
At the beginning of July, there were 15,000 units of work in progress valued as
follows:
Materials (100% complete) $9,000

Labour and overheads (40% complete) $1,250
At the end of July, there were 5,000 units of work-in-progress. They were 100%
complete for materials and 50% complete for labour and overheads.
Required: -
Prepare the Process Account using the weighted average method.
11.10.2 FIFO costing of production
The FIFO method of valuation deals with production on a first in, first out basis. The
assumption is that the first units completed in any period are the units of opening
inventory that were held at the beginning of the period.
This means that the process costs must be allocated between: -
1. Opening WIP units

2. Units started and completed in the period
3. Closing WIP units
This means that if opening WIP units are 60% complete with respect to materials
and 30% with respect to conversion costs (labour and overheads), only 40% more
work will need to be carried out with respect to materials and 70% with respect to
conversion costs.
Lecture Example 11
During July, the following costs were incurred
Materials (30,000 units) $24,900

196
At the beginning of July, there were 15,000 units of work in progress valued as
follows:
Materials (100% complete) $9,000

Labour and overheads (40% complete) $1,250
At the end of July, there were 5,000 units of work-in-progress. They were 100%
complete for materials and 50% complete for labour and overheads.
Required: -
Prepare the Process Account using the FIFO method.
11.10.3 Which method to choose?
FIFO inventory valuation is more common than the weighted average method, and
should be used unless an indication is given to the contrary. You may find that you
are presented with limited information about the opening inventory, which forces you
to use either the FIFO or the weighted average method.
The rules are: -
1. If you are told the degree of completion of each element in opening inventory,
but not the value of each cost element, then you must use the FIFO method.
2. If you are not given the degree of completion of each cost element in opening
inventory, but you are given the value of each cost element, then you must
use the weighted average method.

Prepare process accounts where losses and gains are identified at different
stages of the process
What happens if the losses do not occur at the end of the process (as we have seen
till now) but part way through a process? In this case, equivalent units must be used
to assess the extent to which costs were incurred at the time at which the loss was
identified.
Lecture Example 12
Prank manufactures chemicals and has a normal loss of 15% of material input.
Losses are identified when the process is 40% complete. Information for the month
of January is as follows: -
197
Material input 200 kg at $5 per kg
Conversion costs $4,100
Transfers to finished goods 160 kg
There is no opening or closing WIP
Required: -
Prepare the process account for the month of January.

Distinguish between by-products and joint products
11.12.1 Joint Products
Joint products are two or more products which are output from the same processing
operation, but which are indistinguishable from each other up to their point of
separation.
Joint products have a substantial sales value. Often they require further processing
before they are ready for sale. Joint products arise, for example, in the oil refining
industry where diesel fuel, petrol, paraffin and lubricants are all produced from the
same process.
11.12.2 By-Products
A by-product is a supplementary or secondary product (arising as the result of a

process) whose value is small relative to that of the principal product.
The distinguishing feature of a by-product is its relatively low sales value in

comparison to the main product. In the timber industry, for example, by-products
include sawdust, small offcuts and bark.
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Value by-products and joint products at the point of separation
11.13.1 Accounting treatment Joint Products
A joint product is regarded as an important saleable item, and so it should be

separately costed. The profitability of each joint product should be assessed in the
cost accounts.
Joint process costs (pre-separation costs) occur before the split-off point. These
costs have to be apportioned between the joint products at the split-off point to
obtain the costs of each of the products in order to value closing inventory and cost
of sales.
The main methods of apportioning joint costs, each of which can produce
significantly different results are: -
1. Sales value of production (market value)

2. Production units
3. Net realisable value
Lecture Example 13
Two products W and X are created from a joint process. Both products can be sold
immediately after split-off. There are no opening inventories or work-in-progress. The
following information is available for the last period:
Total joint production costs $776,160
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Product Production units Sales units Selling Price per unit
W 12,000 10,000 $10

X 10,000 8,000 $12
Using the sales value method of apportioning joint production costs, what was the
value of the closing inventory of product X for the last period?
A. $68,992
B. $70,560
C. $76,032
D. $77,616
Lecture Example 14
In a process where there are no work-in-progress inventories, two joint products (J

and K) are created. Information (in units) relating to last month is as follows:
Product Sales Opening inventory Closing inventory of

of finished goods finished goods
J 6,000 100 300
K 4,000 400 200
Joint production costs last month were $110,000 and these were apportioned to joint
products based on the number of units produced.
What were the joint production costs apportioned to product J for last month?
A. $63,800
B. $64,000
C. $66,000
D. $68,200
Lecture Example 15
During September the following costs were incurred in a process:

200
The production from the process was as follows:
Kg
Product A 1,000 selling price $8.40 per kg
Product B 2,000 selling price $4.50 per kg
All the output of A and B incurred further processing at a cost of $4.80 per kg for A
and $2.20 per kg for B.
Calculate a cost per kg for A and B using the net realizable value approach.
11.13.2 Accounting treatment By-Products
A by-product is not important as a saleable item, and whatever revenue it earns is a

'bonus' for the organisation. Because of their relative insignificance, by-products are
not separately costed. In fact, by-products do not pick up a share of the costs.
Process costs are only shared between the joint products alone.
There are four methods to account for by-products: -
1. Income from by-product is added to sales of the main products

2. By-product income is treated as a separate source of income
3. Sales income of the by-product is deducted from the cost of production in the
period
4. Net realizable value of the by-product is deducted from the cost of production
in the period

Prepare process accounts in situations where by-products and/or joint
products occur
When preparing process accounts, joint costs should be treated as normal output
from a process. The treatment of by-products in process costing is similar to the
treatment of normal loss.
The by-product income is credited to the process account and debited to a by-
product account. To calculate equivalent units in a period, by-products (like normal
loss) are zero equivalent units.
201
Lecture Example 16
During December 2010, P Co recorded the following results:
Production costs $150,000

Sales of the main product amounted to 90% of output during the period. The
remaining 10% of production was held as closing inventory at 31 December 2010.
Sales revenue from the main product during December 2010 was $180,000.
A by-product is produced. Output has a net sales value of $2,500. Of this output,
$2000 was sold during the month and the remaining $500 was still in inventory at 31
December 2010.
Calculate the profit for December using the four methods of accounting for by-
products.
202
KEY NOTES
203
1. Job costing
Job costing is a costing method applied where work is undertaken to customers'

special requirements and each order is of comparatively short duration.
Individual jobs are given a unique job number and the selling prices of jobs are
calculated by adding a certain amount of profit to the cost of the job.
Job costing may be used by: plumbers, electricians, builders, engineering

companies, architectures, tile layers etc.
2. Batch costing
A batch is a group of similar articles which maintains its identity during one or
more stages of production and is treated as a cost unit. The cost per unit
manufactured in a batch is the total batch cost divided by the number of units in
the batch.
Cost per unit in batch = Total production cost of batch

Number of units in batch
Batch costing is used by manufacturing companies with manufacture products

that are too small to identify the cost per unit; for example, engineering
component industry, footwear and clothing manufacturing industries.
3. Cost plus pricing
Cost plus pricing means that a desired profit margin is added to total costs to
arrive at the selling price.
Mark-up profit is calculated as a percentage of the total costs of the job.
Margin profit is calculated as a percentage of the selling price of the job.
4. Process costing
Process costing is a costing method used where it is not possible to identify

separate units of production, or jobs, usually because of the continuous nature of
the production processes involved.
Average cost per unit = Costs of production

Expected or normal output
204
The output of one process forms the material input of the next process. Also,
closing work-in-progress (WIP) at the end of one period forms the opening WIP
at the beginning of the next period.
It is common to identify process costing with continuous production, e.g.
o Oil refining
o Paper
o Foods and drinks
o Chemicals
5. Normal loss
Normal loss is the loss that is expected in a process and is often expressed as a
percentage of the materials input to the process.
Average cost per unit = Total cost of inputs

If normal loss is sold as scrap, the revenue is used to reduce the input costs of
the process. If normal loss does not have a scrap value, it is valued in the
process account as $Nil.
6. Abnormal Loss/Gain
If the loss or the gain in a process is different to what we are expecting, then we
have an abnormal loss or an abnormal gain in the process. If losses are greater
than expected, the extra loss is abnormal loss. If losses are less than expected,
the difference is known as abnormal gain.
Abnormal loss and gain units are valued at the same cost as units of good output.
The following steps should be followed when answering questions which include
normal loss, abnormal loss or abnormal gain: -
a. Draw the process account, and enter the inputs, i.e. units and values.
b. Enter the normal loss units and scrap value if any.
c. Enter the good output units only.
d. Balance the units. The balancing figure is either abnormal loss or gain.
e. Calculate the average cost per unit: -
205
f. Value the good output and abnormal loss or gain at this average cost per unit.
7. Process Accounts
Process A/c
Units $ Units $
Input cost Raw Material x x Output x x
Labour x Normal Loss x x
Overheads x
Abnormal Gain x x Abnormal loss x x
x x x x
Scrap A/c
Units $ Units $
Normal loss x x Cash Received x x
Abnormal Loss x Abnormal Gain x x
x x x x
Abnormal Loss/Gain A/c

Units $ Units $
Process x x Scrap x x
Income Statement Income Statement -
Gain x Loss x
x x x x
8. Equivalent Units
Equivalent units are notional whole units which represent incomplete work, and
which are used to apportion costs between work in process and completed
output.
Different degrees of completion
Since material is input at the start of the process, it is only the addition of labour and
overheads that will be incomplete at the end of the period. This means that
206
material cost should be spread over all units but conversion costs should be
spread over the equivalent units.
Work remaining in process (WIP) and fully-completed units can be valued using
either weighted average method or the FIFO method.
9. Weighted average costing of production
In the weighted average method, opening inventory values are added to current
costs to provide an overall average cost per unit. The cost of opening inventory is
added to the costs incurred during the period, and completed units of opening
inventory are each given a value of one full equivalent unit of production.
Therefore, no distinction is made between units in process at the start of a period
and those added during the period.
10. FIFO costing of production
The FIFO method of valuation deals with production on a first in, first out basis.
The assumption is that the first units completed in any period are the units of
opening inventory that were held at the beginning of the period.
This means that the process costs must be allocated between: -

1. Opening WIP units
2. Units started and completed in the period
3. Closing WIP units
11. Which method to choose?
a. If you are told the degree of completion of each element in opening

inventory, but not the value of each cost element, then you must use the
FIFO method.
b. If you are not given the degree of completion of each cost element in
opening inventory, but you are given the value of each cost element,
then you must use the weighted average method.
12. Joint Products
Joint products are two or more products which are output from the same
processing operation, but which are indistinguishable from each other up to their
point of separation.
Joint products have a substantial sales value. Often they require further
processing before they are ready for sale.
207
13. By-Products
A by-product is a supplementary or secondary product (arising as the result of a

process) whose value is small relative to that of the principal product. The
distinguishing feature of a by-product is its relatively low sales value in
comparison to the main product.
14. Accounting Treatment Joint Products
Joint process costs (pre-separation costs) occur before the split-off point. These
costs have to be apportioned between the joint products at the split-off point to
obtain the costs of each of the products in order to value closing inventory and
cost of sales.
The main methods of apportioning joint costs, each of which can produce
significantly different results are: -
1. Sales value of production (market value)

2. Production units
3. Net realisable value
15. Accounting Treatment By-Products
There are four methods to account for by-products: -
1. Income from by-product is added to sales of the main products

2. By-product income is treated as a separate source of income
3. Sales income of the by-product is deducted from the cost of production in the
period
4. Net realizable value of the by-product is deducted from the cost of production
in the period
208
QUESTIONS
209
1. The following statements refer to organisations using job costing:
(i) Work is done to customer specification.
(ii) Work is usually completed within a relatively short period of time.
(iii) Products manufactured tend to be all identical.
Which two of these statements are CORRECT?

A. (i) and (ii)
B. (i) and (iii)
C. (ii) and (iii)
2. The cost of a job is $100,000.
i. If profit is 25% of the job cost, the price to be charged for the job is
$_________.
ii. If profit is 25% margin, the price to be charged for the job is $_________.
3. Information relating to two processes (X and Y) was as follows:
Process Normal loss Input Output

as % of input litres litres
X 8 65,000 58,900
Y 5 37,500 35,700
For each process, was there an abnormal loss or an abnormal gain?
Process X Process Y
A. Abnormal gain Abnormal gain

B. Abnormal gain Abnormal loss
C. Abnormal loss Abnormal gain
D. Abnormal loss Abnormal loss
4. A company operates a process in which no losses are incurred. The process

account for last month, when there was no opening work-in-progress, was as
follows:
210
The closing work-in-progress was complete to the same degree for all elements
of cost.
What was the percentage degree of completion of the closing work-in-progress?

A. 12%
B. 30%
C. 40%
D. 75%
5. A company which operates a process costing system had work-in-progress at

the start of last month of 300 units (valued at $1,710) which were 60% complete
in respect of all costs. Last month a total of 2,000 units were completed and
transferred to the finished goods warehouse. The cost per equivalent unit for
costs arising last month was $10.
The company uses the FIFO method of cost allocation.
What was the total value of the 2,000 units transferred to the finished goods
warehouse last month?
A. $19,910
B. $20,000
C. $20,510
D. $21,710
6. In process costing, if an abnormal loss arises, the process account is generally

A. debited with the scrap value of the abnormal loss units
B. debited with the full production cost of the abnormal loss units
C. credited with the scrap value of the abnormal loss units
D. credited with the full production cost of the abnormal loss units
7. Burgress operates a continuous process into which 3,000 units of material

costing $9,000 was input in a period. Conversion costs for this period were
$11,970 and losses, which have a scrap value of $1.50, are expected at a rate of
211
10% of input. There were no opening or closing stocks and output for the period
was 2,900 units.
What was the output valuation?

A. $20,271
B. $20,520
C. $20,970
D. $22,040
8. What is a by-product?
A. A product produced at the same time as other products which has no value
B. A product produced at the same time as other products which requires further
processing to put it in a saleable state
C. A product produced at the same time as other products which has a relatively
low volume compared with the other products
D. A product produced at the same time as other products which has a relatively
low value compared with the other products
9. In process costing, a joint product is
A. A product which is later divided into many parts

B. A product which is produced simultaneously with other products and is of
similar value to at least one of the other products
C. A product which is produced simultaneously with other products but which is
of a greater value than any of the other products
D. A product produced jointly with another organisation
10. Two products G and H are created from a joint process. G can be sold
immediately after split-off. H requires further processing into product HH before it
is in a saleable condition. There are no opening inventories and no work in
progress of products G, H or HH. The following data are available for last period:
$
Total joint production costs 350,000
Further processing costs of product H 66,000
Product Production Closing inventory

units units
G 420,000 20,000
HH 330,000 30,000
212
Using the physical unit method for apportioning joint production costs, what was
the cost value of the closing inventory of product HH for last period?
A. $16,640
B. $18,625
C. $20,000
D. $21,600
213
ANSWERS
214
1. A
2. i. $125,000
Sales 125 $125,000

COS 100 $100,000
Profit 25 $25,000
ii. $133,333
Sales 100 $133,333

COS 75 $100,000
Profit 25 $33,333
3. C
Process X
Input 65,000 NL 5,200 (65000 x 8%)
Output 58,900
AL 900
65,000 65,000
Process Y
Input 37,500 NL 1,875
AG 75 Output 35,700
37,575 37,575
4. D
Closing WIP = $144,000

4,000
= $36
215
Finished Goods = $480,000
10,000
= $48
$36 x 100
$48
= 75% complete
5. A
Total Costs
% EU
Opening WIP 300 40 120
Started &
Completed 1,700 100 1,700
2,000 1,820
1820 x $10 = 18,200 +

1,710
19,910
6. D
7. D
Process A/c
Units $ Units $
Material 3,000 9,000 NL 300 450
Conv. 11,970
AG 200 FG 2,900 22,040
3,200 20,970 3,200 36,150
Cost / EU = (9,000 + 11,970) - 450

3,000 - 300
= $7.60
216
Finish Goods = 2,900 x $7.60
= $22,040
8. D
9. B
10. C
350,000
G H
420,000 330,000 = 750,000
= $350,000 x 330,000
750,000
= $154,000 +
66,000
220,000
330,000
= $20,000
217
Chapter 12
SERVICE AND OPERATIONS COSTING
Identify situations where the use of service/operation costing is appropriate.
Service/operation costing can be used by companies operating in a service industry

or by companies wishing to establish the cost of services carried out by some of their
departments.
Service organisations do not make or sell tangible goods. In fact, the output of
service organisations/departments can be described as: -
Simultaneous production and consumption

Heterogeneity the nature and the standard of the service will be variable
Intangibility
Perishability cannot be stored
Service costing is used in the following circumstances.
1. A company operating in a service industry will cost its services, for which
sales revenue will be earned; examples are electricians, car hire services,
road, rail or air transport services, hairdressers, banks, colleges and hotels.
2. A company may wish to establish the cost of services carried out by some of
its departments, i.e. establishing a specific cost for an internal service. For
example costs of the vans or lorries used in distribution, the costs of the
computer department, or the staff canteen.
Therefore, service costing has two basic purposes: -

i. To control the costs in the service department
ii. To control the costs of the user departments and prevent the
unnecessary use of services.
218
Illustrate suitable unit cost measures that may be used in different
service/operation situations.
The main problem with service costing is the difficulty in defining a realistic cost unit
that represents a suitable measure of the service provided.
Frequently, a composite cost unit may be deemed more appropriate. Therefore, two
variables will be considered. Hotels, for example, may use the 'occupied bed-night'
as an appropriate unit for cost ascertainment and control.
Typical cost units used by companies operating in a service industry are: -
Service Cost unit
Road, rail and air transport Passenger/mile or kilometre, ton/mile,

services tonne/kilometre
Hotels Occupied bed-night; guest days
Hospitals Patient-days
Catering establishment Meals served
The total cost of providing a service will include labour, materials, direct expenses
and overheads. In service costing, labour may be the only direct cost involved in
providing a service. Overheads will make up the remaining total costs.
The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units in providing the
service.
Cost per service

unit = Total costs for period
Number of service units in the period
Lecture Example 1
The RCA Worldwide, with annual running costs of $5 million, has the following
students: -
Attendance
Number Weeks p.a. Hours/week
1st year students 2,700 30 28
219
2nd year students 1,500 35 30
Required: -
Calculate a cost per suitable cost unit for RCA.
Lecture Example 2
Which of the following are characteristics of service costing?
i. High levels of direct labour costs as a proportion of total cost

ii. Use of composite cost units
iii. Use of equivalent units
A. (i) only
B. (i) and (ii) only
C. (ii) only
D. (ii) and (iii) only

Carry out service cost analysis in simple service industry situations
If organisations in the same industry use the same service cost units, then
comparisons between companies can be made easily.
Lecture Example 3
A transport business has 6 lorries in operation, 5 days a week for 50 weeks of the
year. Each vehicle is expected to make 4 journeys a day, delivering an average load
of 5 tonnes to each customer. The average customer is located 25 km from the
transport headquarters. Fuel and other variable running costs per kilometer traveled
(laden or unladen) are budgeted to be $0.50. Other fixed running costs amount to
$225,000 per annum.
What is the standard running cost per tonne kilometer? _______
220
KEY NOTES
221
1. Service/Operation Costing
Service/operation costing can be used by companies operating in a service

industry or by companies wishing to establish the cost of services carried out by
some of their departments. Service costing is used in the following
circumstances.
i. A company operating in a service industry will cost its services, for which
sales revenue will be earned
ii. A company may wish to establish the cost of services carried out by some of
its departments
2. Unit Cost Measures
The main problem with service costing is the difficulty in defining a realistic cost
unit that represents a suitable measure of the service provided.
Frequently, a composite cost unit may be deemed more appropriate.
The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units in providing
the service.
Cost per service

unit = Total costs for period
Number of service units in the period
222
QUESTIONS
223
1. A companys canteen has the following income and expenditure in a particular
month: -
$ $
Income 72,000
Food 18,000
Drink 4,000
Fuel costs 3,500
Maintenance of machinery 1,800
Repairs 1,250
Wages 5,650
During the month, the canteen served 1,200 meals for 30 days.
Calculate the average cost per meal served and the average income per meal
served.
2. Which of the following is unlikely to be used by the rooms department of a hotel?
A. Room occupancy
B. Cleaning cost per room
C. Meals served per guest
D. Average cost per occupied bed
3. In many service industries, the cost of direct materials consumed will be

relatively low compared to the labour, direct expenses and overhead cost.
A. True
B. False
4. Transport Co operates a small fleet of delivery vehicles. Standard costs have

been established as follows.
Loading 1 hour per tonne loaded

Loading costs:
Labour (casual) $2 per hour
Equipment depreciation $80 per week
Supervision $80 per week
Drivers wages (fixed) $100 per man per week
Petrol 10c per kilometre
Repairs 5c per kilometre
Depreciation $80 per week per vehicle
224
Supervision $120 per week
Other general expenses (fixed) $200 per week
There are two drivers and two vehicles in the fleet.
During a slack week, only six journeys were made.
Tonnes carried One-way distance

Journey (one-way) of journey
Kilometres
1 5 100
2 8 20
3 2 60
4 4 50
5 6 200
6 5 300
Required:
Calculate the expected average full cost per tonne/kilometre for the week.
225
ANSWERS
226
1. Average income per meal = $72,000
1,200 x 30
= $2
Average cost per meal = $34,200

1,200 x 30
= $0.95
2. C
3. True
4.
Variable costs Journey 1 2 3 4 5 6

$ $ $ $ $ $
Loading labour 10 16 4 8 12 10
Petrol (both ways) 20 4 12 10 40 60
Repairs (both ways) 10 2 6 5 20 30
40 22 22 23 72 100
Total costs
$
Variable costs (total for journeys 1 to 6) 279
Loading equipment depreciation 80
Loading supervision 80
Drivers wages 200
Vehicles depreciation 160
Drivers supervision 120
Other costs 200
1,119
Journey One way distance

Tonnes Kilometres Tonne/kilometres
1 5 100 500
2 8 20 160
3 2 60 120
4 4 50 200
5 6 200 1,200
6 5 300 1,500
3,680
227
Cost per tonne/kilometre $1,119 = $0.304
3,680
Note that the large element of fixed costs may distort this measure but that a variable
cost per tonne/kilometre of $279/3,680 = $0.076 may be useful for budgetary control.
228
Chapter 13
ALTERNATIVE COST ACCOUNTING
TECHNIQUES
After having looked into traditional costing techniques, in this chapter four alternative
cost management techniques will be introduced. These are: -
1. Activity based costing (ABC)

2. Target costing
3. Life cycle costing
4. Total quality management (TQM)

Explain activity based costing (ABC), target costing, life cycle costing and total
quality management (TQM) as alternative cost management techniques
Differentiate ABC, target costing and life cycle costing from the tradition
costing techniques (note: calculations are not required)
13.1.1 Activity-based costing (ABC)
13.1.1.1 Absorption Costing vs. ABC
As already discussed, in absorption costing, we allocate overheads to production

and service departments. All service departments overheads are then reallocated to
production departments to find the overhead absorption rate per basis of activity
(these vary directly with the volume produced e.g. machine hours, labour hours or
number of units). Hence, costs are traced to the product because each product item
is assumed to consume the resources.
However, in many modern-manufacturing operations, overheads are not primarily

influenced by volume. In fact, the majority of overheads in a modern manufacturing
operation are largely unaffected by changes in production volume.
ABC is an alternative costing method to absorption costing. ABC links overhead

costs to the products or services that cause them by absorbing overhead costs on
the basis of activities that drive costs (cost drivers) rather than on the basis of
production volume.
229
In ABC, activities are the focus of, the costing process, e.g. equipment preparation,
order handling and quality control. Costs are traced from activities to products based
on the products demands for these activities during the production process
By grouping costs on the basis of cost drivers, we will be able to both manage costs
better (by managing the activity) and to calculate the cost of production.
Examples of cost drivers would be: -
Ordering costs no. of orders

Set-up costs no. of set-ups
Packing costs no. of packing orders
13.1.1.2 Steps in establishing and applying ABC
There are 5 main steps in establishing and applying ABC: -
1. Identify activities that consume resources and incur overhead costs.

2. Allocate overhead costs to the activities that incur them.
3. Determine the cost driver for each activity or cost pool.
Each group of costs which are influenced by a particular cost driver is referred
to as a 'cost pool'.
4. Collect data about actual activity for the cost driver in each cost pool
5. Calculate the overhead cost of products or services.
This is done by calculating an overhead cost per unit of the cost driver.
Overhead costs are then charged to products or services on the basis of
activities used for each product or service.
Extracted from Article Activity-Based Costing by K. Garrett, Student Accountant

February 2010
230
13.1.1.3 The Advantages of ABC
1. More accurate cost information is obtained. It identifies ways of reducing

overhead costs in the longer-term. This will enable managers to make better
decisions, particularly in respect of pricing and marketing activities.
2. It provides much better insights into what drives overhead costs. ABC recognises
that overhead costs are not all related to volume. It also identifies activities and
costs that do not add value.
3. ABC can be applied to all overhead costs, not just production overheads.
13.1.1.4 Disadvantages of ABC
ABC may not be universally beneficial. There are four major issues to be considered:
1. Cost vs benefit
The need to analyse costs on a radically different basis will require resources,
which will lead to additional costs. Clearly the benefits which will be obtained
must exceed these costs.
In general terms, an organisation which has little competition, a stable and

standardised product range and for which overheads represent a small
proportion of total cost, will not benefit from the introduction of ABC.
2. Need for informed application
While ABC is likely to provide better information for decision makers, it must
still be applied with care. ABC is not fully understood by many managers and
therefore is not fully accepted as a means of cost control.
3. Difficulty in identifying cost drivers
In a practical context, there are frequently difficulties in identifying the

appropriate drivers. ABC costs are based on assumptions and simplifications.
The choice of both activities and cost drivers might be inappropriate.
4. Lack of appropriate accounting records
ABC needs a new set of accounting records, this is often not immediately
available and therefore resistance to change is common. The setting up of
new cost pools is needed which is time-consuming.
231
Worked out example (no calculations required for exam)
The following example looks at the different activities within a company, their cost
and their cost driver. The cost per driver is found by dividing the total cost of the
activity by the quantity of the cost drivers. Overhead costs are then charged to
products or services on the basis of activities used for each product or service.
Activity Cost Pool Cost Driver Volume Cost/ Driver

$ $
Process set up 37,500 100 set ups 375 / set up
Material 9,000 50 purchase orders 180 / purchase
procurement order
Maintenance 10,000 10 standard 1000/
maintenance plans maintenance
plan
Material handling 22,500 2,000 material 11.25 / material
movements movement
Quality control 20,500 250 inspections 82 / inspection
Order processing 13,000 300 customers 43.33 /
customer
$112,500
Lecture Example 1
In activity based costing systems, costs are accumulated by activity using:
A. Cost drivers
B. Cost centres
C. Cost pools
D. Cost benefit analysis
Lecture Example 2
A cost driver is:
A. An item of production overhead

B. A common cost which is shared over cost centres
C. Any cost relating to transport
D. An activity which generates costs
232
Lecture Example 3
Which of the following are benets of using activity based costing?

(1) It recognises that overhead costs are not always driven by the volume of
production.
(2) It does not result in under or over absorption of xed overheads.
(3) It avoids all arbitrary cost apportionments.
(4) It is particularly useful in single product businesses.
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1 and 4 only
13.1.2 Target Costing
A target cost is a cost estimate derived by subtracting a desired profit margin from a
competitive market price.
13.1.2.1 Target Costing Process
1. Target costing begins by specifying a product an organisation wishes to sell.

