MANAGEMENT ACCOUNTING

PART 1

CPA SECTION 2

STUDY TEXT
PAPER NO. 5 MANAGEMENT ACCOUNTING

GENERAL OBJECTIVE

This paper is intended to equip the candidate with knowledge, skills and attitudes that will

enable him/her to apply management accounting principles and concepts in business

5.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:

• Estimate the cost of goods and services

• Analyse product costs for manufacturing and non-manufacturing activities

• Prepare marginal and absorption cost statements

• Analyse an organisation's activities through budgetary control process

• Analyse variances for decision making

• Use computers in cost management.

CONTENT

5.1 Nature and purpose of cost and management accounting

- The nature of cost accounting and costing terms

- The role of cost accounting in management
- The purposes of cost accounting information
- Scope of cost accounting
- Meaning of management accounting, scope, limitations, applications
- Relationship between cost, financial and management accounting
- Selection of an ideal cost accounting system
5.2 Cost classification

- Definition and purpose of cost classification

- Methods of cost classification: By nature/elements of manufacturing costs;
Functional classification; Behavioral classification; Controllability; Time;

Financial accounting; Identification with inventory; For decision making

5.3 Cost estimation

- Meaning of cost estimation

- Methods of estimating cost; non-mathematical methods like engineering
method. accounts analysis method and high-low method; mathematical

methods like scatter graph method, OLS regression method (simple linear

regression only)

5.4 Cost accumulation

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 - Accounting for materials and inventory; material cost records, purchasing
procedures, receipt and issues of material, methods of valuing material

issues, inventory control procedures; economic order quantity (EOQ) and

economic batch quantity(EBQ) models and back flush

- Accounting for labour: Methods of labour remuneration, labour control

procedures, maintenance of labour records

- Accounting for overheads: Types of overheads, manufacturing, distribution

and administration, service departmental cost allocation and apportionment,

overheads analysis, overhead absorption rates, over or under absorption

- Activity based costing

5.5 Cost bookkeeping

- The flow of costs in a business enterprise

- Cost bookkeeping- interlocking and integrated ledger systems
5.6 Costing methods

- Job order costing

- Batch costing
- Process costing (including work in progress; joint and by-products)
- Service costing
- Unit costing
5.7 Marginal and absorption costing

- Distinction between marginal and absorption costing

- Valuation of products under marginal and absorption costing
- Preparation of marginal and absorption statements; cost of production and
profit determination

- Applications of marginal costing: Break-even analysis and charts (single

product)

- Simplified decision problems; accept or reject, special order, dropping a

product, make or buy

- Operating statements
5.8 Budgeting and budgetary control

- Nature and purposes of budgets

- Preparation of budgets; master budgets, functional (department budgets. cash
budgets), proforma financial reports (income statements and balance sheets)

- Purpose of budgetary control; operation of a budgetary control system,

organisation and coordination of the budgeting function

- Distinction between budgeting and budgetary control in the private and public
sectors

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5.9 Standard costing

- Types of standards
- Principles of setting standards
- Standard cost card
- Behavioural aspects of standard costing
- Generation of standard cost information
- Materials, labour and overheads variances; price and efficiency variances
5.10 Cost management

- Value chain-research and development-design-production-marketing

distribution and customer care

- Just in time (JIT)

- Use of computers in costing; job costing, inventory management, labour
costing, cost entre analysis. coding, budgeting and decision making

5.11 Overview of Perfonmance Measurement

- Purpose of performance measurements

- Financial performance measures: profitability, liquidity, activity and gearing
- Non-financial performance measures. The balanced score card perspective
5.12 Emerging issues and trends

CONTENT PAGE

Topic 1: Nature and Purpose of Cost and Accounting.................................................................... 5

Topic 2: Cost Classification ............................................................................................................18
Topic 3: Cost Estimation................................................................................................................ 26
Topic 4: Cost Accumulation ........................................................................................................... 37
Topic 5: Cost Bookkeeping .......................................................................................................... 104
Topic 6: Costing Methods ............................................................................................................ 112
Topic 7: Marginal and Absorption Costing .................................................................................. 149
Topic 8: Budgeting and Budgetary Control .................................................................................. 180
Topic 9: Standard Costing .............................................................................................................203
Topic 10: Cost Management .......................................................................................................... 226
Topic 11: Overview of Performance Measurement. ...................................................................... 234

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 CHAPTER 1
NATURE AND PURPOSE OF COST AND
ACCOUNTING

THE NATURE OF COST ACCOUNTING AND MANAGEMENT

ACCOUNTING
Cost accounting can be defined within the accounting system as internal reporting for use in
management planning, control, and in making routine and non-routine decisions, and external
reporting to the extent that its product-costing function satisfies external reporting requirements for
reporting to shareholders, government, creditors, investors and various outside interested parties.

Cost is the measurement of the sacrifice of economic resources, which has already been made or is to
be made in the future, in order to achieve a specific objective. Cost management deals with estimated
future or planned costs as well as with past, historical costs. It consists of the following basic
activities, whether it is for a manufacturing or service business or for a profit or nonprofit
organization:

1. Cost recording and reporting, including classifying, summarizing, communicating, and

interpreting cost data to interested parties, internal or external.
2. Cost measurement or estimation for specific products, services, or subunits of the organization.
3. Cost planning,It involves selecting the goals of the organization and its subunits, expressed as
operating objectives, and then identifying the means of accomplishing them. Plans are
summarized in budgets which are expressed in terms of money measurements. For example, a
cost budget should be prepared so as to plan for expected expenditures. The profit budget
outlines the planned revenues and expenses of the coming time period. The production and cost
of goods manufactured budget shows planned inventory levels, units of product which the
company plans to make, and the costs of the various types of inputs which will be needed in
carrying out the production plans. A budget also achieves control through the comparison of
actual and budgeted costs resulting variance determination and analysis.
4. Cost control,It sets predetermined standards (such as standard costs and budgets) by which
performance can be measured. It then reports differences between planned and actual
performances to direct attention to what went wrong. Furthermore, cost control aids in fixing
responsibility for departures from a plan so that corrective actions can be taken. For example, a
cost accounting report to a production department manager may show that the cost of
manufacturing one unit of output is significantly higher than the standard cost. Investigation
may reveal that the higher cost is due to the inefficient labor, excessive spoilage of materials, or
use of faulty equipment and improper production methods.
5. Cost analysis, obtaining accurate product-costing data and managing it to assist managers in
making critical decisions such as pricing, product mix, and process technology decisions and
analyzing cost data, translating them into the information useful for managerial planning and
control, and for making short-term and long-term decisions. This phase involves measurement
of accurate and relevant cost data and analyzing them for decision making.

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THE ROLE OF COST ACCOUNTING IN MANAGEMENT
• Ascertainment of cost of product: Cost Accounting ascertains cost of production of each job,
process, or work order by applying different methods of cost accounting, such as job costing,
process operation costing, contract costing etc. according to the suitability and needs of the
organization.
• Fixation of selling prices: Cost accounting helps to find out cost of production and fixation of
selling prices of the product or process job or operation. It also helps in preparing necessary
tenders or quotations.
• Measurement of efficiency: Cost accounting measures the efficiency of each product, process or
departments by applying standard cost method.
• Cost control procedure: Cost accounting controls cost by setting standards and compared with
the actual .The deviation between them are identified and if required necessary controlling
measures may be taken.
• Reporting to the Management: Cost accounting reports to the management periodically which
may be monthly, quarterly or half yearly. According to the reports of the cost accounting, the
management takes necessary decisions.
• Financial accounting records transactions in a subjective manner. It means according to the nature
of expenses.

PURPOSES OR OBJECTS OF COST ACCOUNTS

Costing serves number of purposes among which the following are considered to be most important.
1. Ascertainment of cost: This was considered to be the primary objective of cost accounting in the
initial stages of its development. However, in modern times this has assumed the secondary
objective of cost accounting. Cost ascertainment involves the collection and classification of
expenses at the first instance. Those items of expenses which are capable of charging directly to
the products manufactured are allocated. Then the other expenses which are not capable of direct
allocation are apportioned on some suitable basis. Thus the cost of production of goods
manufactured is ascertained. In this process, cost accounts involve maintenance of different books
to record various elements of cost. Cost of production is ascertained by using any of the costing
technique such as historical costing, marginal costing, etc.
2. Cost control: At one time cost control was considered as secondary objective of cost accounts.
But in modern times it constitutes the primary purpose because of its utmost importance in all
business undertakings. Cost control is exercised at different stages in a factory, viz., acquisition of
materials, recruiting and deployment of labour force, during the production process and so on. As
such we have material cost control, labour cost control, production control, quality control and so
on. However, control over cost is exercised through the techniques of budgetary control and
standard costing. The control techniques enable the management in knowing the operating
efficiency of a business.
3. Determination of selling price: Every business organisation aims at maximizing profit. Total
cost of production constitutes the basis on which selling price is fixed by adding a margin of
profit. Cost accounting furnishes both the total cost of production as well as cost incurred at each
and every stage of production. No doubt other factors are taken into consideration before fixing
price such as market conditions the area of distribution, volume of sales, etc. But cost plays the
dominating role in price fixation.

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4. Frequent preparation of accounts and other reports: The management of every business
constantly rely upon the reports on cost data in order to know the level of efficiency relating to
purchase, production, sales and operating results. Financial accounts provide information only at
the end of the year because closing stock value is available only at the end of the year. But cost
accounts provide the value of closing stock at frequent intervals by adopting a “continuous stock
verification” system. Using the value of closing stock it is possible to prepare final accounts and
know the operating results of the business.
5. To provide a basis for operating policy: Cost data to a great extent helps in formulating the
policies of a business and in decision-making. As every alternative decision involves investment
of capital outlay, costs play an important role in decision-making. Therefore availability of cost
data is a must for all levels of management. Some of the decisions which are based on cost are
a) Make or buy decision,
b) Manufacturing by mechanisation or automation,
c) Whether to close or continue operations in spite of losses.

FUNCTIONS OF COST ACCOUNTANT

The functions of cost accountant may be enumerated under the following:
Traditional Functions
The traditional functions comprise of the routine functions of cost accountant. Such functions are as
follows:
a) To establish various cost centres in the organisation.
b) To ascertain the cost of every product, job or process both in terms of total and per unit of
product.
c) To design suitable system for defining responsibilities and controlling cost.
d) To provide necessary data to enable management in fixing the price.
e) To prepare reports on wastages of material, loss of labour time, idle capacity of machines so
as to improve profitability of business.
f) To implement cost control techniques such as budgetary control and standard costing.
g) To prepare cost schedules to assist management in making decisions and in formulating
policies.
h) To design suitable forms for organizing an effective system of reporting which ensures
provision of adequate cost data to all levels of management.
i) To assist management in the valuation of closing stock of raw materials and work-in-progress
so that too much of capital is not locked up in unnecessary inventories.
j) To prepare periodical cost statements and profit and loss account.
INSTALLATION OF COST ACCOUNTS
At the outset it is to be understood that a common cost accounting system cannot be installed for all
types of business undertakings. The cost accounting system depends upon the nature of business and
the product manufactured. Before a suitable system of cost accounting is installed it is necessary to
undertake a preliminary investigation so as to know the feasibility of installing cost accounting system
to such business. While introducing a system of cost accounts it should be borne in mind that cost
accounting system must suit the business. There should not be any attempt to make the business suit
the system. One more consideration that is of practical importance is that the benefits derived from
cost accounting system must be more than the investment made on it. This means the system must be
simple and it must lead to savings through the control of materials, labour and overheads when

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Compared to expenses incurred in maintaining it. For the successful functioning of the costing
system, the following conditions are essential:
a) There must be an efficient system of material control.
b) A sound and well-designed method of wage payment must be set up.
c) The existence of sound basis for collection of all indirect expenses and a basis for its
apportionment to various production departments.
d) The integration of cost and financial accounts to facilitate reconciliation of profit as shown by
these two systems of accounts.
e) The use of printed forms so as to facilitate quick compilation of cost reports.
f) The duties and responsibilities of cost accountant must be made clear.

Factors to be considered before installing a cost accounting system

The following factors are to be considered before installing a cost accounting system:
1. History of business unit: The history of a business unit implies the duration of its existence,
position in the industry, the rate of growth, policy and philosophy of management and the like.
The history of business unit serves as the basis for designing the cost accounts in respect of
necessity, simplicity, and investment involved in installing cost accounts.
2. Nature of the industry: The nature of business such as manufacturing, mining, trading, etc.
determines the costing techniques to be applied. Similarly, the type of product manufactured also
determines the method of costing that is to be employed. In other words, there is no all-purpose
technique and method of costing that can be applied universally.
3. Product range: The range of products manufactured and sold also determines the method of
costing to be selected. Accordingly range of products must be analysed in terms of size, models,
fashions, area of market, competitors and whether the products are made to customer’s
specification or for stocking and selling.
4. Technical considerations: Technical considerations that influence the installation of cost
accounts are as follows:
a) Size and layout of the factory
b) The existence of production and service departments
c) Flow of production
d) Capacity of machines and degree of mechanization
e) Existence of laboratories
f) Internal transport and material handling equipments
g) Production control techniques
h) Inspection and testing of materials and finished goods.
5. Organizational factors: The problem of installing cost accounting is somewhat difficult in case
of an existing business when compared to new business. However, the existing set up of the
organisation should be least disturbed should the need arise. In order to fix up responsibility to the
executives it may be necessary to group the departments. The organisational factors to be
considered are :
1) Size and the type of organisation such as line, line and staff, functional and committee
organisation,
2) The levels of management, top level, middle level and bottom level management,
3) Extent of delegation and responsibility,
4) Extent of centralization and decentralization,

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 5) Extent of departmentation,
6) Availability of modern office equipments, and
7) Number of managerial and supervisory staff.
6. Selling and distribution method: The chief factors to be considered with regard to distribution
process are the warehousing facilities, external transport, market research and other promotional
measures, terms of sale and procurement of orders from customers.
7. Accounting aspects: The factors to be considered in respect of accounting are:
a) Number of financial records,
b) Existing forms,
c) Registers used, and
d) Number of copies required.
8. Area of control to be exercised: The area where cost control is to be exercised is to be identified
so that each manager may take action relevant to his activities. If material control occupies
significant area of control, it must be given topmost priority for exercising control over materials.
9. Reporting: The cost accounting system to be installed must ensure frequency and promptitude in
reporting cost data to all levels of management. It must also to be pointed out that duplication of
reporting is to be avoided. Further, only those information which are relevant for the management
in a particular context alone should be reported.
10. Uniformity: The practice of adopting uniform costing facilitates inter-firm comparison among
various firms belonging to the same industry. Further it also has the benefit of adopting common
costing practice if a holding company has number of subsidiaries.
11. Use of electronic data processing: In modern days it has become a common practice to use
electronic data processing equipments and computers. In this situation it is essential to ensure that
the equipment meets the needs of the system but not the other way round.
12. Practical considerations: The cost accounting system to be installed must be flexible in
operation and must be capable of adaptation to changing conditions. The system must be
periodically scrutinized so as to make necessary changes owing to development in business.

Practical Difficulties in Installing Cost Accounting

In addition to the above problems, a cost accountant will encounter the following practical difficulties
at the time of installation of cost accounting system:
1. Lack of support from management: Wherever costing system is installed. It is essential to seek
the support of various departmental managers. Very often the managers show hostile attitude
towards the costing system. They feel that this system will interfere in their routine work and
probably as a means of checking their efficiency. Under such circumstances it is better to
convince them about the utility of costing system for the business as a whole.
2. Resistance by existing accounting staff: Very often the existing accounting staff resists the
installation of the cost accounting system on two grounds. Firstly, they feel that the new system
of accounting might lead to excess work. Secondly, they are afraid of their job security. But this
difficulty may be overcome by encouraging them about the usefulness of cost accounting as a
supplement to financial accounts and the generation of more employment opportunities from the
installation of cost accounting system.
3. Non-cooperation from middle and bottom level management: At times the middle and
bottom level managers such as foremen, supervisors and inspectors also fail to extend their
wholehearted cooperation fearing additional work which may be entrusted to them.

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 4. This problem may be overcome by suggesting them about the simplicity of the system and the
existence of a separate cost accounting department to look after costing matters. However, they
may be required to provide necessary reports concerning their area of activity so as to enable
functioning of cost accounting department efficiently.
5. Lack of trained staff: This was no doubt a problem in olden days. Today this problem is
overcome, thanks to the establishment of The Institute of Cost and Works Accountant of India in
our country which offers professional course in costing and also offers training facilities through
various companies to the candidates undergoing the course. In spite of this facility, it is
somewhat difficult to get the competent and experienced staff at the time of installation. This
problem can be overcome by paying attractive salaries to the cost accountants.
6. Heavy expenses in installing and maintaining the system: The setting up of a separate costing
department with staff often poses a problem. In addition to installation, the operating expenses in
the form of printing and stationery, heating and lighting, depreciation and insurance, rent and
rates are to be incurred. However, as was mentioned earlier, the system of cost accounting must
be a useful investment, i.e., benefits derived from it must be more than the investment made on
it. If this is not possible, for the time being the system must be discarded.

SCOPE OF COST ACCOUNTING

The scope of any subject refers to the various areas of study included in that subject. As regards the
scope of cost accountancy is concerned, it has vast scope. The following topics fall under the preview
of cost accountancy:
1) Costing
2) Cost Accounting
3) Cost Control Techniques
4) Budgeting and
5) Cost Audit

1. Costing
Costing is the technique and process of ascertaining the cost. Costing is the process of determining the
costs of products, services or activities.
The above definition is very significant in as much as it carries the main theme of cost accountancy.
This definition emphasizes two important aspects, viz
(a) The technique and process of costing: The technique of costing involves two distinct steps,
namely,
(i) collection and classification of costs according to various elements and
(ii) allocation and apportionment of the expenses which cannot be directly charged to
production. As a process, costing is concerned with the routine ascertainment of cost
with a formal procedure.
(b) Ascertainment of cost: It involves three steps;-
(i) Collection and analysis of expenses,
(ii) Measurement of production at different stages and
(iii) Linking up of production with the expenses.
To achieve the first step, costing has developed different systems such as Historical, Estimated and
Standard Cost. For achieving the second step, costing has developed different methods such as single

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or output costing. Job costing, contract costing, etc.Finally, for achieving the last step costing has
developed important techniques such as Absorption Costing, Marginal Costing and Standard Costing.

The three terms indicated as ‘systems’, ‘methods’, ‘techniques’ are independent factors but co-exist
together. Ascertainment of cost of production is based on all these terms. For example, continuous
type of industries may use process costing as a method, using actual cost as a system, under Standard
Costing Technique.

2. Cost Accounting
Cost Accounting is the branch of accounting dealing with the classification, recording, allocation,
summarization and reporting of current and prospective costs.

The above definition reveals the following aspects of cost accounting:

a) Cost classification: This refers to grouping of like items of cost into a common group.
b) Cost recording: This refers to posting of cost transactions into the various ledger maintained
under cost accounting system.
c) Cost allocation: This refers to allotment of costs to various products or department.
d) Cost determination or cost finding: This refers to the determination of the cost of goods or
services by informal procedure, i.e. Procedures that do not carry on the regular process of cost
accounting on a continuous basis.
e) Cost reporting: This refers to furnishing of cost data on a regular basis so as to meet the
requirements of management

3. Cost Control
Cost control represents the employment of management devices in the performance of any necessary
operation so that pre-established objectives of quality, quantity and time may be attained at the lowest
possible outlay for goods and services. The terminology published by ICMA, London, defines cost
control as “The guidance and regulation by executive action of the cost of operating an undertaking.”
According to this definition, cost control aims at guiding the actuals towards the lines of target and
regulates the actuals if they deviate from the targets. This guidance and regulation is done by the
executive who is responsible for causing the deviation. This process will become clear by
enumerating the steps involved in any cost control technique.
a) Fixation of targets in terms of cost and production performance.
b) Ascertaining the actual cost and production performance.
c) Comparison of actuals with the targets.
d) Analysing the variance by causes and the person responsible for it.
e) Taking remedial steps to set right unfavourable variations.
Cost control is exercised through a variety of techniques such as inventory control, quality control,
budgetary control, standard costing, etc. The advantages of cost control are as follows:
a) It helps in utilizing the resources to the full extent.
b) It helps in reduction of prices which are benefited by customers.
c) It helps in competing successfully in the market.
d) It increases the profit earning capacity of the business.
e) It increases the goodwill of the business.

4. Budgeting
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Budget is an overall blue print of a comprehensive plan of operations and actions expressed in
financial terms. According to him budgeting process involves the preparation of a budget and its
fullest use not only as a devise for planning and co-ordinating but also for control.”

5. Cost Audit
Cost audit is the verification of the correctness of cost accounts and of the adherence to the cost
accounting plan.

MEANING OF MANAGEMENT ACCOUNTING, SCOPE,

LIMITATIONS, APPLICATIONS
Management Accounting is the process of identification, measurement accumulation, analysis,
preparation, interpretation and communication of financial information used by management to plan,
evaluate and control within an organization and to ensure appropriate use of and accountability for its
resources.
The scope or field of management accounting is very wide and broad based and it includes a variety
of aspects of business operations. The main aim of management accounting is to help management in
its functions of planning, directing, controlling and areas of specialization included within the any
organization. The scope of management accounting can be studied as follows:

1. Financial accounting
Financial accounting forms the basis for analysis and interpretation for furnishing meaningful data to
the management. The control aspect is based on financial data and performance evaluation, on
recorded facts and figures. So, management accounting is closely related to financial accounting in
many respects.

2. Cost accounting
Cost accounting is the process and techniques of ascertaining cost. Planning, decision making and
control are the basic managerial functions. The cost accounting system provides the necessary tool for
carrying out such functions efficiently. The tools includes standard costing, inventory management,
variable costing etc.

3. Budgeting and forecasting

Budgeting means expressing the plans, policies and goals of the firm for a definite period in future.
Forecasting on the other hand, is a prediction of what will happen as a result of a given set of
circumstances. Forecasting is a judgment whereas the budgeting is an organizational object. These are
useful for management accounting in planning.
4. Inventory control
Inventory is necessary to control from the time it is acquire till its final disposal as it involves large
sum. For controlling inventory, management should determine different level of stock. The inventory
control technique will be helpful for taking managerial decisions.

5. Statistical method
Statistical tools not only make the information more impressive, comprehensive and intelligible but
also are highly useful for planning and forecasting.

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6. Interpretation of data
Analysis and interpretation of financial statements are important part of management accounting.
After analyzing the financial statements, the interpretation is made and the reports drawn from this
analysis are presented to the management. Interpreting the accounting data to the authorities in the
management is the principal task of management accounting.

7. Reporting to management
The interpreted information must be communicated to those who are interested in it. The report may
cover Profit and Loss Account, Cash Flow and Funds Flow statements etc.

8. Internal audit and tax accounting

Management accounting studies all the tax matters to assist the management in investment decisions
vis-a-vis tax planning as a resource to enjoy tax relief.
Internal audit system is necessary to judge the performance of every department. Management is able
to know deviations in performance through internal audit. It also helps management in fixing
responsibility of different individuals.

9. Methods of procedures
This includes maintenance of proper data processing and other office management services. It may
have to deal with filing, copying, duplicating, communicating and management information system
and also may have to report about the utility of different office machines

Uses of management accounting

Management accounts will enable to:
• compare your accounts with original budgets or forecasts
• manage your resources better
• identify trends in your business
• highlight variations in your income or spending which may require attention
They should be used for the following:

Record keeping
• recording business transactions
• measuring results of financial changes
• projecting financial effects of future transactions
• preparing internal reports in a user-friendly format

Planning and control

• collecting cash
• controlling stocks
• controlling expenses
• co-ordination and monitoring of strategy/performance
• monitoring gross margins

Decision making

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• using cost information for pricing, capital investment and marketing
• evaluating market and product profitability
• evaluating the financial effect of strategies and plans

Limitations of Management Accounting

Though management accounting is helpful tool to the management as it provides information for
planning, controlling and decision making, still its effectiveness is limited by a number of reasons.
Some of the limitations of management accounting are as follows:

1. Based on accounting information

Management accounting is based on data and information provided by financial accounting and cost
accounting. As such the correctness and effectiveness of managerial decisions will depend upon the
quality of data provided by cost and financial accounts. So, effectiveness of management account is
limited to the reliability of sources of information.
2. Lack of knowledge
The use of management accounting requires the knowledge of number of related subjects. Deficiency
in knowledge in related subjects like accounting principles, statistics, economics, principle of
management etc. will limit the use of management accounting.
3. Management accounting is only a tool
The tools and techniques of management accounting provide only information and not decisions.
Decisions are to be taken by the management and implementation of decisions is also done by
management.
4. Evolutionary stage
Management accounting is still in a development stage and has not yet reached a final stage. The
techniques and tools used by this system give varying and differing results. It is still named as internal
accounting and/ or operational accounting.
5. Personal prejudices and bias
The interpretation of financial information may differ from person to person depending upon the
capability of the interpreter. Analysis and interpretation of data and information may be influenced by
personal basis. As such, the objectivity of decision may be affected by personal prejudices and bias.
6. Psychological resistance
Changes in traditional accounting practices and organizational set up are required to install the
management accounting system. It calls for a rearrangement of the personnel and their activities and
framing of new rules and regulations which generally may not be liked by the people involved.

RELATIONSHIP BETWEEN FINANCIAL ACCOUNTING AND COST

ACCOUNTING
Cost accounting is very closely-related to financial accounting. Some authorities on the subject
consider cost accounting to be the branch of financial accounting. But it may be said that cost
accounts is complementary to financial accounts, i.e., a subject which is necessary to make financial
accounts whole or complete. Financial accounts and cost accounts are both similar in certain respects.
But in some other respects they differ from one another. These points of similarities and
dissimilarities are enumerated below:

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Points of Similarities
a) The fundamental principles of double entry are applicable in both the systems of accounts.
b) The invoices and vouchers constitute the common basis for recording transactions under both the
systems of accounts.
c) The results of business are revealed by both the systems of accounts.
d) The causes for losses and wastages of a business are provided by both these systems of accounts.
e) The determination of future business policy is guided by both these systems of accounts.
f) A basis for comparison of expenses is being provided by both the accounting systems.
g) Accuracy of accounts is maintained under both the systems by means of exercising check over
errors and commissions which might creep in either of accounts.

Points of Dissimilarities
Points of differences Financial Accounts Cost Accounts

1. Purpose The purpose of financial The purpose of cost accounting is

accounts is external reporting internal i.e., to the management of every
mainly to owners, reporting, business
creditors, tax authorities,
government, and prospective
investors
Cost accounts are maintained voluntarily
2. Obligation This is to be maintained In some cases government has directed
compulsorily The preparation of some companies to maintain cost
accounts must be in accordance accounts to improve efficiency.
with the statutory provisions.
.
3. Recording (a) Financial accounts records (a) Cost accounts records
transactions in a subjective transactions in a subjective
manner, i.e., according an manner. i.e., according to
objective manner to the purpose for which costs are
nature of expenditure incurred

(b) In financial accounts (b) In cost accounts costs are

expenses are recorded in expressed by proper analysis
totals and classification in order to
find out cost per unit

(c) Financial accounts records (c) Cost accounts records only those
all transactions which takes costs which affect production
place in the business. and sales

(d) Financial accounts (d) Cost accounts records both

records only historical and estimated costs
historical costs

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 4. Analysis of Financial accounts disclose Cost accounts show the profitability or
Profit profit for the entire business as otherwise of each product, process or
a whole operation so as to reveal the areas of
profitability

5. Control (a) It does not make use of any (a) It makes use of some important
control techniques. control techniques such a
(b) techniques such a Marginal Costing
Marginal Costing any (b) It exercises control over
technique materials using some techniques
such as ABC analysis level
(c) Control over labour is not setting, economic order quantity
exercised etc.
(c) Control over labour is exercised
and efforts are taken to minimise
idle time, over time etc.

6. Duration of Generally, financial accounts Cost accounting furnishes cost data at

reporting provides financial information frequent intervals. Some reports are
once a year daily. Some are weekly and some
monthly

7. Evaluation of The information provided by The cost data helps in evaluating the
efficiency financial accounts is not efficiency of the businesses
sufficient to evaluate the
efficiency of the business

8. Pricing It fails to guide the formulation It provides adequate data for formulating
of pricing policy pricing policy pricing policy.

9. Valuation Stock is valued at cost or Stock is always valued of cost price

market price of stock
whichever is less

DIFFERENCES BETWEEN COST AND MANAGEMENT ACCOUNTING

Management accounting is defined as “the application of appropriate techniques and concepts in
processing the historical and projected economic data of an entity to assist management in
establishing a plan for reasonable economic objectives and in the making of rational decisions with a
view towards achieving these objectives.” It includes the methods and concepts necessary for
effective planning for choosing among alternative business actions, and for control through the
evaluation and interpretation of performance. Its study involves consideration of ways in which
accounting information may be accumulated, synthesized, analyzed and presented in relation to
specific problems, decisions and day-to-day tasks of business management.

16
Management accounting can also be defined as the application of professional knowledge and skill in
the preparation and presentation of accounting information in such a way as to assist management in
the formulation of policies and in the planning and control of the operation of the undertaking.”
If we examine the above two definitions of management accounting it appears that both the systems
of accounts serve the same purpose.

However, they differ from one another in respect of the following

Points of Cost Accounting Management Accounting

differences

1.Growth of The history of cost accounting This system of accounting evolved in the
dates back Accounting to middle of 20th century. Hence it is of recent
fourteenth century origin where compared to cost accounting

2. Object The main objects of cost accounts The main objective of management
is to ascertain and control cost accounting is to provide useful information to
management for decision-making.

3. Basis of It is based on both present and It is concerned purely with the transactions
future recording transactions for relating to future.
cost ascertainment

4. Scope Cost accounting has narrow scope It has a wide scope in as much as it covers the
as it covers matters relating to areas of financial accounts, cost accounts,
ascertainment and control of cost. taxation, etc.

5. Utility Cost accounts serves the needs of

both internal management and Management accounting serves the needs of
external parties only internal management

6. Types of It deals only with monetary It deals with both monetary and non-
transactions i.e., it covers only transactions monetary transactions, i.e., both
quantitative aspect quantitative dealt with and qualitative aspects

It does not follow a definite principle and

7. Observation Cost accounts follow a definite Instead, the data to be presented and format
principle of principles for for recording. depends up on the need of the
ascertaining cost and a format management

SELECTION OF AN IDEAL COST ACCOUNTING SYSTEM

The following are the essentials of an ideal cost accounting system:
1. Accuracy: The system of cost accounting must provide for accuracy in terms of both cost
ascertainment and presentation. Otherwise it will prove to be misleading.

17
2. Simplicity: Cost accounting system involves detailed analysis of cost. To avoid complications in
the procedure of cost ascertainment an elaborate system of costing should be avoided and every
care must be taken to keep it as simple as possible.
3. Elasticity: The cost accounting system should be capable of adopting itself to the changing
situations of business. It must be capable of expansion or contraction depending upon the needs of
the business.
4. Economy: The costs of operating costing system must be less. It must result in increased benefit
when compared to the expenditure incurred in installing it.
5. Comparability: The records to be maintained must facilitate comparison over a period of time.
The past records must serve as a basis to guide the future.
6. Promptness: An ideal costing system is one which provides cost data in an analytical form to the
management. So all the departments of a factory must analyse and record the relevant items of
cost promptly in order to furnish cost information on a regular basis to various levels of
management. This helps in checking up the progress of the business on a regular basis.
7. Periodical preparation of accounts: With a view to facilitate the comparison of results
frequently, it is desirable to prepare accounts periodically. Constant comparison of actual result
with standard result enables to spot out areas of inefficiency. This can be set right by taking
remedial measures.
8. Reconciliation with financial accounts: The system of cost accounts must be capable of
reconciling with financial accounts so as to check accuracy of both the system of accounts.
9. Uniformity: The various forms and documents used under costing system must be uniform in
size and quality of paper. Printed forms must be used to avoid delay in the preparation of reports.
This also reduces the burden of clerical staff. Forms of different colours can be used to distinguish
different documents.
10. Equity: The basis of apportioning indirect expenses to products, departments or jobs must be fair
and equitable.

CHAPTER 2
COST CLASSIFICATION

DEFINITION
Cost classification may be defined as ‘the arrangement of cost items in a logical sequence having
regard to their nature and purpose to be fulfilled’. Costs are classified according to the cost objectives.
18
Cost objective is the activity for which a separate measure of cost is desired. They include, cost stock
valuation, cost for decision-making and cost for control purposes. The table below shows a summary
of cost classifications given cost objectives:

Cost objective Possible classification

1. Stock valuation • Manufacturing and non-manufacturing costs
• Period and product costs
• Direct and indirect costs

2. Decision making • Cost behavior: Variable, fixed, semi variable,

• Relevance: opportunity, sunk cost, historical cost, standard costs

3. Control purposes • Controllable and non-controllable

• Avoidable and non-avoidable

25
MANUFACTURING COSTS
These are the costs incurred to produce a product. Remember that a product refers to both goods and
services. The elements of manufacturing costs are: direct material costs, direct labour costs; and
overhead costs. The elements make up the total cost of a product, as shown below:
Direct expenses are expenses incurred for a particular job, project or service e.g. royalties, franchise,
hire of special equipment, materials, labour, etc. they are traceable to that specific job.

These costs are discussed further in the following sections.

(a) Material costs:
Material refers to all the physical inputs into the production process. They do not only refer to purely
unprocessed materials or natural resources but refers to any material input in the manufacturing
process. Finished goods for one company can be raw materials for another for instance; packed wheat
flour is a finished good for the milling industry but a raw material to the banking industry.

Raw materials can be classified as direct or indirect

Direct materials are those materials that can be easily traced to a product without any extra cost or
inconvenience. Examples include leather and sole for a shoe making industry.
Direct Materials are those materials that become an integral part of the finished product and that can
be physically and conveniently traced to it.

Direct expenses are expenses incurred for a particular job, project or service e.g.
• Royalties
• Franchise
• Hire of special equipment

19
Indirect materials are materials that become an integral part of the finished product but may be
traceable into the product only at great cost or inconvenience. Examples include glue and thread for a
shoe making industry.
COST CLASSIFICATION
An analysis of the various materials input into a production process is as follows
• Raw material
• Components and subassemblies
• Consumable materials
• Maintenance materials

(b) Labour
Labour is the physical and mental human input in a production process. Labour costs can be divided
into direct labour costs and indirect labour costs.

Direct labour cost refers to wages paid to workers who are directly involved in the production of
each item produced. Such labour cost can be physically traced to the creation of product without
undue cost. The cost can be readily identified with specific product or unit. For instance, wages paid
to factory supervisors, forklift truck drivers, factory store room clerks, etc.

The term direct labor is reserved for those labor costs that can be essentially traced to individual units
of products. Direct labor is sometime called touch labor, since direct labor workers typically touch the
product while it is being made. The labor cost of assembly line workers, for example, is a direct labor
cost, as would the labor cost of carpenter, bricklayer and machine operator

Indirect labor costs refer to the wages paid to workers whose efforts cannot be readily identified with
specific product units or batches e.g. laborers paid to maintain all the premises utilized for production
of goods and services.
Labor costs that cannot be physically traced to the creation of products, or that can be traced only at a
great cost and inconvenience, are termed indirect labor and treated as part of manufacturing overhead,
along with indirect materials. Indirect labor includes the labor costs of janitors, supervisors, materials
handlers, and night security guards. Although the efforts of these workers are essential to production,
it would be either impractical or impossible to accurately trace their costs to specific units of product.
Hence, such labor costs are treated as indirect labor.

NOTE
Direct Materials cost combined with direct labor cost is called prime cost.
In equation form:
Prime Cost = Direct Materials Cost + Direct Labor Cost
For example total direct materials cost incurred by the company is shs.4, 500 and direct labor cost is
Shs. 3,000 then prime cost is sh7,500 (sh4,500 + sh3,000).

(c) Overhead costs

They are also called indirect production costs. They include all costs of manufacturing except direct
materials and direct labour. They are incurred for the benefit of all products thus the amount of
overhead allocated can only be an estimate. They include indirect materials, indirect labour and other
20
indirect expenses that cannot be traced directly to a product. They are at times referred to as factory
burden, factory overheads or manufacturing expense.

Examples of manufacturing overhead include items such as indirect material, indirect labor,
maintenance and repairs on production equipment and heat and light, property taxes, depreciation, and
insurance on manufacturing facilities. Indirect materials are minor items such as solder and glue in
manufacturing industries. These are not included in direct materials costs. Indirect labor is a labor cost
that cannot be trace to the creation of products or that can be traced only at great cost and
inconvenience. Indirect labor includes the labor cost of janitors, supervisors, materials handlers and
night security guards. Costs incurred for heat and light, property taxes, insurance, depreciation and so
forth associated with selling and administrative functions are not included in manufacturing overhead.
Studies have found that manufacturing overhead averages about 16% of sales revenue. Manufacturing
overhead is known by various names, such as indirect manufacturing cost, factory overhead, and
factory burden. All of these terms are synonymous with manufacturing overhead.

NOTE
Manufacturing overhead cost combined with direct labor is called conversion cost.
In equation form:
Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost

FUNCTIONAL CLASSIFICATION
Non-manufacturing costs are costs incurred by all activities that support the production of goods and
services. They are administration costs, selling costs and distribution costs. These are explained as
follows:

a) Production costs: these are costs incurred in the manufacturing process. They include material
costs, labour costs and overhead costs as discussed above.
b) Administrations cost: Is the sum of costs associated with the overall management of the
enterprise, which cannot be readily identified with one of the major functional areas e.g. salary of
the factory manager would be seen as a production cost but the salary of the personnel officer
will be viewed as administrative cost since the personnel function does work for all other
functions of the enterprise.
c) Selling Cost: this is the sum of costs associated with the securing of orders from customers.
Included in this area will be items such as the salaries paid to the salesmen and expenditure on
advertising.
d) Distribution costs: these are costs associated with warehousing the products and their delivery
to customers. They are incurred in getting the finished product to customers for instance,
depreciation of the distribution van.
e) Finance costs: These are costs incurred to secure funds to finance the organization’s activities.
These include interests on loans and overdrafts, dividends to shareholders, interests on
debentures etc.
f) Research and development costs: These are costs that are incurred to invent new products or to
modify the existing ones, as well as costs incurred to acquire more information on such products.
Classification according to behavior
Classification according to behavior

21
Cost behavior means how costs will respond or react to changes in the activity level. ie. as we
increase output or sales, are the costs rising, dropping or remaining the same. Cost Behavior can be
used to produce various classifications of costs such as:

BEHAVIORAL CLASSIFICATION
Costs will be classified according to nature or behavior in relationship to change in the levels of
production such as:
i) Variable costs
ii) Fixed costs
iii) Semi fixed costs

i) Variable costs
These are costs that increase or decrease, in total, in direct proportion to changes in the total level of
activity or number of units produced i.e. that portion of the cost of an activity that change with the
level of output. They are costs which tend to vary directly with the levels of output.

Examples of variable costs include, cost of raw materials, direct expenses,wages paid to casual
employees paid on an hourly basis and fuel cost based on mileage.
With variable costs, the cost level is zero when production is zero. The cost increases in proportion to
the increase in the activity level because variable cost per unit of activity level is constant, thus the
variable cost function is represented by a straight line from the origin. The gradient of the function
indicates the variable cost per unit.
For a cost to be variable there should be an activity base which drives it. This activity base is a
measure of effort that operates as a casual factor in the incurrence of variable costs. Thus to control
these costs, cost accountants should be well acquainted with the various cost drivers (activity bases)
within the organization.

To illustrate variable costs

Variable cost
Cost

Activity

ii) Fixed Costs

These are costs whose total will tend to remain fixed irrespective of changes in output they do not
change with the level of output. They are also called autonomous costs, as they remain the same
irrespective of the activity level e.g. Salaries, rent etc.

22
The classification of cost into fixed and variable costs would only hold within a relevant range beyond
which all costs are variable. The relevant range is the activity limits within which the cost behavior
can be predicted.

To illustrate fixed costs

Fixed cost
Cost

Activity

iii) Semi variable costs

These are costs with both a fixed and variable cost component.ie.they are fixed up to certain output
levels and thereafter increase and get fixed at higher levels. They are partially fixed and partially
variable

The fixed component is that portion which is constant irrespective of the level of activity. They are
variable within certain activity levels but are fixed within other activity levels, as shown below:
examples include salesmen salaries (salary plus commission), telephone charges, water bills, electrical
costs etc.

To illustrate semi variable costs

Variable cost
Fixed cost

Activity

Direct and Indirect costs

23
Direct costs are costs that can be traced specifically and identified to the end product of the
production process without any extra cost or inconvenience. Direct costs consist of costs that can be
directly attributed to a specific output, product or level of activity. Direct costs include direct raw
materials and direct labour also called prime costs in aggregate.

PRIME COST = Direct Material Cost + Direct Labour Cost + Direct expenses

Indirect costs are costs that will not be directly attributable to a specific product. They are regarded
as overheads. Identification of overheads to specific products is done through cost allocation and
apportionment. They include supervisors’ salaries, rent, electricity, depreciation of building etc.
In order to trace a cost, it must first be possible, i.e. practical, to measure the service or supply and
then determine the related cost. Note that it is not the nature of the cost but its traceability that
determines whether the cost is direct or indirect.
COST CLASSIFICATION
CLASSIFICATION ACCORDING TO CONTROLLABILITY
Controllable cost: Refers to the cost, which can be influenced by the actions of a person in whom
authority for such control is vested. Cost is said to be controllable at a particular level of management
if that level has the power to authorize its incurrence. In other words, controllable costs are costs that
are reasonably subject to regulations by the manager with whose responsibility those costs are being
identified. For instance, a decision to hire more personnel to an organization at affordable rates can be
controlled.

Non controllable cost: is a cost which cannot be influenced by a person in whom authority for such
control is vested. They are costs, which cannot be adjusted without affecting the long term objective
of the firm. For example if the trade union demands an increase in wages, the increment is a non -
controllable cost. Similarly, the depreciation of a building is a non-controllable cost to a manager as
he does not have authority over depreciation.
In decision making, only controllable costs are relevant because they can be changed by the decision
maker. There is little or nothing that the decision maker can do about the non-controllable costs thus
they are irrelevant in decision making.

CLASSIFICATION ACCORDING TO NORMALITY

Normal costs: these are costs that are expected to be incurred given a specific level of production.
They may also be referred to as standard costs.

Abnormal costs: abnormal costs are costs above the normal costs given a specific level of activity.
For instance, abnormal costs may be incurred in production where the prices of materials have
significantly and adversely varied from the standard.

CLASSIFICATION ACCORDING TO TIME

Historical costs: these are costs that were incurred at a given time in the past. They are irrelevant for
decision making. An example is acquisition cost of an asset.

24
Predetermined costs: these are estimated costs that have been estimated for purposes of decision
making. An example of such costs include overheads which are absorbed on a given predetermined
overhead absorption rate. They are not always accurate.

CLASSIFICATION BASED ON IDENTIFICATION WITH INVENTORY

Under this classification, costs are classified according to the function they perform in an
organization. Costs can functionally be classified as:
33S T U D Y T E X T
(a) Product costs: are all the costs incurred in production of units during a time period e.g. raw
material costs, direct labour costs and production overheads. Such costs are capitalized and expensed
(charged to the profit and loss account) only when the manufacturer sells inventory. These costs may
be carried from one period to the other.

(b) Period costs: these are costs mainly incurred in the ordinary running of the business enterprise.
They include costs like electricity bill paid, salaries and allowances and rent payments. They are
referred to as period costs since they are expensed in the period they are incurred.

CLASSIFICATION FOR DECISION MAKING

a) Sunk costs: these are costs, which have already been incurred. They cannot be changed by any
decision made after incurrence. Such costs are irrelevant for decision making. For example, cost
of a delivery van already acquired by the organization shall be irrelevant as it cannot be changed
by any course of action taken by management.
b) Marginal cost: is the additional cost of producing an extra unit of output.
c) Opportunity cost: is defined as the cost of the next best foregone alternative or the potential
benefit that is lost by taking one course of action and giving up the other. For instance, by
deciding to take on a leave and forego wages, the opportunity cost of the decision shall be the
foregone wages.
d) Differential cost/incremental cost: these are costs that differ among alternatives.
e) They are costs relevant for decision making. They may be either variable or fixed. For instance,
if taking up a different business apartment amounts to an extra Shs2,000 rent expense, the
differential (incremental) cost of the decision shall be the Sh.2,000.
f) Imputed cost
g) Is an expense not incurred directly, but actually borne e.g example, a person who owns a home
debt-free has an imputed rent expense equal to the amount of interest that could be earned on the
proceeds from the sale of the home if the home were sold.
h) Replacement cost
i) The amount it would cost to replace an asset at current prices. If the cost of replacing an asset in
its current physical condition is lower than the cost of replacing the asset so as to obtain the level
of services enjoyed when the asset was bought, then the asset is in poor condition and the firm
would probably not want to replace it
j) Standard cost
k) A management tool used to estimate the overall cost of production, assuming normal operations.
l) Budgeted cost

25
 m) This is the cost estimated to be incurred and used for budgeting purposes. It is a cost included in
the budget representing cost expected. Most of the times, budgeted cost will be derived from
standard cost.

CHAPTER 3
COST ESTIMATION

MEANING OF COST ESTIMATION

A cost estimate is the approximation of the cost of a program, project, or operation. The cost estimate
is the product of the cost estimating process. The cost estimate has a single total value and may have
identifiable component values. A problem with a overrun can be avoided with a credible, reliable, and
accurate cost estimate. An estimator is the professional who prepares cost estimates.

METHODS OF ESTIMATING COST

Non mathematical methods
26
These include;
• Engineering method
• Accounts analysis
• High-low method

1. ENGINEERING METHOD
This method is used when no previous records of costs exist. It is a very detailed method that goes
into the nitty-gritty of what constitutes a product in terms of how much material or how much labor.
From this a suitable level of activity can be determined. The result of the direct observation of
physical quantities is then converted into a cost estimate. This approach can be lengthy and expensive.
It adopts the element of motion study from the scientific theory of management.
This method is based on a detailed study of each operation where careful specification is made for
materials, labor and equipment necessary to produce a product. It involves identifying the level of
input required of an activity in form of raw material and labor while total cost is based on the cost of
each input. This approach is applicable where no past data exists. The main setback of the approach is
that it requires a complex analysis of all the constituents of an activity and the requirements of an
activity in terms of costs detailed into materials, labor, overheads and time.

2. ACCOUNT ANALYSIS
Under account analysis method, the accountant examines and classifies each ledger account as
variable, fixed or mixed. Mixed accounts are broken down into their variable and fixed components.
They base these classifications on experience, inspection of cost behavior for several past periods or
intuitive feelings of the manager.
This is with a view to develop a cost function in the form y=a +bx

ILLUSTRATION
Suppose a company ABC has the following costs with a value of 7000 units.

Amount Variable Fixed

Direct labour 150,000 150,000 -
Materials 125,000 125,000 -
Repairs and maintenance 5,000 5,000 -
Depreciation 15,000 - 15,000
Administration overheads 1,000 - 1,000
Indirect labour 4,000 - 4,000
300,000 280,000 20,000

Required;-
Determine the cost equation using account classification method and determine the cost of producing
1,400 units

SOLUTION
280,000
Variable cost b = =Shs 40
7,000

27
 a = shs 20,000

Substituting in the Equation y= a +bx

Y= 20,000 + 40x
Hence the cost of producing 1400 units is

Y= 20,000 + 40(1,400)
Shs. 76,000

ILLUSTRATION
In the year 2012 VIP incurred the following expenses to maintain 1500 lecturers.
Sh
Administration expenses (40% variable) 4,000,000
Lecturing pay (60% variable) 8,000,000
Airtime allowance (fixed) 1,000,000
Sundry expenses (50% fixed) 500,000
Soda allowance (variable) 300,000

Required;-
a) Using accounts analysis method, express an equation in form y = a + bx
b) Using the equation expressed above, estimate the total cost of 2000 lecturers incurred to be
employed in 2013.
SOLUTION
Total cost Variable Fixed
Administration expenses 4,000,000 1,600,000 2,400,000
Lecturing pay 8,000,000 4,800,000 3,200,000
Airtime allowance 1,000,000 - 1,000,000
Sundry expenses 500,000 250,000 250,000
Soda allowance 300,000 300,000 ______
6,950,000 6,850,000

6,950,000
b= = 4633.33 a = 6,850,000
1500

(a) y = a + bx ∴ y = 6,850 + 4633.33x

(b) For 2000 lecturers

Total cost y = 6,850,000 + 4,633.33 ×2,000 = Shs. 16,116,660

3. HIGH –LOW (OR RANGE) METHOD.

In this method the highest and lowest activity together with their corresponding costs is identified.
The two points i.e. the lowest and the highest are used to derive a cost function in the form of
y = a + bx

28
This method is based on an analysis of historical information of costs at different activity levels. The
high-low method finds the equation of the straight line joining the two points corresponding to the
highest and lowest activity levels. What we need to do is to separately identify the fixed and variable
cost elements so that each can be predicted for anticipated future activity levels.
The variable cost is estimated by calculating the average unit cost between the highest and lowest
volumes and the fixed and total cost function can then be derived.
For example, if the costs of producing the highest and lowest levels of production (10 units and 12
units) are shs.30 and shs.35 respectively then the variable costs per unit are sh. 5/2 units or sh. 2.50.
The fixed costs are thus £5 and the total cost = sh.5 + sh. 2.50x where x = production level.

ILLUSTRATION
Production Total cost
(units) sh.
High 120 3,500
Low 100 3,000
Change 20 500

sh.500
Variable cost = = sh.25 per unit
20

Fixed cost = sh. 3,000 – (100 x sh. 2.5) = sh.500

Total cost = sh.500 + sh.25 x units

Limitations
The limitations of the high-low method are as follows
• Its reliance on historical data, assuming that (i) activity is the only factor affecting cost and (ii)
historical costs reliably predict future costs.
• The use of only two values, the highest and the lowest, means that the results may be distorted
because of random variations in these values.

MATHEMATICAL METHODS
These include;-
• Scatter graph method
• Ordinary Least Squares Regression Method

THE SCATTER GRAPH METHOD

For this method a scatter diagram is constructed which is used to visually i.e. by inspection deduce a
relationship from observed pattern if there is any. By obtaining any two points on constructed graph,
we can fit a straight line if the pattern suggests a linear relationship.

Y
- Non-linear relationship
x x x x - Quadratic since has one
x x
x x x turning point
x x xx x
29 x x x x
x
x x
 Y

x x x No relationship between x and y

x
x x x xx
x x
x x x x x
x x x x x
x x

x x Linear but inverse relationship

x x
x x
x
x x
x
x x

ILLUSTRATION
Cost and activity data are plotted in a similar manner to that above and a line drawn at an angle which
is judged to be the best representation of the slope of the plotting.

30
 Sh.
1800 -
1600 -
1400 -
1200 - x x
x x x
1000 - x x x
x x
x x
800 - x x x
x
600 -
400 -
200 -

10 20 30 40 50 60 70 80 90 100 110
Units of output

Scatter graph showing visual line of best fit.

The dotted line is drawn to show the intersection with the vertical axis and thus gives an estimate of
the fixed content of the cost being considered, in this case 6400. The slope of the line, i.e. the variable
element, is found as follows:
Cost @ zero activity = sh.400
Cost @ 100 units activity = sh.1,250
1,250−400
= sh. 8.5
100−0
Therefore the estimate cost function = sh. 400 + 8.5x where x = units of output, i.e. the independent
variable.
The graphical method is simple to use and provides a visual indication of approximate cost behavior.
Because each individual is likely to draw a different line with a different slope the method is
subjective and approximate. A more objective and accurate approach is to calculate the line of best fit
mathematically using the least squares method.

Advantages of visual fit method

1. It takes into account all the observations unlike the high low method.
2. It is easy to apply.

Disadvantages of visual –fit method

1. It cannot be used for two or more independent variables
2. We cannot measure the size of probable error.
3. It is subjective to some extent.

ORDINARY LEAST SQUARES REGRESSION METHOD

Regression analysis is a technique that uses a statistical model to measure the amount of change in
one variable (dependent variable) that is associated with changes in amounts of one or more variables.
This method is used to determine the equation of the line of best fit by minimizing the sum of the
squares of the vertical
When it has been established that a causal relationship exists in the data and that a linear function is
appropriate the statistical technique known as least squares is frequently used to establish values for
the coefficients a and b (representing fixed and variable cost respectively) in the linear cost function.

31
 y = a + bx
where y is total cost – the dependent variable
and x is the agreed measure of activity – the independent variable

The values of a and b are determined after substituting data.

i) In the normal equation below.
∑ y = n a + b ∑ x............................................(i)
∑ x y = a∑ x + b ∑ x ...................................(ii)
2

ii) In the formulas below

b=
n∑ xy − ∑ x ∑ y
a=
∑ y − b∑ x _ _
or a = y − b x
n∑ x 2 − (∑ x ) 2 n

When it has been established that a causal relationship exists in the data and that a linear function is
appropriate the statistical technique known as least squares is frequently used to establish values for
the coefficients a and b (representing fixed and variable cost respectively) in the linear cost function.
y = a + bx

where y is total cost – the dependent variable and x is the agreed measure of activity – the
independent variable

Characteristics of linear regression

1. It is objectively determined.
2. It makes use of all the data or observations
3. It minimizes the sum of squares of the error terms
4. If there is a linear relationship between the dependent and independent variable, this method
gives the best predictions within the relevant range.

ILLUSTRATION
The following table shows the number of units of a good produced and the total costs incurred.
Units produced Total costs
100 40,000
200 45,000
300 50,000
400 65,000
500 70,000
600 70,000
700 80,000

Calculate the regression line for y and n.

SOLUTION

32
Notes on the calculation
The calculation can reduced to a series of steps as follows;-
Step 1:
Tabulate the data and determine which is the dependent variable, y, and which the independent x.
Step 2:
Calculate∑ 𝑥, ∑ 𝑦, ∑ 𝑥 2 , ∑ 𝑥 𝑦 (leave room for a column for ∑ 𝑥 2 which may well be needed
subsequently)
Step 3;
Substitute in the formation in order to find b and a in that order.
Step 4;
Substitute a and b in the regression equation.

The calculation is set out as follows, where x is the activity level in units of hundreds and y is the cost
in units of sh.1, 000.
x y xy x2
1 40 40 1
2 45 90 4
3 50 150 9
4 65 260 16
5 70 350 25
6 70 420 36
7 80 560 49
28 420 1,870 140 n=7

𝑛 ∑ 𝑥𝑦 − ∑ 𝑥 ∑ 𝑥
b=
𝑛 ∑ 𝑥 2 − (∑ 𝑥)2

Try to avoid rounding at this stage since, although n 𝑛 ∑ 𝑥𝑦 are large, their difference is much
smaller.
(7 𝑥 1,870)− (28 𝑥 420) 13,090− 11,760 1,330
= (7 𝑥 140)− (28 𝑥 28)
= = = 6.79
980− 784 196

∑𝑦 𝑏∑𝑥 420 28
a = – = – �6.79 𝑥 �
= 60 – 27.16= 32.84
𝑛 𝑛 7 7

Therefore the regressional line for y on x is:

y = 32.84 + 6.79x (x in hundreds of units produced, y in sh.1,000).

(Always specify what x and y are very carefully)

This line would be used to estimate the total costs for a given level of output. If, say, 250 units were
made we can predict the expected yield by using the regression line where x = 2.5.

y = 32.84 + 6.79 x 2.5 = 32.84 + 16.975 = 49.815

33
i.e. we predict total costs of sh.49,815 for production of 250 units.

Using the regression line for forecasting

In the previous example, having found the equation of the line of best fit, we used this to forecast the
total cost for a given level of activity.
The validity of such forecasts will be dependent upon two main factors.
• Whether there is sufficient correlation between the variables to support a linear relationship
within the range of the data used.
• Whether the forecast represents an interpolation or an extrapolation

ILLUSTRATION
The following data have been collected on costs and output:

Output (000s) 1 2 3 4 5 6 7
Costs (sh.000s) 14 17 15 23 18 22 31

Required;-
Calculate the coefficients in the linear cost function.
y = a + bx
Using
i) The Normal Equation and (ii) the coefficient formulae

SOLUTION
Output (x) Costs (y) Xy x2
1 14 14 1
2 17 34 4
3 15 45 9
4 23 92 16
5 18 90 25
6 22 132 36
7 31 217 49
Σx = 28 Σy = 140 Σxy = 624 Σx2 = 140

Where n = 7 (i.e. number of pairs of readings)

i) Using the normal equations
140 = 7a + 28b ………..I
624 = 28a + 140b ……….. II
And eliminating one coefficient thus
624 = 28a + 140b ………..I
560 = 28a + 112b ……….. 1 x 4
64 = 28b

34
 ∴ b = 2.286 and, substituting this value in one of the equations, the value of a is found to be
10.86

∴ Regression line is y = 10.86 + 2.26x

ii) Using the coefficient formulae

(140 𝑥 140)− (28 𝑥 624)

a= = 10.86
7(140)− 282

7(624)− (28 𝑥 140)

b= = 2.286
7(140)− 282

When the coefficients have been calculated the cost function can be used for forecasting simply by
inserting the appropriate level of activity i.e. a value for x, and calculating the resulting total cost.

For example, what are the predicted costs at output levels of:
a) 4,500 units (i.e. 4.5 in ‘000s), and
b) 8,000 units (i.e. 8 in ‘000s)

y = 10.86 + 2.286 (4.5) = sh. 21,147

Note: A prediction within the range of the original observations (1 to 7 in Example 1) is known as an
interpolation.
y = 10.86 + 2.286 (8) = sh.29,148
Note: A prediction outside the range of original observations is known as an extrapolation.
PRACTICE EXERCISES (Solutions on page 243)
QUESTION 1
The management of Limuru Processing Company Limited wishes to obtain better cost estimates to
evaluate the company’s operations more effectively.

The following information is provided to you for analysis:

Year 2004 Equivalent production Overheads

Month Units (‘000’) Sh.’000’
January 1,425 12,185
February 950 9,875
March 1,130 10,450
April 1,690 15,280
May 1,006 9,915
June 834 9,150
July 982 10,133
August 1,259 11,981
September 1,385 12,045
October 1,420 13,180

35
 November 1,125 13,180
December 980 10,430

Additional information:
1. In November, the opening work in progress inventory contained 1,000,000 units that were 30%
complete with respect to conversion costs.
2. During the same month of November, the manufacturing department transferred 1,500,000 units.
3. The closing inventory for the month of November was 1,200,000 units and the units were 305
incomplete with respect to conversion costs
4. Using the above information, you have obtained the following variables by applying simple
regression analysis.
Sh. ‘000’
Constant 3,709
Slope 6,487

Required:
i) Use the high-low method to estimate the overhead cost function.
ii) Use the regression method to determine the overhead cost function.
iii) Compute the equivalent units of production with respect to conversion costs for the month of
November using the FIFO method.
iv) Use the regression function formulated in (ii) above to estimate the overhead cost for the month of
November.

QUESTION 2
(a)Explain the advantages and disadvantages of the high-low method of cost estimation.
(b)Central Machinery Ltd. is preparing its budget for the year ending 30 June 2004. For the fuel
expenses consumption it is decided to estimate an equation of the form, y = a + bx, where y is
the total expense at an activity level x, a is the fixed expense and b is the rate of variable cost.

The following information relate to the year ended 30 June 2003:

Month Machine Fuel Oil Month Machine Fuel oil
hours expense hours expense
2003 (Sh. ‘000’) (Sh. ‘000’) 2004 (Sh. (Sh. ‘000’)
‘000’)
July 34 640 January 26 500
August 30 620 February 26 500
September 34 620 March 31 530
October 39 590 April 35 550
November 42 500 May 43 580
December 32 530 June 48 680

36
 The annual total and monthly average figures for the year ended 30 June 2003 were as
follows:

Machine hours Fuel oil expense

(‘000’) (Sh. ‘000’)
Annual total 420 6,840
Monthly average 35 570

Required:
(i) Using the high-low method, estimate and interpret the fixed and variable cost elements of the
fuel oil expense.
(ii) Using the results in (i) above, predict the fuel oil expense for November 2004 if experience
indicates that 41,000 machine hours will be used.
(iii) Briefly explain any two limitations of High-low method of cost estimation that may be
overcome by using simple linear regression analysis.

CHAPTER 4
COST ACCUMULATION

DEFINITION
Cost accumulation is the use of an accounting system to collect and maintain a database of the
expenses incurred by a business in the course of its operation. The two main forms of cost
accumulation are
a) a job order system where direct materials, staffing and overhead costs are collected under
assigned job number
b) A process costing system where costs are maintained and associated with a particular cost center.

ACCOUNTING FOR MATERIALS AND INVENTORY

MATERIAL COSTING
37
Inventory consists of raw materials, W.I.P, consumer goods and spare parts etc.
Material costing entails the study of the inventory control systems of the items.

Stock costs
i) Purchase costs
Actual amount paid to the supplier of the stock item.
ii) Ordering costs
Costs of obtaining inventory Include
a) Clerical and admin cost associated with purchasing and receiving goods.
b) Transportation costs from supplier
iii) Holding costs
Are costs incurred as a result of keeping inventories of stores
It depends in quantities held may include:-
a) Cost of storage and stores operation e.g. rent and storage spares, salaries for staff.
b) Insurance costs – the higher the rate for inventory held the higher the premium.
c) Cost of capital – opportunity cost of capital held in the stocks
d) Risks of deterioration / deterioration cost.
iv) Stock – out costs.
Arises where stocks kept are low which may lead to the company not being able to satisfy
demand since stocks are not enough
These costs include:-
a) Lost contribution due to unrealized sales.
b) Loss of future sales due to dissatisfied customers.
c) Loss of goodwill
d) Cost of production stoppage
e) Extra cost of urgent orders.
v) Optimal stock level
Stocks held should be maintained at optimal levels to help regulate the GNL of costs due to
problem of overstocking and undertaking.

This levels will help determine when the order, how much to order, the quantity to be held. These
levels include:-
a) The re-order level
This is that point once reached and order was to be placed with the supplier. It is the quantity in stocks
that goods will be ordered to avoid stock-outs. It is determined by considering the expected the
expected demand during re-order or lead time.

This is the amount that will be consumed during the time for waiting for deliveries. It should satisfy
the highest demand.

Recorder = max .consumption × max. Reorder period.

b) Maximum Stock level

The highest quantity of stock that can be held at any particular time .Stocks may not be allowed to go
beyond this level.
38
Max. Stock Level = re-order level + order quantity - (Minimum consumption × Min.re-order period)

c) Minimum stock levels

This is the lowest quantity of stocks that should be held. Stocks should not be allowed to fall below
this level. Also known as buffer level

Max. Stock = re-order + re-order - (Normal × Normal)

Level level quantity consumption lead time

Reorder level = Maximum Consumption x Maximum Re-order period

280000 x 5=1,400,000 units

Minimum Stock Level = Re-order level (Normal cons. ×Normal lead-time)

1,400,000 – (200,000 ×4) =600 units

Maximum Stock level = Reorder level + Qty. demanded – (Min stock ×Min. lead-time)
= 1,400,000 + 5,000 – (50,000 ×3)
= 1,381,000 units

STOCK VALUATION
In a period stocks are normally purchased at different price and for product costing purposes and
profit determination stock have to be appropriately valued. This is because when stocks are
transferred to the stores they loss their identity and the issue price may not be accurately determined
because they are many in the store.

There are two systems of stock valuation i.e.

a) Periodic stock take system /physical stock takes
This involves actual counting, checking and verification of stock available in the stores at the end
of the period. The stock will normally be determined after stock take to enhance accuracy,
normally close down for the stock take exercise.
b) Perpetual / Continuous system
A transaction system where stock records are maintained as per transaction each receipt or issue
of stock is recorded and stock records. Therefore readily available and this help address the
problem of overstocking/under stocking.

To enhance accuracy each stock item must have its own stock record where the transactions will be
recorded. There are several methods which can be used to maintain records for valuation purposes.
These methods have been discussed below.

1) First in first out (FIFO)

Accounting: Method of inventory valuation based on the assumption that goods are sold or used in
the same chronological order in which they are bought. Hence, the cost of goods purchased first (first-
in) is the cost of goods sold first (first-out). During periods of high inflation-rates, the FIFO method

39
yields higher value of the ending inventory, lower cost of goods sold, and a higher gross profit (hence
the higher taxable income) than that yielded by the last-in first-out (LIFO) method. The 'in' office
basket is an illustration of FIFO method

ILLUSTRATION
NyaliMbali Ltd. are retailers who sell ceramic tiles. During the months of July to September 2000,
there were price fluctuations. Due to the above problem the company had to adjust its selling prices.

The following transactions took place during the period.

3 July Opening stock was 5,000 tiles valued at Sh 825,000.
10 July Orders placed with the company increased, so extra tiles had to be
obtained from Mombasa. Therefore 22,000 tiles were purchased at a cost Sh
140 each but in addition, there was a freight and insurance charge of Sh 5 per
tile.
31 July During the month 20,0000 tiles were sold at a price of Sh 220 each.
4 August A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.
30 August The sales for the month of August were 14,000 tiles at a selling price of Sh
230 each.
1 September A further 24,000 tiles were purchased at a cost of Sh 195 each.
30 September 270,000 tiles were sold during September at price of Sh 240 each.

The cost accountant of NyaliMbali Ltd decided he would apply first-in-first-out basis.

Required:
(i) A stores ledger account using first-in-first-out method and showing stock values at 30
September 2000.

SOLUTION
NyaliMbali Ltd
Stores Ledger Account for July to September 2000 (Using FIFO Basis)
DATE RECEIPTS ISSUES BALANCES
Year Units Cost/ Value Unit Cost/ Value Units Cost/ Value
2000 unit (Shs) unit (Shs) unit (Shs)
July 3 5000 165 825,000
July 10 22,000 145 3,190,000 22,000 145 3,190,000
27,000 4,015,000
July 31 - - - 5,000 165 825,000
15,000 145 2,175,000
20,000 3,000,000 7,000 145 1,015,000
Aug 4 14,000 175 2,450,000 14,000 175 2,450,000
21,000 - 3,465,000
Aug 30 7,000 145 1,015,000
7,000 175 1,225,000
14,000 2,240,000 7,000 175 1,225,000
Sept 1 24,000 195 4,680,000 24,000 195 4,680,000
31,000 5,905,000
Sept 30 7,000 175 1,225,000
20,000 195 3,900,000
27,000 5,125,000 4,000 195 780,000

40
Totals 60,000 10,320,000 61,000 10,365,000

Sales: 31 July: 20,000 x 220 4,400,000

30 August: 14,000 x 230 3,220,000
30 September: 27,000 x 240 6,480,000
14,100,000

2) Last in first out (LIFO)

Accounting: Method of inventory valuation based on the assumption that the goods purchased most
recently (the last in) are sold or used first (the first out). The remaining items are assumed to have
been purchased at successively-earlier periods. In this method, value of the inventory at the end of an
accounting period is based on the value of items purchased earliest. During periods of high inflation
rates, the LIFO method yields lower value of the ending inventory, higher cost of goods sold, and a
lower gross profit (hence lower taxable income) than that yielded by the application of the first-in,
first-out (FIFO) method. During prolonged inflationary periods, however, LIFO method can seriously
understate the value of inventory because the cost of replacing it would be much higher than the value
shown in accounts. The 'Out' office-basket is an illustration of LIFO method.

ILLUSTRATION
The following information relates to item P003 stocked by 2000 products Ltd for the month of April
2012:

Receipts Issues
Date Units Units Unit cost (Sh)
April3 2,400 18
4 3,200
6 2,600 20
12 2,700
14 3,000 22
18 2,800 21
20 2,200
22 2,600 23
25 3,800
26 3,100 24
27 2,500 25
28 3,200 26
29 6,900

The closing balance for March 2012 was a batch of 3,000 units received at a unit price of Sh 19.

Required:
a) Stores perpetual inventory record for item P003 for May 2012 under LIFO system of stores
issues.

41
 b) Closing stock valuation.

SOLUTION
(a)

2000 Products Ltd

Store Perpetual Inventory Record for item P0003 for April 2000 Using LIFO
DATE RECEIPTS ISSUES BALANCE
Year Units Cost/Unit Value Units Cost/Unit Value Units Cost/Unit Value
2000
April Shs Shs Shs Shs Shs Shs
1 3,000 19 57,000
3 2,400 18 43,200 - - - 2,400 18 43,200
5,400 100,200
4 - - - 2,400 18 43,200
800 19 15,200
3,200 58,400 2,200 19 41,800
6 2,600 20 52,000 - - - 2,600 20 52,000
4,800 93,800
12 - - - 2,600 20 52,000
100 19 1,900
53,900 2,100 19 39,900
14 3,000 22 66,000 - - - 3,000 22 66,000
5,100 105,900
18 2,800 21 58,800 - - - 7,900 - 164,700
20 - - - 2,200 21 46,200 5,700 - 118,500
22 2,600 23 59,800 - - - 8,300 - 178,300
25 - - - 2,600 23 59,800
600 21 12,600
600 22 13,200
3,800 85,600 4,500 - 92,700
26 3,100 24 74,400 - - - 7,600 167,100
27 2,500 25 62,500 - - - 10,100 229,600
28 3,200 26 83,200 - - - 13,300 312,800
29 - - - 3,200 26 83,200
2,500 25 62,500
1,200 24 28,800
6,900 174,500 6,400 - 138,300
TOTALS 22,200 - 499,900 18,800 418,600

b)
Valuation of Closing Stocks

Units Cost/Unit Amount

Shs Shs
2,100 19 39,900

42
 2,400 22 52,800
1,900 24 45,600
6,400 138,300

3) Weighted Average
Under this method the price of material issued is determine by computing the average price of all
items held in stock.
The quantity for each batch are considered when calculating the average price, the average price
is calculated by dividing the total cost of stock items held by the total quantities available.

Weighted average price = Total cost of all items held in stock

Number of stocks items available in store

ILLUSTRATION
NyaliMbali Ltd. are retailers who sell ceramic tiles. During the months of July to September 2000,
there were price fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 July Opening stock was 5,000 tiles valued at Sh 825,000.
10 July Orders placed with the company increased, so extra tiles had to be obtained from
Mombasa. Therefore 22,000 tiles were purchased at a cost Sh 140 each but in
addition there was a freight and insurance charge of Sh 5 per tile.
31 July During the month 20,0000 tiles were sold at a price of Sh 220 each.
4 August A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.
30 August The sales for the month of August were 14,000 tiles at a selling price of Sh 230 each.
1 September A further 24,000 tiles were purchased at a cost of Sh 195 each.
30 September 270,000 tiles were sold during September at price of Sh 240 each.

The cost accountant of NyaliMbali Ltd decided he would apply weighted average method
Required:
(i) A stores ledger account using weighted average method and showing stock values at 30
September 2000.

SOLUTION
NyaliMbali Ltd
Stores Ledger Account for July to September 2000 (Using the Weighted Average Approach)
Date RECEIPTS ISSUES BALANCES
Year Units Cost/ Value Unit Cost/ Value Units Cost/ Value
2000 unit (Shs) unit (Shs) unit (shs)
July 3 - - - - - - 5,000 165 825,000
July 10 22,000 145 3,190,000 - - - 22,000 145 3,190,000
27,000 149 4,015,000

July 31 - - - 20,000 149 2,974,074 7,000 149 1,040,926

Aug 4 14,000 175 2,450,000 - - - 14,000 175 2,450,000

21,000 - 3,490,926
Aug 30 - - - 14,000 166 2,327,284 7,000 166 1,163,642

43
 Sept 1 24,000 195 4,680,000 24,000 195 4,680,000
31,000 188 5,843,642
Sept 30 - - - 27,000 188 5,089,624 4,000 188 754,018

Totals 60,000 10,320,000 61,000 10,390,982

4) Simple Average cost
The price of material issued is determined as an average prices existing in stocks. Quantities will not
be considered when calculating average price.
Issued quantities reduces quantity of earlier purchases receipt once the issued quantity is more than
the quantity in the patch, the price of the patch is removed from the existing prices.

Average price = Total of Existing Price

No of prices

ILLUSTRATION
A company records the following transactions concerning the major products during the first quarter
of the year 2012
RECEIPTS
Date Quantity Price
January 2 2000 25
February 7 1000 27.50
March 25 1600 30

ISSUES
January 9 800
February 14 800
February 17 600
March 9 400
March 28 800

Required;-
A stores ledger card using the simple average method

STORES LEGDGER CARD USING SIMPLE AVERAGE METHOD

Date RECEIPTS ISSUES BALANCES
Quantity Price/unit Amount Quantity Price/unit Amount Quantity Amount
January 2 2000 25 50000 - - 2000 50000
9 - - - 800 25 20000 1200 30000
February 7 1000 27.5 27500 - - - 2200 57500
14 - - - 800 26.5 20800 1400 36700
17 - - - 600 26.5 15600 800 21100
March 9 - - - 400 27.5 11000 400 9750
25 1600 30 48000 - - - 2000 57750
28 - - - 800 28.75 23000 1200 34750

Standard Cost Method

It is a predetermined cost at the beginning of the period.

44
 All issues during the period will be valued at the standard price. The standard price will only consider
the expected purchase price. If the expected purchase is expected to be 20.25 the standard price of
23/= can be set and this is the price of all issues

ILUSTRATION
Consider the following
January Details Units Cost/Unit
4 Receipt 5200 80
6 Issue 4800 -
9 Receipt 4800 92
15 Issue 3600 -
16 Receipt 3600 96
17 Issue 2880 -
19 Issue 1920 -
23 Receipt 4800 104
25 Issue 1840 -
27 Receipt 3200 108
31 Issue 6000 -

The opening balance was 2000 units valued at sh.80 per unit

Required
Stores ledger card using standard price method if the standard issue price is sh.95

SOLUTION
Date RECEIPT ISSUE BALANCE
January Quantity Cost/Unit Amount Quantity Cost/Unit Amount Quantity Amount
1 - - - - - - 2000 160000
2 5200 80 416000 - - - 7200 576000
6 - - - 4800 95 456000 2400 120000
9 4800 92 441600 - - - 7200 561600
15 - - - 3600 95 342000 3600 219600
16 3600 96 345600 - - - 7200 565200
17 - - - 2880 95 273600 4320 291600
19 - - - 1920 95 182400 2400 109200
23 4800 104 499200 - - - 7200 608400
25 - - - 1840 95 174800 5360 433600
27 3200 108 345600 - - - 8560 739200
31 - - - 6000 95 570000 2560 209200

Special cases in stock valuation

1) Carriage Inwards
The cost of stock includes the purchases cost plus any other incidental cost incurred to bring stock
to their current or saleable state which includes insurance of goods in transit.

45
2) Returns
a) Sales Returns / Returns in words
Sales are issues to production recorded on the issue side of the stocks ledger and therefore when
returned should be recorded at the receipt side at the price issued.

b) Purchases Returns/ Return outwards

Purchases are recorded on the receipt side. The returns should be recorded on the issue column at
the price purchases.

3) Losses
Stock losses if identified after stock counts should be adjusted so that the a/c reflects the actual
quantity losses will be recorded on the issue column and valued consistently with the method in
use.

INVENTORY CONTROL PROCEDURES

Major Types of Inventory Control Systems
There are two broad of inventory control systems, the Reorder Level and the Periodic Review
systems. These systems are examined below but naturally many hybrid systems exist in practice and
many variants of the basic types will be found.

Reorder Level System.

This system is also known as the two-bin system. Its characteristics are as follows:
a) A predetermined re-order level is set for each item.
b) When the stock level falls to the re-order level, a replenishment order is issued.
c) The replenishment order quantity is invariably the EOQ.
d) The ‘two-bin’ system comes from the simplest method of operating the system whereby the
stock is segregated into two bins. Stock is initially drawn from the first bin and a
replenishment order issued when it becomes empty.
e) Most organizations operating the re-order level system maintain stock records with calculated
re-order levels which trigger off the required replenishment order.

Basic Terminology
Brief definitions of common inventory control terms are given below
a) Lead or procurement time. The period of time, expressed in days, weeks, months, etc. between
ordering (either externally or internally) and replenishment, i.e. when the goods are available for
use.
b) Demand. The amount required by sales, production, etc. Usually expressed as a rate of demand
per week, months or year. Estimates of the rate of demand during the lead time are critical factors
in inventory control systems.
c) Economic Ordering Quantity (EOQ) or Economic Batch Quantity (EBQ). This is a calculated
ordering quantity which minimizes the balance of cost between inventory holding costs and
reorder costs.
d) Physical stock. The number of items physically in stock at a given time.
e) Free stock. Physical stock plus outstanding replenishment orders minus unfulfilled requirements.
f) Buffer Stock or Minimum Stock or Safety Stock. A stock allowance to cover errors in forecasting
the lead time or the demand during the lead time.
46
g) Maximum Stock. A stock level selected as the maximum desirable which is used as an indicator
to show when stocks have risen too high.
h) Recorder level. The level of stock at which a further replenishment order should be placed. The
reorder level is dependent upon the lead time and the demand during the lead time.
i) Reorder Quantity. The quantity of the replenishment order. In some types of inventory control
systems this is the EOQ, but in some other systems a different value is used.

A Simple Stock Situation Illustrated.

The figure below shows a stock situation simplified by the following assumptions: regular rates of
demand, a fixed lead time, and replenishment in one batch.

Slope indicates
AverageMaximum
Anticipated Rates
Reorder level of Demand
(700 units)

800 -
Reorder
700 -
Quantity
(usu. EOQ)
600 -
In this case
Stock level

500 - 600 units

400 -
300 -
200 -
100 - Safety Lead Time
stock (5 wks)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Time (in days or week etc)

Notes:
a) It will be seen from figure above that the safety stock in this illustration is needed to cope with
periods of maximum demand during the lead time.
b) The lead time as shown is 5 weeks, the safety stock 200 units, and the reorder quantity 600 units.
c) With constant rate of demand, as shown, the average stock is the safety stock plus ½ Reorder
quantity, for example, in figure above the average stock is:
200 + ½ (600) = 500 units.

ILLUSTRATION
A simple manual reorder system illustrated.
The following data relate to a particular stock item.
Normal usage 110 per day
Minimum usage 50 per day
Maximum usage 140 per day
47
 Lead time 25-30 days
EOQ (Previously calculated) 5000

Required;
Calculate various control levels

SOLUTION
Using this data the various control levels can be calculated
Re-order Level = Maximum Usage ×Maximum Lead Time
= 140 × 3
= 4,200 units

Minimum Level = Re-order Level – Average Usage for Average Lead Time
= 4.200 – (110 × 27.5)
= 1,175 units

Maximum Level = Re-order Level + EOQ – Minimum Anticipated Usage in Lead Time
= 4,200 + 5,000 – (50 ×25)
= 7,950 units

ECONOMIC ORDER QUANTITY (EOQ)

This is that quantity that is most economical to order. It is the quantity that minimizes the total
inventory cost of holding and ordering.
It is that size of an order that gives the maximum consumption.
It is obtaining and maintaining inventory at optimal levels.

NB: purchase cost is part of inventory cost. However under EOQ purchase price is assumed to be
constant irrespective of quantity ordered.
It is also assumed that the company will not experience stock out therefore the purchase cost and
stock-out will be ignored under EOQ

To be able to calculate a basic EOQ certain assumptions are necessary.

a) That there is a known, constant stockholding cost.
b) That there is a known, constant order cost.
c) That rates of demand are known and constant.
d) That there is a known, constant price per unit, i.e. there are no price discounts.
e) That replenishment is made instantaneously, i.e. the whole batch is delivered at once.

NOTE:
a) It will be apparent that the above assumptions are somewhat sweeping and they are good reason
for treating any EOQ calculation with caution.
b) The rationale of EOQ ignores buffer stocks which are maintained to cater for variations in lead
time and demand.

48
The EOQ Formula
It is possible, and more usual, to calculate the EOQ using a formula. The formula method gives an
exact answer, but do not be misled into placing undue reliance upon the precise figure. The
calculations are based on estimates of costs, demand, etc. which are, of course, subject to error. The
derivation of the EOQ formula is given below;-

Derivation of EOQ model

a) Graphic method

Total costs

Holding cost
TC Cost

Ordering cost

Q=EOQ Quantity (Q)

Total cost will be minimized when:-

Holding cost = ordinary cost
𝑄 𝐷
𝐶𝑙 = 𝐶0
2 𝑄
2𝐷𝐶0
Q2 = 𝐶𝑙
2𝐷𝐶0
Therefore EOQ model = �𝑄 = � �
𝐶𝑙

b) Calculus approach
Total cost = ordering cost + purchase costs + holding costs
𝐷 𝑄
TC = 𝑄 𝐶0 + 𝐷𝑐 + 𝐶𝑙
2

𝛿𝑇𝐶 −𝐷𝐶𝑂 1
FOC 𝛿𝑄
= − 𝑄2
= 𝐶
2 𝑙
=0

49
 1 𝐷𝐶𝑂
𝐶𝑙 = 2
2 𝑄

2.𝐷𝐶𝑂
Q2 = 𝐶𝑙

2𝐷𝐶𝑜
=Q=� 𝐶𝑙

𝛿 2 𝑇𝐶 2𝐷𝐶𝑜
SOC = 𝛿𝑄 2
= 𝑄3

But D, Co, Q ≥ 0
𝛿 2 𝑇𝐶
Thus 𝛿𝑄 2
> 0 (+ve)

TC is minimized when
2𝐷𝐶𝑜
Q=� 𝐶𝑙

ILLUSTRATION
A company uses 50,000 widgets per annum which are sh.10 each to purchase. The ordering and
handling costs are sh.150 per order and carrying costs are 15% of purchase price per annum, i.e. it
costs sh.1.50 p.a. to carry a widget in stock (sh.10 x 15%).

To graph the various costs involved the following steps are necessary:
Where
Total Costs per annum = Ordering Cost per annum + Carrying Cost per annum.

Where
Ordering cost per annum = No. of orders ×sh. 1.50

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
No. of orders =
𝑂𝑟𝑑𝑒𝑟 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦

(For example, if the order quantity was 5,000 widgets,

50,000
No. of orders = = 10
5,000

Ordering cost per annum = 10 ×sh150 = sh.1,500

And

50
 Carrying cost per annum = average stock level × sh. 15
𝑜𝑟𝑑𝑒𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Average stock level =
2

(For example if the order quantity is 5,000)

5,000
Carrying costs p.a. = ×sh. 1.15 = sh. 3,750
2

Based on the above principles, the following table gives the cost for various order quantities.
Column I II III IV V VI
Order Average No. Annual Ordering Average Stock Holding Total Stock
Quantity of orders p.a. Cost Stock Cost p.a.
50000 Col. II x sh,150 Col. I Col. IV x £1.5 Cols III + V
Col. I Sh. 2 Sh. Sh.

1,000 50 50×150=7,500 1000/2=500 500×1.5=750 7500+7508,250

2,000 25 25×150=3,750 2000/2=1,000 1000×1.5=1,500 3750+1500=5,250
3,000 16 2/3 16 2/3×150=2,500 3000/2=1,500 1500×1.5=2,250 2500+2250=4,750
4,000 12 ½ 12 1/2×150=1,875 4000/2=2,000 2000×1.5=3,000 1875+3000=4,875
5,00 10 10×150=1,500 5000/2=2,500 2500×1.5=3,750 1500+3750=5,250
6,000 8 1/3 8 1/3×150=1,250 6000/2=3,000 3000×1.5=4,500 1250+4500=5,750

We have Co = sh. 150; D = 50,000 widgets; Cc = sh. 10 x 15% = sh. 1.50 per widget.
2 𝑥 150 𝑥 50,000
This gives EOQ = �
1.5

= √10,000

= 3162 widgets.

GRAPHICALLY
Table 1 Ordering and stock Holding Costs for various Order Quantities
The costs in Table 1 can be plotted in a graph and the approximate EOQ ascertained.

9000
8000
7000
6000
Total Cost
5000
costs

(Col VI)
4000 Stock Holding
3000 cost (Col V)
2000
1000 Ordering cost
0-
1000 2000 3000 4000 5000 6000 7000
EOQ Order size
51
The figure above represents a Graph of data in the Table above
From the graph it will be seen that the EOQ is approximately 2,300 widgets, which means that an
average of slightly under 16 orders will have to be placed a year.

Notes:
a) From a graph closer accuracy is not possible and is unnecessary anyway.
b) It will be seen from the graph that the bottom of the total cost curve is relatively flat, indicating
that the exact value of the EOQ is not too critical.

ILLUSTRATION
A company had annual demand of 800,000 units the purchase per unit is 80 while the cost of pressing
are order is Sh.4,000. The annual inventory holding cost is 5% of the inventory value. Currently the
company has been purchasing 20000 units time, they place an order.

Required;
i) Calculate the total cost of current inventory policy
ii) Calculate the EOQ
iii) Calculate the cost savings if the company adopts EOQ policy

SOLUTION
i) Total inventory cost = ordering cost + purchasing + holding cost for stocks out cost.

D Q
TC = Co + DC + ch + stockout cos t
Q 2

 800,000   80,000 
= x 4000  +  x(5% x80 ) + (800,000 x80 )
 80,000   2 

= 40,000 + 160,000 + 64,000,000 = 64,200,000

2 Dco 2 x800,000 x 400

EQQ = = = 40,000units
ch 4

ii) Cost selling = Total Cost using – Total Cost using

Current policy EOQ

 800,000 x 4000   40,000 

T .C =   + (800,000 x80 ) +  x5% x100 
 40,000   2 

52
= 64,160,000

Cost saving = 64,200,000 – 64,160,000

= Sh40,000
Economic Order Quantity in the Presence of Discounts
A company may qualify for quantity discounts if it purchases stock items in bulk. This will have an
effect of rendering the effective purchase cost.
In determining whether the company should take advantage of quantity discount we compare the total
cost of using the E.O.Q without discount and the total cost after taking the advantage of discount.
A particularly unrealistic assumption with the basic EOQ calculation is that the price per item remains
constant. Usually some form of discount can be obtained by ordering increased quantities. Such price-
discounts can be incorporated into the EOQ formula, but it becomes much more complicated. A
simpler approach is to consider the costs associated with the normal EOQ and compare these costs
with the costs at each succeeding discount point and so ascertain the best quantity to order.

Steps
1. Compute EOQ without discounts and hence use the EOQ to compute total costs.
2. Using the discounted purchase cost and more stock to qualify for it compute the total cost (C.
3. Compare the Total Cost in step 1 or 2 and make recommendations

Financial Effects of Discounts

Price discounts for quantity purchases have three financial effects, two of which are beneficial and
one adverse.
a) Lower price item.
b) The larger order quantity means that fewer orders need to be placed so that ordering costs are
reduced.

Adverse Effects
a) Increased costs arise from the extra stockholding costs caused by the average stock level being
higher due to the larger order quantity.

ILLUSTRATION
EOQ with Discounts
A company buys 400 units of an item at the cost of Sh. 5000 at unit at an ordering cost of Sh 2000 at
order. The carrying cost has been determined to be 20% of the costs of average cost. The company
then received 2% discount offer for purchases of 100 or more unit.

Required;
Step I
Determine the best inventory for these items.
√2Dco
𝐸𝑂𝑄 =
Ch

53
 20
𝐶ℎ = x 5000 = 1000
100

√2 x 400 x 2000
𝐸. 𝑂. 𝑄 = = 40 Units
1000

𝐷𝑐𝑜 𝑄
𝑇. 𝑐 = + 2𝑐𝑏 + 𝐶ℎ
𝑄 2

400 40 𝑥 1000
� 𝑥 2000� + (400 𝑥 5000) + � � = 2,040,000
40 2

Step II
Taking the discount
C = 0.9 ×5000 = 4900
Ch = 0.2 ×4900 = 980
Q = 100 units
Co = 2000
𝐷𝑐 𝑄
𝑇. 𝑐 = + 𝐷𝑐 + 𝐶𝑙
𝑄 2

400 100 × 980

𝑇. 𝑐 = � × 2000� + (400 × 49000) + � � = 2,017,000
100 2

Step III
Recommendation – The Company should take advantage of the discount.

ILLUSTRATION
Bora Supermarket carries on its operation in Nakuru Town. On annual basis, it orders 480,000 pens
from a Nairobi based distributor. A packet of twenty four pens delivered to Bora’s warehouse costs
Sh.480 including transport charges. The supermarket borrows money from BCD Bank at an interest
rate of 10% per annum to finance its inventories.

The supermarket also incurs Sh.1,500 to place an order for the pens and Sh.8 carrying costs for each
pen

Required:
i) Economic order quantity (EOQ) for the pens.
ii) Total costs at the economic order quantity.
iii) For orders of 72,000 pens and above, the distributor has offered a discount rate of 10% on the
delivery price

Advise the management of the supermarket on whether to take advantage of the discount offer.

SOLUTION

54
i) D = 480,000 pens

480
C= = 20
24

Co = 1500

Ch.= 8 + (10% x 20) = Sh. 10

√2Dco
𝐸𝑂𝑄 =
Ch

�2 × 480,000 × 1500
𝐸. 𝑂. 𝑄 = = 1,200 Units
10

Total cost. = Purchase cost. + Ordering cost. + Holding cost

ii) Total cost = Purchase Cost + Ordering Cost + Holding Cost

480,000 1200 × 10
E.O.Q= 48,000 × 20 + × 1,500 +
12 2

= Sh 9,720,000

iii) Advice to the management

P = 0.9 ×20 = 18
D = 480,000
C = 18
Q = 7,200
Ch. = 8 + (10% x 18) = 9.8

480,000 480,000 72,000 𝑥 9.8

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = � 𝑥 18� + 𝑥 1500 + = 9,002,800
100 72 2

Difference= sh.9,720.000 – 9,002,800=sh.717,200

The company should take advantage of the discount because is more economical

Safety Stock and Re-Order Levels

So far it has been assumed that the demand and the lead time have been known with certainty. In such
circumstances the re-order level is the rate of demand times the lead time.
This means that regardless of the length of the lead time or of the rate of demand no buffer stock is
necessary when there are conditions of certainty.

55
This results in a stock profile as follows:

Reorder Level
Stock Level

Lead Time Time

Re-order level in conditions of certainty (no safety stock)

It will be seen from the graph above that, in conditions of certainty, the re-order level can be set so
that stock just reaches zero and is then replenished. When demand and/or lead time vary, the re-order
level must be se so that, on average, some safety stock is available to absorb variations in demand
and/or lead time. In such circumstances the re-order level calculation can be conveniently considered
in two parts:
a) The normal or average rate of usage times the normal or average lead time (i.e. as the re-order
level calculation in conditions of certainty) Plus.
b) The safety stock.

Safety Stock Calculation by Cost Tabulation

The amount of safety stock is the level where the total costs associated with safety stock are at a
minimum. That is, where the safety stock holding plus the stock-out cost is lowest. (It will be noted
that this is a similar cost situation to that previously described in the EOQ derivation). The appropriate
calculations are given below based on the following illustration.

ILLUSTRATION
An electrical company uses a particular type of thermostat which costs £5. The demand averages 800
p. a. and the EOQ has been calculated at 200. Holding costs are 20% p.a. and stock out costs have
been estimated at sh.2 per item that is unavailable. Demand and lead times vary, but fortunately the
company has kept records of usage over 50 lead times as follows:

(a) (b) (c)

Usage in lead time Number of times Recorded 𝒃
Probability 𝟓𝟎

56
 25-29 units 1 .02
30-34 units 8 .16
35-39 units 10 .20
40-44 units 12 .24
45-49 units 9 .18
50-54 units 5 .10
55-59 units 5 .10
Total 50 1.00
From the above the re-order level and safety stock should be calculated

SOLUTION
Using the mid- point of each group calculate the average usage in the lead time.
x t tx
27 1 27
32 8 256
37 10 370
42 12 504
47 9 423
52 5 260
57 5 285
50 2,125

2125
Average usage = = 42.5
50

ECONOMIC BATCH QUANTITY (EBQ)

This is a model for manufacturing firms which produces component for use in the production of a
finished product.
The production technology is such that the production rate of the component is higher than the usage
rate. The balance of stock at the end of each day is put in storage facilities and it assumed to the max.
Stock level at the end of the production
The components are these produced in batches. Production stop for some time then started again
hence forth.
EBQ is the quantity to be produced per production run in order to minimize total cost model policy
variables include:-
i) Economic batch quantity
ii) Length of production run
iii) Max stock level
iv) Length of the break between production runs
v) Reorder level
vi) Associated costs including
vii) Variable cost of production
viii) Holding cost of inventory items
ix) Set-up costs i.e. cost of mobilizing production resources e.g. order of Rm.

Derivation of EBQ
57
Let R = set up costs per set up
S = Set up cost per set up

C = variable production cost per unit

Ch= Holding cost per unit per annum
i = Holding cost as a percentage of variable production costs per units

Ch = Ci
Q = economic batch quantity
P = production rate in units per day or any other period
U = usage rate in units per day or any other period
d = Length of production run in days or any other period
B = Length of the break between production runs

Then:
TC = Total variable production costs + set up costs + holding costs

𝑅
TC = RC + 𝑆 + Average inventory x Cl
𝑄

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑠𝑡𝑜𝑐𝑘 𝑙𝑒𝑣𝑒𝑙

But average inventory =
2
Maximum stock level = (P-U)d2
d = Q/P

𝑄 𝑈
Therefore maximum stock level = (𝑃 − 𝑈) 𝑜𝑟 �1 − � 𝑄
𝑃 𝑃

𝑈
�1− � 𝑄
𝑃
Therefore average inventory = 2

𝑅 𝑄 𝑢
TC = RC + 𝑆 = 𝐶 �1 − �
𝑄 2 𝑙 𝑃

𝛿𝑇𝐶 −𝑅𝑆 1 𝑈
FOC = + 𝐶 �1 − � = 0
𝛿𝑄 𝑄2 2 𝑙 𝑃

1 𝑈 𝑅𝑆
= 𝐶𝑙 �1 − � =
2 𝑃 𝑄2

2𝑅𝑆
Q2 = 𝑈
𝐶𝑙�1− �
𝑃

2𝑅𝑆
EBQ = � 𝑈
𝐶ℎ �1− �
𝑃

ILLUSTRATION

58
ABC Ltd manufactures components X for use in an assembly the usage rate of the component is lower
than the production rate.
The following data has been used for the components.
Production rate = 4000 Units per day
Usage rate = 1200 unit
Inventory holding cases = Sh. 20 @ unit @ annum
Unit variable production costs = Sh. 2000
Set-up cost = Sh. 110,000
Acquisition lead time = 10 Working days
Days in a year = 250 working days

Required;-
Formulate the best inventory policy for component X

SOLUTION
Inventory Policy
2𝑅𝑠 2 𝑥 300,000 𝑥 110,000
1) EBQ = �
𝐶𝑙�1−𝑢�
= � 200�1−1200� = Sh 68,660.65 Units
𝑝�
4000�

2) Length of production run

𝑄 68,660
d= = = 17 days
𝑃 4000

3) Max. stock level = (p-u) d

(4,000 – 12,000) 7
436,000 Units

𝑀𝑎𝑥 𝑠𝑡𝑜𝑐𝑘 𝑙𝑒𝑣𝑒𝑙 47,600

4) Length of break = = = 29 𝑑𝑎𝑦𝑠
𝑈𝑠𝑎𝑔𝑒 𝑟𝑎𝑡𝑒 1,200

5) Re-order level = Usage during lead time

= Usage rate × lead time
= 1,200 ×10
= 12,000 Units

6) Total costs = Set-up cost + Production cost + Holding cost

𝑅 𝑄
= 𝑠 + 𝑅𝐶 + 𝐶𝐿 �1 − 𝑢�𝑝�
𝑄 2

68,660 1,200
= (300,000 𝑥 110) + (20 × ) + 20 �1 − �
2 4,000

=Sh33,686,614

ASSUMPTION OF EBQ

59
 1) The annual requirements are assumed to be constant.
2) The variable production cost are assumed to be constant
3) The holding cost are assumed to be constant
4) The usage rate in units per day and the production rate in units per day to be constant.
5) They are assumed to be no stock out hence no stock out cost

BACK FLUSH
Back-flush accounting is a costing short-cut. It relies on businesses having immaterial amounts of
work-in-progress and it is therefore particularly suitable for businesses operating just-in-time
inventory management. If the amount of work-in-progress is negligible, what is the point in
meticulously valuing it? Fretting that some products might be 25% complete and others 60%
complete, and then adding carefully calculated labour and overheads to these (immaterial) items is a
complete waste of time and effort. That type of accounting is perhaps the modern-day equivalent of
alleged ancient arguments about how many angels could dance on the point of a needle.

In back-flush accounting costs are not associated with units until they are completed or sold. Back-
flush accounting is sometimes called delayed costing, which is a helpful name, as costs are not
allocated to production until after events have occurred.
Standard costs are then used to work backwards to flush out manufacturing costs into production,
splitting them between stocks of finished goods (if any) and cost of sales. No costs, whether material
or conversion costs, are allocated to work-in-progress.

Basically, back flush accounting is when you wait until the manufacture of a product has been
completed, and then record all of the related issuances of inventory from stock that were required to
create the product. This approach has the advantage of avoiding all manual assignments of costs to
products during the various production stages, thereby eliminating a large number of transactions and
the associated clerical labor.

Back flush accounting is entirely automated, with a computer handling all transactions. The back
flushing formula is:
Number of units produced × unit count listed in the bill of materials for each component
= Number of raw material units removed from stock

Back flushing is a theoretically elegant solution to the complexities of assigning costs to products and
relieving inventory, but it is difficult to implement. Back flush accounting is subject to the following
problems:
• Requires an accurate production count. The number of finished goods produced is the
multiplier in the back flush equation, so an incorrect count will relieve an incorrect amount of
components and raw materials from stock.
• Requires an accurate bill of materials. The bill of materials contains a complete itemization of
the components and raw materials used to construct a product. If the items in the bill are
inaccurate, the back flush equation will relieve an incorrect amount of components and raw
materials from stock.

60
 • Requires excellent scrap reporting. There will inevitably be unusual amounts of scrap or
rework in a production process that are not anticipated in a bill of materials. If you do not
separately delete these items from inventory, they will remain in the inventory records, since the
back flush equation does not account for them.
• Requires a fast production cycle time. Back flushing does not remove items from inventory
until after a product has been completed, so the inventory records will remain incomplete until
such time as the back flushing occurs. Thus, a very rapid production cycle time is the best way to
keep this interval as short as possible. Under a back flushing system, there is no recorded amount
of work-in-process inventory.
Back flushing is not suitable for long production processes, since it takes too long for the inventory
records to be reduced after the eventual completion of products. It is also not suitable for the
production of customized products, since this would require the creation of a unique bill of materials
for each item produced.
The cautions raised here do not mean that it is impossible to use back flush accounting. Usually, a
manufacturing planning system allows you to use back flush accounting for just certain products, so
you can run it on a compartmentalized basis. This is useful not just to pilot test the concept, but also to
use it only under those circumstances where it is most likely to succeed. Thus, back flush accounting
can be incorporated into a hybrid system in which multiple methods of production accounting may be
used.

ACCOUNTING FOR LABOUR

Labour costing
Entails analysis of labour related costs, labour remuneration, and recording of labour costs to products
It entails an analysis of the cost of purchasing labour hours and employees services rendered to an
organisation and other cost related to labour. Categories include:-
i. Direct labour
ii. Indirect labour

Direct labour
Refers to employees engaged in the production process and are the ones who make the products. Their
cost form part of direct cost of production e.g. machine operators in a factory etc.

Indirect labour
Refers to employees not engaged in direct production, they support the process. Their costs do not
form part of labour cost of production and treated as production overhead e.g. indirect employees in
the office.

Labour related costs

It may not include actual pay but also other indirect cost related to the organization labour cost
includes:-
1) Cost of labour turnover
2) Cost of idle time
3) Cost of fraud in payroll.

WAGES ALLOCATION
61
Gross rate represents the total pay to an employee however the entire amount paid to direct workers is
to be part of costs for part of product cost purposes because some elements of gross rate will be
treated as labour costs. The elements have been discussed below;-

1. Basic wage
Basic wages is the amount contracted for. There are various methods by which basic wages can be
paid out.

They include
(a) Fixed rate or fixed salary per month or per annum
Here, the employees earn a fixed amount despite the amount of work done. For instance, a
production manager may be allowed a salary of Shs500,000 per month, whether the company
production is at peak or off-peak.
(b) Piece rate or piece work
Under this method, the earnings depend on the level of activity or output achieved and it is
expressed as Earnings = Output (units) x basic rate per unit
Under the piece rate system, there are three schemes of remuneration. These are straight piece rate,
straight piece rate with a guaranteed minimum pay and a differential piece rate.
i) Differential piece rate
ii) Straight piece rate with a guaranteed minimum pay
iii) Straight piece rate

i) Straight piece rate

Here, the basic rate per unit remains constant irrespective of the number of units produced.
For instance, if 200 units are produced at a basic rate of Shs1000 per units, then the earnings
will be
= Shs.1,000 per unit x 200 units
= Shs.200,000

ii) Straight piece rate with a guaranteed minimum pay

Under this scheme, although the employee is paid on the number of units produced, one is
guaranteed of some main wage since there are occasions when production does not take place
due to power failures, machine breakdowns, etc. Therefore, a standard rate is agreed upon for
the production of each unit based upon an expected time to produce one unit and the normal
rate per hour.

iii) Differential piece rate

Here, employees’ basic rate of pay per unit changed as the level of activity changes. Under
differential rate system, the workers time rate is fixed at a higher level than the usual rate of
payment if the output exceeds the expected (usually set) level. The objective of this system is
to provide an incentive to the workers while retaining the simplicity of the system. It is most
appropriate for easily measurable output to which groups of workers contribute e.g. car
assembly lines. The low piece rate is applicable where a worker is not able to achieve the
standard (normal) output and the highest piece rate is for those above standard. It does not

62
 provide the security of a guaranteed minimum wage but has the enhanced incentive of
increased rates for higher production.
If it does not guarantee minimum wages on time basis, this may lead to high wage differential
in the company and consequently demotivation. For this reason, the differential price rate
system as well as many variations of the piece rate system contains a minimum (guaranteed)
pay.

(c) Time rate or time work

Under this method, employees earnings depend on the time spent on the job. Total wages can
be expressed as;
Total earnings = Basic rate per hour × total hours worked
Under this system there are various schemes that may be applied. They include

Flat time rate

Under flat time rate, each worker is paid for the time spent without considering the volume of
production during that period. The basic rate per hour remains constant irrespective of the number
of hours worked. For instance, assume that an employee worked for 200 hours on a specific
assignment. Assume further that the basic rate per hour is Shs100. The total earnings under flat
time rate will be
= Shs100 per hour x 200 hours
= Shs20,000
LABOUR COSTS
Measured day rate
This is where although the employee is paid on the basis of the number of hours worked, before
such payment is made, one must have completed a given piece of assignment.

Graduated time rate

Under this scheme, the rate of pay is adjusted to reflect changes in the cost of living

2. Time keeping
A labour cost control routine should ensure that payments are paid only to employees who have spent
time at the work place and that payments are at agreed rates of pay including overtime premium and
shift premium payments where relevant. Where an employee is paid a fixed sum for an agreed length
of working week, it may be decided by a check by the supervisor that the employee is at work is all
that is necessary.
Where the employee is being paid at the rate per hour for the time spent at work together with
premium rates for overtime work, it is likely that a detailed record of time spent on the premises is
required. This is done by having the employee to register his arrival and departure times.

3. Time analysis
This is usually achieved by having the employee complete a daily or weekly timesheet or by having
job cards or piecework tickets. Where time sheets are issued, the employee records the time analysis
stating how much time was spent on each job and recording idle time. This sheet will then be
authorized by the supervisor. Job cards move with a job as it passes from one employee to another.
There may be time clocks at each work center where the time spent on the job is recorded.

63
Where this routine is used, employees may also be required to clock idle time on an idle time card,
which will be analyzed to determine the cause of idle time. Where payments are made in return for
output units, piecework tickets may be completed which are signed by the supervisor certifying the
number of units claimed. The analysis of employee time will facilitate:
• Correct charge of direct labour cost to each job
• Correct charge of indirect labour cost to cost centers
• Control of labour costs by job and cost center
• Calculation of employee bonus
• Measurement of efficiency

4. Improvement in the differential piece rate system

An improvement of the high day rate system is the measured day work system. This system attempts
to grade workers according to their efficiency and pay them a fixed amount based on which bracket
they fall. For example, a company may have the following efficiency brackets paid at the respective
rates.
Efficiency Bracket Fixed rate
90% to 95% Shs.50,000 per month
96% to 100% Shs.60,000 per month
101% to 105% Shs.70,000 per month

Suppose a worker falls in the 96% to 100% bracket, the actual amount of wages to be paid to him is
Shs.60,000. The challenge here is that some employees may be more or less efficient than graded.
Does the company still pay them the same amount as indicated in the efficiency table? This calls for a
consistent review of the employees’ efficiency and remuneration scheme.
Where, for instance, an employee has performed more efficiently, the company may pay an excess
amount based on the evaluation. Assuming the employee in the same bracket as above achieves 104%
efficiency, the company may decide to pay him/her the basic amount plus an extra amount based on
evaluation i.e

104−100
= Shs.60,000 + ×(70,000 - 60,000)
105−100

4
= Shs.60,000 + ×10,000
5

= Shs.60,000 + 8,000

= Shs.68,000

ILLUSTRATION

Patanisho Quarry Ltd remunerates its casual workers based on each day’s work. Workers are graded
into various efficiency bands after training and then paid a fixed sum according to efficiency bands as
follows.

Efficiency band Wage rate per week

64
 % Sh.
81-90 800
91-100 900
101-110 1,000
111-120 1,100

Additional information;
1. Workers are guaranteed of their fixed pay within their efficiency bands irrespective of the
output achieved.
2. A wage rate of Sh. 700 per week is paid for efficiency levels below 81%.
3. Any excess units of production beyond the upper efficiency band limit are paid at Sh. 5 per
unit.
4. A 100% efficiency level repressing 1,200 units per week.
5. The data for a four-week period for three workers in a given time was as follows:

Weeks
Worker Efficiency band 1 2 3 4
% Units Units Units Units
1 81-90 1,210 860 1,280 1,330
2 101-110 1,220 1,240 1,190 1,250
3 11-120 1,500 1,540 1,390 1,460

Required;
Total earnings for each of the three workers for the four-week period

SOLUTION
Patanisho Quarry Ltd
Total earnings for each of the three workers for four week period
Efficiency band Wage rate Per week Expected Units to be produced
% Sh Sh
≤ 81 700 1,200 960
× 80
100
81-90 800 1,080
1,200
× 90
100
91 – 100 900 1,200
1,200
× 100
100
101 – 110 1,000 1,320
1,200
× 110
100
111 – 120 1,100 1,440
1,200
× 80
100

65
2)
Week 1 Week 2 Week 3 Week 4 Total
Bonus Bonus Bonus Bonus
W1 81-90 1,210-1,080 = 130 - 1,280-1,080 1,330 – 1,080
130×5 - 200 ×5 250 × 5
650 - 1,000 1,250 3,900
W2: 101 -110 0 0 0 0
0 0 0 0
0 0 0 0 0
W3: 111-120 1,500 – 1,440 1,540-1,440 - 1,460-1,440
60×5 100×5 - 20×5
300 500 - 100 900
Total earnings = Basic Wage + Bonus
Worker 1 = [(800 x 3) + 700] + 3,900 = shs .6, 000
Worker 2 = (1,000 x 3) + 900 = shs. 3,900
Worker 3 = (1,100 x 4) + 900 = shs .5,300

5. Overtime Premium
This is the compensation paid to employees in addition to normal wages for hours worked in excess of
normal working hours. The overtime is that time paid for over and above the basic hours for the
period. Overtime premium is the difference between the rate at which normal working hours are paid
and the rate at which overtime hours are paid.

The overtime premium treatment depends on the cause of overtime.

a) If it is normal to work overtime due to general increase in production overtime premium is treated
as indirect wage and charged to production. This will help ensure that units completed during
normal time units completed during overtime carry the same unit cost.
b) If overtime is as a result of customer’s request it should be charged to the customer i.e. overtime
premium will be treated as part of wages for units produced by the customers.