Ideally only those features valued by customers will be included in the product
design.
2. The price at which the product can be sold at is then considered. This will
take into account the competitors products and the market conditions
expected at the time that the product will be launched.
3. From the above price a desired margin is deducted. This leaves the cost
target. An organisation will need to meet this target if their desired margin is
to be met.
4. Costs for the product are then calculated and compared to the cost target
mentioned above.
5. If it appears that this cost cannot be achieved, then the difference (shortfall) is
called a cost gap. This gap would have to be closed, by some form of cost
reduction, if the desired margin is to be achieved.
13.1.2.2 Target Cost Gap
Where a gap exists between the current estimated cost levels and the target cost, it
is essential that this gap be closed. Efforts to close a target cost gap are most likely
to be successful at the design stage. It is far easier to design out cost during the
pre-production phase than to control out cost during the production phase.
233
13.1.2.3 Ways to reduce a cost gap
1. Review the products features.
2. Remove features that add to cost but do not significantly add value to the
product when viewed by the customer.
3. Team approach - The company should bring together members of the

marketing, design, assembly and distribution teams to allow discussion of
methods to reduce costs. Open discussion and brainstorming are useful
approaches here.
4. Review the whole supplier chain - each step in the supply chain should be
reviewed, possibly with the aid of staff questionnaires, to identify areas of
likely cost savings. For example, the questionnaire might ask are there more
than five potential suppliers for this component? Clearly a yes response to
this question will mean that there is the potential for tendering or price
competition.
5. Reduce waste or idle time that might exist. Where possible, standardised
components should be used in the design. Productivity gains may be possible
by changing working practices or by de-skilling the process. Automation is
increasingly common in assembly and manufacturing.
These techniques are known as value-engineering.
Lecture Example 4
Which of the following BEST describe target costing?
A. Setting a cost by subtracting a desired profit margin from a competitive market

price
B. Setting a price by adding a desired profit margin to a production cost
C. Setting a cost for the use in the calculation of variances
D. Setting a selling price for the company to aim in the long run
234
13.1.3 Life-Cycle Costing
Life-cycle costing tracks and accumulates the actual costs and revenues attributable
to each product from inception to abandonment. It enables a products true
profitability to be determined at the end of the economic life.
Traditional cost accounting systems do not accumulate costs over a products entire
life but focus instead on (normally) twelve month accounting periods. As a result the
total profitability of a product over its entire life becomes difficult to determine.
13.1.3.1 Product Life Cycle
Every product goes through a life cycle.
1. Development. The product has a research and development stage where

costs are incurred but no revenue is generated. During this stage, a high level
of setup costs will be incurred, including research and development, product
design and building of production facilities.
2. Introduction. The product is introduced to the market. Potential customers will

be unaware of the product or service, and the organisation may have to spend
further on advertising to bring the product or service to the attention of the
market. Therefore, this stage will involve extensive marketing and promotion
costs. High prices may be changed to recoup these high development costs.
3. Growth. The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit. Marketing and
promotion will continue through this stage. Unit costs tend to fall as fixed
costs are recovered over greater volumes. Competition also increases and
the company may need to reduce prices to remain competitive.
4. Maturity. Eventually, the growth in demand for the product will slow down and
it will enter a period of relative maturity. It will continue to be profitable.
However, price competition and product differentiation will start to erode
profitability. The product may be modified or improved, as a means of
sustaining its demand.
5. Decline. At some stage, the market will have bought enough of the product
and it will therefore reach 'saturation point'. Demand will start to fall and prices
will also fall. Eventually it will become a loss maker and this is the time when
the organisation should decide to stop selling the product or service. During
this stage, the costs involved would be environmental clean-up, disposal and
decommissioning. Meanwhile, a replacement product will need to have been
235
developed, incurring new levels of research and development and other setup
costs.
The level of sales and profits earned over a life cycle can be illustrated
diagrammatically as follows.
13.1.3.2 Benefits of life cycle costing
The benefits of product life cycle costing are summarised as follows:
1. All costs (production and non production) will be traced to individual products
over their complete life cycles and hence individual product profitability can be
more accurately measured.
2. The product life cycle costing results in earlier actions to generate revenue or
to lower costs than otherwise might be considered.
3. Better decisions should follow from a more accurate and realistic assessment
of revenues and costs, at least within a particular life cycle stage.
4. Product life cycle thinking can promote long-term rewarding in contrast to

short-term profitability rewarding.
5. It helps management to understand the cost consequences of developing and

making a product and to identify areas in which cost reduction efforts are
likely to be most effective. Very often, 90% of the products life-cycle costs
are determined by decisions made in the development stage. Therefore, it is
important to focus on these costs before the product enters the market.
236
6. Identifying the costs incurred during the different stages of a products life
cycle provides an insight into understanding and managing the total costs
incurred throughout its life cycle. Non production costs will become more
visible and the potential for their control is increased.
7. More accurate feedback on the success or failure of new products will be

available.
Lecture Example 5
The following statements relate to life-cycle costing:
(i) It helps forecast a products profitability over its entire life.

(ii) It takes into account a products total costs over its entire life.
(iii) It focuses on the production of monthly profit statements throughout a
products entire life.
Which of the statements are true?
A. (i) only
C. (i) and (iii) only
13.1.4 Total Quality Management (TQM)
13.1.4.1 Introduction
Total quality management (TQM) describes the situation where all business
functions are involved in a process of continuous quality improvement. It focuses on
delivering products or services of consistent high quality in a timely fashion. In the
past most companies considered quality to be an additional cost of manufacturing,
but recently they have begun to realize that quality saves money.
The basic principle of TQM is:
Costs of prevention (getting things right first time) are less than the costs of
correction.
Therefore companies should focus on getting things right first time (zero defect
philosophy) and then getting them better next time (continuous improvement). There
must be real commitment to continuous improvement in all processes by all
management.
237
In his article, Mark Lee Inman9 listed eight requirements of quality: -
1. Accept that the only thing that matters is the customer

2. Recognize the importance of the customer-supplier relationship
3. Move away from relying on inspecting to a predetermined level of quality and
move towards preventing the cause of the defect in the first place
4. Each employee or group of employees must be personally responsible for
defect-free production or service
5. Any level of defects is unacceptable
6. All departments should try to get things right first time
7. Quality certification programmes should be introduced
8. The cost of poor quality should be emphasized as good quality generates
savings
13.1.4.2 Cost of Quality
A cost of quality report should be prepared to indicate the total cost to the
organisation of producing products or services that do not conform with quality
requirements. Four categories of costs should be reported:-
1. Prevention Costs are the costs incurred in preventing the production of

products that do not conform to specification. They include the costs of
preventive maintenance, quality planning and training, the extra costs of
acquiring higher quality raw materials and quality circles.
2. Appraisal Costs are the costs incurred to ensure that materials and products
meet quality conformance standards. They include the costs of inspecting
purchased parts, work in process and finished goods, quality audits and field
tests.
3. Internal Failure Costs are the costs associated with materials and products
that fail to meet quality standards. They include costs incurred before the
product is dispatched to the customer, such as the costs of scrap, repair,
downtime, and work stoppages caused by defects.
4. External Failure Costs are the costs incurred when products or services fail to
conform to requirements or satisfy customer needs after they have been
delivered. They include the costs of handling customer complaints, warranty
replacement, repairs of returned products and the costs arising from a
damaged company reputation. Costs within this category can have a dramatic
impact on future sales.
9 ACCA Students Newsletter, May 1995
238
Prevention and appraisal costs are sometimes referred to as the costs of quality
conformance or compliance. Costs of compliance are incurred with the intention of
eliminating the costs of failure.
Internal and external failure costs are also known as the costs of non-conformance
or non-compliance. Costs of non-compliance are the result of production
imperfections and can only be reduced by increasing compliance expenditure.
Lecture Example 6
A customer returns a faulty product to a firm for repair under a warranty scheme.
The firm operates a total quality management system.
Which of the following best describes the cost of the repair?
A. An internal failure cost

B. An external failure cost
C. An appraisal cost
D. A prevention cost
Lecture Example 7
A company uses total quality management (TQM) and has recorded the following
costs of quality for a period.
$
Staff training 8,000
Inspection 12,000
Warranty claims 20,000
Rework of faulty items detected before delivery to customers 15,000
What would be the net benefit of spending an extra 10% on prevention cost to save
20% on external failure cost?
A. $2,000
B. $3,200
C. $5,000
D. $6,200
239
KEY NOTES
240
1. Activity Based Costing (ABC)
ABC links overhead costs to the products or services that cause them by
absorbing overhead costs on the basis of activities that drive costs (cost
drivers).
2. Target Costing
Three steps: -
Take the selling price
Deduct the desired margin
The remainder will be the target cost. If the expected cost is higher
than the target cost, there is a cost gap.
3. Life-cycle Costing
Life-cycle costing tracks and accumulates the actual costs and revenues
attributable to each product from inception to abandonment. It enables a
products true profitability to be determined at the end of the economic life.
4. Total Quality Management
Total quality management (TQM) focuses on delivering products or services

of consistent high quality in a timely fashion. The basic principle of TQM is:
Costs of prevention (getting things right first time) are less than the costs of
correction.
A cost of quality report should include four categories of cost: -

i. Prevention costs - costs incurred in preventing the production of
products that do not conform to specification.
ii. Appraisal Costs - costs incurred to ensure that materials and products
meet quality conformance standards.
iii. Internal Failure Costs - costs associated with materials and products
that fail to meet quality standards.
241
iv. External Failure Costs - costs incurred when products or services fail to
conform to requirements or satisfy customer needs after they have
been delivered.
Prevention and appraisal costs are sometimes referred to as the costs of

quality conformance or compliance. Internal and external failure costs are also
known as the costs of non-conformance or non-compliance.
242
QUESTIONS
243
1. In which circumstance is activity based costing a more useful approach to
product costing: -
A. One product is produced
B. Overheads form a high proportion of total costs
C. Overhead expenditure is driven by the volume of output
D. It is very difficult to identify the relevant cost drivers
2. What is the name of the costing approach used where the products selling price
is identified and ways are established of meeting production costs and making
an acceptable profit?
Choose one answer.

A. Total life cycle costing
B. Target costing
C. Benchmarking
D. Activity based costing
3. Which of the following costs would be included to find the life-cycle cost of a
product?
(i) Research and development costs

(ii) Production costs
(iii) Distribution costs
(iv) Marketing costs
A. (i), (ii), (iv)

B. (ii), (iii), (iv)
C. (i), (ii), (iii)
D. All of the above
4. Activity-based costing seeks to identify suitable:
Choose one answer.

A. Cost drivers
B. Expense drivers
C. Activity drivers
D. Value drivers
244
5. In activity-based costing, overhead costs are allocated into:-
Choose one answer.

A. Cost accounts
B. Cost centers
C. Cost groups
D. Cost pools
6. Kint Co manufactures shoes. The shoes are sold to large retailers who insist
upon the highest standard of quality. The shoes have to be manufactured to
precise dimensions and to be dyed to an exact colour shade. Below is a list of
expenses incurred in the last month:
$
Customer complaints department 3,456
Finished goods inspection 3,588
Shade matching 1,479
Quality control system development 5,110
Operative training 1,500
Rework 8,850
Machine maintenance 850
Goods inwards inspection 600
Compensation payments to customers for defective goods 4,600
Pre-despatch failure analysis 3,877
The production director attended a course on total quality management (TQM)

recently and was told that quality initiatives could save money.
a. Define the following costs of quality:

(i) Prevention costs;
(ii) Appraisal costs;
(iii) Internal failure costs;
(iv) External failure costs
b. Categorise the expenses from the month into the four categorise of quality
cost given in (a).
245
7. Which of the following describes target costing?
A. A method of costing that sets a target cost by subtracting a desired profit

margin from a competitive market price.
B. A method of costing that sets a target price by adding a desired profit margin
to actual cost.
C. A method of costing that targets selected business departments and aims to

minimize their costs.
D. A method of costing whose target is to reduce unit cost without impairing

value to the customer.
246
ANSWERS
247
1. B
2. B
3. D
4. A
5. D
6.
a. Costs of quality
Prevention costs: These represent the cost of any action taken to investigate,
prevent or reduce defects or failures.
Appraisal costs: These are the costs of assessing the quality achieved.
Internal failure costs: These are costs arising within the organization relating to a
failure to achieve the specified level of quality.
External failure costs: These are costs arising when the failure to achieve the
specified level of quality is detected outside the organization.
b. Analysis of costs
Prevention costs
Quality control devpt.
Operative training
Machine maintenance
Shade matching
Appraisal costs
Finished goods inspection
Goods inward inspection
Internal failure costs

Rework
Failure analysis
External failure costs

Customer complaints
Compensation payment
248
Note: Rework could also be categorized ax external failure costs.
Quality control development could be categorized as an appraisal cost
Shade matching could be categorized as as appraisal cost.
Goods inward inspection could be categorized as a prevention cost.
7. A
249
250
Chapter 14
NATURE AND PURPOSE OF
BUDGETING
Explain why organisations use budgeting
A budget is a quantified plan of action for a forthcoming accounting period. A budget

is a plan of what the organisation is aiming to achieve and what it has set as a target.
A forecast is an estimate of what is likely to occur in the future.
The budget is 'a quantitative statement for a defined period of time, which may
include planned revenues, expenses, assets, liabilities and cash flows. A budget
facilitates planning'.
The objectives of a budgetary planning and control system are: -
1. To ensure the achievement of the organisation's objectives

2. To compel planning in line with the objectives of the organisation
3. To communicate ideas and plans to individual managers
4. To coordinate the different activities so that managers are working towards
the same common goal
5. To evaluate the performance of management
6. To establish a system of controlling costs by comparing actual results with the
budget
7. To motivate employees to improve their performance and beat targets
251
Describe the planning and control cycle in an organization
The overall planning and control cycle is summarized in the diagram below: -
Set mission
Identify objectives
Search for alternative courses of

action
Long-term
planning process Gather data about alternatives
Select course of action
Implement long-term plan in the

form of annual budgets
Budget
process Monitor actual results Control
process
Respond to divergences from

plan
252
Stage 1:- Set Mission
This involves establishing the broad overall aims and goals of the organization its
mission may be both economic and social. Most organizations now prepare and
publish their mission in a mission statement.
Mission statements often include the following information:

Purpose and aim(s) of the organization
The organization's primary stakeholders: clients/customers, shareholders,
congregation, etc.
How the organization provides value to these stakeholders, for example by
offering specific types of products and/or services
Stage 2:- Identify Objectives
This requires the company to specify objectives towards which it is working. The
objectives chosen must be quantified and have a timescale attached to them.
Objectives should be SMART: -
Specific
Measurable
Achievable
Relevant
Time limited
Stage 3:- Search for possible courses of action
A series of specific strategies should be developed. Strategy is the course of action,

including the specification of resources required, that the company will adopt to
achieve its specific objective.
To formulate its strategies, the firm will consider the products it makes and the
markets it serves. E.g. of strategies are: -
Developing new markets for existing products
Developing new products for existing markets
Developing new products for new markets
Stage 4:- Gathering data about alternatives and measuring pay-offs
253
Stage 5:- Select course of action
Having made decisions, long-term plans based on those decisions are created.
Stage 6:- Implementation of short-term (operating) plans
This stage shows the move from long-term planning to short-term plans the annual
budget. The budget provides the link between the strategic plans and their
implementation in management decisions.
Stage 7:- Monitor actual outcomes
Detailed financial and other records of actual performance are compared with budget
targets (variance analysis)
Stage 8:- Respond to divergences from plan
This is the control process in budgeting, responding to divergences from plan either
through budget modifications or through identifying new courses of action
Lecture Example 1
Which of the following is not an essential feature of a budget?
A. There is clearly defined budget period.

B. It is a combination of financial and non-financial data set by reference to key
budget assumptions.
C. It permits managers flexibility in terms of the policies that should be pursued
to meet corporate objectives.
D. It has been formally approved and accepted as realistic by managers.

Explain the administrative procedures used in the budgeting process
In organising and administering a budget system the following characteristics may

apply:
a) Budget centres: Units responsible for the preparation of budgets. A budget centre
may encompass several cost centres.
254
b) Budget committee: This may consist of senior members of the organisation, e.g.
departmental heads and executives (with the managing director as chairman). Every
part of the organisation should be represented on the committee, so there should be
a representative from sales, production, marketing and so on. Functions of the
budget committee include:
i. Coordination of the preparation of budgets, including the issue of a manual

ii. Issuing of timetables for preparation of budgets
iii. Provision of information to assist budget preparations
iv. Comparison of actual results with budget and investigation of variances.
c) Budget Officer: Controls the budget administration The job involves:
i. liaising between the budget committee and managers responsible for budget
preparation
ii. dealing with budgetary control problems
iii. ensuring that deadlines are met
iv. educating people about budgetary control.
d) Budget manual:
This document, which is usually prepared by the management accountant:
i. charts the organisation

ii. details the budget procedures
iii. contains account codes for items of expenditure and revenue
iv. timetables the process
v. clearly defines the responsibility of persons involved in the budgeting system.
Lecture Example 2
The administration of the budget process in a large organization is normally the

responsibility of:
A. The board of directors.

B. The audit committee.
C. The chief executive.
D. A budget committee working in conjunction with the finance function.
255
Lecture Example 3
Which of the following statements is valid:
A. The budget committee should set the budgets for cost centre managers.
B. Cost centre managers should prepare their own budgets.
C. Management accountants should prepare budgets for cost centre managers
D. Senior management should prepare cost centre budgets.

Describe the stages in the budgeting process
14.4.1 Stages in the Budgetary Process
These may be identified as follows:
Stage1: Communicating policy guidelines to preparers of budgets
The long-term plan forms the framework within which the budget is prepared. It is
therefore necessary to communicate the implications of that plan to the people who
actually prepare the budget.
Stage 2: Determining the factor that restricts output Principal Budget

Factor
Generally there will be one factor which restricts performance for a given period.
Usually this will be sales, but it could be production capacity, or some special labour
skills.
Stage 3: Preparation of a budget using the principal budgetary factor
On the assumption that sales is the principal budget factor, the next stage is to
prepare the sales budget. This budget is very much dependent on forecast sales
revenue.
Stage 4: Initial preparation of budgets
Ideally budgets should be prepared by managers responsible for achieving the

targets contained therein. This is referred to as participative budgeting.
256
Stage 5: Co-ordination and review of budgets
At this stage the various budgets are integrated into the complete budget system.
Any anomalies between the budgets must be resolved and the complete budget
package subject to review. At this stage the budget income statement, balance sheet
and cash flow must be prepared to ensure that the package produces an acceptable
result.
Stage 6: Final acceptance of budgets
All of the budgets are summarized into a master budget, which is presented to top
management for final acceptance.
Stage 7: Budget review
The budget process involves regular comparison of budget with actual, and
identifying causes for variances. This may result in modifications to the budget as the
period progresses.
257
KEY NOTES
258
1. A budget is a quantified plan of action for a forthcoming accounting period.
2. Planning and Control Cycle
Set mission
Identify objectives
Search for alternative courses of

action
Long-term
planning process Gather data about alternatives
Select course of action
Implement short-term plan in the

form of annual budgets
Budget
process Monitor actual results Control
process
Respond to divergences from

plan
3. Objectives should be SMART: -
a. Specific
b. Measurable
c. Achievable
d. Relevant
e. Time limited
259
4. Budget centres: units responsible for the preparation of budgets
5. Budget committee: consists of senior members of the organisation. It: -

a. Coordinates the preparation of budgets, including the issue of a
manual
b. Issues timetables for preparation of budgets
c. Provides information to assist budget preparations
d. Compares actual results with budget and investigation of variances.
6. Budget officer: controls the budget administration
7. Budget manual:
a. charts the organisation
b. details the budget procedures
c. contains account codes for items of expenditure and revenue
d. timetables the process
e. clearly defines the responsibility of persons involved in the budgeting
system.
8. Stages in the Budgetary Process
Stage 1: Communicating policy guidelines to preparers of budgets

Stage 2: Determining the factor which restricts output Principal Budget
Factor
Stage 3: Preparation of a budget using the principal budgetary factor
Stage 4: Initial preparation of budgets
Stage 5: Co-ordination and review of budgets
Stage 6: Final acceptance of budgets
Stage 7: Budget review
260
QUESTIONS
261
1. The main purpose of budgeting are:
(i) To give authority to spend

(ii) To control expenditure
(iii) To aid decision making
A. (i) only
C. (ii) only
2. The budget committee is made up of representatives from the finance function

and co-ordinates the budget planning process.
This statement is:

A. True
B. False
3. A budget manual will include which of the following?
(i) An organization chart

(ii) A budget timetable
(iii) Copies of budget forms
(iv) Key assumptions to be used in the budget
A. (ii), (iii) and (iv)

B. (ii) and (iv)
C. (iii) and (iv)
D. All of these
262
ANSWERS
263
1. B
2. B
3. D
264
Chapter 15
BUDGET PREPARATION
Explain the importance of principal budget factor in constructing the budget.
As described in the budgeting process, in every organisation, there is some

factor that restricts performance for a given period. This factor is known as the
principal budget factor or limiting factor. In the majority of organisations, this
factor is sales demand but it can also be shortage of materials or inadequate
plant capacity.
Decisions must be taken at an early stage to minimize the impact of any

principal budget factor. Once this factor has been identified and individual
functional budgets are being set, it is important to ensure that coordination of
functions takes place. For example, it would not make sense to set a sales
budget with a sales volume in excess of exiting plant capacity, unless
decisions were made on improving capacity, subcontracting work or cutting
back on the sales budget.
Lecture Example 1
A government funded hospital offers free treatment to patients.
Which of the following is the most likely principal budget factor?
A. Demand
B. Labour hours
C. Materials
D. Cash

Prepare sales budgets
Prepare budgets for production, raw materials usage and purchases, labour,
fixed and variable overheads.
A functional budget is a budget of income and/or expenditure which applies to a

particular function. The main functional budgets are:
265
1. Sales budget
2. Production budget
3. Raw material usage budget
4. Raw material purchases budget
5. Labour budget
6. Overheads budget
15.2.1 Sales Budget
A sales budget can be prepared both in units and in value.
15.2.2 Production Budget
Budgeted production levels can be calculated as follows: -
Budgeted production =
Forecast sales + closing inventory of finished goods opening inventory of
finished goods
15.2.3 Material Budget
15.2.3.1 Material usage budget
Material usage = Budgeted production for each product x the quantity required
to produce one unit of the product
15.2.3.2 Material purchases budget
Material purchases budget = Material usage budget + closing inventory

opening inventory
15.2.4 Labour Budget
Labour budget = no. of hours x labour rate per hour
15.2.5 Overhead Budget
The overhead budget will be made up of variable costs and fixed costs
Lecture Example 2
The XYZ company produces three products, X, Y, and Z. For the coming accounting
period budgets are to be prepared using the following information:
266
Budgeted sales
Product X 2000 units at $100 each

Product Y 4000 units at $130 each
Product Z 3000 units at $150 each
Standard usage of raw material
M1 M2
(kg per unit) (litres per unit)
Product X 5 2
Product Y 3 2
Product Z 2 1
Standard cost of raw material $8 $4
Stocks of finished goods

X Y Z
Opening 500u 800u 700u
Closing 600u 1000u 800u
Stocks of raw materials

M1 M2
Opening 21,000 10,000
Closing 18,000 9,000
Labour
X Y Z
Standard hours per unit 4 6 8
Labour is paid at the rate of $3 per labour hour
Variable overheads at $2 per labour hour
Fixed overheads at $1 per labour hour
Prepare the following budgets:
(a) Sales budget (quantity and value)

(b) Production budget (units)
(c) Material usage budget (quantities)
(d) Material purchases budget (quantities and value)
(e) Labour budget (hours and value)
(f) Overhead budget ($)
267
SALES BUDGET
units/value
FINISHED GO ODS INV BUDGET

Sales X
Openining Inventory (X)
LABO UR BUDGET Closing Inventory X
hours/value Production Required X
PRO DUCTION BUDGET

units
O VERHEADS Units Produced x kg

BUDGET per unit from Cost Card
value
MATERIAL USAGE BUDGET

Kg/Liters etc
RAW MATERIAL INV BUDGET

Production Usage X
Opening Inventory (X)
Closing Inventory X
Material Required X
MATERIAL PURCH BUDGET

Kg/litres/value

Prepare cash budgets
Cash budgets are vital to the management of cash. They show the expected inflows
and outflows of cash through the company. They help to show cash surpluses and
cash shortages.
It is especially important to maintain a cash balance necessary to meet ongoing

obligations. However, holding cash carries with it a cost the opportunity cost of the
profits which could be made if the cash was either used in the company or invested
elsewhere. Cash management is therefore concerned with optimising the amount of
cash available to the company and maximising the interest on any spare funds not
required immediately by the company.
268
Management can therefore use cash budgets to plan ahead to meet those
eventualities arranging borrowing when a deficit is forecast, or buying short-term
securities during times of excess cash.
Lecture Example 3
The following information relates to Maze Ltd, a publishing company.
The selling price of a book is $15, and sales are made on credit through a book club
and invoiced on the last day of the month.
Variable costs of production per book are materials ($5), labour ($4), and overhead
($2).
The sales manager has forecast the following volumes:
Nov Dec Jan Feb March April May June July Aug
No of 1000 1000 1000 1250 1500 2000 1900 2200 2200 2300
books
Customers are expected to pay as follows:

One month after the sale 40%
Two months after the sale 60%
The company produces the books two months before they are sold and the creditors
for materials are paid two months after production.
Variable overheads are paid in the month following production; wages are paid in the
month of production.
The company is going through a restructuring and will sell one of its freehold
properties in May for $25,000, but it is also planning to buy a new printing press in
May for $10,000. Depreciation is currently $1,000 per month, and will rise to $1,500
after the purchase of the new machine.
The companys corporation tax (of $10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2011, of
$1,500.
Required
a. Produce a cash budget for the six months from 1 January 2012 to 30 June
2012.
b. How can Maze finance the short-term deficits that will arise between January
and June 2012?
269
Prepare master budgets (income statement and statement of financial
position)
When all the functional budgets have been prepared, they are summarized and
consolidated into a master budget which consists of:
1. Budgeted income statement
2. Budgeted statement of financial position
3. Cash budget

Explain and illustrate what if analysis and scenario planning
15.5.1 What If Analysis
What if analysis is a form of sensitivity analysis which allows the effects of changing
one or more data values to be quickly recalculated. It enables each of the input
values to be changed both individually and in combination to see the effects on the
final result.
Worked out Example
Michelle Ltd is considering launching a new product which has the following details:
Selling price per unit $5

Annual sales volume 1000 units
Variable costs per unit $2
Annual fixed costs $2000
Assume that production and sales volume are always equal.
Calculate the expected profit
($5 $2) = $3 x 1000 = $3000 - $2000 = $1000
If sales volume falls by 20% , calculate the effect on profit
Sales volume will now be 800, i.e. 200 less. Total contribution will be lower by 200 x
$3 = $600. Hence profit will now be $1000 - $600 = $400, i.e. 60% lower
270
15.5.2 Scenario Planning
Scenario planning has proved to be a very useful tool in budgeting. Scenarios

describe the relevant future environments in which the business may have to
operate. The scenarios are supported by a business model that reflects the essence
of these scenarios.
The Scenario Planning Process: -
1. Identify the fundamental business question or issue that the business

wishes to address
2. Identify the critical factors to answer the business question
3. Identify the current and future variables that may impact the critical
factors
4. Generate scenarios
5. Add more detail to these scenarios
6. The scenarios can now be re-created within a business model
7. Once the scenario planning process has been completed, there is a full,
analytical description of potential alternatives in which the business may
operate and finally to make strategic choices
271
KEY NOTES
272
1. Principal Budget Factor
The factor that restricts performance for a given period.
2. The Functional Budget
A functional budget is a budget of income and/or expenditure which applies to

a particular function.
i. Sales Budget
A sales budget can be prepared both in units and in value.
ii. Production Budget
Budgeted production levels can be calculated as follows: -
Budgeted production =
Forecast sales + closing inventory of finished goods opening
inventory of finished goods
iii. Material Budget
Material usage budget
Material usage = Budgeted production for each product x the quantity

required to produce one unit of the product
Material purchases budget
Material purchases budget = Material usage budget + closing inventory

opening inventory
iv. Labour Budget
Labour budget = no. of hours x labour rate per hour
v. Overhead Budget
The overhead budget will be made up of variable costs and fixed costs
273
3. Cash Budget
Cash budgets are vital to the management of cash. Management can use
cash budgets to plan ahead to arrange borrowing when a deficit is forecast, or
buy short-term securities during times of excess cash.
4. Master Budget
A master budget is a set of budgeted financial statements, including a

budgeted income statement, a cash budget and a budgeted statement of
financial position.
5. What If Analysis
What if analysis is a form of sensitivity analysis which allows the effects of

changing one or more data values to be quickly recalculated
6. Scenario Planning
Scenario planning has proved to be a very useful tool in forecasting.

Scenarios describe the relevant future environments in which the business
may have to operate. The scenarios are supported by a business model that
reflects the essence of these scenarios.
274
QUESTIONS
275
1. A retailer forecasts the following data for the coming period;
Sales $500,000
Opening inventory $40,000
Closing inventory $50,000
Mark-up 25%
What amount should be budgeted for purchases?
A. $365,000
B. $385,000
C. $390,000
D. $410,000
2. A manufacturing company always carries finished goods inventory equal to 20%

of the next months budgeted sales. Sales for the current month are 2,000 units
and are budgeted to be 20% higher next month.
How many units will be produced in the current month?
A. 2,080
B. 1,920 (400 + 2000 480)
C. 2,000 (no adjustment)
D. 2,400 (2000 + 400)
3. A company manufactures two products, exe and wye, from the same direct
material. In period three an equal number of each product will be produced. Each
unit of exe requires 2kg of material and each unit of wye requires 3kg of material.
The company always holds a closing inventory of raw material sufficient for 40%
of the next periods production. The budgeted closing raw material inventory for
period two is 900kg.
What is the budgeted production of exe for period three?
A. 225 units
B. 450 units
C. 900 units
D. 1,125 units
276
4. Which of the following is part of a master budget?
A. Labour budget
B. Material purchases budget
C. Budgeted income statement
D. Production budget
5. What would be the usual order of budget preparation for a manufacturing

company, whose principal budget factor is sales demand?
A. Production budget, sales budget, purchases budget.

B. Production budget, purchases budget, sales budget.
C. Sales budget, production budget, purchases budget.
D. Sales budget, purchases budget, production budget.
6. Which of the following best describes a principal budget factor?
A. A factor that affects all budget centres.

B. A factor that is controllable by a budget centre manager.
C. A factor which limits the activities of an organisation.
D. A factor that the management accountant builds into all budgets.
7. A company manufactures and sells one product which requires 8 kg of raw

material in its manufacture. Raw material costs $5 per kg. The budgeted data
relating to the next period are as follows:
Units
Sales 19,000
Opening inventory of finished goods 4,000
Closing inventory of finished goods 3,000
Kg
Opening inventory of raw materials 50,000
Closing inventory of raw materials 53,000
a. What is the budgeted raw material purchases for next period (in kg)?
_______
b. What is the budget cost for raw materials? _________
8. X plans to sell 24,000 units of product FZ next year. Opening inventory of FZ is

expected to be 2,000 units and X plans to increase inventory by 25% by the end
of the year. How many units of product R should be produced next year?
__________
277
9. A hardware store has budgeted sales of $36,000 for its power tool department in
July. Management wants to have $7,000 in power tool inventory at the end of
July. Its beginning inventory of power tools is expected to be $6,000. What is the
amount of merchandise purchases in $?
A. $36,000
B. $43,000
C. $42,000
D. $37,000
10. A store has the following budgeted sales for the next five months.
May $210,000
June $186,000
July $180,000
August $220,000
September $240,000
Cash sales are 25% of total sales and all credit sales are expected to be
collected in the month following the sale. The total amount of cash expected to
be received from customers in September is _______________
11. A plan that shows the expected cash inflows and cash outflows during the
budget period, including receipts from loans needed to maintain a minimum cash
balance and repayments of such loans, is called:
A. An income statement.
B. A statement of financial position.
C. A cash budget.
D. An operating budget.
12. The following sales are predicted for a companys next four months.
September October November December
Unit sales 480 560 600 480
Each months ending inventory of finished goods should be 30% of the next
months sales. At September 1, the finished goods inventory is 140 units. The
budgeted production of units for October is
278
A. 572 units.
B. 560 units.
C. 548 units.
D. 600 units.
E. 180 units.
279
ANSWERS
280
1. D
Sales 125 $500,000

COS 100 $400,000
GP 25
Op Inv. 40,000
Purchases 410,000
45,000
Cl Inv. 50,000
400,000
2. A
Sales 2,000
Cl Inv 480 (20% x [2000 x 1,2])
2,480
Op Inv. (400) (20% x 2000)
2,080
3. B
Closing Inv. = 900 (40% of production)
Production = 900 / 40%

= 2250 kg
2250 kg to produce equal units of exe and wye
each exe needs 2 kg

each wye needs 3 kg
5 kg
2250 kg = 450 units

5x
where x = number of units
281
4. C
5. C
6. C
7.
a. Production budget
Sales 19000
Cl Inv 3000
22000
Op Inv (4000)
Production 18000
x 8kg
Required 144,000
Required 144000
Cl Inv 53000
197000
Op inv (50000)
147,000
b. 147,000 x $5 = $735,000
8. 24,500 units
Sales 24000
Cl Inv 2500 (2000 x 1.25)
26500
Op Inv (2000)
Required 24,500
282
9. D
Sales 36000
Cl Inv 7000
43000
Op Inv (6000)
Required 37,000
10.
September
Sept Sales (25% x

240000) 60,000
Aug Sales (75% x
220,000) 165,000
225,000
11. C
12. A
560 units + (0.3 x 600 units) (0.3 x 560 units) = 572 units
283
Chapter 16
FLEXIBLE BUDGETS
16.1 Introduction
Budgetary control involves controlling costs by comparing the budget with the actual
results and investigating any significant differences between the two. Any differences
(variances) are made the responsibility of key individuals who can either exercise
control action or revise the original budgets.
If this control process is to be valid and effective, it is important that the variances
are calculated in a meaningful way. One of the major concerns is to ensure that the
budgeted and actual figures reflect the same activity level.

Explain the importance of flexible budgets in control
Explain the disadvantages of fixed budgets in control
Identify situations where fixed or flexible budgetary control would be
appropriate
16.2.1 Fixed Budgets
A fixed budget is a budget which is normally set prior to the start of an accounting
period, and which is not changed in response to changes in activity or
costs/revenues. It is produced for a single level of activity, i.e. based on estimated
production.
Comparison of a fixed budget with the actual results for a different level of activity is
of little use for budgetary control purposes. This is because we will not really be
comparing like with like.
16.2.2 Flexible Budgets
A flexible budget is a budget that adjusts or flexes for changes in the volume of
activity. The flexible budget is more sophisticated and useful than a fixed budget,
which remains at one amount regardless of the volume of activity.
For example, a firm may have prepared a fixed budget at a sales level of $100,000.
Flexible budgets may be prepared at different activity levels e.g. anticipated activity
284
100% and also 90%, 95%, 105% and 110% activity. Flexible budgets can be useful
but time and effort is needed to prepare them.
16.2.3 Flexed Budgets
A flexed budget is a budget prepared to show the revenues, costs and profits that
should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances will be
much more meaningful.
The high-low method may have to be used in order to determine the fixed and
variable elements of semi-variable costs. However, please note that fixed costs
remain unchanged regardless of the level of activity and should not be flexed.

Flex a budget to a given level of volume
Calculate simple variances between flexed budget, fixed budget and actual
sales, costs and profits
Lecture Example 1
A company has prepared the following fixed budget for the coming year.
Sales 10,000 units

Production 10,000 units
$
Direct materials 50,000
Direct labour 25,000
Variable overheads 12,500
Fixed overheads 10,000
$97,500
Budgeted selling price $10 per unit.
At the end of the year, the following costs had been incurred for the actual
production of 12,000 units.
$
Direct materials 60,000
Direct labour 28,500
285
$114,500
The actual sales were 12,000 units for $122,000
Required: -
Prepare a flexed budget for the actual activity for the year and calculate any
variances which have arisen.
Lecture Example 2
Which of the following best describes a flexible budget?
A. A budget which shows variable production costs only.

B. A monthly budget which is changed to reflect the number of days in the
month.
C. A budget which shows sales revenue and costs at different levels of activity.
D. A budget that is updated halfway through the year to incorporate the actual
results for the first half of the year.

Define the concept of responsibility accounting and its significance in control
Budgetary control and responsibility accounting are seen to be inseparable.
Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area. This is known as a responsibility accounting unit.
As discussed in Chapter 1, an area of responsibility may be structured as: -
1. a cost centre the manager is responsible for cost control only

2. a revenue centre the manager is responsible for revenues only
3. profit centre the manager has control over costs and revenues
4. investment centre the manager is empowered to take decisions about capital
investment for his department. Later on, we will be discussing two measures of
performance in investment centres: return on investment and residual income
A common problem is that the responsibility for a particular cost or item is shared
between two (or more) managers. For e.g. the responsibility for material costs will be
shared between production and purchasing managers. It is important that the
reporting system should be designed so that the responsibility for performance
achievements is identified as that of a single manager.
286
Explain the concept of controllable and uncontrollable costs and revenues
The main problem with measuring performance is in deciding which costs are
controllable and which costs are traceable. The performance of a manager is
indicated by the controllable profit and the success of the division as a whole is
judged on the traceable profit.
Controllable costs and revenues are those costs and revenues which result from
decisions within the authority of a particular manager within the organization. These
should be used to assess the performance of the managers.
For example, depreciation on machinery in Division A is a traceable fixed cost

because profit centre managers do not have control over the investment in non-
current assets.
Most variable costs are controllable in the short term because managers can
influence the efficiency with which resources are used.
Some costs are non-controllable, such as increases in expenditure items due to

inflation. Other costs are controllable in the long term rather than the short term. For
example, production costs might be lower by the introduction of new machinery.
However, its results will be seen in the long term.
287
CONTROLLABLE PROFIT STATEMENT 10
$ $
Sales (external) XXX
(internal) XXX
XXX
Controllable divisional variable costs (XXX)
Controllable divisional fixed costs (XXX)
Controllable divisional profit XXX
Other traceable divisional variable costs (X)
Other traceable divisional fixed costs (XXX)
Traceable divisional profit XXX
Apportioned head office cost (XXX)
Net profit XXX

Prepare control reports suitable for presentation to management (to include
recommendation of appropriate control action)
The following control report will be presented only to the responsible manager. It will
include a number of recommendations how any variance will be controlled or
eliminated
10Jay S., Performance Management, Student Accountant 2004, http://www.accaglobal.com/us/en/student/acca-

qual-student-journey/qual-resource/acca-qualification/f5/technical-articles/performance-measurement.html
288
Budget Actual Variance
Current Year Current Year Current Year
month to date month to date month to date
Managing Director
Factory A
Factory B
Administration costs
Selling costs
Distribution costs
R&D costs
Production director
Factory A
Machining department
Casting department
Assembly department
Inspection and quality
control
Factory managers office
Head of machining
department
Direct materials
Direct labour
Indirect labour
Power
Maintenance
Other
289
KEY NOTES
290
1. Budgetary Control
Budgetary control involves controlling costs by comparing the budget with the
actual results and investigating any significant differences between the two.
Any differences (variances) are made the responsibility of key individuals who
can either exercise control action or revise the original budgets.
2. Fixed Budgets
A fixed budget is a budget which is normally set prior to the start of an
accounting period, and which is not changed in response to changes in
activity or costs/revenues. It is produced for a single level of activity, i.e.
based on estimated production.
3. Flexible Budgets
A flexible budget is a budget that adjusts or flexes for changes in the volume
of activity. The flexible budget is more sophisticated and useful than a fixed
budget, which remains at one amount regardless of the volume of activity.
4. Flexed Budgets
A flexed budget is a budget prepared to show the revenues, costs and profits
that should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances
will be much more meaningful.
5. Responsibility Accounting
Each manager must have a well-defined area of responsibility and the
authority to make decisions within that area.
a cost centre the manager is responsible for cost control only
a revenue centre the manager is responsible for revenues only
profit centre the manager has control over costs and revenues
investment centre the manager is empowered to take decisions
about capital investment for his department. Later on, we will be
discussing two measures of performance in investment centres: return
on investment and residual income
6. Controllable costs and traceable costs

Controllable costs and revenues are those costs and revenues which result
from decisions within the authority of a particular manager or unit within the
organization. These should be used to assess the performance of the
managers.
Traceable costs are considered in judging the success of a division as a

whole.
291
QUESTIONS
292
1. Which TWO of the following are true for flexible budgets?
(i) A budget which is continually updated to reflect actual results

(ii) A budget which has built in contingency to allow for unforeseen events
(iii) A budget which identifies the cost behaviour of different cost items
(iv) A budget which allows comparison of like with like
A. (i) and (ii)

B. (i) and (iv)
C. (ii) and (iii)
D. (iii) and (iv)
2. Maradona operates a central distribution warehouse which it classifies as a cost

centre. The warehouse can stock up to 600,000 units of finished goods per month.
If demand for warehouse space exceeds this amount in any given month extra
capacity can be purchased from a nearby factory for fixed payments of $30,000
for each capacity increase of up to 40,000 additional units per month. Stock is
picked from shelves by hourly paid labourers who are paid $16 per hour and in
this time are expected to pick 20 stock units. Picked units are loaded on to
customer vehicles by fork-lift trucks.
Budgeted costs per month throughout 2007, at two different capacity levels are as
follows:
Warehouse space required

Cost element Behaviour of cost 200,000 units 500,000 units
$ $
Warehouse rental Stepped fixed (see above) 160,000 160,000
Stock picking costs Variable 160,000 400,000
Fork-lift costs Semi variable 500,000 1,100,000
During May 2007 when demand was for 724,000 units and 36,250; labour hours
were worked; actual costs for each cost element were reported as:
Warehouse rental $284,000

Stock picking costs $622,640
Fork-lift costs $1,528,822
Required:
Prepare a flexed budget statement of warehouse costs for May 2007 for an
activity level of 724,000 units.
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ANSWERS
294
1. D
2. Flexed Budget
Demand 724,000 units

$
Warehouse rental (W1) 280,000
Stock picking costs (W2) 579,200
Fork-lift costs (W3) 1,548,000
$2,407,200
Working 1: To cope with demand 124,000 units in excess of capacity a further

160,000 units of capacity will be required.
Total cost $160,000 + $120,000 = $280,000
Working 2: Stock picking costs are a variable cost.
The variable cost per unit = Change in total cost

Change in volume
= ($400,000 - $160,000) = $0.8 per unit

(500,000 - 200,000)
(Alternatively Standard rate $16.00 per hour standard rate of 20 units per hour =
$0.8 per unit
Stock picking cost at 724,000 units = 724,000 x $0.80 per unit = $579,200
Working 3: Fork-lift costs are semi variable
The variable cost per unit = Change in total cost

Change in volume
= ($1,100,000 - $500,000) = $2.0 per unit

(500,000 - 200,000)
The fixed element, by substitution:

Total cost = fixed cost + variable cost
At 200,000 units
$500,000 = Fixed cost + 200,000 x $2.0
Fixed cost = $100,000.
At 724,000 units total cost = $100,000 + (724,000 x $2.0) = $1,548,000
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Chapter 17
STATISTICAL TECHNIQUES IN
BUDGETING
In this chapter, we will be looking at different statistical techniques which can be
used to arrive at budgeted figures. The main problem faced when forecasting costs
is that of trying to find how costs vary with the level of activity. Useful techniques in
cost estimation are: -
a. High low method

b. Scatter diagrams
c. Regression analysis
Sales forecasts may also make use of past sales data. Techniques which may be
useful here are: -
a. Scatter diagrams and regression again

b. Time series analysis
c. Life cycle models
d. Adjust historical information and forecast information for price movements

Explain the advantages and disadvantages of using high low method to
estimate the fixed and variable element of costing.
As described in chapter 3, the high low method is one of the methods used to
analyse semi-variable costs into their fixed and variable elements.
The main steps are: -
1. Review records of costs in previous periods.
Select the period with the highest activity level.

Select the period with the lowest activity level.
2. Find the variable cost per unit
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3. Find the fixed costs
Total cost at high activity level (Total units at high activity level Variable cost per
unit)
Advantages of the High-Low Method
1. Easy to use
2. Easy to understand
3. Quick method
Limitations of the High-Low Method
1. It relies on historical cost data predictions of future costs may not be reliable
2. It assumes that the activity level is the only factor affecting costs
3. It uses only two values to predict costs all data falling between the highest
and lowest values are ignored
4. Bulk discounts may be available at large quantities
Lecture Example 1
Month Production (units) Costs ($)
Jan 4,500 19,125

Feb 4,700 19,875
Mar 4,900 20,625
Apr 5,100 21,875
Calculate the variable cost per unit and the total fixed costs and use these to
forecast the cost expected if production is 6,500 units. Note that when
production is greater than 5000 units, an additional machine must be used and
depreciation increases by $500/month.

Construct scatter diagrams and lines of best fit
Information about two variables that are considered to be related in some way can
be represented on a form of graph known as a scatter diagram, each axis
representing one variable. For example, the level of advertising expenditure and
297
sales revenue of a product, or the level of electricity cost and the number of units
produced can be plotted against each other.
The values of the two variables are plotted together to show a number of points on
the graph. The way in which these are scattered or dispersed indicates if any
relationship is likely to exist between the variables.
For example; the following scatter graph shows the relationship between 2 variables;
the independent variable can be the units, the dependent variable can be production
cost.
Line of Best Fit
The "best-fit" line (trend line) is the straight line which passes as near to as many of
the points as possible. By drawing such a line, we are attempting to minimise the
effects of random errors in the measurements.
For example, if our points look like this
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The line of best fit would be drawn as follows: -
When we have our line of best fit drawn on the scatter diagram, we can use it to read
off values for the variables at any points on the axes.
In doing this, we have to assume that the line of best fit is accurately drawn and that
the relationship established, based on past data, will also apply in the future - this is
known as extrapolating the trend.
Using scatter diagrams with lines of best fit is useful as a forecasting technique and
has the advantage of relative simplicity.
It suffers, from the following disadvantages:

Attempts to forecast future information from past information
Assumes relationships are linear
Uses a line of best fit which is matched to the points on the scatter diagram by
eye - this is likely to be a major cause on inaccuracy unless the points in the
scatter are very tightly clustered together.
A more mathematical technique, regression analysis, is available to improve the

accuracy of the line of best fit.
299
Analysis of cost data.
i. Explain the concept of correlation coefficient and coefficient of
determination
ii. Calculate and interpret correlation coefficient and coefficient of
determination
iii. Establish a linear function using regression analysis and interpret the
results
Use linear regression coefficients to make forecasts of costs and revenues
Explain the advantages and disadvantages of linear regression analysis
Linear regression analysis is based on working out an equation for the line of best fit.
The line of best fit will be of the form

y = a + bx
where
y is the value of the dependent variable (on vertical axis)
a is the intercept - fixed costs
b is the slope of the line - variable costs
x is the value of the independent variable (on horizontal axis)
i. How do we calculate a and b?

x is the activity level (independent variable)
n is the sample size number of pairs of data
These formulae are given in the exam. Remember always start working b,
then move to a.
300
Lecture Example 2
The total costs of a business for differing levels of output are as follows:
Output Total Costs

Units 000
500 70
200 30
300 50
800 90
1000 110
Required: -
i. What are the fixed and variable elements of the total cost using linear
regression analysis?
ii. Estimate the total costs if output is: -
a) 400 units
b) 900 units
c) 1,200 units
17.3.1 Correlation
Correlation measures the strength of the relationship between two variables.
One way of measuring how correlated two variables are, is by drawing the line of
best fit on a scatter graph. When correlation is strong, the estimated line of best fit
should be more reliable.
Another way of measuring how correlated two variables are, is to calculate a

correlation coefficient, r.
301
17.3.2 Different degrees of correlation
Perfect positive linear Perfect negative linear
Moderate positive correlation Moderate negative correlation
No correlation
302
17.3.3 The correlation coefficient (r)
The correlation coefficient measures the strength of a linear relationship between

two variables. It can only take on values between -1 and +1.
r = +1 indicates perfect positive correlation
r = 0 indicates no correlation
r = -1 indicates perfect negative correlation
The correlation coefficient is calculated as follows: -
This formula is also given in the exam.
Lecture Example 3
Using the details in Lecture Example 2, find the correlation coefficient and comment
on the result obtained.
17.3.4 Coefficient of determination (r2)
The coefficient of determination is the square of the correlation coefficient. It

measures how much of the variation in the dependent variable is explained by the
variation of the independent variable. The value of r2 can be between 0 and 1.
For example, if r = 0.97, r2 = 0.94 or 94%.
94% of the variation in the dependent variable (y) is due to variations in the
independent variable (x). 6% of the variation is due to random fluctuations.
Therefore, there is high correlation between the two variables.
303
Lecture Example 4
Using the details in Lecture Example 2, find the coefficient of determination and
comment on the result obtained.
Lecture Example 5
The correlation coefficient between advertising expenditure and sales revenue is

calculated to be 0.85. Which of the following statements is true?
A. There is a weak relationship between advertising expenditure and sales

revenue
B. 85% of the variation in sales revenue can be explained by the corresponding
variation in advertising expenditure
C. 72% of the variation in sales revenue can be explained by the corresponding
variation in advertising expenditure
D. Sales revenue will increase by 85% more than advertising expenditure will
increase
17.3.5 Advantages and Disadvantages of Linear Regression
Advantages
1. It provides a more reliable approach to forecasting, as it arrives at the

equation of the regression line from the use of mathematical principles, known
as the least squares method.
2. Unlike the high low method, which uses only two past observations,
regression analysis can build into the regression line a large number of
observations - this is likely to make the relationship derived more accurate.
Disadvantages
1. It is only valid where the relationships involved are linear.
2. It still uses past data to forecast future values of the variables - if the
relationship which existed in the past is not valid for the future, the forecast
will be inaccurate.
3. It is a more complex technique to apply, requiring the mathematical derivation

of values for a and b in the regression equation.
304
Lecture Example 6
Machine Age (years) Annual maintenance cost ($)

000
1 6 124
2 2 47
3 7 190
4 5 60
5 3 115
From the above information, you are required to :-
(i) Calculate the values of a and b using linear regression
(ii) State the equation of the regression line.
(iii) Use your regression line to estimate the maintenance cost of a machine that
is 10 years old.

Explain the principles of time series analysis (cyclical, trend, seasonal
variation and random elements)
Calculate moving averages
Calculation of trend, including the use of regression coefficients
Use trend and seasonal variation (additive and multiplicative) to make budget
forecasts
Explain the advantages and disadvantages of time series analysis
17.4.1 Time Series
A time series is a series of figures or values recorded over time. The data often
conforms to a certain pattern over time. This pattern can be extrapolated into the
future and hence forecasts are possible. Time periods may be any measure of time
including days, weeks, months and quarters.
A graph of a time series is called a histogram.
305
Example: -
A time series has four components: -

1. a trend is the underlying long-term movement over time in values of data
recorded.
2. seasonal variations or fluctuations are short-term fluctuations in recorded
values, due to different circumstances e.g. sales of ice creams will tend to be
highest in the summer months.
3. cycles or cyclical variations are medium-term changes in results caused by
circumstances which repeat in cycles, e.g. booms and slumps in the
economy.
4. no-recurring, random variations. These may be caused by unforseen
circumstances such as a change in government, a war, technological change
or a fire. Hence these are non-repetitive and non-predictable variations.
The actual time series is: -
Y = T+S+C+R
Where Y = the actual time series

T = the trend series
S = the seasonal component
C = the cyclical component
R = the random component
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In the exam, it is unlikely that you will be expected to carry out any calculation of C.
Therefore, C will be ignored.
17.4.1.1 Time series analysis and forecasting
This is carried out in two steps:

1. establishing the long-term underlying trend using moving averages or linear
regression. A moving average is an average of the results of a fixed number
of periods.
2. establishing the regular seasonal variations (SV).
17.4.2 Trend and Linear Regression Analysis
The trend can be found by linear regression analysis.
17.4.3 Trend and Seasonal Variations
Seasonal variations arise in the short-term. It is very important to distinguish

between trend and seasonal variation. Seasonal variations must be taken out, to
leave a figure which might be taken as indicating the trend (deseasonalised data).
One such method is called moving averages. A moving average is an average of

the results of a fixed number of periods, i.e. the mid-point of that particular period.
Please note that when the number of time periods is an even number, we must
calculate a moving average of the moving average. This is because the average
would lie somewhere between two periods.
17.4.4 Seasonal Variations
These seasonal variations can be estimated using the additive model or the
proportional (multiplicative) model.
The additive model
This is based upon the idea that each actual result is made up of two influences.
Actual = Trend + Seasonal Variation (SV) + Random Variations (R)
The SV will be expressed in absolute terms. Please note that the total of the
average SV should add up to zero.
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The multiplicative model
Actual = Trend SV factor x Random Variations
The SV will be expressed in proportional terms, e.g. if, in one particular period the
underlying trend was known to be $10,000 and the SV in this period was given as
+12%, then the actual result could be forecast as:
$10,000 112/100 = $11,200.
Please note that the total of the average SV should sum to 4.0, 1.0 for each quarter.
Lecture Example 7
The following sales figures are available for the last two years for Sauce Co. All of
the figures represent actual sales except for quarter 2 of 2012, which is an estimate.
The financial director is satisfied that this estimate can be relied upon.
Year Quarter One Quarter Two Quarter Three Quarter Four

000 units 000 units 000 units 000 units
2010 900 1,100

2011 1,200 1,000 1,050 1,300
2012 1,400 1,150
The following centred moving averages have been calculated, using a base period of
four quarters:
Year Quarter One Quarter Two Quarter Three Quarter Four

000 units 000 units 000 units 000 units
2011 1,068.75 1,112.5 1,162.5 1,206.25
2012 1,243.75 1,287.5
The average seasonal variations for 2010 have already been made available to you
and are 0.908 for quarter 3 and 1.082 for quarter 4. The random component is
negligible and can therefore be ignored.
Required:
Using the information provided above, and assuming a proportional

(multiplicative) model, forecast the sales of Sauce Co for the last two quarters
of 2012. Calculate your seasonal adjustments to four decimal places.
(ACCA F5 June 2012 Qs 3 amended)
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Lecture Example 8
Using the data from example 3 together with the trend already calculated; calculate
the average seasonal variation using the multiplicative model.
Lecture Example 9
The trend for train passengers at Bravo Train Centre is given by the relationship
y = 5.2 + 0.24x
Where y = the number of passengers in millions per annum
x = time period beginning at 20X1 = 1
Forecast the trend for 20X9.
Lecture Example 10
Matthews Western division anticipates steadily growing demand for its products,
subject to some seasonal variation.
Recently it has employed the services of a statistician to help forecast sales. The
following extracts from the statisticians report are available.
Based on linear regression analysis the quarterly trend in sales units for the Western
division may be represented by the equation:
y = 1,500 + 60x
where
y = forecast sales trend in cases per quarter
x = the quarter number, where the first quarter of the year 2000 = 1, the second
quarter of the year 2000 = 2, etc.
The average seasonal variation in sales follows an additive model with the following
quarterly variations.
Quarter 1 2 3 4
Seasonal Variation (Cases) +50 40 60 +50
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Use the information provided by the statistician to forecast sales in cases for
the last quarter of 2004 for the Western division.
(CAT Paper T7 June 2004 Qs 1 Part)
17.4.5 Advantages and Disadvantages of Time Series Analysis
Advantages
1. it is useful when forecasting data which has a regular seasonal pattern as

may be the case with sales of certain products
2. it is a rather simplistic approach
Disadvantages
1. it assumes that past trends will continue indefinitely and that extrapolating
data based on historic information will give valid conclusions. In reality, the
sales of products may be influenced by the actions of competitors, particularly
in relation to new products becoming available on the market.

Describe the product life cycle and explain its importance in forecasting
The product life cycle concept suggests that all products pass through a number of
stages from development to decline. We have looked into this concept in Chapter 13.
If an organisation knows where a product is in its life cycle, they can use this
knowledge to plan the marketing of that product more effectively and, the
organisation may be able to derive an approximate forecast of its sales from a
knowledge of the current position of a product in its life cycle.
There are limitations of the model, which include:
1. It is over-simplistic to assume that all products comply with a life cycle curve
that follows the standard model shown above.
2. It is difficult for management to establish with precision the position of a

product on its cycle curve.
310
Adjust historical and forecast data for price movements.
An aspect of budgeting which requires great care is the estimation of future costs
based on historical figures in an environment of rising prices. When using past
accounting data as the basis for forecasting future figures, old costs need to be
adjusted to show what they would be at current, or rather at next years, prices. The
Retail Price Index (RPI) is a government produced index used to measure the
general rate of price change in the economy.
Lecture Example 11
The management accountant of TM Products Ltd is trying to estimate the nature of

the firms cost function for overheads, using the high low method. From information
gathered from the last five years accounts the highest and lowest activity levels,
their costs and the Retail Price Index are:
Month RPI Total monthly Monthly

overhead costs production
Units
Highest Jun 2012 160 $32,500 24,000

Lowest Mar 2008 140 $25,700 15,500
Required:
Using this information, determine monthly fixed costs and unit variable cost.