NB: Overtime cost by abnormal conditions e.g. shortage of materials, machine breakdown is at
premium should be expensed transferred to P& L statement

6. Shift Premium
Additional amount paid to an employee for working in a different shift i.e. working night shift instead
of day shift.
It is treated as indirect wage and transferred to over debt cost.

7. Idle time Premium

Idle time is non-predictive time paid for i.e. workers are paid but no goods have been produced e.g.
when there is machine breakdown, power failure or tea breaks. Idle time can either be avoidable or
unavoidable. It could be due to production disruptions whereby there is machine breakdown,
inefficient scheduling of jobs or shortage of raw materials or policy decisions i.e. changes in
production specifications or retraining skills.
Labour costs for paying for hours of avoidable time are costs that simply should not have occurred.
Therefore, they should be written off in the profit and loss account.

66
Unavoidable idle time is that which cannot be helped. It is uncontrollable or unnecessary cost to the
business e.g. tea breaks, unexpected fall in demand for a product or a strike at the suppliers affecting
vital supplies. Unavoidable idle time of direct workers may be included in the cost of products as a
production overhead. All other idle time is treated as period costs.

Idle time ratio = Idle time × 100

Total hours worked

PAY OF INDIRECT WORK

Represents pay for hours worked on other jobs. The amount should be treated as an indirect wage for
the job in consideration. It should be charged as a job or a/c for in as an O/H cost.
An incentive paid to employee to recognize the employees’ efforts during production. For individual
bonus, it will be a/c as part of direct wages since it can be identified as an effort for particular job.
For group bonus the bonus is treated as an indirect wage cost since individual efforts cannot be
identified and also amount is paid to the entire group.

Indirect workers’ pay

Pay to indirect workers e.g. cleaners, supervisors should be treated as indirect wage. However if they
happen to participate in production the pay for time at production will be treated as direct wage.

ILLUSTRATION
Zawadi Ltd is a small company which manufactures a range of plastic commodities.
In order to manufacture a lunch box, the following five manual processes are required:
Process Time required per lunch box Wage rate per hour(sh.)
Minutes
1 15 65
2 25 50
3 10 40
4 30 35
5 20 30

The weekly production target is 7,200 lunch boxes packed in cartons each containing twelve
lunch boxes.
The company’s working week has 40 hours.

Required;-
1. Number of casual workers required for each of the processes
2. Labour cost incurred per week to manufacture 7,200 lunch boxes.

SOLUTION
(i) Number of casual workers required for each processes.
1. 15 × 7200 = 108000 Min = 1800hrs

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 60
= 45 workers

2. 25 × 7200 = 180,000 = 3000 hrs.

= 3000 = 75 workers
40

3. 10×7200 = 72000 = 1200 hrs.

60
=1200hrs
40 = 30 workers

4. 30 ×7200 = 21600 min – 3600 hrs.

60

= 3600
40 = 90 workers

5. 20 ×7200 = 144000 Min – 2400 hrs.

60
2400 Hrs
40= 60 workers

ii) Labour cost

Process = 1800 x 65 = 11700
3000 x 50 = 150000
1200 x 40 = 48000
3600 x 35 = 12600
2400 x 30 = 70,000

Total labour cost = 513000

C Hrs. Normal Over Std. Time Time.

Employee Worked Time Time Time Taken Saved
Moraa 45 42 3 63 45 18
Mogaka 42 42 - 51 39 12

i) Basic Pay = Time worked x Rate/hrs.

Moraa = 42×400 = 16,800
Mogaka = 42 ×400 = 16800
ii) Overtime pay = Overtime x Overtime rate/hr
Moraa = 3 × 400 × 1 1/3 = 1600

iii) Bonus = Time saved x Rate x Hr x 50%

Moraa = 18 × 400 × 50% = 3600
Mogaka = 12 × 400 ×50% = 2400

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iv) Gross wages = Basic pay + Overtime pay + Bonus
Moraa = 16,800 + 1600 + 3600 = 22,000
Mogaka = 16,800 + 2400 + 0 = 19200

v) Cost per flower pot moulded

Moraa: Basic 42 x 400 = 168000
Bonus = 3600
20400

Units produced = 189 – 6 = 183

Cost per unit = Total direct wages = 20,400
Output units 183

= sh.111.50 per unit

Mogaka Basic = 39 ×400 = 15,600

Bonus 2,400
18,000

Units paid = 204 – 4 = 200

Cost per day = 18,000

200
= Sh. 90/unit

LABOUR TURNOVER
It is the number of employees leaving or being recruited in a period of time. It is expressed as a
percentage of the total labour force. It is expressed as;

Labour turnover = Replacement ×100

Average no. of employees in a period

Causes of labour turnover; these causes outline the reasons why an employee may leave an
organization. They include
• Illness and accidents
• Retirement and death
• Rate of payment; the employee may find that the remuneration is not commensurate to the
amount of work done
• Poor working relationship between the management and the employee
• Lack of opportunity for career or lack of job satisfaction

Costs of labour turnover

Costs of labour turnover can be broadly categorized into replacement costs and preventive costs.

69
Replacement costs are costs incurred as a result of hiring a new employee. They include cost of
selection and placement (advertising and interviewing), inefficiencies in new labour, lower
productivity, cost of training, loss of output due to delay in new labour becoming available, increased
wastage and spoilage due to lack of expertise among the new staff, possibility of more frequent
accidents, cost of tools and machine breakages.

Preventive costs are costs incurred in order to prevent employees from leaving an organization.
They include cost of personnel administration in maintaining good relationships and cost of welfare,
services and pension schemes.

INCENTIVE SCHEMES
Employees do not put extra efforts if there is no reward for their efforts. Employers reward workers in
a direct proportion to work accomplished.
In these schemes, workers can earn more if they produce more out and therefore get incentives to
make them produce more.
Grouped into the following categories
1) Direct financial plans
2) Indirect financial plans
3) Plans other than financial

1) Direct financial plans

Are schemes whose compensation is in direct proportion to output efforts.
Compensation of a worker is determined either individually or in a group.
A scheme whose compensation is based on individual performance is known as individual incentive
scheme and where it is made with reference to a group working together is known as group incentive
scheme.
Individual /Premium Bonus Scheme
Are schemes based on individual efforts and thus they provide greater incentive to an individual effort
when compared to group schemes.
The higher the effort, the higher the incentive
It is easier to measure performance since work is individual based. Schemes include:-

Rowan scheme
a) DavidRowan of Glasgow (U.S.A) introduced the scheme, under which time wage is guaranteed as
in the case of Halsey scheme. For the performance of a job, standard time is fixed; otherwise
operation or task is exactly in the same manner as in the case of Halsey scheme. For the hours of
his actual work, the worker gets his time wage; on this point also it doesn’t differ from the Halsey
scheme. The bonus of the worker, who is able to finish the job in less than the allowed time, is
equal to his time wage for that proportion of the time taken as the saved time bears to the time
allowed. In other words, the ratio between the bonus & the time saved is equal to the ratio
between the time taken & the time allowed.

i.e., Bonus Hours = Time Taken

Time Saved Time Allowed

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 Or Bonus hours: Time Saved:: Time Taken: Time Allowed

Advantages
a) Because the premium is proportionate to the time saved, if the rate has been wrongly fixed, the
effect will be less serious. So Rowan scheme is safer than the Halsey scheme, as far as the point
of view of employer is concerned.
b) The worker is in the most advantageous position when 50% of the time allowed is saved by him,
because otherwise his earning per hour will increase at a diminishing rate, if any more time is
saved by him. As a result, the chances of wastage, defectives, breakdown etc. will be less as there
is a limit to speed.
c) Fixed overhead per unit will be lower as a result of higher output.
d) Since both the employer & the employee enjoys the time saved; though proportion is not the same
as in the case of the Halsey scheme, to some extent labour cost also diminishes.
e) Better wage is earned by the employees; their improvement in efficiency is rewarded.

Disadvantages
a) The workers do not like the idea of sharing the savings by both employer & employee, since the
time is saved by the workers. The bonus hours will not exceed the 25% of the time allowed in any
case.
b) Apart from workers efficiency, saving of time depends upon standard of tools, materials &
implements & also upon the working conditions. No useful purpose will be served unless the best
of these are assured.

Purpose of Rowan Premium Bonus Scheme:

• An incentive scheme to reward direct labor for saving time during the production process
• This method rewards the production worker with a proportion of the time saved

ILLUSTRATION
Mr. A is being paid sh.9 per hour. The time allowed to complete a task is 12 hours. The actual time
taken by Mr. A to complete the task is only 8 hours

Required;
Compute the gross pay of Mr. A after completing the task.

SOLUTION
Mr. A’s gross pay
= (8 hours × sh.9) + (Time taken/Time allowed ×Time saved ×Rate per hour)
= (8 hours×sh.9) + (67% × 4 hours × sh.9)
= sh.96.12

A = Time Wages – 7875

Bonus = 7875
B. Time wages – 8640
Bonus – 3/50 x 8640 = 345.6

71
C = 50 × 185 = 9250
Bonus 2/60 x 9250 = 308.33

Halsey bonus scheme (50/50)

F.A. Halsey of the U.S.A. introduced this scheme.
Under this scheme, for performing a job, operation or task, a standard time is specified.
The hourly rate is fixed & the workers are guaranteed so that even if, within the standard time
specified, the job is not completed by them, guaranteed time rate may be received by them.
The worker becomes entitled to bonus, if he is in a position to complete the job in less than the
specified time; bonus being equal to his time wage for 50% of the time saved in addition to the time
wage which he is entitled for the actual time worked.

The total earning is obtained by multiplying the sum of time allowed & time taken by half the hourly
rate.

Advantages:
a) The scheme & the calculation of the remuneration are easily understandable by the worker.
b) As time wage is guaranteed, penalty is not imposed on the slow workers; whereas rewards are
provided to the slow workers for their efficiency.
c) The workers are encouraged to save as much time as possible due to the bonus, because for the
higher time saved bonus will be higher.
d) Employers are enabled to obtain more output from the workers under the scheme, & as a result of
that, per unit fixed overhead get diminished.

Disadvantages:
a) Since the employers & employees share the savings in time, this may not be liked by many
employees’ organizations & they argue that the workers should get the entire benefits as the
savings is done by them.
b) Compared to the other incentive plans, the workers are being offered less incentives under this
scheme.
c) Apart from the workers, savings in time also depends upon the tool’s standards, materials, and
machinery & working conditions. So the desired result cannot be expected unless the best of these
are assured.
d) Chances of more spoilage, wastage, defectives & breakdown of machinery are there under this
scheme, as for the purpose of maximizing the bonus, the workers will try to save as much time as
possible. As a result, greater supervision cost has to be involved.

ILLUSTRATION
Employees Adam Smith and John are each assigned a job and they each take 3, 2.5 and 2 hours
respectively to complete the job. The time rate is sh.40 per hour and the time allowed for each job is 3
hours.

Required
a) Using the Halsey plan calculate the total earnings of each employee
b) Calculate the effective hourly rate of pay

72
SOLUTION
a)
Adam Smith John
Time allowed 3 3 3
Time taken 3 2.5 2
Time saved - 0.5 1

Total earnings = 50% × Time saved × Time taken

Adams = (50% × 0) + 3 × 40 = 120
Smith = (50% × 0.5 × 40) + 2.5 × 40 = 110
Johns = (50% × 1 × 40) + (2× 40) = 100

b) Effective hourly rate of pay

Adams =120= sh.40
3
Smith = 110=sh.44
2.5
Johns = 100=sh.50
2

Halsey weir (33 1/3)

Under the Halsey-Weir scheme, a worker is entitled to bonus which is equal to his time wage for
331/3% (often 30%) of the time saved; instead of 50% in case of the Halsey scheme. Thus except the
above, there is no difference between the Halsey scheme & the Halsey-Weir scheme.

ILLUSTRATION
Calculate the total earnings of a worker & the effectively rate of labour wages per hour where
payment of bonus is under (a) the Halsey (50%) scheme & (b) the Rowan scheme from the below
mentioned particulars:
Basic wage rate per hour – shs.10.80, Time allowed for the job – 48 hours, Actual time taken – 36
hours.

SOLUTION
(a) Under Halsey (50%) Scheme

Total wages = Normal time wage + 50% of (time saved×time rate)

Shs.
Normal time wage = 36 hours @ shs.10.80 = 388.80
Bonus = 50% of (Time saved×time rate) = 50% (12×10.80) 64.80
Total Wages 453.60

Effective hourly rate = shs. 453.60/36 = shs.12.60

73
Alternatively

Total wages = (Time taken+50% of time saved) ×time rate

= (36 hours+50% of 12) × shs.10.80 = shs.453.60

(b) Under Rowan Scheme:

Total wages = Normal time wage + Time saved ×Time taken×Time rate
Time allowed

Shs.
Normal time wage 36 hours @ Shs.10.80 388.80
Bonus =Time saved ×(Time taken×Time rate)
Time allowed
= 12×(36×10.80) 97.20
48 486.00

Effective hourly rate = shs.486.00/36 = shs. 13.50

Alternatively;
Bonus as a percentage of Time rate = (Time saved/Time allowed)×100
= (12/48)×100 = 25%
Bonus = 25% of shs.10.80 = shs. 2.70

Bonus as a fraction of time rate = (Time saved/Time allowed)×Time rate

= (12/48)×10.80 = shs.2.70

Effective hourly rate for time taken = shs.10.80+shs.2.70 = shs.13.50

Total Wages = 36 hours×shs.13.50 = shs.486

ILLUSTRATION
40 hours is taken by a worker to do job for which time allowed is 50 hours. $. 1.25 per hour is his
daily rate. Calculate the works cost of the job under the following methods of payment of wages:
(i) Time rate; (ii) Piece rate; (iii) Halsey plan &(iv) Rowan plan.
Additional information: (i) Material cost $.60; (ii) Factory overhead 125% of wages

Solution: Calculation of wages under different methods:

i) Time Rate: Wages for 40 hours (actual time taken) @ shs. 1.25 = 50.00
ii) Piece Rate:Wages for 50 hours (time allowed for the job) @ shs. 1.25 = 62.50
iii) Halsey Plan:Normal time wage = 40 hours @ shs.1.25 = 50.00
Bonus=50% of (Time saved× Time rate) =50% of (10×1.25) = 6.25

74
 Shs.56.25

iv) Rowan Plan:Normal time wage = 40 hours @ shs.1.25 = 50.00

Bonus= Time saved/Time allowed×(Time taken× Time rate)
=10/50×(40×1.25) = 10.00
Shs. 60.00

Grant bonus scheme

In these schemes, employers are rewarded on the basis of efforts applied.
In differential piece work system effort is met by use of graduated rate of payment per unit.
Higher attract higher rates per unit. The other schemes are based on time and their incentive is a share
of gains based on employer efforts. The incentive in the aggregate proportion from financial gain of
employees effort arising as a result of reduced time on production. Each job or work issued has its
own time set and if the employees work for less time he sales on standard time.

The financial adv. from time saved is shared between employee and employer based on agreed
proportion.

Incentive = Agreed proportion of time saved x Rate per hour

Time saved = Standard time – Actual time worked.

Group Bonus Scheme

Where individual schemes are not applicable group bonus schemes may be applied, these schemes are
appropriate where production is done by a group of employees working together as a team e.g.
construction of motor vehicle assembly.
It is difficult to measure individual performance and bonus will be paid to the group. It would be
shared equitably by members of the group e.g. it can be shared in proportion to their wage level or
time taken by employees on the job.
Group wages are treated as indirect wages.

ILLUSTRATION
A factory issues a job to two employees, Mark and Markus, paid at the rate of sh.210/hr. and
sh220/hr. respectively. Mark is issued with 400 containers and it takes twelve minutes to produce
each. Markus is issued with 240 containers and it takes nine minutes to produce e ach
For every hour saved a bonus is paid at the rate of 60% of bonus rat3e which is sh240/hr. The factory
works 42 hours week and overtime and overtime is paid at the rate of time and one third. At the end of
the week Mark band Markus clock cards shows 54 and 50 hours respectively and the work complete.
However Mark worked 4 hours on the indirect job given that week. However, 40 and 60 containers of
Mark and Markus fail to pass inspection due to faulty materials. It was agreed to credit all output for
bonus purposes.

Required;
i) Bonus due
ii) Total gross wage due

75
 iii) Direct wages cost/containers passing inspection. Overtime is worked regularly throughout the
year as company policy due to labour shortage

Solution
Mark Markus
Expected units 400 640
Expected time 80hrs. 96hrs.
Amount payable Sh210 sh220
Actual hours 54 50
Time saved 26 46

Bonus due:
Mark 26 × 200 × 60% =Sh.3,120

Markus 46 × 200 × 60% =sh. 5,520

Total Gross:
Mark 3,120 +( 42×210)+ (12 ×280) =
sh. 15,300
Markus
5,520 + (42 ×220) +( 8× 293) =
sh17,104
Direct Wages:
Mark 15,300 – 4 × 11/3 × 210 =sh. 39.39
400 – 40

17,104 = sh29.49
Markus 640 - 60

CHARACTERISTICS OF AN EFFECTIVE BONUS SCHEME

i) Efficiency in production: when the volume of production is so important, the bonus incentive
scheme should reward higher producers i.e. should be based on output achieved.
ii) Effect on workers: the scheme should be designed to motivate the employees. It should be simple
and understood by those of average intelligence.
iii) Both the employer and the employees should share the gains in labour efficiency.
iv) This will motivate the employees to be more efficient since they benefit from the gains made.
v) The method of calculating the bonus should be known and acceptable to the employees
vi) The standard hours set should be achievable and realistic. When the standards are high then the
employees will not achieve them and the bonus will not be earned

Benefits associated with group bonus schemes include

76
• It encourages cooperation and teamwork among workers since each member in the group has an
interest in the work.
• It reduces absenteeism since an absent worker is found to reduce the group earnings and the group
may dislike him
• The approach reduces supervision time and cost, thus it is administratively much simpler.
• It greatly reduces the number of rates to be negotiated.
• It may encourage flexible working arrangements within the group.

Disadvantages of group bonus schemes

• It may not provide a strong incentive to the individual workers, as it is group based.
• Less hardworking group members are similarly rewarded as the very hardworking ones: this may
cause demotivation in the group.
• It is hard to determine each group members’ fair share of the bonus.
Co-ownership incentive scheme (Profit Sharing Schemes)
Profit-sharing scheme is where a proportion of company profits is allocated to employees either in the
form of cash or in company stock. The actual proportion of company profits to be allocated is
normally calculated by a formula which is known in advance. This converts employees from mere
salary seekers to individuals who are part of the organization.
Their purpose is to enable employees to benefit from the success of their employer in a tax efficient
way and, at the same time, encourage them to participate in their success. Approved profit-sharing
schemes facilitate the allocation of company shares rather than the distribution of company profits in
the form of cash. To receive the tax advantages, a profit-sharing scheme must be set up under trust
and approved by the Revenue. The trust receives a proportion of the company’s profits, which it uses
to buy shares for allocation to individual employees.
Employees must agree to leave their shares in the scheme for at least two years (unless they leave due
to injury, redundancy or retirement). If they leave for any other reason, they must leave their shares in
the scheme until they have been held for two years. If shares are sold within five years, income tax is
payable on a percentage of their value or on the proceeds of the sale (whichever is the smaller). Shares
which are held for more than five years and then sold are not liable for any income tax.

CONTROL OF LABOUR COSTS

Most of the firms aim at maximizing profits by minimizing costs, while optimizing on the revenues
received. Labour costs being a significant expense in the books of account must be controlled in order
to ensure that no overpayments are made and that only authorized payments are effected.

For effective control, the following techniques should be applied

i) Production planning
The preparation of a production planning schedule well in advance with a supporting schedule of man
hour requirements should result in the most efficient use of the man power available. Idle time should
be reduced as much as possible and if possible avoided entirely. The scheme should also enable the
management to predict long term labour requirements.
ii) Labour budget and use of labour standards
A standard of expected performance is required for various reasons.
(1) to make production schedule and labour budgets,

77
 (2) to measure productivity by comparing actual time against an expected time and taking control
action if necessary. Without a labour standard, productivity cannot be measured or controlled
and greater productivity is the only realistic way of reducing labour costs
iii) Labour performance reports
This should provide a periodic stimulus for controlled action. It is from the report that management is
able to identify where the weaknesses were and take appropriate action.
In other words, control action is very effective where regular feedbacks are provided.
iv) Wages incentive schemes
Employees’ productivity can be increased in various ways. One of the major ways that the employees
can be motivated to be more productive and more efficient is through introduction of successful
wages incentive schemes. These schemes reward both the company and employees for raising
productivity.

v) Identification of direct labour

The cost accounting system must be able to identify direct labour cost with a product, job or process.
Cost control may then be applied by the manager responsible for the product, job or process.

MAINTENANCE OF LABOUR RECORDS

Labour costs are accumulated by various departments. These departments are;-
i) Personnel department
ii) Production planning department
iii) Time keeping department
iv) Wages department

(i) Personnel department

It is responsible for engagement, discharge and transfer of employees, classification and method of
remuneration. It determines which employee to hire, the amount of remuneration based on the
negotiation and to which branch or department the hired employee shall work.

(ii) Production planning department

It is responsible for scheduling work and issuing job orders to the production department.
It schedules the work as it comes based on a number of factors such as urgency of the assignment and
availability of resources: materials, time and /or others.

(iii) Time keeping department

It is responsible for recording the attendance time and job time i.e. time spent by each worker in a
factory and time spent by each worker on each job.
The documents used are
1. Clock card: it is a document on which is recorded the starting and finishing time of an
employee for the ascertainment of total actual attendance time.
2. Job card; it records time spent on a job
3. Time sheet; It is a record of how a person’s time has been spent daily or weekly.
Time sheets on which the employee enters all particulars himself are commonly issued to
indirect workers e.g. maintenance staff

78
(iv) Wages department
It is responsible for preparing the payroll and the payment of wages. The routine will require analysis
of clock cards and check of overtime authorization, calculation of bonus, compilation of gross
earning, calculations of deductions, and preparation of pay details for each employee showing net
wages.
To arrive at the net amount of wages, a range of deductions are made from gross earnings.
Some of the deductions are statutory or obligatory in nature while others are voluntary. In Kenya,
statutory deductions are pay as you earn (PAYE) tax, pensions, and employees, national insurance
contributions. The employer is obliged to deduct and submit the deductions to the relevant parastatal
bodies to which they act as agents. Examples of such bodies include Kenya Revenue Authority
(KRA) to whom PAYE tax deducted is remitted, National Hospital Insurance Fund to whom the
national insurance contributions deducted are submitted. Voluntary deductions include items such as
trade union subscription, charity deductions and contributions to saving schemes.

(v) The cost accounting department

It is responsible for the accumulation and classification of all costs. It will identify the direct and
indirect costs and identify the direct costs with specific jobs, process or product to which they are
charged.

ACCOUNTING FOR OVERHEADS

OVERHEAD COSTING

Overheads are any cost not directly attributed to any cost unit. They can’t be identified with any
particular cost unit. They are incurred for the benefit of cost providers.
They include indirect material cost e.g. fuel and lubricant for machine electronics for welding etc.
Also indirect labour
Overheads may be divided into production overheads, administration overheads and selling and
distribution. With this, they may be charged to production cost centers i.e. making, finishing and
packing departments, service costs centers, for example, maintenance and power generation or other
non-production cost centers for example administration, selling and distribution. Production
overheads for instance, are added to the prime cost in order to obtain the total production costs.

Classification Overheads
i) According to behaviour
Can be classified as semi-variable, fixed or semi-fixed costs, Purpose for this classification is for
decision making and cost control.
ii) According to function
This is classification depending with the purpose for which are referred. Is classified into number of
production overheads and none production overheads, administration and saving overheads, The
purpose for this class is to help for accounting of overhead cost costs for products cost purpose.

Steps involved in accounting for overheads

i) Accumulation of Overheads costs.
Involves identifying the overhead cost and charging them to their respective accounts
ii) Allocation and Apportionment

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Refers to charging Overhead to specific departments i.e. dividing the overhead cost among the
departments
Allocation is the process of identification of overhead cost with cost centers. It is charging of
overhead cost identified as incurred in cost center. An expense identified with a dpt. will be charged
that department individually e.g. depreciation, insurance, will be charged on plant departments.
Appointment is charging of proportions of overhead to cost center based on benefits they have used
from overhead cost .The ha overhead cost have been incurred for the benefit of a number of cost
canters or for the purpose of entire organization, the amount should be shared among departments
hence referred to as appointment.
iii) Re-appointment of service departments Overheads
A service department is one that renders services that contribute in an indirect manner to the
manufacture of a product. They don’t produce but support production activities e.g. canteen stores.
These departments do not exist on their own they help other departments hence their overheads must
be shared equitably.
Overhead application
This is charging overhead cost to products that have been manufactured in a cost center.
Cost center – Part of entity where manager are responsible for cost

ALLOCATION AND APPORTIONMENT

- Once overhead cost have been identified and accumulated they will be charged to cost centers.
This process involves allocations and appointment, allocation is direct since Overheads can be
identified with specific departments or costs centres.
- Allocation of overheads is the process by which the whole cost items are charged directly to a cost
unit or as a cost center. Examples of such costs include the salary of a service department manager.
- In apportionment costs must be shared to various departments based on how they have benefited
from overhead cost
- Proper assessment of benefits received by a department is important since it provides the most
equitable basis of apportionment.
- Benefit from each overhead cost will be assessed separately since the measure of benefits cannot
be uniform.
The common basis used in measuring
BASIS Overheads
1. Area occupied - Used for space related overhead.e.g. rent rates, lighting, air
conditioning etc.
2. Book value of building - Building Overheads e.g. departments, repairs, insurance.
3. Book value of plant and - Plant and machine Overheads like insurance, depreciation,
machine. Maintenance etc.
4. No. of employees - Canteen Overheads, supervision, staff welfare cost etc.
5. Direct wages/salaries - Staff training, pension contribution, employee’s liability etc.
6. Technical estimates e.g. - Electricity, water etc.
Kgs/lt
7. Value of materials - All Overheads relating to material cost e.g. material handling
store keeping storage.
8. Direct of labour/machine hrs - General Overheads

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ILLUSTRATION
A company has the following costs
Overhead Amount (sh.)
Consumables Department P1 250,000
P2 150,000
S1 100,000
S2 50,000
Depreciation of factory 1,000,000
Supervision 1.5M
Depreciation of equipment 800,000
Canteen 900,000
Heat & Air Conditioning 500,000
Insurance of Equipment 200,000
The information relating to department is as follows:-
Dpt. Area occupied No. of employees Bk. Value of equipment’s.
P1 1,200 30 3,000,000
P2 1,600 30 2,500,000
S1 800 15 1,000,000
S2 400 15 500,000

Required
Calculate the amount that will be distributed to each department.

SOLUTION
Overheads Basis Ratios Amount P1 P2 S1 S2
Consumables Allocation - 550,000 250,000 150,000 100,000 50,000
Depreciation Are occupied 3:4:2:1 1,000,000 400,000 400,000 200,000 100,000
of factory
No. of
Supervision Employees 2:2:1:1 1,500,000 500,000 500,000 250,000 250,000
Depreciation. Book value of 6:5:2:1 800,000 243,857 285,714 114,265 37142
of equipment Equipment

Number of
Canteen Employees. 2:2:2:1 900,000 300,000 300,000 130,000 150,000
Heating Area. 3:4:2:1 500,000 150,000 200,000 100,000 50,000
Insurance Book. Value 6:5:2:1 200,000 85,714 71429 28571 14286
of. equipment
3,950,000 1,928,571 1,907,143 942,856 671,428

Overheads of service department

Service department is one which exists to support the production activities.
It does not contribute directly in the conversion of r/m to finished products. Since there is no
production that takes place in the department the overheads will be shared by the department that have
benefited from service department.

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Reapportionment of overheads (secondary apportionment) occurs when service department costs
are charged to user departments. For example, the maintenance department overhead costs are
summarized and then charged to the user department, which will probably include other service or
non-production departments.
Service departments do not participate directly in the manufacturing process but play a supportive
indirect role. Products do not pass through the support departments. It is for this reason that service
department costs have to be reapportioned to the production cost centers or departments.

Apportionment is based on proportion of benefits received from service dpt. measured using the
following basis.

Service dpt. Basis

Stores No. of requisition, materials consumed etc.
Maintenance Maintenance hrs.
Canteen No. of employees
Purchase dpt. No. of orders, materials purchased etc.

The re-apportionment of service department costs may be implemented in a number of ways.

The three extremes are:

a) Direct Method; where costs of each service department are only charged to production centers.
Administration; selling and distribution centers are not charged with the cost of the service
departments as they are not production centers.
b) Where the reciprocal nature of service costs is fully recognized; that is service departments serve
each other, a different approach is adapted. This can be implemented in a number of ways:
1. The repeated distribution method: this recognizes fully the reciprocal nature of service
departments. It apportions the overhead costs. It continuously reapportions a share of a service
cost center to other service centers instead of eliminating a center once its costs have been
reapportioned.
2. Using an algebraic approach: this recognizes the reciprocal nature of the service
departments and expresses it as an equation.
c) A compromise method (elimination method or stepwise method) may be used where by the costs
of each service cost centers are re-apportioned in turn. The costs of the first service center will be
reapportioned to all user centers including other service centers, if any. The first service center,
however, is then eliminated from any further reapportionment. The cost of the second service
center including any costs already reapportioned from the first service center is then reapportioned
to all user centers other than the first service center. The process is continued until all service
centers are eliminated.

Service department providing services to other service department.

Where service department providing services to production and to other service departments the OC
will be after the service department have received their share and then other amount charged to

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production department. This will ensure that each department shares its equitable share of O/H costs
of services department it has benefited from.

METHODS USEDIN RE-APPORTIONMENT OF OVERHEADS

The following method may be used to re-apportion overhead of service department. In this case
1. Direct allocation method
2. Step wise allocation/elimination method
3. Repeated distribution method
4. Simultaneous/algebraic equation method
Direct allocation Method
In this method, services provided by services to each other are ignored. Overheads from service
department will only be apportioned to production department i.e. only production department shared
the cost not recommended as it ignores services provided by service department for themselves which
may lead to some department having unfair share of overhead cost
Step wise allocation/elimination method
In this method the service department that provides most services to the other service department is
identified and its overheads will be re-apportioned first. Once the app. no further re-apportion will be
made to other departments i.e. close down.
The 2 is department providing most services to remaining services to remaining service department
will be re-apportioned next then close down, this procedure is repeated until the last service
department is re-apportioned.

ILLUSTRATION
MMC Ltd. produces machine parts on a job-order basis. Majority of the business contracts are
obtained through bidding. Business firms competing with MMC Ltd. bid full cost plus 20 per cent
mark up. Recently, with the expectation of increase in sales MMC Ltd. reduced its mark up from 25
per cent to 20 per cent.

The company operates two support departments and two production departments. The budgeted costs
and the normal activity levels for each department are given below:
Support Departments Production Departments
Maintenance Power Grinding Assembly
Overhead costs (Shs.) 1,000,000 2,000,000 1,000,000 500,000
Number of employees 8 7 30 30
Maintenance hours 2,000 200 6,400 1,600
Machine hours - - 10,000 1,000
Labour hours - - 1,000 10,000

Additional information:
1. The direct costs of the maintenance department are allocated on the basis of employees while
those of power department are allocated on the basis of maintenance hours.
2. Departmental overhead rates are used to assign costs to products. Grinding department uses
machine hours and assembly department uses labour hours.

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MMC Ltd. is preparing to bid for a contract, job K, that requires three machine hours per unit
produced in grinding and zero hours in assembly department. The expected prime costs per unit are
Shs. 670.

Required:
a) Allocate the support service costs to the production departments using the direct allocation
method.
b) Allocate the service costs to the production departments using the sequential allocation method

SOLUTION
(a) Overhead allocation (direct method)
Profit statement (absorption costing)
Production departments Support departments
Grinding Assembly Maintenance Power
Sh. Sh. Sh. Sh.
Direct costs 1,000,000 500,000 1,000,000 2,000,000
Maintenance 500,000 500,000 (1,000,000) -
Power 1,600,000 400,000 - (2,000,000)
3,100,000 1,400,000 - -

(b) Overhead allocation (sequential method)

Production departments Support departments
Grinding Assembly Maintenance Power
Sh. Sh. Sh. Sh.
Direct costs 1,000,000 500,000 1,000,000 2,000,000
Power department 1,280,000 320,000 400,000 (2,000,000)
Maintenance 700,000 700,000 (1,400,000)
2,980,000 1,520,000 - -

Workings
MMC Ltd.
(a) Power cost allocated according to maintenance hours

6,400 + 1,600 = 8,000

6,400 x 2,000,000 = 1,600,000
8,000
1,600 x 2,000,000 = 400,000
8000

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 (b) Maintenance cost allocated to employees
30 + 30 = 60
30 x 1,000,000 = 500,000
60
30 x 1,000,000 = 500,000
60

(c) Power apportioned to machine hours

2,000 + 6,400 + 1,600 = 10,000
2,000 x 2,000,000 = 400,000 ⇒ Maintenance
10,000

6,400 x 2,000,000 = 1,280,000 ⇒ Grinding

10,000

1,600×2,000,000 = 320,000 ⇒ Assembly

10,000

Maintenance - Allocated according to number of employees

Grinding 30 x 1,400,000 = 700,000
60

Assembly 30 x 1,400,000 = 700,000

60

Repeated Distribution
This recognizes fully the reciprocal nature of service departments. It apportions the overhead costs. It
continuously reapportions a share of a service cost center to other service centers instead of
eliminating a center once its costs have been reapportioned.
This method differs from the elimination method in that it continues to reapportion a share of a
service cost center to other service centers instead of eliminating a center once its costs have been
reapportioned in the first instance. The cycle is repeated until the numbers become so small that no
further reapportionments are required

Simultaneous/Algebraic Equation Method

In this method, we form two equations which give the total costs of service departments after sharing
overheads from the other service department.

The total overheads cost will be allocated on the basis of the total cost from the equation.
Total cost will be the allocated cost plus a share of other overheads of the other service departments.
Total Overheads = Allocated Overheads + A share of overheads from service department.

Since total overheads are unknown the equation of total overheads will be formed and solved to
determine total overheads of service departments.

The total overheads will be shared to departments that have benefited.

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Let X = Total overheads of service department 1
Y = Total overheads of service department 2

This method requires that the reciprocal nature of the service costs is expressed in a set of
simultaneous equations which are solved by matrix algebra
Let x = Total cost of the maintenance cost center
Let y = Total cost of the power generating cost center

Then x = 23050 + 0.20Y

Y = 26100 + 0.20x

The equation shows that;

Maintenance cost = initial allocated and apportioned costs of Shs.23050 plus 8% of the total cost of
the power generating center
Power generating cost = initial allocated and apportioned costs of Shs. 26100 plus 20% of the total
cost of maintenance center

ILLUSTRATION
Bingwa Ltd. has three production departments and two service departments.
The following are the budgeted factory overheads for the year ended 31 December 2011:

The service department costs are to be apportioned as follows:

Production departments Service departments

A B C 1 2
Service department 1 20% 40% 30% - 10%
Service departments 2 40% 20% 20% 20% -

Required:
Re-apportion the service department costs to the production departments using the simultaneous
equation method.

SOLUTION
Re-apportioning the service department costs using the simultaneous method
S1 = 30,000 + 20% S2
S2 = 36,000 + 10% S1

36,000 = S2 -10% S1
30,000 = S1 -20%S2

36,000 = -10%S1 = S2
30,000 = S1 -20% S2
39,000 = 1.02S2

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 Therefore S2 =38,235

And S1 =37,647

Overheads reapportionment schedule

A B C 1 2
Shs ‘000’ Shs ‘000’ Shs ‘000’ Shs ‘000’ Shs ‘000’
Apportioned and allotted 96,000 84,000 60,000
Reapportionment as follows
S2: 38,235 (20%, 40%, 30%) 7,647 15,294 11,471
S1: 37,647 (40%, 20%, 20% ) 15,059 7,529 7,529
118,706 106,823 79,000

OVERHEADS ABSORPTION
Once overheads have been allocated, apportioned and reapportioned to product departments the
overheads will be charged to units or to products produced in that department. This is known as
recovery/application/absorption of overheads.
It is defined at charging of production overheads to units produced in a production department.
It involves two steps:
i) Computation of overheads rate (AR)
ii) Application of the rates to cost unit.

Computation of overheads absorption rates

Overheads are incurred for the benefits of a no. of units or for the entire department and thus a way of
sharing the overheads to cost units will need to be determined.

Overhead Absorption Rate (OAR)

Overhead Absorption Rates are usually computed for the purpose of department and units of the base
selected for overheads absorption
Only are absorption rate is computed and used for any single group of overheads for each department.
It may be based on actual figures or estimated figures.
Actual figures are determined at the end of the period and in this case OAR is based on the actual
overheads and actual units of the base selected.

Certain limitations arise from use of actual data and therefore actual rates are not preferable. This is
due to:-
i) Actual data can only be compared at the end of the period delaying computation of the
product cost.
ii) Actual rates may vary from period to period making comparison to be difficult
iii) It causes delay in determination of selling prices

Estimated data is the budgeted data at the beginning of that period.

Predetermined overhead rates are computed from the data and is based estimated overheads and
estimated units of the base

87
Determination of suitable method and charging overheads
Adoption of unsuitable method of overheads absorption may lead to misleading results and therefore
distort product cost
Generally the following factors should be considered when determining the method of charging
overheads.
1) Type of industry
This helps indicate the method of production is whether production is continuous through job orders
provision of services etc. Different methods will be appropriate and different industries.
2) Nature of the manufacturing process
This determines whether the manufacturing is manual (labour intensive) or mechanical (machine
intensive)
3) Formation of overheads
This refers to the computation of overheads cost and each department.

4) Stability of re-apportionment method prices and labour rates

Material costs and labour costs can only be used as the basis of the rates are stable. This is to ensure
that some products are charged with same overheads.
5) Operating capacity
This is analysing whether the company is operating at capacity, under capacity or over capacity. It
helps determine the number of units that will share the overheads cost.
6) Policy of the management
The method should not be inconsistent with the management policies or overhead absorption.

Methods of overhead absorption

i) Direct labour hours
This method gives consideration for time spent in production overheads are charged to cost units
based on labour hours required in production.
It is appropriate where production is labour intensive.
OAR = Budgeted Overhead
Budgeted labour hours

ii) Machine hours

In this method, overheads are charged to cost unit based on machine hours required in production. It is
used where production is machine intensive.
OAR = Budgeted Overhead
Budgeted machine hours

iii) Direct material cost percentage

Overheads are charged as a percentage of direct material cost.
It is appropriate where material data is readily available and where most of the overheads are material
related.
OAR = Budgeted Overhead×100%
Budgeted material cost

iv) Direct labour cost percentage rate

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Overheads are charged as a percentage of labour costs. It is used where departments are labour
intensive and some rate of payment is paid. It is not appropriate where labour cost is based on pieces
produced and where overtime premium and bonuses are paid since they distort labour cost of output.
OAR = Budgeted Overhead×100%
Budgeted labour cost

Prime cost percentage

This is applicable under the conditions of material and labour percentage above.
OAR = Budgeted Overhead×100%
Budgeted prime cost
NB
The cost related basis may not be appropriate due to distorted costs where there is regular changes in
prices and rates of payment
They will only be appropriate where price and rates are stable

Units of output
Overheads are charged per unit produced. It is appropriate where similar products are produced. It
will not be preferred where products of different sizes or different qualities since they require different
resources.
OAR = Budgeted Overhead
Budgeted Output

ILLUSTRATION
The following information was extracted from the books of ABC Ltd.
Budget A B
Machine hours 10,000 12,000
Output unit 1000 1500
Material cost 32,000 28,000
Labour cost 40,000 38,000
Labour hours 18,000 22,000
Budgeted overheads 36,000 42,000

Required
Calculate the overhead absorption rate of a department using
i) Direct labour hours
ii) Direct machine cost percentage
iii) Direct labour cost percentage
iv) Prime cost percentage
v) Units of output
vi) Direct machine hour

SOLUTION

A B

89
i) OAR = Budgeted OH 3,600 42,000
Budgeted labour. Hrs. 1,800 22,000
= Sh. 2/hr. = Sh. 1.9/hr.

ii) OAR = Budgeted OH 36,000 42,000

Budgeted Machine. Hrs. 10,000 12,000
= Sh. 3.6/hr. = Sh. 3.5/hr.

iii) OAR = Budgeted OH x 100 36,000 x 100 42,000 x 100

Budgeted mgt. cost 32,000 28,000
= 112.5% = 150%

iv) OAR = Budgeted OH × 100 36,000 × 100 42,000 x 100

Budgeted labour cost 40,000 38,000
= 90% = 105%

v) OAR = Budgeted OH x 100 36,000 x 100 42,000 x 100

Budgeted Prime cost 72,000 66,000

= 50% = 63.4%
Prime cost = direct labour cost + direct mat. Cost
A = 40,000 + 32,000 = 72,000
B = 35,000 + 28,000 = 66,000
vi) OAR = Budgeted OH 36,000 42,000
Budgeted Output 1,000 1,500
=36 out unit =28

APPLICATION OF OVERHEAD ABSORPTION RATE TO OUT UNITS

In order to determine the total cost of a product, the overheads are charged to the products on the basis
of the computed OAR.
The overheads charged to a cost unit will be the function of the OAR for the department and the units
of the base that a product requires.
Overhead charge or absorbed = OAR x Units of base/units

OVER/UNDER ABSORPTION OF OVERHEADS

Overheads are absorbed using predetermined overhead absorption rate based on the budgeted data at
the beginning of the period.
Budgeted data may be different from actual at the end of the period i.e. the actual may be more or less
than the budget since budget is an estimate.
The difference between the actual and the budgeted data is known as over/under absorption of
overheads.
Over absorption arises where absorbed overheads to production is more than actual overheads. This
means that more overheads have been charged to production which results in overstatement of cost of
production as well as product cost.

90
Under absorption arises where absorbed overheads is less than actual overheads.
This means that production cost is understated as well as the production cost.

Causes of over/under absorption

1. Poor estimation of cost data (poor budgeting)
2. Adoption of unsuitable method of overheads absorption
3. Changes in method of production during the period
4. Unforeseen changes in product capacity resulting in production of more or less units than
budgeted.
5. Seasonal fluctuations in overheads cost due to inflation, deflation etc.

Treatment of over/under absorption

Over/under absorption results in overstatement/understatement of cost of production and therefore
adjustment need to be made on production cost of goods sold and inventories.
The treatment depends on whether the amount is substantial or not.
This treatment include
i) Use of supplementary rates.
If the amount is substantial i.e. has a significant effect on cost of production, the cost of goods
sold and the cost of inventories at the end of the period will need to be adjusted to reflect the
actual.
ii) Write off to P&L statement
If the amount is not substantial and will not have a significant effect on inventory values, the
amount will be written on to P&L is expensed as a cost for the period
iii) Carry over to the next period
In this case the amount will be put in an overhead suspense a/c and carried forward to the next
year it will be off set with next year’s overheads.
The problem with this method is that cost of production will not reflect the actual cost for the
period.
iv) Over/under absorption = Absorbed OH – Actual O/H

ILLUSTRATION
Matatu Auto Spares Ltd. uses budgeted overhead rate in allocating overheads to individual job orders
on the basis of machine hours in department A and on the basis of direct labour cost for department B.
The budgeted forecast for the six month period to June 2009 was as follows:
Department
A B
Material costs (Sh.) 100,000 80,000
Labour costs (Sh.) 80,000 120,000
Machine hours 10,000 30,000
Labour hours 40,000 30,000
Factory overheads (Sh.) 200,000 240,000

The actual results for the period were as follows:

Department
A B

91
 Factory overheads (Sh.) 95,000 98,000
Labour hours 38,800 41,500
Machine hours 5,000 4,880

The following information relates to job order number B2:

Department
A B
Material costs (Sh.) 30,000 24,000
Labour costs (Sh.) 40,000 18,000
Machine hours 6,000 8,000
Labour hours 2,400 4,000
Required:
(i) The budgeted overhead rate for department A and department B.
(ii) The total overhead cost for Job B2.
(iii) The cost per unit for Job B2 given that the output is 10,000 units.
SOLUTION
Matatu Auto Spares Ltd
i) Budgeted overhead rate for department A and department B
Overheads absorption rate =
𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒
Department A
OAR =
𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠

200,000
10,000
Shs 20/ machine hour

Department B

OAR =
𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑙𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡

240,000/120,000

2 × 100% =200%

ii) Total overhead cost for Job B2

Overheads absorbed= O.A.R × actual units of the base

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 Overheads for Job No. B2
Shs
Department A =20× 2,400 48,000
Department B= 200%×18,000 36,000
Total Overheads 84,000

iii)The cost per unit for job B2 given that the output is 10,000 units

Cost Statement
Shs
Material cost (30,000 + 24,000 54,000
Labour cost (40,000 + 18,000) 58,000
112,000
Add overheads 84,000
Total Cost 196,000

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 196,000

𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑
= 10,000
= shs. 19.6 Per unit.

ILLUSTRATION
Mjengo Ltd. Is a medium sized company which operates three production departments and two
service departments. The three production departments are: Machinery department D, machinery
department E and Assembly department. The two service departments are materials procurement and
general support department.

The annual overhead costs are as follows:

Sh. Sh.
Indirect salaries and wages
Machinery department: D 2,500,000
E 2,500,000
Assembly 3,750,000
Materials procurement 2,750,000
General support 3,700,000 15,200,000
Indirect materials
Machinery department: D 1,250,000
E 2,012,500
Assembly 262,500
Materials procurement 0
General support 25,000 3,550,000

Others:
Electricity 1,250,000
Taxes 2,500,000
Insurance of machinery 375,000

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 Depreciation of machinery 3,750,000
Insurance of buildings 625,000
Salaries of the workers 2,000,000 10,500,000
2,9250,000

1. The following are additional information is available from books of Mjengo Ltd.

Book value Area occupied Number of Direct Machine

Machinery (square metres employees labour hours
hours
Machinery
department : D 20,000,000 25,000 750 2,500,000 5,000,000
E 12,500,000 12,500 500 2,500,000 2,500,000
Assembly 2,500,000 37,500 750 5,000,000
Stores 1,250,000 37,500 250
Maintenance 1,250,000 12,500 250
37,500,000 125,000 2500
2. The total direct and indirect materials issued to the production department are as follows:
Machinery D 10,000,000
E 7,500,000
assembly 2,500,000
20,000,000

Required:
(a) Overheads analysis sheet.
(b) Reallocation of service department costs
(c) Overhead rates for each production department

SOLUTION
(a) Overhead analysis sheet

Production departments Service departments

Machinery Machinery Assembly Material General
Item of Basis of Total D E procurement support
expenditure allocation Sh 000 Sh 000 Sh000 Sh000 Sh000 Sh000
Indirect wages and Direct 15,200 2,500 2,500 3,750 2,750 3,700
salaries
Indirect materials Direct 3,550 1,250 2,012 262.5 - 25
Electricity Area 1,250 250 125 375 375 125
Taxes Area 2,500 500 250 750 750 250
Insurance of Book value of 375 200 125 25 12.5 12.5
machinery machinery
Insurance of Area 625 125 62.5 187.5 187.5 62.5
buildings
Salaries of site Number of 2,000 600 400 60 200 200
workers employees

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Depreciation of Book value of
machinery machinery 3,750 2,000 1,250 250 125 125
29,250 7,245 6,725 6,200 4,400 4,500

Total allocated and apportioned

(b) Reallocation of service departments costs

Item of Basis of Total Production departments Service departments

expenditure allocation
Machinery Machinery Assembly Materials General
D E procurement support
Sh. Sh. Sh. Sh. Sh. Sh.
Materials Value of - 2,200,000 1,650,000 550,000 4,400,000 -
procurement materials
issued
General Direct - 1,125,000 1,125,000 2,250,000 - 4,500,000
support labour
hours
Total overhead costs
(c)
Machinery department D = 7,425,000 + 2,200,000 + 1,125,000
Machinery department D = 10,750,000 = Sh. 2.15 per machine hours
5,000,000

Machinery department E = 6,725,000 + 1,650,000 + 1,125,000

Machinery department E = 9,500,000 = Sh. 3.80 per machine hours
2,500,000

Assembly department = 9,000,000 = Sh. 1.80 per machine hours

5,000,000

ACTIVITY BASED COSTING (ABC)

ABC is a costing method which recognizes that costs are incurred because of the activities which take
place within the organization and for each activity a cost driver may be identified.
Those costs which are driven or incurred by the same cost drivers are grouped together into cost pools
and the cost drivers are then used as a basis for charging the cost of each activity in the product.
A cost pool is a collection of costs which may be charged to products by the use of a common cost
driver. A cost driver is any activity or activities, series of which take place within an organization and
which cause costs to be incurred. The essence of ABC is that activities are the cost drivers, not
products. Products do consume activities. If the cost of activities and their relationship to products is
understood, there can be established basis for product costing, performance measurement and
profitability analysis.

Some examples of cost pools and related cost drivers are as shown below.
Cost pool Cost driver
Power Number of machine operations

95
Material handling Quantity or weight of materials handled
Material receipt Number of batches of materials received
Production planning Number of jobs or materials planned
Sales administration Number of customers or orders received
Set up costs Number of jobs run

The development of ABC has been a response to a change in the cost base of many manufacturers
over the last decades. In earlier times, most manufacturing was labour intensive. The variable cost of
direct labour greatly outweighed all other costs and the overheads were a relatively small component
of the total cost. Traditional absorption costing was accurate enough in these circumstances.
Nowadays, most manufacturing processes are automated. The fixed overhead cost of depreciation is
now an important component of the total cost. At the same time, work forces have been greatly
reduced. This means that the variable cost of direct labour is now a much smaller proportion of the
total cost. Traditional absorption costing has become inaccurate as a result and misleading product
costs have led to poor decision making.
ABC analyses costs as short-term variable cost and long-term variable costs. Short-term variable costs
equate with variable costs under the traditional absorption costing. These characteristics are volume
related and change proportionately with the volume of production. Long-term variable costs are
equivalent to fixed costs under traditional cost accounting. Under ABC, such costs do vary with
activity even though there is a time lag e.g. salaried production engineers will not be immediately
made redundant if the number of products decline but they may be if decline continues.

Guidelines to activity based costing

(i) Identification of the organization’s major activities
(ii) Identification of the cost drivers. These are factors which determine the size of the costs of the
activity or causes of the incurrence of costs. Volume related cost drivers are commonly used for
costs that vary with the production levels in the short term.

Examples of some costs and their cost drivers are shown below
Activity Possible cost driver
Car fuel cost Number of kilometers
Materials handling Number of production runs
Production scheduling Number of production runs
Mailing costs Number of mails sent

(iii) Collection of the costs of each activity into cost pools. Cost pools are equivalent to cost centers.
They are used to describe locations to which overhead costs are initially assigned.
(iv) Charging support overheads to products on the basis of their usage of the activity. A product’s
usage of an activity is measured by the number of the activity’s cost driver it generates. The
service costs are only allocated to the production department according to the usage of the
services provided.

96
Absorption costing and ABC are similar in many respects. In both systems, direct costs go straight to
the product and overheads are allocated to production cost centers/cost pools. The difference lies in
the manner in which overheads are absorbed into products.

Selecting the cost drivers

In the main, the cost driver will be measured in terms of volume of transactions. However, ABC also
tries to identify costs that are not contributing to the value of the product / service so the following
questions are relevant:
• What services does this activity provide?
• Who receives the service?
• Why do you require so many people?
• What might cause you to require more/less staff?
• Why does over/idle time exist?

Three types of cost driver emerge;-

Pure activity output volume – where the basic transactions of the activity are identical in terms of
their resource demands such as the purchasing of raw materials or a similar range of items.
Activity/output volume/complexity – where the basic transactions differ in terms of their resource
demands as when purchases are made from different overseas suppliers.
Situation – where an underlying factor can be identified as driving the workload of an activity such as
the number of suppliers when supplier vetting and liaison were vital components of the cost pool.

Example of cost drivers

The following are examples of cost drivers in the manufacturing sector.
Activity Cost driver
Material procurement Number of purchase orders
Material handling Number of movements
Quality control Number of inspections
Engineering services Number of change orders
Maintenance Number of break downs
Line set-up Number of set-ups

For the service sector the following taken from the field of health care may serve as an example. The
cost drivers from the basis of costs charged to patients.
Activity Cost driver
Patient movement Number of in-patients
Booking appointments Number of patients
Patients reception Number of patients
X-ray:
Equipment preparation Time taken
Patient preparation Time taken
Patient aftercare Time taken
Film processing Number of images
Film reporting Number of images

97
The Merits of Activity Based Costing
The following are the main claims made regarding ABC:
• More realistic product costs are provided especially in Advanced Manufacturing Technology
(AMT) factories where support overheads are a significant proportion of total costs.
• More overheads can be traced to the product. In modern factories there are a growing number of
non-factory floor activities. ABC is concerned with all activities so takes product costing beyond
the traditional factory floor basis.
• ABC recognises that it is activities which cause cost, not products and it is products which
consume activities.
• ABC focuses attention on the real nature of cost behaviour and helps in reducing costs and
identifying activities which do not add value to the product.
• ABC recognises the complexity and diversity of modern production by the use of multiple cost
drivers, many of which are transaction based rather than based solely on production volume.
• ABC provides a reliable indication of long-run variable product cost which is relevant to strategic
decision making.
• ABC is flexible enough to trace costs to processes, customers, areas of managerial responsibility,
as well as product costs.
• ABC provides useful financial measures (e.g. cost driver rates) and non- financial measures (e.g.
transaction volumes).
• The principle of using activities to trace costs can be applied across a range of
service industries as well as manufacturing firms

CRITICISMS OF ABC
• A full ABC system with numerous cost pools with multiple cost driver undeniably more complex
than traditional systems and will thus be expensive to administer.
• Much of work is defense related and pricing is on a cost-plus basis hence the need to show
accurate product costs. The applicability of ABC to companies has to use market-based pricing
and do not have the same high technology
structure has been questioned.
• Many practical problems are unresolved. Examples include: common cost driver selection, non-
linearity of cost driver rates etc.
Perhaps the key word in that definition is traceable, whether or not a cost can be traced objectively to
the production/delivery of a good/service.