Explain the purpose of index numbers
Calculate simple index numbers for one or more variables
What is an index number?
An index number is an economic data figure reflecting price or quantity compared

with a standard or base value. The base usually equals 100 and the index number is
usually expressed as 100 times the ratio to the base value11 .
11 https://en.wikipedia.org/wiki/Index_(economics)
311
For example, if a product costs $100 in 2015 but it cost $50 in 2010,
$50 = 100
$100 = 200
its index number would be 200 relative to 2010.
The year that is used as the initial year for comparison is known as the base year.
The base year should also be fairly recent on a regular basis.
Types of index numbers
1. Simple Indices
A simple index measures the changes in either price or quantity of a single item in
comparison to the base year.
Therefore there are two types of simple indices:
A price index this measures the change in the money value of a group of
items over time.
A quantity (volume) index this measures the change in the non-monetary

values of a group of items over time.
The formulae for calculating simple indices are:
Simple price index = pn x 100
p0
Simple quantity index= qn x100
q0
Where p0 is the price for the base period

pn is the price for the period under consideration
q0 is the quantity for the base period
qn is the quantity for the period under consideration
Lecture Example 12
7,500 items were sold in 2012 compared with 5,000 in 2011.
Calculate the simple quantity index for 2012 using 2011 as base year.
312
Lecture Example 13
A product which cost $12.50 in 2011, cost $13.65 in 2012.
Calculate the simple price index (or price relative) for 2012 based on 2011.
2. Chain Base Index Numbers
A value in any specific time period is based on the value of the same entity in the
preceding period. Each index number is calculated using previous year as base.
If the rate of change is: -
increasing, then the index numbers will be rising;
constant, the numbers will remain the same
decreasing the numbers will be falling.
Chain base index= This years value x 100

Last years value
Lecture Example 14
A business had the following amounts from the sale of playstations:
$
2008 1,000
2009 1,100
2010 1,210
2011 1,331
2012 1,464
Required: Is the annual rate of increase in revenue from sales of playstations

increasing?
3. Composite Indices
Composite indices are used when we have more than one item.
313
Worked out example
2010 2011
$ $
Product A 2.00 2.25
Product B 2.50 2.65
Product C 3.50 3.00
A simple aggregate price index would be calculated:
p0 = 2 + 2.50 + 3.50 = $8.0
pn = 2.25 + 2.65 + 3.00 = $7.90
Year pn / p0 Simple aggregate price index
2010 8 / 8 = 1.0 100
2011 7.9 / 8 = 0.987 99
This index ignores the amounts of each product which was consumed. To overcome
these problems, we can use a weighting which is an indicator of the importance of
the component
4. Weighted Indices
Lecture Example 15
RCA produces three products.
Selling Price Selling Price

2011 2012
$ $
Product R 12 13
Product C 9 10
Product A 22 30
Weightings are assigned to each of the three products as follows:
314
Weighting
Product A 4
Product B 5
Product C 1
Calculate a weighted price index for 2012 for these three products with 2011 as
the base year.
Lecture Example 16
In a production process, 20 batches of product A and 30 of product B each year are

produced. The costs are as follows:
Item 2011 2012

Product A $6.00 $6.50
Product B $2.00 $2.50
Construct a price index using:
a) Quantity weights
b) Value weights
5. Laspeyres, Paasche and Fisher Indices
Laspeyresand Paasche indices are special cases of weighted aggregate indices.

Laspeyres index is a multi-item index using weights at the base date. It is
sometimes called base weighted index.
Paasche index is a multi-item index using weights at the current date. Hence, the
weights are changed every time period.
Lecture Example 17
Item 20X2 20X3

Price Quantity Price Quantity
(1) (2) (3) (4)
Product A $6.00 20 $6.50 35

Product B $2.00 30 $2.50 50
315
Required: -
Calculate
a) i) a Laspeyres price index (i.e. weighted by the quantities of each item at the
base date)
pnq0 x 100
p0q0
ii) a Paasche price index (i.e. weighted by the quantities of each item at the
current date)
pnqn x 100
p0qn
b) i) a Laspeyres quantity index (i.e. weighted by the prices of each item at the
base date)
p0qn x 100
p0q0
ii) a Paasche quantity index (i.e. weighted by the prices of each item at the
current date)
pnqn x 100
pnq0
Fishers ideal index is found by taking the geometric mean of the Laspeyres index
and the Paasche index.
Fishers ideal index = (Laspeyres x Paasche)
Lecture Example 18
The Laspeyres index of retail prices for 2010 is 134.5. The corresponding Paasche
index is 137.5.
Required
Calculate Fishers ideal index.
316
17.8 Advantages and Disadvantages of Indices
Advantages
1. Indices present changes in data or information over time in percentage term,

i.e. more meaningful information.
2. The use of indices makes comparison between items of data easier and more
meaningful- it is relatively easy to make comparisons and draw conclusions
from figures when you are starting from a base of 100.
3. The ability to calculate separate price and quantity indices, allows

management to identify the relative importance of changes in each of two
variables. A typical application of this technique is to allow management to
identify price and quantity effects and their relative influence on changes in
total revenue and total costs.
Disadvantages
1. The Laspeyres and Paasche approaches give different results. This suggests
that there may be no single correct way of calculating an index, especially the
more sophisticated index numbers. The user of the information should bear in
mind the basis on which the index is calculated.
2. The overall result obtained from multi-item index numbers, such as Laspeyres
and Paasche are averages - they may hide quite significant variations in
changes involved in the component items.
3. An index number, to be meaningful, should only be applied to the items which

are included in the index calculation.
4. Index numbers are relative values, not absolute figures and may not give the
whole picture. For example, Division A has achieved growth of 10% compared
to last year while Division B has only achieved 5%. At first glance it may
appear that Division A is performing better than Division B. The actual sales
figures for the period are $27,500 for Division A and $262,500 for Division B.
The absolute increase in sales revenue compared to last year is $2,500 for
Division A ($2,200/$25,000 x 100% = 10% increase) but $12,500 for Division
B ($12,500/$250,000 x 100%= 5 % increase)
317
KEY NOTES
318
1. High Low Method
The high low method is one of the methods used to analyse semi-variable
costs into their fixed and variable elements. To find the variable cost per unit:
To find the fixed costs
Total cost at high activity level (Total units at high activity level Variable cost per
unit)
2. Scatter Diagram
Two variables that are considered to be related in some way can be
represented on a form of graph known as a scatter diagram.
3. Line of Best Fit

The "best-fit" line is the straight line which passes as near to as many of the
points as possible.
4. Linear Regression Analysis

Linear regression analysis is based on working out an equation for the line of
best fit.
y = a + bx
These formulae are given in the exam. Remember always start working b,
then move to a.
5. Correlation
Correlation measures the strength of the relationship between two variables.
One way of measuring how correlated two variables are, is to calculate a

correlation coefficient, r. It can only take on values between -1 and +1.
319
This formula is also given in the exam.
6. Coefficient of determination (r2)

The coefficient of determination is the square of the correlation coefficient. It
measures how much of the variation in the dependent variable is explained
by the variation of the independent variable.
7. Time Series
A time series is a series of figures or values recorded over time. The data
often conforms to a certain pattern over time. This pattern can be extrapolated
into the future and hence forecasts are possible.
A time series has four components: -

a trend is the underlying long-term movement over time in values of
data recorded
seasonal variations or fluctuations are short-term fluctuations in
recorded values, due to different circumstances
cycles or cyclical variations are medium-term changes in results
caused by circumstances which repeat in cycles
no-recurring, random variations. These may be caused by unforseen
circumstances.
The actual time series is: -
Y = T+S+C+R
8. Product life cycle

The product life cycle concept suggests that all products pass through a
number of stages from development to decline. If an organisation knows
where a product is in its life cycle, they can use this knowledge to plan the
marketing of that product more effectively and, the organisation may be able
to derive an approximate forecast of its sales from a knowledge of the current
position of a product in its life cycle.
9. Historical and forecast data for price movement

When using past accounting data as the basis for forecasting future figures,
old costs need to be adjusted to show what they would be at current, or rather
at next years, prices.
320
An index number is a technique for comparing, over time, changes in some
feature of a group of items by expressing the property each year as a
percentage of some earlier year.
Types of index numbers: -
Simple Index measures the changes in either price or quantity of a single

item in comparison to the base year.
Chain base index number expresses each years values as a percentage of

the value for the previous year.
Composite index is used when we have more than one unit.
Weighted Aggregate Index measures the change in overall price or overall

quantity of a number of different items compared to the base year
Lapeyres index is a multi-item index using weights at the base date
Paasche index is a multi-item index weights at the current date
Fishers ideal index is found by taking the geometric mean of the Laspeyre
index and the Paasche index.
Fishers ideal index = (Laspeyres x Paasche)
321
QUESTIONS
322
1. The following statements have been made about linear regression analysis:
(i) It provides more accurate estimates than the high low technique.
(ii) It can only be used to estimate variable cost
(iii) It assumes that cost behaviour is linear.
(iv) It only takes into account two observations of cost and output.
Which of the following statements about the use of linear regression analysis in
cost estimation are true?
A. (i) and (ii)

B. (i) and (iii)
C. (ii) and (iii)
D. (iii) and (iv)
2. Which of the following are components of a time series analysis?
(i) Trend
(ii) Seasonal variation
(iii) Cyclical variation
A. (i) and (ii) only

B. (i) and (iii) only
C. (ii) and (iii) only
3. A time series model of sales volume has the following trend and additive
seasonal variation.
Trend
Y= 5,000 +4,000 X
Where Y= quarterly sales volume in units
X= the quarter number (Where the first quarter of 2009= quarter 17, the second
quarter of 2009= quarter 18 etc).
Seasonal Variation Seasonal Variation

Quarter (units)
First +3,000
Second +1,000
Third -1,500
Fourth -2,500
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What would be the time series forecast of sales units for the third quarter of
2010?
A. 79,500
B. 95,500
C. 97,000
D. 98,500
4. A firm has used linear regression analysis to establish the relationship between
total cost and activity in units.
What does the slope of the regression line represent?
A. The variable cost per unit

B. The fixed cost per unit
C. The average cost per unit
D. Total variable costs
5. Which of the following could be included in a time series based sales forecast?
A. Trend
B. Seasonal variation
C. Cyclical variation
D. Random fluctuation
A. 1 only
B. only
C. 1, 2 and 3 only
D. 1, 2, 3 and 4
6. A company uses a multiplicative time series model to forecast sales. The trend in
sales is linear and is described by the following equation:
Trend = 400 + 10T
where T = 1 denotes the first quarter of 2010, T = 2 denotes the second quarter
of 2010 etc.
The average seasonal variations are as follows
Quarter 1 2 3 4
% Variation -30 +40 +10 -20
What is the sales forecast for the third quarter of 2011?
324
A. 423 units
B. 480 units
C. 517 units
D. 3,157 units
7. Which of the following are feasible values for the correlation coefficient?
1. +1.40
2. +1.04
3. 0
4. -0.94
A. 1 and 2 only
B. 3 and 4 only
C. 1, 2 and 4 only
D. 1, 2, 3 and 4
8. The following statements relate to the advantages that linear regression analysis
has over the high low method in the analysis of cost behavior:
1. The reliability of the analysis can be statistically tested

2. It takes into account all of the data
3. It assumes linear cost behavior
Which statements are true?
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1, 2 and 3
9. The following table shows the number of units produced each month and the
total cost incurred:
Cost
Units ($ 000)
January 100 40
February 200 45
March 300 50
April 400 65
May 500 70
June 600 70
July 700 80
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a. Calculate the regression line, y = a + bx.
b. Calculate the correlation coefficient.
10. Regression analysis is being used to find the line of best fit (y = a + bx) from five
pairs of data. The calculations have produced the following information:
x = 540, y = 755, x 2 = 61,000, xy = 83,920
What is the value of b in the equation for the line of best fit (to 2 decimal
places)?
A. 0.01
B. -1.40
C. 0.89
D. 1.40
11. Which of the following is NOT a feasible value for the correlation coefficient?
A. +1.3
B. +0.8
C. 0
D. -0.8
12. If the correlation coefficient of a set of data is 0.8, what is the coefficient of
determination? ___________
13. Two years ago the price index appropriate to the cost of material X had a value
of 120. It now has a value of 160.
If material X costs $2,000 per kg today, what would its cost per kg have been
two years ago?
A. $1,500
B. $1,667
C. $2,667
D. $3,200
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14. A company recorded the following prices and usage of materials over the last
two periods.
Period 1 Period 2
usage price per kg usage price per kg
kg $ kg $
Material 1 200 12 210 15

Material 2 10 20 16 21
Period 1 is the base period with an index value of 100.
What is the value of a Laspeyre price index (to the nearest whole number) of the
businesss material costs for period 2?
A. 71
B. 121
C. 123
D. 142
15. Four years ago material X cost $5 per kg and the price index most appropriate to
the cost of material X stood at 150. The same index now stands at 430.
What is the best estimate of the current cost of material X per kg?
A. $1.74 ($5 x 150 430)
B. $9.33 ($5 x (430 150) 150
C. $14.33 ($5 x 430 150)
D. $21.50 ($5 x 430 100)
16. The data in the table below has been extracted from a companys cost
accounting records. It shows the total costs and the inflation index for the periods
in which the costs were incurred. Cost behaviour patterns are the same in both
periods.
Output level Total cost Inflation index

6,000 units $10,500 1.05
8,000 units $13,390 1.03
The variable cost per unit, to the nearest $0.01, at an inflation index of 1.06 is:
A. $1.45
B. $1.59
C. $1.53
D. $1.50
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17. The table below contains details of an airlines expenditure on aviation fuel.
Year Total expenditure Total distance Fuel price

on aviation fuel flown index
$ million km million
2008 600 4,200 120
2009 1,440 4,620 240
The following statements relate to the changes between 2008 and 2009.
1. The quantity of fuel consumed increased by 140%

2. The quantity of fuel consumed increased by 20%
3. The quantity of fuel consumed per km flown increased by 20%
4. The quantity of fuel consumed per km flown increased by 109%
Which statements are true?
A. 1 only
B. 2 only
C. 2 and 3 only
D. 2 and 4 only
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ANSWERS
329
1. B
2. D
3. B {5,000 + (23 x 4,000) - 1,500 = 95,500} the 3rd quarter of 2010 is 23.
4. A
5. C
6. C (400 + 70) x 1.1 (the 3rd quarter of 2011 is 7)
7. B
8. B
9. y = 32.860 + 67.85x ; r = +0.98
x y xy x y
100 40 4,000 10,000 1,600

200 45 9,000 40,000 2,025
300 50 15,000 90,000 2,500
400 65 26,000 160,000 4,225
500 70 35,000 250,000 4,900
600 70 42,000 360,000 4,900
700 80 56,000 490,000 6,400
2,800 420 187,000 1,400,000 26,550
b = 7 (187000) - (2800) (420)

7 (1400000) - (2800)
= 1309000 - 1176000
9800000 - 7840000
= 133,000
1,960,000
= 0.067 x 1000
330
= 67.85
a = 420000 - 67.85 (2800)

7 7
= 60,000 - 27140
= 32,860
10. C
b = 5 (83920) - (540) (755)

5 (61000) - (540)
= 419600 - 407700
305000 - 291600
= 11,900
13,400
= 0.89
11. A r should be between -1 and +1
12. r2 = 0.82 = 0.64
13. A (2000 x 120 / 160)
14. C {(200 x 15) + (10 x 21)} / {(200 x 12) + (10 x 20)} x 100 = 123
15. C
16. B
$10,500 / 1.05 = $10,000

$13,390 / 1.03 = $13,000
331
Using the high-low method
($13,000 - $10,000) / (8,000 6,000) = $1.50 per unit
At inflation index of 1.06 = $1.50 x 1.06 = $1.59
17. B {(1440 x 120 / 240 / 600) -1} x 100 = 20%
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Chapter 18
BEHAVIOURAL ASPECTS OF
BUDGETING
18.1 Introduction
The purpose of a budgetary control system is to assist management in planning and

controlling the resources of their organisation by providing appropriate control
information. The information will only be valuable, however, if it is interpreted
correctly and used purposefully by managers and employees. The correct use of
control information therefore depends not only on the content of the information
itself, but also on the behaviour of its recipients.
A number of behavioural problems can arise: -
(a) The managers who set the budget or standards are often not the managers who
are then made responsible for achieving budget targets.
(b) The goals of the organisation as a whole, as expressed in a budget, may not
coincide with the personal aspirations of individual managers. This is known as
dysfunctional behaviour.
(c) When setting the budget, there may be budgetary slack (or bias). Budget slack
is a deliberate over-estimation of expenditure and/or under-estimation of revenues in
the budgeting process. This results in a budget that is poor for control purposes and
meaningless variances.

Explain the importance of motivation in performance management
Motivation is the drive or urge to achieve an end result. Hence, if employees and
managers are not motivated, they will lack the drive or urge to improve their
performance and to help the organization to achieve its goals and move forward.
The management accountant should therefore try to ensure that employees have
positive attitudes towards setting budgets, implementing budgets and feedback of
results.
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Factors such as financial and non financial rewards, prestige and esteem, job
security and job satisfaction may all play a part to motivate management and
employees.

Identify factors in a budgetary planning and control system that influence
motivation
Management accounting planning and control systems can have a significant effect
on manager and employee motivation.
These include: -
The level at which budgets and performance targets are set
Manager and employee reward systems
The extent to which employees participate in the budget setting process

Explain the impact of targets upon motivation
A budget represents a target, and aiming towards a target can be a powerful

motivator. However, whether the target will actually cause employees to do better is
thought to depend on how difficult the target is perceived to be. Employees have
different perceptions of targets, but generally it is thought that:
if targets are very low, actual performance can be pulled down from where it might
naturally have been
if targets are habitually very high, then employees might give up and, again,
performance can be reduced if you know that no matter how hard you try you will
fail to meet the target, its easy to conclude that you might as well not try at all.
So, the aim is to set budgets which are perceived as being possible, but which entice
employees to try harder than they otherwise might have done. The concept of a
motivating budget is a powerful one, although the budget which is best for
motivating might not represent the results which are actually expected. Managers
can, and perhaps should, build in a margin for noble failure.
The relationship between budget difficulty and actual performance is typically

represented in Figure 1, which shows the following:
When the budget is very easy, actual performance is low. It has been pulled
down by the low demands made of employees.
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When the budget is very difficult, actual performance is low. Why try when you
are doomed to failure?
When a budget is set at the level of the expectations (the best estimate of
what performance will actually be), employees are likely to perform as
expected.
If a more difficult aspirational budget is set, employees will try harder, and if
the budget is judged just right then their actual performance will be at its
maximum, though often falling short of the budget.
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Lecture Example 1
Fill in the blanks with any of these two terms: -
aspirations; expectations
An __________________ budget is based on reasonable expectations and is most

useful for planning and decision making.
An ___________________ budget improves motivation by setting targets of an

intermediate level of difficulty.

Discuss managerial incentive schemes
Managers may receive financial rewards (for e.g. bonuses) or non-financial rewards
(for e.g. promotion or greater responsibility) based on their ability to meet budget
targets.
Budgets by themselves have a limited motivational effect. It is the reward structure

that is linked to achieving the budget requirements, or lack of reward for non-
achievement, which provides the real underlying motivational potential of budgets. A
manager will need to regard the reward as being worthwhile if his behaviour is to be
influenced so that he/she strives actively towards the achievement of the budget.
However, some problems may arise with using pay as an incentive: -

1. Formal reward and performance evaluation systems can encourage
dysfunctional behaviour. Managers tend to pad their budgets to make the
subsequent variances more favourable.
2. Pay can be a demotivator if targets are not challenging and fair.

Explain top down, bottom up approaches to budgeting
Discuss the advantages and disadvantages of a participative approach to
budgeting
18.6.1 Top down / imposed budget
This is also called an authoritative or non-participative budget as it is set without

allowing the ultimate budget holder the opportunity to participate in the budgeting
process.
336
These budgets will begin with upper level management establishing parameters
under which the budget is to be prepared. Lower-level personnel have very little
input in setting the overall goals of the organization as they are essentially reduced
to doing the basic budget calculations consistent with directives.
One disadvantage of the top-down approach is that lower-level managers may view
the budget as a dictatorial standard. They lack ownership of the budget and as
such, they will be reluctant to take responsibility for it. Further, such budgets can
sometimes provide ethical challenges, as lower-level managers may find themselves
put in a position of ever-reaching to attain unrealistic targets for their units.
However, it can be argued that this top down approach may be the only approach to
budgeting which is feasible if: -
the organisation is newly-formed
the business is very small
low level employees have no interest in participating in the process
they are not technically capable of participating in budget setting
only top level management have access to information which is necessary for
budgeting purposes
18.6.2 Bottom up / participative budget
The budget holders have the opportunity to participate in setting their own budgets.
In fact, the lowest level organisational units are asked to submit their estimates of
expenditure for the next year. Senior management, meanwhile, has made a forecast
of the income it expects to receive. There may be a negative variance between the
forecast revenue and the sum of the departments budgets. The variance is resolved
by lengthy discussions or arbitrary decisions. This type of budget is also called
participative budget.
It is argued that bottom-up budgets improve employee morale and job satisfaction.
Furthermore, the budget is prepared by those who have the best knowledge of their
own specific areas of operation. This type of budget leads to better communication
and increases managers understanding and commitment.
On the negative side, a bottom-up approach is generally more time consuming and
expensive to develop and administer. Another potential shortcoming has to do with
the fact that some managers may try to "pad" their budget, giving them more room
for mistakes and inefficiency. As we have already discussed, this is known as
budgetary slack.
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18.6.3 Negotiated budget
In practice, different levels of management often agree budgets by a process of

negotiation. The budgeting process is therefore a bargaining process. Budgets lie
somewhere between what top management would really like and what junior
managers believe is feasible.
Lecture Example 2
In what circumstances might participative budgets not be effective?
A. In centralized organisations
B. In well-established organisations
C. In very large businesses
D. During periods of economic affluence
Lecture Example 3
Which of the following statements about participative budgeting is/are false?
A. Morale and motivation are improved

B. They may cause managers to introduce budgetary slack
C. They are quicker to produce than non-participative budgets
Goal Congruence vs Dysfunctional Behaviour
Goal congruence ensures that all members of the organisation pull in the same
direction towards helping the organisation to achieve its overall goals and objectives.
If individuals in an organisation fail to demonstrate congruent behaviour, decisions

taken may benefit that individual personally or the division which that individual
works for, but it may not benefit the organisation as a whole dysfunctional
behaviour.
Lecture Example 4
Which TWO of the following are MOST likely to influence the motivation of budget
holders?
(1) The contents of the budget manual

(2) The extent of participation in budget setting
338
(3) The level of difficulty at which budgets are set
(4) The structure of the budget committee
A. 1 and 2
B. 2 and 3
C. 3 and 4
D. 1 and 4
339
KEY NOTES
340
1. Budgetary Control
The purpose of a budgetary control system is to assist management in
planning and controlling the resources of their organisation by providing
appropriate control information.
2. Dysfunctional Behaviour
The goals of the organisation as a whole, as expressed in a budget, may not
coincide with the personal aspirations of individual managers.
3. Budgetary Slack (bias)

Budgetary slack is a deliberate over-estimation of expenditure and/or under-
estimation of revenues in the budgeting process. This results in a budget that
is poor for control purposes and meaningless variances.
4. Motivation
Motivation is the drive or urge to achieve an end result. What affects
motivation?
The level at which budgets and performance targets are set
Manager and employee reward systems
The extent to which employees participate in the budget setting
process
5. Top down budget (authoritative or non-participative)

It is set without allowing the ultimate budget holder the opportunity to
participate in the budgeting process.
6. Bottom up budget (participative)

The budget holders have the opportunity to participate in setting their own
budgets. Bottom-up budgets improve employee morale and job satisfaction.
7. Goal Congruence
Goal congruence ensures that all members of the organisation pull in the
same direction towards helping the organisation to achieve its overall goals
and objectives.
341
QUESTIONS
342
1. The following statements relate to the participation of junior management in
the budgeting setting process:
(i) it speeds up the budget setting process.

(ii) it increases their commitment to budgets.
(iii) it incorporates their knowledge into budgets.
(iv) it improves their morale and motivation.
Which of the statements are true?
A. (i), (ii) and (iii)

B. (i), (ii) and (iv)
C. (ii), (iii) and (iv)
D. (ii) and (iii) only
2. When the personal aspirations of individual managers do not concide with the
goals of the organisation as a whole, this is known as:
A. Goal congruence
B. Dysfunctional behavior
C. Budgetary slack
D. Participating budget
3. The deliberate over-estimation of expenditure and/or under-estimation of

revenues in the budgeting process is known as:
A. Goal congruence
B. Dysfunctional behavior
C. Budgetary slack
D. Participating budget
343
ANSWERS
344
1. C
2. B
3. C
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Chapter 19
CAPITAL EXPENDITURE BUDGETING
AND DISCOUNTED CASH FLOWS
Discuss the importance of capital investment planning and control
Capital investment involves expenditure on non-current assets for use in a

project which is intended to provide a return by way of interest, dividends or
capital appreciation. Capital investment decisions are crucial to the running of a
business in the long term. It affects the following areas:
i. Growth
Without capital investment companies cannot grow and expand. The decisions
made affect the long term.
If the wrong capital investment decisions are done, then this can burden a
company unnecessarily. However a company must invest in order to maintain its
market share and hopefully grow.
ii. Risk
Capital investment is a long term investment. It requires long term funding. This
long term commitment brings with it risks; e.g. the risks of defaulting on the
financing. However, the potential gains made from the investment may fluctuate
more than the previous gains made by the business. Such fluctuations make the
company more risky.
iii. Funding
Capital investment is often a large amount - this means the company will need
to look for finance, both internally and externally. The choice of finance type is
crucial, as it needs to be appropriate for the investment type and the company at
the time
iv. Complexity
Investment decisions are often based on future estimates, often in many years
time. Estimates and variables are used which are often interrelated.
346
The estimates and variables will also change over time due to changes in the
environment in which the company operates (economic, political, social,
technological, environmental and legal).

Define and distinguish between capital and revenue expenditure
19.2.1 Capital Expenditure
Capital expenditure can be defined as expenditure on productive assets which

are intended for use on a continuing basis in an enterprises activities, e.g. non-
current assets such as buildings, lifts, heating, machinery, vehicles, and office
equipment. This can be for expansion and/or to improve quality for profitability
purposes.
Capital expenditure appears as a non-current asset in the statement of financial

position. Depreciation is charged in the income statement as an expense.
All the costs incurred in self constructed assets (a business builds its own non-
current asset) should be included as a non-current asset in the statement of
financial position.
19.2.2 Revenue Expenditure
This expenditure is on day to day items, i.e. where the benefit is received short
term. This includes salaries, telephone costs or rent. It is incurred for the
purpose of trade, i.e. for expenditure classified as selling and distribution
expenses, administration expenses and fixed charges or to maintain the existing
earning capacity of non-current assets.
Revenue expenditure is included as an expense in the period in which it is

incurred.
19.2.3 Capital Income
Capital income is the proceeds from the sale of non-current assets and non-
current asset investments.
19.2.4 Revenue Income
Revenue income is derived from the sale of trading assets and from interest and
dividends received from investments held by the business.
347
Lecture Example 1
Which of the following are examples of revenue expenditure?
A. Improvements to the earning capacity of non-current assets

B. Purchase of inventories
C. Purchase of a company car by an estate agency business
D. Addition of an extension to a building

Outline the issues to consider and the steps involved in the preparation of a
capital expenditure budget
19.3.1 Issues to consider re capital expenditure
The quality of management decisions relating to the acquisition of non-current assets

will affect the level of profitability in a business. Once acquired, assets must be used
effectively. A profitable rate of return must be obtained to justify the continued use of
these assets and audit should be carried out to check that the expected benefits
have been realized.
19.3.2 Steps involved in the preparation of a capital expenditure

budget
Step1: Identify investment required
The case for the expenditure should be summarised, preferably on a standard

form, giving details of the equipment, etc, required, the anticipated cost and
estimates of any internal materials or labour required for installation.
Step 2: Evaluate capital expenditure
The data presented should then be evaluated by the accounts department

following the approach adopted by the organisation. This approach may range
from a simple payback assessment, i.e. how quickly will the investment be paid
back from the profits arising, to more sophisticated procedures allowing for the
time-value of money. These methods will be described later on in this chapter.
Step 3: Authorise capital expenditure and disposal
Very large proposals may require approval by the board of directors, while
smaller proposals may be approved at divisional level
348
Step 4: Implement, monitor and review investments
The time required to implement the investment proposal or project will depend
on its size and complexity. Following implementation, the investment project
must be monitored to ensure that the expected results are being achieved and
the performance is as expected: - this is known as post-completion audit. The
whole of the investment decision-making process should also be reviewed in
order to facilitate organisational learning and to improve future investment
decisions.

Explain and illustrate the difference between simple and compound interest,
and between nominal and effective interest rates
19.4.1 Simple interest
Simple interest is calculated on the original principal only.
Example
You invest $100 for 3 years and you receive a simple interest rate of 10% a year
on the $100. This would be $10 each year. Simply $100 x 10% = $10.
19.4.2 Compound interest
The important thing to remember is that you get interest on top of the previous
interest. This is called compound interest.
Example
Suppose that a business has $100 to invest and wants to earn a return of 10%.
What is the future value at the end of each year using compound interest?
Yr 1 - 100 x 1.10 = $110

Yr 2 - 110 x 1.10 = $121 or 100 x (1.10)2
Yr 3 - 121 x 1.10 = $133 or 100 x (1.10)3
This future value can be calculated as:
FV = PV (1+r)n
349
Where FV is the future value of the investment with interest
PV is the initial or present value of the investment
r is the compound annual rate of return or rate of interest
expressed as a proportion
n is the number of years
e.g. (100 x 1.1)3 = 133
19.4.3 Nominal interest rate
The nominal interest rate is given as a percentage. A compounding period is

also given. In the above example, the 10% is the nominal rate and the
compounding period is a year.
The compounding period is important when comparing two nominal interest

rates, for example 10% compounded semi-annually is better than 10%
compounded annually. In the exam, unless told otherwise, presume the
compounding period is a year.
19.4.4 Effective annual rate of interest (annual percentage rate APR)
The effective interest rate, on the other hand, can be compared with another
effective rate as it takes into account the compounding period automatically, and
expresses the percentage as an annual figure.
In fact, when interest is compounded annually the nominal interest rate equals
the effective interest rate.
To convert a nominal interest rate to an effective interest rate, you apply the
formula:
= (1 + i/m)mt 1
Where m is the number of compound periods

i is the interest rate
t is the number of time periods
Example
What is the effective rate of return of a 15% p.a. monthly compounding

investment?
Effective rate = (1 + (0.15/12)) 12 - 1 = (1 + 0.0125)12 - 1 = 0.1608 = 16.08%
350
Example
What effective rate will a stated annual rate of 6% p.a. yield when compounded
semi-annually?
Effective Rate = (1 + (0.06/2)) 2 - 1 = 0.0609 = 6.09%
Lecture Example 2
XY Bank adds interest monthly to investors accounts. The current rate of

interest is 12% p.a. If Paul deposited $2,000 on 1 July 2010, how much interest
will he have earned by 31 December 2010? ___________

Explain and illustrate compounding and discounting
19.5.1 Compounding
We have already looked at compounding in Section 19.4. Just a reminder that

the formula for compounding is: -
FV = PV (1+r)n
19.5.2 Discounting
Discounting is compounding in reverse. It starts with a future amount of cash

and converts it into a present value.
A present value is the amount that would need to be invested now to earn the
future cash flow, if the money is invested at the cost of capital.
Hence, when looking at whether we should invest in something we will be

looking at future cash flows coming in. We want to know what these future cash
flows are worth now, in todays money ideally.
PV = FV
(1 + r) n
If the future value is in one years time, then you take this FV and multiply it by
1/interest rate (discount rate)
351
Example
A business is to receive $100 in one years time and the interest rate/discount
rate is 10%. What is the PV of that money?
PV = 100 /1.10
PV = $90.9
Example
A business is to receive $100 in two years time and the interest rate/discount
rate is 10%. What is the PV of that money?
PV = 100 /1.102
PV = $82.6
Example
$133 is received in 3 years time. Interest rate 10%. What is the PV?
= 133 / 1.13 = $100
Lecture Example 3
How much would you need to invest now (to the nearest $) to earn $5,000 after
5 years at a compound interest rate of 8% a year?
Lecture Example 4
What is the present value of $5,000 receivable at the end of year 3 at a cost of
capital of 7% per annum?
19.5.3 Discount Rate
The present value can also be calculated using a discount factor (saving all the
dividing by 1.1 etc.)
The discount factor can be calculated as 1/ (1+r) to the power of n

So, the discount factor for 10% in 3 years is:
352
1/1.13 = 0.751
So 133 x 0.751 = $100
There are also tables that give you a list of these discount factors a copy of
these tables is included at the end of these notes.
Hence, to calculate a present value for a future cash flow, you simply multiply
the future cash flow by the appropriate discount factor.

Explain the distinction between cash flow and profit and the relevance of cash
flow to capital investment appraisal
Lets say you buy some goods for $100 and sell them for $200. However, $80 of
the receipt is on credit and you have not received it yet.
Profit looks solely at the income and costs. It matches these together,
regardless of timing of the actual cash payment or receipt.
Sales $200
Costs (100)
Profit 100
Cash flow, on the other hand, does not attempt to match the sale with the cost
but rather the actual cash paid and received.
Cash received $120

Cash paid (100)
Increase in Cash flow 20
Therefore, cash flows look at when the amounts actually come in and out: - the
money actually spent, saved and received. This is vital to capital investment
decision making - as the timing of inflows and outflows have a value too - the
time value of money.
Not only should the timing of the cash flows be taken into account when
planning on investments but also the type of cash flows to include. We call these
relevant costs.
353
Identify and evaluate relevant cash flows for individual investment
Relevant costs are those whose inclusion affects the investment decision.
The cash flows that should be included in a capital budgeting analysis are those
that will only occur if the project is accepted
You should always ask yourself Will this cash flow change ONLY if we accept
the project?
If the answer is yes, it should be included in the analysis because it is

incremental
Hence, the only cash flows that should be taken into consideration in capital
investment appraisal are: -
Future (ignore past / sunk costs)
Incremental (A cost that would have been paid anyway can be ignored.
Examples of relevant incremental costs include repair costs arising from
use, hire charges and any fall in the resale value of owned assets which
results from their use)
Cash (Accounting items like depreciation ignore as they are not cash)
An opportunity cost (the value of a benefit foregone a result of choosing a

particular course of action) is always a relevant cost.
Lecture Example 5
Hard Times Ltd is evaluating a proposed expenditure on an item of equipment

that would cost $200,000. A technical feasibility study has been carried out by
consultants, at a cost of $25,000. The equipment would have a life of four years,
and annual profits, after deducting annual depreciation of $30,000 would be
$8,000.
Identify the cash flows that should be evaluated for this project.
Lecture Example 6
A machine was purchased for $20,000 and has an estimated life of five years. It is
not currently being used in the business.
354
A special order has now been received from a customer which would require the use
of the machine for five months. The current net realizable value of the machine is
$10,000. If it is used for the job, its value is expected to fall to $7,000. The machine
has a carrying value of $6,000.
Due to this special order, costs will increase by $50/month.
Required
Determine the relevant cost of using the machine for the special order.

Explain and illustrate the net present value (NPV) and internal rate of return
(IRR) methods of discounted cash flow
Calculate NPV and IRR. Interpret the results for investment viability
Discounted cash flow, or DCF, is an investment appraisal technique that takes into
account both the timing of cash flows and also the total cash flows over a projects
life.
We will be discussing two methods which follow the DCF technique: -

1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
19.8.1 Net Present Value
The NPV is the value obtained by discounting all the cash outflows and inflows for
the project capital at the cost of capital and adding them up. Hence, it is the sum of
the present value of all the cash inflows from a project minus the PV of all the cash
outflows.
NPV is positive the cash inflows from a capital investment will yield a return in
excess of the cost of capital. The project is financially attractive
NPV is negative the cash inflows from a capital investment will yield a return
below the cost of capital. From a financial perspective, the project is therefore
unattractive
NPV is exactly zero - the cash inflows from a capital investment will yield a return
exactly equal to the cost of capital. The project is therefore just about financially
attractive.
355
If a company has 2 projects under consideration it should choose the one with
the highest NPV.
Lecture Example 7
Clab is considering investing in new equipment. The cost of this equipment is

$45,000 and it will have a five-year life.
The estimated cash flows are: -
Year $
1 8,000
2 9,000
3 12,000
4 9,500
5 9,000
The firm currently has a return of 12% and this is considered to be its cost of capital.
Calculate the NPV of the investment
Recommend whether or not the investment should go ahead.
Lecture Example 8
A company is considering whether to buy an item of equipment for $20,000. The

project would also require another initial investment of $8,000. The cash profits for
the project would be: -
Year Cash Profit

$
1 15,000
2 20,000
3 12,000
4 7,000
The equipment would have a resale value of $5,000 at the end of Year 4. The cost
of capital is 10%.
Calculate the NPV of the project. Recommend whether the project should be
undertaken.
356
19.8.2 Internal Rate of Return
The internal rate of return (IRR) is essentially the discount rate where the initial
cash out (the investment) is equal to the PV of the cash in. So, it is the
discount rate where the NPV = 0. If the IRR is higher than a target rate of
return, the project is financially worth undertaking.
Consequently, to work out the IRR we need to do trial and error NPV
calculations, using different discount rates, to try and find the discount rate
where the NPV = 0. This is known as the interpolation method.
The steps in this method are: -
Step 1: - Calculate two NPV for the project at two different costs of capital. It is
important to find two costs of capital for which the NPV is close to 0, because
the IRR will be a value close to them.
Step 2: - Having found two costs of capital where the NPV is close to 0, we can
then estimate the cost of capital at which the NPV is 0, i.e. the IRR. A formula
is used: -
L+ NPV L
NPV L - NPV H x (H - L)
L= Lower discount rate
H = Higher discount rate
NPV L = NPV @ lower rate
NPV H = NPV @ higher rate
Worked Example
If a project had an NPV of $50,000 when discounted at 10%, and -$10,000 when
discounted at 15%, what is the IRR?
Answer
10 + (50,000/60,000) x 5% = 14.17%
50,000 (10,000) 15% - 10%
357
Lecture Example 9
A capital investment has proposed the following cash flows: -
Year $
0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000
The target rate of return is 17%.
Required: -
i. Calculate the NPV of the project if the cost of capital is 15%

ii. Calculate the NPV of the project if the cost of capital is 20%
iii. Calculate the IRR of this project
iv. Should the project be accepted?
19.8.3 Mutually Exclusive Investments
Both NPV and IRR use discounted cash flow techniques. NPV provides an absolute
measure of return, whereas IRR provides a relative measure. The rule for deciding
between mutually exclusive projects is to accept the project with the higher NPV.
Lecture Example 10
Demo is considering two investment opportunities, Project A and Project B.

These have the following cash flows: -
Year 0 1
Project A ($000) (200) 240
Project B ($000) (100) 125
Demo has a cost of capital of 10%.
Find the NPVs and IRRs of the two projects. Which project should be
chosen?
358
Calculate present value using annuity and perpetuity formulae(s)
19.9.1 Annuity
An annuity is a fixed (constant) periodic payment or receipt which continues

either for a specified time or until the occurrence of a specified event, e.g.
ground rent.
Example
$100 will be received at the end of every year for the next 3 years. If cost of
capital is 10%, what is the PV of these amounts together?
Strictly speaking it is:

Yr 1 100 / 1.1 = 91
Yr 2 100/1.1/1.1 = 83
Yr 3 100/1.1/1.1/1.1 = 75
All added together = $249
This is easier is to calculate using an annuity discount factor - this is simply

the 3 different discount factors above added together
So using normal discount factors:
Yr 1 1/1.1 = 0.909
Yr 2 1/1.1/1.1 = 0.826
Yr 3 1/1.1/1.1/1.1 = 0.751
All added together 2.486 = Annuity factor (or get from annuity table)
So $100 x 2.486 = 248.6 = 249
Lecture Example 11
A payment of $4,000 is made for the next 3 years. The cost of capital is 8%.
What is the PV of this annuity?
359
Lecture Example 12
Find the present value of an annuity of $3,000 for five years, compound interest
at 4% pa, the first receipt being in one years time.
19.9.2 Perpetuity
Perpetuity is a periodic payment or receipt continuing for a limitless period.
Calculating the PV of a perpetuity:

Cash flow
Interest rate
Worked Example
What is the present value of an annual income of $50,000 for the foreseeable
future, given an interest rate of 5%?
Answer
50,000 / 0.05 = $1,000,000
Lecture Example 13
An investment will yield future cash flows of $3,000 for the foreseeable future.
What is the present value of this income at a discount rate of 20%?
Lecture Example 14
A project requires an initial outlay of $15,000 and will then generate $2,000
annually. Should the project be accepted at a discount rate of 16%?

Calculate payback (discounted and non-discounted)
Interpret the results of payback calculations
19.10.1 Payback Period (non discounted)
The payback period is the length of time that it takes for a project to recoup its
initial cost out of the cash receipts that it generates. This period is sometimes
referred to as "the time that it takes for an investment to pay for itself."
360
The basic premise of the payback method is that the more quickly the cost of an
investment can be recovered, the more desirable is the investment. Hence, this
method focuses on liquidity.
The payback period is expressed in years. When the net annual cash inflow is
the same every year, the following formula can be used to calculate the payback
period.
Formula / Equation:
The formula or equation for the calculation of payback period is as follows:
Payback period = Investment required / Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes incremental net
annual cash inflow.
Example - Constant Cash Flow
Initial cost 3.6 million

Cash in annually 700,000
What is the payback period?
3,600,000 / 700,000 = 5.1429 years
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case
1.7 months
So the answer is 5 years and 1.7 months
Lecture Example 15
An expenditure of $2million is expected to generate cash inflows of $500,000

each year for the next seven years. What is the payback period for the project?
361
Example - Irregular Cash Flows
When the cash flows associated with an investment project change from year to
year, the simple payback formula that we outlined earlier cannot be used. To
understand this point, consider the following data:
Year 0 - Capital out (800) -800

Year 1 - Cash in 100 -700
Year 5 - Cash in 120 +110
When the cumulative cashflow becomes positive then this is when the initial
payment has been repaid and so is the payback period
So in the final year we need to make $10 more to recoup the initial 800. So,
thats $10 out of $120. 10/120 x 12 (number of months) = 1.
So the answer is 4 years 1 month.
19.10.2 Payback Period (discounted)
The payback period incorporates the time value of money into the payback
method. All the cash flows are discounted at the companys cost of capital. The
discounted payback period is therefore the time it will take before the projects
cumulative NPV becomes positive.
362
Example
Year Cash flow
0 -1,700
1 500
2 500
3 600
4 900
5 500
Calculate discounted payback at a rate of 12%
Year Cash flow 12% Discounted Cumulative

Cash flow
0 -1,700 1 -1,700 -1,700
1 500 0.893 446.5 -1253.5
2 500 0.797 398.5 -855
3 600 0.712 427.2 -427.8
4 900 0.636 572.4 144.6
5 500 0.567 283.5 428.1
Discounted payback = 3 years 9 (427.8/572.4 x 12) months
NPV = $428,100
363
Lecture Example 16
XYZ plc is evaluating a possible investment project and uses a 10% discount rate to
determine its net present value.
Project A
$000
Initial cash outflow 400
Incremental cashflows
Year 1 100
Year 2 120
Year 3 140
Year 4 120
Year 5 100
Calculate for project A: -
a. the payback period

b. the discounted payback period
c. the NPV at a discount factor of 20%
d. the internal rate of return.
364
KEY NOTES
365
A. Capital Expenditure
Capital expenditure includes expenditure on productive assets which are
intended for use on a continuing basis
B. Revenue Expenditure
Revenue expenditure is on day to day items, i.e. for the purpose of trade
C. Steps involved in the preparation of a capital expenditure budget

i. Identify investment required
ii. Evaluate capital expenditure
iii. Authorise capital expenditure and disposal
iv. Implement, monitor and review investments
D. Simple Interest
Simple interest is calculated on the original principal only
E. Compound Interest
FV = PV(1 + r)n
F. Nominal Interest Rate

The nominal interest rate is given as a percentage together with a
compounding period.
G. Converting a nominal interest rate into an effective interest rate
(1 + i/m)mt 1
H. Discounting
PV = FV
(1 + r) n
I. Relevant cash flows

i. Future
ii. Incremental
iii. Cash
iv. Opportunity cost
J. Net Present Value (NPV)

The NPV is the sum of the present value of all the cash inflows from a project
minus the PV of all the cash outflows.
K. Internal Rate of Return (IRR)

It is the discount rate where the NPV = 0
366
IRR formula: -
L+ NPV L
NPV L - NPV H x (H - L)
L. Mutually Exclusive Investments

Accept the project with the higher NPV
M. Annuity
An annuity is a fixed periodic payment which continues either for a specified
time or until the occurrence of a specified event
N. Perpetuity
Perpetuity is a periodic payment or receipt continuing for a limitless period.
The PV of a perpetuity: -
Cash flow
Interest Rate
O. Payback period (not discounted)

The payback period is the length of time that it takes for a project to recoup its
initial cost.
Payback period = Investment required / Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes incremental

net annual cash inflow.
P. Payback period (discounted)

The discounted payback period is the time it will take before the projects
cumulative NPV becomes positive.
367
QUESTIONS
368
1. The net present value of a proposed project is $20,000 at a discount rate of 5%
and $(28,000) at 10%.
What is the internal rate of return of the project, to the nearest one decimal place?
A. 7.1%
B. 7.5%
C. 2.3%
D. 8.6%
2. A company is considering purchasing a new machine for $25,000. This would

increase the annual cash flow of the company by $6,500 in each of the next six
years. If the cost of capital is 9 per cent per annum, the net present value of this
investment is:
A. $4,159
B. $10,780
C. $10,901
D. $14,000
3. Investment is possible in one or more of three projects expected life 4 years.
A B C
$ $ $
Outlay 10,000 7,000 1,250
Expected returns (T1 T4) 4,000 2,500 325
The firm can borrow the finance at 10% pa.
Which project(s) should be undertaken?
A. A only
B. A and B
C. A and C
D. A and B and C
4. The internal rate of return is the interest rate that equates the present value of
expected future net cash receipts to
A. The initial cost of the investment outlay

B. The depreciation value of the investment
C. the terminal (compounded) value of future cash receipts
D. the firms cost of capital
369
5. A company has identified two mutually-exclusive projects which have an
equivalent effect on the risk profile of the company.
Project 1 Project 2
Discounted payback period 2.8 years 3.2 years
Net present value $17,200 $15,700
Internal rate of return 18% 22%
Average accounting rate of return 19% 21%
Cost of capital is 15%
Assuming that the directors wish to maximise shareholder wealth and no shortage
of capital is expected, which project should the company choose?
A. Project 1 because it has the shortage payback period

B. Project 1 because it has the higher net present value
C. Project 2 because it has the higher internal rate of return
D. Project 2 because it has the higher accounting rate of return
6. A project has a normal pattern of cash flows (i.e. an initial outflow followed by
several years of inflows).
What would be the effects on the internal rate of return (IRR) of the project and its
discounted payback period (DPP) of a decrease in the companys cost of capital?
IRR DPP
A. Decrease Decrease
B. Decrease Increase
C. No change Decrease
D. No change Increase
7. A project has a normal pattern of cash flows (i.e. an initial outflow followed by
several years of inflows).
What would be the effects on the internal rate of return (IRR) of the project and its
payback period of an increase in the companys cost of capital?
IRR Payback Period

A. Increase Increase
B. Increase No change
C. No change Increase
D. No change No change
370
8. Consider the following graph.
NPV
Project X
Project Y
0 15% Discount
rate
Which statement is true?
A. Project Y has a higher internal rate of return than project X

B. At discount rates of less than 15% project Y is preferred to project X
C. Project X is preferred to project Y irrespective of discount rate
D. Project Y is preferred to project X irrespective of discount rate
9. Details of a new machine are as follows.
Capital cost $120,000

Expected operating life 5 years
Expected scrap value at the end of five years $20,000
Annual depreciation $20,000
Expected annual cash inflows from operations $40,000
What is the payback period?
A. 6 years
B. 5 years
C. 3 years
D. 2 years
371
10.
Net
present
value
0 Interest rate
5% 10% 15%
Which of the following is correct with regard to the above graph?
(1) The IRR is 10%

(2) The NPV at 15% is positive
(3) The projects total inflows exceed the total outflows
A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3
11. Mr Manaton has recently won a competition where he has the choice between
receiving $5,000 now or an annual amount forever starting now (i.e. a level
perpetuity starting immediately). The interest rate is 8% per annum.
What would be the value of the annual perpetuity to the nearest $?
A. $370
B. $500
C. $400
D. $620
372
ANSWERS
373
1. A
IRR = 5% + 20 + (10% - 5%)

20 + 28
2. A
NPV = ($6,500 x Annuity factor) - $25,000 = ($6,500 x 4.486) - $25,000

= $4,159
3. B
Project A B C
NPV @ 10% $2,680 $925 $(220)
Therefore, undertake A and B
4. A
5. B
The NPV method is superior to all the other criteria for investment appraisal.
6. C
The IRR is independent of the cost of capital. If the cost of capital is reduced, later
cash flows will be discounted less dramatically and therefore the DPP will
decrease.
7. D
Both the internal rate of return and the payback period are independent of the cost
of capital.
8. A
True because the NPV profile of project Y crosses the discount rate axis beyond
that for project X.
B False at discount rates less than 15% project X has a higher NPV
and is therefore preferred.
374
C and D False at discount rates less than 15% project X is preferred,
whereas at rates greater than 15% project Y is preferred.
9. C
Payback = $120,000 = 3 years

$40,000
10. A
IRR occurs when NPV is zero.
11. A
Perpetuity = Cashflow (the first one being in one year's time)

Interest
discount the $5,000 for one year
5000 = 4629.62
1.08
$5000 now is valued at $4629.62 within one year
4629.62 = Cashflow
0.08
cashflow = 4629.62 x 0.08

= $370
375
Chapter 20
STANDARD COSTING AND
BASIC VARIANCE ANALYSIS
Explain the purpose and principles of standard costing
A standard cost is a predetermined estimated unit cost of a product or service.

Therefore, a standard cost represents a target cost.
Standard costing has a variety of uses: -

1. it is useful for planning, control and motivation
2. it is used to value inventories and cost production for cost accounting
purposes
3. it acts as a control device by establishing standards (planned costs),
highlighting activities that are not conforming to plan and thus alerting
management to areas which may be out of control and in need of corrective
action.
Variances provide feedback to management indicating how well, or otherwise,

the company is doing. Standard costs are essential for calculating and analysing
variances.
There are four main types of cost standards: -
1. Basic standards these are long-term standards which remain

unchanged over a period of years. They are used to show trends over
time.
2. Ideal standards these standards are based upon perfect operating
conditions. Therefore, they include no wastage, no scrap, no breakdowns,
no stoppages, no idle time. Ideal standards may have an adverse
motivational impact because they are unlikely to be achieved.
3. Attainable standards these standards are based upon efficient but not
perfect operating conditions. These standards include allowances for the
fatigue, machine breakdown and normal material losses. Attainable
standards motivate performance as they can be achieved with a certain
amount of hard work.
4. Current standards these standards are based on current level of
efficiency. They do not provide any incentive to improve on the current
level of performance.
376
Lecture Example 1
Performance standards that have remained unchanged over a long period of time
are known as:
A. Ideal standards
B. Current standards
C. Basic standards
D. Long-term standards

Explain and illustrate the difference between standard marginal and
absorption costing
Standard costing systems can be either an absorption costing system or a marginal

costing system. These differ in much the same way that ordinary absorption costing
and marginal costing systems differ.
Marginal costing systems focus on contribution: in a standard costing system,

there is a standard contribution per unit, equal to the difference between the
standard selling price and the standard marginal cost.
Absorption costing systems focus on profit per unit, and the standard profit
per unit of product is the difference between its standard sales price and
standard full cost.

Establish the standard cost per unit under absorption and marginal costing
A standard cost card shows full details of the standard cost of each product.
377
Standard Cost Card Product x
$ $
Direct Material x kgs @ $x x
x liters @ $x x
x
Direct labour x hrs @ $x x
x hrs @ $x x
x
Standard Direct Cost x
Variable production overheads x
Standard variable cost of (Marginal
production x Costing)
Fixed production overhead x
(Absorption
Standard full production cost x Costing)
Administration & marketing
overhead x
Standard cost of sale x
Standard profit x
Standard sales price X
A variance is the difference between a planned, budgeted, or standard cost and the
actual cost incurred. The same comparisons may be made for revenues.
The process by which the total difference between standard and actual results is
analysed is known as variance analysis.
When actual results are better than expected results, we have a favourable variance
(F). If, on the other hand, actual results are worse than expected results, we have an
adverse variance (A).
378
Calculate sales price and volume variance
Total Sales Variance
Sales Price Sales Volume

Variance Variance
The sales price variance shows the effect on profit of selling at a different price
from that expected.
The sales price variance = Actual units should have sold for $x
Actual units did sell $x
Sales Price Variance $ x (F/A)
The sales volume variance = Budgeted sales volume x units

(absorption costing) Actual sales volume x units
Sales Volume Variance in units x units (F/A)
x standard profit per unit $x
Sales Volume Variance in $ $x (F/A)
379
(marginal costing) Actual sales volume x units
x standard contribution per unit $x
Lecture Example 2
Hard Work Ltd has prepared the following standard cost card for its product HW: -
$ per unit
Materials (4kg at $4 per kg) 16
Labour (5 hrs at $6 per hr) 30
Variable overheads (5hrs at $2 per hr) 10
Fixed overheads (5 hrs at $3 per hr) 15
71
Budgeted selling price is $76 per unit.
Budgeted sales and production is 10,000 units.
The actual results are as follows:
Sales and production 10,500 units for $835,000
$
Materials (38,000 kg) 159,600
Labour (48,000 hrs) 310,000
Required:
Calculate variances in as much detail as possible.
380
For given or calculated sales variances, interpret and explain possible causes,
including possible interrelationships between them
The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what
the sales revenue should have been for the actual quantity sold, and what it was.
The sales volume profit variance is the difference between the actual units sold and
the budgeted (planned) quantity, valued at the standard profit (under absorption
costing) or at the standard contribution (under marginal costing) per unit. In other
words, it measures the increase or decrease in standard profit as a result of the
sales volume being higher or lower than budgeted (planned).
Possible causes of sales variances: -
1. unplanned price increases

2. unplanned price reduction to attract additional business
3. unexpected fall in demand due to recession
4. increased demand due to reduced price
5. failure to satisfy demand due to production difficulties

Calculate materials total, price and usage variance
The direct material total variance can be subdivided into the direct material price
variance and the direct material usage variance.
381
Total Materials Variance
Materials Price Materials Usage

Variance Variance
The direct material total

variance = actual units should have cost $x
actual units did cost $x
Direct Material Total Variance $ x (F/A)
The direct material price

variance = actual kgs should have cost $x
actual kgs did cost $x
Direct Material Price Variance $ x (F/A)
The direct material usage

variance = Actual units should have used x kgs
Actual units did use x kgs
Usage Variance in kgs x kgs (F/A)
x standard cost per kg $x
Usage Variance in $ $x (F/A)

For given or calculated materials variances, interpret and explain possible
causes, including possible interrelationships between them
The direct material total variance is the difference between what the output actually
cost and what it should have cost, in terms of material.
382
The direct material price variance calculates the difference between the standard
cost and the actual cost for the actual quantity of material used or purchased. In
other words, it is the difference between what the material did cost and what it
should have cost.
The direct material usage variance is the difference between the standard quantity of
materials that should have been used for the number of units actually produced, and
the actual quantity of materials used, valued at the standard cost per unit of material.
In other words, it is the difference between how much material should have been
used and how much material was used, valued at standard cost.
Variance Favourable Adverse

Material price Unforeseen discounts received Price increase
More care taken in purchasing Careless purchasing
Change in material standard Change in material standard
Material usage Material used of higher quality than Defective material
Standard Excessive waste
More effective use made of material Theft
Errors in allocating material to jobs Stricter quality control
Errors in allocating material to jobs

Calculate labour total, rate and efficiency variance
The total labour variance can be subdivided between labour rate variance and labour
efficiency variance.
383
Total Labour Variance
Labour Rate Labour Efficiency

Variance Variance
The direct labour total variance = Actual units should have cost $x
Actual units did cost $x
Direct Labour Total Variance $ x (F/A)
The direct labour rate variance = Actual hrs should have cost $x
Actual hrs did cost $x
Direct Labour Rate Variance $ x (F/A)
The direct labour efficiency variance Actual units should have

= taken x hrs
Actual units did take x hrs
Efficiency Variance in hrs x hrs (F/A)
x standard rate per hr $x
Efficiency Variance in $ $x (F/A)

For given or calculated labour variances, interpret and explain possible
causes, including possible interrelationships between them
The direct labour total variance is the difference between what the output should
have cost and what it did cost, in terms of labour.
The direct labour rate variance is the difference between the standard cost and the
actual cost for the actual number of hours paid for. In other words, it is the difference
between what the labour did cost and what it should have cost.
384
The direct labour efficiency variance is the difference between the hours that should
have been worked for the number of units actually produced, and the actual number
of hours worked, valued at the standard rate per hour. In other words, it is the
difference between how many hours should have been worked and how many hours
were worked, valued at the standard rate per hour.