ILLUSTRATION
Assume that a firm makes four products A, B, C and D. Data for the past period are as follows:
Product Output No. of Direct labour Machine Material cost Material
units production hrs. per unit hours per per unit components
runs in period unit Shs per unit
A 25 3 2 2 30 8
B 25 4 4 4 75 5
C 250 7 2 2 30 8
D 250 10 4 4 75 6
24

Direct labour cost sh.7 per hour.

98
Overhead costs Sh.
Short-run variable costs 8,250
Long-run variable costs: 7,680
Scheduling costs 3,600
Material handling costs 7,650
27,180

Find the unit production cost

a) Using conventional product costing using a labour hour or machine hour overhead absorption
rate.
b) Using ABC with the following cost drivers:
Short-term variable costs Machine hours
Scheduling costs: No. of production runs
Set-up costs: No. of production runs
Materials handling costs: No. of components
c) Compare the results from the two methods

SOLUTION
a) Compare costing
Total machine hours in period
Product Hours
A 25 ×2 = 50
B 25 × 4 = 100
C 250 x 2 = 500
D 250 x 4 = 1,000
1,650
OAR based on machine hours = sh.27,180 = sh.16.47 per machine hours
1,650

Cost summary using conventional costing

A B C D Total
Sh. Sh. Sh. Sh. Sh.
Direct materials 750 1,875 7,500 18,750
Direct labour 350 700 3,500 7,000
Prime costs 1,100 2,575 11,000 25,750 40,425
Overheads @ 16.47 per mc hour 824 1,647 8,235 16,470 27,176
Total cost 1,924 4,222 19,235 42,220 67,601
Units produced 25 25 250 250
Cost per unit (rounded) 77 169 77 169

Calculation of cost driver rates

Short-term variable costs sh.8,250 machine hours = sh.5 per machine hour
1,650

Scheduling costs 7,680 production runs = sh.320 per production run

99
 24
Set up costs 3,600 production runs =sh.150 per production run
24
Material handling costs sh.7,650 components = sh.2 per component
3,825

Number of components in period = 25 x 8 x 25 x 5 + 250 x 8 + 250 x 6 = 3,825.

b) Using ABC
Cost summary using ABC
A B C D Total
Sh. Sh. Sh. Sh. Sh.
Prime cost 1,100 2,575 11,000 25,750 40,425
Short run variable costs @ sh.5 per machine hour 250 500 2,500 5,000 8,250
Scheduling @ sh.320 per run 960 1,280 2,240 3,200 7,680
Set-up @ sh.150 per run 450 600 1,050 1,500 3,600
Materials handling @ sh.2 per component 400 250 4,000 3,000 7,650
Total cost 3,160 5,205 20,790 38,450 67,605
Units produced 25 25 250 250
Costs per unit 126.4 208.2 83.16 153.8

Slight difference in total cost due to rounding of figures

c) Comparing the results we obtain

Products
A B C D
Sh. Sh. Sh. Sh.
Unit cost: conventional 77 169 77 169
Unit cost: ABC 126.4 208.2 83.16 153.8
Percentage change using ABC +64% +23 +8% -9%

It will be seen that ABC charges more overheads to lower volume production and tends to charge
relatively less to higher volume production, especially product D in this case.
The above example has deliberately been kept simple in order to show the principles of the ABC
method.

PRACTICE EXERCISES (Solutions on page 245)

QUESTION 1
Wangu Manufacturing Company Ltd. is located at the industrial area in Nairobi. The company uses
four different machine groups, A, B, C and D in its manufacturing process.

The overhead costs budget for the year ending 31 December 2003 is as follows:

Sh. ‘000’
Indirect wages 12,000

100
Holiday pay and national insurance 10,200
Supervision 16,680
Machine maintenance (wages) 14,000
Supplies 2,600
Power 4,200
Tooling costs 13,300
Insurance of machinery 2,520
Insurance of buildings 1,600
Depreciation 10,500
Rent and rates 12,400
100,000

At present, overheads are absorbed into the cost of the company’s products by means of a single
direct wages percentage of 70 percent. The company wishes to change to machine hour overhead
absorption rate for each of its four different machine groups.

The following data is available for each of the four machine groups:
Machine groups
A B C D Total
Sh. ‘000’ Sh. ‘000’ Sh. ‘000’ Sh. ‘000’ Sh. ‘000’
Tooling costs 5,400 4,100 2,600 1,200 13,300
Supervision 5,170 4,720 3,630 3,160 16,680
Supplies 1,200 800 200 400 2,600
Cost of machines 32,000 24,000 10,000 18,000 84,000

Machine maintenance hours 3,000 2,000 4,000 1,000 10,000

Number of direct workers 6 6 2 2 16
Total number of workers 26 34 15 10 85
Floor space (square feet) 3,000 2,400 1,600 1,000 8,000
Machine running hours 30 60 25 10 125
Machine power rating (kilowatts) 55,000 27,000 8,000 15,000 105,000

Required:
(a) Machine hour overhead absorption rate for each of the four groups of machines.
(b) The overhead cost to be absorbed by product XY123 if:
(i) It utilizes the following time resources of the indicated machine groups:

Hours Machine group

8 A
3 B
1 C
4 D

(ii) Direct labour cost is Sh. 22,000,000 and the direct wages percentage method is used.

101
QUESTION 2
The following budget and actual results relates to Cypo Ltd. for the last three quarters for the year
ended 31 March 2004.

Budget: Quarter 2 Quarter 3 Quarter 4

to 30/9/2003 to 31/12/2003 to 31/3/2004
Sales (units) 10,000 14,000 12,200
Production (units) 8,000 14,200 12,400
Fixed overheads (Sh. ‘000’) 10,400 19,170 17,360

Actual results
Sales (units) 9,600 12,400 10,200
Production (units) 8,400 13,600 9,200
Fixed overheads (Sh. ‘000’) 11,200 18,320 16,740

The value of the opening and closing stock of the units produced is arrived at by using the FIFO stock
valuation method. The budgeted and actual opening stock for the quarter ended 30 June 2003 was
2,600 units and its valuation included Sh. 3,315,000 of fixed overheads. The company absorbs its
fixed overheads using a pre-determined fixed overhead absorption rate per unit which is the same for
each quarter. It is assumed that variable costs per unit and selling price per unit remained the same
for each of the three quarters.

Required:
(a) Calculate the under or over-recovery of fixed overheads for each quarter and indicate how it will
affect the profit or loss for the year ended 31 March 2004.
(b) Using the actual results given above, explain whether absorption costing gives a higher profit
figure than marginal costing.
(c) Explain briefly why absorption costing is usually considered to be unsuitable as an aid to decision
making.

QUESTION 3
Ardhi Company is considering the type of remuneration scheme to adopt for its employees. The
following information is availed to you for your analysis:
Mambo Saidi Mbogo
Actual hours worked 38 36 40
Hourly rate of pay (Sh.) 30 20 25
Output (units) A 42 120 -
B 72 76 -
C 92 - 50

A B C
Standard time allowed per unit (minutes) 6 9 15

For the calculation of piecework earnings the company values each minute at the rate of
Sh.0.5.

102
 Required:
Calculate the earnings for each employee using:
Basic guaranteed hourly rates;
i) Piecework rates;
ii) Premium bonus, given that an employee earns the premium bonus at the rate of
two thirds of the time saved.

QUESTION 4
MMC Ltd. produces machine parts on a job-order basis. Majority of the business contracts are
obtained through bidding. Business firms competing with MMC Ltd. bid full cost plus 20 per cent
mark up. Recently, with the expectation of increase in sales. MMC Ltd. reduced its mark up from 25
per cent to 20 per cent.

The company operates two support departments and two production departments. The budgeted costs
and the normal activity levels for each department are given below:

Support Departments Production Departments

Maintenance Power Grinding Assembly
Overhead costs (Shs.) 1,000,000 2,000,000 1,000,000 500,000
Number of employees 8 7 30 30
Maintenance hours 2,000 200 6,400 1,600
Machine hours - - 10,000 1,000
Labour hours - - 1,000 10,000

Additional information:
1. The direct costs of the maintenance department are allocated on the basis of employees while
those of power department are allocated on the basis of maintenance hours.
2. Departmental overhead rates are used to assign costs to products. Grinding department uses
machine hours and assembly department uses labour hours.

MMC Ltd. is preparing to bid for a contract, job K, that requires three machine hours per unit
produced in grinding and zero hours in assembly department. The expected prime costs per unit are
Shs. 670.

Required:
a) Allocate the support service costs to the production departments using the direct allocation
method.
b) What will be the bid for job K if the direct allocation method is used?
c) Allocate the service costs to the production departments using the sequential allocation method.
d) What will be the bid for job K if the sequential allocation method is used?
e) Briefly explain the problems encountered in sett setting overhead cost standards.
f) Distinguish between cost allocation and cost apportionment

103
 CHAPTER 5
COST BOOKKEEPING
KEY TERMS
Integrated accounting system; A system of accounting where the cost and financial accounts are
kept in the same set of books. This system avoids the need for separate set of books for financial and
costing purposes

Interlocking accounting system; this is an accounting system where separate cost accounting and
financial accounting books are maintained although both use the same basic accounting data

COSTS FLOW IN AN A BUSINESS ENTERPRISE

We say that costs flow through an accounting system. That is because they accumulate as the product
progresses through the various stages of production. Let's look at a typical product.
Before a product is started, no costs have been incurred. Workers stand ready to make the product,
inventory waits patiently in the warehouse, and the manufacturing plant contains all the resources
necessary to perform the manufacturing operation.
We first add materials into production, from the inventory. At the same time the accounting
department transfers the cost of inventory items to the Work in Process account, and the product or
job now has a value.
Next the workers start to convert the raw inventory into a product. As labor is added, the accounting
department transfers payroll costs to the Work in Process account, increasing the value of the product
or job.

104
Overhead costs are allocated to the product or job, based on the costing method used. As work
progresses on the product or job, it accumulates labor, materials and overhead costs. Finally, the total
finished product or job cost is transferred to Finished Goods, and when it is sold the cost is transferred
to cost of goods sold

COST BOOK KEEPING AND INTEGRATED SYSTEMS

Refers to a system of recording various cost information in the books of account

There are two systems as cost book keeping

1. Non- integrated accounts/inter locking
2. Integrated account

INTERLOCKING ACCOUNTS
Are systems in which the cost accounts are distinct from the financial account: both sets are kept in
agreement or are readily reconcilable.
Under this system, separate cost accounting and financial accounting books are maintained although
both use the same basic accounting data. The financial accounting books have the normal and credit
entries within themselves. In addition, a memorandum account, also known as Cost Ledger Control
account is maintained and all the items to be transferred to the cost accounts are posted in this
account.

Cost accounting books on the other hand contain impersonal accounts necessary for costing purposes
in addition to a Financial Ledger Control Account, also known as Cost Ledger Control
Account which enables the financial and Cost Ledger to be interlocked. The interlocking cost
accounting system, costing and financial profit differ and have therefore to be reconciled at the end of
the financial year.

INTEGRATED ACCOUNTS
This is a system where cost accounts and financial accounts are combined in one set of accounts.

Features/Advantages
In integrated account, ledger system has a number of features which may be viewed as preferable to
the interlocking ledger system. In the recent decade, there has in fact been a move towards greater
integration of accounting information requirements in a single unified system (an integrated ledger
system).
Such an integrated ledger system has the following advantages
1. Only one set of account is maintained and therefore there would be one profit results hence no
need of reconciling.
2. There is no duplication of work hence a saving in clerical cost.
3. Information obtained can be used by the management for decision making as well as for financial
reporting purposes.
4. Integrated account system help to coordinate the various forms of an organization.
5. It facilitates the use of IT systems.

105
6. Cost data can be obtained without delay as cost accounts are posted directly from the basics of
original entry.

Disadvantages
1) Differences in the valuation of stock – In financial accounting stock is valued base on the lower of
cost and net realizable value whole in cost accounting stock is valued based on the input cost. The
difference in the valuation often brings a challenge in integrated accounts.
2) Problems associated with items appearing in cost accounting only e.g. overhead absorption,
notion cost and changing of depreciation based on the usage.

Items of expenditure that is unique to the two systems of accounting.

i. Appropriations of profits not dealt within the costing systems e.g. corporations tax, dividends
paid and proposed etc.
ii. Expenditure of a purely financial nature (i.e. nothing to do with manufacturing e.g. losses on
sale of fixed assets, interest on bank loans, bank charges etc.

In the financial Systems, the required ledgers are:

a) The General Ledger
b) Debtors Ledger (or Sales ledger)
c) Creditors Ledger (or Purchases ledger)

In the cost book-keeping system, the required ledgers are:

i) General Ledger Adjustment Account: It is sometimes called the cost ledger account.
ii) All the items extracted from the financial account are recorded in this account. The balance in
this account represents the total of all the balances of the impersonal accounts extracted from
the financial books. It completes the double entry in the cost accounts.
iii) Stores Ledger Control Account: This account shows all the transaction of materials e.g.
purchases, issuance of materials, returns to suppliers, etc. The balance of this account
represents in total the detailed balance of the stores account.
iv) Work in Progress Ledger Control Account: It shows the total work in progress at any
particular time.
v) Finished Goods Ledger Control Account: Receipts from production and transfer to
distribution department are entered in this account and the balance of this account shows the
total value of finished goods in stock.
vi) Production Overheads Control Account: It gives the total production overheads incurred in
the manufacture or production of goods in question.
vii) Wages Control Account: It shows the total wages incurred in the production of goods.
viii) Selling and Distribution Overheads Control Accounts: It gives the overheads incurred in
marketing the goods produced. Examples of such costs will include advertising costs, sales
commission, repairs made to the distribution van etc.
ix) Administrative Overheads Control Accounts: This will give the total of administrative
overheads incurred in the organization. These costs are not related to production. Such costs
will include salary to the general manager, salary to accounts department staff

Link between Cost and Financial Books

106
The link between the two sets of books is achieved by operating a cost ledger control account and a
financial ledger control account (Cost Ledger Contra Account) in the financial and cost books
respectively. In the cost ledger control account, all the items which affect the costs accounts are
recorded, the same items are recorded in the financial ledger control accounts, but on the opposite side
of the account hence the account completes the double entry. The Cost Ledger
Control Account is just a memorandum entry and is, therefore, made in addition to the normal entries
in the financial books of account.

DOUBLE ENTRY SYSTEM IN INTEGRATED A/C

To record purchase on materials
Dr: stores control/raw materials A/C
Cr: Bank/creditors A/C

To record materials returned to suppliers

Dr: Suppliers/Creditors
Cr: Stores control/Raw materials
To issue materials to production
Dr: Work in progress A/C Direct materials
Dr: Production overhead A/C- (for indirect materials)
Cr: Stores control A/C

To record wages
Dr: Wages A/C
Cr: Bank/Wages payable A/C

To change wages in production

Dr: Work in progress A/C (Direct wages)
Dr Production wages A/C (Indirect wages)
Cr: Wages A/C

To record manufacturing expenses

Dr: Production OHDs A/C
Cr: Bank/Expenses payable A/C

To change overheads to production

Dr. Work in progress A/C
Cr: Production OHD A/C

N/B
If the actual overheads is different from the OHD absorbed there is a case of over or under absorption
and the difference should be posted to in OHD adjustment A/C and later transferred to the part A/C

To record the cost of goods produced

Dr: Finished goods A/C
Cr: Work in progress A/C

107
To record the cost of goods sold
Dr: Cost of sales A/C
Cr: Finished goods A/C

To record sales
Dr: Bank/Debtors A/C
Cr: Sales A/C

ILLUSTRATION
Bora Ltd. Commenced its operations on 1 march 2005 with a fully paid up issued share capital of
Sh.500,000 represented by fixed assets of Sh.275,000 and cash at bank of Sh.225,000. The company
has two departments; A and B.

As at 30 may 2005, the following transactions had taken place:

1. Credit purchases from suppliers amounted to Sh.573, 500 of which Sh.525, 000 were in respect of
raw materials and Sh.48, 500 were in respect of purchases classified in the ledger accounts as
production overhead items.
2. Production overhead costs absorbed in the period were:
Sh.
Department A 110,000
Department B 120,000
3. The following overhead costs were paid out by cheque:
Sh.
Administration cost 25,000
Production overheads costs 20,000
Selling costs 40,000

4. Issues of raw materials from the stores were as follows:

Sh.
• Department: A 180,000
:B 192,500
372,500
• Production overhead items totaled Sh. 65,000.
5. The amount of staff wages was Sh.675, 000, Sh.500, 000 was paid out in cash while Sh.175, 000
still owed.
6. The staff wages were analyzed as follows:
Sh.
Work in progress department A 300,000
Work in progress department B 260,000
Administration overheads 25,000
Production overheads item 42,500
Selling overheads 47,500
675,000

108
7. Accruals as at 30 May 2005 were Sh.26, 000 for security of productions facilities and Sh.39, 000
for consultancy on production procedures.
8. The costs of finished goods were:
Sh.
Department: A 570,000
Department : B 555,000
9. Sales on credit amounted to Sh. 870,000 and the cost of these credit sales was Sh. 700,000.
10. Depreciation on production plant and equipment was Sh. 15,000.
11. Cash received from debtors totaled Sh. 520,000 and payments made to creditors
totaledSh.150,000.

Required:
(i). Using integrated cost accounting system, record the above transactions for the three months
ended 30 May 2005.
(ii). Profit and loss account for the period ended 30 May 2005 and balance sheet as at 30 May
2005.

SOLUTION
a) i)
Fixed assets a/c Selling overhead a/c
Sh. Sh. Sh. Sh.
Bal b/d 275,000 Bal c/d 275,000 Bank 40,000 P & L 87,500
275,000 275,000 Wages 47,500
87,500 87,500

Creditors a/c Stores a/c

Sh. Sh. Sh. Sh.
Bank 150,000 Stores 525,000 Creditors 525,000 WIP: A 180,000
Bal c/d 488,500 Production B 192,000
Overhead 48,500 Production
Production Overhead 65,000
Overhead 65,000 Bal c/d 87,500
638,500 638,500 525,000 525,000

Cash book Production overhead a/c

Sh. Sh. Sh. Sh.
Bal b/d 225,000 Wages 500,000 Creditors 48,500 WIP: A 110,000
Debtors 520,000 Creditors 150,000 Depreciation 15,000 B 120,000
Overheads: Bank 20,000 P&L 26,000
Production 20,000 Stores 65,000
Selling 40,000 Wages 42,500
Administration 25,000 Creditors 65,000
Bal c/d 10,000 256,000 256,000

109
 745,000 745,000

Wages a/c Administration overhead a/c

Sh. Sh. Sh. Sh.
Bank 500,000 WIP: A 300,000 Bank 25,000 P&L 50,000
B 260,000 Wages 25,000
Overhead 50,000 50,000
Production 42,500
Selling 47,500
Administration 25,000
675,000 675,000

WIP A a/c WIP B a/c

Sh. Sh. Sh. Sh.
Finished Finished
Stores 180,000 570,000 Stores 192,500 555,000
goods goods
Wages 300,000 Bal c/d 20,000 Wages 260,000 Bal c/d 17,500
Production Production
110,000 120,000
overhead Overhead
590,000 590,000 572,500 572,500

Debtors Depreciation
Sh. Sh. Sh. Sh.
Sales 870,000 Bank 520,000 Bal c/d 15,000 Production
Bal c/d 350,000 Overhead 15,000
870,000 870,000 15,000 15,000

ii)
Profit and Loss Account for the period ended 30 May 2005
Sh. Sh.
700,000 Sales 870,000
Cost of sales 170,000
Gross profit 870,000 870,000

Gross profit 170,000

Administration cost
cost 50,000
Selling cost 87,500
Production expenses 26,000
Net profit 6,500

110
 170,000 170,000

Balance sheet as at 30 May 2005

Sh. Sh.
Fixed assets 260,000 Capital 500,000
Finished goods 425,000 Profit 6,500
WIP: A 20,000 Creditors 488,500
B 17,000 Wages Owings 175,000
Debtors 350,000
Bank 10,000
Stores 87,500
1,170,000 1,170,000

Causes of Difference between Financial Accounting and Cost Accounting Profits Results
− Purely financial expenses e.g. bud debts, discount allowed, interest expenses, losses on disposals
of assets etc.
− Purely financial incomes e.g. dividends received, gain on sale of assets, decrease in provision for
bad and doubtful debts etc.
− Appropriation of profits e.g. dividend paid, transfer to reserved, tax
− Differences in the valuation of stock
− Differences in depreciation charged.
− Notional cost appearing in cost accounting
− Over under absorption of overheads in cost accounting
− Timing differences

PRACTICE EXERCISES (Solutions on page 250)

QUESTION1
More Ltd. is a medium size manufacturing company and it maintains separate cost and financial
accounting books. The financial accountant provided the following statement for the year ended 31
March 2004.
More Ltd
Manufacturing, trading and profit and loss account for the year ended 31 March 2004
Sh. Sh.
Direct materials
Opening stock 150,000
Add: purchases 1,800,000
1,950,000
Less: closing stock 200,000
Direct materials cost 1,750,000
Add: direct wages 250,000

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Prime cost 2,000,000
Add: factory overheads 300,000
2,300,000
Add: opening work-in-progress 125,000
2,425,000
Less: closing stock 130,000
Production cost carried forward 2,295,000

Sales 4,500,000
Less cost of goods sold
Opening stock 240,000
Production cost brought forward 2,295,000
2,535,000
Less: closing stock 255,000
Gross profit 2,280,000
2,220,000
Other incomes
Discount received 45,000
Income from investment 1,094,000 1,139,000
3,359,000
Expenses
Depreciation 280,000
Interest on loan 36,000
Debenture interest 25,000
Administration expenses 600,000 941,000
Net profit 2,418,000

The records from cost accounts showed the following:

1. Stock valuation as at 31 March were as follows:
2003 2004
Sh. Sh.
Raw materials 160,000 196,000
Work-in-progress 121,000 125,000
Finished goods 258,000 260,000

2. Factory overheads were absorbed at 15% of direct material costs.

3. Other costs included:
Sh.
Interest on capital 140,000
Notional rent 420,000
Administration over absorbed 32,000
Selling and distribution over absorbed 25,000
Depreciation 242,000

4. Profit as per cost was Sh. 2,328,400

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 Required:
Prepare a profit reconciliation statement for the year ended 31 March 2004. (20 marks)

CHAPTER 6
COSTING METHODS

DEFINITION
Costing method refers to:
(i) Financial recording and reporting method in which a parent firm's investment in a subsidiary is
shown at cost, without indicating the effect of the subsidiary’s profit or loss on the investment.
See also equity method.
(ii) Inventory valuation based on the acquisition cost (invoice price of the purchases less discounts
plus transportation).

JOB ORDER COSTING

The main purposes of job costing are to establish the profit or loss on each completed job and to
provide a valuation of uncompleted jobs, i.e. the Work-in Progress (WIP).

This is done by creating a Job Cost Card for each job on which would be entered the following
details:
• Direct Labour costs - including time based and piecework earnings.
• Direct Material costs - based on stores issues, special purchases, bills of material
• Direct expenses - expenses incurred specifically for the particular job, e.g. tool hire, royalties

Based on these details and labour and machine time bookings the production departmental overheads
would be calculated using the times recorded and the predetermined overhead absorption rates for
labour or machine time as appropriate. A job is normally valued at factory cost until it is dispatched
when an appropriate amount of selling and administration overheads would be added usually as a

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percentage of the works cost. The total of the partly complete job costs represent the firms work-in-
progress and on completion the costs are removed from W-I-P and charged to the Cost of Sales
account (DR Cost of Sales, Cr:Work in progress

ACCOUNTING FOR JOB ORDER COSTING

The following journal entries relate to material procurement and issue from the store to the production
process.
1. (a) Direct materials purchase
Dr Stores ledger control A/c XX
Cr Cash A/c XX
To record cash purchases

Dr Stores ledger control A/ c XX

Cr Creditors A/ c - for credit purchasers XX
To record credit purchases

(b) Return of materials to suppliers

Dr Cash A/ c or creditors control A/ c XX
Cr Stores ledger control A/ c XX
To record return of materials to suppliers

(c) Issue of materials from the store

Dr W.I.P. Control A/c X
Cr stores ledger control A/c for direct materials. XX
To record issue of direct materials from the store

Dr Factory overheads control A/ c XX

Cr Stores ledger control A/ c XX
To record issue of indirect materials from the store
Labour cost is measured and accumulated in the same way as material cost. It includes both direct and
indirect labour. Direct labour can be traced directly to the individual job where as indirect labour
cannot or if it has to be traced, it can only be done with expenditure of great effort.

Labour costs are accumulated based on the time tickets prepared by workers. The worker needs to
indicate the duration of time he/she spent on a specific job or, when not assigned to a specific job,
what type of indirect labour task he was assigned to and the amount of time expended on the task.

Total labour costs are calculated based on the time sheets submitted at the end of the day by all the
workers. An example of a time ticket is shown below STING

Below are the journal entries passed to record direct and indirect labour.
2. (a) Direct Labor
Dr W.I.P. Control A/e XX
Cr Cash a/c XX
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 To record direct labour Paid in cash
(b) Accrued Direct Wages
Dr W.I.P. Control Ale XX
Cr Wages Control Ale XX
To record direct wages to be paid (accruing at a specific)
(c) Indirect Wages
Dr Factory overheads control AI c XX
Cr Wages Control Alc XX
To record indirect wages (labour cost) incurred

Production overheads go along with direct materials and direct labour in determining the cost per unit
or in batch processing or the cost of a particular job. However, it is difficult to assign manufacturing
overheads because they cannot be traced directly to a particular job and it consists of many unlike
items with the variable and fixed cost components with fixed cost constituting a large part of
manufacturing overheads. Overheads are, therefore, assigned to units of production through an
allocation process.

The following journal entries are passed to record production overheads allocated for a job.

3. Production Overheads

(i) (Not yet paid) Dr Factory overhead control A/ c XX

Cr Expenses/Creditor control A/c XX
To record unpaid production overheads

(ii) (When paid) Dr Expense / creditors Ale XX

Cr Cash A/c XX
To record payment of production overheads

After the allocation of manufacturing overheads, total cost for a job can then be determined and
summarized in a job Cost Sheet or job cost account. Examples of the above are shown below

OTHER TRANSACTIONS
4. Finished goods transferred to the store:
Dr Finished goods stock control A/c XX
Cr W.I.P Control A/c XX
To record transfer of finished goods to the store

5. Sale delivery of finished goods to customers:

(i) On Credit: Dr Debtors control A/c XX
Cr Sales A/c XX
To record credit sales

(ii) In Cash: Dr Bank/Cash A/c XX

Cr (Sales A/c XX
To record cash sales
115
6. Cost of goods sold to customers:
Dr Cost of sales A/c XX
Cr Finished goods control A/c XX
To record cost of goods sold to customers
7. (i) When there is over absorption of production overheads:
Dr Factory overheads control A/c XX
Cr P & L A/c XX
To record over absorption of production overheads

(ii) When there is under absorption of production overheads:

Dr P& L A/c XXX
Cr Factory overheads control A/c XXX
To record under absorption of production overheads

8. When there are non-manufacturing overheads:

Dr P & L A/c XXX
Cr Non-manufacturing overheads control A/c XXX
or
Non-manufacturing overheads/expenses are regarded as period costs & are therefore not changed To
W.I.P control A/c.

Note: Overheads entries apply when there is an interlocking accounting system.

ILLUSTRATION
At the start of the year, no jobs were in process. During the year, job no 2.1, 2.2 and 2.3 were started;
materials were purchased at a cost of Shs.100,000. Materials worth Shs.75,000 were used of which
Shs.70,000 were direct. (Shs.10,000 on job 2.1, Shs.40,000 on job 2.2 and the balance on job no.2.3).
Labour costs worth Shs.250,000 were incurred of which Shs.220,000 was direct labour (Shs.80,000
on job 2.1, Shs.75,000 on job 2.2 and the balance on job 2.3).
Other manufacturing overhead costs of Shs.72,800 were incurred; manufacturing overhead is applied
to production on the basis of direct labour costs. Estimated manufacturing overhead for the year was
Shs.100,000 and estimated direct labour cost for the year was Shs.200,000. Jobs 2.2 and 2.3 were
completed with job 2.3 being sold for Shs.200,000

Required:
a) Pass the necessary journal entries to record the above transactions.
b) Prepare a costing profit and loss account for the period above.

SOLUTION
Dr Cr
SHS SHS
1 Materials 100,000
Cash 100,000
2 Work in Progress 70,000

116
 Manufacturing overheads 5,000
Materials 75,000
3 Factory Labour 250,000
Cash 250,000
To record labour costs incurred
4 Work in progress 220,000
Manufacturing overheads 30,000
Factory labour 250,000
5 Manufacturing overheads 72,800
Cash 72,800

6 Work in Progress (see working below) 110,000

Applied manufacturing overhead 110,000
To record applied overheads

7 Finished goods; Job 2.2 152,500

Finished goods; job 2.3 117,500
Work in Progress 270,000
To record transfer of jobs to finished goods

8 Cash 200,000
Sales 200,000
To record sale of job 2.3

9 Cost of goods sold 117,500

Finished goods 117,500
To record transfer of job 2.3 to cost of sales

10 Applied manufacturing overheads 110,000

Manufacturing overheads 107,800
Cost of sales 2,200
To record over absorbed overheads

Costing profit and loss account

SHS SHS SHS
Sales 200,000
Cost of goods sold
Opening stock of work in progress(WIP) - -
Opening stock of raw materials - -
Add: direct material cost 70,000
Direct labour cost 220,000
Applied overheads 110,000 400,000
400,000

117
Less: Closing Raw materials 0
Closing W.I.P (130,000)
Cost of goods manufactured 270,000
Add Opening Finished goods inventory 0
Goods available for sale 270,000
Less Closing Finished goods inventory (152,500)
Cost of goods sold 117,500
Over applied overheads (2,200)
Cost of goods sold 115,300
Profit for the period 82,500

Note: The cost of goods sold as computed above is the same as computed below when various costs
are accumulated as shown in the table.

Working
Overheads absorption rate = Estimated manufacturing overheads
Estimated direct labor cost
= Shs.100,000× 100%
Shs.200,000
= 50%

Therefore, total manufacturing costs absorbed = 50% × total direct labour cost
= 50% ×220,000 = 110,000
COSTING
Accumulated costs of jobs;
Direct materials Direct labour Applied Total Cost
overheads
Job no 2.1 10,000 80,000 40,000 130,000
Job no 2.2 40,000 75,000 37,500 152,500
Job no 2.3 20,000 65,000 32,500 117,500

BATCH COSTING
This is a form of costing which is used where a quantity of identical articles are produced together as
a batch. The general procedures are very similar to costing jobs. The batch would be treated as a job
during manufacture and the various costs (material, labour and overheads) collected in the usual
manner. On completion of the batch the total batch cost would be divided by the number of good
articles produced so as to provide the average cost per article. Batch costing procedures are common
in a variety of industries including; clothing, footwear, engineering components.

ILLUSTRATION
The budgeted variable overheads of Githurai Ltd for the year 2001 are given as below:

Department Overhead (Shs) Absorption base

A 150,000 15,000 direct labour hours

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B 200,000 25,000 direct labour hours
C 120,000 20,000 direct labour hours
D 300,000 30,000 machine labour hours

Additional information
1. Selling and administering overheads are charged at 10% of total production costs while the profit
markup is 25% of total costs:
2. An order for 2,000 units was received from a customer. The batch number of this order is 510.
The following additional information in respect of this batch is provided below:
• Direct materials - 87,000/ =
• Direct Labor - Dept. A (150 direct labor hrs) @ Shs.12. per hour.
- Dept B (40 direct labor hrs) @ Shs.15 per hr
- Dept C (60 direct labor hrs) @ Shs.20 per hr
- Dept D (100 direct labor hrs) @ Shs.10 per hr
• A total of 50 machine hours were used in this job

Required: Calculate:
a) Total cost of the batch
b) Cost/Unit
c) Selling Price of the batch
d) Selling Price unit.

SOLUTION

Direct Materials Direct labour Manufacturing overheads

Item Total Ticket Labour hrs Total Base of Rate Total
Code Cost Cost absorption Per
hr
N 87,000 Dept A 150 @Sh12 1800 Direct labour hr 10 1500
Dept B 40 @Sh15 600 Direct labour hr 8 320
Dept B 60 @Sh20 1200 Direct labour hr 6 360
- Dept C 100 @Sh10 1000 Machine hr 10 500
Totals 87,000 4,600 2,680

Cost Summary:
Shs.
Direct materials 87,000
Direct Labour 4,600
Manufacturing Overheads 2,680
Total Production Cost 94,280
Selling and admin costs (10%) 9,428
Total cost of Batch 103,708

119
(a) Total cost of the batch Shs.103, 708

(b) Cost per unit

= Total cost of the batch = Sh.103, 708 = Shs.51.86 per unit
Total no of units 2,000 Units
(c) Selling price of the batch; Cost plus 25% markup

Shs
Cost of the Batch 103,708
Mark up @ 25% 25,927
Selling Price of the Batch 129,635

Selling price per unit

= Selling Price of the Batch= Sh.129, 635 = Shs.64.82 per unit
Total no of units2,000 Units

PROCESS COSTING
This is a product costing method applicable where similar products are produced continuously in a
series of production steps commonly known as processes.
It is used where production is continuous in a series of production steps and similar products are
produced.
This is a costing method that is applied where there are standard operations with continuous
production of homogeneous and identical units. Products are produced in the same manner and
consume the same amount of material and labour. The output is the final product of a sequence of
operations. In this type of costing, costs are accumulated on the basis of process, and individual units
of output are thus assigned the average cost per unit. The cost per unit is arrived at by dividing the
total process costs by the number of input of the next process and further materials can be added at
each stage production. Therefore, cost per unit for the second and subsequent processes is a
cumulative cost. For example, the cost per unit for the output transferred from process 2 is the cost of
production for both process 1 and 2 and not for process 2 above.

Common features
1. Similar units are produced continuously
2. The continuous nature of production results in some units being incomplete at the end of the
period.
3. Loss is a common feature due to spoilage, wastage, evaporation etc.
4. Costs cannot be identified with individual products.
5. In some cases output may be multiple products.

Definitions
a) Process losses
This represents loss of material due to spoilage, evaporation which arises due to the nature of the
product processes.
Process uses can be categorized into:-

120
 i) Normal loss: This is the expected losses and they are unavoidable. They are cost by
inherent factors to production processes e.g. evaporation.
Normal loss is based on past experiences and indicates the expected loss under normal
working conditions.
No cost is allocated to normal loss. However, any amount realised from sale of normal loss
units reduces the cost of good output in unit cost calculation.
ii) Abnormal loss
These are extra units lost above the normal loss units.
It arises due to unfavourable working conditions i.e. substandard materials, accidents,
carelessness etc.
It carries its own cost and will be valued a good unit and the amount transferred to P&L
iii) Abnormal gain
This represents the expected loss transferred out as good output.
They are units which were expected to be loss but they were not lost.
It arises due to improved working conditions i.e. high quality material, less accidents etc.
It is also accounted at the cost of good output.
b) Scrap
These are the discarded materials with some recovery value which is either disposed of without
further processing or can be reintroduced in place of raw materials.

c) Waste
These are discarded substance with no recovery value and normally they are disposed at a cost i.e.
a cost is incurred to dispose the waste. This cost is treated as part of process cost for the process
which generated the waste.

Accounting for processes

Process costing is centered on four key steps.
The exact volume of work done in each step will depend on whether there are losses, W.I.P, joint and
by-products etc. These steps includes:-
i) Determination of inputs and outputs
ii) Calculating cost per unit and outputs
iii) Calculating the total cost of outputs
iv) Computing the necessary accounts

The procedure for process costing is as follows;-

The production factory is divided into a number of processes.
• An account is opened and maintained for each process.
• Each process account is debited with materials, labor, direct expenses and overheads
apportioned to the process.
• The good output of a process is transferred as input to the next process. At the end of the
period, the products will include various items. These are normal loss, abnormal loss, finished
goods (or output to the next process) and work in progress.
• The finished output of the last process is transferred to the finished goods account.

Process costing with presence of process losses and gains

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Losses in a process are a common feature and they should be well accounted because they have an
impact on production cost.
Most manufacturing processes result in some portion of the raw materials used not being converted
into a reliable half hence losses. These losses may take the form of waste, scrap, rework, and spoilt
units.
Waste: are materials lost in the process, which are irrecoverable or have no recoverable value. The
term also refers to discarded substances having no value and is disposed off
Scrap: Material held after a productive process, which are irrecoverable or have no recoverable value.
The term also refers to discarded materials, which have some recoverable value which is usually
either disposed off without further treatment, or reintroduced into the production process in place of
the raw materials. Scraps are process losses that can be sold for some small value.
Rework: These are finished goods that do not meet quality standards but which with some additional
work can be sold.
287
Loss: Refers to finished or partially finished units, which cannot be reworked or used for their
intended purpose. They may be discarded or sold for minimal value. There are two types of spoilage;
i. Normal Loss: is loss expected and unavoidable even under the most efficient systems of
production. Normal spoilage cost is normally included in product cost.
ii. Abnormal Spoilage: This is loss that is avoidable with efficient operating conditions.
The cost is regarded as controllable and can be eradicated if due diligence and supervision are
exercised. The cost is normally treated as a loss and charged to profit and loss account.

Normal loss
Cost of normal loss is absorbed by the cost of good units.
Normal losses are unavoidable costs that are expected to occur under efficient operating conditions.
They are inherent in the production process and cannot be eliminated or controlled.

Illustration
1000 kgs at sh.3.60/kg were input to a process and there was a 10% loss due to evaporation.
900 good units should result and their cost per unit would be:
1000 × sh.3.60/900 = sh.4/unit.

The level of normal loss selected as being the standard for the period under review is based on various
factors such as past experience, quality control records from the past periods and industry norms.
These costs are assigned to the good output using two approaches;

(a) Recognition and Re-Assignment Approach In this approach, the normal spoilage is included in
the equivalent units computation; further, the normally spoilt units will be assigned costs just like any
other unit. The spoilage costs will then be reallocated to these good units that have passed the
inspection point. The steps to follow under this method are:
i) Compute equivalent units including normal spoilage.
ii) Assign costs to all units including normal spoilage.
iii) Reassign normal spoilage costs to good output.

ILLUSTRATION

122
ABC Ltd. produces and sells a certain type of insecticide, YMX. In the year just ended, ABC material
input into production process I was 2000 units at Shs.10 per unit. Labour costs incurred amounted to
Shs.30,000 while overhead costs absorbed amounted to 20,000. The normal loss in the process is 5%.
Compute the cost of spoilage and the cost per unit of output transferred to process II after reassigning
the normal loss costs.
SOLUTION
(The process I account will help us solve the problem)

Process I Account
Materials 2,000 20,000 Transferred to process II 1,900 66,500
Labour cost 30,000 Normal loss 100 3,500
Overhead cost 20,000 -
70,000 70,000

Cost per unit = Shs.70,000/2,000 units = Shs.35 per unit

Reassigning of costs to the good units

= 3500/1900 per good unit = Shs.1.84 (2.d.p)
Therefore, cost per good unit shall be Shs. (35 + 1.84) = Shs.36.84

(b)Omission Approach: Under this approach, the normally spoilt units are not included in the
calculation of equivalent units. This means that the cost of the normally spoilt units will automatically
be distributed to the good output. By excluding the normal spoilage in the computation to the good
output, a lower figure will be derived. This is the most commonly used method of accounting for
normal losses. The weaknesses of this method are;
i) The cost of normal spoilage is spread equally into the finished goods and the ending W.I.P
regardless of whether the ending W.I.P. has passed the inspection stage or not.
ii) It does not allow the manager to see the costs of spoilage because these costs are not computed.

Using the illustration above

SOLUTION
The process I account will appear as follows
Process 1 Account
Materials 2,000 20,000 Normal loss (5%) 100 -
Labour cost 30,000 Transferred to process II 1,900 70,000
Overhead cost 20,000 -
70,000 70,000

The cost per unit of the good units shall be computed using the formula given below
Cost per unit = Total accumulated cost
Expected output

Expected output = Total input (units) – Normal loss (Units)

Thus the cost per unit of production transferred shall be

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 = Cost per unit = Shs.70,000= Shs.3.684
95% ×20,000 units

The situation above exists where normal loss with no scrap value exists. There are instances where the
normal loss will have a scrap value. For instance, in the Jua Kali industry, the metal scraps may be
used to mend patches or be sold out for some other use. In this case, the revenue obtained from the
sale of scrap is offset against costs incurred in the production process to arrive at the total costs to be
allocated to each unit. In accounting terms, the cashbook is debited with the amount received from the
sale of scrap and the process account is credited with the equivalent.

ILLUSTRATION
1,000 kgs at sh.4.00/kg were input to a process and there was a 20% loss due to filtration. The
materials filtered out could be sold for sh.0.50kg.
Required;
Prepare a process account.

SOLUTION
800 good units should result and their cost per unit would be:

1,000 × 4 – 200 ×0.50= sh.4.875/unit

800
Process account
Units Sh. Units Sh.
Material 1,000 4,000 Normal loss 200@ sh.0.5 100
- - To finished goods 800@ sh.4.875 3,900
1,000 4,000 1,000 4,000

Abnormal losses
Abnormal losses and gains carry their own costs and will be valued at the cost of good output. They
are separately analyzed and the amount to P&L.
These costs do not add any production benefit to the company and are treated as accounting losses.
They are controllable losses which are not expected to occur under efficient operating conditions e.g.
improper mixing of ingredients, omission of some important chemical in the manufacture of a
product, etc. Abnormal losses are considered to result from production inefficiencies that should be
eliminated and are not an inherent part of the production process.
The cost of abnormal spoilage not included in the process cost nor included in inventory valuation but
reported separately as abnormal is written off directly as losses for the period in which it occur.
Abnormal losses, just as normal losses, may or may not have a scrap value. Abnormal loss with or
without scrap value is treated in a similar way in the process account. The sales revenue received from
sale of abnormal loss units is offset against the cost of abnormal loss in the abnormal loss account to
arrive at the net abnormal loss that shall be charged to the profit and loss account in the period in
which it arises.

Abnormal gain

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In some instances, the actual output may be greater than expected or, put in other words, actual loss
less than normal or expected. In such circumstances, abnormal gains are considered to have arisen.
The main objective of preparing the process account is to determine the cost per unit of expected
output (Normal output).
In a case where abnormal gains have no scrap value, (i.e. where if scrapped would not have a value)
the cost per expected output
= Input cost
Expected output

ILLUSTRATION
In August 2000 kgs of a material were introduced to a process at a cost of sh.6/kg, and 200 hours
labor were spent at a cost of sh.15/hour. Overheads are absorbed at the rate of sh.4/ labour hour.
Normal losses are incurred at the rate of 5% of input and lost units can be sold for sh.0.9 per
Kilogram. 1,800 kgs were produced.

Required;-
Calculate the total absorption cost of the good output, the treatment of any abnormally lost or gained
units, and also show the process account and loss account.

Solution
Input costs less sale of normal loss = (2,000 ×sh.6) + (200 ×sh.15) + (200 ×sh. 4) – 100 × 0.9 =
15,710

Expected output = 2,000 × 0.95 = 1,900 (actual output = 1,800; abnormal loss = 100).

𝒔𝒉.15,710
Cost per unit = = sh.8.2684
1,900

Process account
Units Sh. Units Sh.
Material 2,000 12,000 To finished goods 1,800 @ 8.2684 14,883
Labour 3,000 Normal loss: sale
Overheads 800 of scrap [email protected] 90
- - Abnormal loss 100@ 8.2684 827
2000 15,800 2,000 15,800

Normal loss account

Units Sh. Units Sh.
Process account 100 90 Cash 100 90
- -
90 90

Abnormal loss account

Units Sh. Units Sh.

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Process account 100 827 Cash 100 90
- Income
- statement 737
827 827

The net cost of the abnormally lost units is Sh.737.

ILLUSTRATION
In May 5000 kgs of a material were introduced to a process at a cost of sh.9/kg, and labour and
overheads amounting to sh.25, 000 were also contributed.
Normal losses are incurred at the rate of 10% of input and lost units can be sold for sh.1 per kilogram
4,700 kgs were produced
Calculate the total absorption cost of the good output, the treatment of any abnormally lost or gained
units, and also show the process account and loss account.

SOLUTION
Input costs less sale of normal loss = (5,000 × Sh.9) + Sh.25, 000 – 500 × 1 = 69,500

Expected output = 5,000 × 0.9 = 4,500 (actual output = 4,700; abnormal gain = 200).

𝑺𝒉.𝟔𝟗,𝟓𝟎𝟎
Cost per unit = = Sh.15.4444
𝟒,𝟓𝟎𝟎

Process account
Units Sh. Units Sh.
Material 5,000 45,000 To finished goods 4,700 @ 15.4444 72,589
Labour and 25,000 Normal loss: sale of
overheads scrap 500 @1 500
Abnormal gain 200 @15.4444 3,089 - -
5,200 73,089 5,200 73,089

Normal loss account

Units Sh. Units Sh.
Process Cash 300 300
account 500 500 To abnormal gain
- account 200 200
500 500

Abnormal gain account

Units Sh. Units Sh.

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Normal loss account 200 200 Process account 200 3,089
Income statement 2,889 -
3,089 3,089

ILLUSTRATION
ABC Chemicals Ltd manufactures a chemical compound branded 'X' used in making plastics. The
chemical compound involves two processes; A and B. The output of process A is passed to process B
where further material is added to mix. The details of the process costs for the production period
ended 30 April were as follows:

Process A:
Direct materials 5,000 kgs at Sh. 10 per kg.
Direct labour Sh. 40,000
Process plant time 200 hours at Sh. 220 per hour
Overheads Sh. 20,000
Process B:
Direct materials 3,000 kgs at Sh. 10 per kg.
Direct labour Sh. 25,000
Process plant time 120 hours at Sh. 220 per hour
Overheads Sh. 12,000

Additional information:
1. The expected and actual output for the processes was as follows.
A B
Expected output 90% of input 95% of input
Actual output 4,200 Kgs 7,340 Kgs

2. Assume no finished stock at the beginning of the period and no work in progress at either the
beginning or the end of the period.
3. Normal loss is sold as scrap for Sh.1.00 per kilogramme from process A and Sh.2.00per
kilogramme from process 3, for both of which immediate payment is received

Required:
(i) Process A account.
(ii) Process B account.
(iii) Abnormal loss/gain account,
(iv) Normal loss account

SOLUTION
a) ABC Chemicals Ltd
Process A
Expected output = 90% × 5,000 = 4,500
Process Plant time = 200 × 220 = 44,000
Scrap value = 1

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 Process B
Expected output = 95%×3,000 = 2,850
Process plant time = 120×250 = shs30,000
Scrap value = 2

Process A Account
Units 𝑪𝒐𝒔𝒕 Amount Units 𝑪𝒐𝒔𝒕 Amount
𝑼𝒏𝒊𝒕 𝑼𝒏𝒊𝒕
Shs Shs
Direct materials 5,000 - 50,000 Output 4,200 34.111 143,267
Direct labour 40,000 Normal loss 500 1 500
Process plant time 44,000 Abnormal loss 300 34.111 10,233
Overheads ____ 20,000 ____ -
5,000 154,000 5,000 154,000

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑙𝑙 𝑢𝑛𝑖𝑡𝑠 − 𝑁𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑠𝑠 /𝑠𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 =
𝑈𝑛𝑖𝑡𝑠 𝑖𝑛𝑡𝑟𝑜𝑑𝑢𝑐𝑒𝑑 − 𝑁𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑠𝑠 𝑈𝑛𝑖𝑡𝑠

154,000−500 153,500
=
5,000−500
= 4,500
= 34.111

Process B Account
Units 𝑪𝒐𝒔𝒕 Amount Units 𝑪𝒐𝒔𝒕 Amount
𝑼𝒏𝒊𝒕 𝑼𝒏𝒊𝒕
Shs Shs
Process A/c 4,200 34.111 143,267 Output 7,340 37.288 273,691
Direct materials 3,000 15 45,000 Normal loss 360 2 720
Direct labour 25,000
Process plant time 30,000
Overheads 12,500
Abnormal gain 500 37.288 18,644 _____ _____
7,700 274,411 7,700 274,411

Abnormal loss/gain account

Units 𝑪𝒐𝒔𝒕 Amount Units 𝑪𝒐𝒔𝒕 Amount
𝑼𝒏𝒊𝒕 Shs 𝑼𝒏𝒊𝒕 Shs

Process A A/c 300 34.111 10,233.3 Scrap value 300 1 300

Scrap value 500 2 1,000 Process B 500 37.288 18,644
Profit and loss 7,710.7
18,944 18,944

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 Normal loss account
Units 𝑪𝒐𝒔𝒕 Amount Units 𝑪𝒐𝒔𝒕 Amount
𝑼𝒏𝒊𝒕 Shs 𝑼𝒏𝒊𝒕 Shs
Process A A/c 500 1 500 Bank 1,220
Process B A/c 360 2 720 -
1,220 1,220
ACCOUNTING FOR WORK-IN-PROGRESS (WIP)
In industries where process of manufacturing is continuous, some units may be incomplete at the end
of the period. A problem arises in unit cost as the complete units.

The solution to this problem is to express output in terms of equivalent units. Equivalent units are
assumed complete units output from a production process if a single unit is started and completed
before another is started.
It is based on percentage of completion of output e.g. if 10,000 units were started but only 8000 units
were completed and the remainder was left in WIP with 60% degrees of completion, the equivalent
units which will be used for cost calculation will be given by:

Equivalents Units
Complete units – 100% = 800
W-I-P 2000 @ 60% = 1200
Equivalent unit of output 9200

The cost incurred in a process are not incurred uniformly and therefore equivalent units will not be
based on the same percentage of completion i.e. output in a process will carry different degrees of
completion for equivalents unit calculation.

Cost items in a process include:-

i) Transfer in cost
This represents cost introduced in a process. These costs are accounted 100% since input is
transferred into the process as complete unit.
ii) Material added is this process
The percentage of completion depends on how the materials are added in the process.
iii) Conversion costs
This refers to the direct labour and overheads. The percentage of completion will depend on how the
cost is incurred.

Accounting for opening W.I.P

Where there is opening W.I.P the cost data relate to two production period i.e. the previous period
costs for opening and the current period costs for work started this period.
There are two methods which can be used in accounting for W.I.P.
i) Weighted Average Method
ii) FIFO Method

i) Weighted Average Method

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In the method, there will be no distinction between input of opening W.I.P and what was transferred
in this period. They will be treated as if they were started at the same time.
The units of output from the process will be assumed to have come from the same batch of input of
opening W.I.P and transfer in.
The costs to account for will relate to the cost incurred in the two periods i.e. the cost will also be
assumed to have been incurred in the same period.

ii) FIFO
In this method, the Opening work in progress and units transferred in this period maintain their
identity and are account separately.
Opening work in progress enters the process first and will be assumed to be completed from O.P
W.I.P and the units started and transferred this period.
The cost incurred will only be relayed to work computed this period i.e. only current cost will be
considered for unit cost calculation.

STEPS IN PREPARING PROCESS COSTING STATEMENT

(1) FIFO Method
(a) Physical flow of units; this identifies the units to be accounted for (units in beginning
WIP inventory plus the units started during the period) and the units accounted for (the units
completed during the current period plus the units in the ending WIP)
(b) Equivalent units of production: the common denominator for completed units and partially
completed units are computed by multiplying the units accounted for by their percentage of
completion by each category of costs i.e. material cost (100%), labour cost, e.t.c. (75%).
(c) Costs to be accounted for: total costs to be accounted for (the cost of units in the beginning WIP
plus the costs added to production during the current period) are identified for each category of costs.
(d) Cost per equivalent unit of production: these are computed by dividing the costs to be
accounted for by the total equivalent units of production.
(e) Costs accounted for (Cost allocation): total costs to be accounted for are allocated for each
category of costs to the units accounted for by multiplying the equivalent units of production by the
cost per equivalent unit of production.
2 8 4 COST ACCOUNTING
WEIGHTED AVERAGE METHOD (WAM)
a) Physical flow of units; the WAM does not keep the beginning inventory units separate from the
units that were started and completed during the period
b) Equivalent units of production: in computing equivalent units of production, the WAM does not
keep the percentage of completion performed in the prior period separate from the percentage of
completion performed in the current period.
c) Costs to be accounted for: in identifying costs to be accounted for, the WAM does not keep the
costs of the units in the beginning inventory at the start of the current period separate from the
costs added to the production during the current period
d) Cost per equivalent unit of production: these are computed by dividing the costs to be
accounted for by the total equivalent units of production
e) Costs accounted for (Cost allocation): total costs to be accounted are allocated for each category
of costs to the units accounted for by multiplying the equivalent units of production by the cost
per equivalent unit of production. The WAM does not keep the cost of the units in beginning WIP
separate from the costs added to production during the current period.
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ILLUSTRATION
Process 2 received units from process 1 and after carrying out work on the units transferred them to
process 3. For one accounting period the relevant data were as follows:
Opening WIP 200 units (25% complete) valued at Ksh. 2,500
800 units received from Process 1 valued at ksh. 4,300
840 units were transferred to process 3
Closing WIP 160 units (50% complete)

The costs for the period were Ksh. 16,580 and no units were scrapped. It is required to prepare the
process accounts for process 2 units:
i) The FIFO method of valuation.
ii) The average cost method of valuation.

SOLUTION
Using FIFO method
Calculation of effective units of production
Units
Completed units transferred out 840
+ Work contained in closing WIP (160×50%) 80
920
- Work contained in opening WIP (200 x 25%) (50)
Effective units for period 870
Period cost per unit = Total cost for period i.e. process costs + transfers in
Effective units for period
= 16,580 + 4,300
870
= Ksh. 24.
This figure is used to give the closing WIP valuation, i.e.
160 × 50%×Ksh 24 = Ksh. 1,920.

The valuation of the number of complete units transferred to process 3 is found from the balance on
the process account as follows:

Process 2 Account
Unit Ksh Units Kshs.
Opening WIP b/f. receipts from 200 2,500 Transfers to 840 21,460
process 1 800 4,300 process 3 Closing
Process costs 16,580 WIP c/f 160 1,920
1,000 23,380 1,000 23,380

Note on illustration (FIFO method):

The transfer value of Ksh. 21,460 is the balance on the account and is Kshs. 1,300 greater than the
period cost per unit already calculated i.e. Kshs. 21,460 - (840 x Kshs. 24) = Kshs. 1,300.