Labour rate Use of apprentices or other workers Wage rate increase
at a rate of pay lower than standard Use of higher grade labour
The idle time variance is always
Idle time adverse Machine breakdown
Non-availability of material
Illness or injury to worker
Lost time in excess of standard
Labour efficiency Output produced more quickly than allowed
expected because of work Output lower than standard set
motivation, because of
better quality of equipment or deliberate restriction, lack of training,
materials, or
or better methods. sub-standard material used
Errors in allocating time to jobs Errors in allocating time to jobs

Calculate variable overhead total, expenditure and efficiency variance
The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead
efficiency variance (based on actual hours).
385
Total Variable Overhead Variance
Variable overhead Variable overhead

expenditure efficiency
variance variance
Variable overhead total variance = Actual units should have cost $x

Var Overhead Total Variance $ x (F/A)
Variable overhead expenditure variance = Actual hrs should cost $x

Var Overhead Exp Variance $ x (F/A)
Variable overhead efficiency variance Actual units should have taken X hrs
Actual units did take X hrs
Efficiency Variance in hrs X hrs (F/A)

For given or calculated variable overhead variances, interpret and explain
possible causes, including possible interrelationships between them
The 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.
386
The variable production overhead efficiency variance is exactly the same in hours as
the direct labour efficiency variance, but priced at the variable production overhead
rate per hour.

Variable overhead Savings in costs incurred Increase in cost of overheads used
expenditure More economical use of overheads Excessive use of overheads
Change in type of overheads used
Variable overhead Labour force working more efficiently Labour force working less efficiently
efficiency (favourable labour efficiency) (adverse labour efficiency)
Better supervision or staff training Lack of supervision

Calculate fixed overhead total, expenditure and, where appropriate, fixed
overhead volume, capacity and efficiency variance
The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance. The fixed production overhead volume variance
can be further subdivided into an efficiency and capacity variance.
387
Total Fixed Overhead Variance
Fixed overhead Fixed overhead

expenditure volume
variance variance
Fixed overhead Fixed overhead

capacity efficiency
variance variance
Fixed overhead total variance = Overhead incurred $x

Overhead absorbed $x
Fix Overhead Total Variance $ x (F/A)
Fixed overhead expenditure variance budgeted overhead expenditure $x

actual overhead expenditure $x
Fix Overhead Exp Variance $ x (F/A)
Fixed overhead volume variance = actual units produced x units

Budgeted units produced x units
Volume Variance in units x units (F/A)
x standard rate per unit $x
Volume Variance in $ $x (F/A)
388
The volume efficiency variance is calculated in the same way as the labour efficiency
variance.
Fixed overhead vol efficiency variance actual units should have taken x hrs
Vol Efficiency Variance in hrs x hrs (F/A)
x standard OAR rate per hr $x
Vol Efficiency Variance in $ $x (F/A)
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
Fixed overhead vol capacity variance

= Budget hours of work X hrs
actual hours of work X hrs
X hrs
Vol Capacity Variance in hrs (F/A)
$x
Vol Capacity Variance in $ (F/A)

For given or calculated fixed overhead variances, interpret and explain
possible causes, including possible interrelationships between them
Fixed overhead total variance is the difference between fixed overhead incurred and
fixed overhead absorbed. In other words, it is the under or over-absorbed fixed
overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed
overhead expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted
(planned) volume multiplied by the standard absorption rate per unit.
Fixed overhead efficiency variance is the difference between the number of hours
that actual production should have taken, and the number of hours actually taken
(that is, worked) multiplied by the standard absorption rate per hour.
Fixed overhead capacity variance is the difference between budgeted (planned)

hours of work and the actual hours worked, multiplied by the standard absorption
rate per hour.
389
Fixed overhead Savings in costs incurred Increase in cost of services used
Expenditure Changes in prices relating to fixed Excessive use of services
overhead expenditure Change in type of services used
Fixed overhead volume Labour force working more efficiently Labour force working less efficiently
Efficiency Lost production through strike
Fixed overhead volume Labour force working overtime Machine breakdown, strikes, labour
Capacity Shortages

Reconcile budgeted profit with actual profit under standard absorption costing
Operating Statement for the period ending .(under Absorption Costing)

$
Budgeted profit x
Sales Volume Variance x F
Sales Price Variance (x) A
x
Cost Variances $F $A
Materials Price x
Usage x
Labour Rate x
Idle x
Efficiency x
Variable Overheads Expenditure x
Efficiency x
Fixed Overheads Expenditure x
Efficiency x
Capacity x
x x (x) A
Actual Profit x
390
Reconcile budgeted profit or contribution with actual profit or contribution
under standard marginal costing
The main differences between absorption and marginal costing operating statements
are: -
1. The marginal costing operating statement has a sales volume variance that is
calculated using the standard contribution per unit (rather than a standard
profit per unit as in absorption costing)
2. There is no fixed overhead volume variance
Operating Statement for the period ending .(under Marginal Costing)

$
Budgeted contribution x
x
Materials Price x
Usage X
Labour Rate X
Idle x
Efficiency X
Variable Overheads Expenditure X
Efficiency X
X x (x) A
Actual Contribution x
Fixed Overheads
Budgeted Fixed Overhead x
Expenditure Variance x
Actual Fixed Overheads (x)
Actual Profit X
391
Calculate actual or standard figures where the variances are given
Variances can be used to derive actual data from standard cost details.
Rather than being given actual data and asked to calculate the variances, you may
be given the variances and required to calculate the actual data on which they were
based.
Lecture Example 3
A company operates a standard marginal costing system. Last month actual fixed
overhead expenditure was 2% below budget and the fixed overhead expenditure
variance was $1,250.
What was the actual fixed overhead expenditure for last month?
A. $61,250
B. $62,475
C. $62,500
D. $63,750
Lecture Example 4
In a period, 6,500 units were made. There was an adverse labour efficiency
variance of $26,000. Workers were paid at $8 per hour which was equal to the
standard labour rate. Total wages were $182,000.
a. Calculate the standard labour hours per unit.

b. Calculate the labour rate variance.
Lecture Example 5
A company uses standard marginal costing. Last month the budgeted contribution
was $20,000 and the only variances that occurred were as follows:
$
Sales price 3,000 Adverse
Sales volume contribution 5,000 Favourable
Fixed overhead expenditure 1,000 Adverse
392
What was the actual contribution last month?
A $18,000
B $19,000
C $21,000
D $22,000
(ACCA Examiners report F2 December 2010 Ex. 2)

Explain factors to consider before investigating variances
When deciding which variances to investigate, the following factors should be

considered:
1. Reliability and accuracy of the figures. Mistakes in calculating budget figures,

or in recording actual costs and revenues, could lead to a variance being
reported where no problem actually exists (the process is actually in control).
2. Materiality. The size of the variance may indicate the scale of the problem and
the potential benefits arising from its correction.
3. Possible interdependencies of variances. Sometimes a variance in one area

is related to a variance in another. For example, a favourable raw material
price variance resulting from the purchase of a lower grade of material, may
cause an adverse labour efficiency variance because the lower grade material
is harder to work with. These two variances would need to be considered
jointly before making an investigation decision.
4. The inherent variability of the cost or revenue. Some costs, by nature, are
quite volatile (oil prices, for example) and variances would therefore not be
surprising. Other costs, such as labour rates, are far more stable and even a
small variance may indicate a problem.
5. Adverse or favourable? Adverse variances tend to attract most attention as

they indicate problems. However, there is an argument for the investigation of
favourable variances so that a business can learn from its successes.
6. Trends in variances. One adverse variance may be caused by a random

event. A series of adverse variances usually indicates that a process is out of
control.
7. Controllability/probability of correction. If a cost or revenue is outside the

managers control (such as the world market price of a raw material) then
there is little point in investigating its cause.
393
8. Costs and benefits of correction. If the cost of correcting the problem is likely
to be higher than the benefit, then there is little point in investigating further.
Possible Control Action
The control action which may be taken will depend on the reason why the variance
occurred.
The variance may be a result of a measurement error, e.g. wastage has been
unrecorded, scales have been misread or employees may adjust their records to
improve their performance. Control action is required to improve the accuracy of
the recording system so that measurement errors do not occur.
In periods of high inflation or where operations are subject to technological

development, price standards are likely to become out of date. In such cases, there
is the need to frequently review and update standards.
Spoilage and wastage will both negatively affect the efficiency of operations. It is
important to highlight the cause of the inefficiency that will lead to control action to
eliminate the efficiency being repeated.
A standard is an average figure, representing the midpoint of different values. Actual

results are likely to deviate from this standard. As long as the variance falls within
this range, it will be classified as a random or chance fluctuation and control action
will not be necessary.
Further Questions
Question 1
XYZ uses standard costing. The following data relates to labour grade II.
Actual hours worked 10,400 hours

Standard Allowance for actual production 8320 hours
Standard Rate per hour $5
Rate Variance (adverse) $416
What is the actual rate of pay per hour?
a. $4.96
b. $5.04
c. $4.95
d. $5.05
394
Question 2
The standard material content of one unit of product A is 10kg of material X which
should cost $10 per kilogram. In June 2009, 5750 units of product A were produced
and there was an adverse material usage variance of $1500.
Calculate the quantity of material X used in June 2009.
Question 3
In January 2010, 6000 units of product X were produces. There was an adverse
material price variance of $5000. The standard price per kilogram is $10 and 5000kg
were used.
What was the actual material price per kilogram?
a. $11
b. $12
c. $10
d. $11.50
Question 4
The standard direct material cost for a product is $50 per unit (12.5kg at $4 per kg).
Last month the actual amount paid for 45,600kg of material purchased and use was
$173,280 and the direct material usage variance was $15,200 adverse.
What was the direct material price variance last month?
a. $8800 adverse
b. $8800 favourable
c. $9120 favourable
d. $9120 adverse
What was the actual production last month?
a. 4160 units
b. 3520 units
c. 3344 units
d. 3952 units
395
Question 5
Mark has the following results:
10,000 hours actually worked and paid costing $126,000.

If the rate variance is $1400 adverse, the efficiency variance $498 favourable and
5020 units were produced, what is the standard production time per unit?
a. 2.01 hours
b. 2.00 hours
c. 1.99 hours
d. 2.02 hours
Question 6
In a period, 7000 units were made. There was an adverse labour efficiency variance
of $30,000. The standard labour rate is $10/hr but workers were paid $12/hr. Total
wages were $204,000.
Calculate the standard labour hours per unit.
a. 2.10 hours
b. 1.95 hours
c. 2 hours
d. 2.05 hours
396
Illustration 112
A company uses standard marginal costing.
Its budgeted contribution for the last month was $20,000. The actual contribution for
the month was $15,000, and the following variances have been calculated:
Sales volume contribution variance $5,000 adverse

Sales price variance $9,000 favourable
Fixed overhead expenditure variance $3,000 favourable
What was the total variable cost variance?
A. $9,000 adverse
B. $9,000 favourable
C. $12,000 adverse
D. $12,000 favourable
The total variance between budgeted contribution and actual contribution is $5,000
adverse ($20,000 - $15,000). The sales volume and sales price variances sum to
$4,000 favourable (5,000 A 9,000 F), so to balance, the variable cost variance
must be $9,000 adverse.
Sales variance 4,000F

Variable cost variance (missing figure) 9,000A
Difference in contribution 5,000A
The correct answer is A.
12 Examiners Report June 2015
397
Illustration 213
A companys actual profit for a period was $27,000.
The only variances for the period were.

Sales price 5,000 adverse
Fixed overhead volume 3,000 favourable
Fixed overhead capacity 4,000 favourable
Fixed overhead efficiency 1,000 adverse
What was the budgeted profit for the period?
A. $25,000
B. $26,000
C. $28,000
D. $29,000
To get to budgeted profit: -
Add back adverse variances and deduct favourable variances to actual profit to
arrive at budgeted profit.
Avoid double-counting: -
The fixed overhead volume variance ($3,000F is equal to the sum of the fixed
overhead capacity variance ($4,000 F) and the fixed overhead efficiency variance
($1,000 A), so it is important not to include all three and only to deduct $3,000 not
$6,000.
Hence,
Actual profit 27,000
Add Sales price variance 5,000
Less Fixed overhead volume variance 3,000
Budgeted profit 29,000
13 Examiners Report December 2014
398
KEY NOTES
399
1. Standard Cost
A standard cost is a predetermined estimated unit cost of a product or service.

There are four main types of cost standards: -
i. Basic standards
ii. Ideal standards
iii. Attainable standards
iv. Current standards
2. Variance
A variance is the difference between a planned, budgeted, or standard cost and

the actual cost incurred. The process by which the total difference between
standard and actual results is analysed is known as variance analysis.
When actual results are better than expected results, we have a favourable
variance (F). If, on the other hand, actual results are worse than expected results,
we have an adverse variance (A).
3. Sales Variances
The sales price variance = Actual units should have sold for $x
Actual units did sell $x
Sales Price Variance $ x (F/A)

(absorption costing) Actual sales volume x units
x standard profit per unit $x
400
(marginal costing) Actual sales volume x units
x standard contribution per unit $x
4. Materials Variances
The direct material total variance = actual units should have cost $x
actual units did cost $x
Direct Material Total Variance $ x (F/A)
The direct material price variance = actual kgs should have cost $x
actual kgs did cost $x
Direct Material Price Variance $ x (F/A)
The direct material usage variance = Actual units should have used x kgs
Actual units did use x kgs
Usage Variance in kgs x kgs (F/A)
x standard cost per kg $x
Usage Variance in $ $x (F/A)
5. Labour Variances
The direct labour total variance = Actual units should have cost $x
Direct Labour Total Variance $ x (F/A)
The direct labour rate variance = Actual hrs should have cost $x
Direct Labour Rate Variance $ x (F/A)
401
The direct labour efficiency variance = Actual units should have taken x hrs
Efficiency Variance in hrs x hrs (F/A)
6. Variable Overheads Variances
Variable overhead total variance = Actual units should have cost $x

Var Overhead Total Variance $ x (F/A)
Variable overhead expenditure variance = Actual hrs should cost $x

Var Overhead Exp Variance $ x (F/A)
Variable overhead efficiency variance = Actual units should have taken X hrs
Actual units did take X hrs
Efficiency Variance in hrs X hrs (F/A)
7. Fixed Overheads Variances
Fixed overhead total variance = Overhead incurred $x

Overhead absorbed $x
Fix Overhead Total Variance $ x (F/A)
Fixed overhead expenditure variance = budgeted overhead expenditure $x

actual overhead expenditure $x
Fix Overhead Exp Variance $ x (F/A)
402
Fixed overhead volume variance = actual units produced x units
budgeted units produced x units
Volume Variance in units x units (F/A)
x standard rate per unit $x
Volume Variance in $ $x (F/A)
The volume efficiency variance is calculated in the same way as the labour efficiency
variance.
Fixed overhead vol efficiency variance = actual units should have taken x hrs
Vol Efficiency Variance in hrs x hrs (F/A)
Vol Efficiency Variance in $ $x (F/A)
The volume capacity variance is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
Fixed overhead vol capacity variance = budget hours of work X hrs

actual hours of work X hrs
X hrs
Vol Capacity Variance in hrs (F/A)
$x
Vol Capacity Variance in $ (F/A)
403
8. Operating Statement Absorption Costing
Operating Statement for the period ending .(under Absorption Costing)

$
Budgeted profit x
x
Materials Price x
Usage x
Labour Rate x
Idle x
Efficiency x
Variable Overheads Expenditure x
Efficiency x
Fixed Overheads Expenditure x
Efficiency x
Capacity x
x x (x) A
Actual Profit x
9. Operating Statement Marginal Costing
The main differences between absorption and marginal costing operating statements
are: -
1. The marginal costing operating statement has a sales volume variance that is
calculated using the standard contribution per unit (rather than a standard
profit per unit as in absorption costing)
2. There is no fixed overhead volume variance
404
Operating Statement for the period ending .(under Marginal Costing)
$
Budgeted contribution x
x
Materials Price x
Usage X
Labour Rate X
Idle x
Efficiency X
Variable Overheads Expenditure X
Efficiency X
X x (x) A
Actual Contribution x
Fixed Overheads
Budgeted Fixed Overhead x
Expenditure Variance x
Actual Fixed Overheads (x)
Actual Profit X
10. The factors to consider before investigating variances
Reliability and accuracy of the figures

Materiality
Possible interdependencies of variances
The inherent variability of the cost or revenue
Adverse or favourable?
Controllability/probability of correction
Costs and benefits of correction
405
QUESTIONS
406
1. A companys budgeted sales for last month were 10,000 units with a standard
selling price of $20 per unit and a standard contribution of $8 per unit. Last
month actual sales of 10,500 units at an average selling price of $19.50 per
unit were achieved.
What were the sales price and sales volume contribution variances for last
month?
Sales price variance ($) Sales volume contribution variance ($)

A. 5,250 Adverse 4,000 Favourable
B. 5,250 Adverse 4,000 Adverse
C. 5,000 Adverse 4,000 Favourable
D. 5,000 Adverse 4,000 Adverse
2. When a manufacturing company operates a standard marginal costing system

there are no fixed production overhead variances.
A. True
B. False
3. A company operates a standard costing system. The variance analysis for last
month shows a favourable materials price variance and an adverse labour
efficiency variance.
The following four statements, which make comparisons with the standards,
have been made:
(1) Inferior quality materials were purchased and used.

(2) Superior quality materials were purchased and used.
(3) Lower graded workers were used on production.
(4) Higher graded workers were used on production.
Which statements are consistent with the variance analysis?
A. (1) and (3)

B. (1) and (4)
C. (2) and (3)
D. (2) and (4)
407
4. A company operates a standard absorption costing system. The standard
fixed production overhead rate is $15 per hour.
The following data relate to last month:
Actual hours worked 5,500

Budgeted hours 5,000
Standard hours for actual production 4,800
What was the fixed production overhead capacity variance?
A. $7,500 Adverse
B. $7,500 Favourable
C. $10,500 Adverse
D. $10,500 Favourable
5. A company uses standard costing and the standard variable overhead cost
for a product is:
6 direct labour hours @ $10 per hour.
Last month when 3,900 units of the product were manufactured, the actual
expenditure on variable overheads was $235,000 and 24,000 hours were
actually worked.
i. What was the variable overhead expenditure variance for last month?
A. $5,000 Adverse
C. $6,000 Adverse
ii. What was the variable overhead efficiency variance for last month?
A. $5,000 Adverse
C. $6,000 Adverse
6. A company sold 20,000 units in a period when budgeted sales were 18,000
units.
On an absorption costing basis the sales volume profit variance for the period
had a value of $ 10,000. The standard fixed overhead absorption rate was
$4.00 per unit.
408
What would the sales volume contribution variance be on a marginal costing
basis?
A. $2,000 adverse
B. $2,000 favourable
C. $18,000 adverse
D. $18,000 favourable
7. A basic standard is:
A. A standard set at an ideal level, which makes no allowance for normal

losses, waste and machine downtime.
B. A standard which assumes an efficient level of operation, but which

includes allowances for factors such as normal loss, waste and
machine downtime.
C. A standard which is kept unchanged over a period of time.
D. A standard which is based on current price levels.
409
ANSWERS
410
1. A
Sales Price Variance
10500 units did earn 204,750 (x 19.50)

shd earn 210,000
5,250 (A)
Sale Volume contribution Variance
Actual sales 10,500

Budgeted sales 10,000
500 (F)
x $8
4,000 (F)
2. False
3. A
Spent less on materials and more on wages and bonuses.
4. B
Fixed production overhead capacity Variance
Budgeted hours 5,000

Actual hours 5,500
500 (F)
x $15
7,500 (F)
5. i. B
Variable Overhead Expenditure Variance
24000 hrs should cost 240,000 (x 10)

did cost 235,000
5,000 (F)
411
ii. C
Variable Overhead Efficiency Variance
3900 units should take 23,400

did take 24,000
600 (A)
x $10
6,000 (A)
6. D
Actual sales 20,000

Budgeted sales 18,000
2,000 (F)
x 5 = 10,000
Profit per unit is $5.
Contribution is $5 + $4 = $9 x 2,000 units = 18,000 F
7. C
412
Chapter 21
SPREADSHEETS
Explain the role and features of a computer spreadsheet system
Most of the numerical forecasting and budgeting techniques mentioned in the

previous chapters will be carried out far more efficiently with the help of computer
software packages. Packages have specific statistical applications (index numbers,
time series analysis, regression) but they can also be of a more general nature (e.g.
spreadsheets and databases).
21.1.1 What is a spreadsheet?
A spreadsheet is a computer package which is divided into rows and columns. The
intersection of a row and a column is known as a cell.
413
Cell contents
The contents of any cell can be one of the following: -
i. Text. A text cell usually contains words, descriptions, key words.

ii. Values. A value is a number that can be used in a calculation.
iii. Formulae. A formula refers to other cells in the spreadsheet, and performs
some sort of computation with them.
414
21.1.2 Formula bar
The formula bar allows you to see and edit the contents of the active cell. The bar
also shows the cell address of the active cell.
21.1.3 Examples of spreadsheet formulae
All Excel formulae start with the equals sign =, followed by the elements to be
calculated (the operands) and the calculation operators. Each operand can be a
value that does not change (a constant value), a cell or range reference, a label, a
name, or a worksheet function.
Formulae can be used to perform a variety of calculations. Here are some examples:
-
1. =C4*5. This formula multiplies the value in C4 by 5. The result will appear in the
cell holding the formula.
2. =C4*B10. This multiplies the value in C4 by the value in B10.
3. =C4/E5. This divides the value in C4 by the value in E5.
4. =C4*B10-D1. This multiplies the value in C4 by that in B10 and then subtracts
the value in D1 from the result.
Note that generally Excel will perform multiplication and division before addition or
subtraction
415
5. =C4*117.5%. This adds 17.5% to the value in C4, for example in sales tax.
6. = (C4+C5+C6)/3. Note that the brackets mean Excel would perform the addition
first.
Without the brackets, Excel would first divide the value in C6 by 3 and then add
the result to the total of the values in C4 and C5.
1. 2^2 gives you 2 to the power of 2, in other words 22. Likewise = 2^3 gives you 2
cubed and so on.
2. = 4^ (1/2) gives you the square root of 4. Likewise 27^(1/3) gives you the cube
root of 27 and so on.
21.1.4 Formulae with conditions
< less than

<= less than or equal to
= equal to
>= greater than or equal to
> greater than
<> not equal to
21.1.5 The SUM button
In Excel, the standard toolbar has a button that simplifies adding a column or row
of numbers. When you click the AutoSum button, Excel creates a sum function for
the column of numbers directly above or the row of numbers to the left. Excel pastes
the SUM( ) function and the range to sum into the formula bar.
416
Identify applications for computer spreadsheets and their use in cost and
management accounting
21.2.1 Uses of spreadsheets
Spreadsheets provide a tool for calculating, analysing and manipulating numerical

data. Spreadsheets make the calculation and manipulation of data easier and
quicker.
For example, the spreadsheet above has been set up to calculate the totals
automatically. If you changed your estimate of sales for one of the departments, the
totals will change automatically.
Spreadsheets can be used for a wide range of tasks due to its ability to manipulate a
large amount of data very quickly to answer what-ifquestions.. Some common
applications of spreadsheets are:
Management accounts
Cash flow analysis and forecasting
Reconciliations
417
Revenue analysis and comparison
Cost analysis and comparison
Budgets and forecasts
What if? analysis / sensitivity analysis
Lecture Example 1
Which of the following is the least suitable application of a spreadsheet package?

A. Budgeting and forecasting
B. Maintenance of customer records
C. Inventory valuation
D. Variance analysis
21.3 Advantages and Disadvantages of spreadsheet software
21.3.1 Advantages of spreadsheets
1. easy to learn and use

2. easier and quicker calculation and manipulation of data
3. enable what-if analysis to be performed quickly
4. enable the analysis, reporting and sharing of financial information.
21.3.2 Disadvantages of spreadsheets
1. since formulae are hidden, the underlying logic of a set of calculations may
not be obvious.
2. a high proportion of large models contain errors
3. a database may be more suitable to use with large volumes of data
Lecture Example 2
An advantage of a spreadsheet program is that it: -
A. can answer ' what if? questions

B. checks for incorrect entries
C. automatically writes formulae
D. can answer when is? questions
418
Lecture Example 3
Which of the following is not a disadvantage of using spreadsheets?
A. Spreadsheets are restricted to a finite number of records, and can require a

large amount of space for data storage
B. There can be sharing violations among users wishing to view or change data
at the same time
C. Spreadsheets do not have the ability to generate graphs and charts for the
analysis of data
Lecture Example 4
The following statements refer to spreadsheets:
(1) A spreadsheet is the most suitable software for the storage of large volume of
data
(2) A spreadsheet could be used to produce a flexible budget
(3) Most spreadsheets contain a facility to display the data within them in a
graphical form
Which of these statements are correct?

A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3
419
KEY NOTES
420
1. What is a spreadsheet?
A spreadsheet is a computer package which is divided into rows and columns.

The intersection of a row and a column is known as a cell.
2. Cell contents
The contents of any cell can be one of the following: -

Text. A text cell usually contains words, descriptions, key words.
Values. A value is a number that can be used in a calculation.
Formulae. A formula refers to other cells in the spreadsheet, and
performs some sort of computation with them.
3. Uses of spreadsheets
Spreadsheets provide a tool for calculating, analysing and manipulating

numerical data. Spreadsheets make the calculation and manipulation of data
easier and quicker.
421
QUESTIONS
422
1. The following statements relate to spreadsheets. Which statement is false?
A. They are an efficient method of storing text based files.

B. They facilitate what if analysis
C. They allow data to be displayed graphically
D. They allow the font, size and colour of text to be changed.
2. A company uses a spreadsheet package to produce budgets for its long

established product. An extract from the spreadsheet is shown below. It is
company policy to maintain finished goods inventory at a level equal to 30%
of next months forecast sales.
A B C D
1
2
3 January February March
4 Production budget
5 Sales (units) 5,000 6,000 8,000
6 Production
Which of the following is a correct formula for cell C6?
A. =5000-6000*0.3=5000*0.3
B. =1.3*C5-D5*0.3
C. =C5=C5*0.3-0.7*D5
D. =C5+ (D5-C5)*0.3
423
ANSWERS
424
1. A
2. D
Remember that Production = Sales + Closing inventory opening Inventory
425
Chapter 22
PERFORMANCE MEASUREMENT
Discuss the purpose of mission statements and their role in performance
measurement
Discuss the purpose of strategic and operational and tactical objectives and
their role in performance measurement
A mission statement contains the overall goals and objectives of the organisation
which are not time specific and not quantified, i.e. what the organization should be
doing in the longer term and how it should go about doing it. Mission statements
often include the following information:
Purpose and aim(s) of the organization

The organization's primary stakeholders: clients/customers, shareholders,
congregation, etc.
How the organization provides value to these stakeholders, for example by
offering specific types of products and/or services
As described in Chapter 1, objectives may be developed at strategic, operational and

tactical levels in order to allow an organisation to measure progress towards the
overall goal. Suitable performance measures therefore need to be set to monitor the
achievement of each objective.
Measures will differ according to the type of objective.
Strategic objectives are often the responsibility of the senior management and will be
measured by indicators that reflect the performance of the whole organisation, e.g.
ROI, net profit %.
Tactical objectives are often the responsibility of middle management and measures
may be used that summarise the performance of a department or division, e.g.
actual profit compared to budget produced monthly.
Operational objectives are often concerned with the day-to-day running of the
organisation and are often physical measures, e.g. quantity of rejects, number of
customer complaints produced daily.
426
Lecture Example 1
Which of the following would not be expected to appear in an organisations mission

statement?
A. The organisations values and beliefs

B. The products or services offered by the organisation
C. Quantified short term targets the organisation seeks to achieve
D. The organisations major stakeholders
Corporate and unit objectives
Corporate objectives concern the firm as a whole; e.g. profitability, market share,
customer satisfaction quality.
Unit objectives are specific to individual units of an organisation, e.g. increase the
number of customers by x%; reduce the number of rejects by x%, respond more
quickly to calls (especially in the case o hospital ambulance service, local police, and
firemen).
Primary and secondary objectives
Some objectives are more important than others. Secondary objectives should
combine to ensure the achievement of the primary corporate goals.
For example, as its primary objective, a company wants to achieve an increase in

profits. As secondary objectives, it has to aim for sales growth, product quality,
customer service and innovation.
The problem of short-termism
Since managers performance is measured on short-term results, there is a bias

towards short-term rather than long-term performance. Companies often have to
make a trade-off between short-term and long-term objectives e.g. reducing quality
control to save operating costs; postponing capital expenditure projects in order to
protect liquidity and profits. Managers may also manipulate results, since bonuses
and rewards are often linked to performance.
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Discuss the impact of economic and market conditions on performance
measurement
Explain the impact of government regulation on performance measurement
External factors may be an important influence on an organisations ability to achieve

objectives. In particular, market conditions and government policy will be outside of
the control of the organisations management and will need to be carefully monitored
to ensure forecasts remain accurate.
General economic conditions
General economic conditions influence the demand and supply for a companys
products. Government economic policy affects demand quite rapidly. Changes in
interest rates are determined largely by government policy and have a direct effect
on credit sales.
Market conditions
A business operates in a competitive environment and suppliers, customers and

competitors all influence one anothers operations. The entry of a new competitor
will certainly affect the organisation.
Government regulation
Government policy will affect the performance of the different organisations.
a. The government may raise the taxes on sales and profits and this will surely
affect demand
b. It may provide funds towards new investment and may offer tax incentives
c. It will influence business through the different legislation, e.g. companies act,
employment law, consumer protection rights
d. The governments economic policy will affect business activity, e.g. interest
rates (mentioned above), inflation, economic growth.

Discuss and calculate measures of financial performance (profitability,
liquidity, activity and gearing)
A key aspect of performance measurement is ratio analysis. Ratios are of little use in
isolation. Firms can use ratio analysis to compare: -
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1. budgets, for control purposes
2. last years figures to identify trends
3. competitors results and/or industry averages to assess performance
22.3.1 Measuring Profitability
Profitability ratios measure the organisations ability to deliver profits.
22.3.1.1 Return on Capital Employed (sometimes known as return on investment

(ROI))
The main ratio to measure profitability in an organization is return on capital

employed (ROCE).
ROCE = Net Profit before interest and tax x 100

Capital Employed
Capital employed is defined as total assets less current liabilities or share capital and
reserves plus non-current liabilities. It is important to exclude all assets of a non-
operational nature, e.g. trade investments and intangible assets such as goodwill.
Profit before interest and tax (operating profit) represents the profit available to pay
interest to debt investors and dividends to shareholders. If we wish to calculate
return on ordinary shareholders funds (the return to equity holders), we would use
profit after interest and tax divided by total equity14.
ROCE represents the percentage of profit being earned on the total capital
employed; and relates profit to capital invested in the business. Capital invested in a
corporate entity is only available at a cost corporate bonds or loan stock finance
generate interest payments and finance from shareholders requires either immediate
payment of dividends or the expectation of higher dividends in the future.
ROCE rewards investors for the risks they are taking by investing in the company.
The higher the ROCE figure, the better it is for investors. It should be compared with
returns on offer to investors on alternative investments of a similar risk. 15
The primary ratio measuring overall return is analysed in more detail by using
secondary ratios:
14 Ratio Analysis, F2/FMA examining team, April 2015, http://www.accaglobal.com/gb/en/student/exam-

support-resources/fundamentals-exams-study-resources/f2/technical-articles/ratio-analysis.html
15 Ratio Analysis, F2/FMA examining team, April 2015, http://www.accaglobal.com/gb/en/student/exam-
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Asset turnover
Return on sales
22.3.1.2 Return on Sales (Operating Margin)
Return on sales looks at operating profit earned as a percentage of revenue.
Operating Margin = Operating profit x 100

Revenue
Good performance is often explained by costs not being controlled and selling
prices being high. It looks at profits after charging non-production overheads.
22.3.1.3 Gross Profit Margin
The trading activities of a business can be analysed using the gross profit margin.
Gross Profit Margin = Gross Profit x 100

Turnover
When particular areas of weakness are found, subsidiary ratios are worked out: -
Production cost of sales / sales

Distribution and marketing costs / sales
Administrative costs / sales
22.3.1.4 Asset Turnover
The asset turnover indicates how well the assets of a business are being used to
generate sales or how effectively management have utilised the total investment in
generating income.
The higher the asset turnover the better but do watch out for the problems caused by
overtrading, i.e. operating the business at a level not sustainable by its capital
employed.
Very often a high asset turnover is accompanied by low sales margins.
Asset Turnover = Turnover

Capital Employed
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Lecture Example 2
Below are the financial statements for RCA Ltd for the years ended 30 June 20X8
and 20X9:
Income statements
20X8 20X9
$000 $000
Revenue 150,000 180,000

Cost of sales (60,000) (65,000)
_______ _______
Gross profit 90,000 115,000

Operating expenses (28,500) (39,900)
_______ _______
Profit from operations 61,500 75,100

Finance cost (10,000) (12,000)
_______ _______
Profit before tax 51,500 63,100
Tax (13,600) (17,300)
_______ _______
Net profit 37,900 45,800
Statements of Financial Position

20X8 20X9
$000 $000
Property, plant and equipment 190,000 266,200

Current assets
Inventory 12,000 15,000
Receivables 37,500 49,300
Bank 500 -
_______ _______
240,000 330,500
_______ _______
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Share capital 10,000 12,000
Share premium 4,000 5,000
Revaluation reserve - 30,000
Retained earnings 78,900 99,700
_______ _______
92,900 146,700
Non-current liabilities
Loan 125,000 150,000
Current liabilities
Trade payables 10,600 21,700
Overdraft - 9,100
Taxation 11,500 3,000
_______ _______
240,000 330,500
_______ _______
Required: -
For each of the two years, discuss and calculate the following ratios for RCA
Ltd:-
1. ROCE
2. Asset Turnover
3. Net Profit Margin
4. Gross Profit Margin
22.3.2 Measuring Liquidity
Liquidity is the ability of an organization to pay its debts when they fall due. There
are two main measures of liquidity: -
1. the current ratio

2. the quick (or acid test) ratio
22.3.2.1 Current Ratio
The current ratio is expressed as:
Current assets : Current Liabilities
If current assets exceed current liabilities then the ratio will be greater than 1 and
indicates that a business has sufficient current assets to cover demands from
creditors.
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A very high current ratio could indicate that a company is too liquid. Hence this is
not necessarily good as cash is an idle asset as it earns no return. The company
can make use of cheap short-term finance.
22.3.2.2 Quick (Acid Test) Ratio
This is expressed as:
Current assets Stocks : Current Liabilities
Inventory often takes a long time to convert into cash. Hence inventory often takes a
long time to convert into cash. If this ratio is 1:1 or more, then clearly the company is
unlikely to have liquidity problems. If the ratio is less than 1:1 we would need to
analyse the structure of current liabilities, to those falling due immediately and those
due at a later date.
In practice, a companys current ratio and acid test should be taken into account with
the companys operating cashflow. A healthy cashflow often compensates for weak
liquidity ratios.
22.3.3 Measuring Efficiency
Measures of activity include:
1. Accounts receivable collection period

2. Accounts payable payment period
3. Inventory turnover period
22.3.3.1 Accounts receivable collection period
This is a measure of managements efficiency and is expressed as:
Receivables x 365 days

Credit Sales
This is an indicator of the effectiveness of the companys credit control systems and
policy. The faster the money is collected, the better for liquidity purposes. Usually,
the longer customers are given to pay their dues, the higher the level of bad debts.
But, on the other hand, if customers are pressured to pay quickly, the company may
find it hard to generate sales.
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22.3.3.2 Accounts payable payment period
The creditor days is a measure of how much credit, on average, is taken from
suppliers. Long payment periods are good for the customer as they increase
liquidity. However, they may damage the relationship with suppliers.
It is expressed as:
Trade Payables x 365 days
Cost of sales
This ratio is an aid to assessing company liquidity, as an increase in creditor days is

often a sign of inadequate working capital control.
22.3.3.3 Inventory turnover period
For how long does a company carry inventory before it is sold? This is expressed
as:
Inventory x 365 days

Cost of sales
The shorter the period the better for liquidity purposes as less cash is tied up in
inventory. The holding period may increase because of: -
1. Build-up of inventory levels as a result of increased capacity following

expansion of non-current assets.
2. Increasing inventory levels in response to increased demand for product.
3. Obsolete inventory not let removed from inventory value
Too little inventory may result in stoppages in production and inability to satisfy
customers demand.
22.3.3.4 Working capital period
The working capital period identifies how long it takes to convert the purchase of
inventories into cash from sales.
Working capital period = working capital x 365 days

cost of sales/operating costs
Working capital = Inventories + receivables - payables
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Lecture Example 3
From lecture example 2,
Calculate and discuss: -
1. Current ratio
2. Quick ratio
3. Inventory turnover period
4. Receivables collection period
5. Payables payment period
22.3.4 Measuring Risk
Measurement of risk considers the financial risk incurred by borrowing.
22.3.4.1 Gearing/leverage
Capital gearing is concerned with the amount of debt in a companys long-term

capital structure. It provides a long-term measure of liquidity. It can be calculated
as:-
Long-Term Debt x 100%

Long-term Debt + Equity
If the firm has excessive debt, then the need to pay interest before dividends will
increase the risks faced by shareholders if profits fall. Remember that interest and
capital repayments are legal obligations and must be met if the company is to avoid
insolvency. The payment of equity dividend is a legal obligation. Despite its risks,
borrowed capital is attractive to companies as lenders accept a lower rate of return
than equity investors due to their secured positions. Also interest payments, unlike
equity dividends, are tax deductible.16
16Ratio Analysis, F2/FMA examining team, April 2015, http://www.accaglobal.com/gb/en/student/exam-

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22.3.4.2 Interest Cover / income gearing
Interest cover is expressed as:
Profit before interest and tax = Number of times

Interest paid
This ratio represents the number of times that interest could be paid out of profit
before interest and tax. The higher the figure, the more likely a company is to be able
to meet is interest payments. If the ratio is more than 4, it is usually considered to be
safe.
Lecture Example 4
From lecture example 2,
Calculate and discuss: -
1. Gearing
2. Interest cover

Discuss and calculate non financial measures
Discuss the importance of non-financial performance measures
Perspectives of the balanced scorecard: -
a. Discuss the advantages and limitations of the balanced scorecard
b. Describe performance indicators for financial success, customer
satisfaction, process efficiency and growth
c. Discuss critical success factors and key performance indicators and
their link to objectives and mission statements
d. Establish critical success factors and key performance indicators in a
specific situation.
Profit based measures have the following problems: -
1. the subjectivity of profit

2. the scope for manipulation of profit
3. the problem of short-termism
On the other hand, non-financial indicators can provide managers with incentives to
improve long-term financial performance. For example, if customer satisfaction is
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low, this could imply that sales demand will fall in the future and this will have a
negative effect on profits.
22.4.1 Balanced Scorecard
In recent years, the trend in performance measurement has been towards a broader
view of performance, covering both financial and non-financial indicators. The most
well-known of these approaches is the balanced scorecard proposed by Kaplan
and Norton.
The balanced scorecard approach emphasises the need to provide management

with a set of information which covers all relevant areas of performance in an
objective and unbiased fashion.
The scorecard contains four key groupings of performance measures. These four
groupings, called perspectives, were considered sufficient to track the key drivers of
both current and future financial performance of the firm. The perspectives focused
on the achievements of the firm in four areas: -
1. The financial perspective concentrates on how the firm appears to its

shareholders and considers what the firms financial objectives are. The
measures used to assess whether these objectives are being achieved
typically include, profit, sales, ROI, cash flow or economic value added (EVA).
2. The customer perspective focuses on the question, what must the firm do to
satisfy its customers so as to achieve its financial objectives?
Outcome measures for the customer perspective generally include measures
of customer satisfaction, market share, customer retention and customer
profitability. These outcome measures can be sub-divided into driver
measures, such as measures relating to lead times, on-time delivery, product
quality and product cost.
3. The internal business perspective considers the question, what must the
firm do well internally in order to support the product/market strategy and to
achieve its financial objectives? Typical outcome measures include those
relating to innovation (product and process) and operations (cycle times,
defect rates).
4. In the learning and growth perspective, the measures focus on the question
what infrastructure must the firm build to create long-term growth and
improvement? In other words, what capabilities must be improved or acquired
to achieve the long-term targets for the customer and internal business
process perspectives? Outcome measures may include metrics on employee
satisfaction, training and retention.
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The balanced scorecard approach to performance measurement offers several
advantages:
1. it measures performance in a variety of ways, rather than relying on one figure

2. managers are unlikely to be able to distort the performance measure - bad
performance is difficult to hide if multiple performance measures are used
3. it takes a long-term perspective of business performance
4. success in the four key areas should lead to the long-term success of the
organisation
5. it is flexible - what is measured can be changed over time to reflect changing
priorities
6. 'what gets measured gets done' - if managers know they are being appraised on
various aspects of performance they will pay attention to these areas, rather than
simply paying 'lip service' to them.
The limitations of the balanced scorecard model are: -
1. it can involve a large number of calculations which may make performance

measurement time-consuming and costly to operate
2. the selection of performance indicators under each of the four perspectives is
subjective
3. this in turn will make comparisons with the performance of other organisations
difficult to achieve satisfactorily
4. it is also very difficult to set standards for each of the key performance
indicators
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22.4.2 Critical Success Factors and Key Performance Indicators
Critical success factors (CSFs) are performance requirements which are

fundamental to an organisation's success (for example innovation in a consumer
electronics company) and can usually be identified from an organisation's mission
statement, objectives and strategy.
Key performance indicators (KPIs) are measurements of achievement of the

chosen critical success factors. Key performance indicators should be:
specific
measurable (i.e. be capable of having a measure placed upon it, for example,
number of customer complaints rather than the 'level of customer satisfaction')
relevant, in that they measure achievement of a critical success factor.
The following table demonstrates critical success factors and key performance
indicators of a college training ACCA students.
Perspective Critical Success Key Performance Indicators

Factor
Financial Shareholder Dividend yield; % increase in share price
success wealth
Cashflow Actual vs Budget
Debtor days
Exam success College pass rate vs national average
Customer Premier college status
satisfaction Tutor grading by students
Flexibility Average number of course variants per subject
(eg full-time, day release, evening)
Process Resource % room occupancy
efficiency utilisation Average class size
Average tutor teaching load (days)
Growth Innovation % of sales from < 1 year old
products Number of online enrolments
Information
technology
The main difficulty with the balanced scorecard approach is setting standards for
each of the KPIs. This can prove difficult where the organisation has no previous
experience of performance measurement. Benchmarking with other organisations is
a possible solution to this problem.
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Lecture Example 5
To which perspective of the balanced scorecard could the measure training day per
employee be most appropriately applied?
A. Customer
B. Internal
C. Growth
D. Financial
Lecture Example 6
Perry plc operates a chain of high class hotels throughout the United Kingdom. The
divisions mission statement is To be the hotel of first choice for business users and
tourists. Although the chain has generally been popular with tourists it is not proving
quite so popular with business users and conference organisers.
Competition in the top segment of the hotel market is fierce, with customers
expecting the highest standards of facilities, service and catering. Over the last two
years the division has invested a large amount of money in modernising its hotels
including the improvement of bedrooms and public rooms, installation of gymnasia
and swimming pools and the information technology features required by business
travellers. A large amount of money has also been spent on staff training to improve
service levels and on a television advertising campaign to promote the improved
hotels to business users.
Head office is concerned that the performance of the hotel chain appears to have
declined over the last few years despite this expenditure.
The following figures are available:
$million
2001 2002 2003
Capital employed 50 70 90
Operating profit 15 16 17
Required: -
Suggest for each of the following headings two critical success factors
suitable for the hotel chain:
(i) financial success;
(ii) customer satisfaction;
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(iii) process efficiency;
(iv) organisational learning and growth.
For each critical success factor suggest one key performance indicator
suitable for the hotel chain.
(CAT Paper T7 June 2004 Qs. 3 amended)

Describe performance measures which would be suitable in contract and
process costing environments
22.5.1 Contract costing
In view of the large scale of many contracting operations, cost control is very
important.
Frequent comparisons of budgeted and actual data are needed to monitor: -

Cost over-runs
Time over-runs
In addition, a note has to be made of:
ratio of cost incurred to value of work certified
amount of remedial work subsequently required
Effectively, the level of profit being earned on the contract can be checked as each
architect or quantity surveyors certificate is received.
In addition, checks should be made on: -

levels of idle time
amounts of wasted material
inventory levels
utilisation of plant
To keep these at an appropriate level, construction companies will use network

analysis to ensure that individual tasks are carried out in a logical order, workers are
sent to contract sites at appropriate times and plant only sent when required.
Accounting standards only allow revenue and contract costs to be recognised when
the outcome of the contract can be predicted with reasonable certainty. This means
that it should be probable that the economic benefit attached to the contract will flow
to the entity.
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If a loss is calculated, then the entire loss should be recognised immediately. If a
profit is estimated, then revenue and costs should be recognised according to the
stage that the project has completed.
There are two ways in which stage of completion can be calculated:-
1. Agreed value of work method (sometimes referred to as the sales basis)
agreed value of work done (work certified)

contract price
2. Cost method
costs incurred to date

total contract costs
Illustration
$
Contract Price 1,000
Estimated total costs 800
Costs to date 600
Agreed value of work done 700
Progress billings invoiced 600
Stage of Completion
Agreed value of work method: 700/1000 x 100 = 70%
Cost method: 600/800 x 100 = 75%
Contract price 1000

Estimated total costs 800
Expected profit 200
Agreed value of work method
Revenue (70% x 1000) 700

Cost of sales () 560
Profit (70% x 200) 140
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Cost method
Revenue (75% x 1000) 750

Cost of sales () 600
Profit (75% x 200) 150
22.5.2 Process costing
As described earlier, process costing is used by is applicable where goods or

services result from a sequence of continuous or repetitive operations or processes.
Several key performance measures are required: -
Levels of abnormal loss

Levels of rejected production
Production time
In addition, inventory levels and cost targets would be monitored as well as any
bottlenecks identified and removed.

Describe measures of performance utilisation in service and manufacturing
environments
Distinguish performance measurement issues in service and manufacturing
industries
Describe performance measures appropriate for service industries
Establish measures of resource utilisation in a specific situation
22.6.1 Service Sector
In recent years, the service sector has grown in importance. Banks, accountancy
and consultancy firms, transport companies have all increased. We shall consider six
main aspects of performance in relation to service organisations: -
1. Financial performance
2. Competitive performance
3. Service quality
4. Flexibility
5. Resource utilization
6. innovation
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1. Financial Performance
Traditional financial analysis distinguishes four types of ratio: profitability, liquidity,

activity and gearing. Analysis of a companys performance using accounting ratios
involves comparisons with past trends and/or competitors ratios.
Typical ratios which can be used by a service organisation include: -

Turnover per product group
Turnover per principal or partner
Staff costs as a % of turnover
Space costs as a % of turnover
Training costs as a % of turnover
Net profit %
Current ratio
Quick asset ratio
Market share
Market share increase
Because it is difficult to trace many common costs to different units of output and
because of the high level of stepped fixed costs, detailed financial ratio analysis is of
limited use.
2. Competitive Performance
Competitive performance focuses on factors such as sales growth, market share,

customer retention and ability to obtain new business.
3. Service Quality
Quality is an important non-financial performance indicator in the service sector.

Inspection and monitoring of the inputs to the service process is very important; e.g.
the quality of solicitors in a practice or the level of staff available in a consultancy
organisation.
For example, in the airline industry, service quality could be measured as follows: -
Quality Measures Mechanics
Competence and courtesy Staff courtesy and attitude Feedback forms/

inspections
Cleanliness Facilities and equipment Feedback forms/
inspections
Availability Equipment availability Internal fault monitors
Communication Information clarity Surveys/ inspections
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4. Flexibility
Three important aspects are: -
Area Measures Mechanics
Speed of delivery Waiting time in queues Inspection

Ability to respond to Diversity of skills Amount of time spent on
customers specifications possessed training
Coping with demand Overcrowding; customer Inspection
queuing time
5. Resource Utilization
Resource utilization is usually measured in terms of productivity. For e.g. in an audit

firm, the main input is the time of staff. The output is the chargeable hours to client.
Productivity can be measured by dividing the chargeable hours with the total
available hours.
6. Innovation
Innovation can be measured in terms of how much it costs to develop a new service,
how effective the process is and how quickly it can develop new services. Hence, we
can calculate the proportion of new services to the total services provided or the time
between identification of a new service and making it available.
22.6.2 Manufacturing Sector
In manufacturing environments, there are four performance measures: -
a) Cost
Raw material inputs Actual vs. target Calculation of quantity and

cost
Overtime costs Overtime hours/total hours Job sheets / payroll
Customer focus % service calls; % claims Service and claim forms
Output Actual vs. target output Inspection
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b) Quality
Quality of material % of defected material Inspection

Maintenance Breakdown maintenance Maintenance records
total maintenance
Product reliability % claims Claim records
Customer satisfaction No of complaints / repeat Feedback forms
orders
c) Time
Here, the focus is on throughput, bottlenecks, customer impact and availability.
Throughput Processing time Production records

Total time
Availability % stock outs Stock records
Customer impact Average delivery time Delivery records
Equipment failure Time between failures Maintenance records
d) Innovation
The ability to introduce new Number of new products Production records

products launched
Ability to accommodate Number of new processes Records of process time
change implemented and time taken
taken to implement
Reputation for innovation Demonstrate competitive Surveys / feedback forms
advantage
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Discuss the meaning of each of the efficiency, capacity and activity ratios
Calculate the efficiency, capacity and activity ratios in a specific situation
As mentioned in Section 8.6, the following are the three main control ratios for
measuring performance in manufacturing businesses: -
22.7.1 Efficiency Ratio
The efficiency ratio measures the performance of the workforce by comparing the
actual time taken to do a job with the expected time.
Efficiency Ratio =
22.7.2 Capacity Ratio
The capacity ratio measures the number of hours spent actively working as a
percentage of the total hours available for work.
Capacity Ratio =
22.7.3 Production Volume or Activity Ratio
The activity ratio compares the number of hours expected to be worked to produce
actual output with the total hours available for work.
Production Volume/Activity Ratio =

Production volume/activity
Efficiency ratio x Capacity ratio = ratio

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Lecture Example 7
A company records the following information concerning a product:

Standard time allowed per unit 16 minutes
Actual output in period 720 units
Actual hours worked 180
Budgeted hours 185
1. What is the efficiency ratio?

A. 93.75%
B. 97.3%
C. 102.5%
D. 106.7%
2. What is the capacity ratio?

A. 102.8%
B. 99.4%
C. 98.6%
D. 97.3%
3. What is the activity ratio?

A. 97.3%
B. 102.5%
C. 103.8%
D. 106.7%

Discuss measures that may be used to assess managerial performance and
the practical problems involved
The personal performance of the manager is not the same as the overall
performance of the responsibility centre he/she manages due to external factors
which are outside of the control of the organization. Hence measures which reflect
the performance of the unit as a whole may not reflect the performance of the
manager.
There are two main ways of measuring managerial performance: -
1. use measures based on controllable costs and revenue e.g. variance analysis in
cost and revenue centres
2. set specific managerial objectives against which performance can be measured
at regular intervals
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In investment centres, divisional performance is measured using: -
a) return on investment (ROI)

b) residual income (RI)
We will be discussing these two measures later on in the notes.

Discuss the role of benchmarking in performance measurement
Benchmarking is the management process which involves comparison of

competences with best practice including comparison beyond the organisations own
industry
Exploring Corporate Strategy by Johnson and Scholes
Benchmarking requires organisations to: -
1. identify what they do and why they do it

2. have knowledge of what the industry does and in particular what competitors do
3. be fully committed to achieving best practice
22.9.1 Types and Levels of Benchmarking
1. Internal benchmarks
Comparisons between different departments or functions within an organization
2. Competitive benchmarks
Comparisons with competitors in the business sector through techniques e.g.
reverse engineering (buying a competitors product and dismantling it to
understand its content and configuration)
3. Functional (operational/generic) benchmarks

Internal functions are compared with those of the best external practitioners of
those functions, regardless of the industry they are in
4. Strategic benchmarks
A type of competitive benchmarking aimed at strategic action and organizational
change
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22.9.2 The Benchmarking Process
Eight steps are typically employed in the benchmarking process.