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This is the amount by which the opening WIP valuation (based on the previous period's costs) is
greater than the current period costs i.e.

Kshs. 2,500 - (200 x 25% × Kshs. 24) = Kshs. 1,300.

Thus, it would be seen that only the current period cost levels, i.e. The Kshs. 24 per unit are carried
forward to the next period in the closing WIP valuation.

Using average cost method

Using this system the effective units are the transfers to the next process (840 units) plus the work
contained in the closing WIP (80 units i.e. 50% of 160 units) that is a total of 920 units.
The costs involved are the total of the opening WIP valuation + the valuation of units transferred in +
the process 2 costs i.e.
Kshs. 2,500 + 4,300 + 16,580 = Kshs. 23,380.
Average cost per unit = 23,380 = Kshs. 25.413.
920
This is used to value both the closing stock and transfers out thus:
Closing stock valuation = 160 x 50% x Kshs. 25.413 = Kshs. 2,033.
Transfers to process 3 = 840 x Kshs. 25.413 - Kshs. 21,347

The process account is as follows:

Units Kshs. Units Kshs.
Opening WIP b/d 800 4,300
Receipts from Transfers to 840 347
Process 1 16,580 Process 3
Process costs Closing WIP c/d 160 33
1,000 23,380 1,000 380

Note-illustration (average cost method):

1. It will be seen that the effect of the average cost method is, in this example, to increase the value
of closing stock and reduce the value of transfers to process 3. This is because the previous period
cost levels (as contained in the opening WIP valuation) were higher than the current cost levels. If
the previous period cost levels were lower than current levels the average cost method would
cause the closing WIP valuations to be lower than when using the FIFO system.
2. The above example has deliberately been kept simple to show clearly the principles involved.
Examples follow which show the added complications of abnormal and normal scrap and where
the elements material, labour and overheads) or the opening and closing WIP are involved. It
must be stressed however. That these added complications merely increase the amount of
arithmetic involved, they do not alter the basic principles explained above so it is important that
these are thoroughly understood before proceeding further.

ILLUSTRATION
This example illustrates the treatment of opening and closing WIP where the WIP is broken down into
its various elements.
The following data relate to process y for accounting period 2.

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At the beginning of period 2, there were 800 units partly completed which had the following values:
Value Kshs Percentage complete
Input material (from process x) 8,200 100
Material introduced 5,600 55
Labour 3,200 60
Overheads 2,400 45

During the period 4,300 units were transferred from process x at a value of Kshs. 46,500 and other
costs were:

Kshs.
Material introduced 24,000
Labour 19,500
Overhead 18,200

At the end of the period, the closing WIP was 600 units which were at the following stage of
completion:

Input material 100% complete

Material introduced 50% complete
Labour 45% complete
Overheads 40% complete

The balance of 4,500 units was transferred to finished goods.

Calculate the value of units transferred to finished goods and the value of WIP and prepare the
process account using

i) The FIFO method and

ii) The average cost method

Solution to the above illustration using FIFO method

As previously, the first step is to calculate the effective units of production for the period. This
follows identical principles to example 4 except that in this example it is necessary to consider the
four elements of the units (input material, material introduced, labour and overheads) instead of
simply the units as whole. When the effective production is ascertained the cost per unit, for each
element, can be calculated.

Calculation of effective units and cost per unit

Cost element Completed + Equiv. - Equiv. = Total Cost Cost per

units Units in units in effective Kshs unit
closing opening production Kshs
WIP WIP
Input
Material 4500 + 600 - 800 = 4300 46500 10.814

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 Material Intro. 4500 + 300 - 440 = 4360 24000 5.505
Labour 4500 + 270 - 480 = 4290 19500 4.545
Overheads 4500 + 240 - 360 = 4380 18200 4.155

Closing stock valuation = 600 units

Kshs. Kshs.
Input material = 100% complete = 600 x 10.814 6,488

Material introduced = 50% complete = 300 x 5.505 1,651

Labour = 45% complete = 270% x 4.545 1,277

Overheads = 40% complete = 240 x 4.155 997

Kshs. 10,363

This value is used in the process account in the normal way with the value of the transfers to finished
goods being the balance on the account.
Process account – process y (FIFO)
Units Kshs. Units Kshs.
Opening WIP b/d 800 19,400
Transfer in from Transfers to
Process x 4,300 46,500 Finished goods 4,500 117,237
Materials Introduced 24,080 Closing WIP c/d 600 10,363
Labour 19,500
Overheads 18,200
5,100 127,600 5,100 127,600

Solution to the above illustration using average cost method

Calculation of effective units and cost per unit
Cost elements Equivalent units in Fully Total Opening Period Total Cost per unit
closing WIP + Complete = effective WIP +costs = cost (b) ÷ (a)
units production values (b)
(a)
Input material 600 x 100% = 600 + 4500 = 5100 Kshs.8200 + 46500 =sh.54700 Sh.10725
Material Intro 600 x 50% = 300 + 4500 = 4800 5600 + 24000 = 29600 6.167
Labour 600 x 45% = 270 + 4500 = 4770 3200 + 19500 = 22700 4.759
Overheads 600 x 40% = 240 + 4500 = 4740 2400 + 18200 = 20600 4.356

Sh.19400 + sh.108200 =sh.127600 Sh.25.997

Value of completed production = 4,500 x Shs. 25.997 = Shs. 116,987.

The value of the closing WIP can be found either by deducting the value of completed production
from total costs or, more tediously, by calculating the various element values, as follows:

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Value of closing WIP
= total cost – value of completed production
= Shs. 127,600 – 116,987 = Shs. 10,613

Or this can be calculated by using the various element values i.e.

600 x shs.10.725 = Shs.6,435.00
300 x shs.6.167 = Shs.1,850.10
270 x shs.4.759 = Shs.1,284.93
240 x shs.4.346 = Shs.10,613.07 (slight rounding error)

The process account can now be completed

Process account – process y (average cost)

Units Kshs. Units Kshs
Opening WIP b/d 800 19,400
Transfers in from Transfers to
Process x 4,300 46,500 Finished goods 4,500 117,237
Materials Introduced 24,080 Closing WIP c/d 600 10,363
Labour
Overheads 19,500
18,200
5,100 127,600 5,100 127,600

ILLUSTRATION
This is more complicated example which brings together the various facets of process costing covered
in the chapter. It includes opening and closing WIP and normal and abnormal losses where the
scrapped units are not fully complete.

The following data relate to process 2 for one accounting period. Process 2 receives units from
process 1 and, after processing, transfers them to process 3.

Opening WIP 600 units

Value Shs Percentage complete %
Input material 720 100
Material introduced 500 60
Labour 340 50
Overheads 270 40

Transfers from process 1: 4, 100 units valued at shs.5,200.

Transfers to process 3: 3, 500 units
Shs
Materials introduced 2,956
Labour 2,200
Overheads 1,900

135
Closing stock 800 units at the following stage of completion
Input materials 100% complete
Material introduced 60% complete
Labour 50% complete
Overheads 40% complete

400 units were scrapped at the following stage of completion

Input material 100% complete
Material introduced 100% complete
Labour 40% complete
Overheads 30% complete

The normal loss is 10% of production and the scrapped units realized 40p each. It is required to
prepare the process account for process 2 using
i) The FIFO method,
ii) The average cost method.

Solution to example 6 using FIFO method

The first stage is to calculate the amount of normal loss to see whether there is any abnormal loss or
gain involved.
The production for the period is calculated as follows:
Opening WIP 600 units
+ Transfers in 4,100
4,700
- closing WIP 800
Production 3,900 units

Normal loss is 10% of 3,900 = 390, and as the actual number scrapped were 400, there were 10 units
of abnormal loss.

The calculation of effective units for cost calculation purposes follows the same principles as in
examples 4 and 5 except that the number of units of abnormal loss must be included in the total
effective production because, as explained, abnormal losses are costed on the same basis as good
production.

Calculation of effective units and cost per unit

Cost element Completed Equiv. Equiv. Equiv. Total Costs Cost

units + unit in +units in - units in = effective Shs per
closing abnormal opening production unit
WIP loss WIP Shs.
Input material 3500 + 800 + 10 - 600 = 3710 2500 1.402
Material intro. 3500 + 480 + 10 - 360 = 3630 2800 0.771
Labour 3500 + 400 + 4 - 300 = 3604 2200 0.610

136
Overheads 3500 + 320 + 3 - 240 = 3583 1900 0.530

(This is the cost of the material introduced, Shs. 2,956, less the resale value of the normal loss,
Shs.156 i.e. 390 @ 40p each. The resale value of the 10 units of abnormal loss is credited to the
abnormal loss account not the process account.)

The costs per unit calculated are then used to evaluate the value of the closing WIP and the abnormal
loss.

Closing WIP valuation Shs.

Input material 800 equivalent units @ Shs. 1.402 1,121.60
Material introduced 480 equivalent units @ 0.771 370.08
Labour 400 equivalent units @ 0.610 244.00
Overheads 320 equivalent units @ 0.530 169.60
Shs.1,905.28
Say Shs. 1,905

Abnormal loss valuation Shs.

Input material 10 equivalent units @ Shs. 1.402 14.02
Material introduced 10 equivalent units @ 0.771 7.71
Labour 4 equivalent units @ 0.610 2.44
Overheads 32 equivalent units @ 0.530 1.59
25.76
Say shs.26.

The process account can now be prepared.

Process 2 account (FIFO)

Units Kshs. Units Kshs.
Opening WIP 600 1,830
Transfers from Normal loss 390 156
Process 1 4,100 5,200
Material - 2,956 Abnormal loss 10 26
Labour - 2,200 Transfers to process 3 3500 11,999
Overheads - 1,900 Closing WIP 800 1,905
4,700 14,086 4,700 14,086

Solution to illustration above using average cost

Calculation of effective units and cost per unit
Cost element Equiv. Equiv. Complete Effective Opening Period Total Cost per
Units + unit in . +units = WIP + cost costs unit Shs.
in abnormal production value Shs.
closing loss Shs.

137
 WIP
Input material 800 + 10 + 3500 = 4310 720 + 5200 =5920 1.373
Material intro. 480 + 10 + 3500 = 3990 500 + 2800 = 3300 0.827
Labour 400 + 4 + 3500 = 3904 340 + 2200 = 2540 0.651
Overheads 320 + 3 + 3500 = 3823 270 + 1900 = 2170 0.568

The various costs per unit are used to evaluate the closing WIP, abnormal loss and the completed
production:
The various costs per unit are used to evaluate the closing WIP, abnormal loss and the completed
production:
Closing WIP Cost per unit Value
Equivalent units
800 X 1.373 = 1,098.40
480 X 0.827 = 396.96
400 X 0.651 = 260.40
320 X 0.568 = 181.76
1,937.52
Say Shs 1,938.
Abnormal loss
10 × 1.373 = Shs.13.73
10 × 0.827 = 8.27
4 × 0.651 = 2.60
3 × 0.568 = 1.70
26.30
Say Shs.26.
Completed production

3,500 × 1.373 = 4,805.50

3,500 × 0.827 = 2,894.50
3,500 × 0.651 = 2,278.50
3,500 × 0.568 = 1,988.00
Shs.11,966.50

These values are used in the process account.

Process 2 account (average cost)

Units Kshs. Units Kshs.
Opening WIP 600 1,830 Normal loss
Transfers from 390 156
Process 1 4,100 5,200 Abnormal loss 10 26
Material 2,956 Transfers to process 3
Labour 2,200 Closing WIP 3500 11,969
Overheads 1,900 800 1,938

4,700 Sh.14,086 4,700 14,086

138
Note: if instead of the abnormal loss, there had been an abnormal gain the treatment would be as
follows for both average cost and the FIFO methods. The total effective production would be found as
in example 5 less the number of abnormal gain units. These units would be evaluated at the cost per
unit calculated and the process account debited with the abnormal gain units and their value. It
follows that abnormal gain units will always be fully complete whereas abnormal loss units may be
partially or fully complete.
JOINT AND BY PRODUCTS
JOINT PRODUCTS
These are two or more products produced in the same process and separated at a certain separation or
split off point.
They are a group of individual products which are produced simultaneously together with each
product having a significant sales unless to merit recognition as a main product.
They are identified as individual products at a certain stage of completion where products separate to
become individual products.

Features of joint products

1. They are produced in the same process.
2. They cannot be distinguished from each other until split off point.
3. They have substantial sales value.
4. They may require further processing after separation.

Accounting for joint products

Joint products are not separately identified until the split off point. Each product should be casted
separately and the main problem is how to account for common costs in the joint costs.
There are several methods that can be used to allocate joint costs which include:
• Units of output
• Sales value at separation point
• Net realizable value

i) Units of output ( Physical measures method)

In this method joint cost are allocated on the basis of relative weight of output of each product relative
to the total output.
This method is suitable where units of measurement of the products are the same.

Limitations
Products may separate at different states in liquids, gases, solids etc.
In this case the method will be unsuitable since the products have different units of measurement.
It fails to recognize the revenue earning power of individual products and allocates the same costs to
all products irrespective of the revenue generated.

ILLUSTRATION
AMC plc incurred joint costs of Shs.2,400 in manufacturing Product A and Product B to the split-off
point; Product A weighed 700 kg and had a sales value at the split-off point of Shs1,800; Product
B weighed 300kg and had a sales value at the split-off point of Shs.1,200 Cost Allocation:

139
Required: Using the physical measure /unit approach, calculate the cost allocated to products A and
B. Prepare the income statement for the period

SOLUTION
Product A = 700 / (700 + 300) ×2,400 1,680
Product B 300 / 1,000 x 2,400 720
2,400
INCOME STATEMENT
Product A Product B Total
Sales 1,800 1,200 3,000
Cost of Goods Sold (1,680) (720) (2,400)
Gross Margin 120 480 600

Gross Margin %:
Product A = 120 / 1,800 = 7%
Product B = 480 / 1,200 = 40%
Total = 600 / 3,000 = 20%

ii) Sales value at separation point (sales value Method)

In this method, costs are allocated to the products on the basis of revenues generated at separation
point.
The method is appropriate where the products become sellable at the split-off point.
Joint costs are apportioned to each product on the basis of proportion that the sales value of the
product have relative to the total.

iii) Net Realizable value

Joint product may have no market value at the point of separation because they need further
processing for them to be ready for sale or they may be processed further to enhance their value.
Net realizable value is defined as the sales value minus additional processing and disposed costs.
In the method, joint costs to be allocated to individual products will on the basis of individual net
realizable value relative to the total net realizable value.

ILLUSTRATION
A production process has joint costs of Sh.12, 000 for the input of 1,000 kgs of material. Two
products are produced from this:
Product A: 600 kgs. Selling price = Sh.25/unit. Separate costs = Sh.4, 000
Product B: 400 kgs. Selling price = Sh.40/unit. Separate costs = Sh.7,000

Required;-
Calculate the inventory value of the production using
(a) Weight to apportion the joint costs
(b) Net realisable value to apportion the joint costs

SOLUTION
(a) Joint costs apportioned using weight

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 Product A Product B
(600 kg) (400 kg)
Separate costs 4,000 7,000
Pre-separation costs60:40 sh.12,000 7,200 4,800
Total costs 11,200 11,800

(b) Joint costs apportioned using net realizable value

Product A Product B
Sh. Sh.
Sales value 15,000 16,000
Post separation/own costs (4,000) (7,000)
Net realizable value 11,000 9,000
Separate costs 4,000 7,000
Pre-separation costs11000/20,000 and 9/20 of sh.12,000 6,600 5,400
Total costs 10,600 12,400

ILLUSTRATION
A production process has joint costs of Sh.12, 000 for the input of 1,000 kgs of material. Two
products are produced from this:
Product A: 500 kgs. Selling price = Sh.25/unit. Separate costs = Sh.4,000
Product B: 400 kgs. Selling price = Sh.40/unit. Separate costs = Sh.7,000
By product: 100 kgs. Selling price = Sh.2/kg

Required;
Calculate the inventory value of the production of the joint products using
(a) Weight to apportion the joint costs
(b) Net realizable value to apportion the joint costs

SOLUTION
(a) Joint costs apportioned using weight
Sales of the by-product will produce revenue of Sh.200, so the joint cost is reduced to Sh.11, 800

Product A Product B
(400 kg) (500 kg)
Separate costs 4,000 7,000
Pre-separation costs 50:40 of Sh.11,800 6,555 5,245
Total costs 10,555 12,245

(b) Joint costs apportioned using net realizable value

Product A Product B
Sh. Sh.
Sales value 500 ×25; Sh.400 ×Sh.40 12,500 16,000

141
 Post separation/own costs (4,000) (7,000)
Net realizable value 8,500 9,000
Separate costs 4,000 7,000
Pre-separation costs 8.5/17.5 and 9/17.5 of Sh.11,800 5,731 6,069
Total costs 9,731 13,069

ILLUSTRATION
Jitegemee limited company uses a process costing system in its operation. In one of the production
processes, two joint products A and B and a by-product C are produced
The following additional information is provided:
1. Each processing run requires 12,500 kilograms of output. The costs incurred are as follow:-
Sh.
Materials 456,250
Labour 295,000
Overheads 268,750

2. It is expected that 20% of the input will be damaged in the production process. This is sold as
scrap at sh. 10 per kilogram. The damaged items are detected at the end of the production process.
3. The output from the production process is as follows:-
Product Output Selling price per kilogram
A 50% 200
B 40% 250
C 10% 20
4. Product A has to be processed further at a cost of sh. 100 per kilogram before sale
5. The joint costs are allocated to the products on the basis of net releasable value

Required:
i. Determine the total cost of the output from the production process
ii. Calculate the allocated joint costs for product A and product B
iii. Prepare a process account for the production process above

SOLUTION

i)
Output units
Input units 12500
N. loss (20% ×12500) 2500
= 10,000kgs

Output units per product

A: 50% × 10,000 = 5000
B: 4% x 10000 = 4000
C: 10% x 10000 = 1000
= 10,000

142
Total process cost
D. materials 456,250
D. labour 295,000
O/Hs 268,75 0
1,020,0000

Less:
Scrap for N. loss (2500 x 10) (25,000)
By-pdt C (1000×20) (20,000)
Total cost Joint costs (A&B) 975,000

ii)
NRV = Sales – Further process
A: (5000 x 200 – (5000 x 100) = 500,000
B: (4000 x 250) – 0 = 1,000,000
= 1,500,000
Joint cost allocation
500,000
A: × 975,000= sh. 325,000
1,500,000

1,000,000
B: × 975,000 = sh. 650,000
1,500,000

Process account
Units Cost Value Units Cost Value
R. materials 12,500 456,250 Joint product: A 5000 325,000
Labour 295,000 B 4000 650,000
O/HS 268,750 By-product 1000 20 20,000
- N. loss 2500 10 25,000
12,500 1,020,000 12,500 1,020,000

BY-PRODUCTS
These are products recovered incidentally from materials used to manufacture main products.
They are one or more products produced incidentally during this manufacture of the main product.
Examples of by-products; wax, hides, molasses, saw dust and coffee husks

Features of a by-product
1. They have relatively low sales value when compared to the main products.
2. They are not intended to be produced.
Joint cost will only be allocated to the recognized main product.
No costs are allocated to the by-product. However any amount realized from sale of by-products
may be accounted for as follows:
i) The sales value on the net realizable value (NRV) of the by-products is added to the sales of
the sales of the main product i.e. it is treated as additional revenue of the main product.

143
 ii) The sales on the net realizable value of the by-products is deducted from the cost of
production of the main product is valued at net cost of production. This is the main method of
accounting and by-products.
iii) The amount realized is treated as a miscellaneous income and transferred to P&L statement.

NB If the method is not given use the amount realized to reduce the product cost of the main product
(Method ii)

SERVICE COSTING
Service costing is a cost accounting method concerned with establishing the costs of services
rendered.
Despite this definition, we should note immediately that even though we may be dealing with services
that are intangible, the cost accounting methods we use are essentially the same as if we were making
cars, biscuits or televisions.
When we set up a service cost accounting system, therefore, we would need to keep in mind the fact
that the progression, for example, of a cheque through the banking system, can be treated as items of
raw material passing through a production process. Similarly, we should readily appreciate that the
provision of a transport service has much in common, from the cost accounting point of view, with the
manufacture of the lorry or van that is being used to provide the service.

Specific Examples: where is service costing applied?

• Transport
• Hotels
• Tourism
• Solicitors
• Education
• Retail distribution
• Financial services

Service costing is also applied within a manufacturing setting.

For example, a manufacturer might wish to calculate the costs of the following services:

• Transport
• Catering
• Computing and IT
• Accounting
• Human resources

The Differences between Product Costing and Service Costing

• There may be very few, if any, materials to worry about
• Overheads will comprise the most significant portion of any costs of which, labour costs may well
comprise as much as 70%

Service Costing: profit or cost centre?

144
Many organisations simply want to determine the costs of operating its services from a management
control and management information point of view. However, there are many organisations now that
operate services for their own organisations as well as sub-contracting them out to other organisations.
For example, there are companies that operate their own payroll section for themselves; and offer this
service to other organisations as well. Other organisations sell CPU time on their computers at times
when they do not use it themselves: for example, in overnight batch work.

One key factor here is that we might be in the situation of assessing the least cost basis for providing a
service, rather than the highest profit possible.

Service Cost Units

What are the cost units for a service? For a manufacturer, cost units would be

• Motor cars
• Packets of biscuits or boxes containing, say, 100 packets of biscuits
• Television sets

Service costing is no longer an elective pursuit, it is a compulsory exercise. It ensures that tariffs
represent prices for customers and competitors. Economic, accounting and engineering costs all play a
role in determining service costs. Engineering costs measure technological relationship between
inputs, outputs, Accounting costs record, analyze historic costs according to industry rules, Economic
costs apply the theories of resource allocation to forward looking costs
Examples of operating costs include repair and maintenance, labour, site rental, utilities, license,
regulatory fees and taxes and depreciation.

Service costing can use either of the methods highlighted below:

• Activity based costing; ABC assigns costs based on the activities required to deliver a service and
the resources these activities absorb. ABC might bring more transparency in the calculation of
transferred cost, making the current costing practice look redundant.
Nevertheless, ABC hides potential inefficiencies of the service provider. Even if an element or asset is
underutilized, its cost is completely shared by the services that use it and there is no incentive for the
provider to improve its efficiency

• Fully distributed cost; in here, the total cost of a service, both direct and indirect costs, are
distributed among the services sold. FDC comes from historic/embedded cost. It relates prices to
information available in accounting, billing systems. However, it requires judgment in allocating
indirect costs devising methodology.

• Long run average incremental cost (LRAIC): this constitutes cost of production of an additional
unit plus an allocated share of common costs. Forward-looking costs are used to approximate costs in
a competitive market, not historical costs which typically reflect inefficiencies and investment in
outdated technologies. LRAIC mimics the competitive marketplace and encourages economic
efficiencies. However, it is difficult to calculate or model the incremental costs, lacks transparency
and negotiation skills and specialized expertise on inputs required. Additionally, an amalgamation of

145
embedded and forward looking costs, blended together and computed on an average cost basis should
not be called incremental cost.

• Marginal cost: this measures the change in total output resulting from a small change in the level of
activity. The marginal cost in this case is the cost of adding a service to an existing portfolio of
products or services.
Fully Distributed Cost (FDC) and Long Run Average Incremental Cost (LRAIC) are the common
ones in literature and in practice. FDC may be “easier” to calculate, but LRAIC promotes operator

ILLUSTRATION
Steer & Wheel Ltd distribute its goods to a regional retailer using a single lorry. The dealer's premises
are 40 km away by road. The lorry has a capacity of 10½ tones and makes journeys twice a day fully
loaded on the outward journeys and empty on the return journeys. The following information is
available for a four week budget control period: period 8 of 2004.

Petrol consumption 8 km per 5 litres of petrol

Petrol cost Shs 0.36 per litre
Oil Shs 8 per week
Driver's wages and NI Shs 140 per week
Repairs Shs 72 per week
Garaging Shs 4 per day based on a seven day week
Cost of lorry when new (excludes tyres) Shs 18,750
Life of lorry 80,00 km
Insurance Shs 650 per year
Cost of a set of tyres Shs 1,250
Life of a set of tyres 25,000 km
Estimated sales value of lorry at the end of its life Shs 2,750
Vehicle licence cost Shs 234 per year
Other overhead costs Shs 3,900 per year
The lorry is operated on a five day week basis.

Required:
Prepare a statement to show the total costs of operating the lorry in period 8 2004 analyzed into
running costs and standing costs.

SOLUTION
Let’s set out an attractive table showing our costs classified according to whether they are running or
standing costs:
Running Standing
Cost
Cost Cost
Petrol consumption X
Petrol cost per litre X
Oil X
Driver's wages and NI X

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Repairs X
Garaging X
Cost of lorry when new (excludes tyres) X
Life of lorry X
Insurance X
Cost of a set of tyres X
Life of a set of tyres X
Estimated sales value of lorry at the end of its life X
Vehicle licence cost X
Other overhead costs X
NOTE: just in case there is any doubt, the driver's wages and NI are standing costs because they do
NOT vary with the number of km driven. Check that you agree with our other classifications.

Statement of Total Costs of Operating the Lorry: Period 8 2004

Vehicle Operating Costs: Period 8 2004
Running Costs
Petrol 720
Depreciation 640
Tyres 160
1,520
Standing costs
Garaging 112
Oil 32
Driver's wages and NI 560
Repairs 288
Insurance 50
Vehicle licence 18
Other overheads 300
1,360
Total Operating Costs 2,880

Workings
Petrol Cost: Km driven: 40 km×2×2 ×5 ×4 = 3,200 km Petrol consumption: 3200 km ÷ 8 km × 5
litres = 2,000 litres Petrol cost = 2,000 litres / Shs 0.36 per litre = Shs 720

Depreciation: (Cost of lorry - residual value ÷ life of lorry) × km driven = (Shs 18,750 - 2,750 ÷
80,000 km) ×3,200 km = £0.2/km ×3,200 km = Shs 640

Cost of Tyres: (cost of tyres ÷ life of tyres) ×km driven = (£1,250 ÷ 25,000 km) ×3,200 km = Shs
0.05/km × 3,200 km = Shs 160

Garaging:Shs 4 ×7 ×4 = Shs 112

Repairs:Shs 72 ×4 = Shs 288

147
Insurance:Shs 650 ÷ 52×4 = Shs 50

Vehicle licence:Shs 234 ÷ 52 ×4 = Shs 18

Other overhead costs:Shs 3,900 ÷ 52 ×4 = Shs 300

UNIT COSTING
The unit cost of a product or service is obtained by assigning total costs to many identical or similar
units.

Companies need to allocate total product costs to units for the following reasons:
i) The company may manufacture thousands or millions of units of products in a given period of
time
ii) Products are manufactured in large quantities, but may be sold in small quantities sometimes at
one time or in dozens or bulk.
iii) It is important to determine with accuracy the cost of goods sold as it is needed, especially at the
point of transfer from finished goods to cost of sales. This calls for a correct and accurate
accounting for product cost per unit in order to properly match costs against related sales revenue.
This also helps managers to maintain cost control over the manufacturing process.
iv) A small change in unit cost can represent a significant change in overall profitability, when selling
millions of units of a product. Managers thus need to keep track of per unit cost on daily basis
through the production process while at the same time dealing with materials and output in large
quantities
v) Materials in the production process might need to be given a value, process costing allows for this
through the determination of equivalent units and cost per equivalent unit of production.

PRACTICE EXERCISES (Solutions on page 253)

QUESTION 1
Timau Ltd produces a detergent which passes through two processes namely mixing and refining to
completion. The following data relate to the refining process for the month of June 2000.
Cost of opening stock: Sh.
Materials 100,000
Labour 25,000
Overheads 60,000

During the month 20,000 units were passed from the mixing to the refining process. Costs incurred
during the month were:

Shs
Labour 125,000
Overheads 108,100

148
 Other materials 45,300

At the end of the month 21,000 units had been completed and passed to finished goods while 4,000
were still in process having reached the following stages:

Materials - 100%
Labour - 40%
Overheads - 60%

Required:
Refining Process Account

QUESTION 2
Tinn Ltd produces a detergent which passes through two processes namely mixing and refining t
completion. The following data relate to the refining process for the month of October 2000:

Opening stock 5,000 units

Cost of opening stock:
Sh
Materials 100,000
Labour 25,000
Overheads 60,000
Total cost 185,000

During the month, 20,000 units were passed from the mixing to the refining process. Costs incurred
during the month were:
Sh
Labour 125,000
Overheads 108,100
Other materials 45,300
Total cost 278,400

At the end of the month, 21,000 units had been completed and passed to finished goods while 4,000
units were still in the process having reached the following stages:
Materials 100%
Labour 80%
Overheads 60%

Required:
Refining process account

149
 CHAPTER 7
MARGINAL AND ABSORPTION COSTING

INTRODUCTION
Marginal and Absorption costing are techniques adopted in reporting profits and product costing in an
enterprise.

They differ in valuation of products and treatment of production overheads absorbed to products.

MARGINAL COSTING / VARIABLE COSTING

This is also referred to as variable costing / direct costing or contribution approach.
Product costs should only be made of variable production overheads.

Fixed production costs are not included as part of product cost.

They are written off to P&L statement.

These costs will be incurred whether production takes place or not and therefore they will be treated
as periodic cost rather than production cost.

ILLUSTRATION
Suppose company X makes two products A and B. A takes 2 labor hours each to make and B takes 5
labor hours. What is the overhead cost per unit for A and B respectively if overheads are absorbed on
the basis of labor hours?

SOLUTION
Step 1- Estimate overheads for the period.
X estimates it to be shs. 50,000

Step 2- Estimate activity level for the period

X estimates a total of 100,000 direct labor hours will be worked

Step 3- Divide the estimated overhead by budgeted activity level.

150
 Absorption rate = Shs.50, 000
100, 000 hours
= shs.0.50 per direct labor hours

Step 4- Absorb overhead into the cost unit by applying absorption rate.
A B
Labor hours/unit 2 5
Absorption Rate(SHS) 0.5 0.5
Overhead absorbed/unit 1 2.5

Note: The activity level of 100,000 hours is the basis over which the overheads will be absorbed.
Different bases will used as shown in the table illustration previously.

Advantages of marginal costing

1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is
avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s
fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed,
and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of
ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead,
efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to
various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of
quantity and graphs. Comparative profitability and performance between two or more products
and divisions can easily be assessed and brought to the notice of management for decision
making.

Disadvantages of marginal costing

1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that
no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs
from inventories affect profit, and true and fair view of financial affairs of an organization may
not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed
overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of
production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there may
be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the net
profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable

151
 item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not
taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions
underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit
planning, absorption costing is the only answer.

ABSORPTION COSTING (FULL-COSTING)

Also referred to as indirect costing, total product costing or traditional costing
In this method, products costs comprise of both fixed and variable production cost.

All costs incurred during production will be treated as product cost and there will be no distinction
between fixed and variable cost i.e. absorption costing method, in addition to direct costs, a share
indirect production costs (overheads) is attributed to cost units by means of overhead absorption rates.
Our first area of study concerns the traditional method of absorbing overheads into product costs, the
detailed mechanics of which will be familiar to you from your earlier studies. Here we are more
concerned with evaluation of this method against others, in particular marginal costing and activity
based costing.

ILLUSTRATION
PQR limited is a manufacturer of sports shoes. The company uses a standard system. The standard
cost per pair of spots shoes is as follows:
Sh.
Direct materials 500
Direct labour: 4 hours × sh. 60 / hour 240
Production overheads
Variable 4 hours × sh. 30 / hour 120
Fixed 100
Standard production cost 960
Standard selling price 1,500

Additional information
1. During the month of March 2011, production was 10,000 units as planned but he sales made
were 8,000 units
2. The total fixed production overhead variance during the month was sh. 100,000 adverse
3. The standard fixed production overhead absorption rate was based on a budgeted activity of
10,00 units
4. There was no opening stock at the beginning of the month
5. All units were sold at the standard selling price
6. Other costs incurred during the month were as follows:

Variable Fixed
Sh.
Selling and distribution 20% of sales 600,000
Administration 1,000,000

152
Required:
Income statement for the month of March 2011 using Absorption costing

SOLUTION
PQR Limited
Income statement (using absorption)
For the month of March 2011
Sh. ‘000’ Sh. ‘000’
Sales (1500×8000) 12,000
Cost of sales
Cost of production (960×10000) 9,600
Closing stock (2000× 960) (1,920) (7,680)
Gross profit 4,320
Expenses
Selling & distribution: Variable (20%×12000) 2,400
Fixed 600 (3,000)
Administration expense (1,000)
Fixed production overheads under-absorbed (100)
Net profit 220

Advantages of absorption costing

i) Fixed costs are substantial and increasing proportion of costs in modern industry. It thus forms a
significant part of costs of production so it should be included. Marginal costing divorces fixed
costs from production.
ii) It is used preferably where stock building is a necessary part of operations e.g. wine making.
Otherwise fictitious losses will be shown in earlier periods to be offset eventually by excessive
profits when goods are sold.
iii) Relying on marginal costs could lead to management setting prices at below total costs but
making slight contribution. This is avoided in absorption costing.
iv) International Financial Reporting Standards suggest that costs and revenues must be matched in
the period when revenues arise not when costs are incurred. It also recommends that stock
valuation must include production overheads incurred in the normal course of business even if
such overheads are time related.

DISTINCTION BETWEEN MARGINAL AND ABSORPTION COSTING

They differ in valuation of products and treatment of production overheads absorbed to products.

Absorption Marginal

153
- Uses variable cost in information - Uses the total cost in information
presentation and analysis for the purpose of presentation and analysis for the purpose of
reporting profit reporting profit.
- Variable production cost is used in the profit - Total production cost is used in
statement for the purpose of calculating determination of gross profit
- Fixed cost is an irrelevant cost and is only - Fixed cost is relevant
deducted as a procedure
- Stock is determined based on variable - Stock is valued based on the total production
production cost cost

Valuation of Products under Marginal and Absorption Costing

Marginal costing
Product costs Shs
D. Material xxx
D. Labour xxx
V. Production O/H xxx
xxx

Absorption costing
Product costs Shs
D. Material xxx
D. Labour xxx
V. Production O/H xxx
Fixed O/H xxx
xxx

PREPARATION OF MARGINAL AND ABSORPTION STATEMENTS

Cost of production and profit determination

Marginal Costing
Profit and Loss Statement
Sales xxx
Less: Cost of sales
Opening stock xxx
Add: production cost
D. Material xxx
D. Labour xxx
V. Production O/H xxx
xxx
Less: Closing stock (xxx) (xxx)
Gross contribution xxx
Less: Other various costs xxx
Net Contribution

154
 Less: Fixed costs
Production xxx
Administration xxx
Selling and distr. xxx (xxx)
N. Profit xxx

Absorption costing
Profit and loss statement
Sales xxx
Less: Cost of sales
Opening stock xxx
Add: production cost
D. Material xxx
D. Labour xxx
V. Production O/H xxx
I. Production O/H xxx
xxx
Less: Closing stock (xxx) (xxx)
Gross Profit xxx
Less: Operating expenses
Administration xxx
Selling and distr. xxx (xxx)
Net Profit xxx

MARGINAL COSTING AND ABSORPTION COSTING

Example 1
In a period, 20,000 units of Z were produced and sold. Costs and revenues were:
Sh.
Sales 100,000
Production cost:Variable 35,000
Fixed 15,000
Administrative + Selling overheads: Fixed 25,000

Required;-
The operating statements for Z

SOLUTION
Operating statements
Absorption costing approach Marginal costing approach

155
 Sh. Sh. Sh.
Sales 100,000 Sales 100,000
Less production cost of sales 50,000 Less marginal cost 35,000
= Gross profit 50,000 = Contribution 65,000
Less admin + selling Overheads 25,000 Less Fixed costs
- Production 15,000
Net Profit 25,000 Admin S + D 25,000 40,000
Net Profit 25,000

The above illustration, although simple, illustrates the general characteristics of both approaches.
The key figure arising in the Marginal statement is the contribution of sh.65,000. The total amount of
contribution arising from product Z (and other products, if any) forms a pool from which fixed costs
are met. Any surplus arising after fixed costs are met becomes the Net profit.

CHANGES IN THE LEVEL OF ACTIVITY

When changes occur in the level of activity, the absorption costing approach may cause some
confusion. In example 1 the activity level was 20,000 units and using the absorption approach, the
profit per unit and cost per unit can be calculated as follows;
Sh.
Selling price per unit 5
Less Total cost per unit Sh.75,000
20,000 3.75
Profit per unit 1.25

If these figures were used as guides to results at any activity level other than 20,000, they would be
incorrect and may mislead. For example, if the level of activity of example 1 changes to 25,000 units,
it might be assumed that the total profit would be 25,000 x sh.1.25 = sh.31,150. However, the results
are likely to be as follows:

Operating statement (Absorption approach)

Sh.
Sales (25,000 x 5) 125,000
Less production cost (£35,000 + 15,000) 58,750
= Gross profit 66,250
Less Admin + Selling overheads 25,000
= Net profit 41,250

The difference is, of course, coursed by the incorrect treatment of the fixed cost. In such
circumstances the use of the marginal approach presents a clearer picture. Based on the data in

In Example 1
The marginal cost per unit and the contribution per unit are calculated as follows:
Marginal cost per unit = Sh35,000

156
 20,000
= Sh1.75
Contribution per unit = Sales Price – Marginal cost per unit
= sh5 - sh1.75
= sh3.25
If once again, the activity is increased to 25,000 units, the expected profit would be:
= (25,000 unit x Contribution per unit) – Fixed costs
= (25,000 x sh3.25) - sh40,000
= Sh41,250

And the operation statement on marginal costing lines would be

Sh.
Sales (25,000 ×5) 125,000
Less marginal cost (£25,000 ×1.75) 43,750
= Contribution 81,250
Less Fixed cost 40,000
= Net profit 41,250

Note: Students will note that the marginal cost and contribution per unit are assumed to be constant
and that the fixed costs remain unchanged.

RECONCILIATION OF MARGINAL PROFITS AND ABSORPTION

PROFITS
PROFIT RECONCILIATION
There is always a difference between the profits reported using marginal costing and absorption
costing. This is brought about by the difference in stock relation.
In marginal costing, stocks are valued at variable cost of production while in absorption cost they are
valued at total cost.
This causes differences in the amounts that are charged to cost of sales which affects the profit
reported.

ILLUSTRATION
Langata is a manufacturing company which produces a single product. The following standard unit
costs relate to the product.

Cost Sh.
Variable manufacturing 90
Fixed manufacturing 70
Variable selling and administration 16
Fixed selling and administration 60
236
Fixed manufacturing costs per unit are based on a predetermined absorption rate established at a
normal activity level of 45,000 production unit per period. Fixed selling and administration costs are
absorbed into the cost of sales at 20% of selling price.
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Under/over absorbed overheads are transferred to the profit and loss account at the end of the period

The following information is available for two consecutive periods.

Period 1 Period 2
Sales – units 42,500 45,000
Sales – value (Sh.) 12,750,000 13,500,000
Production units 40,000 46,000
Variable manufacturing costs (Sh.) 3,600,000 4,140,000
Variable selling and administration costs (Sh.) 3,200,000 3,150,000
Fixed selling and administration costs (Sh.) 680,000 720,000
2,700,000 2,700,000
Required
a) Income statements for each of the two periods under the absorption costing basis
b) Income statements for each of the two periods under the marginal costing basis
c) Reconciliation of the profits under the absorption costing and the marginal costing basis for each
of the periods.

SOLUTION
MARGINAL AND ABSORPTION COST
Product cost
Marginal Absorption
Variable manufacturing 90 Variable manufacturing 90
90 Fixed manufacturing 70
160

INCOME STATEMENT USING MARGINAL COSTING

Period 1 Period 2
Sh. Sh. Sh. Sh.
Sales 12,750,000 13,500,000
Less: marginal cost of sales
Opening stock (2500 x 90) 225,000 -
Variable manufacturing 3,600,000 4,140,000
3,825,000 4,140,000
Less closing stock - (3,225,000) (90,000) (4,050,000)
Gross contribution 8,925,000 9,450,000
Less other variables
Variable distribution 680,000 680,000 720,000 720,000
Net contribution 8,245,000 8,730,000
Less fixed costs
Fixed manufacturing 3,200,000 3,150,000
Fixed selling and administration 2,700,000 5,900,000 2,700,000 (5,850,000)
NET PROFIT 2345000 2,880,000
INCOME STATEMENT USING ABSORPTION COSTING
PERIOD 1 PERIOD 2

158
 Sh. Sh. Sh. Sh.
SALES 12,750,000 13,500,000
LESS COST OF SALES
Opening stock (2500 x 160) 400,000 -
Variable manufacturing 3,600,000 4,140,000
Fixed manufacturing cost 2,800,000 3,220,000
6,800,000 7,360,000
Less closing stock - 6,800,000 (160,000) (7,200,000)
5,950,000 6,300,000
Less Expenses
Variable selling & distribution 680,000 720,000
Fixed selling & distribution 2,550,000 2,700,000
Under absorbed fixed s/distribution 150,000 70,000
Under absorbed fixed manufacturing cost 400,000 (3,780,000) - (3,350,000)
Net profit 2,170,000 2,950,000

Fixed manufacturing Fixed selling & distribution Total

Sh. Sh. Sh.
OHD absorbed 2,800,000 25,500,000 5,350,000
Actual OHD 3,200,000 2,700,000 5,900,000
(550,000)
OHD absorbed 3,220,000 2,700,000
Actual OHD 2,150,000 2,720,000
70,000 0

Reconciliation statement for the periods

Shs
Period 1
Profit as per marginal costing 2,345,000
Less: Understatement of opening stock 175,000
Profit as per absorption costing 2,170,000

Period 2
Profit as per marginal costing 2,880,000
Add: Understatement of closing stock 70,000
Profit as per absorption 2,950,000

APPLICATION OF MARGINAL COSTING

Marginal costing is applied internally by management in decision making such as:
i) Cost volume profit analysis (CVP)
ii) Planning
iii) Decision making (non-routine)
iv) cost control
v) measurement of efficiency
vi) Evaluation of profitability

159
Cost Volume and Profit Analysis (CVP)
Cost volume profit (CVP) analysis is the study of the effects on future profit of changes in fixed cost,
variable costs, sales price quantity and mix.
The purpose of the C.V.P analysis is to understand the relationship amongst the aforesaid variables to
forecast profits, determine the volumes to be achieved to meet target profit, and such other short term
decisions. The CVP analysis is based on the premise of marginal costing.

The marginal costing technique recognizes variable cost as the product costs and fixed costs as period
costs. The principle is that only variable costs will change with a change in volume of production and
sales, but the fixed costs will remain the same.

Cost volume profit (CVP) analysis is a systematic approach of examining the relationship between
changes in volume and changes in total sales, expenses and net profit. The underlying objective of
CVP is to know the effect of fluctuation in the activity volume on financial results.
The following is a typical cost volume profit diagram that depicts how sales revenue, fixed costs and
variable costs respond to changes in the volume of sales and production. The volume of production
and sales is measured by the X-axis and revenue, costs and profit (loss) are measured by –axis in the
CVP chart.

The short run decisions where CVP analysis may be useful include choice of product mix, product
pricing, special order acceptance, shut down of a plant etc.

Assumptions of CVP analysis

1. Revenues, costs and profit functions are assumed to be linear with respect to volumes of output.
2. Costs can be split into fixed and variable statement
3. Fixed costs remain constant throughout the analysis
4. The selling price per unit remains constant
5. Variable cost per unit remains constant
6. The only factor affecting cost and revenue is output i.e. output is the only revenue and cost driver
7. Technology in production and efficiency level remains constant.
8. Only production is produced and sold. In case of multiple productions the sale mixture will
remain constant.
9. All units produced will be sold.

Let X: No of units produced and sold/activity level

D= Price per unit
V = Variable cost per unit
F = Fixed costs
R = Total sales revenues in monetary form and activity level in monetary terms.
C = Total costs
TI = Profits

Marginal costs equation

160
Contribution signifies an alternative measure of profit which is computed as sales less total variable
costs of sales
Accordingly Contribution = Sales – Variables
Contribution for the period provides a pool (since it recognizes a surplus generated by sale revenue
over variable costs) out of which fixed costs for the period are met and any surplus constitutes the
profit. It is called contribution because it literally contributes towards fixed costs and profit)

Therefore Contribution = Fixed costs + Profit

The elements in tradition break even chart (in a single product situation)
A traditional break even chart records revenues and cost on the vertical axis and volume of activity on
other horizontal axis. The lines representing sales revenue and total costs signify break-even point.
At any volume level the space between the total cost line and fixed costs line signifies variable cost.
In traditional chart, the fixed cost line is drawn first and thereupon the variable cost is drawn in order
to signify total cost

The contribution break even chart (in a single product situation)

The basic elements of a contribution break even chart are the same as that of the traditional break
even chart.

The only difference is that it shows the variable cost line instead of the fixed cost line. This is done in
order to overcome the major problem with traditional break even chart that it is not possible to read
contribution directly from the chart.
The same lines for total costs and sales revenue are shown so the breakeven point and profit can be
interpreted in the same way as with convectional chart.
The contribution can read as the difference between the sales revenue line and the variable costs line.

Profit/ volume chart (in simple product situation)

This is yet another mode of presentation of break-even chart. This is also known as contribution
volume graph. In this, a single a single line is drawn depicting the profit or loss at each level of
activity. The point of intersection of the line and the horizontal axis is the breakeven point. The basic
feature of this chart is that the vertical axis indicates profits and losses and the horizontal axis is
drawn at zero profit or loss.

Cost Volume Profit (C.V.P) analysis by formula

C-V-P analysis can be undertaken by graphical means which are dealt with later in this chapter, or by
simple formulae which are listed below and illustrated by examples

a) Break-even point (in units) = Fixed Costs

Contribution/unit

b) C/S Ratio = Contribution/unit x 100

Sales price/unit

c) Break-even point (£sales) = Fixed Costs x Sales price/unit

161
 Contribution/unit

= Fixed Costs x 1
C/S ratio

d) Level of sales to result in target profit (in units) = Fixed Costs + Target profit
Contribution/unit

e) Level of sales to result in target profit after tax (in units)

Fixed Cost + [ Target profit]

1 – Tax rate
=
Contribution/unit

f) Level of sales to result in target profit £sales)

= (Fixed Cost + Target profit) x Sales price/unit
Contribution/unit

Note: The above formulae relate to a single firm or one with an unvarying mix of sales. With a multi -
product firm it is possible to calculate the break- even point as follows:

Break-even point (sh. sales) = Fixed Costs × Sales Value

Contribution

ILLUSTRATION
A company makes a single product with a sales price sh10 and a marginal cost of sh6. Fixed costs are
sh60,000 per annum.
a) Number of units to break even
b) Sales at break-eve point
c) C/S ratio
d) What number of units will need to be sold to achieve a profit of sh20,000 p.a.?
e) What level of sales will achieve a profit of sh20,000 p.a.?
f) As (d) with a 40% tax rate.
g) Because of increasing costs the marginal cost is expected to rise to £6.50 per unit and fixed costs
to sh70,000 p.a. If the selling price cannot be increased what will be the number of units required
to maintain a profit of £20,000 p.a. (ignore tax)?

SOLUTION
Contribution = Selling price – Marginal Cost
= sh10 - sh6
= sh4
a) Break-even point (units) = sh60,000
4
= 15,000
b) Break-even point (£sales) = 15,000 x sh10
162
 = sh150,000
c) C/S ratio = sh4
10
= 40%
d) Number of units for target profit = sh60,000 + sh20,000
4
= 20,000
e) Sales for target profit = 20,000 x sh10
= 200,000
(Alternatively, this figure can be deduced by the following reasoning. After break-even point the
contribution per unit becomes net profit per unit, so that as 15,000 units were required at break-even
point, 5000 extra units would be required to make sh.20,000 profit.
Therefore total units = 15,000 + 5,000 = 20,000
20,000 x sh10 = sh.200,000

f) Number of units for target profit with 40% tax = 60,000 + sh. 20,000
1-0.4
sh4
= 23,333
g) Note that the fixed costs, marginal cost and contribution have changed
No. of units for target profit = Sh70,000 + sh20,000
Sh3.50
= 25,714 units

Note: The C/S ratio is sometimes known as the P/V ratio

LIMITATIONS OF CVP ANALYSIS

1. It can be time consuming
2. The analysis can only be applied to a single product
3. Where there is difficulty in classifying costs between fixed costs variable , it is difficult to
apply break even analysis
4. At all levels of output , it assumes that the fixed costs are fixed or constant
5. At all levels of output, it assumes that the per unit variable costs are the same or fixed
6. At all levels of output , it assumes that sales price are fixed or constant
7. Inventory is not taken into consideration
8. It is not useful for production planning

Graphical Approach
This may be preferred
a) Where a simple overview is sufficient
b) Where there is a need to avoid a detailed, numerical approach when, for example, the
recipients of the information have no accounting background.
The basic chart is known as a Break Even chart which can be drawn in two ways. The first is known
as the traditional approach and the second as the contribution approach. Whatever approach is
adopted, all costs must be capable of separation into fixed and variable elements, i.e. semi-fixed or
semi-variable costs must be analysed into their components.
163
The Traditional Break-Even Chart
Assuming that fixed and variable costs have been resolved, the chart is drawn in the following way:
a) Draw the axes
Horizontal: showing levels of activity expressed as units of output or as percentages of total capacity.
Vertical: showing values of sh. ’s or sh. 00s as appropriate for costs and revenues.
b) Draw the cost lines
Fixed cost. This will be a straight line parallel to the horizontal axis at the level of the fixed costs.
Total cost. This will start where the fixed cost line intersects the vertical axis and will be a straight
line slopping upward at an angle depending on the proportion of variable cost in total costs.
c) Draw the revenue line
This will be a straight line from the point of origin sloping upwards at an angle determined by the
selling price.

ILLUSTRATION
A company makes a single product with a total capacity of 400,000 litres p.a. Cost and sales data are
as follows:
Selling price sh.1 per litre
Marginal cost sh.0.50 per litre
Fixed costs sh.100, 000
Draw a traditional break-even chart showing the likely profit at the expected production level of
300,000 litres.
SOLUTION
From Figure below it will be seen that break-even point is at an output level of 200,000 litres and that
the width of the profit wedge indicates the profit at a production level of 300,000. The profit is
sh.50,000.

Traditional Break-Even Chart

Profit at anticipated c
400 - Sales
production level
Sh. 000 Profit

300 - Break Even d

Point
b
200 -
Margin Variable Cost
of
a Safety Total Cost
100 -
Loss
Fived Cost

f
0 50 100 150 200 250 300 350 400
Output (000 litres)
Notes: The ‘margin of safety’ indicated on the chart is the term given to the difference between the
activity level selected and break-even point. In this case the margin of safety is 100,000 litres.

164
The Contribution Break-Even Chart
This uses the same axes and data as the traditional chart. The only difference being that variable costs
are drawn on the chart before fixed costs resulting in the contribution being shown as a wedge.

ILLUSTRATION
By using the illustration above except that a contribution break-even chart should be drawn.

Solution (see the following figure below)

c
Sales
400 -
Profit
Sh. 000
300 - Break Even d
Point
b Fixed
200 - Cost
Contribution e

a Total Cost
100 -
Loss
Fived Cost

0 f
0 50 100 150 200 250 300 350 400
Output (000 litres)
Notes:
a) The area c.o.e represents the contribution earned. There is no direct equivalent on the traditional
chart.
b) The area of d.a.o.f represents total cost and is the same as the traditional chart.
c) It will be seen from the chart that the reversal of fixed costs and variable costs enables the
contribution wedge to be drawn thus providing additional information.

An alternative form of the contribution break-even chart is where the net difference between sales and
variable cost i.e. total contribution, is plotted against fixed costs. This is shown in Figure below once
again using the same data as in the illustration above.

Notes on figure below

a) Sales and variable costs are not shown directly.
Both forms contribution chart, figures above and below, show clearly that contribution is first used to
meet fixed costs and when these costs are met, the contribution becomes profit

Alternative Form of Contribution Break Even Chart

165
 400 -
Sh. 000
300 -

200 - Break Even

Point Profit
b
100 -
Loss
Loss
Contribution
Fixed Cost

0 50 100 150 200 250 300 350 400

Output (000 litres)

Optimizing the Level of Activity

Where the cost and/or revenue functions are non-linear, for example as shown in figure 14.14, then it
is possible to determine the optimal level of activity in accordance with the objectives of the firm.
This can be done in two ways, either by drawing graphs of the functions as in figure 14.14 and 14.15
or more directly by the use of differential calculus. It will be recalled that the process of
differentiation provides a ready means of finding the rates of change of non-linear functions and of
their turning points. If the non-linear functions represent cost and revenue then the rates of change are
marginal cost and marginal revenue respectively and the turning points of the functions are the point
of minimum cost and maximum revenue respectively.
The following example uses differentiation to find the optimal activity level.

ILLUSTRATION
A firm has the following cost and revenue functions:
1
Variable cost function, c = sh. � 𝑞 2 + 10𝑞�
2
3
Demand function, p = �sh. 150 + 𝑞�
4
Where P = price in sh.
c = Variable cost in sh’s
q = number of units sold per period
The fixed costs are sh.1,000 per period.
It is required to determine
a) The price, quantity and resulting profit if the firm’s objective is to maximize sales revenue.
b) The price, quantity and resulting profit if the firm’s objective is to maximize profit.

SOLUTION
a) Let R = revenue
Then R=pq
3
= (150 - 𝑞) q
4
3
= 150q - 𝑞 2
4

166
 𝑑𝑅
For maximum revenue, = 0 (with a negative second derivative).
𝑑𝑞

1
Thus 150 - 1 𝑞 = 0
2

𝑑2 𝑅
(Note that = - 1½ i.e. negative, as required for a maximum point)
𝑑𝑞2

∴ q = 100 at maximum revenue point.