1. Identify processes, activities, or factors to benchmark and their primary
characteristics.
2. Determine what form is to be used: strategic, functional, competitive, or
internal.
3. Determine who or what the benchmark target is: company, organization,
industry, or process.
4. Determine specific benchmark values by collecting and analyzing information
from surveys, interviews, industry information, direct contacts, business or
trade publications, technical journals, and other sources of information.
5. Determine the best practice for each benchmarked item.
6. Evaluate the process to which benchmarks apply and establish objectives and
improvement goals.
7. Implement plans and monitor results.
8. Recalibrate internal base benchmarks.
22.9.3 Advantages of Benchmarking
1. Benchmarking sets the foundation of performance improvement by showing

how to improve continuously
2. It helps with cost reduction
3. It improves the quality of operations
4. It can be used both in the public and private sector
5. It is an effective method of implementing change
22.9.4 Disadvantages of Benchmarking
1. Benchmarking reveals the standards attained by competitors but does not

consider the circumstances under which the competitors attained such
standards
2. A bigger disadvantage of benchmarking is the danger of complacency and

arrogance. Many organizations tend to relax after excelling beyond
competitors' standards, allowing complacency to develop. The realization of
having become the industry leader soon leads to arrogance, when
considerable scope for further improvements remains
3. Many organizations make the mistake of undertaking benchmarking as a

stand-alone activity. Benchmarking is only a means to an end, and it is
worthless if not accompanied by a plan to change
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Lecture Example 8
A manufacturing company benchmarks the performance of its accounts receivable

department with that of a leading credit card company.What type of benchmarking is
the company using?
A. Internal benchmarking
B. Competitive benchmarking
C. Functional benchmarking
D. Strategic benchmarking

Produce reports highlighting key areas for management attention and
recommendations for improvement
When producing reports on this area, it is important to: -

1. use an acceptable report format
2. present calculations of performance measurement in an appendix
at the end of the report
3. offer recommendations and conclusions as to how performance
may be improved.
451
KEY NOTES
452
1. Mission Statement
A mission statement contains the overall goals and objectives of the

organisation which are not time specific and not quantified.
2. Objectives
Strategic objectives are often the responsibility of the senior management and
will be measured by indicators that reflect the performance of the whole
organisation
Tactical objectives are often the responsibility of middle management and
measures may be used that summarise the performance of a department or
division
Operational objectives are often concerned with the day-to-day running of the
organisation and are often physical measures
Mission Statement
Strategic Objectives
Critical Success Factors
Key Performance Indicators
3. Measuring Profitability
ROCE = Net Profit before interest and tax x 100

Capital Employed
Asset Turnover = Turnover

Capital Employed
Net Profit Margin = Net Profit x 100

Turnover
453
Gross Profit Margin = Gross Profit x 100
Turnover
4. Measuring Liquidity
Current Ratio = Current assets : Current Liabilities
Quick Ratio = Current assets Stocks: Current Liabilities
5. Measuring Efficiency
Accounts Receivable Collection Period = Receivables x 365 days

Sales
Accounts Payable Payment Period days = Trade Payables x 365 days

Purchases
Inventory Turnover Period = Inventory x 365 days

Cost of sales
Working Capital Period = working capital x 365 days

cost of sales/operating costs
6. Measuring Risk
Gearing = Long-Term Debt x 100%

Long-term Debt + Equity
Interest Cover = Profit before interest and tax = Number of times

Interest paid
7. Balanced Scorecard
The balanced scorecard contains four key groupings (perspectives)
454
The financial perspective concentrates on how the firm appears to its
shareholders and considers what the firms financial objectives are.
The customer perspective focuses on the question, what must the
firm do to satisfy its customers so as to achieve its financial objectives?
The internal business perspective considers the question, what must
the firm do well internally in order to support the product/market
strategy and to achieve its financial objectives?
In the learning and growth perspective, the measures focus on the
question what infrastructure must the firm build to create long-term
growth and improvement?
8. Critical Success Factors and Key Performance Indicators
Critical success factors (CSFs) are performance requirements which are

fundamental to an organisation's success
Key performance indicators (KPIs) are measurements of achievement of the

chosen critical success factors.
9. Contract Costing
Cost control is very important. Frequent comparisons of budgeted and actual

data are needed to monitor: -
Cost over-runs
Time over-runs
10. Process Costing
Several key performance measures are required: -

o Levels of abnormal loss
o Levels of rejected production
o Production time
11. Service Sector
Six dimensions: -
Financial performance
Competitive performance
Service quality
Flexibility
Resource utilization
Innovation
455
12. Manufacturing Sector
Cost
Quality
Time
Innovation
13. 3 Control Ratios
Production volume/activity
Efficiency ratio x Capacity ratio = ratio

14. Benchmarking
Benchmarking is the management process which involves comparison of

competences with best practice including comparison beyond the
organisations own industry
15. Types and Levels of Benchmarking
1. Internal benchmarks
Comparisons between different departments or functions within an
organization
2. Competitive benchmarks
Comparisons with competitors in the business sector
3. Functional benchmarks
Comparisons with organisations with similar core activities and practices
4. Strategic benchmarks
A type of competitive benchmarking aimed at strategic action and
organizational change
456
QUESTIONS
457
1. Which of the following is the best definition of return on capital employed?
A. Profit before interest and tax Ordinary shareholders funds x 100
B. Profit before interest and tax (Ordinary shareholders funds + Non-
current liabilities) x 100
C. Profit after interest and tax Ordinary shareholders funds x 100
D. Profit after interest and tax (Ordinary shareholders funds + Non-
current liabilities) x 100
2. A firm with current assets of $40 million and current liabilities of $20 million buys
$5 million of inventory on credit which increases its inventory level to $10 million.
What will the effect be on its current ratio and quick (acid test) ratio?
Current Ratio Liquidity Ratio

A.Increase by 25% Unchanged
B.Reduce by 10% Unchanged
C. Increase by 25% Reduce by 20%
D. Reduce by 10% Reduce by 20%
3. A chain of supermarkets compares the performance of its fleet of delivery lorries

with that of a successful company that delivers goods by road.
Which type of benchmarking is it using?
A. Internal
B. Competitive
C. Functional
D. Strategic
4. Pad Limited has the following results:
Sales $100,000
Cost of sales ($20,000)
Gross profit $80,000
Expenses ($30,000)
Net profit $50,000
What is the net profit margin (profit to sales ratio)?
A. 50%
B. 80%
C. 62.5%
D. 200%
458
5. Which one of the following is not a perspective of the balanced scorecard?
A. Internal business processes

B. Mission and strategy
C. Learning and growth
D. Customer
6. An extract from a companys trial balance at the end of its financial year is given
below:
$000
Sales revenue (85% on
credit) 2,600
Cost of sales 1,800
Purchases (90% on credit) 1,650
Inventory of finished goods 220
Trade receivables 350
Trade payables 260
Required:
Calculate the following working capital ratios:

(i) Inventory days
(ii) Trade receivables days
(iii) Trade payables days
7. The use of the balanced scorecard rather than a profit-based measure is likely to
help solve the following problems:
(1) Subjectivity
(2) Short-termism
Which is/are true?

A. 1 only
B. 2 only
C. Both1 and 2
D. Neither 1 nor 2
459
8. The Eastland Postal Service is government owned. The government requires it to
provide a parcel delivery service to every home and business in Eastland at a low
price which is set by the government. Express Couriers Co is a privately owned
parcel delivery company that also operates in Eastland. It is not subject to
government regulation and most of its deliveries are to large businesses located
in Eastlands capital city. You have been asked to assess the relative efficiency of
the management of the two organisations.
Which of the following factors should NOT be allowed for when comparing the
ROCE if the two organizations to assess the efficiency of their management?
A. Differences in prices charged

B. Differences in objectives pursued
C. Differences in workforce motivation
D. Differences in geographic areas served
460
ANSWERS
461
1. B
2. D
Old current ratio = 40:20 = 2:1
New current ratio = 45:25 = 1.8:1
Therefore a reduction of 10%
Old liquidity ratio = 35:20 = 1.75:1

New liquidity ratio = 35:25 = 1.4:1
Therefore a reduction of 20%
3. C
4. A (50/100)
5. B
6.
Working capital ratio Calculation Days
Inventory days 220/1800 x 365 44.6

Receivables days 350/(0.85 x 2,600) x 365 57.8
Payables days 260/(0.90 x 1,650) x 365 63.9
7. B
8. C
462
Chapter 23
ECONOMY, EFFICIENCY AND
EFFECTIVENESS
A not-for-profit organisation is an organisation whose attainment of its prime goal
is not assessed by economic measures. However, in pursuit of that goal it may
undertake profit-making activities. (Bois); for example charities, statutory bodies
offering public transport or the provision of services such as leisure, health or public
utilities such as water or road maintenance.
Not-for-profit organisations have multiple stakeholders. This gives rise to multiple

objectives. Organisations will need to prioritise/compromise as, very often, it is
impossible to say which is the overriding objective.
In not-for-profit organisations, performance measures are difficult to define. Their

success cannot be judged against competition nor by profitability. Hence, other
methods of performance have to be used.

Discuss the measurement of performance in non-profit seeking and public
sector organizations
Explain the concepts of economy, efficiency and effectiveness
Describe performance indicators for economy, efficiency and effectiveness
Establish performance indicators for economy, efficiency and effectiveness in
a specific situation
23.1.1 Value for Money
In not for profit organisations, performance is judged in terms of inputs and outputs
and hence the value for money criteria of economy, efficiency and
effectiveness.
Effectiveness is the relationship between an organisations outputs and its

objectives. It ensures that the outputs of a service or programme succeed in
achieving objectives.
Efficiency is the relationship between inputs and outputs. It is concerned with
maximizing output for a given input.
Economy is attaining the appropriate quantity and quality of inputs at lowest
cost. Therefore, economy is concerned with the cost of inputs.
463
23.1.2 Indicators to assess overall performance
1. Effectiveness
Financial indicators
a. Quality of service/output measures; e.g. exam results; pupil/teacher ratio

b. Utilisation of resources; e.g. hospital bed occupancy; are trained teacher fully
used to teach the subjects they have been trained for?
c. Flexibility; e.g. average waiting time
Non-financial indicators
a. Workplace morale
b. Staff attitude to dealing with the public
c. Client satisfaction in the service being provided
2. Efficiency
Financial indicators to measure efficiency
a. Cost per unit of activity (eg cost per student)

b. Variance analysis
c. Comparisons with benchmark information
d. Cost component as a proportion of total costs
e. Costs recovered as a proportion of costs incurred (eg payment received from
householders requesting collection of bulky/unusual items of refuse)
3. Economy
A-value-for-money (VFM) audit will look also at the economy of the use of resources,
for e.g. in the case of state education, it will look into the cost wages of school
teachers, the cost of books, equipment.
Lecture Example 1
A government body uses measures based upon the three Es to the measure for
money generated by a publicity funded hospital. It considers the most important
performance measure to be cost per successfully treated patient.
464
Which of the three Es best describes the above measure?
A. Economy (A measure of cost related to input)
B. Effectiveness (A measure of output related to objectives)
C. Efficiency (A measure of output related to input)
D. Externality (Not one of the three Es)
Lecture Example 2
Lewisville is a town with a population of 100,000 people. The town council of

Lewisville operates a bus service which links all parts of the town with the town
centre. The service is non-profit seeking and its mission statement is to provide
efficient, reliable and affordable public transport to all the citizens of Lewisville.
Explain the meaning of the following terms in the context of performance

measurement and suggest a measure of each one appropriate to a bus
service.
(i) Economy;
(ii) Effectiveness;
(iii) Efficiency
(CAT June 2006 Qs 3 amended)
465
KEY NOTES
466
1. Not-For-Profit Organisation
A not-for-profit organisation is an organisation whose attainment of its prime

goal is not assessed by economic measures Not-for-profit organisations have
multiple stakeholders. This gives rise to multiple objectives. Organisations will
need to prioritise.
2. The Three Es
Effectiveness is the relationship between an organisations outputs and its

objectives.
Efficiency is the relationship between inputs and outputs. It is concerned
with maximizing output for a given input.
Economy is attaining the appropriate quantity and quality of inputs at lowest
cost.
467
QUESTIONS
468
1. The performance of a publicly funded hospital is monitored using measures
based upon the three Es. The most important performance measure is
considered to be the achievement of hospital targets for the successful
treatment of patients.
Which of the three Es best describes this above measure?

A. Economy
B. Effectiveness
C. Efficiency
D. Externality
2. How is the efficiency ratio calculated?
3. What does economy mean in terms of measuring the performance of an Not-

for-Profit Organisation?
469
ANSWERS
470
1. B
2. (Standard hours produced actual hours worked) x 100%
3. Spending money carefully
471
Chapter 24
RETURN ON INVESTMENT AND
RESIDUAL INCOME
Decentralisation is the delegation of decision-making responsibility. Decentralisation
is a necessary response to the increasing complexity of the environment that
organisations face and the increasing size of most organisations.
One danger of decentralisation is that managers may use their decision-making

freedom to make decisions that are not in the best interests of the overall company
(so called dysfunctional decisions). To redress this problem, senior managers
generally introduce systems of performance measurement to ensure that decisions
made by junior managers are in the best interests of the company as a whole.

Calculate return on investment and residual income
In an investment centre, managers have the responsibilities of a profit centre plus

responsibility for capital investment. Two measures of divisional performance are
commonly used:
1. Return on investment (ROI) =

controllable (traceable) profit %
controllable (traceable) investment
2. Residual income = controllable (traceable) profit - an imputed interest

charge on controllable (traceable) investment.
Illustration 1
In 2011 a divisions controllable return on investment was 25% and its controllable
profit was $80,000. The cost of capital was 18% per annum.
What was the divisions controllable residual income in the last year?
$80,000____ = 25%
Capital Employed
472
Capital Employed = 80,000 = $320,000
25%
Profit 80,000
Imputed Interest (320 x 18%) 57,600
Residual Income 22,400
Lecture Example 1
Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a
profit of $2.2m per annum. Division X's cost of capital is 10% per annum. The
division is considering two proposals.
Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of
$0.15m.
Proposal 2 involves the disposal of assets at their net book value of $2.3m. This
would lead to a reduction in profits of $0.3m.
Proceeds from the disposal of assets would be credited to head office not Division X.
Required:
Calculate the current ROI and residual income for Division X and show how
they would change under each of the two proposals.

Explain the advantages and limitations of return on investment and residual
income
24.2.1 Advantages of ROI
1. a simple and low cost calculation it uses readily available information

2. a widely used measure, so comparisons with other organizations should be
readily available
3. as ROI gives a result in percentage terms, it can be used to compare units which
differ in size
24.2.2 Disadvantages of ROI
1. the measure is based on accounting information (profit figures and asset

figures). Different accounting policies, such as depreciation, may impact the
figure calculated
2. it may be open to manipulation by managers, especially if bonuses are at stake
473
3. the measure may be distorted by inflation as historical cost accounts do not
reflect the current value of the assets
4. ROI may discourage investment and re-equipment in more technologically up to
date assets. Old assets, almost fully depreciated, will give a low asset base in
the ROI calculation, which will result in an increased figure for ROI and give the
impression of an improved level of performance
5. ROI may lead managers to take decisions which are to their advantage but
which do not benefit the organization as a whole - it leads to dysfunctional
behaviour
24.2.3 Advantages of RI
1. investment centre managers see the imputed interest charge this makes them
aware of the financial implications of their investment decisions
2. RI should avoid dysfunctional decision making it ensures decisions are taken
which benefit both the investment centre and the company or group as whole
goal congruency
24.2.4 Disadvantages of RI
1. RI is still an accounting-based measure

2. RI gives an absolute measure very difficult to compare the performance of
investment centres of different sizes the bigger investment centre will tend to
produce the bigger figure for RI
3. An appropriate target, which is seen to be fair to all divisions, may be difficult to
determine
4. A major problem inherent in the RI calculation is the determination of an
appropriate imputed interest rate
Lecture Example 2
A company has a capital employed of $200,000. It has a cost of capital of 12% per
year. Its residual income is $36,000.
What is the companys return on investment?

A. 30%
B. 12%
C. 18%
D. 22%
474
Lecture Example 3
A company wishes to evaluate a division which has the following extracts from
income statement and statement of financial position.
Income statement:
$000
Sales 500
Gross profit 200
Net profit 120
Statement of financial position:
$000
Non-current assets 750
Current assets 350
Current liabilities (450)
Net assets 650
a. What is the return on investment for the division?

b. What is the residual income for the division if the company has a cost of
capital of 18% ?
Lecture Example 4
The following statements relate to performance evaluation methods:
(1) Residual income is not a relative measure

(2) The return on investment figure is a relative measure
(3) Residual income cannot be calculated for an individual project
Which of the above are correct?

A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3
475
KEY NOTES
476
1. Decentralisation
Decentralisation is the delegation of decision-making responsibility.
2. Return on investment (ROI)
= controllable (traceable) profit %

controllable (traceable) investment
3. Residual income
= controllable (traceable) profit - an imputed interest charge on

controllable (traceable) investment.
477
QUESTIONS
478
1. In the last year a divisions controllable return on investment was 25% and its
controllable profit was $80,000. The cost of finance appropriate to the division
was 18% per annum.
What was the divisions controllable residual income in the last year?
A. $5,600 $80,000 (0.25 0.18)

B. $22,400 $80,000 ($80,000 0.25 0.18)
C. $74,400 $80,000 ($80,000 (0.25 0.18)
D. $76,400 $80,000 ($80,000 0.25 0.18)
2. A division earns a residual income of $200,000. The imputed interest charge

is $150,000 and its cost of capital is 20% per annum. What is the divisions
return on capital employed?
A. 5.3%
B. 6.7%
C. 26.7%
D. 46.7%
3. A division has a capital employed of $2,000,000 and earns an operating profit

of $600,000. It is considering a project that will increase operating profit by
$20,000 but would increase its capital employed by $80,000. A rate of 15% is
used to compute interest on capital employed.
What will be the effect on residual income and return on capital employed if
the division accepts the project?
Residual income Return on investment

A. Increase Increase
B. Increase Decrease
C. Decrease Increase
D. Decrease Decrease
4. The Northern Division of Gemas Co. currently earns a return on investment of

15.5% based on capital employed of $2,680,000. The divisional management
team have decided to implement a project which will require an investment of
$320,000. The project is expected to generate a profit of $53,000 per annum.
The divisional cost of capital is 13%.
What will be the residual income of the division after the project is
implemented? _____________
479
5. Which of the following are suitable measures of performance at the strategic
level?
(1) Return on investment

(2) Market share
(3) Number of customer complaints
A. 1 and 2
B. 2 only
C. 2 and 3
D. 1 and 3
6. The manager of a division is considering a new project. The project is

expected to increase the divisions annual net profit by $153,900, but it will
cause net current assets to rise by $810,000.
The managers performance is evaluated against a target Return on

Investment. The target is 18%. However the use of Residual Income is being
considered.
The cost of capital for the division is 16%.
Would the manager adopt the project if the performance measure was either
(i) Return on Investment (ROI) or (ii) Residual Income (RI)?
(i) ROI (ii) RI

A. Yes Yes
B. Yes No
C. No Yes
D. No No
480
ANSWERS
481
1. B
25% = 80,000
investment
investment
25%
= $320,000
RI = Controllable profit 80,000

imputed interest 57,600 (18% x 320000)
22,400
2. D

imputed interest 150,000 (20% x 75000000)
200,000
ROI = 350000 X 100

750000
= 46.70%
3. B
Current

imputed interest 300,000 (15% x 2,000,000)
300,000
ROI = 600,000 X 100

2,000,000
= 30%
482
After project is accepted

imputed interest 312,000 (15% x 2,080,000)
308,000
ROI = 620,000 X 100

2,080,000
= 29.8%
4. B
15.5% = Profit X 100

2,680,000
profit = $2,680,000 x 15.5%

= $415,400
RI = Controllable profit 468,400 (415,400 + 53,000)

imputed interest 390,000 (2,680,000 + 320,000) x 13%
78,400
5. A
6. A
ROI = 153,900 X 100

810,000
= 19% higher than target of 18% take project

(810,000 x
imputed interest 129,600 16%)
24,300 positive take project
483
Chapter 25
COST REDUCTIONS AND
VALUE ENHANCEMENT
Compare cost control and cost reduction
Cost control essentially involves the setting of targets for cost centre managers and
then monitoring performance against those targets.
A cost control systems entails six requirements: -
1. effective delegation of authority and assignment of responsibility for costs

2. an agreed plan that sets up clearly defined and agreed goals
3. motivation to encourage individuals to reach the goals established and agreed
4. timely reporting with alternative suggestions how to reduce costs
5. recommendations and action which must be followed
6. effective follow-up system to ensure that corrective measures are being
effectively implemented
Examples of cost control techniques: - budgetary control, standard costing and

control of capital expenditure.
Cost reduction is the reduction in unit cost of goods or services without impairing
suitability for the use intended, i.e. without reducing value to the customer. Hence, it
looks at methods of improving profitability by reducing costs without necessarily
increasing prices.

Describe and evaluate cost reduction methods
A number of techniques are widely used as a means of attempting to achieve cost

reduction, particularly in manufacturing companies.
1. Standardisation of materials and components
This relates to a policy of reducing the variety ad range of materials and components
purchased by the manufacturer and of components produced.
Its advantages are: -
484
i. The manufacturer can buy or make large quantities, hence gaining the benefit
of reduced unit cost
ii. Having proved the efficiency of a material or component, the manufacturer
knows that the quality and content will not change
iii. Inventory control will be easier as there is a reduction in variety
iv. Better service can be provided to customers in the provision of spare parts
v. Less time will be needed to train operatives who handle the component
Its disadvantages are: -
i. If there is only one supplier of the material or component, the manufacturer will
be at risk if supplies are interrupted
ii. There may be restriction on the design of a new model if the manufacturer
wishes to continue the policy for economic reasons
iii. For the same reason, a standard component may be used in one model when
it would be better technically if a special component was used.
2. Standardisation of product
This refers to the production of articles to the same standard, or a range of products
each of which is standardised, e.g. a particular model of a car may be available in
different colours but apart from this, the cars are identical.
The advantages are: -
i. The manufacturer derives the benefit of long runs of production with reduced
unit cost
ii. Tooling is simpler because it is geared to one method of production
iii. Mechanization can be extensive because of the uniformity of the production
method
iv. The consequent buying of large amounts of the same materials and parts
results in a reduction of unit cost
v. Production management is simpler, being confined to standard processes
vi. Less training of operatives is required because the processes do not change
vii. There are fewer demands on the design staff
viii. Inspection costs are low
ix. Customers know they are buying a proven product and that the quality will not
change
Its disadvantages are: -
i. the manufacturer may feel safe in doing what he knows best and may become
complacent about the success of the product, so that when the product faces
new competition or the public becomes disloyal, he is too slow to recognise it
485
ii. if the product has to be altered, then equipment, technical knowledge and
managerial experience may be too fixed to adapt successfully
3. Reducing Labour Costs: Work Study
Work study is a means of raising the productivity/efficiency of an operating unit by

the reorganization of work. There are two main parts to work study: method study
and work measurement.
Method study is the systematic recording and critical examination of existing and
proposed ways of doing work in order to develop and apply easier and more
effective methods, and reduce costs.
Work measurement involves establishing the time for a qualified worker to carry out
a specified job at a specified level of performance.
4. Other Techniques would include: -
i. value analysis and value engineering 17

ii. investment appraisal techniques applied to re-equipping the factory
iii. zero-based budgeting
A cost reduction team can be used to identify scope for achieving cost reductions but
it is important that costs saved do not outweigh the costs of the team itself.
A cost reduction scheme will also bring about changes. These changes may harm
morale and upset the proper working of departments. Hence, a cost reduction
scheme should have a definite start and finish and should incorporate well-defined
targets.
Lecture Example 1
Which of the following is not an example of cost reduction techniques: -
A. budgetary control
B. value analysis
C. redesigning and simplifying a product
D. using standardised components
17Value engineering design the best possible value at the lowest possible cost: focus is on the
design stage
486
Describe and evaluate value analysis
Value analysis is a form of cost reduction. Hence, it examines the factors affecting
the cost of a product or service, in order to devise means of achieving the specified
purpose most economically at the required standard of quality and reliability. Are
customers willing to pay for upholstery which is relatively expensive for the
manufacturer to buy? If customers would pay the same price for a car produced with
cheaper upholstery, the company will modify the specification.
It is important to distinguish between four types of value: -
Cost value - the cost of producing and selling an item.

Exchange value the market value of the product or service.
Use value the value an item has because of the uses to which it can be put,
e.g. using a car to go from A to B.
Esteem value - the value put on an item because of its beauty, craftsmanship
etc, e.g. the colour, image or top speed of a car.
25.3.1 The Value Analysis Method
Value analysis can be carried out in 5 key steps: -
Step 1: establish the precise requirements of the customer for a particular product or
service. Hence the manufacturer can establish whether each function incorporated
into the product contributes some value to it.
Step 2: Establish and evaluate alternative ways of achieving the requirements of the
customers. The least cost alternative should be selected.
Step 3: Authorise any proposals put forward as a result of step 2.
Step 4: Implementation of proposals and follow-up.
Step 5: Evaluate feedback from new proposals to establish the benefits from the
change.
25.3.2 Value Analysis Its Benefits
1. Increased sales as customers will be impressed by the interest shown in their

requirements.
2. Higher morale amongst staff resulting from the team approach.
487
3. Economic and financial benefits arise from the elimination of unnecessary
complexity and the better use of resources.
Lecture Example 2
The following statements have been made about value analysis.
1. it seeks the lowest cost method of achieving a desired function

2. it always results in inferior products
3. it ignores esteem value
4. it is applicable to both physical products and services
Which TWO of the above statements are true?

A. 1 and 4
B. 1 and 2
C. 3 and 4
D. 2 and 3
488
KEY NOTES
489
1. Cost Control
Cost control involves the setting of targets for cost centre managers and then
monitoring performance against those targets.
2. Cost Reduction
Cost reduction is the reduction in unit cost of goods or services without
impairing suitability for the use intended, i.e. without reducing value to the
customer.
3. Cost Reduction Methods

Standardisation of materials and components
Standardisation of product
Reduction of labour costs through work study method study and work
measurement
Other techniques would include: -
value analysis and value engineering
investment appraisal techniques applied to re-equipping the factory
zero-based budgeting
4. Value Analysis
Value analysis is a form of cost reduction. Hence, it examines the factors
affecting the cost of a product or service, in order to devise means of
achieving the specified purpose most economically at the required standard of
quality and reliability.
Cost value - the cost of producing and selling an item.

Exchange value the market value of the product or service.
Use value the value an item has because of the uses to which it can be
put.
Esteem value - the value put on an item because of its beauty,
craftsmanship etc
490
QUESTIONS
491
1. Cost control is concerned with the monitoring of actual costs against planned
or budgeted costs with the aim of identifying variances and taking corrective
action where possible.
A. True
B. False
2. The term used for different methods which try to reduce unit costs without
impairing suitability for the use intended is known as _______
____________.
3. a. Work study is the systematic recording and critical examination of existing

and proposed ways of doing work in order to develop and apply easier and
more effective methods, and reduce costs.
b. Work measurement involves establishing the time for a qualified worker to

carry out a specified job at a specified level of performance.
Which statement/s is/are true?
A. Both are true

B. Both are false
C. (a) is true
D. (b) is true
492
ANSWERS
493
1. True
2. Cost reduction
3. D
494

ACCA F2 Course Notes

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ACCA F2 Course Notes

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F2 Course notes

The purpose of cost and management accounting is to provide financial information

Management information is generally supplied in the form of reports. Reports may be

Cost accounting is part of management accounting. Cost accounting is mainly

Preparing statements (e.g. budgets, costing)

Therefore, management accounting goes beyond cost accounting. In general, cost

Management Financial Accounting

The following assertions relate to financial accounting and to cost accounting:

(i) The main users of financial accounting information are external to an

Which of the following statements are true?

A. Assertions (i) and (ii) are both correct.

The main functions of management are: -

Planning involves establishing objectives and selecting appropriate strategies to

Planning can be either short-term (tactical and operational planning) or long-term

1.3.2 Decision Making

A management control system measures and corrects the performance of activities

1.4.2 Tactical Planning

1.4.3 Operational Planning

All managers are involved in making day-to-day decisions. 'Front-line' managers

Operational information is derived almost entirely from internal sources. It is

Which of the following statements are correct?

(i) Strategic information is mainly used by senior management in an

A. (i) and (ii) only

1.5 ACCA SYLLABUS GUIDE OUTCOME 5:

A cost centre is a production or service location, function, activity or item of

1.5.2 Revenue centre

A revenue centre is accountable for revenues only. Revenue centre managers

1.5.3 Profit centre

1.5.4 Investment centre

An investment centre is a profit centre with additional responsibilities for capital

1.6 ACCA SYLLABUS GUIDE OUTCOME 6:

1.6.1 Cost centres

1.6.2 Revenue centres

1.6.4 Investment centres

For which of the following is a profit centre manager responsible?

1.7 ACCA SYLLABUS GUIDE OUTCOME 7:

DATA PROCESS INFORMATION

It is the management accountant who is expected to provide the information to

Most organizations require the following types of information:-

Is this statement true or false?

1.8 ACCA SYLLABUS GUIDE OUTCOME 8:

Good information should be ACCURATE.

Accurate - Information should be accurate because using incorrect information could

Accessible Information should be accessible via the appropriate channels of

The following statement refers to a quality of good information:

Is this statement true or false?

1.9 ACCA SYLLABUS GUIDE OUTCOME 9:

Management accounting information may fail to meet its objective of assisting

1. Failure to meet the requirements of good information listed above

2. The problem of relevant costs and revenues

The figures presented to assist in management decision-making are those

Future ignoring costs (and revenues) that have already been

Incremental ignoring items such as the reapportionment of existing,

Cash flows ignoring book values, historical costs, depreciation

Should we focus only on information derived internally? No, we should

2. Cost accounting is mainly concerned with establishing inventory valuation,

4. The main functions of management are: -

8. A management control system is a system which measures and corrects the

Responsibility Centre Authority Level

DATA PROCESS INFORMATION

11. Good information should be ACCURATE.

12. Limitations of Management Accounting Information

a. Failure to meet the requirements of good information listed above

2. Higher level management take: -