3
∴ q = £ �150 − 𝑞�
4
3
= sh. �150 − (100)�
4
= sh.75
∴R=pq
= (sh. 75 𝑥 100)
= sh.7,500

Profit at maximum revenue point is:

Shs
Revenue 7,500
1
Less: Costs = � (100)2 + 10(100)sh. + 1,000� (7,000)
2
500
Profit per period

b) For maximum profit, marginal revenue should equal marginal cost.

i.e.
𝑑𝑅 𝑑𝐶
=
𝑑𝑄 𝑑𝑄

𝑑𝑅 1 𝑑𝐶
�𝐵𝑢𝑡 = 150 − 1 𝑞 𝑎𝑛𝑑 = q + 10�
𝑑𝑄 2 𝑑𝑄
1
∴ 150 − 1 𝑞 = q + 10
2

Giving, after some re-arrangement : q = 56 at maximum profit point

3
The resulting price per unit is: p= sh. �150 − 𝑞�
4
= sh. 108
Profit at maximum profit point is

Sh.
Revenue sh. (56 x 108) 6,048
1
Less: Costs = sh. � (56)2 + 10(56) + 1,000� 3,128
2
2,920
Profit per period

SIMPLIFIED DECISION PROBLEM

167
They are a onetime decisions but once made they remain binding for a long period of time.
In making these decisions it is only the relevant costs that are considered i.e. irrelevant cost are not
taken into account.

Relevant costs.
The term relevant pertinent to the decision at hand, Relevant costs represent those future costs that
will be changed by a particular decision. They are the costs appropriate to a specific management
decision.

Relevant costs are costs that change with respect to a particular decision. Sunk costs are never
relevant. Future costs may or may not be relevant. If the future costs are going to be incurred
regardless of the decision that is made, those costs are not relevant. Committed costs are future costs
that are not relevant. Even if the future costs are not committed, if we anticipate incurring those costs
regardless of the decision that we make, those costs are not relevant. The only costs that are relevant
are those that differ as between the alternatives being considered.

Including sunk costs in a decision can lead to a poor choice. However, including future irrelevant
costs generally will not lead to a poor choice; it will only complicate the analysis. For example, if I
am deciding whether to buy a Toyota Camry or a Subaru Legacy, and if my auto insurance will be the
same no matter which car I buy, my consideration of insurance costs will not affect my decision,
although it will slightly complicate the analysis.

Rules about relevant costs

1. Only relevant costs should be considered when revaluating the financial consequences of a
decision. This is because a decision is forward looking.
2. A relevant cost is a future cash flow that will arise or be reduced as a direct consequence of the
decision.
3. A relevant cost is a future cost. This means that any cost that has been incurred in the past
(historical cost cannot be relevant to a decision.
4. A relevant cost is a cash flow. Any costs that are not cash flow items are not relevant. E.g. non-
cash charges such as depreciation of fixed assets.
- Notional costs such as notional interest charges and
- Absorbed fixed overheads.
5. A relevant cost is one that will arise as a direct consequence of decision being taken.
If a decision is a future cash flow that would be incurred anyway regardless of the decision hence
should be ignored.
6. As general rule, variable costs are relevant and fixed costs are unchanged regardless of a decision
hence irrelevant.

Determination of relevant costs

i) Direct material cost
a) Expected purchase cost of materials is relevant cost
b) Stocks that have already been purchased. Their original purchase cost is irrelevant as a sunk
cost. However the current purchase price (account paid to replace such stocks) if used is
relevant cist

168
 c) Stocks in store but with no use except
i) Be resold
The relevant cost is the resale value if the materials are used in a decision disposed.
ii) Be disposed
It used on a decision, the disposal cost will not be incurred and therefore will be treated
as an opportunity savings hence relevant.
iii) Be used as a substitute material for another
It is used on a decision the alternative material will have to be purchased; therefore the
purchase cost of this material becomes relevant.

ii) Direct labour cost

a) Amount paid to employee to execute a duty in a decision is relevant cost.
b) It labour is in short supply that cares, there may be two options
• Work overtime –relevant cost will be will the normal wages + overtime premium
• To divert from current production
Relevant cost will be the normal wage + the lost contribution from the fewer units produced
in normal production due to labour diversion.
NB: If both are available in a decision, select whichever is cheaper
c) If labour is idle that is excess labour force which is un-utilized
Use of this labour in a decision means utilization of excess hours and the about cost will be
irrelevant

iii) Overheads
Variable overheads
It is an incremental cost which varies with activity level and it is therefore relevant
Fixed overheads
It is expected to remain constant irrespective of activity level and therefore irrelevant.
However, if there is actual increase arising from a decision made, the amount of increase is relevant
cost

Illustration
A company has spent Sh.100, 000 acquiring patent rights to manufacture a product. It hopes to sell
30,000 units at a selling price of Sh.10 each and the variable costs of production will be Sh.7 per unit.
Should the company proceed with production?

Solution
Sh.100, 000 is known as a past cost or a sunk cost. That money is gone and what the company has to
do is to concentrate on future cash flows. The future cash flows will generate a contribution of:
30,000 × (Sh.10 - Sh.7) = Sh.90, 000

Therefore, proceeding with production will increase the company’s wealth, so it should proceed.

[Note: The incorrect approach would be to look at all costs: 30,000 (Sh.10 - Sh.7) - Sh.100, 000 = -
Sh.10, 000. This incorrect because the business has no control over the past cost of Sh. 100,000. The
company has to make the best of what can be done in the future.]

169
Illustration
A company rents a factory for sh.100, 000 per year. Half of the factory is already occupied by a
machine. The company is considering installing an additional machine which would produce 20,000
units for a variable cost of sh.5 per unit. These units would sell for sh.7 each. Half of the factory rent
would be apportioned to the new machine.

Should the company purchase new machine?

Solution
The factory rent of sh.100, 000 will be paid irrespective of whether the factory is empty, has one
machine or two machines. It is a fixed cost, is non-incremental and is therefore irrelevant to the
decision.
The new machine will generate a contribution of 20,000 × (sh.7 - sh.5) = sh.40, 000
The new machine should therefore be purchased.

Illustration
A company is considering installing a machine which would produce 20,000 units for a variable cost
of sh.5 per unit. These units would sell for sh.7 each. Additional space would have to be rented at a
cost of sh.50, 000.
Should the company take on this project?

Solution
Here the rent of sh.50, 000 is an incremental cost and is therefore relevant to the decision.
The new machine will generate a contribution of 20,000× (sh.7 - sh.5) - sh.50, 000 = - sh.10, 000.
Therefore, the project should not be taken on.

Illustration
A company has some inventory that was bought for sh.10, 000.
• It could be sold for sh.4, 000 or used to make a product that would sell for sh.15, 000.
• There is no other use for the inventory.
Additional costs needed to convert the inventory into the product are sh.9, 000. The material could be
bought now for sh.8, 000

Required;-
What should the company do?

Solution
The sh.10, 000 cost of the inventory is irrelevant: it is a sunk or past cost.
The sh.8, 000 current price is irrelevant because the company has no use for the material so would not
buy more.

The sh.4, 000 resale value of the inventory is relevant as the company could receive that cash by
selling the inventory. Therefore, sh.4, 000 is a future incremental cash flow. If the company keeps the

170
inventory and produces the product sh.4, 000 will not be obtained and the sh.4, 000 is known as an
opportunity cost.

If the company proceeds with the new product, the incremental cash flows will be:

Sh.
Sales revenue 15,000
Conversion costs (9,000)
Opportunity cost of not selling the material (4,000)
Contribution 2,000

ILLUSTRATION
A 1 year contract has been offered which will utilize an existing machine that is only suitable for such
contract work. The machine cost shs.25, 000 five years ago and has been depreciated £4,000 per year
on a straight line basis and thus has a book value of shs.5,000. The machine could be sold now for
shs. 8,000 or in 1 years’ time for sh.1000. Four types of material would be needed for the contract as
follows:

Units Price per unit

Material In stock Required for Purchase Current Buying- Current
contract Price of stock in Price Resale Price
sh. sh. sh.
W 1,200 300 1.80 1.50 1.20
X 200 1,100 0.75 2.80 2.10
Y 3,000 600 0.50 0.80 0.60
Z 1,800 1,200 1.80 2.00 1.90

W and Z are in regular use within the firm. X could be sold if not used for the contract and there are
no other uses for Y, which has been deemed to be obsolete.

Required;
What are the relevant costs in connection with the contract (ignoring the time value of money)?

SOLUTION
Machine costs. The historic cost is a sunk cost and is not relevant. The depreciation details given
relate to accounting conventions and are not relevant.
The relevant cost is the opportunity cost caused by the reduction in resale value over the one year
duration of the contract, i.e. sh.8000 – 1000 = sh.7,000.

Material costs.
W
Although there is sufficient in stock the use of 300 units for the contract would necessitate the need
for replenishment at the current market price.
∴ Relevant cost = 300 x sh.1.50 = sh.450

171
X
If the contract were not accepted 200 units of X could be sold at sh. 2.10 per unit. The balance of 900
units required would be bought at the current buying-in price of sh.2.80.

Sh.
∴ Relevant cost = 200 x sh.2.10 = 420
900 x sh.2.80 = 2540
2,940

Y
If the 600 units were used on the contract they could not be sold so the opportunity cost is the current
resale price of sh.0.60 per unit.
∴ Relevant cost = 600 × sh.0.60 = sh.360
Z
Similar reasoning applies to W, i.e. replenishment at current buying in price.
∴ Relevant cost = 1200 × sh.2 = sh. 2,400
𝑠ℎ.70,000+𝑠ℎ.20,000
No. of units for target profit =
𝑠ℎ.3.50
= 25,714 units

Note: The Contribution /Sales (C/S) ratio is sometimes known as the Profit/Volume(C/V) ratio.

ILLUSTRATION
Plasma plc. deals in plastic buckets and bottles. It is uses polystyrene for manufacturing buckets, and
polyethylene terephthalate for manufacturing bottles. For every unit of bucket and bottle, it requires
0.5 kg of the required raw material, each.
Plasma has received a bulk order for 1000 buckets and 800 bottles, and is evaluating this order. The
data relating to the raw material requirements are as follows

Polystyrene Polyethylene terephthalate

Required quantity for the order 500 kg 400 kg
Inventory in hand 150 kg 80 kg
Original cost of inventory in hand (sh./kg) 60 80
Current purchase price of materials (sh./kg) 65 74
Current resale price of the materials (sh./kg) 66 60

Polystyrene is regularly used by the company in the production of buckets. However, plasma has
decided to stop using the production of bottles and so polyethylene terephthalate is no longer in use by
the company and it has no alternative use within the business.

Required;-
What is the total relevant cost of materials for the project?

SOLUTION
Relevant costs are cost related to a future decision

172
As mentioned in the given case plasma has stopped the production of bottles and the related raw
material has no alternative use. Hence it can be said that those materials can be sold in the market.

However, plasma has received a bulk order for buckets and bottles. Hence those materials will be
used for the production of the bulk order.

The relevant cost of the required raw materials can be calculated as follows;-

Sh.
Cost of raw materials required for the production of buckets
(500 kg × sh65) 32,500
Cost of materials required for the production of bottles
(320 kg ×74) 23,680
Opportunity cost of the raw materials required for the
production of bottles (80 kg × 60) 4,800
Relevant cost 60,980

ACCEPT OR REJECT DECISIONS

Products are normally sold at cost plus profit and capacity may remain un-utilized due to demand
constraints at the current selling price.

Companies may consider accepting offers at price below the current price so as to utilize idle capacity
If the revenue covers the relevant cost, the offer should be accepted

Other factors to be considered for an accept or reject decision to be considered. They include;-
• The firms policy regarding the selling price
• Possibility of future demand of the company’s product
• Whether the fixed cost will remain constant
• Effect on other sales especially when the existing customers learn about the reduced selling price
• Available idle capacity

ILLUSTRATION
TSLM Company Ltd. manufactures clothing and sells directly to clothing retailers. One of its
departments manufactures T-shirts. The department has a production capacity of 80,000 T-shirts per
month.

Currently, the company has excess capacity which has resulted from liquidation of one of its major
customers in the month of April 2012. For the next quarter, monthly production and sales volume is
expected to be 50,000 T-shirts.

The expected costs and revenues per T-shirt at this activity level are as follows:

173
 Sh.
Direct materials 35
Direct labour 50
Production overheads: Variable 8
Fixed 30
Marketing and distribution costs 12
Total costs 135
Selling price 160
Profit 25

Additional information:
1. TSLM Company Ltd. is expecting an upsurge in demand and considers that the excess capacity is
temporary.
2. ABC Ltd. has offered to buy for its employees 2,000 T-shirts each month for the next three
months at a price of Sh.95 per T-shirt.
3. ABC Ltd. would collect the T-shirts from TSLM Company Ltd. factory and thus no marketing
and distribution costs will be incurred.
4. ABC Ltd. would require its logo to be imprinted on the T-shirts. This would cost TSLM Company
Ltd. an extra Sh.5 per T-shirt.
5. TSLM Company Ltd. has an agreement with its employees that entitles the employees at least six
months’ notice in the event of any redundancies.
6. No subsequent sales to this customer are anticipated.

Required:
Advise TSLM Company Ltd. whether to accept or reject the offer from ABC Ltd.

SOLUTION
Accept or reject offer
Relevant costs
Sh.
Direct materials 35
Direct labour 50
Variable OHDs 8
Additional cost 5
Total cost 98

Offer price to ABC = 95

Advice;
Reject the offer because the selling price is below the cost of production

DROPPING A PRODUCT
174
From time to time management will be faced with the problem of deciding to abandon an unprofitable
activity. This is really a least-cost alternative decision and so made on the criterion of relative
marginal costs.

It is sometimes suggested that, where a given product is apparently making a loss, manufacture and/or
marketing of this product should cease, to improve the company’s overall profit performance.

ILLUSTRATION
A company produces three products for which the following operating statement has been produced:

Product X ProductY Product Z Total

Sh. Sh. Sh. Sh.
Sales 32,000 50,000 45,000 127,000
Total Costs 36,000 38,000 34,000 108,000
Profit/(Loss) (4,000) 12,000 11,000 19,000

The total cost comprise 2/3 variable 1/3 fixed.

The directors consider that as product X shows a loss it should be discontinued.

Required
Based on the above cost data should product X be dropped?
What other factors should be considered?

SOLUTION
First calculate the fixed costs, as: 1/3 (36,000) + 1/3(38,000) + 1/3(34,000) = Sh.36,000
Rearrange the operating statement in marginal costing form:
Product X Product Y Product Z Total
Sh. Shs Sh. Shs
Sales 32,000 50,000 45,000 127,000
Less marginal Costs 24,000 25,333 22,667 72,000
= CONTRIBUTION 8,000 24,667 22,333 55,000
Less Fixed Cost 36,000
= Net Profit 19,000

From this it will be seen that product X produces a contribution of sh. 8,000.
Should it be dropped the position would be:
Shs
Contribution Product Y 24,667
Contribution Product Z 22,333
Total contribution 47,000
Less Fixed Assets 36,000
=Net Profit 11,000

Thus dropping Product X with an apparent loss of sh.4,000 reduces total profits by sh.8,000 which is,
of course, the amount of contribution lost from Product X. Other factors which need to be considered:

175
a) Although Product X does provide some contribution, it is at a low rate and alternative, more
profitable products or markets should be considered.
b) The assumption above was that the fixed costs were general fixed costs which would remain even
if X was dropped. If dropping X results in the elimination of the fixed costs originally
apportioned to X, then the elimination would be worthwhile. However, this is unlikely.

MAKE OR BUY DECISIONS

This involves evaluating whether it will be advantageous to manufacture items or to purchase the
items from outside suppliers.

Outsourcing is the process of obtaining goods or services from outside suppliers of providing the
same services within the organization.
In arriving on such a make or buy decision, the price asked by the outside supplier should be
compared with the marginal cost of producing the component parts. Other consideration affecting the
decision is:
i) Continuity and control of supply e.g. can be the outsource company be relied upon to meet the
requirement in terms of quality, delivery dates and price stability.
ii) Alternatives use of resources. Can resource used make this article be transferred.

The choice between making or buying a given component is one which is likely to face all businesses
at some time. It is often one of the most important decisions for management for the critical effect on
profits that may ensue. The choice is critical, too, for the management accountant who provides the
cost data on which the decision is ultimately based.
A make or buy problem involves a decision by an organisation about whether it should make a
product or carry out an activity with its own internal resources or whether it should pay another
organisation to carry out the activity. The make option gives management more direct control over the
work, but the buy option may have benefits in that the external organisation has expertise and special
skills in the work making it cheaper.

There are certain situations where the make or buy decision is not really a choice at all. There can be
no alternative to making, where product design is confidential or the methods of processing are kept
secret. On the other hand, patents held by suppliers may preclude the use of certain techniques and
then there is no choice other than buying or going without. The supplier who has developed a special
expertise or who uses highly specialized equipment may produce better-quality work which suggests
buying rather than making. In other cases, the special qualities demanded in the product may not be
available outside and so making becomes necessary.

Where technical considerations do not influence the make or buy decision, the choice becomes one of
selecting the least-cost alternative in each decision situation. Comparative cost data are necessary,
therefore, to determine whether it is cheaper to make or to buy. In general this requires a comparison
of the respective marginal costs or, in some cases, the incremental costs of each alternative.
Incremental costs are relevant in decisions which include capacity changes. For example, a certain
component has always been bought out because the plant and equipment for its manufacture has not
been installed in the factory. When considering the alternative to buying, the cost of making
comprises all the incremental costs (including additional fixed expenditure) arising from the decision.

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The incremental cost also includes the opportunity cost of the investment in capital equipment, that is,
the expected return from an alternative investment opportunity. A decision to buy a part which has
previously been manufactured may release capacity for other uses or for disposal so that the
incremental cost of the decision also includes the relevant fixed cost savings

ILLUSTRATION
The availability of Material B is limited to 8,000 kg
Product A B C
Demand (units) 2,000 2,500 4,000
Variable cost to make (sh. per unit 12 14 16
Buy-in price (sh. per unit) 15 19 18
Kg of B required per unit 3 2 1
(included in variable cost)

Which products should the company make and which should it buy?

SOLUTION
A B C
Sh. Sh. Sh.
Buy-in price 15 19 18
Cost to make 12 14 16
Saving (per unit) –sh. 3 5 2
Kg of B 3 2 1

Saving per kg -sh. 1 2.50 2

Ranking 3 1 2

Product Units Material B(kg)

B MAKE 2,500 5,000
C MAKE 3,000 3,000
8,000kg

C BUY 1,000
A BUY 2,000

ILLUSTRATION
A firm is considering whether to manufacture or purchase a particular component 2543 .This would
be in batches of 10,000 and the buying in price would be sh6.50 per unit. The marginal cost of
manufacturing Component 2543 is sh4.75 per unit and the component would have to be made on a
machine which was currently working at full capacity. If the component was manufactured, it is
estimated that the sales of finished product FP97 would be reduced by 1000 units. FP97 has a
marginal cost of sh60/unit and sells for sh80/unit. Should the firm manufacture or purchase
Component 2543

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 SOLUTION
A superficial view, based on the preceding example, is that because the marginal cost of manufacture
is substantially below the buying in price, the component should not be bought in and thus further
analysis is unnecessary. However, such an approach is insufficient in this more realistic situation and
consideration must be given to the loss of contribution from the displaced product.
Cost analysis - Component 2543 in batches of 10,000

Sh.
Marginal Cost of manufacturer = sh4.75/unit x 10,000 47,500
+ Lost contribution for FP97 = sh20/unit x 1000 20,000
67,500
Buying in price = sh6.50/unit x 10,000 65,000

There is a saving of Sh.2,500 per 10,000 batch by buying in rather than manufacture.

Note: The lost contribution of sh.20,000 is an example of an opportunity cost.. This is the value of a
benefit sacrificed in favor of some alternative course of action. Where there is no alternative use for
the resource, as in Example 4, then the opportunity cost is zero and can thus be ignored.

OPERATING STATEMENTS
An income statement is a core financial statement that presents a company's operating results over a
specific period of time, often quarterly or annually. Also known as an operating statement, an
earnings report, or a profit and loss statement (P&L), an income statement starts with revenues and
then subtracts costs and expenses (such as cost of goods, depreciation, amortization, and taxes) to
calculate net income. Along with a balance sheet, a retained earnings statement, and a cash flow
statement, an income statement is one of the key financial statements that summarize the finances of a
company.
All companies need to generate revenue to stay in business. They use revenues to pay expenses,
interest payments on debt, and taxes owed to the government. After these costs of doing business are
paid, the amount left over is called net income. Net income is theoretically available to shareholders,
though instead of paying out dividends, the firm’s management often chooses to retain earnings for
future investment in the business

Anyone interested in active investing, picking stocks or investigating the financial health of a
company must know how to read financial statements, including the statement of operations. The
importance of the information contained in the statement of operations cannot be overemphasized.
A firm’s ability or inability to generate earnings over the long term is the key driver of stock and bond
prices. Operating profit (EBIT) is the source of debt repayment, and if a company can’t generate
enough EBIT to pay its debt obligations, it will have to enter bankruptcy or sell itself. Net income is
the source of compensation to shareholders (owners of the company), and if a company cannot
generate enough profit to compensate owners for the risks they’ve taken, the value of the owners’
shares will plummet. Conversely, if a company is healthy and growing, higher stock and bond prices
will reflect the increased availability of profits.

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PRACTICE EXERCISES (Solutions on page 253)
QUESTION 1
The following information has been extracted from the books of Solarcross Ltd for the year to 31
March 2000:
Units ‘000’
Production 30
Sales 24
Production cost incurred: Sh. ‘000’
Direct material 7,200
Direct labour 1,800
Variable overheads 1,500
Fixed overheads 2,700
Selling and administrations costs:
Sales and salaries 450
Variable sales commission 300
Promotion and advertising 480
Other fixed costs 720

The company’s unit selling price is Sh 550.

Required:
a) Profit and loss statement under direct costing approach.
b) Profit and loss statement under indirect costing approach.
c) An explanation of the difference in profit or loss in (a) and (b) above

QUESTION 2
.
a) The following data relate to Kenya Ltd for the year ended 31 December 1999.

Sh. ‘000’
Sales 24,000
Less: Total costs 20,000
Net profit 4,000

Fixed costs account for 40% of the total costs.

Required:
i) Margin of safety.
ii) Break-even point in sales
iii) Sales required to earn profit of Sh 6,000,000.
iv) In order to increase sales, the management has the following two options:
1. To increase sales by 25% on incurring a sales promotion cost of Sh 2,500,000.
2. To increase sales by 15% on reducing selling price by 5%.
b) Advise the management on which option they should take.
QUESTION 3
Jamii Company Ltd manufactures and sells a single product. The following information regarding the
company’s operations for the year ended 30 September 2001 was presented to you.

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Profit and loss account for the year ended 30 September 2001

Sh. ‘000’ Sh. ‘000’

Sales 30,000
Less:
Production costs
Direct material 6,500
Direct labour 5,400
Production overhead variable 7,000
Prime costs 18,900
11,100
Other expenses;-
Selling – Variable 2,600
- Cost 1,997
Administration 2,100 6,697
Net profit 4,403

The following changes are expected to occur during the year ending 30 September 2002:

1. Selling price will be adjusted downward by 3% in order to attract more customers.

2. Material prices will rise by 2% due to inflation.
3. There will be a reduction in labour cost of 4%.
4. Production overheads will increase by 3%.
5. Increase in the efficiency of sales persons will reduce direct selling costs by 5%.
All other factors are expected to remain constant.

Required:
a) Break-even point in sales value
b) The margin of safety in sales value
c) The sales value at which profit of Sh. 4.5 million will be achieved
d) A summary operating statement that shows the net profit of Sh. 4.5 million above.

CHAPTER 8

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 BUDGETING AND BUDGETARY CONTROL

INTRODUCTION
Key terms
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 whereas 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'.
There is, however, little point in an organisation simply preparing a budget for the sake of preparing a
budget. A beautifully laid out budgeted income statement filed in the cost accountant's file and never
looked at again is worthless. The organisation should gain from both the actual preparation process
and from the budget once it has been prepared.

A budgetary control system is a means of monitoring revenue and costs, and thereby exercising
control in an entity by devising budgets and comparing budgeted figures with the actual results, to
find out discrepancies if any and to take corrective actions.

Budgetary slack is a limiting factor that restricts further production

Principal budget factor–These are the main components which have to be budgeted for. They are the
most important cost or resources that have to be budgeted for i.e. gives the first priority
Pudding the budget -This is the process of making few adjustments or correction to the original
budget where the original budget is not attainable or has mistakes
Rolling budget –This is the process of preparing a budget based on the previous period budget
In this process we make the estimated charges in revenues and cost on the previous period budget to
give us the current period budget

NATURE AND PURPOSES OF BUDGETS

Drawing up the budget

THE BUDGET MANUAL

As one of the objectives of budgeting is to improve communications it is important that a manual is
produced so that everyone in the organisation can refer to the manual for guidance and information
about the budgetary process. The budget manual does not contain the actual budgets for the ensuing
period - it is more of an instruction/information manual about the way budgeting operates in the
particular organisation and the reasons for having budgeting. Contents obviously vary from
organisation to organisation but the following are examples of the information such a manual should
contain.

Manual contents
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• foreword - preferably by Chief Executive/managing Director
• objectives/explanation - explanation of budgetary planning and control
of the budgetary process - objectives of each stage of the budgetary process
- relationship to long-term planning
• Organization structures - Structure of the organization showing titles, responsibilities and
and responsibilities relationships
- Titles and manes of current budget holders
• Main budgets and - outline of all main budgets and their accounting relationships
relationship - explanation of key budgets (e.g. Master Budget, Cash Budget,
Sales Budget)
• Budget development - Budget committee, membership and terms of reference
- sequence of budget preparation
- timetable for budget preparation and publication
• Accounting procedures - name and terms of reference of the budget officer (usually the
accountant)
- coding lists
- sample forms
- timetable for accounting procedures, production of reports,
closing dates.

PREPARATION OF BUDGETS
MASTER BUDGET
The Master budget is the overall quantifications of the budgeting plan. In it, functional budgets are
incorporated. A functional budget is a budget of income and/or expenditure for a particular function.
The master budget therefore combines all the budgets of the various departments in an organization. It
is useful in ensuring that all the individual budgets are consistent with one another and also presents a
‘unit’ picture of the entire organization.

All these budgets translate into the projected profit and loss a/ c and the budgeted Balance Sheet. The
relationship between all these budgets is summarized in the next page.

Usefulness
(a) It is a good medium of communication between the various departments as it consolidates the
functional budgets
(b) It enables an overall plan in achieving the budget to be prepared. Budgeted income statements
budgeted cash flow statements and forecasted b lance sheets are pre pared using the budget
(c) The master budget incorporates the targets of every department and therefore acts as a measure of
performance evaluation

Problems
(a) Budgets are based on forecasting. This means that they are vulnerable to uncertainty in the
environment.
(b) Master budgets is based on certain assumptions that may not prove correct over the period

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FUNCTIONAL BUDGET
Functional budget are prepared for an individual function. For each operation in the organization a
budget is prepared
Sales budget, purchases budget, production budget, cash budget etc. are ex ample of functional
budget.
This budget are consolidated to arrive at a master budget

Usefulness
a) A functional budget give target to the individual functional manager
b) Those who actually implement the budget prepare the functional budget. They are familiar with
the problems at the grassroots level. Therefore the budgets are more realistic and motivating.

Problems
(a) As the functional manager prepares the functional budget, the target may not be in line with the
strategic objectives or may conflict with the organizational objectives or inter departmental
objectives. This problem can be avoided by encouraging co-ordination between the functional
managers.
(b) Functional budgets are based on forecasts. There are many extern al as well as well as internal
environmental factors (such as a change in demand for a product, non-availability of a particular
raw material high attrition causing shortages of skilled labour, etc.)that affect the functional
budgets. If these factors behave differently than predicted, this may render the budgetary system
ineffective

Production budget
The production budget is usually expressed in quantity and represents the sales budget adjusted for
opening closing finished stocks and work in progress.
It summarizes the production requirements for the forthcoming period to match the forecasted sales
above. Budgeting of ending inventory is crucial as it ensures that economic stock levels are
maintained i.e. no excess stocks are carried thus minimizing on holding costs and avoiding tying of
capital and that there is adequate level inventory in to avoid shortage costs and unnecessary ordering
costs. The production budget is expressed as units of each type of product. Various factors considered
while preparing the production budget include available production capacity; the sales forecast and
finished goods stock level policy, among others.
The cycle for the preparation of the production budget usually is determined by the budget committee.
It follows the following steps:
• Consider the possible ways in which the available production capacity may be expanded if
required.
• Linkage of production capacity available to the stock level
• Determine the detailed budgets within the production budget.

ILLUSTRATION
ABC Ltd. which deals in products Cee and Dee wishes to prepare an operating budget for the
forthcoming period. The information regarding the products, cost and sales level is as follows:

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 Department
Cee Dee
Materials required
Aye (kg) 4 6
Bee (litres) 2 8
Labour hours required
Skilled (hours) 8 4
Semi-skilled (hours) 4 10
Sales level (units) 4,000 3,000
Opening stock (units) 200 400

The following additional information is relevant:

1. Material Aye costs Sh. 100 per kg and material Bee costs Sh.70 per litre.
2. Skilled and semi-skilled workers are paid Sh.120 and Sh.80 per hour respectively.
3. Opening stocks were 600kg for material Aye and 2,000 litres for material Bee.
4. Closing stock of both materials and finished goods will be enough to meet 10% of demand.

Required;
Compute the Production (units)

SOLUTION
a)
i) Production Budgets

Products Cee Dee

Units Units
Budgeted closing stock 400 300
10% of sales = 10% x 400/300 4,000 3,000
Budgeted sales (200) (400)
Budgeted opening stock 4,200 2,900

Direct Materials budget: this shows the estimated quantities and costs of all the raw materials and
components needed for the output demand by the production budget. Sufficient raw materials must be
available to meet the production process and, in addition, provide ending raw materials working
inventory for the period under consideration. Direct raw materials budget is expressed in units. It
consists of;-

i. Direct Materials Usage Budget

ii. Direct Materials Purchases Budget

Direct Materials Usage Budget: it shows the estimated quantities of materials required for budgeted
production.

Compute the material usage (kg and litres)

SOLUTION
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Material Usage (Kg and litres)
Materials Aye Bee
Kg Litres
Cee (4,200 x 4) 16,800 (4,200 x 2) 8,400
Dee (2,900 x 6) 17,400 (2,900 x 8) 23,200
34,200 31,600

Direct Materials Purchases Budget: It ensures that materials are within the planned materials stock
levels i.e. after considering both usage and material stocks required.

Format
Material

Budgeted closing stock (units) xxx

Add: Budgeted material usage (units) xxx
Less: Budgeted opening stock (units) (xx)
Budgeted materials purchases in units xxx a
Material prices xxx b
Budgeted materials produced in value xxx a x b

ILLUSTRATION
Compute the Material purchases (kg. Litres and sh)

SOLUTION
Materials purchase (Kg – Litres and Shs)
Aye Bee
Kg, shs Litres, shs
Budgeted closing Stock10% of demand 3,420 3,160
Budgeted material usage 34,200 31,600
Budgeted opening stock (600) 2,000
Budgeted material purchase (kg,litres) 37,020 32,760
Material price ×100 ×70
Material purchase (shs) 3,702,000 2,293,200
Direct Labour budget: this is crucial as it forecasts the number of labour hours required and thus
helps the company to know whether sufficient labour time is available to meet production needs in the
budget period. It is based on production budget estimate. This budget helps the company know
whether it will need additional labour force in the future and how much it will incur as labour costs.

ILLUSTRATION
Compute the Labour (hours and shillings)

SOLUTION
Labour cost budget (hours and Shs)
Skilled Semi-Skilled Total
Cee – 4,200 × 8 33,600 4,200 × 4 16,800 50,400

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Dee – 2,900 × 4 11,600 2,900×10 29,000 40,600
Labour in (hours) 45,200 45,800 91,000
Labour cost × 120 × 80 -
Total labour cost(shs) 5,424,000 3,664,000 9,088,000

NON- PRODUCTION BUDGETS

Selling and Distribution Cost Budget: It is the forecast of all costs incurred in selling and
distributing the company’s product during the budget period. It is closely concerned with the sales
budget in that it is mainly based on the volume of sales projected for the period. Expenses included
are selling office costs, salesmen salaries and commission, advertising expenses,
etc.

Administration Costs Budget: It represents the costs of all administration expenses.

Each department or budget centre will be responsible for the preparation of its own budget.
Management, Secretarial, Accounting and Administration costs, which cannot be directly related to
the production, are included here. The budget will be mainly incremental i.e. previous year’s figure
will tend to apply for its next budget with an allowance for inflation.

Research and Development Cost Budget: These are costs, which are discretional in nature i.e. they
are determined on need basis by the managers concerned. Research cost is the cost of original
investigation undertaken in order to gain new scientific or technical knowledge and directed towards a
specific practical aim objective.
Development cost is the cost of using scientific or technical knowledge in order to produce new or
substantially improved materials, devices, products, processes systems or services prior to the
commencement of commercial production.

Capital Expenditure Budget: It represents the expenditure on all fixed assets during the budget
period. Addition intended to benefit future accounting periods, or expenditure which increases the
production capacity, efficiency lifespan or economy of existing fixed assets are also incorporated.

CASH BUDGET
It shows the expected receipts and payment of money for a given period.
A cash budget is useful because
i) Shows the expected surplus in the short run and long run so that the amounts can be invested in
a profitable venture
ii) Shows the expected deficit in the short run and long run so that the necessary arrangement can
be made to finance the deficit

Functions or cash budget

i) It ensures that cash is available for revenue expenditure
ii) Helps to indicate where, when and how cash will be needed and whether this permanent or
temporarily.
iii) Helps to preserve liquidity throughout the year
iv) It relieves surplus cash for investment of expansion of facilities

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 v) It guides management on financial capital expenditure both internally and externally

CASH BUDGET FORMART

Jan Feb. March
Balance b/d xxx xxx xxx
Sales receipts xxx xxx xxx
Process from sale of assets - - xxx
Dividend income - xxx -
Rent receivable xxx xxx xxx
Total (a) xxx xxx xxx
Less payments
Payments to supplies xxx xxx xxx
Rent paid xxx xxx xxx
Interest paid - xxx -
Asset paid for xxx - -
Salaries and wages xxx xxx xxx
Total payment B xxx xxx xxx
Balance c/d (a – b) xxx xxx xxx

Preparing the cash budget

A cash budget is a detailed budget of estimated cash inflows and outflows incorporating both revenue
and capital items.
The preparation of cash budgets or budgeted cash flow statements has two main objectives:
To provide periodic budgeted cash balances for the budgeted balance sheet.
To anticipate cash shortages / surpluses and thus provide information to assist management in short
and medium-term cash planning and longer-term financing for the organisations.

Method of preparation
• Forecast sales
• Forecast time-lag on converting debtors to cash, and hence forecast cash receipts from credit
sales.
• Determine stock levels, and hence purchase requirements
• Forecast time-lag on paying suppliers, and thus cash payments for purchases.
• Incorporate other cash payments and receipts, including such items as capital expenditure and tax
payments.
• Collate all this cash flow information, so as to determine the net cash flows.

Layout of the cash budget

A tabular layout should be used, with:
• Columns for weeks, months or quarters (as appropriate)
• Rows for cash inflows and outflows.

ILLUSTRATION
The opening cash balance on 1 January was expected to be sh.30,000. The sales budgeted were as
follows:

187
 sh.
November 80,000
December 90,000
January 75,000
February 75,000
March 80,000
Analysis of records shows that debtors settle according to the following pattern.
60% within the month of sale
25% the month following
15% the month following

Extracts from the purchases budget were as follows:

sh.
December 60,000
January 55,000
February 45,000
March 55,000
All purchase are on credit and past experience shows that 90% are settled in the month of purchase
and the balance settled the month after.
Wages are sh.8, 000 has to be settled in February and the company will receive settlement of an
insurance claim of sh.25,000 in March.

Required;
Prepare a cash budget for January, February and March.
Solution
Workings Receipts from sales
January
cash
Sh.
November (15% x 80,000) 12,000
December (25% x 90,000) 22,500
January (60% x 75,000) 45,000
79,500
February
cash
sh.
November (15% x 90,000) 13,500
December (25% x 75,000) 18,750
January (60% x 8,000) 45,000
77,250

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 March cash
sh.
November (15% x 75,900) 11,250
December (25% x 75,000) 18,750
January (60% x 8,000) 48,000
78,000
Payments for purchases
January
cash
sh.
December (10% x 60,000) 6,000
January (60% x 50,000) 49,500
55,500

February
cash
sh.
January (10% x 50,000) 5,500
February (90% x 45,000) 40,500
46,000

March
cash
sh.
February (10% x 45,000) 4,500
March (90% x 55,000) 49,500
54,000

Cash budget
January February March
sh. sh. sh.
Opening balance 30,000 24,000 17,250
Receipts from sales 79,500 77,250 78,000
Insurance claim _____ _____ 25,000
= Total cash available 109,500 101,250 120,250
Payments
Purchases 55,000 46,000 54,000
Wages 15,000 15,000 15,000
Overheads (less depreciation) 15,000 15,000 15,000
Taxation _____ 8,000 ______
Total payments 85,500 84,000 84,000
Closing balance c/f 24,000 17,250 36,250

189
Note: The above example has been kept simple to show clearly the underlying principles which must
be understood. Typical complications which often appear include the following: purchases, wages,
etc., may not be given directly but have to be derived from stock/sales figures and where there are bad
debts the receipts from sales are not equal to 100% of sales and so on.

PROFORMA FINANCIAL REPORTS

(INCOME STATEMENTS AND BALANCE SHEETS)
In business, pro forma financial statements are prepared in advance of a planned transaction, such as a
merger, an acquisition, a new capital investment, or a change in capital structure such as incurrence of
new debt or issuance of stock. The pro forma models are the anticipated results of the transaction with
particular emphasis on the projected cash flows, net revenues and taxes. Consequently, pro forma
statements summarize the projected future status of a company, based on the current financial
statements.

For example, when a transaction with a material effect on a company's financial condition is
contemplated, the finance department will prepare, for management and board review, a business plan
containing pro formafinancial statements demonstrating the expected effect of the proposed
transaction on the company's financial viability. Lenders and investors will require such statements to
structure or confirm compliance with debt covenants such as debt service reserve coverage and debt to
equity ratios. Similarly, when a new corporation is envisioned, its founders will prepare pro forma
financial statements for the information of prospective investors.

Pro forma figures should be clearly labeled as such and the reason for any deviation from reported
past figures clearly explained.
Also, banks will request pro forma statements in lieu of tax returns for a startup business in order to
verify cash flow before issuing a loan or line of credit.

Pro Forma Income Statements

A pro forma income statement is similar to a historical income statement, except it projects the future
rather than tracks the past. Pro forma income statements are an important tool for planning future
business operations. If the projections predict a downturn in profitability, you can make operational
changes such as increasing prices or decreasing costs before these projections become reality.
Pro forma income statements provide an important benchmark or budget for operating a business
throughout the year. They can determine whether expenses can be expected to run higher in the first
quarter of the year than in the second. They can determine whether or not sales can be expected to be
run above average in June. The can determine whether or not your marketing campaigns need an extra
boost during the fall months. All in all, they provide you with invaluable information—the sort of
information you need in order to make the right choices for your business.
How do I create a pro forma income statement?
Sit down with an income statement from the current year. Consider how each item on that statement
can or will be changed during the coming year. This should, ideally, be done before year’s end. You
will need to estimate final sales and expenses for the current year to prepare a pro forma income
statement for the coming year.

190
Pro forma gross profit
Assuming that the expected sales are to increase by 10 percent next year. Multiply this year’s sales of
sh.1, 000,000 by 110 percent to get sh.1, 100,000. Then, in this case, you assume there will be no
increase in the cost of each item you are selling, but you will need 10 percent more items to sell in
order to achieve your sales goals. So, you multiply this year’s cost of goods sold (let’s assume a figure
of sh.500, 000), by 110 percent to get sh.550, 000.
To figure the pro forma gross profit for next year, subtract the pro forma cost of goods sold from the
pro forma sales. Sh.1, 100,000 minus sh.550, 000equalto gross profit, or sh.550, 000.

Pro forma total expenses

assuming salaries and other expenses will increase by 5 percent. Therefore, multiply historical
salaries of sh.200, 000 and historical expenses of sh.100, 000 by 105 percent each. The pro forma
salaries for next year will be sh.210, 000 and your pro forma expenses will be sh.105, 000.
Figure the pro forma total expenses by adding pro forma salaries and pro forma other expenses
together. In our case the pro forma total expenses will be sh.315, 000.

Pro forma profit before taxes

Pro forma profit before taxes is figured by subtracting the pro forma expenses from the pro forma
gross profit, or sh.315, 000 from sh.550, 000 for a pro forma profit before taxes of sh.235, 000.

Pro forma taxes

Pro forma taxes are figured by taking estimated tax rate, in this case 30 percent, and multiplying it by
the pro forma profit before taxes of sh.235, 000. This produces a pro forma tax of sh.70, 500.

Pro forma profit after taxes

Pro forma profit after taxes is figured by subtracting the pro forma tax of sh.70, 500 from the pro
forma profit before taxes of sh.235, 000. The pro forma profit after taxes, in this case, would be
projected at sh.164, 300.
Remember that pro formas are essentially best guesses. Continually update of the projections by
recalculating your pro formas using any new and actual financial information as a base should be
done. Doing this on a monthly or quarterly basis will help to assure that projections are as close to
being accurate as possible.

Pro-forma balance sheets

A pro forma balance sheet is similar to a historical balance sheet, but it represents a future projection.
Pro forma balance sheets are used to project how the business will be managing its assets in the
future. For example, a pro forma balance sheet can quickly show the projected relative amount of
money tied up in receivables, inventory, and equipment. It can also be used to project the overall
financial soundness of the company. For example, a pro forma balance sheet can help quickly
pinpoint a high debt-to-equity ratio.

Pro forma current assets

• Cash
To obtain a company’s estimated cash position, there is need to do a careful cash flow projection.

191
• Pro forma accounts receivable
To estimate the accounts receivable on December 31, one needs to take into consideration the
average collection time of receivables and the sales projections for prior periods.
• Pro forma total current assets
Pro forma total current assets are determined by adding projected cash and projected accounts
receivable.

Pro forma fixed assets

• Pro forma land
Land is the easiest of pro forma asset values to calculate. Because land does not depreciate, it will
always have the same value.
• Pro forma buildings
Buildings do depreciate. Let’s assume we are depreciating the building over thirty years. A
company bought its building for sh.300, 000. Each year the building will depreciate by sh.10, 000.
By December 31, 1999, the building will be three years old, so the total depreciation will be
sh.30, 000. This will be reflected later in the accumulated depreciation total. Under the building
heading we show the original value of the asset or sh.300, 000.
• Pro forma vehicles
Vehicles also depreciate. They depreciate over a much shorter period of time than do buildings.
Let’s assume we are depreciating a company’s truck over a seven-year period. The truck was
purchased for sh.73, 500 on January 1, 1999. So, each year the truck will depreciate by sh.10,
500. On December 31, 1999, after one year of depreciation, the truck will have an accumulated
depreciation of sh.10, 500.
• Pro forma total assets
Pro forma total assets are determined by adding up the pro forma total current assets and pro
forma total fixed assets.

Pro forma current liabilities

• Pro forma accounts payable
Pro forma accounts payable are determined by figuring out how much one will spend on supplies
during the last months of the year and how long it takes you to pay your bills.
• Pro forma accrued payroll
It should be easy to determine a pro forma accrued payroll. This is by checking the payroll
calendar to find out what employee pay periods will remain unpaid by the beginning of the pro
forma balance sheet period.
• Pro forma total current liabilities
To obtain pro forma total current liabilities, add up pro forma accounts payable, accrued payroll,
and notes, or portions thereof, payable, within one year.

Pro forma long-term liabilities

• Pro forma mortgage payable
The size of a pro forma mortgage note payable is calculated by taking the mortgage payable at the
end of the current year and subtracting the principal, not interest, payments that will be made
during the upcoming year. To obtain that portion of the mortgage that will be classified as a long-
term liability, subtract what is classified as current liability.

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• Pro forma total liabilities
Pro forma total liabilities are determined by adding up current and long-term liabilities.

Pro forma owners’ equity

• Pro forma common stock
The common stock portion of the owners’ equity will not change from year to year unless new
stock is issued.
• Pro forma retained earnings
Pro forma retained earnings can be tricky to determine. They are the last item to be calculated on
a pro forma balance sheet.

Total assets must balance the total liabilities and owners’ equity.
Also, total liabilities added to total owners’ equity must equal total liabilities and owners’ equity. So,
you can determine total owners’ equity by subtracting total liabilities from total liabilities and owners’
equity.
Common stock added to retained earnings must equal total owners’ equity. So, by subtracting
common stock from total owners’ equity, retained earnings can be determined. This completes a pro
forma balance sheet.

OBJECTIVES OF BUDGETARY CONTROL SYSTEM

1. To plan various activities of the organization
A budget is a formal expression of the future plan. It helps in determining the individual goal of
each activity or department and planning their action in achieving the goal. Budgets provide
premises for detailed operational plans to be followed during the budget period
2. To coordinate the activities of the organization
Every department may prepare their individual plan believing that they are doing the best for the
organization, but this may result in a conflict with the objectives of other departments. The
budgetary control system helps t3o resolve conflicts between departments and therefore helps
the organization to progress as a whole
A master budget is a consolidation of all the other functional budgets. While preparing a master
budget, all the budgets target are reviewed and any conflict between them is resolved. This system
converts the budget into a common plan
3. To devaluate performance of the executives
The budget sets targets for implementation. Such targets are compared with actual performance at
regular intervals. The performance of the executives is also evaluated.
4. To identify areas the areas of efficiency and inefficiency
The budget provides a yardstick for measuring performance and identifying deviations. Such
deviations are then analyzed to determine the efficiency of the personnel as well as the machines.
Once any in efficiencies have been identified, corrective action n is taken to overcome these
inefficiencies.
After budget has been prepared, feedback on performances is given at a regular interval and any
variances are investigated. This helps in achieving the organizational objectives.
5. To provide basis for the control system

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 Budgeting is a management tool. Its emphasis is on managing costs and revenues. By doing so, it
ultimately manages the activities. It provides a guideline of what allowable limit of cost should
be.
Again budget provides a good measure of performance. Accordingly top management can resort
to select control to concentrate more on areas of weakness. This approach is called management
by exception.
It also aids lower level management to evaluate their own performance by comparing .it with the
budgeted.
6. To motivate managers
Budgets provide challenges as well as incentives for better performance. A budget is used as a
tool to measure the performance of managers; it motivates managers to work effectively and
efficiently to meet the target. Sometimes, monetary rewards and promotions are given if the
targets are achieved. This motivates managers to improve their performance. I f achieving higher
productivity is linked managers will be encouraged to achieve it.
7. To Increase profitability
While reviewing the budgets before they finalized. If overestimation of expenditure is identified,
senior managers will curtail the excess provision for expenditure. Also, by comparing the
budgeted expenditure with the actual expenditure, managers can pin point any extravagant
expenses and can avoid them in future by avoiding these extravagant, profitability can be
increased.
8. To ensure best use of available resources
Men, material, machinery and money are referred to as the four M’Ss and are the factors of
production. These factors are vital for production and thus should be optimally utilized. At the
time of devising budgets, management identifies current and future limiting factors and manages
them in such a way that they will become hindrances in the future
9. To provide a means of communication
Budget targets are the expectations. If the individual functional managers prepare the budget, they
communicate the functional objectives through the budget. In the same way, top level
management sets the target to be achieved during the budget year. Therefore, the budget acts as a
medium of communication (horizontally as well as well as vertically) between all the levels of
management within the organization

OPERATION OF A BUDGETARY CONTROL SYSTEM, ORGANIZATION AND

COORDINATION OF THE BUDGETING FUNCTION
The co-ordination and administration of budgets is usually the responsibility of a budget committee
(with the managing director as chairman). The budget committee is assisted by a budget officer who is
usually an accountant. 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 the following
a) Co-ordination of the preparation of budgets, which includes the issue of the budget manual
b) Issuing of timetables for the preparation of functional budgets
c) Allocation of responsibilities for the preparation of functional budgets
d) Provision of information to assist in the preparation of budgets
e) Communication of final budgets to the appropriate managers
f) Comparison of actual results with budget and the investigation of variances

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 g) Continuous assessment of the budgeting and planning process, in order to improve the planning
and control function

The budget preparation process is as follows.

The procedures involved in preparing a budget will differ from organisation to organisation, but the
step- by-step approach described here is indicative of the steps followed by many organisations. The
preparation of a budget may take weeks or months and the budget committee may meet several times
before an organisation's budget is finally agreed.

Step 1
Communicating details of the budget policy and budget guidelines
The long-term plan is the starting point for the preparation of the annual budget.
Managers responsible for preparing the budget must be aware of the way it is affected by the long-
term plan so that it becomes part of the process of meeting the organisation's objectives. For example,
if the long-term plan calls for a more aggressive pricing policy, the budget must take this into account.
Managers should also be provided with important guidelines for wage rate increases, changes in
productivity and so on, as well as information about industry demand and output.

Step 2
Determining the factor that restricts output
The principal budget factor (or key budget factor or limiting budget factor is the factor that limits an
organisation's performance for a given period and is often the starting point in budget preparation.
For example, a company's sales department might estimate that it could sell 1,000 units of product X,
which would require 5,000 hours of grade A labour to produce.

If there are no units of product X already in inventory, and only 4,000 hours of grade A labour
available in the budget period, then the company would be unable to sell 1,000 units of X because of
the shortage of labour hours. Grade A labour would be a limiting budget factor, and the company's
management must choose one of the following options.
a) Reduce budgeted sales by 20%.
b) Try to increase the availability of grade A labour by 1,000 hours (25:1) by recruitment or
overtime working.
c) Try to sub-contract the production of 1,000 units to another manufacturer, but still profit on the
transaction.
In most organisations the principal budget factor is sales demand: a company is usually restricted
from making and selling more of its products because there would be no sales demand for the
increased output at a price which would be acceptable/profitable to the company. The principal budget
factor may also be machine capacity, distribution and selling resources, the availability of key raw
materials or the availability of cash. Once this factor is defined then the rest of the budget can be
prepared. For example, if sales are the principal budget factor then the production manager can only
prepare his budget after the sales budget is complete.
However in the public sector, the principal budget factor will not be profit related. You need to think
about the limiting factor for these organisations in terms of activity, for insurance consultant
availability, cash budget or accommodation.

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Remember that state-run organisations providing services free at the point of consumption often face
almost unlimited demand for their services. Therefore resources available usually comprise the
limiting factor: -
a) Cash from government grants and ministries
b) Trained staff such as nurses and doctors
c) Equipment such as MRI scanners and hospital beds

Step 3
Preparation of the sales budget
For many organisations, the principal budget factor is sales volume. The sales budget is therefore
often the primary budget from which the majority of the other budgets are derived.
Before the sales budget can be prepared a sales forecast has to be made.
Sales forecasting is complex and involves the consideration of a number of factors.
a) Past sales patterns
b) The economic environment
c) Results of market research
d) Anticipated advertising
e) Competition
f) Changing consumer taste
g) New legislation
h) Distribution
i) Pricing policies and discounts offered
j) Legislation
k) Environmental factors

Management can use a number of forecasting methods.

a) Sales personnel can be asked to provide estimates.
b) Market research can be used (especially if an organisation is considering introducing a new
product or service).
c) Various mathematical techniques can be used to estimate sales levels.
d) Annual contracts, under which major customers set out in advance monthly ranges of possible
sales, can be reviewed.
On the basis of the sales forecast and the production capacity of the organisation, a sales budget will
be prepared. This may be subdivided, possible subdivisions being by product, by sales area or by
management responsibility.

Step 4
Initial preparation of budgets
Finished goods inventory budget
Decides the planned increase or decrease in finished inventory levels.
Production budget
Stated in units of each product and is calculated as the sales budget in units plus the budgeted increase
in finished goods inventories or minus the budgeted decrease in finished goods inventories.
Budgets of resources for production
Materials usage budget is stated in quantities and perhaps cost for each type of material used. It
should take into account budgeted losses in production.
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Machine utilization budget shows the operating hours required on each machine or group of
machines. .
Labour budget or wages budget will be expressed in hours for each grade of labour and in terms of
cost. It should take into account budgeted idle time.
Overhead cost budgets
Production overheads
Administration overheads
Selling and distribution overheads
Research and development department overheads
Raw materials inventory budget
Decides the planned increase or decrease of the level of inventories.
Raw materials purchase budget
Can be prepared in quantities and value for each type of material purchased once the raw material
usage requirements and the raw materials inventory budget are known.
Overhead absorption rate
Can be calculated once the production volumes are planned, and the overhead cost centre budgets
prepared.

Step 5
Negotiation of budgets with superiors
Once a manager has prepared his draft budget he should submit it to his superior for approval. The
superior should then incorporate this budget with the others for which he or she is responsible and
then submit this budget for approval to his or her superior.
This process continues until the final budget is presented to the budget committee for
approval.
At each stage of the process, the budget would be negotiated between the manager who
had prepared the budget and his/her superior until agreed by both parties.

Step 6
Co-ordination of budgets
It is unlikely that the above steps will be problem-free. The budgets must be reviewed in relation to
one another. Such a review may indicate that some budgets are out of balance with others and need
modifying. The budget officer' must identify such inconsistencies and bring them to the attention of
the manager concerned. The revision of one budget may lead to the revision of all budgets. During
this process the budgeted income statement and budgeted statement of financial position and cash
budget should be prepared to ensure that all of the individual parts of the budget combine into an
acceptable master budget.

Step 7
Final acceptance of the budget
When all the budgets are in harmony with one another they are summarized into a master budget
consisting of a budgeted income statement, budgeted statement of financial position and cash budget.
Step 8
Budget review
The budgeting process does not stop once the budgets have been agreed. Actual results should be
compared on a regular basis with the budgeted results. The frequency with which such comparisons
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are made depends very much on the organisation's circumstances and the sophistication of its control
systems but it should occur at least monthly. Management should receive a report detailing the
differences and should investigate the reasons for the differences. If the differences are within the
control of management, corrective action should be taken to bring the reasons for the difference under
control and to ensure that such inefficiencies do not occur in the future.
The differences may have occurred, however, because the budget was unrealistic to begin with or
because the actual conditions did not reflect those anticipated (or could have possibly been
anticipated). This would therefore invalidate the remainder of tile budget.
The budget committee, who should meet periodically to evaluate the organisation's actual
performance, may need to reappraise the organisation's future plans in the light of changes to
anticipate conditions and to adjust the budget to take account of such changes.
The important point to note is that the budgeting process does not end for the current year once the
budget period has begun: budgeting should be seen as a continuous and dynamic process.

BENEFITS OF BUDGETING
a) It is the major formal way in which the organisational objectives are translated into specific plans,
tasks and objectives related to individual management and supervisors. It should provide clear
guidelines for current operations
b) It is an important medium of communication for organisational plan, objectives and of the
progress towards meeting those objectives.
c) The development of budgets (done properly) helps to achieve co-ordination between the various
departments and functions of the organisation.
d) The involvement of all levels of management with setting budgets, the acceptance of defined
targets, the two way flow of information and other facets of a properly organised budgeting
system all help to promote coalition of interest and to increase motivation.

PROBLEMS ASSOCIATED WITH BUDGETING

Various problems and difficulties which may occur in connection with budgeting given below but it
does not necessarily follow that they will occur in any given organisation
a) There may be too much reliance on the technique as a substitute for good management
b) The budgetary system, perhaps because of undue pressure or poor human relations, may cause
antagonism and decrease motivation.
c) Variances are just as frequently due to changing circumstances, poor forecasting or general
uncertainties as due to managerial performance.
d) Budgets are developed round existing organisational structures and departments which may be
inappropriate for current conditions and may not reflect the underlying economic realities.
e) The very existence of well documented plans and budgets may cause inertia
and lack of flexibility in adapting to change.
f) There is a major problem in setting the levels of attainment to be included in budgets and
standards.

DISTINCTION BETWEEN BUDGETING AND BUDGETARY CONTROL IN THE

PRIVATE AND PUBLIC SECTORS
Public Sector Budgeting Theory and Strategy

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Main Types of Budget
Budgets can cover a variety of activities and purposes. Each budget type will be produced for a
specific reason and there will be differences in content and approach:
• budgets can be produced for either capital or revenue; resource budgets (e.g. for labour) can
also be produced. This would be seen as a way of planning or controlling labour inputs;
• budgets can be produced for sales, income and revenues;
• working capital budgets, e.g. for stock or cash. It is essential that cash flow is effectively
managed and the optimum benefit obtained from cash resources. Budgets for stock, debtors
and creditors can be seen as a way of controlling the use of current assets and liabilities;
• aggregate or consolidated budgets can be prepared for the organisation as a whole;
• budgets can be subjective based (i.e. what expenditure is on, e.g. wages, premises or supplies)
or objective based (i.e. what the budget is being spent on, e.g. the cost charged to a particular
service or activity). The latter is usually preferred as it enables decision makers make rational
choices but the former is simpler from the control perspective. These budgets can be produced
at multiple levels throughout the organisation for example, at a service level, for a group of
services or a single unit.

Environment and Objectives

Public and private sector organisations operate in different environments and some of the approaches
taken to budget setting will differ. Some of the essential differences between the two sectors are
summarised in the table below.
Private and public sector objectives - a comparison
Private sector Public sector
Market driven Resource constrained (i.e. funded by taxation)
Resources influenced by market demand Resources controlled by government through
grant settlements
Reliance upon external sales Activity generally determined politically
Need for flexibility Fixed budgets
Profit oriented Service/community oriented
Single or limited number of objective(s) Multi (and often conflicting) objectives
Outputs identifiable and measurable Outputs subjective and qualitative
Decisions made by: Decisions made by:
• Shareholders • Electorate
• Customers • Service Users
• Workforce • Employees
• Management • Management
• Board • Politicians
The boundaries between the two sectors have however become less apparent in recent years due to the
effects of externalisation, competitive tendering, the development of both internal and external trading
activities and an increasing emphasis on partnerships amongst both statutory agencies and the private
sector.

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Nevertheless these key differences will influence the approach which public sector bodies take to
budgeting particularly in relation to the need for processes and procedures to be adapted to reflect the
external environment in which they operate and translate this into the setting of budget requirements.

Satisfying external and internal environments

In common with private sector organisations those operating in the public sector must also adapt their
budgeting processes to reflect their internal and external environments.
Public sector budget preparation will be influenced by a number of internal factors including:
• the proposed income and expenditure of the organisations services;
• the revenue consequences of any proposed capital expenditure;
• the use of balances and reserves;
• contributions from trading activities and any surpluses or deficits from the collection fund
(local authorities only);
• growth and savings.
Public sector bodies do not operate in a vacuum and their actions have a significant effect on the
national economy as they are funded by some form of taxation. They also have an effect on the Public
Sector Borrowing Requirement (PSBR) by borrowing money to fund expenditure.

By aggregating budgets throughout the public sector central government can then monitor its
activities against its plans or targets (as set through Comprehensive Spending Reviews and Public
Service Agreements) and take appropriate action to ensure that these are met.

The revenue expenditure of public bodies is funded at national level by either taxation or fees/charges
and at local government level by government grants, local taxation and fees/charges. Statutory
frameworks also exist to ensure that public sector organisations set balanced budgets. Balanced
budgets are ones where the organisation’s estimated revenue expenditure can be met from all sources
together with contributions from reserves.

Objectives of public sector budgeting

Budgeting in the public sector context shares many similarities with the private sector but contains a
greater focus on the relationship with policy development, performance monitoring and statutory
objectives. The key objectives of public sector budgeting are:
• assisting in planning expenditure to meet policy requirements;
• policy implementation and control;
• measuring and monitoring performance;
• to determine the total expenditure of the organisation and ensure that it is consistent with total
revenues (e.g. fixing the rate of local taxation);
• provide the basis for authorising expenditure and collection of fees and charges;
• provide the basis for budgetary control;
• satisfaction of statutory requirements.

Current developments in the public sector and their impact on budgeting theory
Over recent years the public sector has faced many challenges due to the rapid pace of change both in
the way services are delivered and in organisational structures and relationships. These changes have
meant that the finance and budgetary function has had to adapt itself to accommodate radically
200
different ways of working and delivering services and to play a key role in developing and
maintaining an effective. As new policy developments are introduced the need for effective
governance and budgetary control arrangements to ensure probity and sound financial management
remain undiminished.

Overview of the Relationship between Budgeting and Strategy Formulation, Long Term
Planning and Control
The budget is a financial and quantitative statement of an organisation’s activities which is prepared
prior to a definitive period of time. It provides managers and policy makers with financial information
to assist them in taking strategic decisions for which they are responsible.

In any large organisation, and particularly in the public sector, there will be conflicting policy
objectives all of which will have different resource implications which may have either capital or
revenue consequences.

An effective budgeting process should allow all of the financial implications of alternative policy
objectives to be assessed thereby enabling policy makers to appraise them and compare the costs
against available resources.

As External Environment to Budgeting has illustrated, public authorities are not only restricted by
resource implications but also by the external environment and political context in which they operate.
The budget allows policy makers to assess their alternative plans and identify their priorities within
their affordable limits.

Budgets are a key element of effective strategy planning. Medium and Long Term Financial Planning
covers the differences between, and objectives of, long term or strategic planning, medium term and
short term financial planning.
The budget is a financial/resource representation of corporate objectives and also a plan of action for
the period covered. Once the budget is adopted by a public authority it's delivery is placed within the
remit of the accountable management who will have approval to incur expenditure in line with stated
financial regulations and a scheme of delegation.

The budget forms the basis of a controlling mechanism for the various resources of a public authority.
Budgetary control can be applied at all managerial levels provided that managers are made
accountable for the budgets for which they are responsible. The budget can also highlight variations
from expectations so that senior management can take remedial action to ensure that expenditure is
contained within the budget and remains consistent with corporate objectives and policies.

PRACTICE EXERCISES (Solutions on page 257)

QUESTION 1
The following information has been assembled by Sancross Products Ltd which manufactures and
retails products A and B. The details given below relate to the year commencing 1 July 200:

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 Standard Product
Price per kg A kg g
Direct material – M1 Sh 4 15 20
M2 Sh 5 14 12

Standard Product
Rate per hour A hours B hours
Direct labour – L1 Sh 8 20 15
L2 Sh 10 22 24

Fixed production overhead is applied on direct labour basis. Administration, selling and distribution
expenses are recovered at the rate of 20% of production cost and profit loaded at 25% of standard
production cost.
Product
A B
Sh ‘000’ Sh ‘000’
Projected sales for the year 12,033 10,053

Finished goods stock position valued at production cost is expected to be as follows:

Product
A B
Sh ‘000’ Sh ‘000’
1 July 2000 3,000 2,000
30 June 2001 5,000 4,000

Direct material stocks valued at standard prices are as follows:

Material
M1 M2
Sh ‘000’ Sh ‘000’
1 July 2000 200 250
30 June 2001 220 270

For the year to 30 June 2001, fixed production overhead has been estimated at
Sh 1,800,000 and direct labour at 1,200,000 hours.
No opening or closing work-in-progress is anticipated.
Required:
a) Production budget in units.
b) Direct materials cost budget.
c) Purchases budget in value.
d) Direct labour cost budget.
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QUESTION 2
You are in charge of making forecasts and preparing budgets. You have been supplied with cost and
revenue forecasts and details of payment as follows:
1. Forecast of revenue and costs for the quarter ending 31 March 2001
January February March
Shs. Shs. Shs.
Direct
Materials (purchases) 112,000 100,000 135,000
Wages 90,000 80,000 100,000
Overhead
Production 34,000 32,000 40,000
Administration 22,000 20,000 27,000
Selling and distribution 13,000 11,000 18,000

Sales 360,000 350,000 440,000

2. Forecast of revenue and costs for the quarter ending 30 June 2001
April May June
Sh. Sh. Sh.
Direct
Materials (purchases) 90,000 67,000 79,000
Wages 72,000 54,000 63,000
Overhead
Production 45,000 36,000 40,000
Administration 22,000 25,000 27,000
Selling and distribution 13,000 11,000 16,000

Sales 350,000 360,000 360,000

Cash balance on 1 April 2001 Sh. 90,000

Other details
• Period of credit allowed by suppliers averages two months.
• Debenture to the value of Shs. 125,000 are being issued in May 2001 and the amount is
expected to be received during the month.
• A new machine is being installed at the end of March 2001 at a cost of Sh 150,000 and
payment is promised in early May 2001.
• Sales commission of 3% is payable within one month of sales.
• A dividend of Sh 100000 is to be paid in June 2001.
• There is a delay of one month in the payment of overheads. There is also a delay in
payment of wages averaging a quarter of a month.
• Twenty per cent of the debtors pay cash, receiving a cash discount of 4% and 70% of
debtors pay within one month and receive a cash discount of 2 ½%. The other debtors pay
within two months.

203
Required:
A cash budget on a monthly basis from the second quarter of the year 2001.

CHAPTER 9
STANDARD COSTING

204
DEFINITION
Standard cost is a planned unit of cost products, services or components produced in a period. The
standard cost may be determined on a number of bases. The main uses of standard costs are in
performance measurement, control, inventory valuation and in establishment of selling prices.

It can also be defined as control technique which compares standard costs and revenues with actual
results to obtain variances, which are to stimulate improved performances
Standard costing is a control technique that uses standard costs and revenues as a yardstick for
measuring actual performances.

It consists of the following steps

(a) Setting the standards(both for the items costs as well as for revenue)
(b) Comparing the actual cost with the standard cost, and the actual revenue with the standard
revenue
(c) Calculating the variance, if any (i.e. identifying whether or not the actual performance deviates
from the desired level
(d) Analyzing and investigating the reason for the variance (to make the exercise cost effective only
the significant variances are investigated)
(e) Taking the corrective action- either by improving the actual performances (if performance is not
up to the mark) or by revising the standards (if they were set at a level that is unachievable for any
reason)

Standard costs are predetermined costs per unit that should be achieved under predetermined
conditions. They are calculated from the management’s standards efficient operation and the
relevant necessary expenditure. Standard costs are useful for cost estimation, performance
measurement, control, price determination etc.

Their usefulness encompasses

(1) Planning
Standard costs are the building blocks for budgeting, which is an operational planning tool.
Setting standards for any cost, revenue or volume of activity is the first step in devising a budget.
(2) Control and performance measurement
Standard cost acts as benchmark (by establishing standards) for comparison with actual
performance (by analyzing variances) in order to evaluate the level of achievements and to fix
responsibility for variances (if any) It is critical decide whether to set standards at an ideal level or
at an achievable level
(3) Improvement and change
Improvement and change in performance can be achieved by monitoring variances over a period
of time. Monitoring variance provides a good insight into the prevailing conditions of the
environmental factors that might have caused changes in the performance. Variance analysis also
provides information on the controllability of costs which helps in improving performance
A standard has a direct impact on the levels of motivation of employees. Performance level may
be improved by setting a standard slightly higher than the achievable standard and thereby
inducing the employees to achieve the new standard.

205
(4) Decision making
Standard costs form the basis for ascertaining the costs of a new product and for ide notifying the
future profitability of a product. Also standard costs are used in determining the price of a
product/job
(5) Alternative method of valuation
Standard costing provides alternative method of valuing inventory (such as FIFO, LIFO and
weighted average method) and costs of production. Standards are suitable for an organization
whose activities involves common or repetitive operations and where the material and component
parts of products can be specified. Standard are normally set at ideal level to reflect perfect
performance under efficient operating conditions. Some organizations use standard costing for
statistical purposes only. The best use of standard costs can, however, be made only if
incorporated into the accounting system. Many ERP systems have built in mechanism for valuing
inventory at standard costs

TYPES OF STANDARDS
Standard may be classified primarily as current standards and basic (static) standards. Apart from
current standards or basic standards, the other mode of expressing standards is normal standards, ideal
standards and attainable standards.

Current standard
These are subject to alterations in prevailing conditions during the period the standards are to be used.
The standards outline costs and efficiencies that are currently being achieved. They may require
periodical review and frequent revisions in order to adjust them with the changes in production
method or price level. Therefore, these standards normally remain valid only for the accounting
period under consideration.

Basic standards
Basic standards are designed to be used over a long a period of time. These are not intended for
revisions in the short run and therefore, they may not reflect current conditions. These standards are
suitable for industries where technical processes and operations are fully established and do not
change materially over time /number of years

Normal standards
These are the average standards that are anticipated to be attained over future period of time typically
long enough to cover a trade cycle.

Ideal standards
These standards are set considering the ideal prevailing conditions and demand a high degree of
efficiency and performance. Ideal standards consider consumption of the minimum quantity of
material at the lowest price, labour at the minimum rate and time, and overhead at the maximum
efficiency. Ideal standards are mostly theoretical and found to be unachievable most of the time. In an
automated production plant efficient methods of production and production control exists, ideal
standards may be most suitable

Attainable or expected standards

206
These standards takes into conditions and circumstances expected to prevail during the period for
which the standards are set. Allowances for wastage are idle times are provided to in the standards.
Expected standards are more realistic than ideal standards.

OBJECTIVES OF STANDARD COSTING

- To provide a formal basis for assessing performance and efficiency.
- To control costs by establishing standards and analysing variance.
- To enable the principle of management by exception' to be practised detailed, operational level.
- To assist in setting budgets.
- The standard costs are readily available substitutes for actual average unit. costs and can be used
for stock and work-in-progress valuations, planning and decision making, and as a basis of pricing
where cost –plus systems are used.
- To assist in assigning responsibility for non-standard performance in order to correct deficiencies
or to capitalise on benefits.
- To motivate staff and management.
- To provide a basis for estimating.
- To provide guidance on possible ways of improving performance

ADVANTAGES OF STANDARD COSTING

- Standard costing is an example of 'management by exception'. By studying the variances,
management's attention is directed towards those items which are nor proceeding according to
plan. Management is able to delegate cost
control through the standard costing system knowing that variances will be reported.
- The process of setting, revising and monitoring standards encourages re- al of methods, materials
and techniques so leading to cost reductions.
- Standard costs represent what the parts and products should cost. They are not merely averages of
past performances and consequently they are a better guide pricing than historical costs. In
addition, they provide a simpler basis of inventory valuation
- A properly developed standard costing system with full participation and involvement creates a
positive, cost effective attitude through all levels of management right down to the shop floor and
thereby increases motivation and goal congruence.

PRINCIPLES OF SETTING STANDARDS

Establishing a correct standard is very important because accuracy of the standards usually determine
the success of the standard cost system. It is more of an art than a science which requires combined
thinking and expertise of all the persons who have responsibility over prices and quantities of input.
As we will see later, the standard cost system has very serious behavioral implications for the staff
whose performance will be measured against the standards. If the staff feels that the standards are too
high, (unachievable), they will be frustrated and will be greatly demotivated.
Also, if a disciplinary action is taken on an employee who fails to achieve the standards, but the
employees feel that it is unfair as the standard was inaccurate, this will bring about resentment,
sabotage and demotivation to the employees. On the other hand, if the standards are too low, they will
be easily achieved by employees and they will not be challenged to work harder.

207
In determining standard cost, each cost should be carefully analyzed to ensure all factors affecting the
cost level (in the period the costs are to be used) have been considered. In addition, managers in
charge of the departments responsible for meeting the standards should approve the bases for the
standards.

For the standard setting process and standards implementation to be successful, the employees
responsible for meeting the standards should have the opportunity to participate in the Standard
Setting Process. They are the best positioned in pinpointing inaccuracies in the set standards.
It is easier to enforce standards once their acceptance is solicited through participation in the setting
process.

The manager overseeing the setting of standards should also have an honest desire to set achievable
targets, and also to assist their lower managers and employees to achieve them.
Also, standards should only be set after there has been interaction between all the individuals
involved.
Last, and very important, the top management must fully support the standard costing process from
Standards Setting to standards implementation. This support gives the standards the enforcement they
need to be effected in the whole organization.

THE STANDARD COST CARD

This is a card record of the Standard or expected costs in producing a given output. It gives the
physical quantities of inputs as well as their monetary values. It also gives the quality required, e.g.
Grade A labour. The process of setting standards results in the establishment of the standard cost for
the product. The make-up of the standard cost is recorded on a standard cost card.

The process of setting standards results in the establishment of the standard cost for the product. The
makeup of the standard cost is recorded on a standard cost card. In practice there may be numerous
detail cards together with a summary card for a given product, or the standard cost details may be on a
computer file. The principles, however, remain the same. A simple standard cost card is shown below;

Part of no. X291 Standard Cost card Batch quality 100

Tool ref. T5983 Description stub joint Drawing no. D59215
Work study ref.WS255 Revised by G.R.P
Revision date 3/12/2002
Cost type and quantity Standard Dept. 7 Dept. 19 Dept. 15 Total
price or rate
Sh. Sh. Sh. Sh.

Direct materials
2.5 kg P101 14.8 kg 37.00 37.00

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1000 units A539 3.75 100 37.50 37.50
74.50
Direct Labour
Machine Operation
Grade 15
4.8 hrs. 7.5 hr. 36.00 36.00
9.2 hrs. 7.5 hr. 69.00 69.00
Assembly
Grade 8
16.4 hrs. 5.75 hr. 94.30 94.30
199.30
Production Overhead
Machine Hour Rate 11 hr. 52.80 101.20 154.00
Labour Hour rate 6 hr. 98.40 98.40
125.80 207.70 192.70 252.40

Standard Cost Summary

Direct materials 74.50
Direct labour 199.30
Production overheads 252.40
Standard cost per 100 526.20

BEHAVIOURIAL ASPECTS OF STANDARD COSTING

Because of the detailed nature of standard costing and Involvement with foremen and production
workers, communication becomes even greater importance. Production workers frequently regard any
form of performance evaluation with deep suspicion and if a cost-conscious, positive
attitude is to be developed, close attention must be paid to the behavioral aspects of the system. Full
participation, realistic standards, prompt and accurate reporting, no undue pressure or censure - all
contribute to an acceptable system. Remember if the system is not accepted by the people involved it
will be unworkable.

VARIANCES ANALYSIS
Variance analysis deals with the systematic evaluation of variances. Refers to an examination of the
conditions of operations which give rise to any cost variance It also provides management with a n
explanation as to why the variance has occurred. This indirectly helps the management to take
suitable steps to control costs wherever necessary
Variance can be split into two types; variance showing
- Price difference and/or
- Quantity and volume difference

Standards may be set and variance can be calculated for each element of cost (such material, labour,
and overheads). It is also possible to calculate variance for each of the factors such as (price, volume
and so on) which determine the cost.

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The variance can either be favorable or unfavorable (adverse). In order to determine whether the
variance is favorable or adverse, we need to consider its impact on the profit of the entity

A cost variance (such as material price or labour rate variance etc.) is favorable if the actual cost is
less than the standard cost and vise- versa
A sales variance such as sales margin price or volume variance etc) is favorable if the actual profit
exceeds the standard the cost and vise –versa

In general there are four causes variance namely

- Inaccurate recording of actual costs and revenues
- Random events(e.g. an accident may damage raw materials used for production causing
adverse material variance)
- Operating efficiency
- Setting in appropriate standards

Fundamental concepts in brief

1. There are two basic dimensions to variances: price and quantity
2. A price variance is always calculated for actual quantity
3. A quantity variance is always calculated using standard price
4. The sales variances are favorable (F) when actual figures are greater than standards and are
adverse when actual figures are lower than standards
5. The cost variance (except fixed overhead efficiency variances and fixed overhead capacity
variance) are favorable when actual figures are lower than standards and are adverse when
(A) when actual figures are lower than standards
6. Budgeted (costs or sales) signified estimated total (costs or sales) for a budget period as
considered in the budget whereas standards (cost or sales) are budgeted (costs or sales) per
unit
7. Wherever standard quantity is mentioned it should be given as budgeted interpreted as
standard quantity for actual production. Many times standard quantity may be given as
budgeted quantity in exam
8. If standard cost is give n per unit, calculate the total standard cost for the actual level of
activity
9. For variable and fixed overheads, wherever absorption rates are given the rates are to be
presumed as standard rates

BASIC VARIANCES
Material variance
Total direct material cost variance
The direct material total cost variance signifies the difference between the actual material cost and the
standard material cost for the actual production
If actual material cost is greater than the standard material for the actual production, the variance is
adverse (A); otherwise the variance is favorable (F)
The total material cost variance is made up of two elements

210
 - The material price variance ; Which is the difference between the actual price of the
materials and the standard price for the actual quantity of goods made
- The material usage variance; which is the difference between what has actually used and
under standard terms at standard material price
If actual consumption is greater than the quantity of material purchased, actual materials costs for
calculation of direct material cost variance) should be derived 2from as the sum of the actual cost of
purchase of raw materials and the extent of opening inventory consumed at standard price
Total direct material cost variance=Standard material cost for actual production – Actual material cost
Where material cost=Actual cost of usage of raw material out of current year’s purchase+ Extent of
opening inventory consumed at standard price (if there is opening inventory of material)
The total of material purchased is different from the materials actually used and raw materials
inventories are valued at standard cost
The material variance will be calculated based on the actual quantity of purchase whereas the material
usage variance would signifies the difference between actual usage and standard usage

Direct material price variance

The direct material price variance signifies the difference between the actual price and the standard
price multiply by the actual quantity purchased
A direct material price variance occurs when raw materials are purchased at a price different from the
standard price. Direct material price arises due to fluctuations in market price, purchasing non-
standard lots and the consequent reduction in quantity discount, increase in or additional transport cost
for a quick delivery making advantage of cash discount, etc.
If actual raw material price is greater than the standard raw material price, it is indicative of incurring
high cost in raw materials and therefore the variance is adverse (A) and otherwise variance is
favorable (F)

Direct material price variance

=ACTUAL QUANTITY PURCHASED X (STANDARD PRICE – ACTUAL PRICE)

MPV = AQ (S.P – A.P)

Direct material usage Variance

Direct material usage variance represents the difference between the actual quantities of raw materials
used in production and the standard quantities that should have been used in actual production
multiplied by standard price. Standard quantity for actual production should be calculated because it
helps to know whether the material is properly used in production in the production or not
The actual quantities of raw materials used in production is greater than the standard quantities, the
variance is adverse (A); otherwise the variance is favorable (F)
A direct material usage variance is caused on account of subsequent or defective materials,
carelessness in
The use or handling of materials, pilferage of raw materials, wastage due to inefficient production
methods or unskilled employees

Direct material variance=Standard Price = (Standard Quantity – Actual Quantity)

211
MUV= SP (SQ – AQ)

NOTE
Material Cost Variance
This is the difference between the standard material cost allowed for the production level achieved
and the actual material cost incurred
Material Cost Variance = Standard Cost – Actual Cost.

Material Price Variance + Material Usage Variance = Material Cost Variance

I.E (S.Q x S.P) – (A.Q x A.P)

Causes
i) Fluctuations on prices
ii) Efficiency or inefficiency in the usage of the materials caused by:
a) Mixing the materials in different proportion
b) Difference in the field of the materials
iii) Use of substitute materials
iv) Use of wrong standards or estimates

Material mix variance

This is that portion of material usage variance arising from mixing the materials in different
proportions from the standard mix ratios.
= STANDARD PRICE (ACTUAL MIX IN STANDARD PROPORTIONS – ACTUAL MIX)

Material yield variance

This is that portion of the material wage variance arising from the difference between the actual
output and the standard or expected output.
= standard cost x (standard yield /output – actual yield)

NB: Material Mix variance + Material Yield Variance= Material Usage Variance.

ILLUSTRATION
BCH Ltd. Produces a type of liquid fertilizer .The production of this liquid fertilizer requires three
different types of chemicals namely: Exe , Wye and Zed .The chemicals are mixed in the proportion
of 0.4,0.3 and 0.3 respectively and their standard costs are sh.12,sh.7 and sh.5 respectively

Additional information
a) In recent past the standard yield has been 80% on 100 litres of the chemical mix.
b)
c) .The company maintains a policy of not carrying any raw materials, as storage space is limited.
d) Annual production of liquid fertilizer has been set at 8,320,000 litres.
e) In the month of April 2006, the company produced 150,000 litres of the fertilizer at a total cost of
sh.1,708,000 .Actual number of litres used and cost per litre for the three chemicals were as
follows:

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 Chemicals Litres Cost per litre
Sh.
Exe 90,000 11.00
Wye 70,000 8.40
Zed 40,000 5.50

The company had expected the usage of Exe ,Wye and Zed chemicals to be 75,000,56250 and 56,250
respectively.

Required;-
(i) Material price variance
(ii) Material yield variance
(iii) Material mix variance

SOLUTION
(A) Material price variance. = actual quantity (standard price – actual price)
Exe: 90000 (12-11) = 90,000 (F)
Wye: 70000 (7-8.40) = 98,000 (A)
Zed: 40000 (3-5.50) = 20,000 (A)
28000 (A)

(B) Material yield variance = Standard Cost per unit (Standard Output – Actual Output)
Standard Cost per Unit
Exe: 12 x 0.4 =4.8
Wye: 7 x 0.3 = 2.1
Zed: 5 x 0.3 = 1.5
8.4
Standard Output = 80% of Material. Mix
1 Litre of 0.8 of Outputs = 8.4

8.4
= 𝑥 1 = 𝑆ℎ 10.5
0.8
Standard Output (80%)
Total
Standard Output = Inputs x 80%
200000 x 80%
= 160000

Therefore Material Yield Variance = 10.5 (160,000 – 150000) = 105,000 A.

(C) Material Mix Variance = Selling price ( Actual mix in standard Proportion – Actual Mix)
Actual Mix Actual Mix in Standard Proportion
Exe: 90000 0.4 ×200,000 : 80000
Wye: 70000 0.3 ×200,000 : 60000
Zed: 40000 0.3×200,000 : 60000
20000

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 Material Mix Variance =
Exe 12(80000 – 90000) = 120,000 (A)
Wye 7(60000 – 70000) = 70,000 (A)
Zed 5(60000 – 40000) = 100,000 (F)
90,000 (A)

(D) Material Usage Variance = S.P. (SQ – A.Q)

Standard Quantity
Input:
Exe: 0.4 ×187500 = 7,500L
Wye: 0.3 × 187500 = 56,250L
Zed: 0.3 ×187500 = 56,250L

Material Usage Variance =

Exe 12(75,000 – 90,000) =180,000 (A)
Wye 7(56,250 – 70,000) =96,250 (A)
Zed 5(50,250 – 40,000) =81,250 (F)
195,000 (A)

Reconciliation
Material Mix Variance = 90,000 (A)
Material Yield Variance = 105,000 (A)
195,000 (A)

Causes of mix variances

a) Mix variances
Favorable Mix variance arises when less of more expensive material and more of the cheaper
materials are used. For instance, in the example above, 128 (F) arises because less of more expensive
material X has been used and more of the cheaper materials Y and Z

b) Yield variance
Favorable yield variance arises when the output is less than expected: when the actual loss exceeds
the normal loss. Use of cheaper but low quality materials may result to a drop in good production. For
instance, the change to a cheaper mix of material has resulted in the drop in yield of good production
in relation to the standard.

LABOUR COST VARIANCE

This is the difference between the standard labour cost allowed for the production level achieved and
the actual labour cost incurred.

Total direct labour Cost Variance

The total labour cost variance is the difference between the standard direct wages for actual
production and the actual direct wages paid.

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If the standard wages for actual production are greater than the actual direct wages paid this indicates
that the labour cost incurred was lower than estimated and therefore the variance is favorable (F);
otherwise the variance is Adverse (A)
Direct labour cost variance = Standard direct wages for production – Actual direct wages paid
= (Standard labour hours for actual production × Standard wages rate Hour)-(Actual labour hours
× Actual wages rate per hour

The total direct labour cost variance is made up of two elements

The direct labour rate variance; which gives the difference between the actual rate of labour and
the standard rate per hour for the actual hours worked
The labour efficiency variance; which is the difference between what was actually used and what
should have been used under standard terms at the standard labour rate.

Direct labour rate variance

The direct labour rate represents the difference between the standard wages rate per hour and the
actual wage rate per hour of the actual hours worked
If the actual direct labour is greater than the standa6d rate, this indicates that higher costs for direct
labour have been incurred compared to the estimated costs and therefore the variance is adverse (A)
; Otherwise the variance is favorable (F)
The causes of labour rate variances usually are changes in basic wage rates, new workers being paid
different rates from standard rates, different rates being paid to workers employed to meet seasonal
demands or to do urgent work etc.
Direct labour rate variance= (Standard wage rate per hour – Actual wage rate per hour) ×Actual
labour hours
LRV = AH (S.R – A.R)

Causes rate variance

a) Higher rates being paid than planned due to wage (increase) awards.
b) Higher or lower grade of workers being used than planned.
c) Payment of unplanned overtime or bonus.

Labour efficiency variance

This is that portion of labour cost variants arising as a result working for more or less hours in
production than expected.
Labour Efficiency variance = Standard rate (Standard Labour hours – Actual labour hours worked)

LEV = SR (S.H – A.H)

Causes of labour efficiency variance

a) Use of incorrect grade of labour e.g. poorly trained personnel.
b) Poor workshop organization or supervision.
c) Incorrect materials or machine problems.
d) Use of better quality labour
e) Increase labour or decrease labour efficiency.

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 NOTE;
In some cases, there may be some hours paid which was non-productive i.e. idle time. Idle time is the
difference between the hours paid and hours worked.
This gives rise to idle time variance
Idle time V = Standard rate (Hrs. paid – Hrs. worked) or Standard rate (idle time)

Labour cost variance

LCV = (S.H x S.R) – A.H x A.R)

Labour rate Variance Labour efficiency Variance

Labour Mix Variance Labour Quantity / Yield variance

1) LQV = S.R (S.H in S mix- A. H in S. mix)
LMV = SR (AH in S. mix – A.H in A mix) 2) LYV = S.C (S. Yield – A. Yield)

OVERHEADS VARIANCES
Variable production overhead variances
The variable production overhead total variance can be subdivided into the variable production
overhear expenditure variance and the variable production overhead efficiency variance (based on
actual hours)

Fixed production overhead variances

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.

The fixed overhead expenditure variance

The fixed overhead expenditure variance occurs if the numerator is incorrect. It measures the under-
or over-absorbed overhead caused by the actual total overhead being different from the budgeted total
overhead.
Therefore, fixed overhead expenditure variance = budgeted (planned) expenditure –Actual
Expenditure.
The fixed overhead volume variance
As we have already stated, the fixed overhead volume variance is made up of the following sub-
variances.
• Fixed overhead efficiency variance
• Fixed overhead capacity variance
These variances arise if the denominator (i.e. the budgeted activity level) is incorrect.
The fixed overhead efficiency and capacity variances measure the under- or over-absorbed overhead

216
 caused by the actual activity level being different from the budgeted activity level used in calculating
the absorption rate.

How to calculate the variances

The following definitions express how each overhead variance should be calculated.
- 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 volume 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 volume capacity variance is the difference between budgeted (planned) hours
of work and the actual hours worked, multiplied by the standard absorption rate per hour.

Total overhead cost variance

TOCV = Standard OH cost – Actual OH cost

Variable OH cost variance Fixed OH cost variance

V. OH efficiency productivity F. OH expenditure variance F. OH volume variance

V. OH expenditure variance FOEV = B.FOH - AFOH FOW =
variance VOPV = VOAR (S.H – A.H) S.C (B.V – A.V)
VOEV =
A.H (VOAR – A.R)

F. OH efficiency / F. OH capacity
productivity variance variance

Where;
TOCV is Total overhead cost variance
OH is overhead
VOH is variable overhead
VOCV is variable overhead cost variance
FOCV is fixed overhead cost variance
VOEV is variable overhead expenditure variance

217
AH is actual hours
SH is standard hour
VOAR is variable overhead absorption rate
VOPV is variable overheads productivity variance
FOEV is fixed overheads efficiency variance
BFOH is the budgeted fixed overheads
AFOH is the actual fixed overheads
BV is the budgeted volume
AV is the actual volume

ILLUSTRATION
A company uses absorption costing for both internal and external reporting purposes as it has a
considerable level of fixed production costs. The following information has been recorded for the past
year.
Budgeted fixed production overheads Sh. 2,500,000
Budgeted ( Normal ) activity levels:
Units 62,500 units
Labour hours 500,000 hours
Actual fixed production overheads Sh. 2,890,350
Actual levels of activity:
Units produced 70,000 units
Labour hours 525,000 hours

Required:
a) Calculate the fixed production overhead expenditure and volume variances and briefly explain
what each variance shows.
b) Calculate the fixed production overhead efficiency and capacity variance and briefly explain
what each variance shows:

SOLUTION
a) Fixed production overhead Expenditure variance

Fixed overhead expenditure variance = (Actual expenditure on fixed overhead – Budgeted fixed
Overhead)
= sh. (2,890,350 – 2,500,000)
= sh. 390,350 ( A)

This variance indicates that the company has spent more than originally budgeted.
Fixed production indicates that the company has spent more than originally budgeted.

Fixed production overhead volume variance

Fixed overhead volume variance = Fixed overhead absorption rate per hour x (Budgeted hours –
Standard hours required for actual production)
= (560,000 (W1) – 500,000) hours x sh. 5 per hour (W2)

218
 = sh. 300,000 (F)

Workings
Standard hours required for actual activity
For that first we shall calculate
Budgeted hours per unit = 500,000 hours / 62,500 units = 8 hours per unit
Standard hours required for actual activity = Actual units x Budgeted hours per unit
= 70,000 units x 8 hours per unit
= 560,000 hours.
W2
Budgeted Fixed overhead
Fixed overhead Absorption Rate (FOAR) =
Budgeted Activity ( s tan dard hours )
= sh. 2,500,000 / 500, 000 hours = sh. 5 per hour.
This variance indicates that the company has used more labor than originally budgeted.

b)Fixed production overhead Efficiency variance.

Fixed overhead Efficiency variance = Fixed overheads absorption rate x (Actual hours worked or paid
– standard hours required for actual production).

= sh. 5 x (525,000 – 560,000) hours

= sh. 175,000 (F)

This variance shows that labour worked for more hours than was originally budgeted thereby
exceeding the budgeted capacity.

SALES VARIANCES
These can be used to analyze the performance of the sales function or revenue centers.
N.B. Sales variance calculations are calculated in terms of profit or contribution margin rather than
sales values. It sales values are used (actual sales compared to budgeted) there’s the risk of ignoring
the impact of the sales effort on profit. When we say profit margins, we assume absorption costing
and contribution margin when we are marginal costing.

Total sales variance

Total sales variances signifies the variance in profit (in absorption costing) or in contribution in
marginal costing as a results of the combined impact of change in price and sales volume. Similarly
total sales value variance signifies the difference between the actual and budgeted sales
If actual sales /actual margins is greater than the budgeted sales / budgeted margin the variance is
favorable (F) and otherwise it is adverse (A)
Under absorption costing environment

Total Sales value variance=Actual sales – Budgeted sales

Total sales profit variance=Actual profit-Budgeted profit

Under marginal costing environment

Total sales margin (contribution) variance= Actual margin – Budgeted margin

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Sales price and volume variance
The actual price variance signifies the variance between the actual selling price per unit and the
standard selling price per unit multiplied by the actual quantity of units sold
The variance identifies that the units are sold for more or less than their standard selling price and the
overall impact on revenue due to the customers and therefore the variance is favorable (F) and
otherwise is adverse (A). Sales price is calculated both under marginal costing environment and
absorption costing environment.

Under the absorption costing method sales price variance is calculated as follows
Sale price variance= (Actual selling price per unit-Standard selling price per unit) × Actual quantity
sold

OR
Sales (profit margin) variance = (Actual profit margin – Standard profit margin) ×Actual sales volume

= [Actual sales price-Standard cost per unit) - (Standard sales price-Standard cost per unit)] × Act6ual
sales volume

In a marginal costing environment, sales price variance is calculated as

Sales price margin variance

= (Actual contribution margin – Standard contribution margin) × Actual sales volume
= (Actual sales price-Standard variable cost per unit)-Standard sales price- Standard cost per unit) ×
Actual sales volume

If the margin is greater than the standard the standard margin the variance is favorable (F); otherwise
is adverse (A)

The sales variance signifies the difference between the actual quantities sold and the budgeted
quantity, multiplied by either the standard profit per unit or standard contribution per unit .It should be
noted that, in absorption costing, the standard profit per unit is used, whereas in marginal costing
environment Standard contribution per unit is used.
The variance identifies whether the standard quantity or sales exceeded the budgeted quantity
measures the overall impact of change in sales volume on profit or contribution 7of the case may be
If actual sale volume is greater than the standard sales volume the variance is favorable (F); otherwise
the variance is adverse (A)
Sales volume variance = (Actual sales quantity- Budgeted sales quantity) - Standard profit per unit or
Standard contribution per unit)
Sales margin variance (SMV)

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 SMV = (B.Q x B. Cont) – (A.Q x A. Con)

Sales margin price variance Sales margin volume variance

Sales margin mix variance Sales margin quantity / yield variance

SMMV = B. cont. (A. Q in s. mix – A.Q in A. mix SMQV = B. cont. (B.Q – A.Q in s. mix)

Where;
B. cont. is the budgeted contribution
BQ is budgeted quantity
AQ is the actual quantity
A cont. is the actual contribution
SMMV is Sales margin mix variance
SMQV is Sales margin quantity yield variance

ILLUSTRATION
From the information provided below, calculate the following variances:

standard Actual
Qty.(units) Unit sales Cost/ Total Qty. Unit Cost/unit Total
price (sh.) unit sales (units) sales (sh.) sales
price(sh.)
A 2,000 4 3.5 8,000 2,200 4.10 3.70 9,020
B 2,500 5 4 12,500 2,000 5.25 4.30 10,500
C 1,750 6 5.25 10,500 2,000 5.75 5 11,500
6,250 31,000 6,200 3,020

i) sales price variance

ii) sales margin price variance
iii) sales volume variance
iv) sales margin volume variance
v) total sales value variance
vi) total sales margin variance

SOLUTION
Sales price variance = (actual selling price per unit – standard selling price per unit) x actual quantity
Product A = sh. (10 – 4) × 2,200 == sh. 220(F)
Product B = sh. (5.25 – 5) ×2,000 = shs.500 (F)
Product C = sh. (5.75 – 6) ×2,000 = sh.500 (A)

221
Sales price margin variance = Actual contribution margin (W1) – standard contribution margin
(W2) x actual sales volume.
Product A = sh. (0.60 – 0.50) x 2,200 = sh.220 (F)
Product B = sh. (1.25 – 1) x 2,000 = sh. 500(F)
Product C = (0.50 – 0.75) x sh.2,000 = sh. 500 (A)

Workings
W1 actual margin
A = sh4.10 - sh3.50 = sh0.60
B = sh. 5.25 – sh. 4 = sh. 1.25
C = sh. 5.75 – sh. 5.25 = sh. 0.50

W2 budget margin
A = sh. 4 - sh3.50 = sh. 0.50
B = sh. 5 – sh. 4 = $ 1
C = sh. 6 – sh. 5.25 = sh. 0.75

Sales volume variance =

(Actual sales quantity – Budgeted sales quantity) × Standard price per unit
Product A = sh. (2,200 – 2,000) × sh. 4 = 800 (F)
Product B = (2,000- 2,500) × sh. 5 = sh.2, 500 (A)
Product C = (2,000 – 1,750) × sh. 6 = sh. 1,500(F)

Sales margin volume variance

(Actual sales quantity – Budgeted sales quantity) x standard profit per unit
Product A = (2,200 – 2,000) x sh.0.50 = sh.100(F)
Product B = (2,000 – 2,500) x sh. 1 = 500 (A)
Product C = (2,000 – 1,750) x sh. 0.75 = sh. 187.5 (F)

Total sales value variance = Actual sales – Budgeted sales

Product A = sh. 9,020 – sh. 8,000 = sh.1,020(F)
Product B = sh.10,500 – sh.12,500 = sh. 2,000(A)
Product C (11,500 – sh. 10,500 = sh. 1,000(F)

Total sales margin variance = Actual margin – budgeted margin

Product A = (2,200 ×sh0.60) – (2,000 × sh. 0.50) = sh. 320(F)
Product B = (2,000×sh. 1.25) – (2,500 ×sh. 1) = sh.nil
Product C = (2,000 ×sh. 0.50) – (1,750×sh.0.75) = sh. 312.5 (A)

ILLUSTRATION
Cole Dale Ltd. Manufactures and sells product CC. The company operates a standard marginal
costing system. The standard cost card for CC includes the following:

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 Sh. Per
unit
Direct materials 20
Direct labour (6 hours @ sh. 7.50 per hour ) 45
Variable production overheads 27
Total 92

The budgeted and actual activity levels for the last quarter were as follows:

Units
Budget Actual
Sales 20,000 19,000
Production 20,000 21,000

The actual cost incurred last quarter were;-

Sh.
Direct materials 417,900
Direct labour (124,950 hours) 949,620
Variable production overheads 565, 740

Required:
a) Calculate the total variances for the direct material , direct labour and variable production
overheads.
b) Provide an appropriate breakdown of the total variance for direct labour calculated in part (a)
above.
c) Suggest two possible causes of each variance calculated in (b)

SOLUTION
a) Material variance
Direct material variance
= standard quantity for actual production at standard price – Actual quantity at actual price
= sh.20 x 21,000 units) – sh.417,900
= sh.420,00 – sh.417,900=
= sh.2,100 (F)

Direct labour variance

= standard hours for actual production at standard rate – actual hours at actual rate
= (21,000 units x sh. 45) – sh.949,620
= sh.945,000 – sh.949, 620
= sh.4, 620 (F)

Variable production overhead variance

= standard cost of actual production – Actual cost of production
= 21,000 units x sh.27) – sh.565,740
= sh.567,000 – sh.565,740

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= sh.1,260

b) Labour variance
Direct labour rate variance
= Actual hours at actual rate – Actual hours at standard rate.
= sh.949,620 – (124,950 hrs. x sh.7.50)
= sh. 949,620 – sh. 937, 125
= sh. 12,495

Direct labour efficiency variance

= standard hours for actual production at standard rate – Actual hours at standard rate
=(6 hrs. x 21,000 units x sh. 7.5) – ( 124,950 hrs. x sh. 7.5 )
= sh. 945,000 – sh. 937,125
= sh. 7,875 (F)
Breakdown of the total direct labour variance is as follows
Total direct labour variance = direct labour rate variance + direct labour efficiency variance
= sh.12,945 (A) + sh. 7,875 (F)
= sh. 4,620 (A)
c) Causes of direct labour rate and efficiency variance
i) Direct labour rate variance
- High graded workers paid at a higher rate.
- New workers being paid at rates different from the standard rates
- Higher than expected wage settlement for the company
ii) Direct labour efficiency variance
- Highly motivated workers
- Insufficient training
- Incomplete supervision
- Workers dissatisfaction
- Bad working conditions
- Use of defective machinery and equipment etc.

ILLUSTRATION
From the following information of lucky Plc calculate.
Budgeted Actual
Product A Product B Product A Product B
Units 400 800 480 790
Sales price Shs.5 Shs.4 Shs.4.75 Shs.3.9
Cost Shs.4.5 Shs. 3 Shs.4.6 Shs.2.9

a) Sales price variance

b) Sales margin price variance
c) Sales volume variance
d) Total sales value variance

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 e) Total sales margin variance.

SOLUTION
a) Sales price variance = (Actual selling price per unit – standard selling price per unit) x
actual quantity sold.
Product A = sh. (4.74 – 5 ) x 480 units = sh. 120
Product B = sh. (3.9 – 4 ) x 790 units = sh. 79 (A)

b) Sales margin price variance = (actual contribution margin – standard contribution margin)
× actual sales volume.
Product A = sh. (0.25 – 0.25) × 480 units = sh. 120 (A)
Product B = sh. (0.90 – 1) × 790 units = sh. 79 (A)

Workings
W1 standard contribution margin
A = sh.(5 – 4.50) = sh. 0.50
B = sh. (4 – 3) = sh.1

W2 Actual contribution margin

A = sh. (4.75 – 4.5 ) = sh. 0.25
B = sh. (3.9 – 3) = sh. 0.90

c) Sales margin volume variance = (Actual quantity – Budgeted quantity ) x standard margin
Product A = (480 – 400) units × sh. 0.50 = sh. 40(F)
Product B = (790 – 800) units ×sh.1 = sh. 10(A)

d) Total sales value variance = Actual sales – budgeted sales

Product A = sh. 2,280 –shs. 2,000 = sh. 280 (F)
Product B = sh. 3,081 –shs. 3,200 = sh. 119(A)

e) Total sales margin variance = actual margin – budgeted margin

Product A = (480 units ×sh. 0.25) – (400 units × sh. 0.50) = sh. 80 (A)
Product B = (790 units × sh. 0.9) – (800 units × sh. 1) = sh. 89(A)

PRACTICE EXERCISES (Solutions on page 259)

QUESTION 1
A company has budgeted to produce 2,750 articles in 22,000 hours, with fixed overheads of Sh
88,000 and variable overheads of Sh 55,000. The company’s production during the period of the
budget was 2,700 articles in 21,500 working hours with fixed overheads costing Sh 90,000 and
variable overheads Sh 58,000.

Required:
Calculate the following variances:
a) Overhead variance.
b) Fixed production overhead variance.

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 c) Variable production overhead variance.
d) Fixed production overhead expenditure variance.
e) Fixed production overhead volume variance.
f) Fixed cost productivity variance.
g) Capacity variance.

QUESTION 2
Tonga Ltd manufactures a single product whose cost structure is given below:
Sh Sh
Direct materials:
Material A (2 kg @ Sh 25 per kg) 50
Material B (3 litres @ Sh 75 per litre) 225 275

Direct labour (4 hours @ Sh 30 per hour) 120

Variable overheads 80
Fixed overheads 25
500

The variable and fixed overheads are absorbed on the basis of the direct labour hours.
During the year ended 31 October 2000, the company produced and sold 40,000 units and incurred
the following costs:

Sh. Sh.
Direct materials:
Material A (78,000 Kg) 205,000
Material B (121,000 Kg) 6,800,000 7,005,000
Direct labour (156,000 hours) 4,900,000
Variable overheads 3,000,000
Fixed overheads 900,000
Total cost 15,805,000

Required:
a) Material mix and yield variances.
b) Variable overhead expenditure and efficiency variances.
c) Standard cost card for 40,000 units.

QUESTION 3
Nyundo Ltd manufactures a product whose standard variable cost is given below:
Direct materials (2 kg @ Sh 3) 6
Direct labour (0.75 hours @ Sh 4) 3
Variable overheads 1

The company treats fixed costs as period costs and therefore they are not charged to products.

The following information relates to the month of March 2001.

226
 1/3/2001 31/3/2001
Sh. Sh.
Stocks (all at standard cost)
Raw materials 12,000 6,000
Finished goods 36,000 42,500

The following information is available for the month of March 2001:

Sh.
Sales @ Sh. 20 per unit 200,000
Material purchases @ Sh. 3.50 per kg 42,000
Direct labour cost (8000 hours) 30,000
Variable overheads 12,000
Material price variance (adverse) 21,000

The management is wondering whether they could have performed better.

Required:
Calculate the following variances in each case stating two possible causes:
a) Material usage variance
b) Labour rate variance.
c) Labour efficiency variance.
d) Variable overhead expenditure variance:
e) Variable overhead efficiency variance.
f) Briefly comment on two possible causes of each variance in (i) above

CHAPTER 10

227
 COST MANAGEMENT

THE VALUE CHAIN

To analyze the specific activities through which firms can create a competitive advantage, it is useful
to model the firm as a chain of value-creating activities. Michael Porter identified a set of interrelated
generic activities common to a wide range of firms. The resulting model is known as the value chain
and is depicted below:
Primary Value Chain Activities
Inbound Outbound Marketing
> Operations > > > Service
Logistics Logistics & Sales

The goal of these activities is to create value that exceeds the cost of providing the product or service,
thus generating a profit margin.
• Inbound logistics include the receiving, warehousing, and inventory control of input materials.
• Operations are the value-creating activities that transform the inputs into the final product.
• Outbound logistics are the activities required to get the finished product to the customer,
including warehousing, order fulfillment, etc.
• Marketing & Sales are those activities associated with getting buyers to purchase the product,
including channel selection, advertising, pricing, etc.
• Service activities are those that maintain and enhance the product's value including customer
support, repair services, etc.

Any or all of these primary activities may be vital in developing a competitive advantage. For
example, logistics activities are critical for a provider of distribution services, and service activities
may be the key focus for a firm offering on-site maintenance contracts for office equipment.
These five categories are generic and portrayed here in a general manner. Each generic activity
includes specific activities that vary by industry.

Support Activities
The primary value chain activities described above are facilitated by support activities. Porter
identified four generic categories of support activities, the details of which are industry-specific.
• Procurement - the function of purchasing the raw materials and other inputs used in the value-
creating activities.
• Technology Development - includes research and development, process automation, and other
technology development used to support the value-chain activities.
• Human Resource Management - the activities associated with recruiting, development, and
compensation of employees.
• Firm Infrastructure - includes activities such as finance, legal, quality management, etc.

Support activities often are viewed as "overhead", but some firms successfully have used them to
develop a competitive advantage, for example, to develop a cost advantage through innovative
management of information systems.

228
Value Chain Analysis
In order to better understand the activities leading to a competitive advantage, one can begin with the
generic value chain and then identify the relevant firm-specific activities. Process flows can be
mapped, and these flows used to isolate the individual value-creating activities.
Once the discrete activities are defined, linkages between activities should be identified. A linkage
exists if the performance or cost of one activity affects that of another. Competitive advantage may be
obtained by optimizing and coordinating linked activities.
The value chain also is useful in outsourcing decisions. Understanding the linkages between activities
can lead to more optimal make-or-buy decisions that can result in either a cost advantage or a
differentiation advantage.

The Value System

The firm's value chain links to the value chains of upstream suppliers and downstream buyers. The
result is a larger stream of activities known as the value system. The development of a competitive
advantage depends not only on the firm-specific value chain, but also on the value system of which
the firm is a part

Types of value chain

There are various types of value chain:
i) Simple value chain: The value chain describes the full range of activities which are required to
bring a product or service from conception, through the different phases of production (involving a
combination of physical transformation and the input of various producer services), delivery to final
consumers, and final disposal after use.
ii) Extended value chain: In the real world, of course, value chains are much more complex than this.
For one thing, there tend to be many more links in the chain. Take, for example, the case of the
furniture industry. This involves the provision of seed inputs, chemicals, equipment and water for the
forestry sector. Cut logs pass to the sawmill sector which gets its primary inputs from the machinery
sector. From there, sawn timber moves to the furniture manufacturers who, in turn, obtain inputs from
the machinery, adhesives and paint industries and also draw on design and branding skills from the
service sector. Depending on which market is served, the furniture then passes through various
intermediary stages until it reaches the final customer, who after use, consigns the furniture for
recycling.
iii) One or many value chains: In addition to the manifold links in a value chain, typically
intermediary producers in a particular value chain may feed into a number of different value chains. In
some cases, these alternative value chains may absorb only a small share of their output; in other
cases, there may be an equal spread of customers.
But the share of sales at a particular point in time may not capture the full story – the dynamics of a
particular market or technology may mean that a relatively small (or large) customer/supplier may
become a relatively large (small) customer/supplier in the future. Furthermore the share of sales may
obscure the crucial role that a particular supplier controlling a key core technology or input (which
may be a relatively small part of its output) has on the rest of the value chain.

iv) One or many labels: There is a considerable overlap between the concept of a value chain and
similar concepts used in other contexts. One important source of confusion –particularly in earlier

229
years before the value chain as outlined above became increasingly widespread in the research and
policy domain – was one of nomenclature and arose from the work of Michael Porter in the mid-
1980s. Porter distinguished two important elements of modern value chain analysis
• The various activities which were performed in particular links in the chain. Here he drew the
distinction between different stages of the process of supply (inbound logistics, operations,
outbound logistics, marketing and sales, and after sales service), the transformation of these inputs
into outputs (production, logistics, quality and continuous improvement processes), and the
support services the firm marshals to accomplish this task.
• He complements this discussion of intra-link functions with the concept of the multilinked value
chain itself, which he refers to as the value system. The value system basically extends his idea of
the value chain to inter-link linkages,

There are six main business functions of a value chain:

• Research and Development
• Design of Products, Services, or Processes
• Productions
• Marketing and Sales
• Distribution
• Customer Service
COST MANAGEMENT
IMPORTANCE OF VALUE CHAIN ANALYSIS
There are three main sets of reasons why value chain analysis is important in this era of rapid
globalization. They are:
• With the growing division of labour and the global dispersion of the production of components,
systemic competitiveness has become increasingly important
• Efficiency in production is only a necessary condition for successfully penetrating global markets.
Value chain analysis helps in understanding the advantages and disadvantages of firms and
countries specializing in production rather than services.
• Entry into global markets which allows for sustained income growth – that is, making the best of
globalization - requires an understanding of dynamic factors within the whole value chain; value
chain analysis helps to explain the distribution of benefits, particularly income, to those
participating in the global economy. This makes it easier to identify the policies which can be
implemented to enable individual producers and countries to increase their share of these gains.
This is an especially topical issue at the turn of the millennium and has captured the attention of a
wide variety of parties.

JUST IN TIME (JIT)

This concept advocates zero inventory and stockless production through just-in-time purchasing and
just-in-time production. Organizations create a closer relationship with the suppliers and arrange for
more frequent deliveries of small quantities. The objective of just-in-time purchasing is to purchase
goods so that delivery is made immediately before their use.
JIT is considered economical since it eliminates the cost of carrying inventory and reduces the
inefficiencies that the inventories create. JIT purchasing increases the number of orders as the
enterprises order more frequently and in smaller quantities. Holding cost is reduced by a significant

230
proportion as it only arises due to waste and inefficiency created by inventory. It calls for 100 per cent
quality. Some of the major features of JIT include:
a) Frequent and reliable deliveries to avoid inventory buildup. Penalties are imposed on those who
do not meet the deadline.
b) Strategic location of firms. This may be closeness to suppliers and/or customers.
c) Improved communication between companies and suppliers through the use of computerized
purchasing systems that allows for online ordering.
d) Single sourcing and building long-term relations with a few trusted suppliers.
e) Increased supplier involvement in the design aspects of a product to ensure that they meet the
company’s quality requirements.
f) Maintenance of strict quality control by all parties. Suppliers guarantee the quality of stock items.

Objectives of JIT /Advantage

The benefits include lower inventory level, emphasis on strict quality control by all parties, faster
market response, smaller manufacturing facilities and lower set up costs.
1. Set up times is significantly reduced in the factory. Cutting down the set up time to be more
productive will allow the company to improve their bottom line to look more efficient and focus time
spent on other areas that may need improvement. This allows the reduction or elimination of the
inventory held to cover the “changeover” time.
2. The flows of goods from warehouse to shelves are improved. Having employees focused on
specific areas of the system will allow them to process goods faster instead of having them vulnerable
to fatigue from doing too many jobs at once and simplifies the tasks at hand. Small or individual piece
lot sizes reduce lot delay inventories which simplifies inventory flow and its management.
3. Employees who possess multiple skills are utilized more efficiently. Having employees trained
to work on different parts of the inventory cycle system will allow companies to use workers in
situations where they are needed when there is a shortage of workers and a high demand for a
particular product.
4. Better consistency of scheduling and consistency of employee work hours. If there is no
demand for a product at the time, workers don’t have to be working. This can save the company
money by not having to pay workers for a job not completed or could have them focus on other jobs
around the warehouse that would not necessarily be done on a normal day.
5. Increased emphasis on supplier relationships. No company wants a break in their inventory
system that would create a shortage of supplies while not having inventory sit on shelves. Having a
trusting supplier relationship means that you can rely on goods being there when you need them in
order to satisfy the company and keep the company name in good standing with the public.
6. Supplies continue around the clock keeping workers productive and businesses focused on
turnover. Having management focused on meeting deadlines will make employees work hard to meet
the company goals to see benefits in terms of job satisfaction, promotion or even higher pay.

Disadvantages of JIT
1) High ordering cost due to high orders
2) There are chances of stock outs in case of failure on the side as the supplier

USE OF COMPUTERS IN COSTING

231
A computer is a set of electronic device that can systematically and sequentially follow a set of
instructions called a program to perform high-speed arithmetic and logical operations on data.
Because of the rapid changes in finances and its related fields, accurate record keeping is critical.
Computerizing a business’ tasks of accounting procedures, increases efficiency. With a computer and
its appropriate software, one can request and receive an in house balance sheet, an income statement,
cash flow and statements of affairs and other accounting reports within a short time: hence an increase
in productivity.

Let’s take time to briefly see the role computers are playing in the field of accounting, changing some
of the things that were manually done and facilitating accounting data processing.

General Ledger
Electronic General Ledgers are labor saving device for the preparation of financial statements and for
establishing multiple income and cost entries. It takes charge of secondary postings.

Inventory Control
Electronic Inventory Control module has multiple functions, which includes tracking inventory for
both costing and tax purposes, aid managers in controlling purchasing (and the overall level of
expenditure) and minimizing the investment in inventory (and subsequent loss of cash flow). It is
integrated with the general ledger so it can automatically set aside the correct amount for processing
further.

Many shops now use stock control systems. The term "stock control system" can be used to include
various aspects of controlling the amount of stock on the shelves and in the stockroom and how
reordering happens.
Typical features include:

• Ensuring that products are on the shelf in shops in just the right quantity.
• Recognizing when a customer has bought a product.
• Automatically signaling when more products need to be put on the shelf from the stockroom.
• Automatically reordering stock at the appropriate time from the main warehouse.
• Automatically producing management information reports that could be used both by local
managers and at Head office.

These might detail what has sold, how quickly and at what price, for example. Reports could be used
to predict when to stock up on extra products, for example, at Christmas or to make decisions about
special offers, discontinuing products and so on. Sending reordering information not only to the
warehouse but also directly to the factory producing the products to enable them to optimize
production.

Computer Aided Manufacturing (CAM)

Today, increasing competition level in the markets require using CA systems that enable firms to
manufacture quality products for customer demands in a short time. Using CAM systems in
manufacturing processes has brought about important changes in firms’ performance measurement
systems.

232
Spreadsheets
Electronic Spreadsheets allow you to do anything that you would normally do with a calculator,
pencil and columnar scratch pad. A typical integrated double entry accounting spreadsheet system
will contain some of the following components: general ledger, inventory levels, order entry, payroll,
time, and billing etc...

Job Order Costing System

A job order costing system is utilized by businesses that manufacture products for specific orders. It is
employed in circumstances where a business wants to know the expenses associated with
manufacturing different jobs, products, or services for a given period. By using this system to
determine the costs of expenses, the expenses are tracked to the activity (job) and then the expenses of
performing the activity are split-up by the unit numbers of the activity to succeed in determining the
cost per-unit average of the product. The costs of producing each job in a job order costing system
must be captured and tracked in order to determine the accurate cost of producing the specific
product. Some costs for a business that would be associated with this may include materials, labor,
and overhead related to producing a product. However, materials labor and overhead will differ from
specific product and specific customer order to the next. Personalized production that is specific to a
customer want or job order need which may involve greater encouragement from our resources than
that of the common productivity movement within the business would be an example of a particular
customer or job order.

INVENTORY MANAGEMENT
Inventory management software is a computer-based system for tracking inventory levels, orders,
sales and deliveries. It can also be used in the manufacturing industry to create a work order, bill of
materials and other production-related documents. Companies use inventory management software to
avoid product overstock and outages. It is a tool for organizing inventory data that before was
generally stored in hard-copy form or in spreadsheets. It is often associated with and is similar to
distribution software.

The Uses of Computers in Inventory Control

Computerization has revolutionized inventory management, as technologies ranging from automatic
scanners to radio frequency identification chips now allow businesses to track their inventory from the
moment a company buys it wholesale to the moment the products leave the building in the hands of a
customer.

Receipt of Goods
A retail store or a central warehouse uses bar code or radio-frequency identification scanning at the
point of receipt of goods. Scanning individual items or shipment pallets allows a company to itemize
all shipments from the supplier, which can be compared against the purchase order for errors or losses
in transit. When your business ships these goods out of the warehouse to their point of sale, a second
scan can automatically tally the remaining stock in the warehouse, and send messages to the
purchasing managers indicating that it is time to reorder.

Retail Turnover

233
Many businesses use similar scanning techniques at the point of checkout. As of 2010, bar code
scanners are more popular than RFID for this purpose. Both will automatically enter the correct price
at the register and prevent data entry errors. They also can create a perfect real-time record of how
much stock remains on the shelves, how much is available in on-site storage, and whether a new
shipment is necessary from the warehouse. Combine this information with warehousing data, and
your business can create additional alerts to key management when a bottleneck occurs. For example,
if a dozen retail stores anticipate needing restocking, but the warehouse does not have sufficient goods
on hand, your business can place a rush order to fill the need.

Stock Management and Cost Reduction

The process of moving goods through a company pipeline is always economically inefficient. The
purchase of the goods represents an investment of company capital, which your business cannot
recoup until you sell your inventory. Warehousing of goods before sale introduces the possibility of
inventory shrinkage in value from theft, damage, deterioration or changes in customer taste. Moving
goods from warehouses to the point of sale involves shipping costs, especially if the shipment is
incorrect, or if the internal shipping process is inefficient. Computerization provides a real-time
picture of this entire work flow process, and allows managers to reduce purchasing costs through
minimizing inventory, increase the efficiency of internal shipping systems, and reduce the possibility
of theft or damage by being able to track each item down to the individual staffer who takes
responsibility for it.

Cost centre analysis

Conducting cost and revenue analyses involves using a spreadsheet-based software tool to help
develop a baseline of programmatic and financial data for your facility. The tool’s completed
spreadsheets provide a picture of current situation and help identify needed changes to increase a
program’s cost efficiency and revenue generation. The tool is also useful for exploring the possible
impact of making changes, such as:
• Changing standard practices;
• Adding new services or facilities;
• Using some services or facilities to subsidize others.

BUDGETING AND DECISION MAKING

DECISION SUPPORT SYSTEMS (DSS)
DSS are alternatively termed end-user computing systems. Their objective is to support managers in
their work, especially decision making.
DSS tend to be used in planning, modeling, analyzing alternatives and decision making. They
generally operate through terminals operated by the user who interacts with the computer system.
Using a variety of tools and procedures the "manager (i.e. the user) can develop his own systems to
help perform his functions more effectively. It is this active involvement and the focus on decision
making which distinguishes a DSS from a data processing system. The emphasis is on support for
decision making not on automated decision making which is a feature of transaction processing.

234
DSS are especially useful for semi-structured problems where problem sol ' is improved by interaction
between the manager and the computer system Tkgemphasis is on small, simple models which can
easily be understood and used h the manager rather than complex integrated systems which need
informal specialists to operate them.

The main characteristics of DSS are:

a) The computer provides support but does not replace the manager's judgment nor does it provide
predetermined solutions.
b) DSS are best suited to semi-structured problems where parts of the analysis can be computerized
but the decision maker's judgement and insight is needed to control the process.
c) Where effective problem solving is enhanced by interaction between the computer and the
manager.

CHAPTER 11
OVERVIEW OF PERFORMANCE MEASUREMENT
INTRODUCTION
Performance measurement is generally defined as regular measurement of outcomes and results,
which generates reliable data on the effectiveness and efficiency of programs.

235
A quantifiable indicator used to assess how well an organization or business is achieving its desired
objectives. Many business managers routinely review various performance measure types to assess
such things as results, production, demand and operating efficiency in order to get a more objective
sense of how their business is operating and whether improvement is required.

All organizations have financial performance measures as part of their performance management.

Proponents of financial performance measures argue that they are necessary because of the primary
objectives of companies.

Maximizing shareholder wealth

• The primary objective of a profit seeking organization is to maximize shareholder wealth.
• This is based on the argument that shareholders are the legal owners of a company and so their
interests should be prioritized.
• Shareholders are generally concerned with the following:
− Current earnings
− Future earnings
− Dividend policy
− Relative risk of their investment.

All of these are driven by financial performance.

Survival and growth

The objective of wealth maximization is usually expanded into three sub-objectives:
• to make a profit
• To continue in existence (survival) - survival is the ultimate measure of success of a business.
Without survival then obviously there will be no fulfillment of other objectives. In order to
survive in the long-term a business must be financially successful
• To maintain growth and development - growth is generally seen as a sign of success, provided it
results in improvements in financial performance.

Growth can be identified in a number of ways both financial and non-financial.

Financial:
• profitability
• revenue
• return on investment (ROI)
• Cash flow.

Non-financial:
• market share
• number of employees
• Number of products.

The relationship between profits and shareholder value

236
Rather than focusing on achieving higher profit levels, companies are under increasing pressure to
look at the long-term value of the business. This is due to the following factors.
• research has suggested a poor correlation between shareholder return and profits
• investors are increasingly looking at long-term value
• Reported profits may not be comparable between companies.
While these issues have been known for some time, they have come into sharp focus due to the
performance of new technology/communications companies.

Shareholder return and profits

Total shareholder return (TSR) is the return shareholders receive both in dividends and capital growth.
Studies have found that there is little correlation between TSR and EPS growth, and virtually no
relationship at all with return on equity, yet many companies are still using profit as their only
measure of performance.
Even where companies state that their objective is to maximize shareholder value, often directors'
bonuses are still based on short-term profitability or EPS targets.

FINANCIAL PERFORMANCE MEASURES

These measures make use of financial statement figures to evaluate the performance of the
organization. Financial performance exists at different levels of the organization.

Traditionally, financial performance measures are split into the following categories:
• Profitability
• Liquidity / working capital
• Gearing
• Investor ratios

PROFITABILITY
Profitability is simply the capacity to make a profit, and a profit is what is left over from income
earned after you have deducted all costs and expenses related to earning the income. The formulas
discussed below can be used to judge a company's performance and to compare its performance
against other similarly-situated companies.

Return on capital employed (ROCE)

ROCE is a key measure of profitability. It shows the net profit that is generated from every sh.1 of
assets employed.
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
ROCE = ×100
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Advantages
− Easy to calculate
− Figures are readily available
− Measures how well a business is utilizing the funds invested in it.
− Often used by external analysts.
Disadvantages
− Research shows a poor correlation between ROCE and shareholder value.

237
− Can be distorted by accounting policies.
− ROCE can be improved by cutting back investment-this may not be in the company’s long-term
best interest.
An increase in ROCE could be achieved by:
• Increasing net profit, e.g. through an increase in sales price or through better control of costs.
• Reducing capital employed, e.g. through the repayment of long term debt.

Gross profit margin

This is the gross profit as a percentage of turnover.
𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
Gross profit margin = × 100
𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟

A high gross profit margin is desirable. It indicates that either sales price is high or that production
costs are being kept well under control.

Net profit margin

This is the net profit (turnover less all expenses) as a percentage of turnover.
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
Net profit margin = × 100
𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟

A high net profit margin is desirable. It indicates that either sales prices are high or that all costs are
being kept well under control.

Asset turnover
This is the turnover divided by the capital employed. The asset turnover shows the turnover that is
generated from each shilling of assets employed.
𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟
Asset turnover =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

A high asset turnover is desirable. An increase in the asset turnover could be achieved by:
• Increasing turnover, e.g. through the launch of new products or a successful advertising
campaign.
• Reducing capital employed, e.g. through the repayment of long term debt.
LIQUIDITY MEASURES
The main reason why companies fail is poor cash management rather than profitability so it is vital
that liquidity is managed.
A company can be profitable but at the same time encounter cash flow problems. Liquidity and
working capital ratios give some indication of the company's liquidity.

Current ratio
This is the current assets divided by the current liabilities.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
Current ratio =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The ratio measures the company's ability to meet its short term liabilities as they fall due.
A ratio in excess of 1 is desirable but the expected ratio varies between the type of industry.

238
A decrease in the ratio year on year or a figure that is below the industry average could indicate that
the company has liquidity problems. The company should take steps to improve liquidity, e.g. by
paying creditors as they fall due or by better management of receivables in order to reduce the level of
bad debts.

Quick ratio (acid test)

This is a similar to the current ratio but inventory is removed from the current assets due to its poor
liquidity in the short term.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Current ratio =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The comments are the same as for the current ratio.

Inventory holding period

Inventory
Inventory holding period = × 365
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

This indicates the average number of days that inventory items are held for.
An increase in the inventory holding period could indicate that the company is having problems
selling its products and could also indicate that there is an increased level of obsolete stock. The
company should take steps to increase stock turnover, e.g. by removing any slow moving or
unpopular items of stock and by getting rid of any obsolete stock.
A decrease in the inventory holding period could be desirable as the company's ability to turn over
inventory has improved and the company does not have excess cash tied up in inventory. However,
any reductions should be reviewed further as the company may be struggling to manage its liquidity
and may not have the cash available to hold the optimum level of inventory.
Receivables (debtor) collection period

Receivables
Receivables collection period = × 365
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

This is the average period it takes for a company's credit customers / debtors / receivables to pay what
they owe.
An increase in the receivables collection period could indicate that the company is struggling to
manage its debts. Possible steps to reduce the ratio include:
• Credit checks on customers to ensure that they will pay on time
• Improved credit control, e.g. invoicing on time, chasing up bad debts.
A decrease in the receivables collection period may indicate that the company's has improved its
management of receivables. However, a receivables collection period well below the industry average
may make the company uncompetitive and profitability could be impacted as a result.

Payables (creditor) period

Payables
Payables period = × 365
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

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This is the average period it takes for a company to pay for its purchases.
An increase in the company's payables period could indicate that the company is struggling to pay its
debts as they fall due. However, it could simply indicate that the company is taking better advantage
of any credit period offered to them.
A decrease in the company's payables period could indicate that the company's ability to pay for its
purchases on time is improving. However, the company should not pay for its purchases too early
since supplier credit is a useful source of finance.

GEARING RATIOS
In addition to managing profitability and liquidity it is also important for a company to manage its
financial risk. The following ratios may be calculated:

Financial gearing
This is the long term debt as a percentage of equity.

𝐷𝑒𝑏𝑡
Gearing = × 100
𝐸𝑞𝑢𝑖𝑡𝑦

A high level of gearing indicates that the company relies heavily on debt to finance its long term
needs. This increases the level of risk for the business since interest and capital repayments must be
made on debt, where as there is no obligation to make payments to equity.
The ratio could be improved by reducing the level of long term debt and raising long term finance
using equity.

Interest cover
This is the operating profit (profit before finance charges and tax) divided by the finance cost.
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
Interest cover =
𝑓𝑖𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡
A decrease in the interest cover indicates that the company is facing an increased risk of not being
able to meet its finance payments as they fall due.
The ratio could be improved by taking steps to increase the operating profit, e.g. through better
management of costs, or by reducing finance costs through reducing the level of debt.

Other investor ratios

Investors will be interested in all of the above measures, along with the following:

Earnings per Share (EPS)

EPS is a measure of the profit attributable to each ordinary share.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

EPS =
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒

For EPS to be truly meaningful, it must be set in context.

• Is EPS growing or declining over time?
• Is there likely to be significant dilution of EPS?

240
 • Is it calculated consistently?

Advantages
− Easily understood by share holders
− Calculation is precisely defined in the accounting standards (IAS 33) avoiding ambiguity.
− Figures are readily available
− Often used as a performance measure between companies, sectors, periods with the same
organization.

Disadvantages
− Research shows a poor correlation between EPS growth and shareholder value.
− Accounting treatment may cause ratios to be distorted.

Dividend cover
This is the net profit divided by the dividend.
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
Dividend cover =
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

A decrease in the dividend cover indicates that the company is facing an increased risk of not being
able to make its dividend payments to shareholders

Dividend yield
• Dividend yield = (Dividend per share/Current share price) × 100%
This is one way of measuring the return to shareholders but ignores any capital growth / loss.

Earnings yield
• Earnings yield = (EPS/Share price) × 100%
This is another one way of measuring the return to shareholders but, as with dividend yield,
ignores any capital growth / loss.

NON-FINANCIAL MEASURES OF PERFORMANCE

Non-financial performance measures are measures of performance based on non-financial information
which may originate in the operating department and may be used to monitor and control the activities
within the accounting department. Examples of non-financial performance measures are:-

Area assessed Performance measures

1. Service quality - Number of complains.
- Customer waiting times.
- Timely delivery of products.
- Proportion of repeat bookings.

2 Production of performance - Set up times.

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 - Output per employee.
- Mature yield percentage.
- Number of defective items.
3 Marketing effectiveness - Trends in market share.
- Growth in sales volume.
- Customers visits per sales volume.
- Growth in number of customers.
- Customers survey response.
4 Human resource - Staff turnover.
- Number of complains reviewed from the
employer.
- Days lost through absenteeism.
- Days lost through accidents or sickness.
- Training and development of employees.
5 Research and development - Frequency of new products.
- Success history of previous products.
- Trends in innovations on existing product.
- Quantity of product.

BALANCED SCORECARD
A balance Scorecard is an integrated set of performance measures derived from the company’s
strategies that gives the top management a fast but comprehensive view of the organizational unit.
(i.e. a division or a strategic business unit (S.B.U)

The balanced scorecard philosophy assumes that an organizations vision and strategy is best achieved
when the organization is viewed from the following four perspectives.
1) Customer perspectives (How customers do see us?)
This gives rise to targets that matter to customer’s perspectives.
2) Internal business process (What must we excel in?)
This aims to improve internal processes and decision making quality control.
3) Learning and growth perspective (Can we continue to improve and create value?
This considers an organization’s capacity to maintain its competitive position through
acquisition of new skills.
4) Financial perspective (How do we look to shareholders?)
This covers traditional measures such as profitability, R. O. I etc.

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 Financial

To succeed financially, how should

we appear to shareholders.

Internal business
process
Customer
Vision and
To achieve our vision strategy
To satisfy our
how should we appear to
shareholders & customers,
our customers?
what business process
Learning & growth
must we excel at?

To achieve our vision, how will

we sustain our ability to change
& improve?

By implementing the balanced scorecard, the major objectives for each of the four perspectives should
be articulated.
These objectives should be translated into specific performance measures and targets for
achievements.
This method integrates traditional financial measures with operations, customer and staff issues vital
in long run competitiveness.

ILLUSTRATION
ABC Ltd has in the past produced just one fairly successful product. Recently, however, a new
version of this product has been launched .Development work continues to add a related product to
the product list. Given below are some details of the activities during the months of November 2009

Units produced Existing product - 25,000units

New product - 5,000units
Cost of units produced Existing product = Sh. 375,000
New product = Sh. 70,000
Sales revenue Existing product - Sh. 550,000
New product = Sh. 125,000

Hours worked Existing product = 5,000 hrs

New product = 1,250 hrs
Development cost Sh. 47,000

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Required:-
Suggest and calculate performance indicators that could be calculated for each of the four
perspectives on the balanced scored card.
1)Customer perspective
125,000
Percentage of sales by new products = ×100 = 18.5%
550,000+125,000

2) Internal business perspective

i) Productivity:
25,000 𝑢𝑛𝑖𝑡𝑠
Existing product = = 5hours per unit
500ℎ𝑟𝑠

5,000 𝑚𝑖𝑛𝑠
New product = = 4hours per unit
1250ℎ𝑟𝑠

ii) Unit cost:

375,000
Existing product = � �= sh. 15 per unit
25,000

3) Financial perspectives
550,000−375,000
Gross profit; Existing product = ×100 =32%
550,000

125,000−70,000
New product = ×100= 44%
125,000

4)Learning curve and growth perspective

47,000
Development costs as a percentage of sales = × 100 = 7%
675,000

Balanced Scorecard as a Strategic Management System

1) Clarifying and translating vision and strategy into specific strategic objectives and identifying
the critical drives of the strategic objectives.

2) Communicating & linking strategic objectives &measures.

Once employees understand the high level objectives and measures, they should establish local
objectives that support the business unit’s global strategy.
3) Plan, set targets & align strategic initiatives. Such targets should be over a 3 – 5 year period
broken down on a yearly basis so that progression targets can be set for assessing the progress
being made towards achieving the long term targets.
4) Enhancing strategic feedback and learning so that managers can monitor and adjust the
implementation of their strategy and if necessary make fundamental changes to the strategy
itself.

Benefits of Balanced Scorecard

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1) It brings together in a single report four different perspectives on a company’s performance that
relate to many of the dispersed elements of the company’s competitive agenda such as becoming
customer oriented, shortening response time, improving quality, emphasizing team work,
reducing new product launch times and managing for the long term.
2) It provides a comprehensive framework for translating a company’s strategic goals into a coherent
set of performance measures by developing the major goals for the four perspectives and
translating these goals into specific performance measures.
3) It helps managers to consider all the important operational measures together i.e. to enables
mangers see whether improvements in one area may have been at the expense of another.
4) It improves communication within the organization and promotes the active formulation and
implementation of organizational strategy by making it highly visible through the linkage
performance measures to business unit strategy.

Limitations of Balanced Scorecard

1) The assumption of the course and effect is too ambitious and lack a theoretical underpinning r
empirical support.
The empirical studies undertaken have failed to provide evidence on the underlying linkages
between non-financial data and future financial performance.
2) There is an omission of important perspective most notable being the environmental impact on
society perspective and an employee perspective. There is nothing to prevent companies adding
additional perspectives to meet their own requirements but they must avoid the temptation of
creating too many perspectives and performance measures as a major benefit of performance
measure is the consciousness and clarity of presentation.

SOLUTIONS TO PRACTICE EXERCISES

COST ESTIMATION
QUESTION 1
i) Use the high-low method to estimate the overhead cost function
Highest cost (OHs) - 15,280 level of activity 1690
Lowest cost (OHs) - 9150 level of activity 834

Range = 15,280 – 9,150 = 6130 = 7.16

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 1690 – 834 856

Y = a + bx whereb = 7.16
Y = 15,280
Therefore 15,280 = a + 7.16 x 1690
a = 15,280 – (7.16 x 1690)
a = 3180
Therefore y = 3,180,000 + 7160x

ii) Use the regression method – determine the overhead cost function
y = a + bx where a = 3,709,000
b = 6487
Therefore y = 3,709,000 + 6487x

iii) Equivalent units of production

Looking at the output side using FIFO method

Completion % Conversion
Opening stock (WIP) 1,000,000 70 700,000
Completely processed during production 500,000 100 500,000
Closing stock (WIP) 1,200,000 1,199,695
Equivalent units with respect to conversion costs 2,399,695

iv) Estimate on cost for the month of November

Y = 3,709,000 +06487x where x = 1125

Therefore y = 3,709,000 + 6487 x 1125

= 11,006,875

QUESTION 2
(a) Advantages of high-low method
 Method is easy to use
 Not many data are needed
 Visually it gives the general direction of the trend
Disadvantages
 Choice of the high and low points is subjective
 Method does not use all available data
 Cannot be used for more than one independent variable
 Not possible to defend the results statistically
 If the two points are outliers, the predictive equation will be wrong.
 Method may not be reliable

(b) (i) High-low method

Machine hours Fuel oil expense
Sh. ‘000’ Sh. ‘000’

246
 High-point (June 2004) 48 680
Low-point (January, 2004) 26 500
Difference 22 180

Variable cost per machine hour = 180,000

22,000

= Sh.8.182 per hour

Substituting for January 2004

Variable costs (26 × 8.182) = 212,730
Fixed cost (difference) 287,270
500,000

Interpretation:
Within the relevant range, Sh.282,270 will be incurred irrespective of the machine hour usage
of the unit i.e. 282,270 is fixed.

The total fuel consumption will thereafter vary at the rate of Sh.8.182 for each machine hour
usage.

(ii) Fuel expense in November, 2004

= 287,264 + 8.182 x 41,000
= Sh.622,726

(iii) Limitations of high-low method

 Relies only on two data points – highest and lowest which may be outside and
therefore not representative of the entire data set.
 The method does not use robust statistical techniques, to measure the predictive
quality of the resultant function.

COST ACCUMULATION
QUESTION 1
(a) Computation of Overhead Absorption Rates per Machine Hour

Overhead Absorption A B C D Total

basis Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’
Indirect wages No. of indirect 3,478 4,870 2,261 1,391 12,000
workers
Holiday pay & No. of workers 3,210 4,080 1,800 1,200 10,200
National (Total)

247
 Insurance
Supervision Actual 5,170 4,720 3,630 3,160 16,680
Machine Machine 4,200 2,800 5,600 1,400 14,000
maintenance maintenance
(wages) hours
Supplies Actual 1,200 800 200 400 2,600
Power Machine power 2,200 1,080 320 600 4,200
Tooling costs Actual 5,400 4,100 2,600 1,200 13,300
Insurance – Cost of 960 720 300 540 2,520
Machinery machines
Insurance – Floor space 600 480 320 200 1,600
buildings
Depreciation Cost of 4,000 3,000 1,250 2,250 10,500
machines
Rent & rates Floor space 4,650 3,720 2,480 1,550 12,400
Total 34,978 30,370 20,761 13,891 100,000

Therefore No. of machine hours: 30 60 25 10

Absorption rate per machine hour 1,165.93 506.17 830.44 1,389.1

(b) PRODUCT XY 123

(i) Absorption rate No. of Hours Overhead

Absorbed
Sh.’000’
A 1,165.93 8 9,327.44
B 506.17 3 1,518.51
C 830.44 1 830.44
D 1,389.10 4 5,556.40
17,232.79

(ii) Overhead:

= 70% of direct wages

= 70% x 22,000,000 = 15,400,000

QUESTION 2
(a) Calculation of fixed overhead absorption rates

248
 Quarter 2 Quarter 3 Quarter 4
Sh. Sh. Sh.
Budgeted FOH 10,400,000 19,170,00 17,360,000
Budgeted Production (units) 8,000 14,200 12,400
FOH absorption rate (per unit) 1,300 1,350 1,400
FOH absorbed (actual units x rate) 10,920,000 18,360,000 12,880,000
Less actual FOH 11,200,000 18,320,000 16,740,000
280,000 40,000 3,860,000
Under absorbed Over absorbed Under absorbed
Effects on Profit & Loss A/c Deduction Add back Deduct
Profit & Loss In Profit & Loss In Profit & Loss

(b) Units in Closing Stock

Quarter 2 Quarter 3 Quarter 4
Sh. Sh. Sh.
Units 2,600 2,400 2,600
Opening stock 8,400 13,600 9,200
Add: Production 11,000 15,000 11,800
Less: Sales 9,600 12,400 10,200
Closing stock 1,400 2,600 1,600

Whether marginal costing or absorption costing produces a higher profit in a given period depends
entirely on the amount of fixed overheads in opening and closing stocks. Fixed overhead content of
stocks.
Quarter 2 Quarter 3 Quarter 4
Sh. Sh. Sh.
F.O content of closing stock 1,820,000 3,510,000 2,240,000
(1,400 x 1,300) (2,600 x 1,350) (1,600 x 1,400)
Less F.O Content of opening
Stock (given) 3,315,000 1,820,000 3,510,000
Difference (1,495,000) 1,690,000 (1,270,000)

Note that opening stock in quarter 3 is the closing stock in quarter 2 and opening stock in quarter 4 is
closing stock in quarter 3.

Absorption costing profit is therefore higher than margin profit in quarter 3 but lower in quarter 2 and
4.

(c) Absorption costing is a product convention with many arbitrary assumptions and subjective
assessments e.g. analysis apportionment and absorption of overheads, treatment of under/over
absorption, the way cost centres are determined, the treatment of service cost centres

In consequence, information based on absorption costing principles is not suitable for use in
decision making.

QUESTION 3
Ardhi Company

249
 i) Basic guaranteed hourly rates used to calculate earnings
Mambo Saidi Mbogo
Actual hours worked 38 36 40
Basic hourly rate of pay 30 20 25
Earnings (Basic x actual hours worked) 1140 720 1000

ii) Piecework rates used to calculate earnings for employees

Mambo Saidi Mbogo
Number of minutes worked 2280 2160 2400
Rate per minute 0.5 0.5 0.5
Earnings (rate x number of minutes) 1140 1080 1200

iii) Premium bonus, given that an employee earns the premium bonus at a rate of 2/3 of the time
saved.
Mambo Saidi Mbogo
Hours allowed 38 23.4 12.5
Hours taken 38 36 40
Hours saved - - -
Bonus hours (2/3 x hours saved) - - -
Bonus wage (bonus hours x hourly rate)

QUESTION 4
(a) Overhead allocation (Direct method)

Production departments Support departments

Grinding Assembly Maintenance Power

Shs. Shs. Shs. Shs.
Direct costs 1,000,000 500,000 1,000,000 2,000,000
Maintenance 500,000 500,000 (1,000,000) -
Power 1,600,000 400,000 - (2,000,000)
3,100,000 1,400,000 - -

3,100,000
(b) Overhead Allocation Rate = = Shs. 310/machine hour i.e. Maintenance
10,000
Department.
Job K cost statement
Shs.
Prime cost 670
Overhead (3 x 310) 930
Total unit cost 1,600
∴ Bid price Shs. 1,600 x 1.2 = Shs. 1,920

(c) Overhead allocation (sequential method)

Production Support departments

250
 departments
Grinding Assembly Maintenance Power
Shs. Shs. Shs. Shs.
Direct costs 1,000,000 500,000 1,000,000 2,000,000
Power department 1,280,000 320,000 400,000 (2,000,000)
Maintenance department 700,000 700,000 (1,400,000) -
2,980,000 1,520,000 - -

2,980,000
(d) Maintenance department Overhead Allocation Rate = = Shs. 298 per machine
10,000
hour.
Job K cost statement
Shs.
Prime cost 670
Overhead (3 x 298) 894
1,564

∴ Bid price Shs. 1,564 x 1.2 = Shs. 1,876.80

(e) Problems exist in setting overhead cost standards in three important areas, namely; setting
cost standards, selecting a standard overhead rate and determining the standard volume for
fixed overhead cost recovery.
The setting of cost standards implies that resources have been acquired at the best price and
that they have been used in the most efficient manner. Since overheads costs are not directly
related to products, the problem is selecting a measurement of activity that can be used as a
surrogate for the output expressed as product volume.
The selection of a standard overhead rate depends on which measurement of activity should
be used. Also, fixed overhead costs, unlike variable overhead costs, do not vary with output.

(f) Cost allocation is the allotment of whole items of cost. Cost apportionment is the sharing of a
common cost amongst cost centres.

Workings

MMC Ltd.

(a) Power cost allocated according to maintenance hours

6,400 + 1,600 = 8,000

6,400
x2,000,000 = 1,600,000
8,000

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 1,600
x2,000,000 = 400,000
8,000

(b) Maintenance cost

Maintenance cost allocated according to employees
30 + 30 = 60

30
x1,000,000 = 500,000
60

30
x1,000,000 = 500,000
60

(c) Power
Apportioned according to machine hours

2,000 + 6,400 + 1,600 = 10,000

2,000
x2,000,000 = 400,000 ⇒ Maintenance
10,000

6,400
x2,000,000 = 1,280,000 ⇒ Grinding
10,000

1,600
x2,000,000 = 320,000 ⇒ Assembly
10,000

Maintenance – Allocated according to number of employees

30
Grinding x1,400,000 = 700,000
60

30
Assembly x1,400,000 = 700,000
60

COST BOOK KEEPING

QUESTION 1
Workings:
Cost Financial Difference
Sh. Sh. Sh.
Opening stock of raw materials 160,000 150,000 10,000
Opening stock of work in progress 121,000 125,000 4,000
Opening stock of finished goods 258,000 240,000 18,000

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Closing stock of raw materials 196,000 200,000 4,000
Closing stock of work in progress 125,000 130,000 5,000
Closing stock of finished goods 260,000 255,000 5,000
Factory overheads 262,500 300,000 37,500
Discount received - 45,000 45,000
Income from investment - 1,094,000 1,094,000
Depreciation 242,000 280,000 38,000
Interest on loan (expenses) - 36,000 36,000
Debenture interest - 25,000 25,000
Administration expense 632,000 600,000 32,000
Interest on capital (not) 140,000 - 140,000
Notional rent 420,000 - 420,000

Profit reconciliation statement for the year ended 31 March 2004

Shs. Shs.
Net profits as per financial account 2,418,000
Add: Depreciation in financial accounts 280,000
Interest on loan 36,000
Debenture interest 25,000
Overstatement in opening stock of work in progress 4,000
Understatement in closing stock of finished goods 5,000
Overstatement in factory overheads 37,500 387,500
2,805,500
Less: Over absorbed administration expense 32,000
Selling and distribution overhead applied 25,000
Depreciation in cost accounts 242,000
Discount received 45,000
Income from investment 1,094,000
Understatement in opening stock of raw materials 10,000
Understatement in opening stock of finished goods 18,000
Overstatement in closing stock of raw materials 4,000
Overstatement in closing stock of work in progress 5,000 1,475,000
4,280,500

Note: Notional charges in cost accounts should be ignored.

ALTERNATIVE
RECONCILIATION STATEMENT
Shs. Shs.
Profit as per cost accounts 2,328,400

Add: Over absorbed Adm. 32,000

Over absorbed S/D 25,000
Discount received 45,000

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 Income Invest 1,094,000
Opening stock Raw Materials 10,000
Opening stock Finished goods 18,000
Closing stock Raw Materials 4,000
Closing stock Work in progress 5,000 1,233,000

Less: Depreciation 38,000

Loan interest 36,000
Debenture interest 25,000
Opening stock work in progress 4,000
Closing stock finished goods 5,000
Overheads 37,500 (145,500)
Profit as per final accounts 3,415,900

COSTING METHODS
QUESTION 1
Timau Ltd
Production Statement: June 2000
Inputs Total output Material Labour Overhead
Units Units Units Units
Baa b/f 5,000 21,000 21,000 21,000 21,000
Mixing Process 20,000 4,000 4,000 1,600 2,400
25,000 25,000 25,000 22,600 23,400

Total Cost Equivalent Units of Production

(Shs) (Shs) (Shs) (Shs)
Balance b/f (W.I.P) 185,000 100,000 25,000 60,000
Costs Added 278,400 45,300 125,000 108,100
Total Costs to account for: 463,400 145,300 150,000 168,100
Cost per Equivalent Unit: 19.633 5.812 6.637 7.184

Costs Accounted for as

follows:
Transfer to finished goods: 412,291 122,050 139,380 150,859
21,000 x 19.633
Closing work in Process: 51,109 23,248 10,619 17,242
Total Costs Accounted for: 463,400 145,300 149,999 168,101
Refining Process A/C
Units Unit Value Units Unit Value
Cost cost
Balb/f (W.I.P) 5,000 185,000 Finished goods 21,000 19.633 412,291
Units added 20,000 Closing W.I.P
Costs added Bal c/f 4,000 12.777 51,109
Raw material - 45,300
Labour 125,000

254
overheads 108,100
25,000 463,400 25,000 463,400

QUESTION 2
Refining Process Account

Process Inputs: Units Cost Transferred to: Units Cost (Shs)

Opening W.I.P 5,000 185,000 Finished Products 21,000 403,074
Input: 20,000 - Closing W.I.P 4,000 60,326.20
Conversion Costs - 125,000
Labour -
Overheads - 108,100
Other Materials - 45,300
25,000 463,400 25,000 463,400

Valuation of Finished Units:

Equivalent Units of:

Materials: Finished Goods + W.I.P= 25,000 UNITS

21,000 + (4,000 × 100%)

Cost per Unit of Raw Material = 100,000 + 45,300 = Sh.5.812

25,000.

Labour: 21,000 + (4,000 x 80%) = 24,200

Cost per unit of labour = 25,000 + 125,000 = Sh. 6.1983

24,200

Overheads: 21,000 + (4,000 x 60%) = 23,400 units

Cost per unit of Overhead = 60,000 + 108,100= Sh. 7.184

23,000

Cost per finished Unit = 5.812 + 6.1983 + 7.184 = Sh. 19.194

Tinn ltd
Production statement

Physical Units:

Inputs: Units Unit Cost

Opening Stock 5,000 -
Units Introduced 20,000 -

255
 25,000
Units Accounted for as:
To finished goods 21,000 -
To work in process 4,000 -
25,000

Cost Statement

Shs.
Opening Stock 185,100
Costs Added
Labour 125,000
Overheads 108,000
Materials 45,300
Costs to Account for 463,400
Accounted for as follows:
To finished goods:
21,000 x 19.194 403,074
To work in process:
Material: 4000 x 5.812 23,248
Labour: 3,200 x 6.1983 19,836.4
Overheads: 2,400 x 7.184 17,241.6
Valuation of work in process 60,326
Total Costs accounted for: 463,400

MARGINAL AND ABSORPTION COSTING

QUESTION 1
a)
Solacross Limited
Profit and Loss Statement for the year ended 31st March 2000:
Using Direct Costing Approach
Shs ‘000’ Shs ‘000’
Sales: (24,000 ×550) 13,200
Cost of Sales
Direct Material 7,200× 24,000 5,760
30,000
Direct labour 1,800× 24,000 1,440
30,000
Variable Overheads 1,500× 24,000 1,200 (8,400)
30,000
GROSS CONTRIBUTION 4,800
Less: Variable Sales Commission 300× 24,000 (240)
30,000
Net Contribution 4,560

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Expenses: Fixed costs of selling &
Administration
Fixed overheads (of production) 2,700
Sales salaries 450
Promotion and advertising 480
Other fixed costs 720 (4,350)
NET PROFIT 210

b)

Solacross Limited
Profit and Loss Statement for the year ended 31st March 2000
Using the Indirect Costing Method

Shs ‘000’ Shs ‘000’

Sales: 13,200
Less Cost of Sales:
Production costs: (7,200 + 1,800 + 1,500 + 720) 13,200
Less: Closing Stock: (13,200 x 6,000)
30,000 (2,640) 10,560
Gross profit 2,640
Expenses of Selling and Administration
Sales Salaries 450
Variable Selling Commission 300
Promotion and advertising 480
Other fixed costs 720 (1,950)
Net profit 690

Differences in the profit using the direct and indirect costing approaches arise due to the valuation of
stocks. In the direct method, cost of stocks is only variable costs while in the indirect method, the
costs of stocks is made up of both variable costs and the fixed production overheads.

In direct costing, fixed production overheads are fully written off or expensed on period costs. In
indirect approach, part of them are carried forward in closing stocks to be written off in the next
accounting period.

QUESTION 2
(b)Kenya Limited:
Shs. ‘000’
Sales 24,000
Less: variable costs @ 60% x 20 million: (12,000)
Contribution: 12,000
Less: fixed costs @ 40% x 20 million (8,000)

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NET PROFIT 4,000

(i) Margin of Safety = Current Sales – Break even Sales

But Break Even Sales = Fixed Costs = 8,000,000

Contribution margin ratio [12,000,000/24,000,000]

= Shs 16,000,000

Margin of Safety = 24,000,000 – 16,000,000 = Shs 8,000,000

(ii) Break Even point in Sales = Fixed Cost = 8,000,000____

Contribution Margin Ratio (120,000,000/24,000,000)

(iii) Sales required to earn a profit of Shs 6,000,000. = Shs 16,000,000

= Fixed Costs + Target Profits = (8,000,000 + 6,000,000) = Shs 28,000,000

Contribution sales ratio (12million/24 million

(iv) Option 1: Fixed costs will rise by Sh 2.5m.

2: Variable cost to sales ratio will be 50/95.

Profit Statements
Option 1 Option 2
Shs ‘000’ Shs ‘000’
Sales 30,000 27,600
Variable costs (50%) (15,000) (14,526)
Contribution 15,000 13,074
Fixed costs (10,500) (8,000)
NET PROFIT 4,500 5,074

NB: Initial profit was Shs 4,000,000.

Advise to Management: decrease sales price by 5% as this will result in the highest net profit.

QUESTION 3
Sh. Sh. Sh.
‘000’ ‘000’ ‘000’
Sales 30,000 × 0.97 29,100
Less Cost of Sales
Materials 6,500 × 1.02 6,630
Labour 5,400 ×0.96 5,184

258
Production overhead (7,000 × 1.03) 7,210 (19,024)
Cost of Sales 10,076
Less other variable costs (2,600 × 0.95) (2,470)
Contribution 7,606
Less Expense
Fixed 1,997
Administration 2,100 (4,097)
NET PROFIT 3,509

a) B.E.P (shs) = Fixed Costs = 4,097,000 x 29,100,000

C/S ratio 7,606,000

= shs 15,674,823

b) Margin of Safety = Budgeted sales – Break even sales

= 29,100,000 – 15674823
= shs 13,425,177

c) Sales value at which profit of sh. 4.5m will be achieved.

Use:
Profit = (P – V) X – Fixed costs
when X is sales in units.

Profit = C/S X – Fixed Costs.

when X is sales in shs.
P – selling price per unit
V- variable cost per unit
C/S – contribution sales ratio

Profit = C/S X – Fixed costs

4,500,000 = 7,606 X – 4,097,000

29100

X = Shs. 32,891,493.
d) Sales 32,891,493
Less Cost of Sales 24,294,493
CONTRIBUTION 8,597,000
Less Expenses (4,097,000)
NET PROFIT 4,500,000

259
BUDGETING AND BUDGETARY CONTROL
QUESTION 1
Sancross Products Ltd
Cost Per Unit of Product A B
Direct Material – M1 60 80
-M2 70 60
Total Material Cost 130 140
Direct Labour:- L1 160 120
L2 220 240
Total Labour Cost 380 360
PRIME COST 510 500
Fixed Production Overheads 380 360
Production Cost 890 360
Administration, selling and Distribution
costs @ 20% 178 172
Total Standard Cost of Product 1,068 1,032
Profit @ 25% of Product cost 267 258
Selling Price 1,335 1,290

a)Production Budget (Workings)

A B
Projected Sales 12,033,000 10,053,000
Selling Price/Unit 1,335 1,290
Sales Units Projected 9,013 7,793
Opening Stock (Shs) Shs 3,000,000 Shs 2,000,000
Opening Stock (Units) 3,000,000/890 2,000,000/860
= 3,371 Units = 2,326 Units
Closing Stock (Shs) Shs 5,000,000 Shs 4,000,000
Units 5,000,000/890 Shs 4,000,000/860
= 5,618 Units = 4,651 Units
Sancross Products Limited

Production Budget (Units) for the year commencing 1 July 2000

A B
Sales 9,013 7,793
Closing Stock 5,618 4,651
Less Opening Stock 14,631 12,444
Production (3,371) (2,326)
11,260 10,118

260
b) Direct Materials Cost Budget
M1 M2
Shs Shs
Product A: 11,260 × 15 × 4 675,600 11,260 × 14 ×5 788,200
B: 10,118 × 20 × 4 809,440 10,118 ×12 ×5 607,080
1,463,800 1,416,520

c)Purchases Cost Budget for Raw Materials

M1 M2
Shs Shs
Direct materials Usage 1,463,800 1,416,520
Add: Closing stock 220,000 270,000
1,683,800 1,686,520
Less Opening stock (200,000) (250,000)
1,483,000 1,436,520

d) Direct Labour Cost Budget

L1 L2
Shs Shs
Product A 20 ×8 ×11,260 1,801,600 22 × 10×11,260 2,447,200
Product B 15 × 8 ×10,118 1,214,160 24 × 10 ×10,118 2,428,320
3,015,760 4,905,520

QUESTION 2
Cash Budget for the 2nd Quarter of Year 2001
Cash Inflows April May June
Sh. Sh. Sh.
Cash from debtors (wk 1) 402,500 351,995 349,820
Debentures issued - 125,000 -
Total cash inflow (A) 402,500 476,995 349,820
Cash Outflows
Purchases 100,000 135,000 90,000
Purchase of machine - 150,000 -
Dividends - - 100,000
Production overheads 40,000 45,000 36,000
Administration overheads 27,000 22,000 25,000
Selling and distribution 18,000 13,000 11,000
overheads
Wages (wk 2) 79,000 58,500 60,750
Sales commission 13,200 10,500 10,800
Total cash out flows (B) 277,200 434,000 333,500
Net cash flow (A – B) 125,300 42,995 16,270
Add: opening cash balance 90,000 215,300 258,295
Closing cash balance 215,300 258,295 274,565

261
Workings:
Debtors’ collection
April May June
Sales in: Sh. Sh. Sh.
February 350,000 35,000 - -
March 440,000 300,300 44,000 -
April 350,000 67,200 238,875 35,000
May 360,000 - 69,120 245,700
June 360,000 - - 69,120
402,500 351,995 349,820

Wages Payment
April May June
Month: Wages Shs Shs Shs
March 100,000 25,000 - -
April 72,000 54,000 18,000 -
May 54,000 - 40,500 13,500
June 63,000 - - 47,250
79,000 58,500 60,750

STANDARD COSTING
QUESTION 1
a) Overhead Variance = Total Budgeted overheads – Total Actual Overheads
= (88,000 + 55,000) – (90,000 + 58,000)
=Shs 143,000 – Shs 148,000
= Shs 5,000A

b) Fixed Production Overhead Variance

= Actual Fixed Overheads – Standard Fixed Overheads
= Shs 90,000 – (2,700 x [88,000/2,750])
= Shs 90,000 – 86,400
= Shs 3,600(A)

c) Variable Production Overhead Variance

= Actual Variable Overheads – Standard Variable Overheads
= 58,000 – [2,700 x (55,000/2,750)]
= 58,000 – 54,000
= Shs 4,000(A)

d) Fixed Production Overhead Expenditure Variance

=90,000 – 88,000

262
 = Shs 2,000(A)

e) Fixed Production Overhead Volume Variance

= (Budgeted – Actual Units) x Fixed Overhead Absorption Rate per unit
=(2,750 – 2,700) 32
= Shs 1,600(A)

f) fixed Production Overhead Efficiency or Productivity Variance

= (Actual Hours – Standard Hours) x F.O.A.R per hour
= (21,500 – 21,600) x 88,000/22,000
= 100(4)
= Shs 400F

g) Capacity Variance Also called Fixed Overhead Capacity Variance

= (Budgeted Hours – Actual Hours) F.O.A.R Per hour
= (22,000 – 21,500) 4
= Sh. 2,000(A)

QUESTION 2
i) Material Mix Variance = (Standard Price of Standard Mix – Standard Price of Actual Mix)

But Standard Price of Standard Mix = Quantity Mixed× Standard Cost of Mix
Quantity per Mix

= 199,000×275 = Shs 10,945,000

5

Standard Price of Actual Mix: A: 78,000 × 25 = 1,950,000

B: 121,000 ×75= 9,075,000 Shs 11,025,000

Material Mix Variance = SH 10,945,000 – Sh.11, 025,000 = Sh. 80,000 (A)

Material Yield Variance = Standard Cost of Mix ( Standard Yield – Actual Yield)

= 275 (199,000 – 40,000) = Sh.55,000 F

5

Therefore Material Usage Variance = Material Mix Variance + Material Yield Variance

= 80,000 (A) + 55,000 (F) = Sh.25,000 A

ii) Variable Overhead Absorption Rate = Sh.80 = Sh. 20/hr = V.O.A.R

4 hrs

263
 Fixed Overhead Absorption Rate = Sh.25 = 6.25/hr
4 hrs

Variable Overhead Expenditure Variance

= Actual Variable Overheads Incurred – Actual Hours x V.O.A.R
= Shs 3,000,000 – (156,000 x 20)
=Shs 3,000,000 – 3,120,000
= 120,000 Favourable

Variable Overhead Efficiency Variance

= (Actual Hours x V.O.A.R) – (Standard Hours x V.O.A.R)
= 3,120,000 – (40,000 x 4 x 20)
= 3,120,000 – 3,200,000
= 80,000 Favourable

NB: Variable Overhead Cost Variance = Standard Variable – Actual Variable

Overhead Overhead

= 3,200,000 – 3,000,000
= Shs200,000

= Variable Overhead + Variable Overhead

Expenditure Variance Efficiency Variance
iii)
Tonga Ltd
Standard Cost Card
Output Level: 40,000 Units

Cost Item: Sh.

Direct Material: A: 40,000 × 2×25: 2,000,000
B: 40,000 × 3 × 75 9,000,000
Total Material Cost 11,000,000
Direct Labour: (4×30 ×40,000) 4,800,000
Prime cost 15,800,000
Variable Overheads: (20 × 4×40,000) 3,200,000
19,000,000
Fixed Overheads: (4×6.25 × 40,000) 1,000,000
Total Production Cost 20,000,000

QUESTION 3
Nyundo Limited

a) Material usage Variance = Standard Price (Standard Quantity – Actual Quantity)

Actual Quantity of Raw Material used is computed as follows:

264
 Cost (Shs) Unit cost Units
Opening Stock: 12,000 1.50 (i) 8,000
Purchases 42,000 3.50 12,000
54,000 20,000
Less closing stock (6,000) 2.50 (ii) (2,400)
Raw material used 48,000 17,600

Opening stocks assumed valued at standard price of Shs 3/2 kg = Shs 1.5

Closing stocks assumed an average of both opening stock and purchases (1.50 + 3.50) = Shs 2.50
2

Standard Quantity = Quantity expected to be used for the actual output.

Quantity produced is computed as follows:

Value (Shs) Unit cost Units

Opening Stock: 36,000 10 3,600
Sales 100,000 10 10,000
136,000 136,000
Less closing stock (42,500) 10 (4,250)
Production 93,500 9,350

NB: Units Cost at Standard = Sh 6 + Sh 3 + Sh 1 = Sh 10

9,350 units of production are expected to use: 2 kg x 9,350 = 18,700 kgs of raw material

∴Material usage Variance = 1.50 (18,700 – 17,600)

= Sh 1,650 (F)

(b) Labour rate variance = Actual Hours (Standard Rate – Actual Hours)

= 8,000 (4 – 3.75)

= Sh 2,000 (F)
(c)Labour efficiency variance = Standard Rate (Standard Hours – Actual Hours)

= 4 ( (9,350 x 0.75) – 8,000)

= Sh 3,950 (F)

265
(d)Variable Overhead Expenditure Variance = Actual Variable – (Actual hours × V.O.A.R)
Overheads

Where V.O.A.R = Variable Overhead Absorption Rate

= 12,000 – (8,000 x 1/0.75) = Sh 1,333 (A)

(e)Variable Overheads Efficiency Variance

= V.O.A.R (Actual labour hours – Standard labour hours

= 1 (8,000 – 9,350) = Shs 4,467 (F)

0.75

(f)Possible causes of:

Favourable Material Usage Variance:
- Good quality of labour
- High quality of material
- Optimum utilization of materials with little or no wastage

Favourable labour rate variance:

- Employment of lower cost labour
- Overestimated labour rate
- Reducing prices of labour in the market

Favourable labour efficiency variance

- High quality of labour
- Motivated labour force
- Underestimated standard output

Adverse variable overhead expenditure variance:

- Underestimated overheads absorption rate
- Lower output level than expected
- Increase in overheads during the period

Favourable variable overhead efficiency variance

- Less hours taken to produce units
- Increased efficiency in the output process

266